Remarks of Commissioner Thomas J. Erickson before the National Grain Trade Council, Phoenix, Arizona

February 10, 2000

Introduction

Good morning. It is good to be back among friends here at the Council. I had thought about opening by saying, "I’m from the government, and I’m here to help." Knowing that few of you would take comfort in such a statement, let me try a variation on that theme: I’m from the government, and I need your help

As you know, these are interesting and challenging times both at the Commission and in the industry at large. Over the past decade, derivatives markets have been invigorated by innovation. Factors like new technologies and the ever increasing globalization of the markets have changed the way the industry works and, indeed, the way we all think about the industry. Under the leadership of our new Chairman, William Rainer, the Commission has committed itself to moving from a frontline regulator to an oversight role. In the midst of all this, the Commission is currently engaged in what seems to be a perpetual reauthorization process – working with our congressional overseers to shape a CFTC that fulfills its mission to the public while at the same time allowing the type of innovation on which the industry thrives

What I would like to do this morning is provide some context and, I hope, some perspective on all this change. First, I would like to outline a few of the initiatives the Commission has undertaken over the past several months in response to this changing world. I would then like to share some of my views on where the Commission and industry are headed and identify some of the challenges we are going to have to face together. For your part, I would like to encourage you to help me out by providing me with feedback about these issues – both here, today, and over the course of the coming months

Commission Initiatives

Let me begin by briefly describing some of what has been keeping us so busy since I arrived at the Commission last June. While some of the issues I will talk about may not seem to affect you directly, I think they do reflect the pace of change, the kind of creative thinking necessary to deal with this change, and the willingness of the Commission to work with the industry to develop workable solutions to difficult problems. I would also add that in the midst of all this change, it will be crucial for all who are interested in the Commission and the industry to take an active role in these processes or face the very real prospect of having decisions made for you by those who may not know your business

Agricultural Trade Options

As you all undoubtedly know, in April of 1998, the Commission announced the creation of a three-year pilot program to permit the offer and sale of trade options on certain agricultural commodities. Trade options are off-exchange options offered to a commercial producer or user of the commodity; trade options on many agricultural commodities have not been permitted for over sixty years. The pilot program permitted qualified parties to engage in the trading of off-exchange trade options and was intended to respond to the increasing need for risk management tools among those in the agricultural community

Needless to say, the program received a less than enthusiastic reception from the industry. However, the Commission continued to work with representatives from all corners of the agricultural community and eventually amended the rules to make them simpler and more flexible by, for example, permitting cash settlement and streamlining disclosure and registration requirements. The amended rules have just become final. I understand from conversations with several of you that the new program will be used and that a number of companies are in the process of completing applications to become trade option merchants

I am hopeful that there will be sufficient participation to provide a strong regulatory justification for the introduction of these risk management tools to farmers

Regulatory Relief for Domestic Futures Exchanges

In June of last year, the Commission received a petition signed by the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Chicago Board of Trade (CBOT) requesting regulatory relief from certain statutory requirements for boards of trade designated by the Commission as contract markets. The exchanges asked for significant relief from various regulatory requirements in three parts. To date, the Commission has responded through two initiatives

The petition first requested relief from the contract market designation process for new contract submissions. The exchanges have for years argued that the CFTC’s review of new contracts was at best redundant and at worst a substitution of the government’s judgment for what was rightly a business decision. In more recent years, the exchanges have added a new wrinkle, that the ability to list new contracts for trading without delay is vital to the exchanges’ competitiveness. On the other hand, the requirement that exchanges meet specified conditions in order to be designated as contract markets has been a part of the statute since 1974, when Congress amended the Act to provide for meaningful government review of all new futures contracts before trading could begin and of proposed amendments to the terms or conditions of existing contracts

Attempting to balance these competing interests, in July of last year the Commission published a proposed rule regarding the procedures for contract designation. In January of this year, a final rule went into effect. Generally, the new rule permits the exchanges to list futures or option contracts for trading without prior Commission approval of the contract or its terms and conditions, including any subsequent amendments to those contracts. The exchanges are required to certify that the contract listed for trading meets the requirements of the Commodity Exchange Act (Act) and the Commission’s rules and to indicate that it is trading subject to this "self-certification." I would also note that this new listing procedure is an alternative to regular and fast-track procedures for contract market designation

A second area in which the exchanges have requested relief is in the contract market rule review process. The exchanges proposed that domestic contract markets be required to provide only notice of new rules or rule amendments to the Commission ten days in advance of their effective date. In November of 1999, the Commission published a proposed rule that – like the contract designation rule – would permit exchanges to implement rule changes and amendments without prior approval provided the exchange certifies to the Commission that the rule changes are consistent with the requirements of the Act and regulations

At the request of several agriculture organizations, the comment period for this proposed rule was extended to February 24, 2000, and, since the proposal remains pending and under Commission consideration, I really cannot say a great deal more about it at the moment

I mentioned that the exchanges’ petition requested relief in three areas: with the third request, the exchanges asked, essentially, for the ability to immediately implement trading rules and procedures comparable to those of a foreign exchange with electronic terminals in the US, provided that the changed rules and procedures apply only to contracts that compete directly with comparable contracts on the foreign exchange

The Commission has not yet taken any action on this part of the exchanges’ proposal, and I, for one, would have serious reservations about implementing such a change. The currently pending proposed rule I just discussed would permit exchanges to implement rule changes without prior approval provided the exchange certifies to the Commission that the rule changes are consistent with the requirements of the Act and regulations. Given that the scope of the Commission’s proposed rule is arguably broader than what the exchanges requested, I would not be comfortable permitting the exchanges to implement rule changes that mimic the rules of foreign exchanges but are otherwise illegal or inconsistent with the Act and regulations without guidance from Congress. In any event, with the rule change proposal that is currently pending, and any that might come along, it is my hope that the industry and Commission can work together to formulate rules with which we can all live

Demutualization

Each of the three largest domestic futures exchanges within the last couple of months has announced a plan for "demutualization" – in other words converting from their traditional not-for-profit, membership structure to for-profit, stock corporations. The exchanges believe that by converting to a for-profit structure, they will be able to more rapidly develop and implement business strategies and respond to competition

Each exchange’s plan has its unique facets, but generally, the plans provide for an exchange of membership interests for shares of stock in the new entity. Both the Chicago Mercantile Exchange and the New York Mercantile Exchange have proposed plans that would convert seats on the exchange to private shares of stock with an attached right to trade on the market. The Chicago Board of Trade’s plan proposes splitting the exchange into two, separate corporate entities, one providing the opportunity for open outcry trading, and the other providing a platform for electronic trading. Both new companies would be for-profit, and current members would have ownership interests in each

The exchanges have come quickly and recently to the notion of demutualization. To date, none of the plans has come to a membership vote. However, in the cases of the CME and CBOT, votes are expected as soon as March of this year

Under the direction of and in coordination with the efforts of Chairman Rainer, my office has undertaken an initial review of potential issues raised by conversion of our traditional exchange markets into for-profit – possibly publicly-held – corporations. Through this process, we have directed an internal review of the Act and regulations, and met with various interested parties to this fascinating transition. The primary objective for me has been to work with the industry to make certain that these structural changes do not become disruptive to the market or create unnecessary regulatory snarls. This is one of those changes that could come quickly and have profound effects on the broader market, and I am anxious to see how the industry responds

Reauthorization

We at the Commission were pleased to find that when the clocks rolled over into a new year, neither the industry nor the Commission experienced any significant Y2K problems. However, I am afraid there still may be one Y2K bug lurking out there – it is called "reauthorization."

Periodically, through the reauthorization process, the US Congress evaluates the work of the Commission and examines the Act in order to evaluate the effectiveness of the agency and to make necessary changes to the Act. The process has already begun: representatives from both the Commission and the industry have provided staff of the House and Senate Agriculture Committees with several days of briefings regarding the issues of the day

Additionally, the Senate Committee on Agriculture this morning held its first hearing addressing the recommendations of the President’s Working Group on Financial Markets (PWG) for the regulation of derivatives. This morning, the principals of the PWG are advocating adoption of the recommendations – suggestions that, in the name of "legal certainty," would, in my opinion, be the beginning of the end of functional or market regulation in the United States. In my opinion, the recommendations of the PWG Report, if followed, potentially would further fragment regulation and leave gaps in the regulatory framework. I also tend to agree with the exchanges’ view that it could force our domestic exchanges to reconsider their designation with the CFTC

I will say, however, that despite my reservations about its conclusions, the PWG Report makes an honest attempt to address one of the most vexing issues we face. In order to be successful, any resolution of the Commission’s reauthorization will have to achieve legal certainty, particularly in the area of OTC derivatives. For me, this means clearly defining the OTC derivatives market, stating the degree of regulation – if any – to be imposed on the various parts of the market, and clarifying the role of the various federal financial regulators in promulgating and/or enforcing any regulatory regime in the OTC market

Do not misunderstand me, I am not an advocate for more or more onerous regulation. And I do not insist that the Commission have jurisdiction in all cases. I am concerned, however, that by drawing artificial jurisdictional lines around certain types of transactions, the PWG Report recommendations would create regulatory gaps – areas of commerce, possibly involving retail customers, where no regulator has jurisdiction. Also, and more broadly, I believe that to the extent Congress believes there is value in the functional regulation of derivatives, the federal government generally is better served by having a single regulator for transactions in instruments that are functionally identical. In this way, industry participants are ensured level playing fields and the "legal certainty" of consistent treatment

I should also mention the work of the Commission in this regard. As I am sure Bob Petersen has reported to you, Chairman Rainer has organized an internal taskforce charged with taking a hard look at the Commission’s current regulatory framework in order to see how we might adjust it to meet the needs of today’s markets. The taskforce has worked with various industry participants, and I believe that the process of examining these regulations has been and will be of tremendous benefit to the Commission and the industry. It is difficult to say where the taskforce’s work might lead us, and we may not all necessarily agree with the end result, but I would once more emphasize that it is imperative for you all to participate in the process to the fullest extent possible

The Promise of Technology in the New World

I have told you a lot about what is going on and what I think about it all, so it is probably fair of you to ask where I think things are headed. And my best, lawyerly answer is that it depends. I do have faith in the industry’s ability to devise instruments we have not yet imagined and vehicles for trading we cannot yet visualize. The common thread, I think, is that technology will continue to be the driving force for market innovation

I noticed that the next speaker on today’s program is David Downey of Interactive Brokers. I admit, I am a bit reluctant to speak on topics so clearly within the expertise of the next speaker. Nevertheless, I thought I would go out on a bit of a limb and talk about technology and some potential regulatory implications. It is easy to do a superficial analysis of electronic trading and come to the conclusion that the US markets have been slow to adopt new technology, and that many of their more nimble foreign counterparts are currently enjoying the competitive and economic advantages of electronic platforms. While there may be a grain of truth to this, I think a more careful analysis indicates the extent to which electronic trading is making inroads in US markets and the promise new technology holds for these markets

There are, today, several electronic trading platforms in use domestically, and the Commission is currently considering applications for two new electronic exchanges, one of which would be Internet-based. I think these facts reflect the possibilities of new opportunities for both existing and future exchanges. Given these possibilities, there are several questions that we will all want to consider. For example:

• Technology increasingly will enable customers to bypass traditional market intermediaries in trading financial products. Should this trigger modifications in our current regulatory safeguards?

• How should the Commission address concerns regarding system capacity and security as increased access continues to test the boundaries of our markets?

• As trading hours expand and raise the possibility of 24-hour online trading, how should the Commission approach issues involving market liquidity?

In the end, I view all the changes we are facing, both on a regulatory level and in the industry in general, as challenges embedded with tremendous potential. It is the industry’s job to harness new technologies, to embrace innovation, and to move forward. As regulators, our job is to ensure that our regulatory framework preserves the public interest in open, fair, and honest markets and to see to it that we do not create obstacles to innovation

Fortunately, we have a touchstone: it is our statutory mission to protect market users and the public from fraud, manipulation, and abusive trade practices and to foster open, competitive, and financially sound futures and option markets. As a functional regulator we look to the nature and the purpose of a transaction in order to determine the nature of our regulatory interest. Accordingly, whatever new contracts or trading platforms may be devised, we can, and are attempting to, formulate an approach that encourages innovation and maintains standards that will continue to instill confidence in our markets

Thanks again for inviting me and for your kind attention. I will be happy to answer any questions you might have at this point

Remarks of Commissioner Thomas J. Erickson before the Silver Users Association, Washington, DC

October 18, 2000

I was pleased to accept Walter Frankland’s invitation to speak with members of the Silver Users Association. This is an exciting time for the CFTC, both because of the new directions the derivatives markets are taking and the attempts of legislators and regulators to adapt to these evolving trends.

Today I would like to share with you my personal observations on the derivatives markets and their regulation. The good news for you as end-users is unprecedented access to information, intermediaries and, increasingly, the market itself. Derivatives market participants are part of a dynamic market whose financial and technological innovation continues to expand expectations – and test regulatory boundaries. This raises the question: What are your expectations as end-users of federal financial regulators, whose job it is to promote the integrity of markets?

The markets are wired, global, and restless. Exchanges are reaching beyond traditional trading floors and across national boundaries. The traditional derivatives marketplace, the open-outcry, member-owned futures exchange, is responding to market demand by developing new technology, new business plans, or both. U.S. exchanges are using electronic trading platforms and finding ways to harness technology for open-outcry trading. The three largest domestic futures exchanges have taken the first steps toward revised business models based upon a demutualized, for-profit corporate structure. Smaller futures exchanges are searching for partnerships that will enable them to trade electronically, and financial intermediaries themselves are contemplating becoming exchanges. Moreover, firms in other, unrelated sectors of the economy are constructing platforms and forming new alliances for business-to-business and business-to-consumer commerce. Once B2B and B2C platforms are in place, such ventures will compete head-to-head with existing exchanges.

As you know, the CFTC and the Congress have spent much of the last year wrestling with the appropriate response to these profound shifts in the marketplace. On the legislative side, both the Senate and the House have taken advantage of the Commission’s reauthorization process to attempt to fix some especially nettlesome problems, most notably the issue of "legal certainty" for over-the-counter derivatives transactions. Closer to home, the CFTC has released its own proposal for a new regulatory approach. The Commission’s proposal attempts to address these changes by balancing discrete private interests with the public interest in open, competitive, and sound markets.

Legislation

I would like to say that the best thing about this legislation is that it is dead, but it still appears to be drawing breath. Throughout this process and, even now, in the closing days of the 106^th Congress, the legislation has been a moving target, with important provisions appearing, disappearing, and reappearing in subsequent drafts. This is probably due, in no small part, to the fact that the House and Senate Agriculture Committees, the House Banking Committee, and the House Commerce Committee all, at various stages, either have taken the lead or have contributed significantly to the drafting. Despite the numerous interests at play, the multiple drafts by the various committees share a common theme: They all envision largely unregulated marketplaces in most derivative products. I think it is important to understand how these bills might work – despite the fact that they probably will not be passed in this session – because I believe they represent the current thinking of many legislators.

Each of the bills essentially defined the CFTC’s jurisdiction with a negative – by telling the agency where it would not have jurisdiction. For example, most derivative products in financial instruments – if traded among sophisticated parties – were excluded from the CFTC’s jurisdiction in the proposed legislation. This was based on the mere assertion that these markets are so big, and so liquid, that they simply are not susceptible to manipulation. Physical commodities, with the exception of a handful of agricultural products, would have been exempted from the Commission’s jurisdiction. These exemptions would have applied to metals markets. As a result, the agency would have had limited abilities to monitor these markets and to address problems when they did occur.

Interestingly, early versions of the legislation did not include metals and energy markets among those exempted from regulation – apparently recognizing both the history of manipulation in these markets and the heightened public interest in their vitality and integrity. Later versions, however, exempted metals and energy from Commission jurisdiction. And the bills did not simply focus on types of products; they also excluded and exempted markets based on types of trading platforms. For example, in one of the last versions of the House bill, electronic exchanges in energy and metal markets were exempted from Commission jurisdiction, leaving even those exchange markets subject only to the anti-fraud and anti-manipulation provisions of the Commodity Exchange Act. In effect, they would have been allowed to operate without oversight by the CFTC or any other federal agency.

More generally, this legislation would have left significant portions of the $100 trillion over-the-counter derivatives market subject to no direct regulation or oversight. In fact, no federal financial regulator or supervisor would have had the legal authority to investigate or bring actions for fraud or manipulation in large portions of the derivatives marketplace.

Regulatory Proposal

As many of you know, the CFTC released its own proposal for regulatory reform in June of this year. Final rules have not yet been published, but it seems clear that, absent legislation, the Commission will move to final rules in the near future. In very general terms, the proposed rules would create three tiers of regulation in which the level of regulatory interest is based on the nature of the product traded and the relative sophistication of the market participant.

Recognized Futures Exchanges

Under the new scheme, recognized futures exchanges, or RFEs, would correlate most closely to today’s designated contract markets, or exchanges, and would be subject to the highest level of regulation based on 15 broad "core principles." RFEs would be open to all types of participants and products and would be subject to the most extensive customer protection.

Derivatives Transaction Facilities

Derivatives transaction facilities, or DTFs, would be subject to an intermediate level of regulation based on seven "core principles" and would be designed for products that, in theory, are less susceptible to manipulation. DTFs would operate as primarily institutional or commercial markets, and participation would be limited accordingly. Institutional DTF markets could choose to accept otherwise non-eligible participants, such as individuals, by subscribing to several additional requirements. However, individuals only could access these markets through a registered, sufficiently capitalized intermediary. DTFs would be "recognized" by the Commission as adhering to an acceptable, if greatly reduced, level of regulatory oversight.

Exempt Multilateral Transaction Execution Facilities

The third tier would provide a self-effectuating exemption from regulation for exempt multilateral transaction execution facilities, or exempt MTEFs. Transactions on exempt MTEFs would be limited to those between institutional traders in contracts for commodities that are "highly unlikely to be susceptible" to manipulation. Exempt MTEFs would not be "recognized" by the Commission. In short, this structure would allow the existing swap market to become more standardized and trade as an exchange does, but without regulation.

Silver markets could operate as RFEs and DTFs and, if approved by the Commission through a case-by-case review process, even could operate as exempt MTEFs.

Questions and Conclusion

Obviously, the legislative and regulatory approaches I have talked about above represent some fairly bold departures from the status quo and, accordingly, raise some fairly significant questions. For example, how is liquidity affected when markets are segregated by types of users and/or types of platforms? Has the case been made that some commodities are less susceptible to manipulation than others? What role should federal regulators have in these markets?

As market users, the way the questions are answered may have profound effects on the way you do business. I have read the Silver Users Association’s letter commenting on the Commission’s regulatory proposal, so I know you are both concerned and engaged, and commend you for your interest. And I know that with all the activity that has taken place in Washington, it may seem difficult to keep your eye on the ball. But perhaps I can lend you my perspective.

I think that much "regulatory reform" can be reduced to the following. The risk and responsibility of participating in derivatives markets is being laid squarely on the shoulders of end-users. This will mean that you, as end-users, will have to understand that all markets are not created equal. It will fall to you to evaluate the integrity, merit, and utility of each market in which you choose to participate. Will the market serve your liquidity and price discovery needs? Does the market accurately reflect commercial activity in the underlying commodities? What rights, obligations, and remedies will you have on a particular market? These questions are not new. The range of possible answers, however, is unprecedented.

Thank you for your kind attention. I am happy to answer any questions

Testimony of Commissioner David D. Spears before the Committee on Agricultural, Nutrition and Forestry

May 5, 1999

Mr. Chairman and Members of the Committee:

I am pleased to appear on behalf of the Commodity Futures Trading Commission (Commission) today to discuss the Commission's pilot program for agricultural trade options. My testimony addresses the Commission's efforts to structure a pilot program to reintroduce trade options in certain agricultural commodities, explores possible impediments to the introduction and use of these instruments, identifies and analyzes issues raised by possible amendments to the pilot program's rules and details steps taken by the Commission to contribute to educating farmers about the potential usefulness of these instruments. The Commission appreciates the Committee's interest in this program and is confident that this hearing, along with the discussion of this issue at the recent derivatives roundtable hosted by this Committee, will assist the Commission in its further consideration of possible changes to the pilot program.

Agricultural Trade Options Defined

An option is a contract giving the purchaser of the option the right but not the obligation to make or take delivery of a specified commodity at a specified price (the strike price) within a specific time period. The option purchaser pays the option seller (or grantor) for this right. The cost of purchasing an option is known as the "premium." Option contracts are unique in that option purchasers are able to protect themselves, for the cost of the option premium, against adverse price movements while maintaining an upside profit potential. For example, a corn producer can protect against lower harvest time prices by purchasing put options with a given strike price. If the harvest time price of corn is below the strike price the producer can elect to exercise the option and earn the strike price on the sale of the corn. Alternatively, if prices are higher at harvest time the producer can choose to allow the option to expire and sell the corn at the higher spot price.

Trade options are off-exchange (OTC) options which are offered by a person having a reasonable basis to believe that the option is being offered to a commercial entity, where the option is entered into for purposes related to its business as such. As explained more fully below, until the Commission's interim final rules establishing a pilot program became effective on June 16, 1998, trade options on the agricultural commodities listed in the Commodity Exchange Act were prohibited. These commodities include, among others, wheat, cotton, rice, corn, soybeans and livestock. Trade options on other unlisted agricultural commodities and all nonagricultural commodities have been permitted under Commission rules subject only to anti-fraud, unlawful representation and prompt execution requirements. 17 CFR §32.4.

Statutory and Regulatory History of Option Trading

In 1936, responding to a history of large price movements and disruptions in the futures markets attributed to speculative trading in options, Congress completely prohibited the offer or sale of option contracts both on- and off- exchange in all commodities then under regulation.⁽¹⁾ This statutory bar continued to apply over the years only to the named agricultural commodities regulated under the 1936 Act. These commodities are referred to as the "enumerated" commodities. Any commodity not so enumerated, whether agricultural or not, was not subject to prohibition.⁽²⁾

In the years following passage of the 1936 Act, the off-exchange offer and sale of commodity options on the nonenumerated commodities was subject to fraud, abuse and sharp practice. That history was one of the factors leading to enactment of the Commodity Futures Trading Commission Act of 1974 (1974 Act), which substantially strengthened the Commodity Exchange Act and broadened its scope. The Act's scope was broadened by bringing all commodities under regulation for the first time. Congress accomplished this by adding to the list of enumerated commodities an expansive catchall definition of "commodity" which included all "services, rights or interests in which contracts for future delivery are presently or in the future dealt in."⁽³⁾

Under the 1974 amendments, the newly created Commodity Futures Trading Commission (CFTC) was vested with plenary authority to regulate the offer and sale of commodity options on the previously unregulated, nonenumerated commodities.⁽⁴⁾ The Act's statutory prohibition on the offer and sale of options on the enumerated agricultural commodities was retained.

Shortly after its creation, the Commission promulgated a comprehensive regulatory framework applicable to off-exchange commodity option transactions in the nonenumerated commodities.⁽⁵⁾ This comprehensive framework exempted "trade options" from most of the Act's provisions.⁽⁶⁾ Trade options on nonenumerated commodities are exempt from all of the requirements applicable to commodity options except for a rule prohibiting certain representations and requiring prompt executions (Rule 32.8) and a rule prohibiting fraud (Rule 32.9).

In contrast to the regulatory framework for commodity options on the nonenumerated commodities, commodity options on the enumerated commodities--the domestic agricultural commodities listed in the Act--were prohibited, as a consequence of both the continuing statutory bar and Commission rule 32.2, 17 C.F.R. 32.2. This prohibition made no exceptions and applied to trade options as well as other options.

The attempt to create a regulatory framework to govern the offer and sale of off-exchange commodity options was unsuccessful. Because of continuing, persistent and widespread abuse and fraud in their offer and sale, the Commission in 1978 suspended all trading in commodity options except for trade options.⁽⁷⁾ Congress later codified the Commission's options ban, establishing a general prohibition against commodity option transactions other than trade and dealer options.

The Commission subsequently permitted the introduction of exchange-traded options on the nonenumerated commodities by means of a three-year pilot program.⁽⁸⁾ Based on that successful experience, Congress, in the Futures Trading Act of 1982, eliminated the statutory prohibition against options on the enumerated commodities, permitting the Commission to establish a similar pilot program to introduce exchange-traded options on those agricultural commodities.⁽⁹⁾ The Commission did so in 1984 under essentially the same rules already applicable to options on all other commodities.⁽¹⁰⁾ In proposing to permit exchange-traded options on the enumerated agricultural commodities, the Commission noted that section 4c(c) of the Act and Commission Rule 32.4 permitted trade options on the nonenumerated commodities and that "there may be possible benefits to commercials and to producers from the trading of these `trade' options in domestic agricultural commodities."⁽¹¹⁾ However, "in light of the lack of recent experience with agricultural options and because the trading of exchange-traded options is subject to more comprehensive oversight," the Commission concluded that "proceeding in a gradual fashion by initially permitting only exchange-traded agricultural options" was the prudent course.⁽¹²⁾ Nevertheless, the Commission requested comment from the public concerning the advisability of permitting trade options between commercials on domestic agricultural commodities. Citing past abuses associated with off-exchange options, the consensus among commenters was that the Commission should proceed cautiously and retain the prohibition on such off-exchange transactions.

Since then, the Commission has reconsidered the issue of whether to remove the prohibition on the offer and sale of trade options on the enumerated commodities several times. In 1991, the Commission proposed deleting the prohibition on trade options on the enumerated commodities and including them under the same exemption applicable to all other commodities. 56 FR 43560 (September 3, 1991). The Commission never promulgated the proposed deletion as a final rule. On December 19, 1995, the Commission hosted a public roundtable to consider this issue once again and to provide a forum for members of the public to provide their views.

The Pilot Program for Agricultural Trade Options

Following the roundtable, the Commission directed its staff to study the issue and to report its recommendations. The Division forwarded the complete text of that study, entitled, "Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts," to the Commission on May 14, 1997.⁽¹³⁾ On June 9, 1997, the Commission published an Advance Notice of Proposed Rulemaking (Advance Notice) in the Federal Register seeking comment on whether it should propose rules to lift the prohibition on agricultural trade options on the enumerated agricultural commodities and if so subject to what conditions. 62 FR 31375. The Advance Notice posed 30 specific questions and included portions of the staff analysis of the issue. The seventy-six comments were almost evenly divided between those in favor of and those opposed to lifting the ban. In addition to the written comments, the Commission received oral and written statements during two public field meetings in July 1997 at which members of the public had an opportunity to address the Commission and to answer its questions regarding these issues. One of those meetings was held in Bloomington, Illinois, and the other was held in Memphis, Tennessee.

In November 1997, the Commission published proposed rules to establish a three-year pilot program to permit the offer or sale of trade options on the enumerated agricultural commodities. 62 FR 59624 (November 4, 1997). The proposal generated 441 comment letters to the Commission; commenters remained divided on whether the Commission should lift the prohibition on agricultural trade options. On June 16, 1998, the Commission's interim final rules establishing the pilot program became effective. 63 FR 18821 (April 16, 1998). In response to suggestions made in many of the comments, the interim final rules are more streamlined and less burdensome than proposed.

The pilot program rules were designed to provide a number of customer protections. These include requirements that option vendors be registered and that they adhere to minimum customer disclosure, financial, and recordkeeping safeguards. In addition, option vendors are required to have a system of internal controls and to report to the Commission on their option activity. The rules also include a number of provisions to discourage the use of trade options for speculative purposes. These include the requirement that agricultural trade options, if exercised, be physically delivered, and limitations on producers being the option grantor, including a prohibition on producers writing covered call options. These customer protection features are discussed more fully below:

a. Registration of Agricultural Trade Option Merchants (ATOM).

As noted in the interim final rules, "registration of commodity professionals is an important means by which the Commission polices the futures and option industry and is the primary mechanism for reassuring the public of the honesty and proficiency of futures professionals." 63 FR 18825. For this reason, the final rules require that any person offering or selling an agricultural trade option must register as an ATOM and likewise that its sales agents must register with the Commission. Moreover, by virtue of the registration requirement, customers have available to them under Section 14 of the Act the Commission's reparations program for resolving disputes arising under agricultural trade option contracts. The registration process for ATOMs and their sales agents is more streamlined than for other types of commodity professionals, however. For example, an ATOM's principals and sales agents are not required to submit fingerprints for background checks, need not take a qualifying proficiency exam and are not required to take yearly ethics courses. Instead, the ATOM's sales agents are required to complete six hours of instruction covering the economic functioning, and the legal requirements for the sale, of agricultural trade options and the registrant's responsibility to observe just and equitable principles of trade relating to such options. The Commission delegated responsibility for processing the registration applications to the National Futures Association (NFA), the self-regulatory organization which performs that function for all other Commission registrants.⁽¹⁴⁾

b. Disclosure.

The pilot program's rules require that the customer be provided two forms of risk disclosure--a statement of the general risks of agricultural trade options provided prior to the customer's first transaction and a second, "transaction-specific" disclosure giving information about the specific option contract being entered into.⁽¹⁵⁾ In addition to providing customers with risk disclosure, the pilot program's rules also require that the option contract itself be in writing and contain a number of specified terms⁽¹⁶⁾ and that ATOMs provide customers with information regarding their positions and accounts in a timely fashion and notify them of the expiration date of each option which will expire within the next month.⁽¹⁷⁾

c. Financial Safeguards.

The pilot program's rules require that to be registered, an ATOM must maintain a minimum net worth of $50,000. In addition, ATOMs must safeguard customer funds which have been paid up-front by holding them in segregation.⁽¹⁸⁾ However, ATOMs may use up-front customer payments to purchase exchange-traded instruments as cover for the trade option transaction.⁽¹⁹⁾

d. Recordkeeping and Reporting.

The Commission adopted, as proposed, recordkeeping rules requiring agricultural trade option merchants to maintain full, complete, and systematic books and records. The maintenance of books and records is crucial to resolving customer complaints and to the Commission's ability to respond to complaints of customer abuse. In addition to the keeping of books and records, the final rules impose routine and special call reporting requirements.⁽²⁰⁾

e. Limitations on Speculative Use.

The pilot program rules require that off-exchange agricultural options be exercised only by physical delivery of the commodity. However, the Commission made this provision more flexible by permitting an option's early termination (for a cash adjustment) by entry into a forward contract. The pilot program's rules also prohibit producers from writing or granting trade options, except when a call option is coupled with the purchase of a put option. These provisions "maintain a close relationship between the option transaction and the participant's cash market activities" and discourage the use of agricultural trade options as speculative vehicles.⁽²¹⁾ 63 FR 18824.

The interim final rules permitting the offer or sale of agricultural trade options also include an exemption for high net-worth individuals or entities as well as relief for similar exchange-traded instruments. Individuals or entities that are commercials and have a net worth of at least $10 million are exempt from compliance with the protections discussed above.⁽²²⁾ Such high-net worth entities trading among themselves need only comply with the anti-fraud requirements which are applicable to trade options generally.

Status of the Pilot Program

To date, although a number of firms or entities have requested registration materials, no one has applied for registration as an ATOM since the interim rules went into effect in June 1998. Therefore, no agricultural trade option contracts legally may be offered, except pursuant to the rule's exemption provision. Because there are no reporting requirements for options offered pursuant to the exemption, the Commission cannot ascertain whether or to what extent such options are being traded between exempt entities. Reportedly, however, agricultural trade options are being offered to some extent pursuant to the exemption. On the other hand, the Commission is not aware of any trade options being offered or sold to producers of non-enumerated agricultural commodities, which are not subject to the pilot program's rules.

In light of the failure of any firm to register as an ATOM by the fall of 1998, Commission staff conducted a number of interviews to determine the reason. Trade sources interviewed by Commission staff indicated a variety of possible reasons for the lack of interest by potential ATOMs in offering agricultural trade options. A number of them suggested that development of a market in these instruments is likely to be demand driven and that low commodity prices have impeded development of demand.

Although options can be effective risk management tools to protect against rising or falling commodity prices, generally they cannot be used to enhance the sale price of a commodity or to lower the cost of obtaining it. For example, the ability of the producer to lock in a given price for corn (e.g., the cost of production) using an option will depend on the availability of options with such a strike price, taking into account the cost of the option. The availability of these options depends upon the current market price of corn as reflected by the supply and demand conditions for the commodity. If the supply of corn is high and/or the demand for corn is low, producers will only be able to obtain options with relatively low strike prices (or to the extent that high strike price options are available, they will pay concomitantly high premiums). Thus, depending on supply and demand conditions, no options may be available with a given strike price and premium combination that permit producers or other market participants to lock in a desired minimum or maximum price.

Since the time agricultural trade options were first permitted under the pilot program, agricultural prices generally have been depressed. As a result, producers likely would not be interested in using them because they would have resulted in the guarantee of a relatively low price. To the extent that producers may prefer to retain the cost of the option premium and remain unhedged during times of low prices, demand for these instruments is likely to remain slack until the current price situation improves.

However, some observers have suggested a different explanation for the lack of interest in these instruments. Various agricultural groups have voiced concern that the pilot program's rules are too onerous, thereby discouraging participation. Particular concerns have been raised that the registration, reporting and disclosure requirements are too burdensome and that certain restrictions on the form of options that producers may enter into limit their usefulness. These groups maintain that, if the regulatory requirements were relaxed, agricultural trade options on would be offered.

In lifting the ban on agricultural trade options, the Commission carefully weighed the potential benefits and costs associated with this action. The major benefits were seen as giving producers greater access to, and more flexibility in the design of, risk management contracts. The costs involved the increased potential for fraud or misuse of option contracts and increased systemic risk. The pilot program's rules attempted to strike an appropriate balance between the two. Nevertheless, the Commission recognizes that the pilot program is "an experiment" and has repeatedly noted that it "has not foreclosed reconsideration of any specific issue" during the pilot period. 63 FR 18823. Accordingly, the Commission has taken very seriously the views of those who maintain that amending the pilot program's rules will enhance their workability and lead to the introduction of trade options to the marketplace.

Commission's Receptivity to the Views of Agriculture

As a result of the Commission's expressed willingness to reconsider the pilot program's rules, I and Commission staff have engaged the agricultural community in an open and frank exploration of the benefits and costs of the pilot program rules. In light of the divergent viewpoints of those in the agricultural sector, the Commission determined that such a dialogue would be beneficial before proposing any specific amendments to the pilot program rules.

As a result, since the rules were promulgated, Commission staff and various Commissioners have met informally with representatives of agricultural interests on a number of occasions to gather their opinions and suggestions regarding the program. Initially, these meetings focused on exploring the existing rules and how the Commission would implement them. Subsequently, meetings with both national and state-level representatives focused on possible changes that might be appropriate.

The views of agricultural interests were also brought to the Commission's attention through more formal channels. For example, the Commission has had an opportunity to receive the views of agriculture through its Agricultural Advisory Committee (AAC), which I chair. The AAC, at its most recent meeting on April 21, 1999, heard presentations on the pilot program by representatives of the National Grain and Feed Association and the National Introducing Brokers Association. AAC members then engaged in a detailed discussion of various possible rule alternatives and the policy issues that such alternatives would raise. The pilot program was also a topic on the agenda of the AAC's August 12, 1998 meeting. The AAC's discussions are transcribed and are available to the Commission for its consideration.

Finally, the Commission and its staff also followed closely the testimony by participants at this Committee's roundtable to discuss futures, derivatives and related public policy issues held on February 25 and 26, 1999 and its hearings to examine crop insurance and risk management strategies held on March 10 and 17, 1999. We found the discussions to be informative and helpful to the Commission's efforts to gather opinions on this topic.

Areas of Possible Future Commission Consideration

The dialogue over the pilot option program rules has not resulted in a single industry-wide view or petition for rulemaking to the Commission. Nevertheless, that dialogue has been beneficial in highlighting a number of areas where there does appear to be some recognition that certain changes to the pilot program rules may be appropriate. Moreover, the dialogue has been beneficial in encouraging a number of producer organizations to develop a common approach to some of these issues. Specifically, nine farm organizations representing a broad cross-section of production agriculture submitted to the Commission their common views on these issues by letter dated April 23, 1999.

Without prejudging any specific issue, some possible areas have been suggested for Commission reconsideration:

a. Registration.

Although registration of ATOMs, as discussed above, is more streamlined than for other Commission registrants, some have suggested that the Commission establish a simple notification process in lieu of registration. Consideration of this alternative would need to take into account the possible loss of certain features associated with registration, including the statutory right of those who deal with Commission registrants to use reparations proceedings and an assurance that registrants meet a minimum level of probity and competence. Commission reparations proceedings offer the customers of registrants an inexpensive, expert forum for resolving disputes arising out of a violation of the Act or Commission rules. Some grain elevators are of the view that the availability of this dispute resolution forum increases their risk of litigation.

A related issue is the pilot program's delegation of the registration processing function to NFA. A possible alternative to this arrangement that has been suggested would be for the Commission itself to process these registration applications. If this change were implemented, it would limit access by a second regulatory authority to an ATOM's books and records, but would entail some additional cost to the taxpayer.

b. Disclosure.

There have also been a number of suggested alternatives to the disclosure requirements. As discussed above, the pilot program requires ATOMs to provide specific risk disclosures prior to each transaction in addition to a general risk disclosure statement. One suggestion has been to provide more information in the general disclosure and not to require transaction-specific disclosures. This would reduce the obligation on an ATOM when entering into a series of transactions with an established customer, but would provide the customer with less specific information.

c. Physical Delivery.

The requirement that the option be exercised only by physical delivery effectively limits the size of the trade option position to the size of the crop grown by producers and the volume of trade carried by elevators and dealers. Doing so discourages excessive leverage in trade option positions, ensures that trade option transactions are between commercials in normal marketing channels and reduces the likelihood they will be used for speculation.

One proposal is to permit cash settlement of the trade option contract.⁽²³⁾   Allowing cash settlement at termination of the contract would enable producers or dealers to capture the gains from the contract while delivering their underlying commodity to some more convenient or otherwise advantageous location. Allowing early termination of the contract through offset would allow producers and dealers further flexibility in entering and exiting positions. The greater the flexibility permitted by the rules, however, the easier it would be to use the instruments for speculation.

A related issue is whether producers should be prohibited from writing call options. The purchaser of an option assumes limited risk. The most that he or she can lose is the amount of the option premium. The writer of an option, however, assumes unlimited risk in return for receiving that option premium. Presumably, agricultural producers could write "covered calls," meaning that the price risk created by the option is hedged or covered by the farmer's crop or livestock, which would similarly rise in price. Some have suggested that permitting producers to write covered calls allows them to enhance their revenues by generating premium income. However, this strategy creates the risk that the cover might be inadequate due to overwriting or to crop failure. In such a case, the producer could face potentially unlimited price risk from the option. This may also leave the ATOM vulnerable to substantial credit risk due to customer defaults.⁽²⁴⁾ Moreover, simply writing a call option leaves the producer exposed to downside price risk.

d. The Exemption Level.

Certain "sophisticated entities" are exempt from the agricultural trade option rules. Commercial entities with a net worth of $10 million or more qualify for the exemption. Although high net worth is no guarantee of financial sophistication, it is an established standard used in other statutes and rules to serve as a proxy for sophistication or the ability to hire sophisticated advice or counsel.

Concern has been expressed that the current level of net worth required to qualify for exemption is too high. However, as the Commission noted in adopting the interim final rules:

The concern is that a relatively large number of individuals engaged in agriculture might meet these financial criteria based not so much on their investment sophistication and ability to gather and manage a sizable asset portfolio, but rather simply reflecting the need to acquire a threshold level of land and machinery to operate successfully a farm or agricultural enterprise.

63 FR 18829. In addition, because farm assets are typically less liquid than financial securities, lowering the exemption level might increase participation, but would do so at the potential risk of increasing participation by less credit-worthy counterparties.

Moreover, some have expressed concern that lowering the exemption level "will create a competitive inequity across the merchandising sector.: A lower exemptive level potentially could favor larger firms and fail to attract sufficient volume in instruments offered pursuant to the pilot program rules to constitute a test of their workability.

e. Possible streamlining

Other changes to the pilot program have been suggested as a means of reducing the paperwork associated with the rules. For example, the pilot program requires written execution of contracts. It has been suggested that oral contracting should be permitted with a written confirmation. Such contracting practices follow state law patterns and are used for forward contracts. This practice could be incorporated into the pilot program rules, but in contrast to forward contracts, may be less useful in the formation of option contracts, particularly where the ATOM collects the option premium up front. A related suggestion is to permit oral as well as written notice to customers in the month before an option expires . Similarly, permitting an oral rather than a written response to customer inquiries for account information might well be a means of reducing paperwork burdens that the Commission may wish to consider. Finally, it has been suggested that the cost and burden of submitting routine reports to the Commission should be reduced. The Commission could reconsider whether less than quarterly reporting would provide it with sufficient information relating to market activity. For example, we could consider a single, annual report as a means of reducing the cost and burden of producing required reports.

An additional suggestion to cut administrative costs would be to permit ATOMs to retain in nonsegregated accounts a small amount of customer funds representing commissions and mark-ups. This would enable ATOMS to use the remainder of the option's purchase price to cover the transaction with an exchange-traded instrument, as permitted currently, without having to maintain a segregated account for the safekeeping of only that portion of the purchase price constituting the ATOM's mark-up.

As the above discussion illustrates, the dialogue between the Commission and agricultural groups has resulted in a number of general and specific suggestions for rule amendments which merit serious consideration.

Education

A third factor affecting whether agricultural trade options will become available and be used is a lack of familiarity among many in the agricultural sector regarding risk management techniques generally and agricultural trade options, specifically. Until the pilot program rules permitted its reintroduction, off-exchange option trading in these agricultural commodities had been prohibited for well over a half-century. Widespread educational efforts will be necessary to give producers a better understanding of what the instruments are and how to use them safely.

To this end, the Commission recently released three educational pamphlets on agricultural trade options prepared by its Division of Economic Analysis. (See copies attached.) These pamphlets provide an overview of agricultural trade options and the pilot program rules for trading them. The first of these brochures, entitled "Agricultural Trade Options -- What Agricultural Producers Need to Know," was issued in December 1998. This brochure acquaints agricultural producers with how they can use agricultural trade options to manage risk. The second and third brochures summarize how to become an agricultural trade option merchant and provide general information to lenders and extension agents, respectively.⁽²⁵⁾

The Commission printed and distributed 3,000 copies of each of these pamphlets. One producer organization requested a copy of the producer brochure for each of its 30,000 members. Budgetary constraints prevented the Commission from filling that request, although the Commission made galleys available for redistribution by others. The Commission also has made these brochures available through its web site at http://www.cftc.gov (Reports and Publications--Popular Brochures On-Line).

In addition, the Commission has been active in efforts to educate producers generally about risk-management strategies. As provided by the Federal Agricultural Improvement and Reform Act of 1996, the Commission has been actively consulting in the implementation of that Act's broad risk management education (RME) mandate to the United States Department of Agriculture. Although futures and option contracts are but two of the many risk management tools included in USDA's education initiative, the Commission has participated in these efforts enthusiastically and is a member of the four-person steering committee set up at USDA to direct the RME effort. I represent the Commission on that steering committee and serve along with the administrators of USDA's Risk Management Agency, Cooperative Research, Education and Extension Service and Outreach Office. The Commission's experience to date as a member of that committee has been highly collaborative in nature and has helped provide farmers with access to the knowledge necessary to utilize a wide range of risk management techniques.

The Commission also makes available information on risk management issues on an on-going basis through its Office of Public Affairs, which provides informational brochures, background reports, and specific information to producers as well as to the press and members of the public. In furtherance of these efforts, the Commission established a web site on the Internet in October 1995 and has continued to add information of educational value to market users and potential market users. Among the materials that may be accessed on the CFTC home page are speeches, press releases, commitments of traders reports and other economic reports, economic studies, informational brochures, information on the CFTC reparations program (including information on filing a claim), and enforcement information. The site also contains links to other futures related sites, including the home pages of domestic and foreign futures exchanges.

Information on risk management is vital, and the Commission is committed to continuation of its education activities. The Commission is also committed to making its pilot program for reintroducing agricultural trade options a success. To that end, the Commission will continue to monitor closely developments associated with the offer or sale of these instruments and to consult with the agriculture community throughout the term of the pilot program.

Finally, I am pleased to announce that Commission staff will be preparing recommendations for revising the pilot program rules for Commission consideration. The Commission is committed to working with industry participants to modify the current rules in order to make the program more useable. We recognize that a successful program will give agricultural producers another risk-shifting alternative in an era when downside price protection is of utmost importance.

¹   Commodity Exchange Act of 1936, Public Law No. 74-675, 49 Stat. 1491 (1936). See, H. Rep. No. 421, 74^th Cong., 1^st Sess. 1,2 (1934); H. Rep. No. 1551, 72d Cong., 1^st Sess. 3 (1932).

²   Examples of nonenumerated commodities include coffee, sugar, gold, and foreign currencies. Before 1974, the Act covered only those commodities enumerated by name. The 1936 Act regulated transactions in wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghum, mill feeds, butter, eggs and solanum tuberosum (Irish potatoes). Act of June 15, 1936, Public Law No. 74-675, 49 Stat. 1491 (1936). Subsequent amendments to the Act added additional agricultural commodities to the list of enumerated commodities. Wool tops were added in 1938. Commodity Exchange Act Amendment of 1938, Public Law No. 471, 52 Stat. 205 (1938). Fats and oils, cottonseed meal, cottonseed, peanuts, soybeans and soybean meal were added in 1940. Commodity Exchange Act Amendment of 1940, Public Law No. 818, 54 Stat. 1059 (1940). Livestock, livestock products and frozen concentrated orange juice were added in 1968. Commodity Exchange Act Amendment of 1968, Public Law No. 90-258, 82 Stat. 26 (1968) (livestock and livestock products); Act of July 23, 1968, Public Law No. 90-418, 82 Stat. 413 (1968) (frozen concentrated orange juice). Trading in onion futures on United States exchanges was prohibited in 1958. Commodity Exchange Act Amendment of 1958, Public Law No. 85-839, 72 Stat. 1013 (1958).

³   The definition of commodity is currently codified in section 1a(3) of the Act.

⁴   Section 4c(b) of the Act provides that no person "shall offer to enter into, enter into or confirm the execution of, any transaction involving any commodity regulated under this Act" which is in the nature of an option "contrary to any rule, regulation, or order of the Commission prohibiting any such transaction or allowing any such transaction under such terms and conditions as the Commission shall prescribe." 7 U.S.C. 6c(b).

⁵   17 CFR Part 32. See, 41 FR 51808 (Nov. 24, 1976) (Adoption of Rules Concerning Regulation and Fraud in Connection with Commodity Option Transactions. See also, 41 FR 7774 (Feb. 20, 1976) (Notice of Proposed Rules on Regulation of Commodity Option Transactions); 41 FR 44560 (Oct. 8, 1976) (Notice of Proposed Regulation of Commodity Options). Options were not traded on futures exchanges at that time.

⁶   As noted above, trade options are defined as off-exchange options "offered by a person having a reasonable basis to believe that the option is offered to the categories of commercial users specified in the rule, where such commercial user is offered or enters into the transaction solely for purposes related to its business as such." 41 FR at 51815; Rule 32.4(a) (1976). This exemption was promulgated based upon an understanding that commercials had sufficient information concerning commodity markets as to transactions related to their business as such, so that application of the full range of regulatory requirements was unnecessary for business-related transactions in options on the nonenumerated commodities. See, 41 FR 44563, "Report of the Advisory Committee on Definition and Regulation of Market Instruments," Appendix A-4, p. 7 (Jan.22, 1976).

⁷   43 FR 16153 (April 17, 1978). Subsequently, the Commission also exempted so-called dealer options from the general suspension of transactions in commodity options. 43 FR 23704 (June 1, 1978).

⁸   46 FR 54500 (Nov. 3, 1981).

⁹   Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).

¹⁰   49 FR 2752 (January 23, 1984).

¹¹   48 FR 46797, 46800 (October 14, 1983) (footnote omitted).

¹² Id.

¹³   The study is available through the Commission's Internet site at http://www.cftc.gov/ag8.htm.

¹⁴   In November 1998, the Commission also authorized NFA to take certain adverse actions concerning these categories of registrants on its behalf.

¹⁵   Where the full premium or purchase price of the option is not collected up front, or where through amendments to the option contract it is possible to lose more than the amount of the initial premium, the provisions of the transaction-specific disclosure statement must reveal the worst possible financial outcome that could be suffered by the customer.

¹⁶   In particular, the contract must include terms specifying the procedure for exercise of the option contract, including the expiration date and latest time on that date for exercise; the total quantity of the commodity underlying the contract; the quality or grade of commodity to be delivered if the contract is exercised and any adjustments to price for deviations from stated quality or grade, or the range [there]of, and a statement of the method for calculating such adjustments; listing of elements comprising the purchase price to be charged, including the premium, mark-ups on the premium, costs, fees and other charges; the strike price(s) of the option contract; additional costs, if any, which may be incurred if the commodity option is exercised; and delivery location, if the contract is exercised.

¹⁷   These requirements are in lieu of a monthly account statement. Many commenters took the view that requiring ATOMs to provide a monthly account statement would impose a costly informational burden for a questionable benefit.

¹⁸   The segregation requirement both discourages a business in financial difficulty from writing options to generate immediate cash and is a means of better safeguarding customer funds.

¹⁹   An ATOM is also required to be audited on a yearly basis in accordance with generally accepted accounting principles and to file a copy of its certified financial statements with the Commission within 90 days after the close of its fiscal year. An ATOM must report immediately to the Commission if its net worth falls below the $50,000 minimum net worth threshold and must notify the Commission of any material inadequacies discovered by a certified public accountant in its internal controls.

²⁰   Routine reports are required for general market surveillance purposes, to permit the Commission to construct a picture of the market and to evaluate the impact of activity in the trade option market on the cash and exchange-traded markets. Special calls are a reporting device used by the Commission for obtaining information only when needed.

²¹   As the Commission noted in adopting this provision, the physical delivery requirement does not preclude development of many types of innovative option contracts. For example, consistent with the rule's requirements, revenue-type option contracts could be offered by referencing the yield on a designated number of acres, based either on the producer's actual yield or a reported average yield, thereby providing a minimum return to a producer per acre.

²²   A party may also qualify for the exemption on the strength of a guarantee by an affiliate.

²³   The pilot program rules currently permit a degree of flexibility through the early termination of the trade options if it is rolled into a forward contract. This enables the option buyer to regain some of the option's time value and to lock-in a final delivery price for the crop.

²⁴  As noted above, one means of covered call writing is permitted under the pilot program rules. This is the use of a mini-max option spread (also known as a "fence" or "window"). In this contract, a producer exchanges the upside gain of a price increase by selling a call in return for insuring against a price decline by using the revenue from the sold call to buy a put. If the strike price on the call is above that on the put, then there is a price range within which the producer bears the price risk. In this context, allowing producers to write call options enables them to reduce the cost of buying a put to insure against a price decline.

²⁵   These pamphlets, which were published in February, 1999 are entitled, "How to become an Agricultural Trade Options Merchant," and "Agricultural Trade Options - Information for Lenders and Extension Agents."

Oral Testimony of Acting Chairman David D. Spears before the Subcommittee on Risk Management, Research and Specialty Crops, Committee on Agriculture, U.S. House of Representatives

August 5, 1999

Mr. Chairman and members of the subcommittee, I am pleased to appear before you today to testify regarding the competitive concerns of U.S. futures exchanges. I ask that the written testimony of the Commission, including an attached survey of Futures Exchange and Contract Authorization Standards and Procedures in Selected Countries, prepared by the Commission’s Office of International Affairs, be entered into the hearing record. Pursuant to your request, the other Commissioners and I will also each present individual testimony.

Exchange competitive concerns were expressed most recently in a June 25, 1999, joint petition by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange ("The Exchanges") requesting an exemption from certain statutory and regulatory requirements for all U.S. futures exchanges.

At the outset, let me assure you that the Commission is firmly committed to addressing the competitive concerns of U.S. futures exchanges. Ensuring the global competitiveness of the U.S. futures industry in general, and U.S. futures exchanges in particular, is a paramount concern of the Commission. I have attached as Appendix A to my individual testimony a list of some 27 major regulatory reform measures taken by the Commission over the last several years. With respect to the petition itself, Commission staff intends to circulate within a few days a proposal to publish the petition for comment in the Federal Register. I should add that the Exchanges’ petition is in part similar to a number of resolutions debated and passed at a July 8, 1999, meeting of our Global Markets Advisory Committee ("GMAC"), Ad Hoc Committee on Regulatory Parity. On July 21, 1999, the GMAC discussed the Ad Hoc Committee’s resolutions.

Even before the Exchanges’ petition was filed, the Commission began to address a central concern raised by that petition, i.e., the ability to list contracts for trading on a more expedited basis. On July 27, l999, the Commission proposed a two-year pilot program to permit the immediate listing of new contracts for trading for a specified period of time prior to Commission approval. This procedure would establish a method for the Commission’s review of new contracts while preserving the public’s opportunity to comment on them, and providing U.S. contract markets flexibility in responding expeditiously to the competitive challenges of the global marketplace. Indeed, only last week, the Exchanges issued a joint statement commending the Commission for this initial action.

Besides responding to the contract approval issue, Commission staff believes a substantial portion of the additional kinds of relief requested by the Exchanges in their petition is already provided for by the Commodity Exchange Act and the existing regulatory scheme. I have attached as Appendix B to my individual testimony a document prepared by T&M staff addressing actions by the Commission under its existing authority that are responsive to many of the specific regulatory parity concerns raised in the petition.

In addition to the regulatory issues raised by the Exchanges' petition, I also believe that it is important to address some of the assumptions underlying their requests.

First, the petition assumes that foreign exchanges will be permitted unlimited access to the U.S. without having to be designated as contract markets under the Act. In fact, the no-action relief granted to foreign exchanges is based upon the presumption that the foreign exchanges are seeking only limited access to the U.S. markets and includes volume reporting requirements and other conditions. To the extent that any foreign exchange substantially increases the quantity or modifies the nature of its contacts within the U.S., the Commission has the discretion to re-examine the relief granted and even require it to become designated as a contract market under Section 5 of the Act.

Second, a careful analysis of the major foreign regulatory regimes suggests that the international playing field may not be as uneven as is sometimes thought. The OIA survey attached to the Commission’s testimony indicates, for example, that while new futures contracts in the United Kingdom are not required to be presubmitted to the regulator, in fact, U.K. authorities tell us that most contracts are submitted in advance and are closely examined by the U.K. Financial Services Authority prior to listing.

Third, the Commission is required by statute to recognize the general public interest in futures markets as well as the needs of market users, including futures commission merchants, other Commission registrants, and customers, ranging from pension funds to small country grain elevators and individual investors. Before the Commission can act on the relief requested by the Exchanges in their petition, it must hear from all members of the interested public through the comments on the petition. Indeed, some have expressed a keen desire to have free and open U.S. customer access to foreign boards of trade. That need evidences the globalization of all futures exchanges, both foreign and domestic. Consistent with this trend, U.S. futures exchanges currently have over 125 trading terminals operating in seven foreign jurisdictions.

Finally, but certainly not least, the Commission recognizes the role of Congress in regulatory relief issues. Some of the Exchanges’ suggestions for regulatory change may well relate to fundamental customer protection and market integrity measures that have formed the cornerstone of U.S. futures regulation for decades. The Commission believes those protections should not be weakened or withdrawn absent a determination by Congress to change the Commission's statutory mandate.

Another very significant issue raised by the petition is a proposal that would reduce U.S. regulatory protection to the lowest level of regulation offered by any jurisdiction gaining access to U.S. markets when trading contracts that clone domestically-traded products. In effect, a U.S. contract market could select the least restrictive elements from various regulatory systems around the world and create a regulatory patchwork that would embody the least restrictive regulatory standards of all of the major foreign financial regulators.

The Commission looks forward to receiving comment on these and all the other issues raised in the Exchanges' petition and believes it is important to reserve judgement on these issues until it has heard from the entire regulatory community through the public comment process.

In closing, I want to stress that the Commission stands ready to cooperate with Congress throughout the reauthorization process, and to work closely with the industry to resolve this and all issues that may arise during that process. On a personal note, Mr. Chairman, as I enter my third month as Acting Chairman of the Commission, I would like to take this opportunity to publicly acknowledge the cooperation of my fellow Commissioners and the hard work and dedication of the Commission’s professional staff.

Appendix A

Appendix B

Testimony of Acting Chairman David D. Spears before the Subcommittee on Risk Management, Research and Specialty Crops, Committee on Agriculture, U.S. House of Representatives

August 5, 1999

Mr. Chairman and Members of the Subcommittee, I am pleased to appear today on behalf of the Commodity Futures Trading Commission to testify regarding the competitive concerns of United States ("U.S.") futures exchanges, as expressed most recently in the June 25, 1999, joint petition by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange ("the Exchanges"). That petition requested an exemption from certain statutory and regulatory requirements for all boards of trade that have been designated by the Commission as contract markets. According to the Exchanges, the petition was filed in response to the Commission's June 2, 1999, Order, which withdrew the Commission's proposed rules governing the use of automated trading systems in the U.S. by foreign boards of trade. This Order also directed our Division of Trading and Markets to begin immediately processing on an interim basis no-action requests from foreign boards of trade seeking to place trading terminals in the U.S. The Order also committed the Commission "to simultaneously initiat[ing] processes to address the comparative regulatory levels between U.S. and foreign electronic trading systems so as not to provide one with a competitive advantage."

The Exchanges state that their petition for exemptive relief should be granted in order to avoid unfair competition from foreign exchanges that have been or will be permitted to establish automated trading systems in the U.S. Since these foreign exchanges will not be required to obtain Commission designation as contract markets in order to operate in the U.S., the Exchanges contend that foreign exchanges will not be subject to the same statutory and regulatory requirements that apply to the U.S. exchanges. Through their petition, the Exchanges are seeking the ability to respond, without delay, to any new contract, contract amendment, advantageous trading practice or less costly regulatory measure offered or likely to be offered by foreign exchanges through their U.S.-based trading terminals.

At the outset, let me say that the Commission is firmly committed to addressing the competitive concerns of U.S. futures exchanges. Ensuring the global competitiveness of the U.S. futures industry in general, and U.S. futures exchanges in particular, is a paramount concern of the Commission. Staff intends to circulate to the Commission the Notice of Petition for Exemption and Request for Comment within the next several days with an eye toward prompt publication in the Federal Register. I should add that the Exchanges’ petition is in part similar to a number of resolutions debated and passed at a July 8, 1999, meeting of our Global Markets Advisory Committee ("GMAC"), Ad Hoc Committee on Regulatory Parity. On July 21, 1999, the GMAC discussed the Ad Hoc Committee’s resolutions.

Even before the Exchanges’ petition was filed, the Commission began to address a central concern raised by that petition, i.e., the ability to list contracts for trading on a more expedited basis. On July 27, l999, the Commission proposed a two-year pilot program to permit the immediate listing of certain new contracts for trading for a specified period of time prior to Commission approval. This procedure would establish a method for the Commission's review of new contracts while preserving the public's opportunity to comment on them, and providing U.S. contract markets flexibility in responding expeditiously to the competitive challenges of the global marketplace. Indeed, only last week, the Exchanges issued a joint statement commending the Commission for this initial action.

This most recent action is consistent with a long line of Commission actions since 1997 streamlining the contract approval process. For example, in April of 1997, the Commission implemented new fast-track procedures relating to the review and approval of applications for contract market designation. In addition, the Commission has periodically revised its Guideline on Economic and Public Interest Requirements for Contract Market Designation, which provides guidance to U.S. exchanges in meeting the statutory requirements for contract market designation.

Before I discuss some of the regulatory issues raised by the Exchanges' petition, I also believe that it is important to address some of the assumptions underlying their requests.

First, the petition assumes that foreign exchanges will be permitted unlimited access to the U.S. without having to be designated as contract markets under the Commodity Exchange Act ("Act"). In fact, the no-action relief scheme constructed for foreign exchanges is based upon the presumption that the foreign exchanges are seeking only limited access to the U.S. markets. For example, under present no-action relief afforded Eurex, less than 5 % of its volume is generated through terminals in the U.S. and it otherwise has very limited contacts to the U.S. The Division of Trading and Markets ("T&M") has found that the limited entry of these foreign exchanges does not necessitate full fledged U.S. contract market regulatory treatment because these exchanges are otherwise competently regulated by their own home regulators. So, for example, when T&M recently granted a no-action request from the London International Financial Futures and Option Exchange ("LIFFE") to make its electronic trading system available in the U.S., it imposed over four pages of conditions that, among other things, require LIFFE to adhere to regular periodic reporting requirements apprising the Commission of its contacts in the U.S. To the extent that LIFFE substantially increases the quantity or modifies the nature of its contacts within the U.S., the Commission has the discretion to re-examine the relief granted to LIFFE and even require it to become designated as a contract market under Section 5 of the Act.

Second, a careful analysis of the major foreign regulatory regimes suggests that the international playing field may not be as uneven as is sometimes thought. For example, as indicated in an attached survey by the Commission’s Office of International Affairs ("OIA"), while it is true that in the United Kingdom ("U.K.") contracts are not required to be presubmitted to the regulator, in fact, U.K. authorities have advised that most contracts are submitted in advance and are closely examined by the U.K. Financial Services Authority. In Germany, while the exchange "admits" contracts to trading, standard conditions of these contracts must be in accordance with exchange rules approved in advance by the relevant regulator. The OIA survey describes the relevant provisions of foreign regulatory systems in greater detail.

Third, the Commission, when addressing the legitimate competitive concerns of the Exchanges, is also required by statute to recognize the general public interest in futures markets and the needs of market users, including futures commission merchants and other Commission registrants, who act as intermediaries between customers and the exchanges, and the customers themselves. Those customers, in turn, range from pension funds and other large institutional investors to small country grain elevators and individual investors. Before the Commission can act on the claims made by the Exchanges in their petition, it must hear from all members of the interested public through the comments on the petition. This latter point is noteworthy because, during public meetings relating to this issue, important elements of our regulated community have expressed concerns about some of the points raised by the Exchanges’ petition. Indeed, some have expressed a keen desire to have free and open U.S. customer access to foreign boards of trade. The need for free and open U.S. customer access to foreign boards of trade evidences the globalization of all futures exchanges, both foreign and domestic. Consistent with this trend, U.S. futures exchanges currently have over 125 trading terminals operating in seven foreign jurisdictions.

Finally, but certainly not least, the Commission recognizes the role of Congress in regulatory relief issues. Some of the Exchanges’ suggestions for regulatory change may very well relate to fundamental customer protection and market integrity measures that have formed the cornerstone of U.S. futures regulation for decades. The Commission believes those protections should not be weakened or withdrawn absent a determination by Congress to change the Commission's statutory mandate.

Two additional issues raised in the petition include requests for relief from the Commission’s large trader reporting requirements and the procedures for the prior review of exchange rule changes. Another issue raised by the petition is a proposal that would reduce U.S. regulatory protection to the lowest level of regulation offered by any jurisdiction gaining access to U.S. markets when trading contracts that clone domestically-traded products. In effect, a U.S. contract market could select the least restrictive elements from various regulatory systems around the world and create a single regulatory patchwork that would embody the least restrictive regulatory standards of all of the major foreign financial regulators.

The Commission looks forward to receiving comments on these and all the other issues raised in the Exchanges' petition and believes it is important to reserve judgement on these issues until it has heard from the entire regulatory community through the public comment process.

Conclusion

I want to emphasize that the Commission stands ready to cooperate with Congress throughout the reauthorization process, and to work closely with the industry to resolve this and all issues that may arise during that process.

Remarks of Commissioner David D. Spears before the National Grain Trade Council, Boston, Massachusetts

September 21, 2000

Introduction

I’d like to thank the National Grain Trade Council for giving me the opportunity to participate in today’s program and to compare notes with some of the leading figures in agribusiness and the futures industry. My remarks today will cover some of the profound changes that are reshaping the world of financial and agricultural risk management, the CFTC’s response to those changes, as set out in the agency’s June 22 regulatory reinvention proposal, and some speculation about what the future may hold for agricultural risk management.

The New World of Risk Management

My official topic today is the CFTC’s regulatory reinvention proposal. However, to really understand that proposal we must put it in context. The Commission is seeking comment on a series of reforms that will fundamentally reshape the regulatory system for futures trading. Those reforms constitute the agency’s response to a series of even more profound changes in the financial marketplace.

Financial markets – including America’s futures and option markets -- are becoming increasingly integrated into a huge, fiercely competitive, global financial marketplace. Capital moves from market to market, crossing borders and time zones with the click of a computer key, as international financial conglomerates seek the best return on their money. Assets are allocated, managed and transferred through a constantly expanding, ever mutating variety of transactions – futures, swaps, forwards, options, swaptions, securities, hybrid instruments. Some of these instruments are traded on organized exchanges and others over-the-counter. At the same time, the lines between these various types of instruments become increasingly blurred as OTC products become more standardized, while exchanges explore ways to offer more individualized/customized products.

In this new global marketplace, traditional open-outcry futures exchanges are experiencing tremendous competitive pressure. OTC derivatives markets have seen a huge increase in volume. For example, according to the Bank for International Settlements, the face value of outstanding OTC derivatives on June 30, 2000 was $105 trillion, up 50 percent from $70 trillion on June 30, 1998. Meanwhile, from January through August of this year, total trading volume on U.S. futures exchanges was down 3% from the same period last year. Every exchange but one showed a decline in volume. Internationally, in July of 1998 Eurex, the European electronic futures exchange, surpassed the Chicago Board of Trade in volume to become the world’s largest futures exchange.

As electronic trading systems become more sophisticated and reliable the very future of open outcry may be in doubt. In April of 1998, the MATIF, the French futures exchange, offered an electronic trading platform operating side-by-side with its existing open outcry system. Within 21 days, 90% of the volume migrated to the electronic system and by the end of June MATIF dropped pit trading altogether. Other overseas futures exchanges have followed a similar pattern. The Sydney Futures Exchange dropped open outcry in favor of electronic trading in November of 1999 and LIFFE in London followed suit in May of 2000.

In addition to reshaping trading on existing open outcry exchanges, electronic trading is paving the way for the creation of new exchanges. If you go back and look at old copies of the CFTC annual Report, the list of designated exchanges remains pretty much unchanged from 1976 through 1997. Beginning two years ago, however, we started seeing applications for new electronic exchanges. In September 1998, the Commission designated the Cantor Financial Futures Exchange to trade various financial futures contracts. In March of this year, we designated Futurecom, the first internet-based futures exchange, as a contract market in live cattle futures. Four months later, we designated the Merchants Exchange of St. Louis to trade two different barge freight futures contracts. Neither of these exchanges has started trading yet, but with the designations approved, the ball is in their respective courts. In addition, the Commission staff is currently reviewing designation applications from two more new electronic exchanges. BrokerTec, a proposed electronic market for bond futures, is backed by several large institutional financial market participants. OnExchange, is an internet-based electronic exchange described by its CEO as a "next generation derivatives enabler" intended to allow both regulated and unregulated derivatives to be traded and cleared through online eMarketplaces. Even more significantly, the staff informs me that we have had inquiries from at least a dozen other potential electronic exchanges in various stages of development.

Of course, U.S. futures exchanges are not sitting idly by as the storm clouds gather. They are working feverishly to meet these competitive challenges on all fronts. Their responses include structural changes. For example, five years ago there were five futures exchanges in New York. Today, due to mergers and consolidations, there are only two, with corresponding increases in economy and efficiency. A much more profound change is the movement to "demutualize" – to revise the very structure of exchanges from their current status as membership organizations to a leaner, meaner corporate structure that can respond more quickly and efficiently to competitive challenges. Other than the Kansas City Board of Trade (which has always had a corporate structure), every U.S. futures exchange is in one stage or another of the demutualization process.

U.S. exchanges are also embracing the benefits of electronic technology. They have added various enhancements, such as electronic order routing systems, to make pit trading more efficient. Development continues on hand-held electronic trading terminals. Most recently, NYBOT announced it is preparing to introduce an "automated trading card" that will provide real-time order and trade processing. U.S. exchanges have also implemented after-hours electronic trading systems, such as the CME’s Globex System and NYMEX’s ACCESS. And they have entered cross-exchange access agreements with various offshore exchanges to broaden markets and extend the trading day. Most recently, the Chicago Board of Trade has taken a very significant step through its alliance with Eurex, giving its members access to new customers, new markets and new technology. I’m sure you will be hearing more about this new system, which recently announced its millionth trade, from your next speaker, Chairman Brennan. So I won’t steal his thunder by going into any more detail on this major CBT initiative.

That is a brief overview of the competitive challenges facing U.S. futures markets and some of the steps they are taking to meet those challenges. However, there is another aspect to the competitive picture and that is the regulatory side – the primary topic of my remarks here today.

Steps Leading to the CFTC’s Regulatory Reinvention Proposal

All financial markets, whether domestic or international, exchange-traded or OTC, are subject to legal restrictions of varying degrees. U.S. futures markets have been around the longest – over 150 years in the case of the CBT. Not surprisingly, they are subject to the oldest and, some would argue, most elaborate set of restrictions – the Commodity Exchange Act and CFTC regulations. In applying the Act and crafting regulations, the Commission must perform a very difficult balancing act. We are charged by law with preserving the integrity of the marketplace and protecting customers from fraud and abuse. At the same time, we must maintain a regulatory system that is flexible enough to allow exchanges to create and innovate as they respond to competitive challenges. We can’t put ourselves in the position of the aeronautical engineer who designs an airplane loaded with so many safety features it can’t get off the ground.

Over the years, the Commission has done a commendable job of striking the right balance and providing appropriate regulatory relief -- from simplifying registration requirements, to streamlining reporting and recordkeeping rules, to allowing brokers to use electronic media to submit information to the Commission, and furnish disclosure documents and account statements to customers. However, the recent changes in the marketplace that I have described are fundamentally reshaping the competitive landscape. This new marketplace demands a more far-reaching approach to regulatory reform.

Therefore, last year, with the encouragement of our Congressional authorizing committees, Chairman Rainer appointed a staff task force to examine the CFTC’s entire regulatory structure, from top to bottom, and come up with a broad-based plan for regulatory reform. The general goals were to come up with recommendations to remove unnecessary regulatory burdens and to move the Commission from direct regulation to oversight regulation, from prescriptive rules to performance standards, and from merit to disclosure-based regulation.

In February of this year, the task force report, entitled "A New Regulatory Framework," was furnished to Congress and made public. Over the following months, with input from industry leaders, market users and other experts, the staff worked to flesh out the task force recommendations into a comprehensive regulatory reinvention proposal. That proposal was published on June 22, 2000, with a comment deadline that was later extended to August 21st. We followed up with a two-day public hearing on June 27 and 28, providing testimony from a cross-section of derivatives industry leaders and experts. On July 19^th, I chaired a meeting of the Commission’s Agricultural Advisory Committee, which gave the agriculture community a separate forum to air its views on the proposal. In addition to the statements and transcripts from those meetings, the record now before the Commission includes 67 comment letters, many with quite lengthy and detailed comments. The staff is currently in the process of reviewing all these materials and formulating recommendations to the Commission for a final regulatory reinvention package.

I can’t tell you exactly what the final rules will look like. They are still being drafted. I can however, give you an overview of the general outlines of the June 22 proposed rules. While there will undoubtedly be a number of changes in the final rules, I would expect them to follow the general outlines laid out in the June 22 proposal.

Overview of the Regulatory Reinvention Proposal

The proposed regulatory reinvention rules were drafted with three basic objectives in mind: (1) to rationalize our regulations to match the goals of the Commodity Exchange Act to the products and participants trading in today’s derivatives markets; (2) to reinforce legal certainty for OTC derivatives; and (3) to modernize CFTC regulation. The intent was to design a more flexible regulatory system that would still meet the Act’s basic objectives of protecting market and price integrity, protecting against market manipulation, protecting financial integrity and protecting customers.

Flexibility is achieved by replacing one-size-fits-all rules with core principles tailored to particular market characteristics. The performance standards embodied in these core principles are broad enough to encompass different technologies and different organizational structures. The proposal includes separate rulemakings to address the functions of trade execution, services by market intermediaries, and clearing. The centerpiece of the proposal, however, is a system establishing three varying levels of regulation for derivatives facilities based upon the nature of the commodity being traded and the sophistication of the trader.

The top tier, subject to a comparatively higher level of regulation, is known as a Recognized Futures Exchange or RFE. Any commodity, including those that may be subject to the threat of manipulation, may be traded on an RFE. Traders on an RFE can include both institutional and non-institutional customers. RFEs would be subject to 15 core principles. Existing futures exchanges would be "grandfathered" as RFEs, but with the ability to opt into a less-regulated tier for qualifying contracts.

However, that option would not be generally available for contracts on the enumerated agricultural commodities. Those basic agricultural commodities tend to rely on futures markets as their primary, if not their only, price discovery mechanism. To protect that vital price discovery function, the enumerated ag commodities would generally be allowed to trade only on an RFE. Within the RFE context, agricultural commodities would be subject to special treatment in other respects as well. While an RFE could amend the rules for its other contracts simply by certifying that the rule changes didn’t violate the CEA, amending the terms and conditions of agricultural contracts would still require CFTC prior approval. An RFE could, however, list new contracts, including new agricultural contracts, by self-certification.

The middle tier of regulation is the recognized derivatives transaction facility, or DTF. There are two types of markets in this category. One type of DTF would be limited to eligible commercial participants trading for their own accounts, often referred to as B-to-B markets. Because the definition of eligible commercial participants is limited to large commercial and institutional traders, most farmers would not qualify. Thus, under the proposed rules, the enumerated agricultural commodities would not be eligible for trading on a commercial DTF. Those agricultural commodities not on the "enumerated" list, such as coffee, sugar and cocoa, could however trade on a commercial DTF.

The second type of DTF would be open to all eligible participants, both commercial and non-commercial. Certain financial commodities listed in the proposed rules could be freely traded in such markets. Other commodities – including enumerated agricultural commodities and other physicals, such as energy contracts, -- could also be traded. They would, however, have to et certain conditions on a case-by-case basis. Those conditions include demonstrating that the commodity has a sufficiently liquid and deep cash market and a surveillance history showing that it would not be subject to manipulation. Non-commercial traders, including most farmers, could trade on a case-by-case DTF, but only if they traded through a large, well-capitalized FCM – one that maintains net capital of at least $20 million. Both types of DTF would be subject to the same seven core principles.

The lowest tier of regulation – essentially an unregulated market -- would be the exempt multilateral trade execution facility, or Exempt MTEF. An exempt MTEF would be limited to institutional traders. It would be subject only to anti-fraud and anti-manipulation requirements. If serving a price discovery function it would also have a transparency requirement. An exempt MTEF would not be allowed to hold itself out to the public as a "regulated" market. Agricultural commodities would not be allowed to trade on an Exempt MTEF.

A separate section of the regulatory reinvention proposal includes relief for intermediaries – FCMs and Introducing Brokers – when intermediating on an RFE. This proposal expands the eligible instruments for investing segregated funds, scales back CFTC registration rules, and relaxes disclosure and competency requirements.

The regulatory reinvention proposal also includes standards for clearing organizations. If there is a clearing function on either an RFE or a DTF, the clearing organization must be recognized by the CFTC. Clearing organizations may be independent of execution facilities, but to be recognized by the Commission they must abide by a set of 14 core principles.

The primary issues for agriculture in the regulatory reinvention proposal include: (1) the requirement that rule changes in an agricultural contract on an RFE will still be subject to CFTC prior approval; (2) the conditions and circumstances under which enumerated agricultural commodities could trade on a DTF; and (3) the net capital requirement for FCMs handling non-institutional customers on a DTF. We have received comments in these areas from a variety of agricultural interests.

For example, the National Grain Trade Council argues in its comment letter that enumerated agricultural commodities must be allowed to trade on DTFs under less restrictive criteria than the Commission has proposed. NGTC also argues that the $20 million net capital threshold for FCMs handling customer trades on eligible participant DTFs is unnecessary and unsound.

A coalition of eight national farm and commodity organizations commented in favor of the proposed standards for enumerated agricultural commodities to trade on a DTF. However, they urged the Commission to make sure producers have an opportunity to comment on any petition to move an agricultural commodity from an RFE to a DTF. They also ask that any such trading

should retain safeguards, such as large trader reporting and appropriate audit trails. With respect to FCMs handling trades on DTFs, the ag groups urge the Commission to "further clarify the responsibilities and obligations of intermediaries representing non-institutional traders."

The National Grain and Feed Association would support greater flexibility in allowing enumerated ag commodities onto a DTF. However, they propose "limit [ing] the ability of exchanges to split markets on the basis of type of trader." NGFA is concerned that separate institutional and non-institutional markets could harm volume and liquidity. NGFA also argues hat the proposed definition of "eligible participants" who could trade on less regulated exchanges is too restrictive. They urge the Commission to "consider other methods of qualifying individuals or companies to trade as eligible participants."

The staff is hard at work drafting final rules, but I can’t predict when they will be issued, especially since Congress could change the equation. If Congress passes a reauthorization bill before it adjourns, we would have to delay the final rules to make sure they were completely consistent with the terms of the legislation.

The Future of Agricultural Risk Management

Let me conclude with a few thoughts on the future of agricultural risk management. Clearly derivatives markets, including agricultural markets, are changing and evolving. The CFTC’s regulatory reinvention proposal is intended to allow that process to continue without unnecessary regulatory barriers. Our goal is to fashion a regulatory system that preserves basic market and customer protections, but is sufficiently flexible and accommodating so that market evolution is determined by the forces of supply and demand, and the needs of market participants, rather than the whims of bureaucrats.

Exactly where those marketplace needs will lead is hard to predict. Perhaps the afternoon’s other speakers, Chairman Brennan and the panel on E-commerce, will provide further enlightenment. I will go out on a limb and make a couple of general predictions, however. I believe the farmers of tomorrow will be more computer literate than today’s farmers. I believe they will use those computers, the internet and other learning tools to become more sophisticated at marketing than today’s farmers. Those are both pretty safe predictions because I’m convinced the farmers that don’t become computer literate and don’t learn to be better marketers won’t be around to be counted.

Another equally safe prediction, based on existing trends, is that the range of marketing options available to farmers will continue to increase – new types of contracts, new methods of trading, new linkages with those who supply farmers’ inputs and those who buy their outputs. The real challenge for farmers will be to find a path through the blizzard of information and to home in on the right marketing plan for their particular situation.

The challenge for the grain industry is the other side of that coin. You must take a leading role in making meaningful marketing information accessible to farmers. It is vital that the right information, describing the right marketing program for any given operation, gets into the hands of the farmer who needs it. I hope the industry is up to that challenge.

Thank you for your kind attention. I will be happy to take any questions you might have.

Remarks of Commissioner David D. Spears before the National Grain Trade Council, Boston, Massachusetts

September 21, 2000

Introduction

I’d like to thank the National Grain Trade Council for giving me the opportunity to participate in today’s program and to compare notes with some of the leading figures in agribusiness and the futures industry. My remarks today will cover some of the profound changes that are reshaping the world of financial and agricultural risk management, the CFTC’s response to those changes, as set out in the agency’s June 22 regulatory reinvention proposal, and some speculation about what the future may hold for agricultural risk management.

The New World of Risk Management

My official topic today is the CFTC’s regulatory reinvention proposal. However, to really understand that proposal we must put it in context. The Commission is seeking comment on a series of reforms that will fundamentally reshape the regulatory system for futures trading. Those reforms constitute the agency’s response to a series of even more profound changes in the financial marketplace.

Financial markets – including America’s futures and option markets -- are becoming increasingly integrated into a huge, fiercely competitive, global financial marketplace. Capital moves from market to market, crossing borders and time zones with the click of a computer key, as international financial conglomerates seek the best return on their money. Assets are allocated, managed and transferred through a constantly expanding, ever mutating variety of transactions – futures, swaps, forwards, options, swaptions, securities, hybrid instruments. Some of these instruments are traded on organized exchanges and others over-the-counter. At the same time, the lines between these various types of instruments become increasingly blurred as OTC products become more standardized, while exchanges explore ways to offer more individualized/customized products.

In this new global marketplace, traditional open-outcry futures exchanges are experiencing tremendous competitive pressure. OTC derivatives markets have seen a huge increase in volume. For example, according to the Bank for International Settlements, the face value of outstanding OTC derivatives on June 30, 2000 was $105 trillion, up 50 percent from $70 trillion on June 30, 1998. Meanwhile, from January through August of this year, total trading volume on U.S. futures exchanges was down 3% from the same period last year. Every exchange but one showed a decline in volume. Internationally, in July of 1998 Eurex, the European electronic futures exchange, surpassed the Chicago Board of Trade in volume to become the world’s largest futures exchange.

As electronic trading systems become more sophisticated and reliable the very future of open outcry may be in doubt. In April of 1998, the MATIF, the French futures exchange, offered an electronic trading platform operating side-by-side with its existing open outcry system. Within 21 days, 90% of the volume migrated to the electronic system and by the end of June MATIF dropped pit trading altogether. Other overseas futures exchanges have followed a similar pattern. The Sydney Futures Exchange dropped open outcry in favor of electronic trading in November of 1999 and LIFFE in London followed suit in May of 2000.

In addition to reshaping trading on existing open outcry exchanges, electronic trading is paving the way for the creation of new exchanges. If you go back and look at old copies of the CFTC annual Report, the list of designated exchanges remains pretty much unchanged from 1976 through 1997. Beginning two years ago, however, we started seeing applications for new electronic exchanges. In September 1998, the Commission designated the Cantor Financial Futures Exchange to trade various financial futures contracts. In March of this year, we designated Futurecom, the first internet-based futures exchange, as a contract market in live cattle futures. Four months later, we designated the Merchants Exchange of St. Louis to trade two different barge freight futures contracts. Neither of these exchanges has started trading yet, but with the designations approved, the ball is in their respective courts. In addition, the Commission staff is currently reviewing designation applications from two more new electronic exchanges. BrokerTec, a proposed electronic market for bond futures, is backed by several large institutional financial market participants. OnExchange, is an internet-based electronic exchange described by its CEO as a "next generation derivatives enabler" intended to allow both regulated and unregulated derivatives to be traded and cleared through online eMarketplaces. Even more significantly, the staff informs me that we have had inquiries from at least a dozen other potential electronic exchanges in various stages of development.

Of course, U.S. futures exchanges are not sitting idly by as the storm clouds gather. They are working feverishly to meet these competitive challenges on all fronts. Their responses include structural changes. For example, five years ago there were five futures exchanges in New York. Today, due to mergers and consolidations, there are only two, with corresponding increases in economy and efficiency. A much more profound change is the movement to "demutualize" – to revise the very structure of exchanges from their current status as membership organizations to a leaner, meaner corporate structure that can respond more quickly and efficiently to competitive challenges. Other than the Kansas City Board of Trade (which has always had a corporate structure), every U.S. futures exchange is in one stage or another of the demutualization process.

U.S. exchanges are also embracing the benefits of electronic technology. They have added various enhancements, such as electronic order routing systems, to make pit trading more efficient. Development continues on hand-held electronic trading terminals. Most recently, NYBOT announced it is preparing to introduce an "automated trading card" that will provide real-time order and trade processing. U.S. exchanges have also implemented after-hours electronic trading systems, such as the CME’s Globex System and NYMEX’s ACCESS. And they have entered cross-exchange access agreements with various offshore exchanges to broaden markets and extend the trading day. Most recently, the Chicago Board of Trade has taken a very significant step through its alliance with Eurex, giving its members access to new customers, new markets and new technology. I’m sure you will be hearing more about this new system, which recently announced its millionth trade, from your next speaker, Chairman Brennan. So I won’t steal his thunder by going into any more detail on this major CBT initiative.

That is a brief overview of the competitive challenges facing U.S. futures markets and some of the steps they are taking to meet those challenges. However, there is another aspect to the competitive picture and that is the regulatory side – the primary topic of my remarks here today.

Steps Leading to the CFTC’s Regulatory Reinvention Proposal

All financial markets, whether domestic or international, exchange-traded or OTC, are subject to legal restrictions of varying degrees. U.S. futures markets have been around the longest – over 150 years in the case of the CBT. Not surprisingly, they are subject to the oldest and, some would argue, most elaborate set of restrictions – the Commodity Exchange Act and CFTC regulations. In applying the Act and crafting regulations, the Commission must perform a very difficult balancing act. We are charged by law with preserving the integrity of the marketplace and protecting customers from fraud and abuse. At the same time, we must maintain a regulatory system that is flexible enough to allow exchanges to create and innovate as they respond to competitive challenges. We can’t put ourselves in the position of the aeronautical engineer who designs an airplane loaded with so many safety features it can’t get off the ground.

Over the years, the Commission has done a commendable job of striking the right balance and providing appropriate regulatory relief -- from simplifying registration requirements, to streamlining reporting and recordkeeping rules, to allowing brokers to use electronic media to submit information to the Commission, and furnish disclosure documents and account statements to customers. However, the recent changes in the marketplace that I have described are fundamentally reshaping the competitive landscape. This new marketplace demands a more far-reaching approach to regulatory reform.

Therefore, last year, with the encouragement of our Congressional authorizing committees, Chairman Rainer appointed a staff task force to examine the CFTC’s entire regulatory structure, from top to bottom, and come up with a broad-based plan for regulatory reform. The general goals were to come up with recommendations to remove unnecessary regulatory burdens and to move the Commission from direct regulation to oversight regulation, from prescriptive rules to performance standards, and from merit to disclosure-based regulation.

In February of this year, the task force report, entitled "A New Regulatory Framework," was furnished to Congress and made public. Over the following months, with input from industry leaders, market users and other experts, the staff worked to flesh out the task force recommendations into a comprehensive regulatory reinvention proposal. That proposal was published on June 22, 2000, with a comment deadline that was later extended to August 21st. We followed up with a two-day public hearing on June 27 and 28, providing testimony from a cross-section of derivatives industry leaders and experts. On July 19^th, I chaired a meeting of the Commission’s Agricultural Advisory Committee, which gave the agriculture community a separate forum to air its views on the proposal. In addition to the statements and transcripts from those meetings, the record now before the Commission includes 67 comment letters, many with quite lengthy and detailed comments. The staff is currently in the process of reviewing all these materials and formulating recommendations to the Commission for a final regulatory reinvention package.

I can’t tell you exactly what the final rules will look like. They are still being drafted. I can however, give you an overview of the general outlines of the June 22 proposed rules. While there will undoubtedly be a number of changes in the final rules, I would expect them to follow the general outlines laid out in the June 22 proposal.

Overview of the Regulatory Reinvention Proposal

The proposed regulatory reinvention rules were drafted with three basic objectives in mind: (1) to rationalize our regulations to match the goals of the Commodity Exchange Act to the products and participants trading in today’s derivatives markets; (2) to reinforce legal certainty for OTC derivatives; and (3) to modernize CFTC regulation. The intent was to design a more flexible regulatory system that would still meet the Act’s basic objectives of protecting market and price integrity, protecting against market manipulation, protecting financial integrity and protecting customers.

Flexibility is achieved by replacing one-size-fits-all rules with core principles tailored to particular market characteristics. The performance standards embodied in these core principles are broad enough to encompass different technologies and different organizational structures. The proposal includes separate rulemakings to address the functions of trade execution, services by market intermediaries, and clearing. The centerpiece of the proposal, however, is a system establishing three varying levels of regulation for derivatives facilities based upon the nature of the commodity being traded and the sophistication of the trader.

The top tier, subject to a comparatively higher level of regulation, is known as a Recognized Futures Exchange or RFE. Any commodity, including those that may be subject to the threat of manipulation, may be traded on an RFE. Traders on an RFE can include both institutional and non-institutional customers. RFEs would be subject to 15 core principles. Existing futures exchanges would be "grandfathered" as RFEs, but with the ability to opt into a less-regulated tier for qualifying contracts.

However, that option would not be generally available for contracts on the enumerated agricultural commodities. Those basic agricultural commodities tend to rely on futures markets as their primary, if not their only, price discovery mechanism. To protect that vital price discovery function, the enumerated ag commodities would generally be allowed to trade only on an RFE. Within the RFE context, agricultural commodities would be subject to special treatment in other respects as well. While an RFE could amend the rules for its other contracts simply by certifying that the rule changes didn’t violate the CEA, amending the terms and conditions of agricultural contracts would still require CFTC prior approval. An RFE could, however, list new contracts, including new agricultural contracts, by self-certification.

The middle tier of regulation is the recognized derivatives transaction facility, or DTF. There are two types of markets in this category. One type of DTF would be limited to eligible commercial participants trading for their own accounts, often referred to as B-to-B markets. Because the definition of eligible commercial participants is limited to large commercial and institutional traders, most farmers would not qualify. Thus, under the proposed rules, the enumerated agricultural commodities would not be eligible for trading on a commercial DTF. Those agricultural commodities not on the "enumerated" list, such as coffee, sugar and cocoa, could however trade on a commercial DTF.

The second type of DTF would be open to all eligible participants, both commercial and non-commercial. Certain financial commodities listed in the proposed rules could be freely traded in such markets. Other commodities – including enumerated agricultural commodities and other physicals, such as energy contracts, -- could also be traded. They would, however, have to et certain conditions on a case-by-case basis. Those conditions include demonstrating that the commodity has a sufficiently liquid and deep cash market and a surveillance history showing that it would not be subject to manipulation. Non-commercial traders, including most farmers, could trade on a case-by-case DTF, but only if they traded through a large, well-capitalized FCM – one that maintains net capital of at least $20 million. Both types of DTF would be subject to the same seven core principles.

The lowest tier of regulation – essentially an unregulated market -- would be the exempt multilateral trade execution facility, or Exempt MTEF. An exempt MTEF would be limited to institutional traders. It would be subject only to anti-fraud and anti-manipulation requirements. If serving a price discovery function it would also have a transparency requirement. An exempt MTEF would not be allowed to hold itself out to the public as a "regulated" market. Agricultural commodities would not be allowed to trade on an Exempt MTEF.

A separate section of the regulatory reinvention proposal includes relief for intermediaries – FCMs and Introducing Brokers – when intermediating on an RFE. This proposal expands the eligible instruments for investing segregated funds, scales back CFTC registration rules, and relaxes disclosure and competency requirements.

The regulatory reinvention proposal also includes standards for clearing organizations. If there is a clearing function on either an RFE or a DTF, the clearing organization must be recognized by the CFTC. Clearing organizations may be independent of execution facilities, but to be recognized by the Commission they must abide by a set of 14 core principles.

The primary issues for agriculture in the regulatory reinvention proposal include: (1) the requirement that rule changes in an agricultural contract on an RFE will still be subject to CFTC prior approval; (2) the conditions and circumstances under which enumerated agricultural commodities could trade on a DTF; and (3) the net capital requirement for FCMs handling non-institutional customers on a DTF. We have received comments in these areas from a variety of agricultural interests.

For example, the National Grain Trade Council argues in its comment letter that enumerated agricultural commodities must be allowed to trade on DTFs under less restrictive criteria than the Commission has proposed. NGTC also argues that the $20 million net capital threshold for FCMs handling customer trades on eligible participant DTFs is unnecessary and unsound.

A coalition of eight national farm and commodity organizations commented in favor of the proposed standards for enumerated agricultural commodities to trade on a DTF. However, they urged the Commission to make sure producers have an opportunity to comment on any petition to move an agricultural commodity from an RFE to a DTF. They also ask that any such trading

should retain safeguards, such as large trader reporting and appropriate audit trails. With respect to FCMs handling trades on DTFs, the ag groups urge the Commission to "further clarify the responsibilities and obligations of intermediaries representing non-institutional traders."

The National Grain and Feed Association would support greater flexibility in allowing enumerated ag commodities onto a DTF. However, they propose "limit [ing] the ability of exchanges to split markets on the basis of type of trader." NGFA is concerned that separate institutional and non-institutional markets could harm volume and liquidity. NGFA also argues hat the proposed definition of "eligible participants" who could trade on less regulated exchanges is too restrictive. They urge the Commission to "consider other methods of qualifying individuals or companies to trade as eligible participants."

The staff is hard at work drafting final rules, but I can’t predict when they will be issued, especially since Congress could change the equation. If Congress passes a reauthorization bill before it adjourns, we would have to delay the final rules to make sure they were completely consistent with the terms of the legislation.

The Future of Agricultural Risk Management

Let me conclude with a few thoughts on the future of agricultural risk management. Clearly derivatives markets, including agricultural markets, are changing and evolving. The CFTC’s regulatory reinvention proposal is intended to allow that process to continue without unnecessary regulatory barriers. Our goal is to fashion a regulatory system that preserves basic market and customer protections, but is sufficiently flexible and accommodating so that market evolution is determined by the forces of supply and demand, and the needs of market participants, rather than the whims of bureaucrats.

Exactly where those marketplace needs will lead is hard to predict. Perhaps the afternoon’s other speakers, Chairman Brennan and the panel on E-commerce, will provide further enlightenment. I will go out on a limb and make a couple of general predictions, however. I believe the farmers of tomorrow will be more computer literate than today’s farmers. I believe they will use those computers, the internet and other learning tools to become more sophisticated at marketing than today’s farmers. Those are both pretty safe predictions because I’m convinced the farmers that don’t become computer literate and don’t learn to be better marketers won’t be around to be counted.

Another equally safe prediction, based on existing trends, is that the range of marketing options available to farmers will continue to increase – new types of contracts, new methods of trading, new linkages with those who supply farmers’ inputs and those who buy their outputs. The real challenge for farmers will be to find a path through the blizzard of information and to home in on the right marketing plan for their particular situation.

The challenge for the grain industry is the other side of that coin. You must take a leading role in making meaningful marketing information accessible to farmers. It is vital that the right information, describing the right marketing program for any given operation, gets into the hands of the farmer who needs it. I hope the industry is up to that challenge.

Thank you for your kind attention. I will be happy to take any questions you might have.

Remarks of Commissioner David D. Spears before the Financial Services Convergence Institute

October 19, 2001

It is an honor to participate in this distinguished panel. At the outset, I would note that the conference brochure describes this panel as discussing regulatory harmony vs. disharmony. Let me assure all of you that achieving international regulatory harmony remains a top priority of the CFTC.

My fellow panelists have outlined some of the conflicting tensions pushing and pulling on business and regulators alike as the global derivatives business continues to evolve. I will try to give you a brief overview of how the CFTC has responded to the changes we have already seen and what the future might hold from a regulatory perspective.

Derivatives markets, once dominated by the U.S., have become increasingly global in scope. Where once there were a mere handful of offshore exchanges, today 45 markets outside the U.S. report volume figures to the Futures Industry Association. Globalization represents more competition for U.S. markets, but it means new business opportunities as well. For example, our most recent monthly data [September 17 – October 12] shows that, of the large traders required to file reports with the CFTC, 23% of those trading agricultural products, 25% of those trading industrial goods and metals, and 38% of those trading financial instruments were foreign-based.

At the same time, markets are becoming increasingly electronic. Internationally, electronic trading has become the model of choice, with exchanges in London, Paris, Sydney and Hong Kong abandoning pit trading in favor of computerized systems over the last few years. The U.S. is almost the last bastion of open outcry. But even here, the Commission has designated 6 new electronic exchanges in the last few years, with 9 more applications in the works. Electronic trading is also making inroads in our established markets. During January through September of this year, 31.5% of the volume in CBT Treasury Futures was traded electronically, with September volume rising to 38.6%, representing average daily volume of almost 247,000 electronic trades.

Global electronic trading creates new challenges for customers. A transaction theoretically could involve a trader located in one country, using an intermediary located in a second country, with back office services based in a third country, on an exchange housed in a fourth, using a clearing system located in a fifth. Internet-based markets, currently in their infancy, can offer even more opportunities, giving customers direct access to trade matching systems without utilizing the services of an intermediary. But without an identifiable broker to turn to, a customer may not know where to turn with a problem or question about a trade. The customer may have no way to check on the fitness or even the identity of the professionals on the other side of the screen, no way to verify the accuracy or usefulness of the wealth of information available over the Internet. If a customer decides to resort to a regulator, he or she may not know which one to call.

Global electronic trading creates equally profound challenges for the regulator. First and foremost, we want to maintain a regulatory system that is flexible and responsive. We want to give innovative business ventures and trading systems the freedom to develop and grow without strangling in a net of outdated, inconsistent prescriptive rules. At the same time, we must retain the authority to protect customers from cross-border fraud and manipulation and to protect the financial system from abnormal price impacts due to market events. In the wake of September 11th, we also need to be more vigilant against those who would use derivatives markets to launder illicit funds, transfer monies to fund terrorist activities, or even to profit from the results of their own evil acts. Likewise, we must also be on guard against cyber-terrorists who might launch an electronic attack on the world financial system.

Responding to such challenges demands coordination and cooperation among regulators and self-regulatory authorities, including the exchanges themselves. The CFTC has a long history of promoting international cooperation. We have cooperative enforcement arrangements with 19 foreign jurisdictions and numerous special purpose arrangements for financial oversight, warehouse information and technical assistance. We have also been a moving force behind various multilateral agreements, such as the 1995 Windsor Declaration, the 1996 Boca Raton Declaration, and the 1997 Tokyo Communiqué that have enhanced international supervisory cooperation and emergency procedures. With respect to the Windsor Declaration, I would like to acknowledge the efforts of my fellow panelist, former CFTC Chairman, Mary Shapiro, who was one of the driving forces behind that international response to the Barings situation.

The CFTC has also been very active in IOSCO, the International Organization of Securities Commissions. IOSCO’s overall mission is to foster international regulatory cooperation and various IOSCO task forces and working groups are tackling the regulatory challenges that I have mentioned. For example, in 1998 the organization adopted a set of 30 objectives and principles for international securities and derivatives regulation, including principles for regulators and self-regulators, principles for enforcement and regulatory cooperation, as well as principles for collective investment schemes, intermediaries and secondary markets. In October 2000, the Commission encouraged IOSCO to update its “Principles for the Oversight of Screen-Based Trading Systems for Derivative Products,” in order to promote greater transparency of market and regulatory rules and better coordination of regulatory responsibilities in cross-border transactions. In April of this year, the Commission joined with regulators from 35 countries in IOSCO’s second annual Internet Surf Day, targeting futures and securities fraud on the Internet. Participants identified more than 2,400 Internet websites for follow-up review, including 278 sites that involved cross-border activity.

One of the biggest benefits of regulatory cooperation is increased competition. Consistent regulatory schemes and open access to qualifying markets (for example, through “passporting”) encourages competition among markets. Competition, in turn, gives markets a strong incentive to provide services with the lowest cost and the highest degree of financial integrity in order to attract more customers. Thus, competition fosters market discipline that can decrease the need for direct regulation.

The Commodity Futures Modernization Act (CFMA), enacted last December, recognizes and encourages regulatory harmony. It removes many of the prescriptive rules that could make harmonization across borders more difficult and acknowledges that a U.S. regulator can rely on certain parts of a foreign regulatory regime if it meets relevant standards. Congressional action on the CFMA included a provision making clear that the Commission was to continue its participation in international organizations and its cooperation with foreign authorities. It also encouraged facilitating cross-border transactions through removing unnecessary legal and practical obstacles, developing international best practice standards, and enhancing international supervisory cooperation.

On September 11, the international regulatory system faced a test that no one could have anticipated or planned for. More than any agreement or declaration, the international response to the terrorist attacks and their aftermath provides dramatic evidence of the ongoing spirit of international regulatory cooperation. Regulators and exchanges worked together through formal and informal channels. When U.S. securities markets closed after the attack, other markets around the world suspended trading in derivatives based on U.S. securities and devised special pricing and redemption arrangements for mutual funds with dominant exposure to U.S. markets. Regulators that didn’t have sufficient authority went to their legislatures for special orders authorizing the necessary actions, with some imposing ad hoc short selling restrictions.

During the post-attack confusion, IOSCO let the Commission use its website so we could post contact numbers to let people find out the status of U.S. firms. Then, as U.S. markets began reopening, the IOSCO Technical Committee held a multi-jurisdiction conference call to smooth the way by sharing information about market conditions. Just last week, that Committee established a special multi-national project to look at reinforcing our contingency planning, account identification and cooperative procedures. COSRA, the Council of Securities Regulators of the Americas, recently adopted a resolution to implement a similar effort. Perhaps most remarkably, our regulatory contacts around the world reported that traders by and large acted responsibly and did not seek to take financial advantage of the disaster.

In conclusion, looking ahead, I see increasing cooperation and coordination among regulators, exchanges and market users alike to address common concerns in our global marketplace. I believe the formal structure of IOSCO, as well as various bilateral and multilateral agreements, combined with the remarkable spirit of fellowship we saw in the wake of September 11, point the way to a bright future for international regulatory harmony.

Remarks of Commissioner Thomas J. Erickson before the FIA Law and Compliance Section, FIA Monthly Meeting in New York, New York

July 28, 1999

Thank you for that kind introduction. I was delighted when Barbara Wierzynski invited me to speak before the FIA's Law and Compliance section. It is important for representatives of the CFTC, whether they are Commissioners or staff, to work closely with those practitioners who counsel both individuals and institutions on the requirements of the Commodity Exchange Act and Commission regulations. As a Commissioner, I am pleased--even relieved--to know that dialogue takes place. The Commission and the markets we regulate benefit from that communication.

I see a number of familiar faces but, for those of you who I have not yet had the pleasure of meeting, let me introduce myself. I am a native of Sioux Falls, South Dakota; I received my undergraduate degree in Government and International Affairs from Augustana College and my Juris Doctor from the University of South Dakota School of Law. After graduating from law school, I worked for Senator Tom Daschle for three years. Thereafter, I joined the National Grain Trade Council, a national trade association that represents futures exchanges and futures market participants. As assistant to the president and legal counsel, I quickly learned the critical importance of futures, options and other derivatives in the U.S. and global economies. Over the last two years, I served as the director of the CFTC's Office of Legislative and Intergovernmental Affairs, where I was involved in a wide array of legislative and regulatory issues. I was confirmed by the U.S. Senate and sworn in as Commissioner late last month.

As many former Commissioners have said, the CFTC is a small agency with a very important mission. The Commission plays an important role in federal oversight of the financial markets and, as such, I do not take the public's trust lightly. The Commission's statutory mission is to protect market users and the public from fraud, manipulation and abusive trade practices and to foster open, competitive and financially sound futures and option markets. I have pledged to work closely with the other CFTC Commissioners, with members of our industry and with other interested members of the public in fashioning regulatory responses that are timely, responsive to the market and mindful of the public interest.

Over the past decade, derivatives markets have been invigorated by innovation. These changes have pushed new competitive issues and public policy concerns to the forefront of the regulatory landscape. Much of my professional career has been spent at the intersection of these market changes and policy considerations. In addition to gaining an understanding of issues related to the CFTC’s regulatory oversight, I also analyzed tax considerations, accounting standards, and bankruptcy concerns for derivatives transactions and firms that participate in those markets. Perhaps the issue that was most influential in shaping my perspective on derivatives markets was the tax issue commonly known as Arkansas Best. During my tenure at the National Grain Trade Council, I had the privilege of coordinating the efforts of a broad-based coalition that included approximately 100 organizations, corporations and firms representing agricultural, energy, transportation, manufacturing and financial interests. This coalition was instrumental in restoring the tradition of ordinary tax treatment for the gains and losses stemming from most hedging transactions. I understand that the tax bills pending in the House and Senate include provisions that would address most of the remaining issues, and the House Bill would allow the more favorable "ordinary" tax treatment to apply to transactions that manage risk, not only to those that reduce risk.

Over the years--both before and after Arkansas Best--I have worked within the reality that markets are the place where different economic interests intersect and compete. In fact, each person here today probably represents an economic interest that differs--however imperceptibly--from the economic interest of each other person in this room. Federal regulators must not only balance discrete private interests but must advance a public interest in open, competitive and sound markets. Regulators also cannot outpace the market and instead must have the opportunity for direct communication with market participants and the multiplicity of economic interests that comprise the markets in order to respond to changing markets.

Perhaps the most uttered phrase in the futures industry over the past year--perhaps the last decade--has been "legal certainty." Of course, I never could quite figure out how the bar could in good conscience lobby for legal certainty without first disclosing to the client the obvious conflict of interest. After all, legal certainty would most certainly kill the careers of a lot of up-and-coming lawyers, but I leave that assessment to you. Nonetheless, the phrase legal certainty has been repeated in a mantra-like manner when discussing many issues affecting the derivatives market, including swaps and Treasury Amendment instruments. Various fixes have been proposed: more regulation, less regulation, statutory fixes, new regulators, fewer regulators, consolidated regulators and many more with which I am sure you are familiar. I look forward to continuing the dialogue on these issues and am confident that we can achieve a resolution that will retain the integrity of what I believe to be one derivatives market. I hope that our dialogue will include consideration of the potential for regulatory arbitrage and increased risk of fraud, especially at the retail level, if the derivatives market is bifurcated. Flexibility in approach will be key to providing the industry with the certainty it deserves.

The over-the-counter derivatives market is the focus of a study currently being drafted by the President's Working Group on Financial Markets, of which the Commission's Chairman is a member. The recommendations of the Working Group will be forwarded to Congress and will be a basis for discussion of the proper regulation of OTC derivatives. The study is a work in progress. Commission staff continues to analyze and draft portions of the study with the other members of the Working Group, including the Federal Reserve, the Treasury Department and the Securities and Exchange Commission. I am hopeful that with the genuine goodwill of all members of the Working Group productive recommendations on these issues will emerge.

Any resolution of the OTC derivatives debate must achieve legal certainty. For me, this means clearly defining the OTC derivatives market, stating the degree of regulation--if any--to be imposed on the various parts of that market, delineating the jurisdiction of the CFTC and other regulators over the market, and clarifying the role of the various federal financial regulators in promulgating and/or enforcing any regulatory regime in the OTC market. To do otherwise would be counterproductive and unfair to both the industry and end-users.

Before closing, I would like to spend a few moments on another issue of great interest to me: electronic trading. Such trading is one of the most significant issues that will face the Commission, other federal financial regulators and the Congress. Financial and legal scholars continue to expand our discourse on electronic financial markets and their effect on regulation. Technology will only continue to test our regulations and push regulators to address the challenges of overseeing electronic financial markets. To the credit of Congress, the Commodity Exchange Act is flexible enough to allow the Commission to respond to changes like these and to provide a regulatory framework that recognizes the different regulatory interests presented by these new financial markets. I am very interested in grappling with the novel issues presented by electronic trading and hope the Commission will continue to craft a useful, common-sense regulatory framework that responds to today’s technological innovations.

These are very exciting and challenging times at the Commission and in the industry. With your help, I will be better positioned to work with my colleagues at the Commission to respond to issues important to the industry today. Without your input, I fear the Commission could end up doing its level best in addressing yesterday's problems--not much help to an ever-changing industry. I know that I have not touched on the entire range of issues that may be of interest to you, such as the placement of foreign terminals in the United States and regulatory reform for the domestic exchange markets, but I would be happy to respond to questions on these or any other issues. Thank you once again for inviting me to be with you today.

Testimony of Commissioner Thomas J. Erickson before the United States House of Representatives Committee on Agriculture Subcommittee on Risk Management and Specialty Crops

August 5, 1999

Chairman Ewing, Ranking Member Condit and Members of the Subcommittee, I am pleased to appear before the Subcommittee on Risk Management, Research and Specialty Crops to discuss the Commodity Futures Trading Commission's (the "Commission") ability to address the competitive concerns of domestic futures exchanges. As you know, this is my first opportunity to testify before this Subcommittee as a Commissioner and I look forward to discussing this most important issue. My remarks this afternoon amplify a few of the points in the Commission's testimony summarized by Acting Chairman Spears. Before I do so, however, I first would like to spend a few moments discussing the Commission's legal authority.

The Futures Trading Practices Act of 1992 authorizes the Commission to exempt any agreement, contract or transaction, or class thereof, from the exchange-trading requirement of Section 4(a) or any other requirement of the Commodity Exchange Act (the "Act"), except Section 2(a)(1)(B). The Commission may exercise this broad exemptive authority by rule, regulation, or order. In enacting Section 4(c), Congress directed the Commission to make certain determinations in granting exemptions. For example, the Act requires that an exemption be consistent with the public interest, which the Conference Report deems to include "the prevention of fraud and the preservation of the financial integrity of markets, as well as the promotion of responsible economic or financial innovation and fair competition." Moreover, the Commission must determine that any exemption "will not have a material adverse affect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory duties under [the] Act." Again, according to the Conference Report, Congress intended that the Commission "look at the potential impact of the new product on such regulatory concerns as market surveillance, financial integrity of participants, protection of customers, and trade practice enforcement." Congress directed the Commission to use this authority "sparingly" and stated that it did not intend "to prompt a wide-scale deregulation of markets falling within the ambit of the Act."

The fact that the Commission must make these determinations is not an impediment to the Commission's ability to consider the issues raised in petitions for exemption. The Act is enormously flexible and allows the Commission to view the markets as a whole and to delineate lines of regulatory interest. In fact, I am certain that there are aspects of the Commission's existing regulatory framework which, after careful analysis and consideration of changes in the market, may prove to be unnecessary. In order to conduct such a review, I believe the Commission must have the benefit of public comment on any petition received under Section 4(c) of the Act. This process is essential for the Commission to make the determinations necessary to exempt markets or transactions from provisions of the Act.

As discussed more fully in the Commission's statement, the Chicago Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange on June 25, 1999, submitted to the Commission a petition requesting broad relief from Commission regulation. Parenthetically, I might note that I received the petition having had only four days to warm my chair at the Commission. As a result, most process decisions with respect to foreign terminals and regulatory relief were already in place. I was pleased, however, that I arrived in time to participate in the Commission's action to propose a two-year pilot program allowing predesignation of new contracts. Just last week, I met with exchange officials in Chicago. My message to them was, and is today, that there must be direct dialogue between exchanges and the Commission on issues facing the exchange markets. Absent that dialogue, I fear the Commission could end up doing its level best in addressing yesterday's problems – not much help to an ever-changing industry.

In my view, there is no question that the Commission can and should consider the issues presented in the exchanges’ petition. To do so thoroughly, however, I believe the Commission must have the benefit of public comment and must encourage continued dialogue by Commission staff and the domestic futures exchanges. Therefore, I fully support publication of the specific and general requests included in the petition submitted by the exchanges.

The Subcommittee also has asked for comment on the introduction of foreign trading terminals in the United States. As I told members of the Senate Agriculture Committee during my nomination hearing on May 5, 1999, the Commission, the regulated industry, and the public interest are better served by rules that are clear, that are not unnecessarily burdensome, that apply equally to all petitioners and that provide legal certainty to transactions. The more we use the no-action process to resolve questions concerning new trading systems and instruments, the more we contribute to legal uncertainty. The no-action process has its place, but in significant areas such as foreign terminals, reasonable, workable rules would prove to be a far-better long-term solution. I am hopeful that the no-action process will be an interim step toward providing legal certainty through the Commission’s promulgation of rules.

I thank you for the opportunity to testify before you on this most important issue, and I look forward to responding to any questions you may have for me.