"Deregulation of the Futures Markets: Who Protects the Public Interest?"





May 21, 1997

I am delighted to be here this evening to speak with members of the Association of the Bar of the City of New York and the New York State Bar Association. I have been involved in the activities of the D.C. Bar and the American Bar Association for many years, and it is truly a pleasure to be among colleagues active in these New York Bar organizations.

When I left the private practice of law last Fall, I knew I would be joining the Commodity Futures Trading Commission during an exciting and challenging time of change in our futures markets. Since its creation in 1975, the Commission has witnessed a rapid evolution of the U.S. futures markets. On the futures exchanges, we have seen an explosion of trading in financial products such as foreign currency and interest rate futures, leaving the once-dominant trading in agricultural products only a small part of exchange trading today. We have experienced enormous growth in the use of privately negotiated, customized off-exchange derivatives contracts, again primarily in financial products. We also have seen the establishment of numerous foreign futures exchanges, creating a truly global marketplace.

It was against this backdrop that legislation was introduced in both the Senate and the House earlier this year to amend the Commodity Exchange Act, the law governing futures and option trading. These bills -- now pending before the Senate Agriculture Committee and a Subcommittee of the House Agricultural Committee -- could have a wide-ranging impact on our financial markets.

I would like to address three areas in which the bills -- if adopted -- could dramatically reduce federal government oversight of our financial markets and, in my view, expose these markets to unnecessary risks: first, the professional markets exemption; second, the Treasury Amendment; and third, the exemption from the Commodity Exchange Act for certain over-the-counter derivative transactions.

Both the House and the Senate bills include a provision exempting so-called professional futures exchange markets from nearly all provisions of the Commodity Exchange Act. Federal oversight of the futures exchanges could be eliminated as long as exchange trading was limited to entities with a net worth of $1 million. The exchanges estimate that approximately 90 percent of their current trading volume is on behalf of such entities. Therefore, it is likely that simple exchange rule changes could convert many markets into professional markets subject to no meaningful federal oversight.

The deregulation of exchange trading possible under the professional markets exemption would greatly restrict federal power to protect against manipulation, fraud, financial instability and other dangers. Although the bills preserve CFTC jurisdiction to bring fraud and manipulation cases after the fact, the Commission would be stripped of many of its regulatory tools designed to prevent those abuses from occurring and to detect them when they do occur.

For example, there would be no Commission surveillance of the professional markets. These markets would not be subject to such federal requirements as large trader reporting, exchange recordkeeping, speculative position limits, competitive trading, open pricing, and audit trail.

Commodity professionals trading exclusively on exempted markets would no longer be subject to registration and fitness and sales practice standards. Statutory and regulatory standards relating to the financial integrity of the markets and their participants would also be eliminated. These standards include segregation of customer funds, net capital requirements, financial reporting, margining of accounts and special bankruptcy protections. In sum, the bills could eliminate seventy years of government protection of the integrity of our markets. Given the interconnection between exchange markets, over-the-counter derivatives markets and cash markets, the resulting undetected fraud, manipulation and financial instability in our exchange markets could pose systemic risks for the broader financial markets.

Indeed, the SEC and the securities exchanges have opposed the professional markets exemption in part because of the risk it poses to the securities markets. The SEC testified that "a broad exemption from regulation under the CEA could seriously impair market integrity in both futures and securities markets." A coalition of the securities exchanges testified that great damage could be done to the securities markets if the professional markets exemption were to apply to equity-based products.

The futures exchanges maintain that they should be able to operate in the same unregulated environment as the over-the- counter markets. But there are significant differences in these markets, and centralized exchange trading involves important public interest considerations that require a higher level of government oversight than over-the-counter markets.

The use of centralized clearing in exchange trading, for example, creates a concentration of financial risk not present in bilateral over-the-counter transactions. That concentration of risk poses more serious systemic threats to our economy than the decentralized risk of the over-the-counter market.

Moreover, there is a strong public interest in protecting the price-discovery and price-basing functions uniquely performed by exchanges. The prices established by the futures exchanges affect trillions of dollars of commercial transactions and ultimately the retail prices for many commodities. This price- discovery function requires protection even if particular sophisticated traders do not.

The bills also include provisions to change the so-called Treasury Amendment. The Treasury Department has proposed its own changes to the Treasury Amendment. The Treasury Amendment to the Commodity Exchange Act currently excludes from the Act the interbank market in foreign currency and the dealer market in government securities. While the specifics of the various proposals differ, in general they exclude from the Act virtually all trading in futures and options on foreign currency and government securities unless such trading occurs on a board of trade open to the general public.

Thus, for the first time exchange trading in these products would be deregulated as long as some element of the general public was excluded. With respect to such exchange trading, the bills' provisions would not even preserve the Act's prohibitions on fraud and manipulation, despite the fact that the Commission's most recent manipulation case involved the Chicago Board of Trade's U.S. Treasury note futures contracts. It should be noted that currently 70% of trading on the Chicago Board of Trade and 40% of all U.S. futures exchange trading is in Treasury Amendment instruments. Thus, the Treasury Amendment proposals would open the door to massive deregulation of exchange trading.

Some proposed changes to the Treasury Amendment would permit the sale of over-the-counter futures and option contracts on foreign currency and government securities to members of the general public without the protections of the Act. Fraud in this area is rampant. The Commission has brought 19 cases involving fraudulent off-exchange sales of foreign currency futures and options since 1990, involving more than 3200 customers who had invested over 250 million dollars. The Commission could lose the regulatory powers necessary to combat such fraud under some of the proposals to change the Treasury Amendment.

The Senate bill and the Treasury Department's proposal would for the first time authorize financial institutions and securities firms to sell over-the-counter futures and options in foreign currencies and government securities to the retail public without the Act's protections. For decades, policymakers, academics and members of the financial community have debated whether banks should be permitted to sell securities to the public. In contrast, there has been virtually no public attention paid to this provision of the pending legislation that would allow banks to sell inherently risky and complex futures and options to the retail public.

The Commission is extremely concerned about the dangers of sale of these instruments to the retail public by any institution without adequate risk disclosure and other customer protections. Both the nature of these instruments and their risks are commonly unknown or misunderstood. The nature of futures and options, their high degree of leverage, and the volatility of commodity prices lead to a significant risk of loss for customers. Bank customers who purchase futures on United States treasury bonds may well believe that they are investing in instruments insured by the federal government and backed by the full faith and credit of the United States government. When interest rates move against them -- as frequently would happen -- these customers could be left with nothing, and they may well look to the U.S. government to make them whole. Although the Treasury Department has been urging Congress to permit banks and securities firms to engage in these sales to the retail public free from the provisions of the Commodity Exchange Act, it has thus far utterly failed to propose customer protections to govern such sales.

The Commission does not believe that any entity, including a bank or securities broker, should be able to sell futures and options to the general public free from such customer protections. Congress has never drawn regulatory distinctions in the Commodity Exchange Act based on the nature of the entity selling futures and options to the public. It is not the nature of the sellers, but rather the inherent risk characteristics of the products themselves that give rise to the necessity for regulation.

Neither the federal banking laws nor the federal securities laws currently provide the regulatory protections necessary for the sale of futures to the general public, as the Commodity Exchange Act does. Furthermore, neither the SEC nor the banking regulators have had experience in regulating sales of futures to the general public, as the CFTC has.

The proposed legislation also contains provisions that would exempt certain private over-the-counter derivatives transactions between sophisticated traders, including swaps, from all provisions of the Act except fraud and manipulation prohibitions. Some proposals would also exempt over-the-counter trading of futures on securities and securities indices from the provisions of the Act for the first time.

Groups pressing for this provision claim that a statutory exemption is necessary to provide "legal certainty" that swaps are not within the jurisdiction of the Commodity Exchange Act and, therefore, are not subject to regulation by the Commission. This argument is being used to obscure the fact that the provision would allow swaps trading to operate in a lawless environment, completely free from government oversight or market regulation.

The Commission has provided legal certainty to the over-the- counter derivatives markets through the prudent and responsible exercise of the exemptive authority granted to the Commission in 1992. Transforming the current regulatory exemptions into a blanket statutory exemption would eliminate the Commission's ability to modify the exemptions based on developments in the market.

As we have seen repeatedly in recent years, the size and nature of this market create a potential for significant risk to the nation's financial markets that requires vigilance by federal regulatory authorities. Recent losses in the over-the-counter markets, such as those by the State of Wisconsin Investment Board, Orange County, Proctor and Gamble, and Gibson Greeting Cards, demonstrate that over-the-counter risks are real and should remain subject to government oversight and governmental authority.

The Commission sees no current need to alter the scope and nature of the exemptions it has granted. However, if conditions in the over-the-counter markets were to change and federal monitoring were to demonstrate that additional regulatory action was necessary, the Commission currently would be able to act quickly without having to seek changes in the law. Such flexibility is not a source of legal uncertainty. Rather, it represents the sound exercise of prudent government oversight and should be the hallmark of any regulatory system. At a time of increasing innovation, complexity and integration in the world financial markets, federal regulators should not have their hands tied if changing conditions require swift government action.

The only swaps which are arguably currently subject to any legal uncertainty are equity swaps. When Congress granted the Commission exemptive authority in 1992, it did not grant authority to exempt swaps from section 2(a)(1)(B) of the Commodity Exchange Act, the codification of the Johnson-Shad jurisdictional accord. If the Commission's current apparent inability to exempt equity swaps from the Commodity Exchange Act is a source of unacceptable legal uncertainty, there are ways to address this uncertainty without abandoning government oversight over the entire over-the-counter derivatives market.

For example, Congress could grant the Commission authority, to be exercised only in consultation with the SEC, to exempt products from the provisions of section 2(a)(1)(B). Such a solution could provide equity swaps with the same legal certainty now available to other types of swaps, without eliminating all government oversight from the over-the-counter market.

Providing the Commission with this narrow exemptive authority also has the benefit that it does not violate the carefully negotiated Johnson-Shad accord. It should be understood that any proposal to eliminate the Commission's authority over futures on securities and securities indices, whether on or off exchange, would constitute an abrogation of that thoughtful and balanced accord and would be highly objectionable to the Commission.

These three provisions in the pending legislation could have a significant negative impact on the integrity of our financial markets. The Commission is committed to working with Congress, the futures industry and all financial market participants to craft legislation that modernizes the Act, but at the same time protects the public interest and the integrity of our markets.