Remarks of Commissioner Thomas J. Erickson before the New York State Bar Association, New York, New York
February 22, 2001
Background on the New Legislation
Thank you for the invitation to join you this afternoon; it's always a pleasure to speak with members of the industry bar and to get a feel for the concerns currently confronting derivatives markets and their participants. At least for today, I think we would all agree that the biggest issue confronting the industry is the implementation of the Commodity Futures Modernization Act of 2000. As many of you know, the CFMA traveled a tortuous route to become law. The House bill that would eventually provide the basis for the CFMA was initially proposed in the spring of 2000 and, just before the election recess, passed the full House without significant debate. But ultimate passage still looked like a real long shot. In fact, in October of last year, just before the 106th Congress was set to end its session, I gave a speech to the Silver Users Association in which I said that the best thing about the bill was that it appeared to be dead. As it turned out, it was a good thing I hedged. The 106th Congress returned for an unusual, post-election, lame-duck session, managing at least one act of bipartisanship – passage of the CFMA of 2000.
On the positive side of the ledger, the CFMA addresses several of the more nettlesome problems that have bedeviled the industry for years. For example, it attempts to resolve questions regarding the legal status of certain over-the-counter derivatives; lifts the ban on the sale of single stock and narrow-based stock index futures; and provides the Commission with clear jurisdiction over foreign currency bucket shops soliciting retail customers. Of course, the CFMA also reorganizes the way our markets are structured.
The New Market Structure
In the wake of the bill's passage, most of the media attention focused on legal certainty for swaps and single stock futures. Much less has been said about the regulatory reform part of the bill. Perhaps this is due to the fact that the reform package is similar to rules the Commission approved in November of last year and subsequently withdrew upon passage of the legislation. I think, though, that the reform package's muted reception also reflects the complexity of the new system. And this very complexity seems to create a kaleidoscopic effect: everyone who looks at the legislation seems to see something different. Some see it as an effort to preserve regulation over retail markets. Some look at it primarily as a way to ensure that certain sophisticated parties, notably banks, are not at all subject to regulation. Still others look at it as essentially an effort to provide legal certainty for particular OTC transactions. These aren't necessarily mutually exclusive goals, but trying to accommodate them all creates a tension that runs throughout the bill. Today, I will briefly discuss this new market structure and make a few observations about what it might mean for the Commission and for you.
As far as markets go, the legislation generally establishes a multi-tiered approach to regulation based on the notion that certain instruments, certain commodities, certain types of trading platforms, and certain market participants require less regulatory oversight than others. Under the new law, at the top of the regulatory pyramid, and subject to the highest level of regulatory scrutiny, are designated contract markets. These markets are closely analogous to traditional exchanges both in terms of the permitted participants and the level of regulatory oversight applied. In fact, all existing exchange markets overseen by the CFTC automatically became designated contract markets on December 21st of last year. These markets must comply with a set of 17 "core principles" which are designed to provide exchanges with more flexibility in their approaches to compliance through self-regulation.
One step down from designated contract markets are derivatives transaction execution facilities, or DTEFs, which cater to primarily non-retail participants. DTEFs must comply with eight core principles. In return, they are allowed to represent that they are regulated by the CFTC; this is an important factor for trading facilities seeking to do business abroad. Finally, the CFMA creates two categories of exempt markets that generally are free from Commission oversight, subject only to the Commission's anti-fraud and anti-manipulation authorities.
So who, and what, can trade on these various markets? That depends. Overlaying the market structure is a series of exemptions and exclusions that define on which tier commodities, contracts, or participants may or must trade. For example, most derivative products in financial instruments – if traded among sophisticated parties – are excluded from the CFTC's jurisdiction. Thus, they can trade over-the-counter or on proprietary trading platforms with no regulation by the CFTC; on exempt markets; on DTEFs; or on designated contract markets, depending upon the level of regulatory oversight desired. All other commodities, with the exception of agricultural products, are exempted from the Commission's jurisdiction. These products may trade on designated contract markets, DTEFs, or even on exempt markets. A handful of agricultural products, commonly referred to as the "enumerated agricultural commodities," must trade on designated contract markets, unless, by rule, the Commission decides to permit trading by DTEFs.
As if that's not complicated enough, electronic platforms enabling sophisticated customers to enter bilateral transactions – presumably trading any product except agricultural products – are excluded from Commission jurisdiction. In fact, those excluded systems are arguably outside the "trading facility" definition in the Act and could never seek to be regulated.
The Commission's Jurisdiction
Let's turn now to a brief discussion of what I see as the new list of nettlesome problems and legal uncertainties spawned by the legislation. And let's start with jurisdiction. One of the few things that has not changed under the new law is the basic statutory grant of jurisdiction to the CFTC. The CFTC has "exclusive jurisdiction" over agreements and transactions "involving contracts of sale of a commodity for future delivery…." The term "commodities" has broad meaning under the Act, covering transactions for future delivery in financial, agricultural and other commodities. The CFMA, however, excludes financial commodities and exempts virtually all others from the Act, leaving agricultural commodities the only ones absolutely subject to the Act – just think of the Act prior to 1975. Despite this retrenchment, the CFMA would permit the trading of contracts in any commodity on Commission regulated markets – even those that may not be "futures." This begs some pretty fundamental questions.
Take, for example, a market in excluded commodities that chooses to trade in a regulated environment. The Commission's jurisdiction over such a market would be based entirely upon the market's consent to be regulated. Is consent by the market alone enough for the Commission to assert jurisdiction over the transactions? If E-Bay – an electronic trading platform of a sort – voluntarily sought to place itself within the Commission's jurisdiction, could the Commission reasonably assert its oversight authority? One wouldn't think so. So how are markets in "excluded" commodities somehow different from E-Bay?
Further, nothing in the legislation prevents a swaps market in excluded commodities from gaining recognition as a DTEF or designated contract market. By consenting to the CFTC's jurisdiction, such a market would be able to represent to its participants and to foreign regulators that it was, in fact, regulated by the CFTC. But swaps were excluded from the CFTC's underlying jurisdiction. I cannot claim to be an expert on jurisdiction, but I've yet to read any analysis that convinces me that a market could effectively submit itself to Commission jurisdiction by waiving objections to what is essentially the Commission's subject matter jurisdiction.
So what are we left with? Pre-CFMA, the Act told us that our jurisdiction extended to instruments that behaved like futures contracts and that these instruments, subject to limited exceptions, must be traded on exchanges. This approach to jurisdiction was relatively simple in that it defined jurisdiction in terms of types of transactions. This enabled the CFTC to carve out exemptions for swaps, for example, while maintaining the integrity of a comprehensive regulatory regime over markets. The tension existed around the edges, where we argued about exactly which instruments behaved like futures contracts. Post-CFMA, in the name of legal certainty, things have gotten much more complex. In order to determine whether something falls within our jurisdiction, we now must look to the type of transaction, the type of participant, the type of underlying commodity, and even the type of platform. All of that must be wedged into the preexisting grant of transactional jurisdiction. And, by the way, we can disregard all market characteristics if someone simply asks us to be their regulator.
Tools Lost and New Responsibilities for Markets
But let's put aside the question of jurisdiction for a moment and look at some less metaphysical, more immediate concerns. As I've mentioned, DTEFs will operate under the Commission's oversight, but without having to comply with some elements of traditional market regulation. So what's lost? Large trader reporting, for one.
The CFMA does not require DTEFs to maintain or provide the Commission with reports of positions held by their customers that exceed certain thresholds. As I've said in the past, large trader reports are an essential tool in the Commission's effort to detect and deter market manipulation. I have heard it said that, given the fact that DTEFs are intended to serve primarily sophisticated or commercial users, we needn't be as concerned with manipulations. I couldn't disagree more strongly.
First of all, I don't know that it's possible to neatly cordon off retail participation from these markets. As qualified participants, pension funds will be a nice proxy for retail. Second, market manipulations reach far beyond the market's participants. Consumers ultimately pay for manipulations in commodity markets: home buyers pay higher interest rates; commuters pay higher prices for gasoline; and we all pay higher prices for heating oil and food. I can't help but see the loss of large trader reports as a potential blow to confidence in our regulatory regime.
Many people – perhaps even most – think this new structure makes a great deal of sense because sophisticated and commercial participants simply do not require the protection that retail participants do. But that alone is really no change from the status quo. The real change is that for commercial markets, regulation is now optional. As a result, much of the information that the CFTC relied on in the past in its effort to ensure market integrity will fall into a gap – not unlike the gap that permitted the Long Term Capital Management incident to occur. Of course, when LTCM happened, lack of transparency and accountability were issues for the regulators to mull; from now on, they will be issues the industry will have to confront.
In the end, my observations with respect to the implementation of the CFMA flow from a broader public interest perspective. If the Commission is to accept responsibility for certain types of transactions, in order for it to serve the public's interest in fair and equitable markets, it needs an unambiguous statement of where its jurisdiction starts and where it stops. By the same token, the industry deserves a clear sense of where its interests and the Commission's meet. That will be our task in the coming years.
It's been widely noted that there are numerous technical problems with the CFMA that will need to be addressed. The Commission is unanimous in its commitment to an expeditious implementation of the CFMA. In fact, CFTC staff is currently working on implementing regulations that will provide some guidance. Where the law is clear on its face, it will be implemented. Where it is less clear, the Commission will have to make some decisions about how to implement particular provisions. As for the legislation itself, I would encourage Congress to quickly address some issues and technical problems. As for other, more conceptual problems, a wait-and-see approach seems more likely and more prudent. Let me conclude today by stating what is crystal clear: the CFMA is the law of the land, and we at the CFTC will do our best both to implement and enforce the legislation.