William J. Rainer, Chairman
Commodity Futures Trading Commission
Before the U.S. Senate
Committee on Agriculture, Nutrition and Forestry
Committee on Banking, Housing and Urban Affairs
June 21, 2000
Thank you, Chairman Lugar, Chairman Gramm, Senator Harkin, Senator Sarbanes, and members of the Committees. I am pleased to appear on behalf of the Commodity Futures Trading Commission to discuss the important issues addressed in S. 2697.
The Commission commends your efforts to modernize the Commodity Exchange Act and to provide legal certainty for over-the-counter derivatives, remove impediments to innovation, and to reduce systemic risk. In furtherance of those recommendations, the bill encourages the development of electronic trading systems and clearing systems for OTC derivatives.
The bill responds to the President's Working Group's request for urgent legislative action on its recommendations, so that the U.S. may retain its leadership in these rapidly developing markets.† Implementation of the Group's proposals is essential to enable U.S. markets to keep pace with the technological and structural changes occurring in markets around the world. Reform of the Commodity Exchange Act is a critical element of this process. The Commission recognizes the challenges involved in an undertaking of this complexity and appreciates your comprehensive approach to this task, as well as the efforts by both Committees to advance the reauthorization process this year.
The Commission welcomes your proposal to enhance legal certainty for over-the-counter derivatives by excluding from the CEA certain bilateral transactions entered into on a principal-to-principal basis by eligible parties. The market for OTC derivatives has expanded dramatically over the past two decades, as financial institutions rely increasingly on these transactions to manage interest rate and foreign exchange risk, for themselves and for clients in all major sectors of the economy.
These financial markets play an important role in the global economy, and legal certainty is a crucial consideration when parties to OTC derivative contracts decide with whom and where to transact business. The Presidentís Working Group recognized that legal certainty for OTC derivatives is vital to the continued competitiveness of U.S. markets.
The Commission has reservations, however, about the bill's exclusion of OTC energy derivatives from the CEA. On this point, S. 2697 diverges from the recommendations of the Presidentís Working Group, which limited the proposed exclusion to financial derivatives. The Commission believes the distinction drawn by the Working Group between financial and non-financial transactions was a sound one and respectfully urges the Committees to give weight to that distinction.
Most dealers in the swaps market are either financial institutions subject to supervision by bank regulatory agencies, or affiliates of broker-dealers regulated by the SEC, or affiliates of FCMs subject to CFTC oversight. "Accordingly, the activities of most derivatives dealers are already subject to direct or indirect federal oversight." (PWG at 16). The same cannot be said of trading in energy derivatives. The decision to extend the exclusion in S. 2697 to energy derivatives would leave these OTC products in a regulatory gap--neither directly regulated as financial products, nor indirectly regulated by an agency with jurisdiction over commercial participants in the energy market. Thus, a principal argument warranting the exclusion of financial derivatives from the CEA--the fact that derivatives trading in these products is subject to direct or indirect federal oversight--does not apply to OTC energy transactions.
Nor are other arguments supporting the financial derivatives exclusion transferable to energy derivatives. The Working Groupís recommended exclusion from the CEA for financial contracts focused on the facts that such contracts are not susceptible to manipulation and do not serve a price discovery function. A consensus exists within the markets and among financial regulators that trading in financial OTC derivatives is not susceptible to manipulation. That case has not been made with respect to energy products.
The unanimous recommendation for an exclusion for financial products resulted from months of deliberation by federal financial regulators. No comparable coordination has occurred between the CFTC and any of the numerous federal entities and programs with jurisdiction over cash markets for energy. An exclusion for trading in energy contracts may create incentives for existing exchanges to convert to restricted, institutional markets, or more likely, may lead large traders to migrate to unregulated markets. Either event would threaten the important price discovery role played by regulated energy futures trading. A step of this magnitude should be preceded by public discussion.
The CFTC therefore believes that there is insufficient evidence to support the bill's exclusion of energy products. Regulatory relief is more appropriately provided through the Commission's exemptive authority. We have a substantial history of responsiveness in this area. For example, the Commission's staff has issued two no-action letters within the past six months to electronic trading platforms, the sponsors of which include several of the largest participants in the energy markets. The staff required compliance with only those minimal regulatory requirements necessary to assure the platforms' transparency and fairness to members. There are many additional examples of adaptive responses. And, as the Committees are aware, bilateral OTC energy trading between commercials, dealing with each other on a principal-to-principal basis, has been exempted from all but the antimanipulation provisions of the CEA since 1993.
The Commission believes that in developing an effective regulatory scheme, it would be appropriate to review contracts and products on a case-by-case basis, relying on the criteria set forth in our regulatory reform package, which considers risk of manipulation, the degree to which a contract serves a price discovery function, and characteristics of the market participants. As the discussion over the treatment of energy commodities progresses, the Commission will be pleased to continue working with the Chairmen and members of the Committees to find an acceptable resolution of this issue.
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The Commission supports S. 2697ís exclusion for electronic trading facilities for OTC financial derivatives to promote an environment in which innovative systems can flourish without undue regulatory constraints. Electronic trading systems have the potential to foster efficiency and transparency and such systems should be permitted to develop unburdened by an anticipatory regulatory structure.
S. 2697 also permits clearing of OTC derivatives and authorizes a mechanism for the CFTC to regulate facilities that clear OTC derivative contracts. Again, the Presidentís Working Group specifically recommended removing legal obstacles to the development of appropriately-regulated clearing systems to reduce systemic risk, and we support this recommendation with the following reservation. The bill would allow securities clearinghouses to clear a broader range of contracts than futures clearinghouses. Futures clearinghouses would have to register in a dual capacity--as futures and as securities clearinghouses--to clear the same mix of contracts available to securities clearinghouses holding a single registration. By declining to grant futures clearinghouses equal opportunity to compete, the bill may put the government in the position of determining winners and losers. We urge the Committees to avoid placing futures clearinghouses at a competitive disadvantage.
The Commission supports the bill's revision of the Treasury Amendment to make clear our jurisdiction over transactions entered into between retail customers and unregulated entities, including so-called "bucket shops." We have long sought legal clarity in this area in order to protect fully the public from foreign currency fraud.
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Section 22 appears to contemplate allowing retail access to derivatives markets. We are continuing to study this aspect of the bill, which has far-reaching implications of uncertain impact. We note that it goes beyond the recommendations of the Working Group, which proceeded on the premise that swaps trading should be limited to market participants with substantial financial resources.
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Earlier this month, the Commission approved for publication in the Federal Register its comprehensive regulatory reform package, which alters fundamentally the Commission's regulation of futures and options markets. This proposal was based on a comprehensive evaluation of the CFTCís current regulatory structure and represents an effort to streamline that structure and to relieve domestic exchanges from unnecessary regulatory requirements. The proposal follows the Congressional directive to transform the Commission from a front-line to an oversight regulator. The Commission looks forward to working with interested parties as we continue to tailor our regulatory reform proposal in a way that most effectively achieves these goals.
S. 2697 attempts to codify much of the Commissionís regulatory reform proposal, and we welcome your support of the Commissionís initiatives. We have noticed, however, that the bill does not include a provision for derivative transaction facilities restricted to commercial participants. Under the Commission's framework, such commercial facilities may list a contract on any commodity, without regard to the nature of the underlying supply. We believe this subcategory of trading facility will be useful to diverse commercial markets and urge the Committees to include it. The CFTC staff is undertaking a comparative analysis of our proposed framework, as released on June 8th, and the relevant provisions of the legislation. We will be pleased to submit the results of that review to the Committees in the near future.
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S. 2697 addresses the issue of equity futures contracts and reflects efforts to develop a plan to amend the Shad-Johnson Accord. The Working Group recommended that the CFTC and the SEC work together to determine whether and how the Accord should be amended, and the agencies have worked diligently on this project over the last several months. We agree in principle that equity futures should be available to the marketplace. On March 2, the two agencies presented to Congress our areas of agreement and issues that remained unresolved up to that point, and on May 23, Chairman Levitt and I met with Chairman Lugar and Chairman Gramm to discuss the issue further. The agency staffs have agreed on many specific areas relative to lifting the ban, such as harmonizing margin requirements, restricting dual trading, testing for sales and supervisory personnel, and the establishment of uniform listing standards for single stock futures, among others. We acknowledge, however, a fundamental disagreement concerning the appropriate legislative approach.
The CFTC has sought to avoid creating a framework that potentially could result in over-regulation of markets and intermediaries and therefore advocated identifying those core provisions from each regulatory regime necessary to ensure an appropriate level of oversight for trading these products. While the agencies agreed that duplicative regulation must be avoided, the CFTC staff expressed concern that an "umbrella" approach, meaning the application of the panoply of securities regulation to these products, could result in overly burdensome regulation. The SEC staff insists that defining equity futures products as securities is essential to its regulatory functions. This fundamental difference in approach has led to an impasse.
With respect to S. 2697, we have no objection to the Shad-Johnson provisions that bear on regulatory issues related to the CFTC's oversight of single stock futures.
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Again, the Commission appreciates the opportunity to present its views. I would be happy to answer any questions you may have.