[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
THE COMMODITY FUTURES MODERNIZATION ACT OF 2000
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCE AND HAZARDOUS MATERIALS
of the
COMMITTEE ON COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
on
H.R. 454
__________
JULY 12, 2000
__________
Serial No. 106-123
__________
Printed for the use of the Committee on Commerce
U.S. GOVERNMENT PRINTING OFFICE
65907CC WASHINGTON : 2000
COMMITTEE ON COMMERCE
TOM BLILEY, Virginia, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana JOHN D. DINGELL, Michigan
MICHAEL G. OXLEY, Ohio HENRY A. WAXMAN, California
MICHAEL BILIRAKIS, Florida EDWARD J. MARKEY, Massachusetts
JOE BARTON, Texas RALPH M. HALL, Texas
FRED UPTON, Michigan RICK BOUCHER, Virginia
CLIFF STEARNS, Florida EDOLPHUS TOWNS, New York
PAUL E. GILLMOR, Ohio FRANK PALLONE, Jr., New Jersey
Vice Chairman SHERROD BROWN, Ohio
JAMES C. GREENWOOD, Pennsylvania BART GORDON, Tennessee
CHRISTOPHER COX, California PETER DEUTSCH, Florida
NATHAN DEAL, Georgia BOBBY L. RUSH, Illinois
STEVE LARGENT, Oklahoma ANNA G. ESHOO, California
RICHARD BURR, North Carolina RON KLINK, Pennsylvania
BRIAN P. BILBRAY, California BART STUPAK, Michigan
ED WHITFIELD, Kentucky ELIOT L. ENGEL, New York
GREG GANSKE, Iowa TOM SAWYER, Ohio
CHARLIE NORWOOD, Georgia ALBERT R. WYNN, Maryland
TOM A. COBURN, Oklahoma GENE GREEN, Texas
RICK LAZIO, New York KAREN McCARTHY, Missouri
BARBARA CUBIN, Wyoming TED STRICKLAND, Ohio
JAMES E. ROGAN, California DIANA DeGETTE, Colorado
JOHN SHIMKUS, Illinois THOMAS M. BARRETT, Wisconsin
HEATHER WILSON, New Mexico BILL LUTHER, Minnesota
JOHN B. SHADEGG, Arizona LOIS CAPPS, California
CHARLES W. ``CHIP'' PICKERING,
Mississippi
VITO FOSSELLA, New York
ROY BLUNT, Missouri
ED BRYANT, Tennessee
ROBERT L. EHRLICH, Jr., Maryland
James E. Derderian, Chief of Staff
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Finance and Hazardous Materials
MICHAEL G. OXLEY, Ohio, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana EDOLPHUS TOWNS, New York
Vice Chairman PETER DEUTSCH, Florida
PAUL E. GILLMOR, Ohio BART STUPAK, Michigan
JAMES C. GREENWOOD, Pennsylvania ELIOT L. ENGEL, New York
CHRISTOPHER COX, California DIANA DeGETTE, Colorado
STEVE LARGENT, Oklahoma THOMAS M. BARRETT, Wisconsin
BRIAN P. BILBRAY, California BILL LUTHER, Minnesota
GREG GANSKE, Iowa LOIS CAPPS, California
RICK LAZIO, New York EDWARD J. MARKEY, Massachusetts
JOHN SHIMKUS, Illinois RALPH M. HALL, Texas
HEATHER WILSON, New Mexico FRANK PALLONE, Jr., New Jersey
JOHN B. SHADEGG, Arizona BOBBY L. RUSH, Illinois
VITO FOSSELLA, New York JOHN D. DINGELL, Michigan,
ROY BLUNT, Missouri (Ex Officio)
ROBERT L. EHRLICH, Jr., Maryland
TOM BLILEY, Virginia,
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Levitt, Hon. Arthur, Chairman, Securities and Exchange
Commission................................................. 21
Parkinson, Patrick M., Associate Director, Division of
Research and Statistics, Board of Governors, Federal
Reserve System............................................. 43
Paul, C. Robert, General Counsel, Commodity Futures Trading
Commission................................................. 39
Sachs, Lewis A., Assistant Secretary for Financial Markets,
Department of the Treasury................................. 47
Material submitted for the record by:
Bond Market Association, prepared statement of............... 61
Chicago Board of Trade, prepared statement of................ 56
Gordon, Scott, Chairman, Board of Directors, Chicago
Mercantile Exchange, prepared statement of................. 58
Parkinson, Patrick M., Associate Director, Division of
Research and Statistics, Board of Governors, Federal
Reserve System, letter dated July 19, 2000, to Hon. Tom
Bliley, enclosing response for the record.................. 64
Sachs, Lewis A., Assistant Secretary for Financial Markets,
Department of the Treasury, letter dated August 8, 2000, to
Hon. Thomas J. Bliley, enclosing response for the record... 66
Skolnik, Barry W., President, North American Securities
Administrators Association, letter dated July 12, 2000,
providing comments for the record.......................... 60
(iii)
THE COMMODITY FUTURES MODERNIZATION ACT OF 2000
----------
WEDNESDAY, JULY 12, 2000
House of Representatives,
Committee on Commerce,
Subcommittee on Finance and Hazardous Materials,
Washington, DC.
The subcommittee met, pursuant to notice, at 10 a.m., in
room 2123, Rayburn House Office Building, Hon. Michael G. Oxley
(chairman) presiding.
Members present: Representatives Oxley, Cox, Largent,
Ganske, Shimkus, Wilson, Fossella, Ehrlich, Bliley (ex
officio), Towns, Stupak, Barrett, Luther, Markey, Rush, and
Dingell (ex officio).
Also present: Representative Ewing.
Staff present: David Cavicke, majority counsel; Brian
McCullough, majority professional staff; Shannon Vildostigui,
majority professional Staff; Robert Simison, legislative clerk;
and Consuela Washington, minority counsel.
Mr. Oxley. The subcommittee will come to order.
Before my opening statement, I would like to recognize the
gentleman from Illinois, Mr. Ewing, a refugee from the
Agriculture Committee, who has been kind enough to sit in on
our hearing since this is the legislation that he authored in
the Agriculture Committee and he Chairs the subcommittee of
jurisdiction there. Tom, welcome.
This subcommittee has dealt with many complex financial
issues over the years with a great deal of success. Last fall
financial modernization was enacted into law after years of
attempts to bring meaning to an evolving financial services
marketplace. Orders and rules were established for the blurring
lines between insurance, securities and banking. Our financial
markets are not the best in the world because they stand still.
Instead constant developments and new products derived from
competition emerge to fill the needs of customers.
Our financial markets have long since passed a time when
their role was limited to the purchase and sale of securities
and futures for investment purposes. Increasing need to
minimize exposure to fluctuating interest rates and uncertain
financial markets provided the impetus for valuable risk
management tools such as financial futures and other financial
derivatives. This evolution has led to futures on broad stock
indices, and more recently narrow baskets of stocks.
As with the financial services legislation, new products
that begin to look alike can cause regulatory and legal
confusion. H.R. 4541, the Commodity Futures Modernization Act
of 2000, contains several provisions that seek to eliminate
confusion and create a defined regulatory structure. Most
people are unaware of how important the derivative market is
for our economy. The amounts involved are staggering, with
trillions of dollars of contracts trading annually. These are
valuable products that should not be jeopardized with legal
uncertainty. Because they rely on a regulatory exemption from
the Commodity Exchange Act, they are subject to changes or
interpretations by future regulators. If we are agreed that the
policy of allowing this flourishing market to continue without
being subject to the CEA, then we need to codify it in
legislation and eliminate that uncertainty. H.R. 4541 addresses
this problem in a fashion similar to the recommendations
outlined in the President's Working Group report.
I am interested to hear the comments of our witnesses about
these provisions and further discussion regarding the legal
uncertainty. Equally important is the repeal of the Shad-
Johnson Accord, which prohibits single-stock futures. Until now
these products were banned because an agreement on the
regulatory regime between the SEC and CFTC was never reached
since the ban was implemented in 1982. The President's Working
Group on Financial Markets agreed last fall that the
prohibition could be repealed if certain regulatory issues and
the concerns about the integrity of the underlying equity
markets were addressed properly. I know disagreements remain
between the agencies on this provision as reported, but failure
to reach agreement now between the SEC and the CFTC is simply
not an option. We have waited 18 years for the temporary ban to
be lifted on a potentially useful financial product. If we wait
any longer, the activity will move offshore, and I am confident
agreement can be reached.
Requests were made of the SEC and the CFTC to work together
to find a compromise solution. I would request that each of
these agencies provide this subcommittee in writing with the
status of the negotiations to detail the specifics of what has
been agreed to and what remains unresolved. I look forward to
the comments of our witnesses and any suggestions they have for
their suggestions on improvements to the legislation. We have a
distinguished group of witnesses today and we look forward to
hearing from them.
It is now my pleasure to recognize the gentleman from New
York, Mr. Towns, the ranking member.
Mr. Towns. Thank you, Mr. Chairman. I also thank you very
much for holding this hearing on this very important bill.
It is unfortunate that the committee has been given such a
short time to deal with this bill because it raises issues that
go to the heart of this committee's jurisdiction. However, I
hope that we could work together to craft a good bill in the
short time given to us. As it has been described, the bill
coming over to our committee from the Agriculture Committee has
three titles. Title I deals with the legal certainty for the
over-the-counter derivative transactions. Title II provides
regulatory relief to the U.S. Futures exchanges. Title III
attempts to address Shad-Johnson and the trading of single-
stock futures.
I would like to focus my remarks on title I and III of the
bill. Title I of the bill is critically important to U.S.
investment in commercial banks and U.S. companies that use OTC
derivatives to manage risk. This title establishes the
necessary legal certainty for these OTC derivatives
transactions. Specifically, the title insures that no court or
regulator can make a determination that could invalidate
billions of dollars of legitimate derivative contracts. This
uncertainty is a cloud hanging over numerous types of
transactions, such as OTC transactions, government securities
and other financial instruments. U.S. financial markets should
not be forced to tolerate the risk of such legal uncertainty.
Mr. Chairman, this is extremely important. However, let me
add we have what I see as a unique opportunity before us. As I
understand it, the language coming out of the Agriculture
Committee addressing legal certainty is strongly supported by
the major financial trade associations, the major U.S.
investment and commercial banks, United States futures
exchanges, all four members of the President's Working Group. I
find this unanimity of agreement to be almost unprecedented. We
should seize this moment. Recognizing that no bill or title is
perfect, there are obvious issues that need to be resolved in
title III. However, with title I receiving this kind of broad
support, it appears evident that we need to act on this
legislation and at a minimum provide OTC derivative
transactions with the necessary legal certainty.
I do want to express my concerns about the portions of the
Commodity Futures Modernization Act of 2000 dealing with
single-stock futures. The bill would permit the trading of the
single-stock futures without the regulatory requirements
imposed on securities. Stock futures will act as a direct
surrogate for individual stocks and will be marketed to retail
investors across this country. The SEC is the expert regulator
charged with oversight of the securities markets. It is
critical that the SEC be able to administer the security
markets provisions it feels are necessary for stock futures.
The bill also would provide stock futures with regulatory
advantages over competing securities products such as stock and
stock options. Customers of single-stock futures would be
exempt from Federal transaction fees imposed on securities and
be subject to different margin levels than for stock options.
This is unfair and should be remedied, and we must find a way
to do that.
For these reasons I believe that the stock futures
provision of the Commodity Futures Modernization Act should be
modified to address the legitimate concerns of the SEC and
securities markets regarding the regulatory and competitive
disparities between futures and securities arising from single-
stock futures. If this cannot be accomplished, if this cannot
be accomplished, I repeat, within the short time remaining in
this congressional session, then the stock futures provision
should be removed from the bill so that Congress can act on the
important legal certainty provisions in the bill. I strongly
feel that under no circumstances should we delay a legal
certainty provision.
On that note, Mr. Chairman, I yield back the balance of my
time. I am anxious to hear the comments coming from our
witnesses.
Mr. Oxley. I thank the gentleman. The Chair now recognizes
the chairman of the full Commerce Committee, the gentleman from
Richmond, Mr. Bliley.
Chairman Bliley. Thank you, Mr. Chairman. Since 1982, when
the SEC and the CFTC could not agree on who was to regulate
single-stock futures, they agreed to ban the product. Although
the ban was never intended to be permanent, they have yet to
reach agreement on who should regulate them. Only in Washington
do we ban something when we can't figure out who regulates it.
Last November, to assist Congress on issues addressing the
commodities markets, the President's Working Group on Financial
Markets issued a report and it detailed changes that should be
made in order that regulation keep pace with the rapidly
evolving marketplace. Among the suggested changes was the
repeal of the ban on single-stock futures. The President's
Working Group agreed that the ban on single-stock futures could
be repealed provided issues of regulatory structure and
integrity of the underlying cash markets could be resolved.
On the basis of this report I, along with Chairman Larry
Combest and Chairman Tom Ewing, wrote to the SEC and the CFTC
asking them to resolve this dispute. The response from the two
agencies was troubling, as they were once again unable to reach
any substantial agreement. Although single-stock futures may
very well turn out to be much fuss about little, their
prohibition is based on little more than an old-fashioned turf
war. This is at odds with the principles of capitalism and
freedom. If the agencies cannot resolve this dispute, Congress
will have to do it for them.
The President's Working Group also stressed the importance
of providing greater legal certainty to over-the-counter
derivatives. Trillion dollar products are currently traded in
reliance on a CFTC exemption and a prayer that a court will not
find the contract to be a future. Systematic risk may exist so
long as these products trade without adequate legal certainty.
That is precisely why the President's Working Group strongly
urges certainty in this area. We need to make sure that those
investing in our markets have confidence that the products in
which they are trading are legally binding. Doing so will
continue the viability of the American market for these
products.
Mr. Chairman, under your leadership, this subcommittee has
worked hard to ensure our financial markets are the envy of the
world. This bill before us today reflects a good starting point
for this committee to continue its work of shaping a framework
which will allow our markets to grow with a certainty that our
investors have come to expect. We don't have a lot of time to
consider this important legislation, but we will do our best.
I yield back the balance of my time.
Mr. Oxley. The gentleman yields back. The Chair is now
pleased to recognize the gentleman from Michigan, the ranking
member of the full committee, Mr. Dingell.
Mr. Dingell. Mr. Chairman, I thank you for recognizing me
and I commend you for holding this important hearing, and I
warmly welcome our distinguished witnesses, especially our
friend, the Chairman of the SEC.
Mr. Chairman, I would begin by observing that this
committee has jurisdiction over the securities industry, and
the securities markets of this country. I note to you in the
exercise of that jurisdiction, we have had a remarkable success
going back to the original 1933 and 1934 acts, and that the
success of this has been to see to it that our markets are the
most trusted and respected in the world, which is why everybody
comes over here to invest in the American securities industry.
I would note, however, that the same successes have not
occurred with regard to the futures markets, which at different
times take on the appearances and some of the characteristics
of cesspools. The protections which one would observe for the
American securities markets are very clear. There are paper
trails, protections against fraud and, in addition to that,
strong prohibitions against insider trading. A market which has
been disciplined by this kind of oversight by the SEC and the
kind of oversight that was crafted by this committee in 1933
and 1934 has brought remarkable success and extraordinary
trust.
As I have observed, the securities market everybody thinks
runs on money. It does not. It runs on public trust, and if the
trust is there, people make lots of money and that is people
inside and outside of the market.
I would like now to be blunt. This committee has
jurisdiction of the securities industry. And while the
Agriculture Committee may have jurisdiction over the futures
market, I should say that they should exercise that with more
diligence than they have done so in the past. I intend to see
that this committee exercises its jurisdiction over the
securities market to protect the American investors and to see
to it that the integrity of that market system is carried
forward and protected.
I would ask to be forgiven for being blunt. This bill is a
real turkey, and most of you know that I am a turkey hunter. If
the bill's many defects are not fixed in this committee, I will
do everything within my power to put this legislation out of
its misery at the earliest opportunity.
First, I support the effort to provide legal certainty for
the OTC derivatives. The Commerce Committee played an
instrumental role in crafting and passing the swaps exemption
in the 1992 Futures Trading Practices Act. I would like to be
in a position to support the legal certainty provisions of H.R.
4541. However, the bill before us contains defective provisions
on the regulation of clearinghouses that must be fixed to
assure appropriate regulation of the risks that may be
concentrated there. I am also concerned that the bill's
definition of eligible contract participants includes retail
investors who have no business in these unregulated
institutional markets.
I have other questions and concerns about this part of the
bill, but these are the principal ones.
Second, my general disdain for the quality of futures
regulation in this country has not improved after reading this
bill. As I understand it, H.R. 4541 transforms the CFTC from a
``front line regulatory agency'' into an ``oversight
regulator'' of what the bill calls ``acceptable business
practices under core principles'' that will be applicable to
registered futures markets. I am still waiting to see something
that would fill that definition. If the CFTC believes that a
registered entity is violating these yet to be determined core
principles, it must first notify the entity in writing, then
recommend an appropriate remedial action to remove the
deficiency, but only after first conducting a cost-benefit
analysis of the remedial action; and finally, the burden of
proof is shifted to the CFTC, which must demonstrate the
violation by a preponderance of the evidence.
Now it would go to several things. First of all, when
events happen in the futures market, they happen very fast
because it is a very volatile market, and the ability to
respond to a major scam or serious misbehavior under these
circumstances is virtually nonexistent. Certainly it is not
possible under any expectation that it might occur in a timely
fashion. I am sure that every crook and swindler in the country
is hoping that these outrageous provisions stay in the bill. I
support reasonable regulatory relief for the futures exchanges,
but H.R. 4541 is clearly contrary to the public interest.
Third, and I have saved the best for last, I see absolutely
no redeeming value whatsoever in the provisions of this bill
that would lift the ban against single-stock futures and create
a defective regulatory structure for these retail products
under the Commodity Exchange Act and the CFTC, the same CFTC
that this bill reduces to a defanged oversight regulator of
core principles.
This part of the bill, section 8, futures on securities,
poses a serious threat to the integrity of the country's
capital markets and undercuts over 6 decades of unparalleled
investor protection and investor confidence and makes a joke of
fair competition between the markets. These provisions are
opposed by anybody who knows anything about securities. The
Securities and Exchange Commission, the American Stock
Exchange, the Boston Stock Exchange, the Chicago Board Options
Exchange, the Chicago Stock Exchange, the Cincinnati Stock
Exchange, the Nasdaq Stock Market, the New York Stock Exchange,
the Pacific Stock Exchange, the Philadelphia Stock Exchange,
the Depository Trust and Clearing Corporation, and the Options
Clearing Corporation, among others.
Mr. Chairman, I ask unanimous consent to include in the
record a May 22, 2000 Business Week article entitled ``The Case
Against Single-stock Futures'' as well as copies of the June
27, 2000 letter of the New York Stock Exchange and the July 11,
2000 memorandum of the United States Securities Markets
Coalition setting forth these entities' detailed concerns with
this bill.
Mr. Oxley. Without objection, so ordered.
[The article follows:]
[Business Week--May 22, 2000]
The Case Against Single-Stock Futures
Commentary By Joseph Weber
As if trading stocks wasn't wild enough these days, the folks at
the Chicago Mercantile Exchange and the Chicago Board of Trade want to
give investors a chance to take a real roller-coaster ride. Exchange
officials are teaming up with friendly legislators in Congress to
revive an idea that some regulators in Washington thought they had
buried 18 years ago--futures contracts on individual stocks. ``We have
all the necessary safeguards in 131ace to be able to trade single-stock
futures, and we see no reason why we shouldn't be able to,'' argues
Scott Gordon, chairman of the board of the Chicago Merc. ``The public
interest would be served.''
And that may be so. But in fact, a strong argument can be made that
single-stock futures are a financial vehicle whose time has most
definitely not come. While they surely would be useful to institutional
investors and a handful of speculators, they pose a risk to small
investors--and may even encourage stock manipulation.
To be sure, futures contracts have an honored place in the panoply
of financial instruments. They can be found for everything from
Treasury bonds to pork bellies. They are widely used as hedges against
adverse price moves and are also popular speculations. In theory, both
speculators and hedgers could make good use of single-stock futures. By
selling futures contracts, money managers could hedge their portfolios
against stock drops. By buying them, they could bet on stock-price
rises when they don't want to--or can't--commit immediately to the
purchase of certain stocks.
True, you can do this already with options. But a futures contract
would be cheaper than an option because it wouldn't include a premium,
as an option does. ``We want the widest possible array of choices,''
says William P. Miller II, a Chicago Mercantile Exchange director who
chairs the End Users of Derivatives Council for the 12,000-member
Association for Financial Professionals.
But that cheapness comes at a cost. For one thing, the futures
market is a veritable lion's den of risk, particularly for small
investors, who can put up just modest amounts of money and either win
or, more often, lose big. If investors bet wrong with options, their
loss is capped at the premium they paid to buy them; with futures, the
potential loss is open-ended. To play the futures market, an investor
need put up as little as 5% of the value of a common futures contract--
vs. the 50% margin required for stocks. What's more, futures players
don't have the same regulatory protections that investors in the stock
market take for granted, such as comparable insider-trading rules.
There is no prohibition of insider trading in the Commodity Exchange
Act.
And fears abound that the high leverage connected with futures
could tempt would-be stock manipulators. An April report on single-
stock futures by the General Accounting Office warns that ``even a
small price movement in the underlying stock could encourage attempts
to manipulate stock prices.'' Ordinarily, futures contracts are far
more volatile than the spot prices of the underlying securities. Thus,
a scamster could make large sums of money in futures by engineering
even small moves in the underlying stock. What's more, there's a
potential feedback loop: If they became popular, the futures ``could
spawn great volatility in stocks,'' warns Bruce I. Jacobs, a portfolio
manager at Jacobs Levy Equity Management who has written a book about
derivatives and stock market crashes.
Because such issues have never been resolved, futures on single
stocks have been in limbo for nearly two decades. In 1981, the
Securities & Exchange Commission and the Commodity Futures Trading
Commission promised to study all the issues surrounding the idea.
Meanwhile, they imposed a ``temporary'' ban. Now, the idea has reared
its head again.
And it has a real chance at success because of domestic and foreign
competitive concerns, such as the emergence of single-stock futures
abroad and similar investment devices in the U.S., as well as the
growth of electronic-trading technology, and a good old-fashioned wish
to end regulation. ``We do have the stars aligned,'' says Senator Phil
Gramm (R-Tex.), chairman of the Senate Banking Committee, who held a
hearing on the Shad-Johnson Accord and markets regulation on May 8 in
Chicago. Gramm and Senate Agriculture Committee Chairman Richard G.
Lugar (R-Ind.) plan to introduce a bill to legalize stork futures. They
may tie the move to reauthorization of the Commodity Exchange Act,
which empowers the CFTC, and which expires on Sept. 30.
Regulators have given the idea a mixed response. SEC Chairman
Arthur Levitt Jr. and CFTC Chairman William J. Rainer are still
haggling over just how the new products would be overseen. Rival
markets are hardly enthusiastic. And no wonder--futures could pose a
competitive threat. The head of the Mere's archrival in the Loop,
William J. Brodsky of the Chicago Board Options Exchange, says single-
stock futures must be treated the same as stocks--with the same
aggressive SEC oversight and stiffer margin requirements--or they
``would worsen the competitive inequities'' among exchanges. CFTC Chief
Rainer says the required margin would be somewhere between the 50%
minimum required for stocks and the 5% to 10% generally required for
commodity futures contracts.
Single-stock futures face an even more fundamental question: Is
Congress rushing to approve a product of limited appeal? The answer to
that may well be yes. Single-stock futures are already offered on about
nine European and Asian exchanges--and they've proved to be anything
but barnburners. They account for less than 1% of the total trading
volume of the foreign futures markets. ``The anecdotal evidence is that
the marketplace doesn't want these things,'' adds Robert E. Whaley, a
professor of finance at Duke University's J.B. Fuqua School of
Business. Similar products are already available in the U.S., but they,
too, command fairly small followings. On the over-the-counter market,
for instance, financial professionals can buy equity swaps. But these
account for only a fraction of the value of OTC derivatives trading,
says the GAO.
Certainly, single-stock futures contracts will be easier to
understand than these jury-rigged instruments. And that could raise a
problem: They would also be simpler to market to unsophisticated
investors, who usually wind up behind the eight ball when they trade
futures. ``The vast majority of small investors in futures trading--
commodity futures--ultimately come out losing money,'' warns John F.
Marshall, a professor of finance at St. John's University. It is, in
his view, ``a zero-sum game.''
Zero-sum or not, this new game has powerful friends on Capitol
Hill, and that alone means that single-stock futures may well be on the
horizon. If they do not turn out to be a flop, as they were overseas,
their potential for abuse could make them a risky innovation. Small
investors may pay the price for the Street's latest big idea.
______
New York Stock Exchange
June 27, 2000
The Honorable Tom Bliley
Chairman
Committee on Commerce
2125 Rayburn House Office Building
Washington, DC 20515
Dear Mr. Chairman: I am writing to share the views of the New York
Stock Exchange, Inc. (NYSE) on H.R. 4541, the Commodities Futures
Modernization Act of 2000. The NYSE is interested in two aspects of
this important legislation--repeal of the Shad-Johnson Accord and legal
certainty for equity swaps. While we commend Chairman Tom Ewing of the
Risk Management Subcommittee of the House Agriculture Committee for his
tireless efforts with regard to Commodity Futures Trading Commission
(CFTC) reauthorization, we are compelled to oppose H.R. 4541, as
reported by the Agriculture Committee.
Single Stock Futures
The NYSE agrees with the President's Working Group on Financial
Markets that the ``current prohibition on single stock futures can be
repealed if issues about the integrity of the underlying securities
markets and regulatory arbitrage are resolved.'' Over-the-Counter
Derivatives Markets and the Commodity Exchange Act, page 32
(1999)(emphasis added). Unfortunately, H.R. 4541 does not adequately
address the issues raised by the Working Group.
For the last six months, the Securities and Exchange Commission
(SEC) and the Commodity Futures Trading Commission (CFTC), the two
agencies with the expertise to address this complex issue, have been
working diligently to develop a joint regulatory framework applicable
to single stock futures. Much progress has been made. However,
difficult issues remain to be resolved.
It is vital that regulatory issues relating to the SEC's ability to
adequately enforce the insider trading and other anti-fraud laws, and
to protect retail investors be resolved properly in the first instance.
If the right balance is not struck, single stock futures entail a high
risk of great harm to retail investors and confidence in the U.S.
securities markets. The United States stock market is unique in the
world because of its enormous size and its high level of individual
investor protection. Today, more than 70 million Americans participate
in the stock market. Individuals and institutions are willing to invest
in the U.S. stock market because they believe in the integrity of the
market. Investor confidence is fragile. Once lost, it can be extremely
difficult to regain.
H.R. 4541's approach to single stock futures falls short in a
number of important areas. The SEC's authority to enforce securities
laws regarding insider trading, manipulation and fraud is too
circumscribed and would leave the SEC unable to fully protect retail
investors and market integrity.
Further, the SEC must have the authority to inspect the
surveillance programs of futures exchanges that trade single stock
futures because without direct access to audit trail, coordinated
market surveillance and inspection authority, the grant of enforcement
authority to the SEC is illusory. The SEC does not have the resources
to detect and deter insider trading and other violations of the
securities laws alone. It depends on the surveillance programs of self-
regulatory organizations (SROs), i.e., the securities markets, to
augment its efforts. The SEC regularly inspects the surveillance
programs of the SROs to ensure that they are adequate. The SEC must
have the same authority with regard to futures exchange surveillance
programs applicable to single stock futures.
H.R. 4541 also provides that the SEC can obtain information from
futures exchanges only with the permission of the CFTC. This
subordinate role for the SEC is unacceptable. To fully discharge its
responsibilities under H.R. 4541, the SEC must have the unfettered
ability to obtain the information that it needs.
H.R. 4541 requires that margin levels for single stock futures be
consistent with the margin on comparable options listed on a securities
exchange. Further work to harmonize margins needs to be done. In
determining whether margins are consistent, all rules governing margin,
including the penalties for violating margin rules, must be consistent.
H.R. 4541 would permit the Federal Reserve Board to delegate its margin
oversight authority to the CFTC alone. In the NYSE's view, the Fed
should delegate its margin authority, not to the CFTC, but to the
Intermarket Margin Board described in H.R. 4541. This Board would
consist of the Fed, SEC and CFTC. Otherwise, margins on single stock
futures, even if consistent at the outset, will not remain consistent
with margins on stock options over time.
H.R. 4541's recognition that a suitability rule must apply to
single stock futures is positive. However, the bill should mandate that
such a suitability rule should be at least as stringent as suitability
rules applicable to stock options. Also, the fact that suitability is a
continuing requirement over the life of an account needs to be
clarified.
Finally, the provisions of H.R. 4541 are anti-competitive. H.R.
4541 provides that single stock futures can only be traded on a futures
exchange. Securities exchanges should have the ability to trade this
product as well. H.R. 4541 also fails to extend the Section 31
transaction fee to single stock futures. This fee is applied to all
stock and stock options sales. Single stock futures will be direct
substitutes for these products. Competitive fairness requires that
single stock futures also be subject to this transaction fee.
Legal Certainty for Equity Swaps
The NYSE's interest in legal certainty for over-the-counter
derivatives is limited to equity swaps based on single stocks and
narrow-based indexes. The NYSE is concerned about the legal status of
these products because they are so closely linked to out own market.
The NYSE supports legal certainty for equity swaps. However, we
believe that exclusion from the CEA for equity swaps needs to be
coupled with Congressional recognition that this type of OTC derivative
is a security. Only by making it clear that equity swaps are subject,
at least, to certain investor protection provisions of the securities
laws can Congress and regulators assure that such products will not be
used to circumvent the insider trading, fraud and manipulation
prohibitions of those laws. It is also important that the proper
margin, capital and sales practice standards apply to these
instruments, and that they be integrated into the surveillance systems
currently applicable to equities and all other equity-based
derivatives. H.R. 4541 falls to clarify that equity swaps are
securities. Without this clarification, we are concerned that the
equity swap market may develop only for regulatory arbitrage, not to
meet the legitimate risk management needs of investors.
The President's Working Group recommended that an exclusion from
the CEA for OTC derivatives should only cover swaps between eligible
swaps participants. The Working Group agreed that consideration should
be given to restricting the extent to which individuals qualify for the
exclusion by not making it available to natural persons who own and
invest, on a discretionary basis, less than $25 million in investments.
H.R. 4541 defines eligible participant to include individuals with $10
million in total assets. This threshold would encompass a large number
of individual investors, and make it all the more pressing for Congress
to clarify that excluded equity swaps are securities. Without such
clarification, these individual investors would not have the benefit of
the customer protections that all other individual investors in
securities currently enjoy.
Thank you for considering the NYSE's concerns about H.R. 4541. We
look forward to working with you and the Committee to address these
issues.
Sincerely yours,
Richard A. Grasso
Chairman and Chief Executive Officer
cc: Congressman John Dingell
Congressman Mike Oxley
Congressman Ed Towns
______
MEMORANDUM
TO: David Cavicke, Consuela Washington
FROM: The U.S. Securities Markets Coalition
RE: H.R. 4541 and Stock Futures
DATE: July 11, 2000
This memo serves to provide comment from the U.S. Securities
Markets Coalition \1\ on H.R. 4541, particularly those aspects of the
bill that would permit the trading of stock futures.
---------------------------------------------------------------------------
\1\ The members of the U.S. Securities Markets Coalition are the
American Stock Exchange, the Boston Stock Exchange, the Chicago Board
Options Exchange, the Chicago Stock Exchange, the Cincinnati Stock
Exchange, The Depository Trust Clearing Corporation, the National
Association of Securities Dealers, the Pacific Exchange, the
Philadelphia Stock Exchange, and The Options Clearing Corporation.
---------------------------------------------------------------------------
Stock futures will act as surrogates for stocks and stock options.
They will trade on public marketplaces, be.marketed to retail
investors, become part of the price discovery process for stocks and
derivatives based on stocks, and, unfortunately, be used in schemes
perpetrated by stock manipulators and scamsters. We therefore find it
quite unsettling that H.R. 4541, for the most part, rejects the notion
of applying the securities laws framework to these products. Instead,
it applies the commodities laws to these products and charges the CFTC
to oversee them. The commodities laws are not designed to address
retail trading of a stock-based product. Moreover, the CFTC, whose role
in supervising the futures markets will be greatly reduced if H.R. 4541
were passed, has little experience in retail stock-based financial
product regulation. While the bill provides the SEC certain limited
authority to apply a handful of securities laws to stock futures, a
number of important statutory protections have been omitted. Moreover,
SEC authority would be limited to mere ``enforcement'' authority. It
would not, for example, have authority to conduct oversight
examinations of futures exchanges or exercise its rulemaking authority
to adopt standards that would deter fraud and manipulation.
As acknowledged by the President's Working Group, the issue of how
to regulate stock futures presents not only market integrity issues but
also important regulatory arbitrage issues. Some of these arbitrage
issues relate primarily to core investor protection concerns, such as
how to address insider trading issues. Other issues, arising from the
similarity between stock futures, stock, and stock options, relate
primarily to fair competition concerns. Most of the issues involve a
combination of both concerns.
We remain stalwart in our view that the most effective and fairest
approach is to treat stock futures as securities. It is the only way to
ensure that the panoply of securities laws protections apply to a
product that is security in all but technical name.\2\ It is also the
only way to ensure that the regulation of stock futures is consistent
with the regulation of stocks and stock options. As a next best
alternative, we believe some form of joint SEC/CFTC regulation of stock
futures could be possible, provided stock futures are treated as
securities but are exempted from securities regulations where
commodities regulation better serves the investing public. The approach
of the Ewing bill, to define stock futures as futures, then engraft
several securities laws provisions onto the futures regulatory scheme,
is the least favored approach, and the one that presents the greatest
erosion of investor and market protections. It is also the approach
that produces the greatest potential for competitive inequalities
between futures and securities. We have identified below certain
essential fixes to the most glaring deficiencies of the Ewing bill. Our
points follow:
---------------------------------------------------------------------------
\2\ Most of the attention in this controversy has been focused upon
the regulation of trading stock futures. Regulation of those that give
investment advice with respect to stock futures and the regulation of
managed pools of stock futures outside of the established securities
framework raise a host of additional investor protection and
competitive issues that have yet to be fully considered.
Stock futures, including those that settle in stock, should be
allowed to trade on securities exchanges. The Ewing bill
restricts the trading of stock futures to futures exchanges. S.
2697, by comparison, allows cash-settled stock futures to trade
both on futures exchanges and securities exchanges. The CFTC
did not object to the provisions of S. 2697 that would allow
stock futures to trade on securities exchanges. Allowing stock
futures to trade on securities exchanges can be accomplished by
defining stock futures as securities under the securities laws
and deleting the exclusive jurisdiction provisions of the CEA.
The exclusive jurisdiction provisions of the CEA are
anticompetitive. In addition to creating legal certainty
problems for swaps, these provisions have allowed the CFTC and
futures exchanges to block securities exchanges from offering a
number of securities derivatives products, including certain
securities hybrids and index participations. At the very least,
however, any compromise that allows stock futures to trade on
other than a securities exchange should allow this ``new''
product to trade both on securities and futures markets.
If stock futures are permitted to trade under the CEA, then
securities exchanges should be allowed to trade futures on all
financial instruments. The current bill represents the futures
exchanges' view of how stock futures should be allowed to
trade--subject to a monopoly on their markets. If Congress is
going to consider scrapping traditional jurisdictional
boundaries for financial products, fairness dictates that the
securities exchanges be provided with an adequate opportunity
to make the case for being able to trade financial futures.
This is also consistent with Congressman Ewing's stated view
that H.R. 4541 should reflect a comprehensive regulatory reform
package.
Margin treatment must be ``truly'' equal between securities
(particularly options) and futures markets. The Ewing bill,
notwithstanding its basic call for ``consistent'' margin levels
between stock futures and stock options, does not create a
mechanism that will ensure this result. The Ewing bill would
provide a tremendous amount of leeway and ambiguity in
determining stock futures margin levels. Its standards for
consistent treatment are too loose and would allow separate
regulators to arrive at significantly different margin levels.
For example, the CFTC would be able to decide stock futures
margin levels and the SEC would determine stock option margin
levels. How can equal treatment be assured where separate
regulators are applying an elastic standard? Even if the margin
board (Fed, SEC, and CFTC) were used as permitted, the Fed, in
turn, would be able to delegate the ultimate setting of margin
levels back to the CFTC and SEC, respectively. The bill also
does not contain a legislative mandate for the Fed to ensure
that the margin levels across securities and futures markets
are equal from a competitive perspective. Nor does the bill
address important margin issues apart from margin levels,
including who customer margin levels should apply to, permitted
margin offsets, and acceptable forms of collateral. For these
reasons, we believe either the SEC or the Fed should singly
determine margin policy for stock, stock options, and stock
futures. If an intermarket margin board is used, once the board
arrives at a margin policy it should be the responsibility of
the SEC to oversee and administer its implementation across all
markets.
Stock futures must be subject to a sales practice program that
is equivalent with that which applies to stock options. The
Ewing bill only requires the NFA to adopt a suitability rule
that is similar to the suitability rule currently applied to
exchange-listed options. Merely adopting such a rule does not
ensure that stock futures sales practices will be adequate,
much less comparable to the high standards established by the
securities markets. For example, as you know, the NASD
administers a comprehensive sales practice program that applies
to stocks and stock options. Also, related issues such as
disclosure (i.e, equivalent of an Options Disclosure) and
product advertising must be addressed. The SEC should be
provided broad rulemaking authority for sales practices across
all public markets for stock, stock options and stock futures
products.
The legislation must mandate a regulatory framework that will
ensure futures exchanges trading stock futures adequately
surveil their markets for market abuses and share such
information with other futures and securities exchanges. Given
that stock futures transactions will directly impact stock
pricing and likely be used as part of stock fraud and stock
manipulation strategies, the SEC should be given authority to
oversee the market surveillance programs of stock futures
markets. Related to this point, stock futures markets should be
required to maintain a real-time consolidated audit trail.
While an audit trail requirement is contained in S. 2697, it is
not made subject to SEC oversight and rulemaking. Congress
should define the basic principles of such an audit trail and
provide the SEC with authority to oversee its operation.
Full anti-fraud anti-manipulation authority of federal
securities laws should apply to stock futures. The Ewing bill
only extends to stock futures a small fraction of the anti-
fraud and anti-manipulation provisions contained under the
federal securities laws. In addition, it does not provide the
SEC with rulemaking and exchange oversight authority, which are
necessary to ensure that appropriate market conduct is
adequately defined and enforced.
Stock futures must be traded in an environment that permits
and fosters multiple trading and adherence to best execution of
customer orders. National Market System principles, including
the establishment of market linkages, the availability of
realtime quote and trade information, and assuring the
practicability of brokers being able to execute investors'
orders in the best market must apply to these instruments. The
SEC has significant experience in this area. On the other hand,
the CFTC has little or no experience in applying these
principles. Moreover, application of these principles should be
consistent with those applied to securities markets.
Accordingly, we believe the SEC should be vested with the
authority to apply NMS principles to stock futures, as it does
to stocks and stock options.
Some form of centralized or linked clearing should be mandated
for stock futures. This is necessary to promote competition in
stock futures across markets for stock futures. For example,
centralized clearing would help to ensure that positions opened
on one exchange could be closed on another exchange.
Tax treatment of stock futures must be made consistent with
that which applies to stock options. Unless the tax laws are
changed, customer transactions in stock futures (traded on
either a futures exchange or securities exchange) would be
subject to favorable ``60/40'' treatment. Essentially, this
means that customers of exchange-traded equity options would be
subject to a higher tax rate than customers of stock futures.
This violates a longstanding congressional policy of providing
equivalent tax treatment for competing products on the options
and futures exchanges. The disparity can be addressed either by
extending 60/40 tax treatment to equity options or denying 60/
40 tax treatment to stock futures. The implementation of any
stock futures legislation could also be made contingent on
achieving tax parity between stock options and stock futures.
Section 31 fees should apply to stock futures. Imposing this
fee on securities markets but not on futures markets would
provide an unfair competitive advantage to the futures
exchanges. In addition, given that the Ewing bill essentially
provides that the SEC shall police the stock futures markets
against insider trading and enforce the handful of several
other enumerated securities protections, it seems appropriate
that the futures markets help fund the SEC budget. Applying
Section 31 fees would be appropriate in this regard.
Unless equivalence of regulation between stock futures and
other securities products can be assured, the securities
exchanges would need certain regulatory relief in order to
remain competitive. For example, the exchanges would need to be
freed from procedural requirements, such as SRO rule filings,
that can cause significant delays and roadblocks to changing
business practices and creating new products. Essentially,
securities exchanges would be facing direct competitors
operating in a deregulated environment (especially when
compared to today's securities exchange markets). They would
need to be able act quickly to respond to changing market
conditions.
There are numerous provisions in the Ewing bill that can be
construed to expand CFTC jurisdiction over instruments that are
securities. For example, new Section 2(c)(2) on pages 18-19
gives the CFTC jurisdiction over options on a commodity (other
than foreign currency or a security) traded on an organized
exchange. The parenthetical does not include all securities
options, specifically options on a group or index of
securities. Second, the bill creates an entity under CFTC
jurisdiction called a derivatives transaction execution
facility (``DTEF'') which is a less-regulated version of a
board of trade. New Section 5a(e) would allow a DTEF to trade
contracts or transactions involving excluded commodities that
would otherwise be excluded from the CEA under H.R. 4541. These
excluded contracts or transactions would include many
securities, such as government securities options, stock
options, etc. The bill should be fixed to prohibit a DTEF from
trading any instruments excluded from the CEA. There are other
places in the bill that might impinge on SEC jurisdiction. The
SEC and Commerce Committee should carefully review the bill and
identify provisions that affect the regulatory jurisdiction of
the SEC.
We will separately provide a line-by-line set of comments on
the Ewing bill shortly.
Mr. Dingell. I agree with many of their comments. I also
ask to include in the record a copy of the February 9, 2000
letter that Mr. Towns, Mr. Markey and I sent to the SEC setting
forth questions that we believed had to be satisfactorily
addressed on this matter. I would observe that the bill before
us does not meet any of the tests that we set forth for a good
bill.
[The letter follows:]
U.S. House of Representatives
Committee on Commerce
February 9, 2000
The Honorable Arthur Levitt
Chairman
Securities and Exchange Commission
450 5th Street, NW.
Washington, D.C. 20545
Dear Mr. Chairman: We are writing concerning the recommendations
regarding single stock futures that were made in the November 9, 1999,
Report of the President's Working Group on Financial Markets, entitled
Over-the-Counter Derivatives Markets and the Commodity Exchange Act.
As you will recall, the principal focus of the aforementioned
report was to address legal uncertainty and unnecessary regulatory
burden questions arising from the treatment of over-the-counter
(``OTC'') derivatives under the Commodity Exchange Act (``CEA''). The
Working Group made recommendations with respect to broadening the swaps
exemption from futures regulation under the CEA, excluding certain
electronic trading systems for swaps from CEA regulation, promoting
development of clearing systems for OTC derivatives, and providing
authority to exempt certain exchange-traded derivatives from CFTC
regulation. While we have a number of questions and concerns about
these recommendations, we are writing you today to request information
and assistance in understanding the far-reaching implications of the
Working Group's recommendation regarding single stock futures.
The report states at page 32, in a section on Other Issues, that:
``The Working Group members agree that the current prohibitions on
single-stock futures can be repealed if issues about the integrity of
the underlying securities market and regulatory arbitrage are
resolved.'' The report then goes on to note that:
``From the perspective of the securities laws, the issues
raised by trading of single-stock futures include levels of
margin, insider trading, sales practices, real-time trade
reporting, and activities of floor brokers, as well as the
exclusive jurisdiction of the CFTC over futures contract
markets. From the perspective of the commodity futures laws,
the issues raised by these instruments include clearing,
segregation, large trader reporting, and direct surveillance.''
The Working Group unanimously recommended that the SEC and the CFTC
``work together and with Congress to determine whether the trading of
single-stock futures should be permitted and if so, under what
conditions.'' (emphasis added)
In light of the highly qualified and conditional natural of the
Working Group's recommendation in this area, and the enormous
complexities involved in satisfactorily resolving all of the issues
raised by trading of single-stock futures, we note with some concern
the recent request by our colleagues, Representatives Combest, Ewing,
Bliley, and Stenholm, for the SEC and the CFTC to ``create and present
to Congress a detailed legislative plan for repealing the current
prohibition on single stock futures'' no later than February 21, 2000
so that ``it may aid us as we consider reauthorization of the Commodity
Exchange Act this session.''
This request appears to presume that all of the issues that were
identified by the Working Group regarding the integrity of the
underlying securities market and regulatory arbitrage either are
unimportant or can be successfully resolved in a short period of time.
We are not at all certain that these issues can be resolved consistent
with the public interest, the protection of investors, and the
maintenance of fair and orderly markets, especially if done in haste
and within the confines of a regulatory structure that bifurcates
regulatory authority over certain financial derivatives between the SEC
and the CFTC. As the Commission considers this matter, we believe it
absolutely imperative that the integrity of our nation's securities
markets and the protections afforded to investors in these markets not
be undermined in any way. Accordingly, we respectfully request, before
the Commission submits any detailed legislative proposals to Congress
relating to this matter, that it satisfactorily address the questions
enclosed with this letter.
Thank you for your assistance and cooperation in responding to this
inquiry. Should you need additional information about this request,
please have your staff contact Mr. Jeffrey S. Duncan (Rep. Markey) at
202-225-2836 or Ms. Consuela Washington (Rep. Dingell) at 202-225-3641.
Sincerely,
John D. Dingell,
Ranking Member, Committee on Commerce
Edward J. Markey
Ranking Member, Telecommunications, Trade and Consumer Protection
Subcommittee
Edolphus Towns
Ranking Member, Finance and Hazardous Materials Subcommittee
cc: The Honorable Tom Bliley
The Honorable Michael G. Oxley
The Honorable Larry Combest
The Honorable Thomas W. Ewing
The Honorable Charles W. Stenholm
Enclosure
Questions for the Honorable Arthur Levitt, Chairman, Securities and
Exchange Commission
February 9, 2000
1. Single stock and narrow-based stock index futures (as well as
options on those products) would function as very close substitutes for
stocks and stock options. Would the availability of these products
pursuant to a regulatory scheme that does not contain all of the
protections afforded under the federal securities. laws undermine the
policy objectives of such laws?
2. If single stock and narrow-based stock index futures (as well as
options on those products) were to be permitted and regulated other
than as securities, how would the SEC be able to protect and ensure the
integrity of the underlying securities?
3. Would the futures markets become the price discovery market for
stocks? If so, what protections should be in place to ensure prices are
established in fair manner? How important is it for the SEC to be able
to establish and police such protections?
4. If single stock futures (or options on such futures) were
permitted, would it be beneficial to the public to be able to trade
them on multiple exchanges and over-the-counter? If so, what market
linkages would need to be in place to ensure investors get the best
available price?
5. Should single stock futures (or options on such futures) be
subject to centralized clearing? If not, what competitive impediments
are associated with issuing and clearing such products through other
clearing mechanisms, particularly if multiple trading is permitted?
6. If single stock and narrow-based index futures (or options on
such futures) were not regulated as securities, how would insider
trading be addressed? The futures exchanges have suggested empowering
the SEC with the ability to apply insider trading rules to single stock
futures to the same extent as it applies those rules to options traded
on a securities exchange. Do you believe this would be an effective
approach? How much responsibility does exchange surveillance play in
this process of deterring and detecting insider trading? Would the SEC
need to have authority to oversee futures exchange surveillance
programs to ensure that insider trading was being adequately policed?
Would the SEC need to have the authority to establish books and records
requirements in order to enforce compliance with insider trading
restrictions?
7. In addition to insider trading, how would more general market
manipulations be addressed? Frontrunning? How much responsibility does
exchange surveillance play in this process of deterring and detecting
market manipulation or frontrunning? Would the SEC need to have
authority to oversee futures exchange surveillance programs to ensure
that market manipulation and frontrunning prohibitions were being
adequately policed? Would the SEC need to have the authority to
establish books and records requirements in order to enforce compliance
with applicable market manipulation and frontrunning restrictions?
8. What is the appropriate margin scheme that should be applicable
to single stock and narrowbased stock index futures (or options on such
futures)? Should stock and stock index futures margin levels be
harmonized with those applicable to securities products? Should a
single regulator set and administer the process? The futures exchanges
have suggested that they would be willing to apply stock options margin
treatment to single stock futures. Would this mean a margin of 20%? Who
would approve changes to this level?
9. We understand some trading of single-stock futures has taken
place on markets outside the U.S. Have you studied the impact that
trading of such products has had on the underlying stock markets? As a
general matter, how are such products regulated? Is the regulation of
futures, options, and stocks subject to a single regulator in such
markets? If so, do you believe this plays a significant role in any
apparent successful oversight of such products?
10. If single stock and narrow-based stock index futures (or
options on such futures) were permitted and not regulated as
securities, presumably the products would be subject to either CFTC
supervision or some type of dual Jurisdiction shared between the SEC
and CFTC. Either scheme, if designed to address the numerous existing
regulatory disparities between securities and futures products, would
create an additional layer of regulation on the financial services
community. Would this result in excessive compliance costs for the
financial community? Is it preferable to link consideration of reform
of the Shad-Johnson Accord with broader regulatory reform, such as
merging the SEC and CFTC, and harmonizing the laws for all stock-based
exchange traded products?
11. What expertise does the CFTC have that would justify it as
being considered as the sole or primary regulator for single stock and
narrow-based stock index futures contracts? There is movement to
convert the CFTC into a ``supervisory'' agency. How would any such
reorganization affect the CFTC's ability to adequately oversee stock-
based futures trading?
12. Exchange-listed stocks and stock options are subject to listing
standards that help to ensure that adequate information about the
underlying instrument is available (i.e., in compliance with securities
registration provisions) and a base level of market liquidity is
present (i.e., minimum public float and holders). What standards should
apply to single stock and narrowbased stock index futures (or options
on such futures)?
13. What audit trail requirements should be applicable to single
stock and narrow-based stock index futures (or options on such
futures)? Should the futures exchanges be required to implement audit
trails as precise and extensive as in the securities markets?
14. What securities market transparency provisions, such as quote
dissemination and transaction reporting requirements, should apply to
single-stock and narrow-based index futures (or options on such
futures)?
15. Narrow-based stock index futures are currently banned along
with single stock futures because they can act as surrogates for
futures on individual securities. Do you believe that any relaxation of
the current ban on narrow-based stock index futures would undermine the
policy objectives of the Shad-Johnson Accord?
16. Should consideration of modifying the Shad-Johnson Accord be
linked with consideration of whether the exclusive jurisdiction clause
of the CEA should be removed? Would removal of the exclusive
jurisdiction clause pave the way for securities exchanges to offer
futures or futures-like products, such as index participations and
zero-strike options?
17. What is the appropriate disclosure regime for single stock and
narrow-based stock index futures (or options on such futures)? For
example, should an equivalent of the Options Disclosure Document apply?
Should there exist enhanced risk disclosure requirements for stock
futures as is required for penny stocks and day traders? For uncovered
options writing?
18. What regulatory requirements should apply to single stock
futures (or options on such futures) to address their possible use in
connection with obtaining control of publicly traded companies? For
example, should Regulation 13D of the Exchange Act or an equivalent
provision apply to these products?
19. What regulatory requirements should apply to single stock
futures to address their use by entities engaged in distributing
securities related to the futures products? For example, should
Regulation M of the Exchange Act or an equivalent provision apply to
these products?
20. The best execution standards applicable to securities brokers
serve an important investor protection function in the equities and
options markets. We are not aware of any similar standards applicable
in the futures markets. If single stock futures (or options on such
futures) were traded on multiple markets, do you agree that best
execution standards would be critical to the fair operation of those
markets? If such standards were applicable, how would they work,
particularly if certain key market transparency measures, such as real
time quote availability (with size) and market linkages, were not
available?
21. Heightened sales practice and suitability requirements apply to
securities options transactions. We are not aware of the existence of
similar standards in the futures markets. Do you believe such
heightened standards should apply to single stock and narrow-based
stock index futures (or options on such futures)? What would be the
results if they did not apply?
22. Should the short swing profit restrictions contained in Section
16 of the Exchange Act apply to single stock futures (or options on
such futures)? What would be the results if they did not apply?
23. Assuming insider trading and other anti-manipulation provisions
were applied to single stock futures, how would issuer repurchase
transactions through the use of futures be addressed? Would an
equivalent of Exchange Act Rule 10b-18 be warranted or necessary?
24. If single stock and narrow-based stock index futures (or
options on such futures) were traded on futures exchanges, would
additional intermarket coordination mechanisms be necessary? For
example, would trading halt policies need to be synchronized? Who would
mandate and oversee this process? Would surveillance monitoring
programs need to be coordinated? What regulator would oversee this
process?
25. In addition to the disparities that exist between securities
and futures products with regard to policies designed to protect the
market and investors, a number of competitive disparities also exist
that might place securities markets in an unfavorable position vis-a-
vis the futures markets unless addressed. For example, favorable ``60/
40'' capital gains treatment is available to all futures products;
however tax code changes would need to be made to broadly extend such
treatment to securities markets. Also, securities markets are subject
to Section 31 transaction fees. There exists no equivalent under the
futures regime. Should these and other competitive disparities be fully
addressed in connection with any revisit of the Shad Johnson Accord?
26. Section 11A of the Exchange Act requires the securities markets
to consolidate last sale prices and quotations and make the data
available on a real-time basis. The CEA does not contain a similar
requirement. If this situation persists and multiple futures markets
trade single stock futures (or options on such futures), it would be
difficult for equity investors to accurately ascertain the price of any
particular stock futures contract during the trading day. As part of
any plan to permit single stock futures, would it be desirable to
require the futures markets to consolidate market data and make it
available to all investors?
27. If single stock and narrow-based stock index futures are
permitted, should the regulation of all securities and securities-based
derivatives be consolidated under one regulator? How can the Shad-
Johnson prohibition be lifted unless the SEC and CFTC are merged?
28. The ability of investors to recover damages under the federal
securities laws exists for cases involving manipulation and fraud (as
well as insider trading) associated with the purchase or sale of
securities. Are identical protections afforded to investors under the
commodities laws with regard to manipulation and fraud? If not, should
investors in single stock and narrow-based stock index futures (or
options on such futures) be afforded such protections?
29. The securities options exchanges maintain rules imposing limits
on the aggregate number of options contracts that a member or customer
may hold or exercise. These rules are intended at least in part to
prevent the establishment of options positions that can be used to
manipulate or disrupt the underlying market so as to benefit the
options position. Should similar limits be applied to single-stock and
narrow-based stock index futures? Who would approve and oversee the
enforcement of such limits? Should any changes be coordinated between
securities and futures markets?
30. The futures exchanges have informally suggested ways of
addressing margin and insider trading concerns associated with
permitting stock index futures (or options on such futures). What are
the complexities and limitations with their approach? Of course, margin
and insider trading are but two of many protections afforded under the
federal securities laws. How would these other protections be
replicated for single stock and narrow-based stock index futures? If
not replicated, would the absence of such protections invite regulatory
arbitrage, thereby undermining the federal securities laws?
31. Large trader reporting is a key requirement of the CEA. Large
trader reports are the linchpin of the CFTC's and futures markets'
surveillance systems. The Government Securities Market Reform Act of
1993 gave the Treasury large position reporting authority for the
Treasury securities markets, which it uses to monitor trading in
Treasury bills, notes, and bonds. The Market Reform Act of 1990 gave
the SEC the authority to implement a large trader reporting system, but
the SEC has failed to do so. The trading of single stock futures would
make the connections between the equities and futures markets even
closer than they are today. Given this close connection and the
importance of large trader reporting system in preventing futures
markets manipulations, shouldn't a large trader reporting system on the
equities markets be a necessary precondition to permitting single stock
futures?
32. If single stock and narrow-based index futures (or options on
such futures) were permitted, would-the SEC have adequate resources to
police this additional market for insider trading, market manipulation,
frontrunning, or other abuses? If not, please provide an estimate of
what additional resources and personnel would be needed?
Mr. Dingell. Mr. Chairman, I am highly skeptical about the
wisdom of authorizing single-stock futures or futures on narrow
stock indices or narrow groups of stocks.
As the GAO warned in its April report, even a small price
movement in the underlying stock could encourage attempts to
manipulate stock prices. I would note to you at this time, Mr.
Chairman, that there is growing concern about the efforts of
organized crime to penetrate and to manipulate the markets.
This certainly will assist that group in their nefarious
attempts.
I would note that futures are a highly leveraged zero sum
game. A lot of people are going to get burned in this, and
trust in the market as well as volatility are going to be moved
into dangerous levels and dangerous areas. The stock markets
have been the envy of the world in this country, and they will
be reduced to a commodity with futures markets being the price
discovery point. This concerns me. Nevertheless, if it is the
judgment of my colleagues that we should authorize these ill-
advised instruments, it is absolutely imperative that the
integrity of the Nation's securities markets and the
protections afforded investors not be undermined in any way. At
a minimum, we need to provide protections substantially similar
to those that we have applied with respect to options on stocks
and narrow indices.
In closing, I want to assure my colleagues that I approach
this issue with an open mind given the general sorry character
of the legislation. I have a measure of skepticism about the
merit of the bill. I am happy to work with you to try to write
a good bill. Barring that, I am committed to using this turkey
for target practice.
I would observe that there is much that can be done to
improve this bill. Perhaps the best thing to do is kill it, but
I am willing to try to make a silk purse out of a sow's ear if
that is the wish of the committee. I yield back the balance of
my time.
Mr. Oxley. The gentleman yields back. The gentlewoman from
New Mexico, Ms. Wilson.
Mrs. Wilson. I will enter any statement for the record.
Mr. Oxley. Bless you.
Dr. Ganske.
Mr. Ganske. Thank you, Mr. Chairman. I am looking forward
to the testimony today. This is how I see this issue now. If an
investor who owns stock in a company worth $50 a share and is
worried about a price drop so he can sell a futures contract,
if the stock dropped below $50 at a specified date, the
contract's purchaser must either take delivery on the stock at
$50 a share or pay the investor the difference per share. If
the stock climbs above $50 by the specified date, the investor
pays $50 per share to the contract's purchaser who profits from
the rise in value.
I must say, Mr. Chairman, I haven't had a single
constituent write me or phone me on this issue so I wonder why
this is coming up. What concerns me about this is the margin
requirement for a stock is 50 percent, while the requirement
for a futures contract is 5 percent. I am worried that the
introduction of single-stock futures will increase speculation
on individual issues.
This was something that was a problem back in 1929, and it
looks to me like the basic idea is back. The futures markets
want to trade single-stock futures which in economic terms are
virtually identical to stocks, and I think this enters a lot of
volatility and speculation into a market which already may have
a lot of speculation and when investors like Warren Buffett,
who lives on the edge of my district, are having a hard time
figuring out what the proper valuation of a stock price is, I
wonder whether the little guy is going to have problems on
that, too. So I will be looking forward to your testimony
today. I thank you.
Mr. Oxley. The gentleman yields back. The gentleman from
Michigan, Mr. Stupak.
Mr. Stupak. Thank you, Mr. Chairman. The piece of
legislation that we are examining today has potential to have a
large impact on our securities market. While there are portions
of this bill which will bring certainty to our financial
markets, I have concern about ending the prohibition on single-
stock futures. This committee has long ensured that the
Nation's securities market were fair to and protected
investors. While we have long understood that investors and the
securities market undertook risk and unlike bank deposits were
subject to the uncertainty of the market, we have always made
sure that the market was fair. We wisely banned insider
trading, created the Securities and Exchange Commission to
police unfair dealing, and we required that brokers sell
products to investors only if suitable for that investor's
profile.
H.R. 4541 would allow for the trading of a new financial
product, a future based on a single stock. Like options, the
value of the future would be directly related to the underlying
exchange-traded security. Like options, these products would
affect the exchange and the over-the-counter stocks owned by
average retail investors. However, unlike options in stocks,
they would not be subject to the insider trading prohibition.
Brokers would not be held to the same suitability standards for
single-stock futures as for exchange-traded securities. Single-
stock futures would receive preferential tax treatment. They
would be exempt from the SEC transaction fees. They would have
a separate margin requirement which could allow consumers to
undertake dangerous levels of margin in their pursuit of high-
flying returns, only to find earth-crashing bankruptcy.
With so many retail investors in the market and with so
many already having problems with the current requirements, and
with the SEC continuing combatting stock fraud and market
manipulation, with all of these events occurring, now is not
the time to remove the rules on a new riskier product. Now is
not the time to return the retail investor to the Wild West,
where ruthless gunslingers live without rules while individual
investors try to stay alive.
Mr. Chairman, I am not opposed to the creation of a new
financial product which may provide benefits to both
institutional and retail investors, I certainly support
insuring that our financial markets continue to be the world
leaders. However, allowing an exchange to sell a high-risk
product to retail investors without the protection of our
Nation's security laws will not improve our markets, it will
harm our markets.
I look forward to this hearing and working with you to
improve this legislation to protect retail investors. I yield
back the balance of my time.
Mr. Oxley. The gentleman yields back. The Chair recognizes
Mr. Markey.
Mr. Markey. Thank you, Mr. Chairman. In George Orwell's
1984, one of the worst things you could do was to commit the
offense of crime think. That was the act of even thinking bad
thoughts about Big Brother or the Party. It was a very serious
offense. We are here today because Brooksley Born, the former
chair of the CFTC, committed an act of regulatory crime think.
She issued a notice to the world that the CFTC was thinking
about whether it should step up oversight for the OTC swaps
market. How shocking. How terrible. The swaps dealers went
berserk. The Fed and Treasury had conniptions. Congress passed
a moratorium on any CFTC's consideration of Brooksley Born's
ideas and now we are considering legislation aimed at making
certain that no future CFTC ever, ever, ever commits regulatory
crime think again.
Now, those of us who served on the conference committee on
the Futures Trading Practices Act of 1992 thought we had
already addressed the issue of the status of the OTC swaps
under the Commodities Exchange Act. We included a provision
aimed at providing the swaps dealers legal certainty that swaps
would not be regulated as futures. At the time the dealers
hailed this as solving the legal certainty problem. But now 8
years later, we are told we need to fix the fix we made.
Now I have no objection to doing this, but it seems like a
bit of an overreaction. But more disturbingly, this bill
contains a provision which would repeal the restrictions on
single-stock futures. Last year the President's Working Group
on Financial Markets stated the Working Group members agree
that the current prohibitions on single-stock futures can be
repealed if issues about the integrity of the underlying
securities market and regulatory arbitrage are resolved. The
report goes on to note that from the perspective of the
securities laws, the issues raised by trading of single-stock
futures include levels of margin, inside trading, sale
practices, real time trade reporting and activities of floor
brokers as well as the exclusive jurisdiction of the CFTC over
futures contract markets. From the perspective of the
commodities futures laws, the issues raised by these
instruments include clearing, segregation, large trader
reporting and direct surveillance.
The Working Group unanimously recommended that the SEC and
CFTC work with Congress to determine whether the trading of
single-stock futures should be permitted and, if so, under what
conditions. In light of that highly qualified and conditional
Working Group recommendation in this area and the enormous
complexities involved in satisfactorily resolving all of the
issues raised by the trading of single-stock futures, I believe
that this Congress is moving too quickly to approve legislation
in this area. I believe it is absolutely imperative that the
integrity of our Nation's securities markets and the
protections afforded to investors in these markets not be
undermined in any way. Accordingly, I believe we must either
transfer jurisdiction over stock index and single-stock futures
to the SEC, or delete the bill's provisions allowing for
single-stock futures.
I yield back the balance of my time.
[Additional statement submitted for the record follows:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, a Representative in
Congress from the State of Louisiana
Thank you Mr. Chairman.
Mr. Chairman, I will keep my remarks this morning very brief as I
am eager to hear from Chairman Arthur Levitt of the SEC, as well as
from our other distinguished witnesses here today. But let me take just
a moment to frame the main issue before us as I see it.
We are here today to discuss a bill, H.R. 4541, that attempts to do
a good thing: Modernize the Commodity Exchange Act (CEA). Modernization
of the CEA, I think, is needed considering that the ``Shad-Johnson
Accord,'' which is codified in the CEA, has left us with a great deal
of legal uncertainty when it comes to regulating specific, complex
financial products out there today.
Specifically, H.R. 4541, would, for the first time, permit the
trading of ``stock futures'' despite that the CFTC and the SEC have
never been able to reach an agreement on their respective jurisdiction
over such futures as the Shad-Johnson Accord contemplated they would.
While I am not opposed to the debut of stock futures trading on our
exchanges, I don't believe that this bill, as reported out of the
Agriculture Committee, adequately addresses the complex investor
protection and competitive fairness issues that need to be considered.
The bill as drafted does not treat stock futures as securities and
does not provide the SEC with the authority to supervise their trading.
Consequently, H.R. 4541 does not provide an appropriate regulatory
framework for the trading of stock futures, and herein lies the main
problem with this bill.
Though it is an obvious point, ``stocks,'' or literally, units of
equity ownership in a corporate entity, are the most widely traded
securities that we know of today. It only stands to reason then that
``stock futures''--or agreements to buy or sell actual SECURITIES for a
fixed price, at a specified point in time--should be subject to at
least some oversight from the SECURITIES and EXCHANGE COMMISSION.
If we treat stock futures as commodities, and exempt them from the
application of the federal securities laws--as H.R. 4541 proposes to
do--my fear is that these futures will serve as surrogates for
individual stocks and will be marketed to retail investors across the
country--free of basic disclosures . . . registration requirements . .
. and other important investor protections that are the bedrock of
securities regulation in this country.
Now I have been a member of this Committee of sometime, and I need
look no further than our experience with H.R. 10 to realize that
jurisdictional battles in the context of financial services legislation
are hard fought.
But in this case, I believe that Chairman Levitt, many members of
this Subcommittee, and the vast majority of the securities industry
participants probably share my concerns about the stock futures
provisions of this bill. In addition to the SEC, the New York Stock
Exchange (NYSE), the Securities Industry Assc. (SIA), the Chicago Board
of Options (CBOE), and the National Assc. of Securities Dealers (NASD)
all oppose H.R. 4541.
So, let me close by saying that I don't think it would be wise for
this Subcommittee, or this Full Committee, to adopt CEA modernization
legislation without addressing the concerns raised by these parties.
With that Mr. Chairman, I yield back the balance of my time.
Mr. Oxley. The gentleman yields back. In deference to the
distinguished Chairman of the SEC, we are going to go forward
with the hearing. The Chair will stay here and we will proceed.
Mr. Levitt. Where has everybody gone?
Mr. Oxley. This is a vote on the Journal. It is usually a
device of the leadership to find out how you are going to vote
on a particular legislation. I prefer to keep the leadership in
the dark as far as my vote is concerned, and would rather hear
from the distinguished Chairman of the SEC. It is an honor to
have you back again to our committee and you may begin.
STATEMENT OF HON. ARTHUR LEVITT, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Mr. Levitt. Thank you very much, Chairman Oxley and thank
you for the opportunity to address this subcommittee concerning
H.R. 4541. This bill would provide legal certainty for over-
the-counter derivatives and lift the ban on single-stock
futures. As you know, the Commission fully supports both of
these objectives. In some important respects, however, I firmly
believe that the bill presents serious and unwarranted risks to
the investing public as well as to our securities markets.
As we consider the implications of the bill, it serves us
well to remember both the wisdom embodied in our securities
regulatory framework and the prosperity that it has fostered.
Its wisdom I think is quite simple: A recognition that
protecting investors is not just the right thing to do, but the
smart thing to do; that it is investor confidence that
ultimately fuels competition; that vibrant markets rest on a
foundation of integrity. I strongly believe that the
unequivocal commitment to protecting investors made by your
predecessors and mine has been critical to the success of the
Nation's securities markets.
The bill before you, consistent with the Working Group's
recommendations, goes a long way toward providing greater legal
certainty for OTC derivatives by excluding certain products
from the CEA. In some important respects, however, the bill
differs from the Working Group's recommendations. My staff and
I would be glad to go into detail and discuss with you the
particulars of those differences. The bill would also lift the
ban on single-stock futures contained in the Shad-Johnson
Accord. Now, I don't have any particular interest in justifying
the historical origins of the ban today. I have made clear my
view that market demand and not regulatory fiat should
determine the availability of investment vehicles. But I do
think we should squarely face the fact that single-stock
futures are an economic substitute for the underlying security.
We must not ignore the fabric of protections that retail
securities investors rely on and the confidence that these
protections engender. Some may dismiss this concern as kind of
a guise for the protection of turf. I assure you that the
questions surrounding how best to ensure that regulatory
disparities do not erode investor confidence are profoundly
serious and substantive.
Building upon the CFTC's acknowledgment that we should
jointly regulate these products, the SEC staff has crafted a
plan under which these products can trade. In my judgment, an
enduring regulatory framework must have a number of salient
elements. First, single-stock futures are undeniably a proxy
for stocks and stock options. Thus, the framework must
recognize the legitimate interests of both the SEC and the CFTC
in determining how best to regulate these products.
Second, the framework must encourage fair competition among
markets by, for example, including mechanisms to harmonize the
regulatory requirements across the securities and commodity
markets, particularly with respect to margin. Competitive
market forces, rather than government regulation, should pick
the winners and pick the losers. Legislation also should
facilitate the listing of the same single-stock futures on
multiple exchanges. This would avoid any one market having an
exclusive franchise by forcing all markets to compete for
investors' business.
Third, the framework must acknowledge that single-stock
futures will be retail products. While complex derivative
products might not attract retail customers, a simple future on
a share of a blue chip stock is sure to do so. Investor
protection therefore becomes absolutely essential, as does
clear and direct SEC authority over market participants that
trade single-stock futures.
Finally, the framework must avoid any harm to existing
capital markets. In lifting the ban on single-stock futures and
reopening jurisdictional issues, legislative changes should not
take away existing SEC authority over financial products. The
Shad-Johnson Accord clarified the SEC's jurisdiction over
securities options. That jurisdiction should not be diminished
in any way, nor should legislation eliminate the SEC's existing
role in evaluating products such as stock indices.
I firmly believe that the commitment to protecting
investors embodied in these four principles is essential to
maintaining the quality of our markets as well as our global
competitive edge. Unfortunately, the bill in its current form
simply fails to honor that commitment.
I would be happy to provide whatever assistance you may
need as you consider these important issues. Thank you very
much.
[The prepared statement of Hon. Arthur Levitt follows:]
Prepared Statement of Hon. Arthur Levitt, Chairman, U.S. Securities and
Exchange Commission
Chairman Oxley and Members of the Subcommittee: I am pleased to
testify today on behalf of the Securities and Exchange Commission
(``SEC'' or ``Commission'') as you consider H.R. 4541, the Commodity
Futures Modernization Act of 2000. My testimony today focuses on two
key topics. First, I address OTC derivatives markets. Second, I address
the competition, investor protection, and market integrity issues
raised by single stock and stock index futures.
i. legal certainty for otc derivatives markets
As you know, the President's Working Group on Financial Markets
(``Working Group'') issued a report last year on OTC Derivatives
Markets and the Commodity Exchange Act (``OTC Derivatives
Report'').1 The OTC Derivatives Report contained several
recommendations related to legal certainty for OTC derivatives
products.
---------------------------------------------------------------------------
\1\ Report of the President's Working Group on Financial Markets,
Over-the-Counter Derivatives Markets and the Commodity Exchange Act
(Nov. 1999).
---------------------------------------------------------------------------
The enormous size of the OTC derivatives markets 2
demonstrates their critical role in our capital markets. Derivatives
contracts play a crucial role in risk management for a vast array of
businesses. Accordingly, I can think of few more important issues for
Congressional consideration than legislation to implement the
recommendations by the Working Group to give legal certainty to the OTC
derivatives market. The Commission reiterates its strong support for
implementation of the recommendations by the Working Group related to
legal certainty for the markets that trade these products.
---------------------------------------------------------------------------
\2\ According to data from the Bank for International Settlements,
at the end of June 1999, the total estimated notional amount of
outstanding OTC derivative contracts was $81.5 trillion. The Global OTC
Derivatives Market at end--June 1999, 45/1999E (Nov. 25, 1999) .
---------------------------------------------------------------------------
The Working Group was given a fairly narrow task--to determine
whether the Commodity Exchange Act (``CEA'') provided an appropriate
regulatory framework for the OTC derivatives markets. The Working Group
unanimously concluded that for certain OTC derivatives the CEA was not
the appropriate framework. In addition, the Working Group determined
that steps needed to be taken to ensure that the CEA did not stifle the
natural development of these markets. For a more detailed discussion of
the Working Group's recommendations, I refer you to earlier Commission
testimony.3
---------------------------------------------------------------------------
\3\ See Testimony of Annette L. Nazareth, Director, Division of
Market Regulation, U.S. Securities and Exchange Commission, Concerning
the Report to Congress on Over-the-Counter Derivatives Markets and the
Commodity Exchange Act by the President's Working Group on Financial
Markets, Before the Senate Comm. on Agriculture, Nutrition, and
Forestry (Feb. 10, 2000). See also Testimony of Annette L. Nazareth,
Director, Division of Market Regulation, U.S. Securities and Exchange
Commission, Concerning Recent Recommendations by the President's
Working Group on Financial Markets, Before the House Comm. on Banking
and Financial Services (Apr. 11, 2000); Testimony of Annette L.
Nazareth, Director, Division of Market Regulation, U.S. Securities and
Exchange Commission, Concerning the Report to Congress on Over-the-
Counter Derivatives Markets and the Commodity Exchange Act by the
President's Working Group on Financial Markets, Before the Subcomm. on
Risk Management, Research and Specialty Crops, House Comm. on
Agriculture (Feb. 15, 2000).
---------------------------------------------------------------------------
The consensus achieved by the Working Group was of historic
significance. Four of the leading U.S. financial regulators unanimously
agreed that the Report's recommendations, which reflected their
combined regulatory expertise, urgently required implementation. The
Commission strongly supports the efforts made in H.R. 4541 to further
the goals of the Working Group. However, as we have stated in the past,
it is not necessary to link resolution of all of the issues raised in
the bill to the passage of the much needed provisions on legal
certainty for OTC derivatives.
H.R. 4541 differs from the Working Group's recommendations
regarding legal certainty in several key respects. For example, the
Bill does not fully adopt the Working Group's recommendations on the
regulation of clearing systems. By expressly providing that clearing
agencies registered with the SEC may voluntarily register with the CFTC
even though they are not required to do so, the Bill creates potential
issues as to which set of regulations would prevail in the event of a
conflict. The Working Group specifically recommended that a clearing
system regulated by one agency should not become subject to regulation
by another agency as a result of clearing OTC derivatives. The
Commission staff would be happy to discuss those differences in detail
with you or your staff and provide technical assistance to the
Subcommittee.
The Commission continues to strongly support the implementation of
the Working Group's recommendations that are designed to provide legal
certainty for the OTC derivatives markets. Those recommendations should
be implemented immediately. We appreciate the Subcommittee's efforts in
furtherance of this goal, and we are committed to working with you as
modifications are made to this bill.
ii. lifting the ban on single stock futures
The Commission supports lifting the ban on single stock futures as
soon as the regulatory issues underlying that ban are resolved. This
year, the Commission devoted tremendous staff resources to designing a
legislative framework to permit the trading of single stock and narrow-
based stock index futures. Disparities between futures and securities
regulation made this a difficult task. As a result of our efforts,
however, the Commission strongly believes that these products can trade
under the regulatory system that we have outlined below.the regulatory
system that I will outline for you today.
Among other things, the Commission staff focused on issues raised
by the Working Group. In its OTC Derivatives Report, the Working Group
identified several issues that would have to be addressed before
trading of single stock futures can begin. Furthermore, the Working
Group noted that these issues were best resolved by the Commission and
the CFTC.
The CFTC and the SEC engaged in extensive discussions on this
topic. Chairman Rainer and I have not agreed on all aspects of a
regulatory framework for single stock futures. However, we did reach
agreement on fundamental principles for creating such a
framework..4 Most important among these principles was that
single stock futures should be subject to joint regulation by the CFTC
and the SEC. This is a positive step forward from outdated notions of
exclusive jurisdiction and the view that because a product can be
considered a ``future'' it should be solely regulated by the CFTC. It
reflects movement towards truly modern financial regulation--regulation
that recognizes the need for agencies with legitimate regulatory
interests and expertise in a product to participate in that product's
oversight.
---------------------------------------------------------------------------
\4\ Letter from the Honorable Arthur Levitt, Chairman, SEC, and the
Honorable William Rainer, Chairman, CFTC, to the Honorable Larry
Combest, Chairman, House of Representatives Committee on Agriculture,
the Honorable Tom Bliley, Chairman, House of Representatives Committee
on Commerce, the Honorable Tom Ewing, Chairman, Subcommittee on Risk
Management, Research, and Specialty Crops, House of Representatives
Committee on Agriculture, and the Honorable Charles Stenholm, Ranking
Member, House of Representatives Committee on Agriculture (March 2,
2000).
---------------------------------------------------------------------------
A. Requirements for a Legislative Framework
1. General Principles for Markets that are Competitive, Fair, and
Free From Fraud and Manipulation--The process of working through
important issues with the CFTC led the Commission staff to identify
requirements for legislation to permit the trading of single stock
futures. Contrary to what some have suggested, this is not a turf
battle between the futures and options markets and the agencies that
regulate them. Single stock futures would be nearly perfect surrogates
for the underlying securities. As a result, there are fundamental
issues of market integrity and investor protection at stake. For this
reason, we should move forward in a reasoned and principled manner, as
we consider how to permit an entirely new product to trade. If
legislation is crafted correctly, markets will compete and regulators
will cooperate. I think it would be useful to review the components
that we believe are critical for an appropriate legislative framework.
Shared Jurisdiction
First, single stock futures are undeniably a substitute for stocks
and stock options, and are fully expected to be a retail product.
Therefore, the framework must recognize the legitimate interests of
both the SEC and the CFTC in regulating these products. Single stock
futures possess attributes of both securities and futures contracts. As
a result, joint regulation of single stock futures is appropriate and
exclusive jurisdiction is ill advised. Shared jurisdiction and joint
regulation entail both recognizing each agency as best qualified to
apply the key components of the laws that it administers and
coordinating the agencies' efforts to ensure efficient market
regulation that is not duplicative or overly burdensome.
At the practical level, this means ensuring that both agencies have
the authority to carry out core functions, and that both encounter no
jurisdictional barriers in the suppression of fraud and manipulation.
Yet, at the same time, mechanisms should be devised to coordinate on
certain costly issues so that the traditional regulator takes the lead.
Encourage Fair Competition
Second, the framework must encourage fair competition among
markets. We do not want a framework that lets differences in regulation
determine winners and losers. Any legislation should allow both
securities and futures markets to enter the competitive fray, but
should not give any type of market an artificial competitive advantage.
For example, the SEC and the CFTC should have joint authority to
harmonize the margin requirements for single stock futures on an
ongoing basis. Otherwise, the market with the more lenient margin
requirements will have an artificial competitive edge. Competition
should be based on better products, services, and prices--not on
regulatory differences.
The legislation also should require coordinated clearing of single
stock futures so that a future purchased on one exchange could be
offset on another exchange that trades the same type of future. This
would allow the same single stock future product to be listed on
multiple exchanges. In the options markets, multiple listing has
narrowed spreads and reduced prices to investors. Coordinated clearing
also makes it more viable for new markets to enter the competitive
arena over time. Without coordinated clearing, new markets will not be
able easily to offer the same products as competitors.
Protect Investors
Third, the framework must acknowledge that single stock futures
will be retail products. Complex derivative products generally do not
attract retail customers but a simple future on a share of a blue chip
stock will. Accordingly, legislation must maintain the SEC's ability to
protect investors and to maintain integrity of the markets on which
they trade. For this reason, the SEC should have clear and direct
authority over the markets and market participants that trade single
stock futures. I think it is important to explore a few examples of
what might happen if the SEC does not have such authority.
In the securities markets, recommendations that brokers make to
investors are governed by the suitability rules of self-regulatory
organizations subject to SEC oversight. The customer protection regime
is quite different under the futures laws. Investors receive a one-time
disclosure document informing them that they can lose money on futures.
The implications of these differences are quite significant. If the
securities law principle of suitability is not applied to single stock
futures, a broker could recommend such a product to any customer with
no liability under the securities laws, even if the recommendation was
unsuitable for the customer. Moreover, in many cases a broker who sells
securities will also be licensed to sell single stock futures. As a
result, the SEC is very concerned that investors will not understand
that the protections they enjoy when they purchase one product from
their broker will not also apply to the other. Worse yet, brokers could
have an incentive to offer the riskier single stock futures to
investors if they could do so without the suitability responsibilities
that attach to the sale of securities. There is no public policy reason
to create a framework with such a disparity in investor protections.
Next, consider a corporate insider who learns that his company is
about to receive an unsolicited bid to be taken over. The insider buys
a substantial amount of single stock futures on a futures exchange and
earns huge profits on the transaction. This case involves insider
trading that takes money out of the pockets of investors who did not
have this information. This is exactly the type of situation that the
Commission needs its full authority to address. Without direct
authority over the futures exchange or a requirement for insider
reporting, the SEC may have difficulty ever learning of the futures
purchase by the insider. Such activities could destroy years of
Commission efforts to protect investors from insider trading abuses.
Investors also currently rely on the Commission to protect them
from unscrupulous, or even just sloppy, practices by investment
advisers and mutual fund managers. A bill should not introduce single
stock futures into the mix of investment opportunities that investment
advisers may recommend to their clients or that portfolio managers may
purchase for the mutual funds they manage without regulation by the
SEC. This would leave investors in funds consisting of single stock
futures without the same protections that investors in mutual funds
have enjoyed since 1940.
These are only a few examples, but I hope they illustrate why the
investor protections contained in the securities laws should be
extended to single stock and narrow-based stock index futures. Please
recognize that the SEC's instruments for investor protection are
interlinked. Enforcement actions coupled with inspections and the
ability to promulgate new regulations are essential ingredients of
ensuring the integrity of America's markets. Direct access to audit
trails, coordinated market surveillance, inspection authority, as well
as suitability and customer protection regulation are all necessary to
the SEC's ability to effectively regulate and protect investors.
Although the SEC actively pursues people who violate the securities
laws, much of our success results from preventing problems before a
single investor is harmed.
The SEC has many decades of experience and legal precedent in
protecting the public--expertise that should be carried over to equity
substitutes such as single stock futures. Our securities markets are
second to none because of the investor confidence that has flourished
under this regulatory framework. It would be extremely unwise to move
ahead with legislation that lacks the elements necessary to ensure the
market integrity, suitability, and customer protections that investors
have come to expect under the securities laws.
Do Not Harm Existing Markets
Fourth, the framework must avoid any harm to existing capital
markets. In lifting the ban on single stock futures and reopening
jurisdictional issues, legislative changes should not take away
existing SEC authority over financial products. For instance, the Shad-
Johnson Accord clarified the SEC's jurisdiction over security options,
and that jurisdiction should not be diminished in any way. Nor should
legislation eliminate the SEC's existing role in evaluating stock
indexes for susceptibility to manipulation and compliance with
appropriate standards that assure they will not become a surrogate for
single stocks. Given the CFTC's exclusive jurisdiction over such
futures, the standard put forward in any bill and the SEC's role in
applying it must be sufficient to deter insider trading through index
futures. Investors have strong expectations about the integrity of
markets that the SEC regulates, and the resulting investor confidence
fuels the success of those markets. Accordingly, legislation should not
eliminate any existing SEC oversight of securities and related markets.
Moreover, we cannot allow market integrity issues in new markets to
migrate to existing capital markets. Because there are times when
problems in one market may be identified and understood only by
reference to another market, legislation must provide for coordinated
surveillance of all markets.
Adherence to these principles will leave U.S. markets for these
products better positioned to compete against their foreign
counterparts. When U.S. markets are forced to compete against each
other for investors' business and to maintain the integrity that
promotes investor confidence and attracts additional business, those
markets should be leaders in the international arena. As markets around
the world compete for customers and capital, one overriding principle
will serve as our competitive advantage: the quality of our markets.
2. Discussion Draft--The Commission staff has prepared a discussion
draft that incorporates these legislative goals into amendments to the
federal securities laws and the Commodity Exchange Act. The SEC's
proposal extends the protections of the federal securities laws to
single stock futures. However, much of the proposal is devoted to
ensuring that those laws do not unnecessarily burden the markets and
intermediaries that trade single stock futures. We look forward to
comments from the CFTC and to having a dialogue with your Subcommittee
on our suggested approach. We are setting out below a brief summary of
the principal elements of that plan--a plan that presumes shared SEC
and CFTC jurisdiction over these products.
First, this draft framework defines single and narrow-based stock
index futures as securities. This triggers SEC oversight and the
application of the securities laws. We then focus on detailed
regulatory relief for some of these intermediaries and markets as a
means to avoid unnecessary or duplicative regulation.
For example, floor brokers on designated contract markets that are
already registered with the CFTC would be completely exempt from SEC
registration. We also create a simple process of notice registration
with the SEC for certain markets and intermediaries that are already
registered with the CFTC. Those markets and intermediaries would have
to comply only with securities law provisions that are considered
``core.'' We clearly exempt these markets and intermediaries from the
numerous non-core provisions of the securities laws where the CEA and
CFTC regulation sufficiently addresses the same public policy concerns.
For the core provisions of the securities laws that would still
apply to these entities, we provide innovative ways to relieve their
regulatory burdens and to coordinate our regulatory efforts with the
CFTC. For example, for many of the proposed rule changes that CFTC-
regulated markets would submit to the SEC we have provided for
immediate effectiveness of such changes and a limited scope of review.
In appropriate areas, such as examinations, we recognize that the CFTC
should be the lead regulator for such CFTC-regulated entities and limit
our activities accordingly.
In addition to the detailed regulatory relief and coordination
provisions, we provide minimum requirements to be incorporated into
listing standards for these products. Such requirements, along with
provisions related to coordinated clearing, are aimed at promoting
market integrity and intermarket competition.
Finally, we incorporate these products into other relevant
securities laws, such as the Securities Act of 1933, the Investment
Company Act, and the Investment Advisers Act. In doing so, we avoid
unnecessarily burdensome regulation under these acts as well.
This discussion draft shows that the protections of the securities
laws can be extended to single stock and narrow-based stock index
futures while still permitting the efficient operation of our markets.
Our discussion draft would achieve the goals of creating a new market
for single stock and stock index futures that is competitive, fair, and
free from fraud and manipulation. U.S. investors deserve nothing less.
U.S. capital markets provide the lifeblood of American business and are
the place where American families invest their hard-earned dollars with
hopes of earning returns that will provide for everything from their
children's educations to their retirements. We cannot afford to put
these markets at risk.
B. Comparison to H.R. 4541
Crafting our plan was not easy. Therefore, I appreciate your
efforts in drafting the bill. Moreover, I am heartened by the bill's
attempt to recognize some of the principles that the Commission feels
are so important in this area. Unfortunately, the bill as written
ultimately does not vindicate those principles and achieve the goals of
the legislative framework previously outlined. The bill does not
sufficiently extend the protections of the securities laws to single
stock and narrow-based stock index futures. The Commission therefore
could not support the legislation in its current form.
As you continue to revise your legislation, I would hope your bill
ultimately can answer questions, such as the following, in the
affirmative:
Does the bill clarify in both the CEA and the securities laws
that the SEC has full authority over single stock and narrow-
based stock index futures and that the securities laws
protections apply to these products?
Does the bill provide for expedited registration of the
intermediaries and exchanges that trade these products with
both the SEC and the CFTC?
Does the bill provide real mechanisms for both the SEC and the
CFTC to ensure that the relevant securities and futures
regulations, such as those related to margin, remain harmonized
on an ongoing basis?
Are there provisions for coordinated clearing of these
products?
Are there provisions that enable the CFTC and SEC to work
together to foster competition in the markets for these
products?
Will both the CFTC and SEC be able to effectively prosecute
frauds involving these products?
iii. conclusion
Once again, the Commission appreciates the efforts that the
Subcommittee has made in bringing derivatives issues to the forefront.
We believe that the regulatory provisions that we have set forth can
support the work of the Subcommittee in its efforts to repeal the ban
on single stock futures and eliminate uncertainty for the OTC
derivatives markets in a way that fosters competition, bolsters market
integrity, and ensures that no harm befalls America's capital markets
or investors.
The Commission appreciates the Subcommittee's efforts with respect
to derivatives issues. Just as derivatives products themselves can be
complex, so too are the issues that surround these products. Having
regulated securities derivative products for decades, the Commission
welcomes the opportunity to actively participate in the dialogue about
derivative products that your bill will engender. We look forward to
sharing our views with your Subcommittee, the Working Group, market
participants, and other legislators as changes continue to be
considered.
Thank you.
Mr. Oxley. Thank you, Chairman Levitt. We accept your
offer. This is enormously difficult legislation for the
committee, as you know. It is very detailed and somewhat
arcane, and so your staff and your help would be most
appreciated. As you know, we are under a time constraint with
the referral of the bill and essentially have until the end of
this month. Even though technically we have until September,
with the August recess, we are really faced with 3 weeks in
which we have to act. The game plan is we have our hearing
today, we mark up the bill in our subcommittee next week, and
then the full committee the last week in July. So time is of
the essence. We are prepared to roll up our sleeves with you
and with our friends on the other side of the aisle to try to
craft legislation that is in the best interests of the
investing public. I think if we all share that same goal, I am
sure we do, we can make enormous progress.
Let me begin with some questions. Do you anticipate
reaching general agreement on regulation of single-stock
futures in time for the committee to reflect that agreement in
this legislation?
Mr. Levitt. I am not certain. The chairman of the CFTC and
I have been talking about this issue for a number of months,
and I think both of us are motivated by what we believe is in
the best interests of our markets and investors.
The issues are very difficult and complex. Our staffs are
meeting almost as we talk, and I am told some progress has been
made. I have advised our staff that I would be prepared to
commit any amount of time to accomplishing a meeting of the
minds that would avoid a legislative solution. I think that we
are far better able to craft this than anyone else, and,
working with our colleagues in the Treasury Department, I can
promise you that progress has already been made and more will
be made. Whether we can meet the very tight legislative
timetable, I simply don't know.
Mr. Oxley. Is it your goal then, that if in fact everything
were to happen the way we would want it, for you to reach an
agreement and then we would essentially codify that agreement
in the legislation?
Mr. Levitt. I guess in the best of all worlds that is how
it would work. The Commission is motivated exclusively by what
we regard as being in the best interest of America's investors.
Putting a highly leveraged new product into the hands of
America's retail investors at a point in time when the market
already has an abundance of speculation is playing a very
dangerous game. Because of that, we are greatly concerned that
the basic protections that have been afforded retail investors
in terms of equity investment be present in allowing a product
which is merely a proxy for a retail stock investment.
Mr. Oxley. Some distinguished people, including Chairman
Greenspan, have said publicly they think that unless we lift
the Shad-Johnson Accord the business essentially will flow
overseas; that is, the traffic in single-stock futures. Does
that cause you some concern?
Mr. Levitt. Let me give you kind of an unorthodox response
to that. As Chairman Greenspan knows, we both are passionate
believers in free markets, but the notion that we would lose
single-stock futures to any market, and that loss could be in
any way a danger to the United States economy or the United
States markets, I think, is an absurdity. If the world is
crying for single-stock options--single-stock futures, let them
have them in my judgment. It is not our job to determine what
products should or shouldn't be traded, but in my judgment in
no way would the U.S. markets or economy be impaired by the
loss of that product to other markets. The use of that product
in Australia and other parts of the world thus far has been a
dismal failure.
My concern is that we are taking legitimate market
products, the futures market, which has been largely an
institutional market, transferring it to a retail incarnation
and leaving it, according to this bill, without the protections
that we give investors in our equity markets.
Mr. Oxley. Having said that, though, if all of us were able
to craft the necessary protections in the marketplace in a
regulatory scheme that we would envision, would you then feel
comfortable with lifting the accord?
Mr. Levitt. Yes. You know, the Accord is kind of a jerry-
built structure to accommodate what I regard to be an
irrational distribution of regulatory authority, but it is what
it is, and if there is a way of lifting it and protecting
investors, I would enthusiastically support it, as I support
other aspects of the bill in terms of relieving the legal
uncertainty from the trading of derivatives. I think that is a
very important and useful objective, although I fail to see its
relationship to this part of the bill. But my answer to your
question is very definitely yes.
Mr. Oxley. If we were to start the world all over again,
wouldn't it make sense to have single-stock futures regulated
by the Securities and Exchange Commission as securities?
Mr. Levitt. Absolutely.
Mr. Oxley. Let me yield to my good friend from New York.
Mr. Towns. Thank you, Mr. Chairman.
Could you please give your views on the argument or
statement that has been made that markets are hindered by the
application of securities regulations? Haven't the options
markets thrived under the securities law?
Mr. Levitt. I remember full well how the options markets
were introduced to America's investors. I was the head of the
American Stock Exchange at that time, and we were early
participants in that market. In those early years, there were
all kinds of complaints and scams and scandals involving the
use of that new product. We had the unfortunate experience of
having to fine and censure 22 specialists on the floor of the
American Stock Exchange in connection with the trading of
options.
Any new product involves a measure of uncertainty and a
measure of risk. Options, because they are more leveraged than
common stock certainly represented that.
Now when you take the futures on single securities, they
are merely proxies for those securities; and one of the
dangers, in my judgment, in this bill is the amount of leverage
that is entailed. The amount of borrowing that a retail
investor could now embark upon is substantially greater. You
are taking a new universe of retail investors, most of whom
have never seen a down market, many of whom in my judgment are
more leveraged than they already should be, and you are
allowing them to use a new product, totally new to them, a
future on an individual stock, which will enable them to buy
that stock for a fraction of what they would have paid had they
bought either an option or the stock itself; and the risk is
unlimited in terms of what happens to that future.
And I suggest to you that, if we take that step, if the
Congress of the United States is prepared to take that step, we
all have a responsibility to America's investors to see to it
that they have the same protections that they have when they
purchase common stock and common stock options.
Mr. Towns. Thank you very much.
According to my staff, you seem to have a plan for trading
single-stock futures that could work. Could you please tell us
about it? I would like to know more about that.
Mr. Levitt. We do have a series of recommendations with
respect to how single-stock futures could work under the joint
oversight of both the CFTC and the SEC. The plan is fairly
detailed. We have submitted it to the CFTC. They are
considering the plan. They have not yet responded to the plan
in detail. It is my hope and expectation that their response to
this plan will enable us to move forward together on a response
to this legislation.
Mr. Towns. Mr. Chairman, I would like to ask that he submit
it for the record, submit the plan for the record.
Mr. Oxley. Without objection.
Mr. Levitt. We will submit the plan.
Mr. Towns. Thank you.
[No response was received by the subcommittee.]
Mr. Towns. I yield back the balance of my time.
Mr. Oxley. The gentleman yields back.
Let me recognize the gentleman from Illinois, Mr. Shimkus.
Mr. Shimkus. Thank you, Mr. Chairman.
This is an interesting time. It is good to have Chairman
Levitt back. A couple of quick questions. I always like to boil
it down.
Of course, in your opening statement you mention that this
isn't a turf battle, but I would submit that turf battles are
pretty important. Especially in our role in the Commerce
Committee, we like to protect our turf; and we think that we do
so in the best interests of the public as much as the Founding
Fathers liked to protect the turf of the executive and the
judicial branch. That is not a bad thing, especially if you
feel that the turf you are protecting, you are doing it based
upon sound principles of protecting the interests of the
investors. That is my little opening statement.
Mr. Chairman, some of these questions may have been asked
when I went to the vote, but in H.R. 4541, it contemplates a
role for your agency in crafting a suitable rule for single-
stock futures along with the National Futures Association. You
have addressed some of the concerns you have with that. Do you
have any additional ones that you may have left out?
Mr. Levitt. Well, the problem with the aspect of the bill
that I think represents a serious risk for America's investors
and markets deals with an assumption that the CFTC will oversee
this product. The bill really calls for exclusive CFTC
jurisdiction. There really is no assurance that there will be
the same kind of oversight or regulation as far as the SEC is
concerned. Whatever input we have would have to be at the
pleasure of the CFTC.
I have suggested before that in light of, again, what I
think is an artificial kind of overall regulatory structure,
the best way to proceed on this would be joint SEC/CFTC
oversight. This bill does not provide for that in any way,
shape or form and leaves, in my judgment, America's investors
very, very vulnerable.
Mr. Shimkus. Let me go on. The bill again states that
margins on single-stock futures could not be less than options
on the same underlying stock. Further, it gives the Federal
Reserve margin authority and even allows it to designate that
authority to intermarket margin boards made up of the Federal
Reserve, CFTC and the SEC. Do you think that this solution will
work?
Mr. Levitt. No, I think the solution is a contrived
solution. I think there is no assurance that the Federal
Reserve board will indeed produce such a board; and I--going
back to my experience in running very complicated businesses, I
reject the notion of boards as a solution to very complicated
underlying problems.
Mr. Shimkus. And I would just encourage you, we do value
your input and especially on this issue. The last thing that we
want to do is throw out a product that will put at risk the
individual investors. I look forward to working with you and
the chairman and, if we move legislation, to move it with your
support.
Mr. Levitt. I appreciate that. Thank you.
Mr. Oxley. Mr. Rush from Illinois.
Mr. Rush. Chairman Levitt, I appreciate you being here this
morning. You had some insightful and cogent remarks as relates
to H.R. 4541. I do have a couple of questions. Are there any
benefits to the small investor in the quest to regulate single-
stock futures? Are there any benefits and, if so, what are
those benefits?
Mr. Levitt. Congressman Rush, are you asking me if I
believe there are significant benefits to the retail investor
in the purchase of futures and single-stock futures?
Mr. Rush. Right. That is the question.
Mr. Levitt. Again, this is a personal answer. It is based
on my experience with handling many, many investors through the
years. I think those benefits at best are marginal. I think I
have expressed before my belief that this is not a product that
America's investors are desperately crying for at this point in
time. There are other products I might say the same thing
about, but it is everyone's right to do with their money what
they will. But I also think it is our responsibility to see to
it that we protect innocent investors from products that can be
used unscrupulously and from products that represent levels of
risk that call for a very specific kind of regulatory
oversight.
Mr. Rush. Although some financial markets feel they would
lose business because of participation by the small investors,
does the single-stock futures market have enough opportunities
to include the small investors' participation?
Mr. Levitt. I think the experience of other markets with
single-stock futures has not proven this to be a very
successful undertaking. However, if it does have a potential
for success with retail investors in our markets, with the
level of speculation that exists today with investors being
moved more by emotion than intellect, I think we have to offer
those investors the kinds of protections that we have tried to
outline in our testimony.
Mr. Rush. Thank you, Mr. Chairman. I yield back the balance
of my time.
Mr. Oxley. The gentleman yields back.
If I can just intervene. That was an interesting comment
you made in terms of the investors being driven more by emotion
than intellect. How would investor protection necessarily aid
that individual who is overtaken by emotion?
Mr. Levitt. Well, my concern about that kind of attitude in
our markets is that it does fuel speculation; and much of the
Commission's work has been dedicated, through a program of
investor education in town meetings, in cautioning investors
about scams in the markets at a point in time. Today the
emphasis in our town meetings, the emphasis in our brochures
and on our website has been to caution investors about
borrowing, about margin. Therefore, when we are thinking of
introducing a product which will exacerbate the level of
borrowing, I think it becomes even more important for us to
assure investors that we maintain the basic protections that
presently exist in our markets.
Mr. Oxley. Thank you.
The gentleman from Oklahoma, Mr. Largent.
Mr. Largent. Thank you, Mr. Chairman.
I would like to ask you, Chairman Levitt, there really
hasn't been a case made for additional CFTC regulation of the
over-the-counter energy derivatives market. Why do you believe
that additional regulatory jurisdiction is necessary?
Mr. Levitt. You know, I don't think that I have any feeling
about that. That is a CFTC matter, and I really am not familiar
with the issue.
Mr. Largent. Okay. Are you looking to expand your oversight
jurisdiction of the gasoline markets?
Mr. Levitt. No.
Mr. Largent. I have no further questions.
Mr. Oxley. The gentleman from Michigan, Mr. Dingell.
Mr. Dingell. Welcome, Mr. Chairman.
Mr. Levitt. Thank you.
Mr. Dingell. I am glad to see you back here again. I have a
series of questions I hope you will answer as briefly as you
can because of the large amount of ground we have to cover.
What will be the impact of single-stock or narrow group
index futures contracts on the underlying stock market, do we
know?
Mr. Levitt. I don't think so.
Mr. Dingell. If we lend additional volatility by reducing
the margin, by moving these into futures from the normal
securities market which has 50 percent margin, what would be
the effect on volatility of the market?
Mr. Levitt. If there was substantial interest in such
business, I think it would increase the volatility.
Mr. Dingell. By what order?
Mr. Levitt. I don't know.
Mr. Dingell. Substantially?
Mr. Levitt. Yes.
Mr. Dingell. You have had some attempts lately by the Mafia
to enter into and manipulate the market in securities. You have
been devoting major efforts to addressing that question. What
would a 5 percent margin and reduced regulation of futures do
to the attempts of organizations like this to manipulate the
market?
Mr. Levitt. I think it would just give them additional
opportunities to do their work.
Mr. Dingell. What would be your ability to deal with those
kinds of attempts by Mafiosi and other groups to enter the
market for that purpose?
Mr. Levitt. Under the provisions of this bill, practically
nonexistent.
Mr. Dingell. Have there been any studies of manipulation of
the markets?
Mr. Levitt. With all due respect, I don't think that we
need studies to understand the impact of the kind of leverage
that we are talking about in terms of manipulation.
Mr. Dingell. You are talking about leverage because of
reduced regulation and----
Mr. Levitt. And increased volatility.
Mr. Dingell. Have there been any studies on increased
volatilities?
Mr. Levitt. I am not certain.
Mr. Dingell. Are there adequate protections and
surveillance mechanisms in the bill before us today of the
level of magnitude that you at the SEC would be able to apply
to securities?
Mr. Levitt. I don't believe so, sir.
Mr. Dingell. Is it fair to observe that a future on a
single-stock would be, for all intents and purposes,
interchangeable with the sale of the stock?
Mr. Levitt. Absolutely.
Mr. Dingell. So the investor should have the same
protections whether there is a sale of a future or a sale of
the underlying security?
Mr. Levitt. Yes.
Mr. Dingell. Now, I want you to submit for the record the
differences between your ability at the SEC to address insider
trading and those at CFTC. It is fair to say, however, that
CFTC has much reduced abilities to address the insider trading
questions, does it not? Much less than you have?
Mr. Levitt. I am not precisely certain about the CFTC's
abilities in this regard. I do know that we have seen more
insider trading today than ever in the history of our markets,
and it is one of the major areas of Commission concern.
Mr. Dingell. If there is reduced authority to address
insider trading questions or reduced ability at the SEC to
require paper trails and things of that kind because of
transference of your responsibilities to the SEC, what would be
the impact on investors?
Mr. Levitt. I think it leaves America's investors extremely
vulnerable.
Mr. Dingell. Would you give us a short statement at your
convenience on the differences between insider trading
authorities and paper trail requirements at the SEC and the
CFTC?
Mr. Levitt. Yes, sir.
Mr. Dingell. Are you given adequate authority under this
bill to police the single-stock futures markets for insider
trading?
Mr. Levitt. No.
Mr. Dingell. Why do you say that?
Mr. Levitt. Because it gives exclusive jurisdiction to the
CFTC.
Mr. Dingell. It also reduces CFTC's authority over insider
trading, does it not?
Mr. Levitt. You know, I don't know the answer.
Mr. Dingell. Would you, at your convenience, respond?
Mr. Levitt. Yes.
Mr. Dingell. So if there was to be some kind of major
problem in the market with regard to volatility, with regard to
market drop, let's say something like happened in 1987 where
the market fell 500 points, and let's say there was some kind
of insider trading or manipulation going on, could the CFTC
under the authorities it has under this legislation or your
agency under the authorities it has under this legislation
respond quickly enough to address the problems that might exist
there?
Mr. Levitt. I don't believe so.
Mr. Dingell. Now, if we are to go forward in lifting the
ban on single-stock futures, what regulatory structures should
we impose and who should enforce it?
Mr. Levitt. In my judgment, if we do that, we should
recognize and the bill should acknowledge that a single-stock
future is a security; and all of the protections offered by the
present securities legislation should be available to investors
in a single-stock future. We should try to create a kind of
regulatory scheme where there is a joint regulation, shared
regulation, by the CFTC and the SEC.
Mr. Dingell. Does this legislation do that?
Mr. Levitt. It does not do that.
Mr. Dingell. It has been said that there is no difference
between an option and a single-stock future; is that true?
Mr. Levitt. That is not true. An option has a limited
amount of risk. A single-stock future has an unlimited amount
of risk. I would suggest to you that a naked option is more
closely aligned to a single-stock future.
Mr. Dingell. So an option you can lose your money but your
loss--your potential loss on a single-stock future is
unlimited, isn't that right?
Mr. Levitt. Yes, sir.
Mr. Oxley. The gentleman's time has expired.
Mr. Dingell. I thank the Chair. I look forward to
continuing this at a later time.
Mr. Oxley. The Chair now recognizes the gentleman from
Iowa, Dr. Ganske.
Mr. Ganske. Thank you, Mr. Chairman.
The idea that stocks are inherently risky and the
government should keep people from speculating with excessive
leverage was obvious in the 1930's. Then people thought the
1929 crash had been worsened because overleveraged investors
were forced to sell. Well, it is hard to remember that 70 years
later; and free market advocates claim, if we don't allow such
blatant gambling on stocks, the action will go to some overseas
market. That seems to be a recurrent theme. We shouldn't let
this go to some overseas market. Mr. Chairman, would you
comment on that, please?
Mr. Levitt. Again, I preface that by saying that my
response to that may seem personal and impetuous, but my answer
to your question is, so be it. If insisting that single-stock
futures for retail investors have the same protections that
investment in stocks do means we lose that market, so be it. It
is a price well worth paying in terms of saving America's
investors from the kinds of dangers that an unregulated market
would represent.
Mr. Dingell. Would the gentleman from Iowa yield?
Mr. Ganske. I would be happy to yield.
Mr. Dingell. I thank the gentleman.
Mr. Chairman, what has been the rush overseas into single-
stock futures where they are offered? It has not been moving
fast. It is something on the order of 1 percent?
Mr. Levitt. That is correct. It has not been successful in
Europe or Australia.
Mr. Dingell. So what they found is that no one really wants
these things overseas?
Mr. Levitt. Thus far.
Mr. Dingell. I thank the gentleman for yielding.
Mr. Ganske. The futures market talk of single-stock futures
as providing ``additional risk management tools,'' as Scott
Gordon, chairman of the Chicago Mercantile Exchange, put it in
an interview. They say you can already duplicate in a single-
stock future with a complicated trade in the options market, so
why worry? Mr. Chairman, would you comment on that?
Mr. Levitt. You know, in general, some of the products that
are in our markets today are ones that I think individual
investors have to be very careful about. I think the
proliferation of new products in our markets has been a
benefit. Our markets are more liquid today than ever before,
and I think our futures markets have been a vital part of
managing risk. Our futures markets have been largely
institutional, and, while I applaud the growth and discipline
of those markets and the inventiveness and creativity of new
products, when you translate what has been largely an
institutional product to a retail product, that is a different
ball of wax and one, regardless of the benefits to our
institutional markets, whose benefits I think are largely
nonexistent to the typical retail investor. And I want to be
absolutely certain, and all of us should be certain, that
investors know what they are doing and are protected from the
kind of leverage that is involved and the opportunity for scam
that is created by subjecting investors to this product.
Mr. Ganske. Mr. Chairman, can you tell us about any scams?
Mr. Levitt. Well, I could tell you about so many scams, but
since America's investors have not had the opportunity to
invest in single-stock futures, I can't go into any of those.
Mr. Ganske. Are there scams overseas?
Mr. Levitt. I don't know the answer to that.
Mr. Ganske. I thank you.
Thank you, Mr. Chairman.
Mr. Oxley. The gentleman's time has expired.
The gentleman from Michigan, Mr. Stupak.
Mr. Stupak. Mr. Levitt, is there any reason to preclude
securities exchanges from trading single-stock futures if they
are allowed to trade on futures exchanges?
Mr. Levitt. No. We have had such extraordinary success at
the Commission by forcing our options markets to trade the same
options to really let competition work. The impact of that has
been to reduce spreads by almost a third. The template is
clear. It is there. If we are going to go ahead with a program
to introduce single-stock futures, they should be available to
every market to compete to reduce the cost of that investment
to the benefit of America's investors.
Mr. Stupak. With the rise in day trading, isn't the
potential for increased leverage in the stock market a real
concern?
Mr. Levitt. It is a real concern, yes sir.
Mr. Stupak. Do you believe that unless the tax treatment
and transaction fee treatment for these products traded on a
futures exchange or securities exchanged are not rationalized,
Congress would be determining winners and losers in the
marketplace?
Mr. Levitt. I think to the extent there are disparities,
regulatory disparities and margin disparities, they absolutely
would be.
Mr. Stupak. Could an investor who decided that futures were
too risky and chose to invest in equities be harmed by single-
stock futures? Specifically, would trading in futures affect
the underlying stock price?
Mr. Levitt. I suppose trading in a single-stock future
could affect the underlying stock price. I don't really know
what impact that would have because, frankly, I don't know the
extent of interest that retail investors would have in this
product in the United States.
Mr. Stupak. Would institutional interest really drive the
harm to the market? If you really get into the futures, if the
institution gets into the futures, could that not undermine the
value of the market as we know it now?
Mr. Levitt. I don't necessarily think so. I think that
institutions are very sophisticated; and if they choose to use
futures as they have used other derivative products to manage
risk, I think that is constructive for our markets. I have very
few problems with the use of futures as an institutional
mechanism.
Mr. Stupak. I yield back the balance of my time.
Mr. Oxley. The gentleman yields back.
The gentleman from Maryland.
Mr. Ehrlich. I yield.
Mr. Oxley. The gentleman yields.
The gentleman from Wisconsin, Mr. Barrett.
Mr. Barrett. Thank you, Mr. Chairman.
Mr. Chairman, I want to thank you for coming to Milwaukee
for the town hall meeting. I am still getting many compliments
for your appearance.
Mr. Levitt. Thank you.
Mr. Barrett. I am learning as quickly as I can on this
topic, and my understanding is that the reason we are here is
back in 1982 this was one of the areas where there was not
agreement reached between the SEC and the CFTC and that there
still remains some disagreement now.
What I would like you to do is perhaps help me understand
where the SEC is coming from on four issues if we have time:
the margin levels, the suitability requirements, the
enforcement authority and the security transaction fees.
Maybe we can start with the margin levels. I know that was
something that Mr. Dingell alluded to in his questioning.
Mr. Levitt. Well, in brief, the bill that is before us
today provides for margin to be determined if--as I understand
it, if the Federal Reserve Board goes along with it, the
creation of a board that would adjudicate margin differences.
I think that that is a problematic, questionable solution
that could very well result in margin levels that are different
based upon the product rather than any kind of consistency, and
I think that could very well lead to arbitraging margin. And,
as Congressman Stupak mentioned before, it represents
government choosing winners and losers by determining where the
best deal may be; and I don't think that is our job.
Mr. Barrett. What would be the response from the CFTC on
that, do you think?
Mr. Levitt. You know, I am not certain. But I think the way
to respond to that----
Mr. Oxley. If I can interject, the CFTC will have an
opportunity to testify and answer that question soon.
Mr. Barrett. It is safe to say that is a disagreement
between the SEC and the CFTC?
Mr. Levitt. I am not certain how the CFTC approaches that
issue. Our position has been that we have got to work together
to see to it that margins are harmonized. I think this bill
misses the point by creating what I regard to be a very
complicated, problematic kind of solution involving a board. I
think we should go directly to the mark and say margin will be
harmonized and an investor will not be able to take advantage
of a product because it is traded over there and they have to
put up less money than if it is traded over here.
Mr. Barrett. The enforcement authority issue, obviously an
area where you have to have agreement. What is the issue that
remains unresolved there?
Mr. Levitt. The real issue is the basis of CFTC
enforcement, which I think is really superb, is largely
predicated on the institutional investor and lacks the kind of
history that the SEC has in terms of protecting individual
American investors. It is almost a cultural difference in that
it lacks the self-regulatory organizations that form the basis
of a partnership between SEC regulation and New York Stock
Exchange and Nasdaq regulation. It lacks a history of
inspection, examination, a history of cases predicated on
protecting individual investors, a surveillance mechanism,
maybe most importantly the whole question of suitability, where
the CFTC might say we place a warning up there for investors,
warning them that there is great speculation involved in terms
of a future.
The SEC requires much more with respect to suitability.
Brokers must determine whether a given investor really should
be buying a product. It is not enough that a broker tells your
Aunt Sally that this future is dangerous. If a broker tells
her, yes, it is dangerous Aunt Sally and she chooses to invest
in it anyway and she loses her money, under SEC regulation we
can prosecute the broker because it is highly unsuitable for
Aunt Sally to be buying a dangerous product. Futures regulation
is a very different kind of oversight geared toward very
different kinds of constituents.
Mr. Barrett. Thank you.
Mr. Oxley. The gentleman's time has expired.
The gentleman from California, Mr. Cox.
Mr. Cox. Thank you, Mr. Chairman.
I want to once again welcome Chairman Levitt; and because I
am tardy to this hearing, I am going to try to catch up on the
testimony. Thank you.
Mr. Oxley. Let me now turn to our guest panelist, Mr.
Ewing, who has a brief statement. The Chair would ask unanimous
consent that Mr. Ewing be recognized for 5 minutes for a brief
statement. The gentleman from Illinois.
Mr. Ewing. Thank you, Mr. Chairman. I don't think that I
will take the entire time. I want to thank you for holding the
hearing.
And to Chairman Levitt, I have the greatest respect for
your knowledge and ability on these issues; and I think that
there is--I hope that there is opportunity for this committee
working with you to improve the legislation that was sent here
dealing with this important subject.
I just have maybe one question. The futures exchanges today
are trading stock indices, and I think that the courts have
actually said that they could trade narrow stock indices. How
do you see the difference between that and the single-stock
futures?
Mr. Levitt. First let me say, Congressman Ewing, that I
greatly respect the work that you have done, the background
that you have brought to introducing this bill, the sincerity
of your motives in terms of doing something which you believe
will be beneficial to America's markets.
I believe that our predecessors who came up with the
agreement between the CFTC and SEC and authorized the trading
of futures on broad indices felt that that would not have the
retail impact that trading a future on a narrow index might
have. Now while the courts ruled in that direction, I certainly
stand behind the motivation that was displayed before. We need
securities laws to apply to indexes that can be manipulated. I
think what is important is a question of degree.
In my judgment, trading a broad index represents little or
no danger to a retail investor. Trading a narrow based index
which does create opportunities for manipulation represents a
greater danger to a retail investor. Trading a single-stock
future, a future on a single underlying stock, represents, in
my judgment, the greatest amount of risk to a retail investor
unprotected by the oversight of securities laws.
Mr. Ewing. Mr. Chairman, I appreciate your attitude of
cooperation and the ability to work on this bill. I believe
that we can find a common ground that will protect our
investors, protect our markets and make this legislation work;
and I certainly look forward to in the next few weeks working
with you and with the other parties involved to try and arrange
and come to those conclusions and certainly with this committee
and other committees of the Congress. Thank you very much.
Mr. Oxley. Mr. Chairman, we again appreciate your
participation in this and look forward to working with you and
your staff on these next couple of weeks to try to craft a
compromise legislation. Again, thank you for your appearance.
Mr. Levitt. Thank you.
Mr. Oxley. The Chair would announce that we have three
votes on the floor of the House. I would propose that we
introduce our next panel. If they will come forward we will
begin your testimony, and then when we have to break we will
take a break. Since we have three votes, it will be probably
somewhere in the nature of a half hour by the time we get over
and get back. The witnesses and others may want to, during that
break, have an opportunity to have lunch or whatever; and we
will just play it by ear.
Mr. Oxley. Let me introduce our second panel of the day. C.
Robert Paul is General Counsel for the Commodity Futures
Trading Commission; Mr. Lewis A. Sachs, Assistant Secretary for
Financial Markets, Treasury Department; and Mr. Patrick M.
Parkinson, Associate Director, Division of Research and
Statistics, at the Federal Reserve.
I am sure that you heard my discussion with Chairman Levitt
in regard to the timetable that this committee faces on this
important legislation, and we particularly appreciate your
coming here with short notice to help us understand this very
difficult issue.
We will begin with Mr. Paul.
STATEMENTS OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY
FUTURES TRADING COMMISSION; PATRICK M. PARKINSON, ASSOCIATE
DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM; AND LEWIS A. SACHS,
ASSISTANT SECRETARY FOR FINANCIAL MARKETS, DEPARTMENT OF THE
TREASURY
Mr. Paul. Thank you, Chairman Oxley, Chairman Towns and
members of the subcommittee. I am pleased to appear on behalf
of the Commodity Futures Trading Commission to discuss the
important issues addressed in H.R. 4541.
The Commission commends the efforts of Chairman Combest,
Chairman Ewing and Congressman Stenholm to modernize the
Commodity Exchange Act by introducing H.R. 4541 to provide
legal certainty for over-the-counter derivatives, remove
impediments to innovation and reduce systemic risk. There are,
however, two areas of concern, the scope of the energy
exemption and new burdens on our enforcement authority, that
preclude the Commission from supporting the legislation in its
current form.
The Commission supports the provisions of H.R. 4541 which
enhance legal certainty for over-the-counter derivatives by
excluding from the CEA certain bilateral transactions and
electronic trading facilities. This bill also permits clearing
of OTC derivatives and authorizes a mechanism for the CFTC to
regulate facilities that clear OTC derivative contracts.
We support this recommendation with the following
reservation: The bill would allow securities clearing systems
to clear a broader range of contracts than futures clearing
systems.
This bill would codify an exemption from most provisions of
the Commodity Exchange Act for transactions in energy
commodities. This is an area in which H.R. 4541 diverges from
the recommendations of the President's Working Group, and the
Commission believes that these provisions raise concerns that
have yet to be resolved.
The exemption for energy commodities is not governed by the
same considerations that form the basis of the Working Group's
recommendations with respect to financial products. The
President's Working Group stated that the activities of most
financial derivatives dealers are already subject to direct or
indirect Federal oversight. The same cannot be said of trading
in energy derivatives. The President's Working Group also found
that most financial OTC derivatives are not susceptible to
manipulation. The case has not been made for energy products.
Last month, the Commission published in the Federal
Register its comprehensive regulatory reform package, which
alters fundamentally the Commission's approach to regulation of
markets and participants under its jurisdiction. H.R. 4541
attempts to codify much of the Commission's regulatory reform
proposal, and we welcome this support of the Commission's
initiative.
The Commission will be moving to oversight regulation in
which the agency will no longer act as a gatekeeper and will
intervene only when a problem arises. To succeed, however, the
Commission must be able to act quickly and effectively to
address fraud and manipulation, as well as to protect the
financial integrity of the markets.
Section 15 of the legislation erects several barriers to
enforcement action by the Commission. When there is a violation
of the core principles, the Commission must delay any action
until it provides an appropriate remedy to the violator.
Moreover, the bill requires that the remedy be based upon a
cost-benefit analysis. Thus, the provision may allow registered
entities to postpone and possibly avoid responsibility for
violation of core principles.
H.R. 4541 addresses the issue of equity futures contracts
and reflects efforts to develop a plan to amend the Shad-
Johnson Accord.
The Working Group recommended that the CFTC and the SEC
work together to determine whether and how the Accord should be
amended. The agencies agree in principle that equity futures
should be available to the marketplace. The agency staffs have
agreed on many specific conditions to lifting the ban, such as
authorizing the SEC to prosecute insider trading, harmonizing
margin requirements, notice registration of each other's
registrants, applying customer suitability rules to all
intermediaries, testing personnel, establishing uniform listing
standards for single-stock futures and providing SIPC coverage
to customer accounts carried by securities intermediaries and
segregation to customer accounts carried by futures
intermediaries. We acknowledge, however, a fundamental
disagreement concerning the appropriate legislative approach.
The Commission has sought to avoid creating a framework
that potentially could result in overregulation of markets and
intermediaries; and, therefore, the CFTC staff has advocated
identifying those core provisions from each regulatory regime
necessary to ensure an appropriate level of oversight for
trading these products. While the agencies have agreed in
principle that duplicative regulation must be avoided, the CFTC
staff expressed concern that an ``umbrella'' approach imposing
the panoply of securities regulation to these products could
result in overly burdensome regulation.
The CFTC believes that it is important to bring single-
stock futures to the market in a way that does not result in
the government favoring one market over another. Subjecting the
futures exchanges to securities laws that address public policy
concerns already addressed by the CEA creates a burden that may
preclude fair competition between futures and securities
exchanges.
The Commission notes, however, that SEC's belief that
defining equity futures products as securities is essential to
fulfilling its regulatory functions. This fundamental
difference in approach has led to an apparent impasse, but the
agencies have nonetheless continued to try to reach a
resolution.
With respect to H.R. 4541, we have no objection to the
Shad-Johnson provisions as they bear on regulatory issues
related to the CFTC agency oversight of single-stock futures,
but the CFTC continues to recommend a regulatory structure that
would allow single-stock futures to trade on both securities
and futures exchanges.
Again, the Commission appreciates the opportunity to
present its views. I would be happy to answer any questions you
may have.
[The prepared statement of C. Robert Paul follows:]
Prepared Statement of C. Robert Paul, General Counsel, Commodity
Futures Trading Commission
Thank you, Chairman Oxley and members of the Subcommittee. I am
pleased to appear on behalf of the Commodity Futures Trading Commission
to discuss the important issues addressed in H.R. 4541.
The Commission commends the efforts of Chairman Combest, Chairman
Ewing, and Congressman Stenholm to modernize the Commodity Exchange Act
by introducing H.R. 4541 to provide legal certainty for over-the-
counter derivatives, remove impediments to innovation, and reduce
systemic risk. This bill responds to the President's Working Group's
request for urgent legislative action on its recommendations so that
the U.S. may retain its leadership in rapidly developing financial
markets. Implementation of the Working Group's proposals is essential
to enable U.S. markets to keep pace with the technological and
structural changes occurring in markets around the world, and reform of
the Commodity Exchange Act is a critical element of this process. The
Commission recognizes the challenges involved in an undertaking of this
complexity and appreciates the comprehensive approach to this task. The
CFTC welcomes many of the provisions of H.R. 4541. There are, however,
two areas of concern--the scope of the energy exemption and new burdens
on our enforcement authority--that preclude the Commission from
supporting the legislation in its current form.
The provisions of H.R. 4541 enhance legal certainty for over-the-
counter derivatives by excluding from the CEA certain bilateral
transactions entered into on a principal-to-principal basis by eligible
parties. Legal certainty is a crucial consideration when parties to OTC
derivative contracts decide with whom and where to transact business,
and the President's Working Group recognized that legal certainty for
OTC derivatives is vital to the continued competitiveness of U.S.
markets.
The Commission supports H.R. 4541's exclusion for electronic
trading facilities for OTC financial derivatives to promote an
environment in which innovative systems can flourish without undue
regulatory constraints. H.R. 4541 also permits clearing of OTC
derivatives and authorizes a mechanism for the CFTC to regulate
facilities that clear OTC derivative contracts. Again, the President's
Working Group specifically recommended removing legal obstacles to the
development of appropriately-regulated clearing systems to reduce
systemic risk, and we support this recommendation with the following
reservation. The bill would allow securities clearing systems to clear
a broader range of contracts than futures clearing systems. Futures
clearing facilities would have to register in a dual capacity--as
futures and as securities clearing facilities--to clear the same mix of
contracts available to securities clearing facilities holding a single
registration. By denying futures clearing systems an equal opportunity
to compete, the bill may inadvertently determine winners and losers. We
urge the Committee to avoid placing futures clearing facilities at a
competitive disadvantage.
The Commission also supports the bill's revision of the Treasury
Amendment to make clear our jurisdiction over transactions entered into
between retail customers and unregulated entities, including so-called
``bucket shops.'' We have long sought legal clarity in this area to
protect the public from foreign currency fraud, and the President's
Working Group acknowledged the need for such a clarification.
H.R. 4541 would codify an exemption from most provisions of the
Commodity Exchange Act for transactions in energy commodities. This is
an area in which H.R. 4541 diverges from the recommendations of the
President's Working Group, and the Commission believes that these
provisions raise concerns that have yet to be resolved.
The Commission notes that this exemption for energy commodities,
particularly as it relates to electronic trading systems that
approximate exchange environments, is not governed by the same
considerations that formed the basis of the Working Group's
recommendations with respect to financial products. While there are
some similarities between the trading of financial products and non-
financial products, there are also significant differences. Most
dealers in the swaps markets are financial institutions subject to
supervision by bank regulatory agencies, affiliates of broker-dealers
regulated by the SEC, or affiliates of FCMs subject to CFTC oversight.
``Accordingly, the activities of most derivatives dealers are already
subject to direct or indirect federal oversight.'' (PWG at 16). The
same cannot be said of trading in energy derivatives. The decision to
extend the exclusion in H.R. 4541 to energy derivatives would leave
these OTC products in a regulatory gap--neither directly regulated as
financial products nor indirectly regulated by an agency with
jurisdiction over commercial participants in the energy market. Thus, a
principal argument warranting the exclusion of financial derivatives
from the CEA--the fact that derivatives trading in these products is
subject to direct or indirect federal oversight--does not fit OTC
energy transactions.
The President's Working Group also stated that most financial OTC
derivatives are not susceptible to manipulation. That case has not been
made for energy products.
The CFTC has already exempted many types of energy trading from the
provisions of the Commodity Exchange Act. But the exemption for energy
commodities included in H.R. 4541 expands the scope of the Commission's
existing exemptions for such contracts. The Commission's 1993 energy
exemption is limited to those parties with the capacity to make or take
delivery or the ability to contract to do so, but H.R. 4541 would
extend the exemption to encompass eligible contract participants as
defined in the bill, not just those acting in a commercial capacity.
The 1993 energy exemption is also limited to transactions in which the
material economic terms are subject to negotiation and that may not be
cleared. H.R. 4541 specifically permits clearing and places no limits
on standardization of contract terms. In essence, unlike the
Commission's current energy exemption, H.R. 4541 would exempt
transactions that may be indistinguishable from those conducted in a
traditional exchange environment. It is this multilateral trading
aspect of the proposed statutory exemption that gives rise to the
Commission's concerns.
The Commission recognizes that under the proposed exemption, energy
transactions remain subject to the CEA's antifraud and antimanipulation
provisions and to such transparency rules or regulations as the
Commission may impose. We support the retention of these provisions.
The Commission's responsibility to police for fraud and manipulation,
however, can best be carried out if the Commission is also granted the
commensurate authority to promulgate regulations, where necessary, in
those areas.
Last month, the Commission published in the Federal Register its
comprehensive regulatory reform package, which alters fundamentally the
Commission's approach to regulation of markets and participants under
its jurisdiction. This proposal is based on a comprehensive evaluation
of the CFTC's current regulatory structure and represents an effort to
streamline that structure and to relieve domestic exchanges from
unnecessary regulatory requirements. The proposal also follows the
Congressional directive to transform the Commission from a frontline to
an oversight regulator. The CFTC recently held two days of public
meetings, with 23 witnesses representing a broad spectrum of interested
parties, to maximize the input the agency receives in crafting this new
framework.
H.R. 4541 attempts to codify much of the Commission's regulatory
reform proposal, and we welcome the bill's support of the Commission's
initiative to give registered entities the flexibility to determine the
best way to structure their business and to meet their self-regulatory
obligations consistent with enumerated core principles.
In administering the new flexible structure envisioned by H.R. 4541
and the Commission's regulatory reform proposal, the Commission will be
moving to oversight regulation in which the agency will no longer act
as a gatekeeper and will intervene only when a problem arises. To be
successful in an oversight capacity, however, the Commission must be
able to act quickly and effectively to address fraud and manipulation,
as well as to protect the financial integrity of the markets.
Section 15 of the legislation erects several barriers to
enforcement action by the Commission. When there is a violation of the
core principles, the Commission must delay any action until it provides
an appropriate remedy to the violator. Moreover, the bill requires that
the remedy be based upon a cost/benefit analysis. Thus, the provision
may allow registered entities to postpone and possibly avoid
responsibility for violations of core principles by tying up the
Commission in legal wrangling over whether the agency successfully met
the cost/benefit test. Another consequence is that this section would
essentially turn back the regulatory clock and force the agency to
revert to frontline regulation and issuance of prescriptive rules.
Section 15 also shifts the burden of proof to the Commission in
making a determination that a registered entity is violating a core
principle. This new obligation would severely limit the Commission's
ability to take appropriate remedial action outside the context of a
formal enforcement proceeding. It is important for the Commission and
regulated entities to be able to avail themselves of procedures
designed specifically to craft regulatory changes without the burden of
proof and evidentiary requirements characteristic of formal enforcement
proceedings. These less formal procedures have worked well in those
situations in which the Commission has found it necessary and
appropriate to take remedial action involving a registered entity.
H.R. 4541 addresses the issue of equity futures contracts and
reflects efforts to develop a plan to amend the Shad-Johnson Accord.
The Working Group recommended that the CFTC and the SEC work together
to determine whether and how the Accord should be amended. The agencies
agree in principle that equity futures should be available to the
marketplace. On March 2, the two agencies presented to Congress our
areas of agreement and issues that remained unresolved through that
point, and on May 23, Chairman Levitt and Chairman Rainer met with
Senators Lugar and Gramm to discuss the issue further. The agency
staffs have agreed on many specific conditions to lifting the ban, such
as harmonizing margin requirements, restricting dual trading, testing
for sales and supervisory personnel, and the establishment of uniform
listing standards for single stock futures. We acknowledge, however, a
fundamental disagreement concerning the appropriate legislative
approach.
The Commission has sought to avoid creating a framework that
potentially could result in over-regulation of markets and
intermediaries, and therefore the CFTC staff has advocated identifying
those core provisions from each regulatory regime necessary to ensure
an appropriate level of oversight for trading these products. While the
agencies have agreed in principle that duplicative regulation must be
avoided, the CFTC staff expressed concern that an ``umbrella'' approach
imposing the panoply of securities regulation to these products could
result in overly burdensome regulation. The CFTC believes that it is
important to bring single stock futures to the market in a way that
does not result in the government favoring one market over another,
either by applying too light a touch or by being too heavy-handed.
Subjecting the futures exchanges to securities laws that address public
policy concerns already addressed by the CEA creates a burden that may
preclude fair competition between futures and securities exchanges. The
Commission notes, however, the SEC's belief that defining equity
futures products as securities is essential to its fulfillment of its
regulatory functions.
This fundamental difference in approach has led to an apparent
impasse, but the agencies have nonetheless continued to try to reach a
resolution. Last week, CFTC and SEC staff met twice with Treasury
Department staff to focus negotiations on specific unresolved issues.
We plan to continue these discussions.
With respect to H.R. 4541, we have no objection to the Shad-Johnson
provisions as they bear on regulatory issues related to the CFTC's
oversight of single stock futures. We wish to note, however, that we
have stated from the outset of the discussion on repeal of the Accord
that the CFTC believes a regulatory structure that would allow single
stock futures to trade on both securities and futures exchanges is
preferable to a structure that allows them to trade only on futures
exchanges.
Again, the Commission appreciates the opportunity to present its
views. I would be happy to answer any questions you may have.
Mr. Oxley. Thank you, Mr. Paul.
We have had the second bell; and I guess, in deference to
the members, we will suspend play here and recess the
committee. The committee will stand in recess until 12:30.
[Brief recess.]
Mr. Oxley. The subcommittee will reconvene with our
apologies. Mr. Parkinson, please proceed.
STATEMENT OF PATRICK M. PARKINSON
Mr. Parkinson. Thank you, Chairman Oxley. I am pleased to
be here today to present the Federal Reserve Board's views on
H.R. 4541, the Commodity Futures Modernization Act. My
testimony will be quite similar to testimony that Chairman
Greenspan and I presented last month to committees in the
Senate and House, respectively. The Board continues to believe
that such legislation modernizing the CEA is essential. To be
sure, the Commodity Futures Trading Commission has recently
proposed issuing regulatory exemptions that would reduce legal
uncertainty about the enforceability of the over-the-counter
derivatives, and would conform the regulation of the futures
exchanges to the realities of today's marketplace. These
administrative actions by no means obviate the need for
legislation, however.
I will focus on three areas that the legislation covers:
First, over-the-counter derivatives; second, regulatory relief;
and third, single-stock futures. In its November 1999 report on
over-the-counter derivatives, the President's Working Group
concluded that OTC transactions should be subject to the CEA
only if necessary to achieve the public policy objectives of
the act; that is, deterring market manipulation and protecting
investors against fraud and other unfair practices.
In the case of financial derivative transactions involving
professional counterparties, the Working Group concluded that
regulation was unnecessary for these purposes because financial
derivatives generally are not readily susceptible to
manipulation and professional counterparties can protect
themselves against fraud and unfair practices. Consequently,
the Working Group recommended that financial over-the-counter
derivative transactions between professional counterparties be
excluded from the coverage of the CEA.
The provisions of H.R. 4541 that address OTC derivatives
are generally consistent with the Working Group's conclusions;
therefore, the Federal Reserve Board believes it would be
appropriate to enact those provisions.
The Working Group did not make specific recommendations
about the regulation of traditional exchange-traded futures
markets. Nonetheless, it called for the CFTC to review the
existing regulatory structures, particularly those applicable
to financial futures, to ensure they remain appropriate in
light of the objectives of the CEA. The Board supports the new
approach to regulation that was outlined in proposals issued by
the CFTC last month. For some time the Board has been arguing
that the regulatory framework for futures trading, which was
designed for the trading of grains futures by the general
public, is not appropriate for the trading of financial futures
by large institutions. The CFTC's proposals recognize that the
current one-size-fits-all approach to regulation of futures
exchanges is inappropriate, and they generally incorporate
sound judgments regarding the degree of regulation needed to
achieve the CEA's purposes.
Similarly, the Federal Reserve Board generally supports the
regulatory relief provisions of H.R. 4541. However, the CFTC
has expressed concerns that the bill unduly restricts its
authority to correct violations of the core principles of
regulation. To facilitate expeditious passage of legislation,
it thus may be prudent to address the CFTC's concerns about its
enforcement authority. The Working Group concluded that the
current prohibition on single-stock futures can be repealed if
issues about the integrity of the underlying securities markets
and regulatory arbitrage are resolved.
The Board believes that such instruments should be allowed
to trade on futures exchanges or on securities exchanges with
primary regulatory authority assigned to the CFTC or the SEC,
respectively. However, the SEC should have authority over some
aspects of trading on these products on futures exchanges. The
scope of the SEC's authority should be resolved through
negotiations between the CFTC and the SEC. Whatever agreement
they reach should be codified through amendments to H.R. 4541.
In any event, the bill should allow securities exchanges to
compete with futures exchanges in listing single-stock futures.
H.R. 4541 reflects a remarkable consensus on the need for
legal certainty for OTC derivatives and regulatory relief for
U.S. futures exchanges, issues that have long eluded
resolution. These provisions are vitally important to the
soundness of our derivatives markets in what is an increasingly
integrated and intensively competitive global economy. The
Federal Reserve Board trusts the remaining differences
regarding single-stock futures can be resolved quickly so that
this important piece of legislation can be expedited through
this Congress.
Thank you. I am pleased to answer any questions you may
have.
[The prepared statement of Patrick M. Parkinson follows:]
Prepared Statement of Patrick M. Parkinson, Associate Director,
Division of Research and Statistics, Board of Governors of the Federal
Reserve System
I am pleased to be here to present the Federal Reserve Board's
views on the Commodity Futures Modernization Act of 2000 (H.R. 4541).
My testimony today will be quite similar to testimony that Chairman
Greenspan and I presented last month to committees in the Senate and
House, respectively. The Board continues to believe that such
legislation modernizing the Commodity Exchange Act (CEA) is essential.
To be sure, the Commodity Futures Trading Commission (CFTC) has
recently proposed issuing regulatory exemptions that would reduce legal
uncertainty about the enforceability of over-the-counter (OTC)
derivatives transactions and would conform the regulation of futures
exchanges to the realities of today's marketplace. These administrative
actions by no means obviate the need for legislation, however. The
greatest legal uncertainty affecting OTC derivatives is in the area of
securities-based transactions, to which the CFTC's exemptive authority
does not extend. Furthermore, as events during the past few years have
clearly demonstrated, regulatory exemptions carry the risk of amendment
by future commissions. If our derivatives markets are to remain
innovative and competitive internationally, they need the legal and
regulatory certainty that only legislation can provide.
In my remarks today I shall focus on three of the areas that the
legislation covers: (1) OTC derivatives; (2) regulatory relief for U.S.
futures exchanges; and (3) repeal of the Shad-Johnson prohibition of
single-stock futures.
otc derivatives
In its November 1999 report, Over-the-Counter Derivatives and the
Commodity Exchange Act, the President's Working Group on Financial
Markets (PWG) concluded that OTC derivatives transactions should be
subject to the CEA only if necessary to achieve the public policy
objectives of the act--deterring market manipulation and protecting
investors against fraud and other unfair practices. In the case of
financial derivatives transactions involving professional
counterparties, the PWG concluded that regulation was unnecessary for
these purposes because financial derivatives generally are not readily
susceptible to manipulation and because professional counterparties can
protect themselves against fraud and unfair practices. Consequently,
the PWG recommended that financial OTC derivatives transactions between
professional counterparties be excluded from coverage of the CEA.
Furthermore, it recommended that these transactions between
professional counterparties be excluded even if they are executed
through electronic trading systems. Finally, the PWG recommended that
transactions that were otherwise excluded from the CEA should not fall
within the ambit of the act simply because they are cleared. The PWG
concluded that clearing should be subject to government oversight but
that such oversight need not be provided by the CFTC. Instead, for many
types of derivatives, oversight could be provided by the Securities and
Exchange Commission (SEC), the Office of the Comptroller of the
Currency, the Federal Reserve, or a foreign financial regulator that
the appropriate U.S. regulator determines to have satisfied its
standards.
The provisions of H.R. 4541 that address OTC derivatives are
generally consistent with the PWG's conclusions. At the margin, the
provisions differ from those recommended by the PWG in terms of the
range of counterparties covered by the exclusions. However, these
differences reflect reasonable judgments regarding the types of
counterparties that can protect themselves against fraud and unfair
practices. Therefore, the Federal Reserve Board believes it would be
appropriate to enact these provisions.
regulatory relief for u.s. futures exchanges
The PWG did not make specific recommendations about the regulation
of traditional exchange-traded futures markets that use open outcry
trading or that allow trading by retail investors. Nevertheless, it
called for the CFTC to review the existing regulatory structures,
particularly those applicable to financial futures, to ensure that they
remain appropriate in light of the objectives of the CEA. In February,
the CFTC published a report by a staff task force that provided a
comprehensive review of its regulatory framework and proposed sweeping
changes to the existing regulatory structure. Last month the CFTC
issued a revised set of proposals for public comment. With some
exceptions, the regulatory relief provisions of H.R. 4541 are
consistent with the CFTC's proposals.
Using the same approach as the PWG, the CFTC has evaluated the
regulation of futures exchanges in light of the public policy
objectives of deterring market manipulation and protecting investors.
When contracts are not readily susceptible to manipulation and access
to the exchange is limited to sophisticated counterparties, the CFTC
has proposed alternative regulatory structures that would eliminate
unnecessary regulatory burden and allow domestic exchanges to compete
more effectively with exchanges abroad and with the OTC markets. More
generally, the CFTC proposes to transform itself from a frontline
regulator, promulgating relatively rigid rules for exchanges, to an
oversight agency, assessing exchanges' compliance with more flexible
core principles of regulation.
The Federal Reserve Board supports the general approach to
regulation that was outlined in the CFTC's proposals. For some time the
Board has been arguing that the regulatory framework for futures
trading, which was designed for the trading of grain futures by the
general public, is not appropriate for the trading of financial futures
by large institutions. The CFTC's proposals recognize that the current
``one-size-fits-all'' approach to regulation of futures exchanges is
inappropriate, and they generally incorporate sound judgments regarding
the degree of regulation needed to achieve the CEA's purposes.
Similarly, the Federal Reserve Board generally supports the
regulatory relief provisions of H.R. 4541. However, the CFTC has
expressed concerns that the bill unduly restricts its authority to
correct violations of the core principles of regulation. To facilitate
expeditious passage of legislation, it thus may be prudent to address
the CFTC's concerns about its enforcement authority.
single-stock futures
The PWG concluded that the current prohibition on single-stock
futures (part of the Shad-Johnson Accord) can be repealed if issues
about the integrity of the underlying securities markets and regulatory
arbitrage are resolved. The Board believes that such instruments should
be allowed to trade on futures exchanges or on securities exchanges,
with primary regulatory authority assigned to the CFTC or the SEC,
respectively. However, the SEC should have authority over some aspects
of trading of these products on futures exchanges. The scope of the
SEC's authority can and should be resolved through negotiations between
the CFTC and the SEC. The Congress should continue to urge the two
agencies to settle their remaining differences. Whatever agreement they
reach should then be incorporated through amendments to H.R. 4541. In
any event, the bill should allow securities exchanges to compete with
futures exchanges in listing single-stock futures.
If it would facilitate repeal of the prohibition, the Federal
Reserve Board is willing to accept regulatory authority over levels of
margin on single-stock futures, as provided in H.R. 4541, so long as
the Board can delegate that authority to the CFTC, the SEC, or an
Intermarket Margin Board consisting of representatives of the three
agencies. The Board understands that the purpose of such authority
would be to preserve the financial integrity of the contract market and
thereby prevent systemic risk and to ensure that levels of margins on
single-stock futures and options are consistent. The Board would note
that, for purposes of preserving financial integrity and preventing
systemic risk, margin levels on futures and options should be
considered consistent, even if they are not identical, if they provide
similar levels of protection against defaults by counterparties, taking
into account any differences in (1) the price volatility of the
contracts, (2) the frequency with which margin calls are made, or (3)
the period of time within which margin calls must be met.
conclusion
H.R. 4541 reflects a remarkable consensus on the need for legal
certainty for OTC derivatives and regulatory relief for U.S. futures
exchanges, issues that have long eluded resolution. These provisions
are vitally important to the soundness and competitiveness of our
derivatives markets in what is an increasingly integrated and intensely
competitive global economy. The Federal Reserve Board trusts that the
remaining differences regarding single-stock futures can be resolved
quickly, so that this important piece of legislation can be expedited
through this Congress.
Mr. Oxley. Thank you, Mr. Parkinson.
Mr. Sachs.
STATEMENT OF LEWIS A. SACHS
Mr. Sachs. Thank you, Mr. Chairman, and members of the
subcommittee. I appreciate the opportunity to appear before you
today to discuss H.R. 4541, the Commodity Futures Modernization
Act of 2000.
Mr. Chairman, the OTC derivatives markets provide a number
of benefits to our economy, enhancing the ability of businesses
to manage their risk profiles, to compete more effectively in
the global marketplace and to deliver more efficiently and at
lower cost a wide range of products and services to the
American consumer. It was with this in mind that last year the
President's Working Group on Financial Markets, chaired by the
Secretary of the Treasury, was requested to conduct a study of
the OTC derivatives markets and the Commodity Exchange Act.
In response, the Working Group developed a set of unanimous
recommendations designed to reduce systemic risk, promote
innovation, protect retail customers, maintain U.S.
competitiveness in these markets and protect the integrity of
the underlying markets. We believe that it is important to move
forward with appropriate legislation designed to accomplish
these important objectives as soon as possible. The legislation
before you today largely incorporates the recommendations of
the Working Group with respect to OTC derivatives, and we
support enactment of these provisions.
Let me touch upon a few of the specific objectives that the
bill addresses. First, H.R. 4541 would provide legal certainty.
With regard to swap agreements, the Working Group sought to
address an area in which the need for change had been clearly
demonstrated. The Commodity Exchange Act was designed to
address issues of fraud, manipulation and price discovery.
Therefore, the Working Group unanimously recommended clarifying
the legal status of these instruments by creating a statutory
exclusion from the CEA only for transactions among large
sophisticated parties involving instruments not readily
susceptible to manipulation and that do not currently serve a
price discovery function. This bill would establish such an
exclusion and would permit the electronic trading of these
instruments, and we are supportive of these provisions.
Second, this bill would provide for the development of
appropriately regulated clearinghouses. Well-designed
clearinghouses can help to reduce systemic risk. Consistent
with the Working Group's recommendation, the bill provides for
the development of clearinghouses through clarification of
their legal status and also requires that they be regulated. We
believe these provisions can make an important contribution
toward mitigating systemic risk.
Finally, this legislation takes an important step toward
protecting retail customers by providing the CFTC with explicit
authority to regulate foreign currency bucket shops. We are
pleased that the provisions have been included in this bill.
Let me discuss the bill's provisions relating to the reform
of the Shad-Johnson Accord. We believe, as the Working Group
report states and has been quoted several times here today,
that the current prohibition on single-stock and narrow based-
stock index futures can be repealed if issues about the
integrity of the underlying securities markets and regulatory
arbitrage are resolved. There are a number of concerns,
however, that the regulatory agencies consider important that
have not yet been resolved.
As we have stated, it is important for the SEC and CFTC to
jointly address these issues. We are committed to making every
effort to facilitate progress in resolving these issues.
However, if these issues cannot be resolved on a timely basis,
we believe that it is important to move forward with
legislation designed to clarify the legal certainty for OTC
derivatives and to implement the other recommendations of the
Working Group.
Turning finally to the bill's provisions regarding
regulatory relief for futures exchanges, we continue to support
the view that it is appropriate to review from time to time
existing regulatory structures to determine whether they
continue to serve valid public policy functions. Broadly, we
are supportive of the CFTC efforts to provide appropriate
regulatory relief to the futures exchanges. We recognize the
need for competitive parity between the exchanges and off-
exchange markets, particularly as the status of off-exchange
markets is clarified.
Before concluding, Mr. Chairman, let me touch upon one
issue that is not part of the bill before you today but which
is related and vitally important to the smooth functioning of
our markets during periods of volatility. I would like to take
this opportunity to strongly urge Congress to adopt the Working
Group recommendations regarding the treatment of OTC
derivatives and certain other financial contracts in cases of
bankruptcy or insolvency. Rarely are there tangible steps the
government can take that can have a meaningful impact on the
mitigation of systemic risk, and this is one such opportunity.
In conclusion, Mr. Chairman, we have an opportunity to
advance legislation that will create a modern legal and
regulatory framework for OTC derivatives. We look forward to
working with you and the other members of this committee and
our colleagues of the Working Group to advance these important
objectives.
That concludes my opening remarks. I would be happy to
answer any questions and ask that my prepared remarks be
submitted for the record.
[The prepared statement of Lewis A. Sachs follows:]
Prepared Statement of Lewis A. Sachs, Assistant Secretary, Department
of Treasury
Chairman Oxley, Ranking Member Towns, members of this Subcommittee,
I appreciate the opportunity to appear before you today to discuss H.R.
4541, the Commodity Futures Modernization Act of 2000.
In November 1999, the President's Working Group on Financial
Markets presented its report Over-the-Counter Derivatives Markets and
the Commodity Exchange Act to the Congress. In this report, the Working
Group, which is chaired by Secretary Summers and includes the Chairmen
of the Federal Reserve, the Commodity Futures Trading Commission and
the Securities and Exchange Commission, set forth a series of unanimous
recommendations designed to reform the legal and regulatory framework
affecting the OTC derivatives market. The legislation before you today
would enact many of those important recommendations.
I would like to begin by providing some background on OTC
derivatives and the recommendations of the President's Working Group on
Financial Markets. I will then turn to H.R. 4541 more specifically,
including the bill's treatment of OTC derivatives, regulatory relief
for the futures exchanges, and the reform of the Shad-Johnson
restrictions on the trading of single stock and narrow-based stock
index futures.
i. otc derivatives and the president's working group's recommendations
Mr. Chairman, our financial sector is the central nervous system of
the American economy. As our economy and our financial markets have
evolved over the past two decades, so too have the needs of the
financial sector. Most notably, in an era of globalization, volatility
of interest rates, increased securitization and the growth of the bond
markets relative to the traditional loan markets, businesses and
financial institutions have required a more diverse and effective set
of tools for managing risk.
In that sense, the over-the-counter derivatives market has grown
directly in response to the needs of the private sector. An OTC
derivative is an instrument that allows a party seeking to reduce its
risk exposure to transfer that exposure to a counterparty that wants
and may be in a better position to assume the risk. This is an
important development that has significantly enhanced the ability of
businesses to manage their risk profiles, to compete more effectively
in the global marketplace, and to deliver more efficiently and at lower
cost a wide range of services and products to the American consumer.
Because of these rising demands, the notional value of global OTC
derivatives has risen more than five-fold over the past decade, to more
than $80 trillion according to estimates produced by the Bank for
International Settlements.
The benefits to the American economy of OTC derivatives would
continue to grow within a proper and appropriate framework of legal
certainty. For example:
By helping businesses and financial institutions to hedge
their risks more efficiently, OTC derivatives enable them to
pass on the benefits of lower product costs to American
consumers and businesses.
By allowing for the transfer of unwanted risk, OTC derivatives
promote the more efficient allocation of capital across the
economy, further increasing American productivity.
By providing better pricing information, OTC derivatives can
help promote greater efficiency and liquidity of the underlying
cash markets that feed into a stronger economy for all
Americans.
And, by enabling more sophisticated management of assets,
including mortgages, consumer loans and corporate debt, OTC
derivatives can help lower mortgage payments, insurance
premiums, and other financing costs for American consumers and
businesses.
Thus, OTC derivatives have the potential to bring important
benefits to our economy. It was with the importance of OTC derivatives
in mind that, last year, the Congress requested that the Working Group
conduct a study of the OTC derivatives market and recommend changes
required to ensure that we continue to reap such benefits.
In response, the Working Group developed its set of unanimous
recommendations designed to achieve four objectives:
First, to reduce systemic risk in the OTC derivatives market
by removing legal impediments to the development of clearing
systems and ensuring that those systems are appropriately
regulated.
Second, to promote innovation in the OTC derivatives market by
providing legal certainty for OTC derivatives and electronic
trading systems. This would strengthen the overall legal
framework governing the OTC derivatives market and, in turn,
would stimulate greater competition, transparency, liquidity,
and efficiency and deliver stronger benefits to US consumers
and businesses.
Third, to protect retail customers by ensuring that
appropriate regulations are in place to deter unfair practices
in all markets in which they participate and by closing
existing legal loopholes that allow unregulated entities to
pursue such unfair practices through foreign currency
transactions.
And fourth, to maintain US competitiveness by providing a
modernized framework that will lead those engaged in the
financial services industry to continue the operations of their
businesses in the United States, and thereby promote the
continued leadership of American capital markets.
Given the scope of the bill before you today--providing legal
certainty to OTC derivatives, reforming the Shad-Johnson Accord, and
providing regulatory relief for futures exchanges--today I would add a
fifth important objective:
To protect the integrity of the markets underlying the
derivatives in question--in particular, the securities markets.
While seeking to accomplish these objectives, we need to recall
that the emergence of the OTC derivatives market has come during an era
of unprecedented economic strength and prosperity.
It is to be expected that in times of distress some participants in
these markets, as in other financial markets, will be adversely
affected. The recommendations we have made, and the provisions in this
bill, will not prevent these situations from occurring, nor are they
intended to do so. What needs to be protected, however, is the
financial system as a whole, and not individual institutions.
We believe that our recommendations with respect to clearing and
those designed to enhance transparency and legal certainty and to
clarify the treatment of derivatives in the case of bankruptcy or
insolvency can contribute to enhancing the stability of the system more
broadly.
ii. the commodity futures modernization act of 2000
Let me now turn to the legislation before you today, H.R. 4541. Mr.
Chairman, we believe that this bill incorporates many of the
recommendations of the Working Group with respect to OTC derivatives
which, if enacted, would promote greater legal certainty for these
instruments and help to advance the Working Group's other objectives.
In particular, with respect to legal certainty, we believe that this
bill, with minor changes, would strike the appropriate balance between
allowing the economy to realize more fully the benefits of derivatives
and, at the same time, ensuring the integrity of the underlying
markets, providing appropriate protection for retail customers, and
where possible, taking steps to mitigate systemic risk.
Moreover, we believe that it is important to move forward with
appropriate legislation as soon as possible. A failure to act in this
area would risk a situation in which the existing legal framework for
our financial markets would lag significantly behind the development of
the markets themselves.
In the absence of an updated legal and regulatory environment,
needless systemic risk might jeopardize the broader vitality of the
American capital markets; innovation might be stifled by the absence of
legal certainty; and American consumers might be deprived of the
benefits that a more appropriate legal framework would promote. We also
risk an erosion of the competitiveness of American financial markets,
with an increasing amount of business moving offshore to jurisdictions
in which the regulatory framework has kept up with the pace of change.
With this in mind, I would like to address the three major areas of
the bill:
First, the bill's approach to OTC derivatives;
Second, the provisions of the bill designed to provide
regulatory relief for futures exchanges; and
Finally, the provisions of the bill providing for the repeal
of the Shad-Johnson restrictions on the trading of single stock
and narrow-based stock index futures.
OTC Derivatives
Let me first discuss the bill's provisions regarding OTC
derivatives. H.R. 4541 would take significant steps toward achieving
the Working Group's goals by enacting most of our recommendations
regarding OTC derivatives. While there are a few changes which we would
like to see enacted, such as amendments to the definition of eligible
contract participants and of excluded commodity, we believe that the
legislation takes an appropriate approach to OTC derivatives and
encourage the Congress to adopt these provisions. Let me touch upon a
few of the specific objectives that this bill helps to accomplish.
First, H.R. 4541 would provide legal certainty. The Working Group
members spent several months studying and developing recommendations
regarding the appropriate status of OTC derivatives under the Commodity
Exchange Act. We focused upon areas in which the need for change had
been demonstrated in our markets.
With regard to swap agreements, the Working Group sought to remove
the cloud of legal uncertainty resulting from questions about the
enforceability of certain swap contracts in U.S. courts. This
uncertainty resulted from a lack of clarity regarding whether the CEA
applies to certain OTC derivative transactions. The CEA was designed
primarily to address issues of fraud, manipulation, and price
discovery. Thus, the Working Group unanimously recommended that the
legal status of such contracts be clarified by creating a statutory
exclusion from the CEA for certain OTC derivative transactions which do
not require regulation for these public policy reasons. The exclusion
is limited to transactions involving qualified participants who do not
require the additional protections of the CEA, and the instruments
subject to the exclusion generally are not susceptible to manipulation,
nor do they serve a primary price discovery function at this time.
H.R. 4541 would establish such an exclusion for certain swap
agreements and thereby ensure that the U.S. OTC derivatives market can
develop within the kind of innovative and legally stable environment on
which the continued competitiveness of our financial markets depend.
Second, H.R. 4541 would provide for the development of
appropriately-regulated clearinghouses. The Working Group's report
recommended that Congress enact legislation to provide a clear basis
for the development of appropriately-regulated clearing systems for OTC
derivatives. Well-designed clearinghouses can help to reduce systemic
risk: first, by diminishing the likelihood that the failure of a single
market participant can have a disproportionate effect on the market as
a whole; and second, by facilitating the offsetting and netting of
contract obligations. In addition to these benefits, however, clearing
tends to concentrate risks and certain responsibilities for risk
management in a central counterparty or clearinghouse. Therefore,
appropriate regulation of clearing systems is essential to ensure that
they indeed serve to mitigate systemic risk.
Under the Working Group framework, regulatory oversight could be
provided by the CFTC, SEC, a federal banking regulator, or by a
recognized foreign regulatory authority, depending on the structure of
the clearinghouse and its activities.
H.R. 4541 provides for the development of clearinghouses, and
requires that they be regulated. It thereby can provide the beneficial
effects of reducing systemic risk by encouraging the development of
such systems through the clarification of their legal status and by
subjecting them to appropriate supervision.
However, we believe that H.R. 4541 could be improved by clarifying
the scope of the SEC's authority to regulate clearinghouses that clear
securities and that also wish to clear OTC derivatives.
Finally, H.R. 4541 takes important steps toward protecting retail
customers. The Working Group recommended that the CFTC be granted
explicit authority to regulate foreign currency ``bucket shops'' and to
prosecute such entities when they attempt to defraud retail customers.
H.R. 4541 provides such authority to the CFTC, thus strengthening
protection for small investors. Again, this is an area in which
problems have arisen, and the need for appropriate oversight clearly
has been demonstrated. We are pleased to see these provisions
incorporated in the bill.
The Shad-Johnson Accord
Let me now turn to the section of the bill addressing reform of the
Shad-Johnson Accord. The members of the Working Group agreed that the
current prohibition on single-stock and narrow-based stock index
futures could be repealed if issues about the integrity of the
underlying securities markets and regulatory arbitrage are resolved.
Our view remains unchanged.
The provisions contained in this bill regarding futures on non-
exempt securities are a good starting point, although a number of
issues remain unresolved. The bill addresses some of the customer
protection and enforcement concerns identified by the CFTC, the SEC,
and others as necessary conditions for repealing the prohibition on
single-stock futures. However, there are a number of concerns that the
regulatory agencies consider important, but that have not been resolved
in the legislation. We hope that the SEC and CFTC can provide specific
comments on these issues in the near future so that they can be
incorporated into this bill.
In particular, certain issues related to the harmonization of
margin requirements will need to be clarified. While we do not see the
need to establish margin requirements in statute, it will be important
for regulatory authorities to establish margin levels that do not
encourage regulatory arbitrage or lead to a substantial increase in
leverage in our financial system.
While we have no objection to the introduction of single-stock or
narrow-based stock index futures, it is vitally important that the
integrity of the underlying markets be preserved, and that these
instruments not be used as a means to avoid the regulations of the cash
markets. Therefore, we continue to encourage efforts by the SEC and
CFTC to reach an agreement on a regulatory framework for these products
that preserves the integrity of the underlying securities markets.
However, if these issues cannot be resolved on a timely basis, we
believe that it is important to move forward with legislation designed
to clarify the legal certainty for OTC derivatives and to implement the
other recommendations of the Working Group.
Regulatory Relief
The third component of this bill addresses regulatory relief for
the futures exchanges. The Treasury Department continues to support the
view that it is appropriate to review, from time to time, existing
regulatory structures to determine whether they continue to serve valid
public policy functions. Like the OTC markets, exchange trading of
derivatives should not be subject to regulations that do not have a
public policy justification. Broadly, we are supportive of the CFTC's
efforts to provide appropriate regulatory relief to the futures
exchanges, consistent with the public interest. To this end, the CFTC
has recently released its regulatory relief proposal for public
comment. We will be submitting a formal comment letter on this proposal
in the near future.
There may, however, be unforeseen consequences to legislating such
regulatory relief. Once such provisions are written into law, the
regulators will have no ability to review and amend them should
subsequent market developments warrant change or should other problems
arise. Again, we are supportive of appropriate regulatory relief for
futures exchanges, but suggest that certain aspects of that relief may
be more appropriately provided through administrative action.
iii. the importance of clarifying the treatment of financial contracts
in bankruptcy
Mr. Chairman, although not part of this bill, I would like to take
this opportunity to strongly urge Congress to adopt the President's
Working Group recommendations regarding the treatment of OTC
derivatives and certain other financial contracts in cases of
bankruptcy or insolvency. Rarely are there tangible steps the
government can take that could have a meaningful impact on the
mitigation of systemic risk. Enacting the recommendations of the
Working Group designed to clarify the treatment of these instruments in
bankruptcy is one of those steps. By establishing a framework through
which creditors and counterparties can work out a swift resolution in
cases of bankruptcy or insolvency, enactment of these recommendations
can serve to reduce the impact of the failure of any one institution on
the stability of the system more broadly.
iv. conclusion
In conclusion, Mr. Chairman, we have an opportunity to advance
legislation that will create a modern legal and regulatory framework
for OTC derivatives designed to promote innovation, protect retail
customers, reduce systemic risk, maintain U.S. competitiveness, and
ensure the integrity of our markets. We look forward to working with
the members of this Committee, other members of Congress, and our
colleagues on the President's Working Group in an effort to further
advance these important objectives.
Thank you.
Mr. Oxley. Thank you, Mr. Sachs. Let me begin my 5 minutes
with Mr. Parkinson. The provisions on legal certainty in the
legislation, does that really solve all of the legal certainty
problems that OTC markets now face?
Mr. Parkinson. I think it solves the most significant legal
certainty problems; that is, those relating to eligible
participants, that is, institutions and wealthy individuals use
of securities-based derivatives, electronic trading systems--
other than perhaps those for agricultural products--and
clearing facilities. What it leaves unresolved is whether the
CEA applies to retail swap transactions, but I would note that
we don't believe that there is a significant amount of retail
activity at this time that is being imperiled by that
uncertainty.
Mr. Oxley. Do the margin provisions in the bill adequately
address concerns about consistent margins on single-stock
futures and options?
Mr. Parkinson. Yes, in the sense that the bill empowers the
Federal Reserve to ensure that margins are consistent, and it
makes clear what is meant by consistency in this context. I
think we do have some technical comments regarding the
provisions that define what consistency means, which I think
would be the major source of potential confusion and conflict.
But yes, I think in that sense it does provide a solution.
Mr. Oxley. Let me ask Mr. Paul, what is the overlap between
your regulatory relief proposal and this bill?
Mr. Paul. Congressman, the bill attempts to codify very
much of our regulatory relief proposal as published in the
Federal Reserve last June. However, our proposal is out for
public comment, and the comment period extends until August 7.
We anticipate getting comments in response to those, perhaps
making further refinements in our proposal, but we believe that
the codification put forth in the legislation is fundamentally
close with our proposal and we would expect where our proposal
ends up that we would support the legislation and would look
forward to working with congressional staffs to fine-tune any
adjustments that would be required so that our regulatory
proposal would match up with the codification.
Mr. Oxley. You heard some criticism from the dais earlier
about shifting from a front-line regulator to an oversight
role. First of all, your comments; and second, how would it
impact this legislation?
Mr. Paul. I will answer the second question first.
One way that it would impact, as I suggested in my remarks,
my opening remarks, is that because we are moving from
prescriptive rules to general core principles, we believe it is
more important than ever that we have enforcement authority
that we can exercise quickly and effectively. And we are
concerned with the form of the legislation currently, that may
delay and hamstring us in administering or taking quick and
decisive enforcement action. So we believe that if we modify
that provision in the legislation, we would be in a position to
continue with our current enforcement efforts, and I guess in
connection with some of the comments made earlier I just want
to make the point that we believe that in our 25-year history
we have a very effective record of meaningful and diligent
enforcement in protecting the futures markets, both for
institutional as well as retail investors.
Mr. Oxley. Mr. Sachs, what has been the Treasury's role in
facilitating agreement between the SEC and CFTC on the
regulation of single-stock futures?
Mr. Sachs. Mr. Chairman, we have only in recent weeks been
asked to see if we can help facilitate those discussions. The
CFTC and SEC have had an extensive period of discussion on
Shad-Johnson to see if they could resolve the remaining issues.
We have held several meetings. We have another one I believe
this afternoon, to see if we can't move the process along
further, to make clear to everyone where there is agreement and
where there is disagreement and to see if we might not be able
to help bridge that gap.
Mr. Oxley. Is it possible for CFTC and the SEC, with your
help, to reach an agreement before we start to mark up this
vehicle?
Mr. Sachs. I don't know the answer to that yet, Mr.
Chairman. It is still early in our involvement. The issues are,
as everyone has stated, quite complicated. The two different
approaches that the different agencies take to the way that
they regulate their own markets are quite different. We are
going to make every effort to try to get this done on a timely
basis to be helpful to your committee. But I can't provide any
guarantees.
Mr. Oxley. This is somewhat similar to operating
subsidiaries during the last session. I hate to reopen old
wounds, but it struck me as there are some similarities here.
Other than the CFTC, who I am sure watched from afar with
fascination, but as far as the role of the Fed and the Treasury
and ultimately getting an agreement from Mount Olympus on op
subs which allowed us to go forward and pass historic
legislation, and perhaps Mr. Sachs we can make history one more
time in that regard.
Mr. Sachs. I hope to be able to come back in a few weeks
and say that everyone was able to learn from the experience of
last year and push this along. I can only--we will be happy to
report to you every several days.
Mr. Oxley. We appreciate your working with our staff. As I
say, we are under a severe time constraint and we want to make
every effort to try to craft legislation. We appreciate your
participation, all of your participation.
The gentleman from Staten Island.
Mr. Fossella. Thank you, Mr. Chairman. Just a brief
question for all members of the panel. Do you have any concern
whatsoever--some opponents of the bill have raised concern
about its impact on the margins and potential for insider
trading and a concern that there will be manipulation of stock.
Do you have any opinion on that? And if so, I would like to
hear it.
Mr. Paul. Let me take the first crack in answering that,
Congressman.
From the very beginning in our negotiations with the SEC,
the CFTC has recognized the importance of harmonizing margins
between the two markets. We have discussed a number of
approaches to that with the SEC. We are in general agreement
that the margins should be harmonized. Whether we do that with
the intervention of the Federal Reserve Board or whether we do
it just between our two agencies, we think either way would
work and we would be willing to take either approach.
With respect to insider trading, we have acknowledged and
are in full agreement with the SEC that it is absolutely
essential that any trading of single-stock futures or narrow-
based indices on the futures side would not provide a vehicle
to circumvent the securities laws and the protections that
currently exist. That is why we have advocated and continue to
support that the SEC be given authority to prosecute insider
trading wherever it takes place, whether it be on the
securities or futures side. We think that the bill does that,
but we are interested in continuing to work with the SEC on any
ways that we can make that stronger and make that clearer.
So I actually think that both agencies are in nearly full
agreement on both those issues.
I will just add one other thing which has come up
throughout the conversation today, and that is customer
suitability. We also agree with the SEC for the need for
customer suitability on the futures side. We agree that to the
extent that any futures registrants should be trading these
products, they should be subject to customer suitability rules
on the futures side equivalent to the rules on the securities
side.
Mr. Fossella. When was the last time you met with the SEC?
Mr. Paul. On this matter was last Friday, and we are
scheduled to meet again this afternoon, which we may be
postponing until tomorrow based on running over today. We
continue to move closer to full agreement.
Mr. Parkinson. On the margin issue, I think this is being
painted as much more difficult than it actually is. We hear
again and again that the margin for single stocks in the
security markets is 50 percent and that margins in the futures
markets are 5 percent. In a sense, but only in a very
misleading sense, that is true. The 50 percent margin is the
initial margin on an individual stock. The 5 percent margin or
5.5 percent margin is the maintenance margin on a stock index.
Maintenance margins in the securities markets are 25 percent,
not 50 percent. Furthermore, if one used the same methodology
that the Chicago exchanges use in coming up with their 5.5
percent on a stock index product, that would translate into a
significantly higher margin for a single stock. I think,
depending on the volatility of the individual stock, that could
be anywhere from 10 percent to 30 percent, with the 10 percent
applying to the lower volatility high-cap stocks, and the 30
percent applying to the truly speculative issues of thinly
capitalized firms.
Thus, I think framing the issue on terms of 50 percent
versus 5 percent makes it look like the differences between the
margining systems used in the futures markets and the margining
systems that are in place in securities markets are much
greater than they in fact are.
Mr. Sachs. I have nothing further to add to either of these
comments.
Mr. Fossella. Mr. Sachs, are you concerned at all, or Mr.
Parkinson, that there may be a competitive disadvantage between
the exchanges?
Mr. Sachs. With respect to single-stock futures?
Mr. Fossella. Yes.
Mr. Sachs. Well, we hope that--we think that it is possible
to craft the legislation such that those advantages would not
be--so that there wouldn't be those advantages and
disadvantages. I think if we can all come to agreement on how
these instruments should be regulated, that there would not be
meaningful differences such that one set of exchanges would
have an advantage over the other. And that is actually
something that we need to keep in mind as we work on this
agreement and as you consider the legislation.
Mr. Parkinson. One obvious point, the H.R. 4541 allows
single-stock futures to be traded on futures exchanges, but
does not permit securities exchanges to trade them, so that
obviously is a severe competitive imbalance. I think we have
urged, and I believe Bob has urged, that as this legislation
moves forward, it should be modified so if we have trading of
single-stock futures, as everyone is urging, that stock
exchanges and futures exchanges be able to compete in listing
the products.
Mr. Fossella. Thank you, Mr. Chairman.
Mr. Oxley. The gentleman's time has expired. The gentleman
from New York, Mr. Towns.
Mr. Towns. Mr. Chairman, I am certain that every question
has been asked and every answer has been given. I think that
what I would basically say is that I look forward to working
with you to try and resolve some of the problems that exist,
and I think that working together we can come up with a
solution and be able to move something forward.
I think that the time to do it is now. We don't have a big
turnaround time, but the point is if we work hard in some of
the areas, I think we can come up with a compromise. I look
forward to working with you and of course, Mr. Chairman,
working with you and trying to resolve those issues to be able
to move this legislation forward.
On that note I yield back the balance of my time.
Mr. Oxley. I thank the gentleman for his comments. Indeed,
I share them as well. We want to thank all of you. This
committee does not want to stand in the way of the SEC and the
CFTC meeting during this critical period of time. In that
regard I would ask unanimous consent that all opening
statements be made part of the record and the subcommittee
stands adjourned.
[Whereupon, at 12:57 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
Prepared Statement of Board of Trade of the City of Chicago
The Chicago Board of Trade is pleased to submit for the record this
testimony on H.R. 4541. We strongly endorse this vital legislation. We
appreciate this Subcommittee's interest in the issues addressed in H.R.
4541 and welcome the opportunity to summarize for you our views on the
legislation.
All commerce involves price risk. Futures markets help to address
that price risk by offering a vehicle for shifting those risks to
others or identifying a going market rate. For many decades,
agricultural futures contracts traded on U.S. futures exchanges were
the only organized, centralized markets for managing price risk. Since
1975, that list of commodities has expanded to include precious metals,
petroleum products, foreign currency and interest rates. In 1982, the
list was expanded again to include stock indexes like the Dow Jones
Industrial Average. All of those markets are regulated under the
Commodity Exchange Act, a statute administered since 1975 by the
Commodity Futures Trading Commission.
In the last fifteen years this landscape has changed. Financial
engineers on Wall Street have invented swaps and other derivatives to
replicate the risk-shifting benefits of futures trading. Swaps have
become enormously popular and profitable, offering tailored, customized
risk-shifting service to most facets of our economy. Swaps are traded
on interest rates, currency rates, commodity prices and equity
securities. Today, swaps are even offered in more standardized versions
on electronic trading platforms. And, swap transactions are not subject
to any form of regulation that even approaches the regulation of
futures or securities markets.
This development triggered or exacerbated three problems.
First, the Commodity Exchange Act covers all futures contracts. All
futures must be traded on CFTC-regulated exchanges, absent an
exemption. If a swap is a futures contract, it is illegal and voidable
by either party to the transaction. As a result, swaps today are said
to operate under a cloud of legal uncertainty caused by the perceived
lack of specificity in the Commodity Exchange Act's coverage.
Second, as the President's Working Group observed last year, the
development and maturation of the swaps market has blurred many of the
traditional ways that swaps were distinguished from futures contracts.
Since swaps are largely unregulated and futures are heavily regulated,
the Working Group unanimously agreed that something should be done to
rectify that competitive disparity without imposing additional burdens
on swaps.
Third, despite the current legal uncertainty, equity swaps are
being offered on single equity securities. In 1982, however, Congress
adopted what is known as the Shad-Johnson Accord and imposed what it
thought was a ``temporary'' moratorium on trading in futures on single
equity securities. (The moratorium was to be temporary while the SEC
and CFTC figured out the best way to regulate single stock futures.
Congress is still awaiting that joint recommendation some 18 years
later.) If equity swaps are futures, they too are subject to that
``temporary'' ban. If swaps are not futures, then the futures exchanges
simply need to start offering equity swaps to avoid the ban. Since
figuring out what transactions are futures and what transactions are
not has stymied Congress, the courts and commentators for many years,
the President's Working Group recommended last year finding a way to
simply lift the ban while addressing any major market integrity issues.
H.R. 4541 attempts to resolve each of these three challenges. It
does so by promoting fair competition to strengthen U.S. markets while
minimizing, but not eliminating, regulatory arbitrage. It treats the
competitive interests of the swaps dealers, futures exchanges and
options exchanges in a fair and even-handed manner. It recognizes and
tries to anticipate the role of technology in the markets of the
future. And it preserves important public and market integrity
protections. H.R. 4541 is comprehensive, balanced and responsible.
First, H.R. 4541 attempts to address the legal uncertainty issue by
creating bright-line tests defining what transactions are subject to
the CEA and what are not. The lines drawn are basically adapted from
last year's President's Working Group Report. Any transactions in
financial commodities, called excluded commodities, not on a physical
trading facility are excluded from the CEA unless they involve a retail
customer. Special rules apply to these transactions when traded on
electronic trading facilities. In that context, the CEA does not apply
to trades that meet two tests: trades must be principal to principal
(not on behalf of customers) and limited only to sophisticated
counterparties or institutions. Excluded transactions may be subject to
clearing arrangements and still be excluded from regulation.
As a result of these provisions, many futures contracts traded
today on CFTC-regulated exchanges, including futures on currencies,
Eurodollars and stock indexes, could be offered without any form of
regulation, even if traded on the same centralized electronic systems
the futures exchanges use. This regulatory arbitrage is even more
pronounced when one considers that over 95% of the market participants
in exchange-traded futures today are the same professional,
sophisticated counter-parties that are eligible to trade in the
excluded futures. The net result of these provisions: same contracts,
same customers, same trading system, but very different regulatory
treatment.
H.R. 4541's second prong attempts to minimize this regulatory
arbitrage by modernizing the regulatory burdens imposed on exchanges.
Instead of current law's innumerable rigid mandates that promote
government micromanagement, H.R. 4541 requires exchanges to meet
flexible performance standards, subject to the CFTC's oversight, in
order to discharge their self-regulatory obligations. Exchanges could
tailor their systems for compliance with specific self-regulatory
requirements to the needs of different markets, rather than the current
``one size fits all'' brand of regulation. On balance, the message of
H.R. 4541 to the futures exchanges is this--Congress will not shackle
your over-the-counter competition; it wants you to compete with them
and is willing to give you many of the tools you believe you need to
compete effectively on a fair, if not completely level, playing field.
The third prong of H.R. 4541 involves a similar message in the area
of equity-based derivatives. The 1982 ban on single stock futures would
be lifted subject to special regulatory requirements that are designed
to accommodate the areas of concern expressed by the Securities and
Exchange Commission, and others. Specifically, single stock futures
must be: 1) cash-settled; 2) not susceptible to manipulation; 3) traded
at margin levels that are consistent with stock options margins; 4)
traded only on stocks that meet SEC eligibility requirements for stock
options; 5) traded without dual trading brokers; and 6) offered only on
exchanges that agree to provide the SEC such information as the SEC and
CFTC jointly consider to be necessary for the SEC to carry out its
enforcement powers. Under those enforcement powers, the SEC is free to
bring actions to enforce core securities law protections in connection
with single stock futures trading: insider trading, short swing
profits, manipulation, front-running, tender offer pricing and
integrity and trading in restricted securities. The SEC would be able
to bring these actions unilaterally without seeking cooperation or
concurrence from the CFTC.
In addition, margins for single stock futures would ultimately be
set and supervised by the Federal Reserve Board or an Intermarket
Margin Board where the SEC and CFTC would have an equal voice. And the
futures industry-wide self-regulatory body, the National Futures
Association, would adopt and enforce a special suitability rule for any
futures professional that recommended a single stock futures trade to a
customer. NFA must consult with the SEC and CFTC, and obtain CFTC
approval of this rule, within 9 months of the date of enactment.
H.R. 4541 responds to the three critical issues that the General
Accounting Office, in its April 2000 report, identified for single
stock futures--insider trading, margin and suitability--by, in effect,
incorporating securities law concepts into the futures regulatory
apparatus. Through these special provisions, H.R. 4541 addresses the
major areas of possible regulatory arbitrage between futures exchanges
and options exchanges. As in the area of off-exchange and on-exchange
futures trading described earlier, the bill minimizes, but does not
eliminate entirely, regulatory arbitrage. Instead, H.R. 4541 promotes
competition by finally allowing the futures exchanges to offer equity-
based derivatives that swaps dealers and options exchanges now may
offer in other guises.
Mr. Chairman, many observers believe that U.S futures exchanges are
falling behind their competition both overseas and over-the-counter.
Today, the Swiss-German electronic exchange, called EUREX, has replaced
the Chicago Board of Trade as the futures exchange with the highest
trading volume. To address these threats, the Board of Trade is
restructuring and reorganizing its business operations to maximize our
chances of capturing the benefits of new technology and innovations. We
know we are in for a fight and we are willing to compete. Rationalizing
regulation and removing competitive barriers imposed by statute, as
contemplated by H.R. 4541, are critical elements in our competitive
battle.
For these reasons, the Chicago Board of Trade strongly endorses
H.R. 4541. It tackles the difficult challenges of modern markets in a
pro-competitive manner without sacrificing important regulatory
interests. We urge you to join the House Agriculture Committee by
giving H.R. 4541 favorable treatment in this Subcommittee and the Full
Committee. We look forward to working with you as your deliberations
progress.
______
Prepared Statement of Scott Gordon, Chairman, Board of Directors,
Chicago Mercantile Exchange
Chairman Oxley, members of the Subcommittee, I am Scott Gordon,
Chairman of the Board of Directors of the Chicago Mercantile Exchange
(CME). The CME welcomes the opportunity to provide this testimony for
the record. More than a year ago, on May 19, 1999, the Exchange
appeared before the Risk Management Subcommittee of the Agriculture
Committee to offer its view of the reauthorization process and the
important issues facing the industry and the Commission. Even at that
early stage of the process, the CME and the Chicago Board of Trade had
taken the lead and proposed a legislative framework for rationalizing
the regulation of derivatives markets.
The CME and CBOT were joined by the New York Mercantile Exchange in
our effort to craft amendments to the Commodity Exchange Act to enhance
competition and customer opportunity. We proposed five principles and a
long list of detailed proposals. We proposed a means to rationalize the
CEA and to restore internal consistency in concert with sound public
policy. Within our framework, each segment of the industry, other than
securities exchanges, which seek protection from legitimate
competition, got exactly what it had been publicly seeking. Our
proposal went farther than the OTC request for codification of the
swaps exemption. We proposed that swaps could be cleared without losing
their exemption. We were diligently following advice of congressional
leaders that we needed to gain sufficient support from the derivatives
industry to ensure passage of much needed reform legislation. We
proposed a five-part plan:
Convert the CFTC to an oversight agency
Reform the artificial competitive constraints imposed by the
Shad/Johnson Accord
Expand access to futures markets
Provide legal certainty to OTC markets
Level the regulatory playing field
Since that testimony, most of the participants and regulators in
the financial services industry have worked in good faith to find a
compromise proposal. The President's Working Group on Financial Markets
issued an extensive report. On February 28, 2000, the Department of the
Treasury submitted a draft amendment to the Commodity Exchange Act that
embodies the recommendations of the PWG.
Chairman Ewing held extensive hearings, listened to all views and
concluded that the time is ripe to alleviate the excessive regulatory
burdens that have greatly disadvantaged U.S. futures exchanges in
comparison to their global competition. Chairman Ewing sought a
consensus-driven solution that balanced the interests of all
participants in the financial services industry.
This intensive effort by Chairman Ewing and the staff of his
Subcommittee produced the bill that is the subject of today's hearing.
We are on record praising H.R.4541 as providing a significant reform of
financial services regulation and creating a more equitable regulatory
environment for futures exchanges. By providing a comprehensive
approach to the inter-related goals of modernizing exchange regulation,
reforming Shad-Johnson and establishing legal certainty for the OTC
market, this bill appropriately balances the interests of all
participants in the financial services industry while promoting the
public interest.
We strongly support Chairman Ewing's proposal to reform the Shad/
Johnson Accord. Eighteen years ago, the Shad-Johnson Accord resolved a
jurisdictional conflict between the SEC and the CFTC. It included a
temporary ban on most equity futures contracts. It was not intended as
a permanent barrier to innovation and growth. Futures exchanges were
able to develop broad based stock index futures under Shad/Johnson.
Those products have matured into vital financial management tools that
enable pension funds, investment companies and others to manage their
risk of adverse stock price movements.
The CME's long standing goal is freedom to list and trade futures
contracts now forbidden by the Shad/Johnson Accord without being
subjected to multiple regulators and without changing the principles
upon which futures trading has been conducted for more than 100 years.
Remember, we created a tremendously useful product, equity indexes, in
the face of overwhelming opposition. The SEC and its exchanges opposed
futures on indexes with all of the same arguments that they now raise
against futures on individual securities. Nonetheless, equity indexes
are among the most popular contracts on securities exchanges as well as
futures exchanges. Futures trading of equity indexes has enhanced
customer opportunity with none of the ill consequences predicted by the
SEC or securities exchanges. In fact, their business has directly
benefited.
The options markets and swaps dealers offer customers risk
management tools and investment alternatives involving both sector
indexes and single stock derivatives. Futures exchanges have been
frozen out. Shad/Johnson's ``temporary'' ban lasted 18 years during
which time single stock futures have thrived in the OTC market in the
form of equity swaps and on option exchanges in the form of synthetic
futures. Recently the President's Working Group, the General Accounting
Office and congressional leaders have all called for an end to the ban.
On December 17, 1999, Chairman Lugar (Senate Agriculture Committee)
and Chairman Gramm (Senate Banking Committee) asked CFTC Chairmen
Rainer and SEC Chairman Levitt for a ``detailed report addressing the
desirability of lifting the current prohibition on single stock futures
together with any legislative proposals . . . no later than February
21, 2000.'' On January 20, 2000, Commerce Committee Chairman Bliley
along with Chairmen Combest and Ewing asked the SEC and CFTC to create
a ``joint legislative plan for repealing the current prohibition on
single stock futures . . . no later than February 21, 2000.'' On March
2d, Chairmen Levitt and Rainer responded by presenting ``the current
views'' of the agencies, but failed to offer a specific legislative
plan.
Of course, we are pleased that the CFTC and SEC have agreed that it
is appropriate that U.S. exchanges be permitted to compete in world
markets and offer U.S. customers the opportunity to manage risks by
means of equity futures contracts. We are also pleased that they have
found a way to accommodate their jurisdictional and regulatory concerns
on several important issues. But it is far too late in the game to be
satisfied with signs of progress. We share Senator Lugar's
``disappointment'' that the agencies were unable to resolve all of
their jurisdictional concerns within the time frame requested.
Today, Shad-Johnson is a bar to useful competition. The SEC invoked
Shad-Johnson to bar futures on the Dow Jones Utilities and
Transportation Averages--because that index did not ``reflect'' the
utilities and transportation sectors. The United States Court of
Appeals overturned and vacated that SEC decision, Board of Trade v.
Securities and Exchange Commission, No. 98-2923 (7th Cir., August 10,
1999). The court of appeals found: ``The stock exchanges prefer less
competition; but if competition breaks out they prefer to trade the
instruments themselves . . . The Securities and Exchange Commission,
which regulates stock markets, has sided with its clients.'' Slip Op.
at 4.
Congress intended the Shad-Johnson ban on single stock futures to
be temporary. The court of appeals found that the ban ``was a political
compromise; no one has suggested an economic rationale for the
distinction.'' Slip Op. at 4. In the absence of such a rationale,
Congress should lift the single stock futures ban and allow the
marketplace to decide whether these instruments would be useful new
risk management tools. Many exchanges around the world trade single
stock futures; no reason exists to deny U.S. customers and markets the
same opportunity.
H.R. 4541 will enact an appropriate division of responsibility
between the SEC and CFTC for futures trading of contracts currently
prohibited by the Shad/Johnson Accord. It protects the SEC's
enforcement authority and forecloses avoidance of securities act
proscriptions by means of futures contracts. It protects options
exchanges from regulatory arbitrage arising out of disparate margin
treatment. It serves the public interest in fair competition and access
to new products. It imposes more restrictions on futures exchanges than
we had hoped for but not so many that we will be unable to fairly test
the market's appetite for new products
Last year, the 106th Congress took dramatic action and modernized
regulation of most financial services firms by adopting the Gramm-
Leach-Bliley Act. The consequences of excluding the derivatives
industry from this progressive groundswell would be disastrous. We hope
that Congress will act expeditiously on H.R. 4541 to ensure that
complete financial regulatory reform becomes part of the legacy of this
Congressional Session. We pledge to work diligently with members of the
House to ensure that the all of the fundamental principles of this bill
are enacted into law this year.
Thank you again, Mr. Chairman, for the opportunity to include our
written testimony in the record of this hearing.
______
North American Securities Administrators
Association, Inc.
Washington, DC
July 12, 2000
David Cavicke, Majority Counsel
2125 RHOB
Washington, DC 20515
Dear Mr. Cavicke: The North American Securities Administrators
Association (NASAA) \1\ appreciates the opportunity to provide comments
on H.R. 4541, the Commodity Futures Modernization Act of 2000. We
support your effort to modernize our futures laws and provide legal
certainty for over-the-counter derivatives.
---------------------------------------------------------------------------
\1\ The oldest international organization devoted to investor
protection, NASAA was organized in 1919. Its membership consists of the
securities administrators in the 50 states, the District of Columbia,
Canada, Mexico and Puerto Rico. NASAA is the voice of securities
agencies responsible for investor protection and efficient capital
formation.
---------------------------------------------------------------------------
NASAA also supports lifting the Shad-Johnson ban on single stock
futures once the regulatory oversight concerns underlying the ban are
addressed. Any regulatory framework must recognize the expertise of
both the SEC and the CFTC in regulating these products and the unique
enforcement role played by the 20-plus states that have adopted the
Model Commodity Code. Both federal agencies and state securities
agencies must have the authority to carry out their core functions;
there should be no barriers in their efforts to curtail fraud and
manipulation.
In 1974, Congress preempted state securities agencies from applying
their laws, including enforcement, to persons and transactions within
the Jurisdiction of the Commodity Exchange Act (CEA). Not long after,
there was a proliferation of off-exchange commodities fraud. In 1978,
Congress passed Section 6(d) of the CEA to provide the states with the
authority to enforce state laws of general criminal application and
allowed the states to enforce the CEA in federal court.
It would be unwise at this time to move ahead with legislation that
lacks the elements necessary to ensure the market integrity and
customer protections that investors have come to expect under the
securities laws.
It is important to recognize that single stock futures will be a
substitute for stocks and stock options and be sold as a retail
product. While complex derivatives are sold mostly to institutional
customers, futures on a single stock are the type of product that will
be attractive to the retail investing public. Single stock futures must
be offered to retail investors with the same protections afforded to
those who now buy stocks and stock options. Americans are investing in
our capital markets in record numbers due largely to confidence in the
markets instilled by our complementary Federal/state/industry system of
regulation.
Any legislation to lift the current ban on single stock futures
must maintain the SEC's ability to protect investors and to maintain
integrity of the markets on which they trade. The SEC should have clear
and direct authority over the markets and market participants trading
single stock futures.
SEC and CFTC Chairmen Arthur Levitt and Bill Rainer have made
considerable progress toward reaching agreement on a regulatory regime
for single stock futures. They should be given sufficient time to
finalize the details of a plan to share regulation of single stock
futures so each agency can utilize its expertise and create a framework
that allows for effective and efficient joint regulation of these
products.
NASAA appreciates the efforts of your Subcommittee to consider H.R.
4541 under a limited time frame. We urge you to amend the current
version of the legislation and extend the protections of the securities
laws to single stock and narrow-based stock index futures. American
investors deserve no less.
Please do not hesitate to contact me at 317-232-6695 or Deborah
Fischione, NASAA's Director of Policy, at 202-737-0900.
Sincerely,
Bradley W. Skolnik
Indiana Securities Commissioner
NASAA President
______
Prepared Statement of The Bond Market Association
The Bond Market Association is pleased to comment on H.R. 4541, the
Commodity Futures Modernization Act of 2000. H.R. 4541 represents an
important step in the regulatory reform of the markets for derivative
financial products. The bill includes a number of proposals designed to
streamline the regulatory environment for derivatives, and clarify
several important areas of legal uncertainty which result in undue
systemic risk. For these reasons, we commend Chairman Oxley for
focusing the subcommittee's attention on H.R. 4541 and we support these
aspects of the bill.
Reauthorization of the Commodity Exchange Act (CEA) presents an
opportunity to clarify the regulation of certain financial products and
to eliminate any misconception regarding the scope of authority
provided under the CEA. We concur with the widely held belief that
swaps are inappropriately regulated as futures, and we believe that the
CEA should codify the principle that swaps should not be regulated as
futures by the Commodity Futures Trading Commission (CFTC). Such
clarification would mitigate legal risk for market participants and
would help maintain over-the-counter markets as viable alternatives to
traditional, organized exchanges. It would also help avoid duplicative
and unnecessary regulation. Congress has the opportunity through the
CEA reauthorization to help assure that the capital markets can
continue to operate as efficiently as possible.
The Bond Market Association represents securities firms and banks
that underwrite, trade and sell fixed-income securities in the U.S. and
international markets. Our interests in H.R. 4541 relate to how the
bill would affect the efficient operation and regulation of the markets
for bonds and other fixed-income securities and related instruments,
and our comments will focus on just those aspects of the bill.
The Financial Markets and the CEA
As the Subcommittee is aware, the financial markets have grown
increasingly complex in recent years. Issuers of securities and other
market participants have become accustomed to having a wide array of
products available to meet very specific financing and hedging needs.
Unfortunately, the United States regulatory system has not kept pace
with the evolution of the marketplace. Issuers, underwriters and
dealers now find themselves laboring to decipher a web of overlapping
and often contradictory statutes and regulations that reduce efficiency
and increase costs. Of particular concern is the potential for private
parties to exploit ambiguities in the CEA to abandon responsibility for
otherwise enforceable contracts--even if there is no fraud or bad
faith--by alleging that a transaction is an illegal off-exchange
futures transaction. We know that this subcommittee, regulators and
participants in these markets have an interest in ensuring the finality
of financial contracts and thereby reducing potential risks to the
financial system as a whole, and we commend Chairman Oxley for
exploring ways to improve and update the Commodity Exchange Act.
The Association takes an active interest in promoting and ensuring
safe and efficient bond markets that allow governmental entities and
corporations to raise debt capital at the lowest possible cost. Toward
that end, the basic policy positions we seek to advance as Congress and
the regulatory agencies deal with issues surrounding the CEA are:
preserving the finality and enforceability of contracts freely
negotiated between market participants;
maintaining the OTC markets as a viable alternative to
traditional organized exchanges; and
avoiding duplicative or unnecessary government regulation in
the trading and clearance of debt instruments.
Consistent with the above principles, we offer the following
summary of our views on certain issues that are integral to the current
discussion of CEA reauthorization. The Association:
supports provisions of the bill which would reaffirm and
clarify the Treasury Amendment and recommends an additional
change;
supports the goals of other provisions of H.R. 4541 designed
to provide ``legal certainty'' for over-the-counter
derivatives; and
supports provisions of the bill related to derivatives
clearing organizations;
urges the adoption of legislation to reduce systemic risk in
the financial markets by reforming bankruptcy and insolvency
law to clarify and enhance the ability to close-out and net
financial contracts.
Treasury Amendment
The market for government securities is well regulated under a
structure tailored to the unique qualities of the market. Under
authority provided by the Government Securities Act of 1986 and
subsequent 1993 amendments, the Treasury Department is a principal
rulemaker for the government securities market. The Treasury
Department, in consultation with other regulators, has published
detailed rules regarding large position reporting and record-keeping.
The National Association of Securities Dealers and bank regulators have
published rules regarding sales practices. The SEC has broad authority
to enforce antifraud statutes on government securities market
participants. The CFTC and the organized exchanges, of course, regulate
activity related to transactions in listed futures contracts on
government securities. This balanced arrangement ensures that the
government securities market remains safe and well-regulated in
addition to serving as a model of market efficiency.
Efficient and sound regulation of the government securities market
is important because it helps ensure that taxpayers pay the lowest
possible interest cost on the government's borrowing and that other
U.S. borrowers whose debt is priced relative to Treasury securities--
corporations, financial institutions, homebuyers, consumers and
others--also enjoy efficiently determined borrowing costs. There are
approximately $3.1 trillion of marketable Treasury securities
outstanding, and over $200 billion of Treasury securities change hands
every day. Any undue risk or uncertainty regarding the market's
regulatory structure can have significant effects on the government's
interest cost and the interest rates faced by other borrowers.
When the CEA was first enacted in 1974, Congress included a
provision precluding the CFTC from regulating ``transactions in foreign
currency, security warrants, security rights, resales of installment
loan contracts, repurchase options, government securities, or mortgages
and mortgage purchase commitments, unless such transactions involve the
sale thereof for future delivery conducted on a board of trade.'' This
provision has become known as ``the Treasury Amendment.'' The Treasury
Amendment is important because it helps prevent duplicative or
conflicting regulation.
Despite the plain meaning of existing statutory language, the
Treasury Amendment does not explicitly address questions regarding the
regulation of financial products which involve government securities.
These include, for example, instruments such as repurchase agreements,
swap contracts and forward delivery contracts. This issue was
addressed, albeit indirectly, by the U.S. Supreme Court in its 1997
decision in Dunn v. CFTC, where the Court generally held that
``transactions in'' foreign currency encompass all transactions
relating to foreign currency. Market participants nevertheless widely
believe that the same standard applies to other financial products
covered under the Treasury Amendment, including government securities.
H.R. 4541 would generally maintain the current structure of the
Treasury Amendment. The bill would specify that the CEA does not apply
to transactions in government securities, foreign currency, security
warrants, security rights, resales of installment loan contracts,
repurchase transactions in a financial commodity--a particularly
important and welcome clarification--or mortgages or mortgage purchase
commitments. Futures contracts related to these products traded on an
``organized exchange'' would still be subject to CFTC regulation under
the bill. The bill retains existing statutory language, implying
Congress' intent to embrace the Supreme Court's interpretation of such
language. However, H.R. 4541 would not expressly codify the Supreme
Court's interpretation of existing law regarding financial products
involving the enumerated instruments. We, therefore, suggest amending
H.R. 4541 to fully clarify the scope of the Treasury Amendment
provisions and address any remaining legal uncertainty regarding the
scope of the Treasury Amendment's applicability. In particular, we
suggest adding language to Section 4 of the bill specifying that the
Treasury amendment exclusions apply to transactions ``in or in any way
involving'' the specified instruments.
Organized Exchanges
H.R. 4541 would also clarify the applicability of the Treasury
Amendment by specifying an exception to the general exclusion for
contracts traded on an ``organized exchange.'' Current law provides an
exception to the Treasury Amendment for contracts traded on a ``board
of trade.'' The definition of ``board of trade'' is somewhat vague with
respect to both evolving electronic trading systems and the roles of
certain traditional market participants such as inter-dealer brokers.
If ``board of trade'' was defined under current law to include
electronic trading facilities or situations where market participants
conduct transactions in a screen-based format and settle them through
an independent clearing mechanism, significant market disruption would
result. In particular, such a definition would subject already
regulated markets to a duplicative layer of government regulation.
We support the clarification of the Treasury Amendment exclusion
from the CEA through the ``organized exchange'' exception. The bill as
introduced, however, included a vague definition of organized exchange
that would have required that transactions take place on a ``bona fide
principal-to-principal basis,'' calling into question the applicability
of the exception to traditional ``back-to-back'' principal
transactions. The Agriculture Committee during its deliberations on
H.R. 4541 clarified the definition of organized exchange by eliminating
the confusing term ``bona fide.'' We strongly support this change and
we urge that it be retained in the legislation.
Legal Certainty for OTC Derivatives
Under current law, the CEA effectively gives a party the right to
rescind a contract if the party is successful in its allegations that
the transaction was actually an illegal, off-exchange futures contract.
Under the CEA, over-the-counter commodity futures transactions are per
se illegal unless they are excluded by the Treasury Amendment or some
other exclusion or exemption. Private parties have taken the position
that such transactions are subject to rescission. This harsh
consequence of voiding a contract is particularly troublesome in light
of the difficult questions associated with defining a future versus a
forward transaction. We believe the financial markets should not be
subject to the risks posed by the ability to abandon contract
obligations when the CEA status of a financial transaction is
challenged. H.R. 4541 includes two key provisions designed to address
this problem.
First, the bill would specify that financial contracts may not be
rescinded ``solely on the failure of the agreement, contract, or
transaction to comply with the terms or conditions of an exemption or
exclusion from any provision of this Act or regulations of the
Commission.'' Second, the bill would specify that the CEA does not
apply to over-the-counter derivative contracts entered into between
``eligible contract participants'' which are not conducted on a
``trading facility'' other than an ``electronic trading facility.''
Together, these two provisions represent a major step towards
addressing the question of the ``legal certainty'' of over-the-counter
derivative contracts, a goal which we fully support.
Clearing Organizations
The process of clearing securities and derivatives transactions is
vital to the efficient operation of the capital markets. Efficient
clearing reduces risks and costs and makes possible the smooth
operation of the markets. Following a transaction, both parties submit
the details of the transaction to a clearing organization. The clearing
organization compares the transaction--ensures that details submitted
by both parties are identical--and, once compared, usually guarantees
the transaction in the unlikely event that one party becomes insolvent
before the transaction settles. Clearing organizations also net
outstanding transactions of individual participants in order to
minimize separate payments for offsetting trades or positions, and
monitor margins or collateral required to be held against net
positions.
H.R. 4541 includes a provision designed to streamline the
regulation of derivatives clearing organizations. Specifically, Section
14 of the bill would generally make it unlawful for derivatives
clearing organizations to operate unless registered with the CFTC. In
order to prevent duplicative levels of regulation, the bill provides an
exemption from this requirement for clearing organizations which are
regulated by the SEC, a federal bank regulator or a foreign regulatory
body. This exemption is critical in helping to ensure that clearing
organizations are not subject to superfluous, conflicting, multiple
levels of regulation. For this reason, we support the exemption.
The bill as introduced contained a provision which would have
mandated CFTC regulation for clearing organizations which clear
futures, options on futures or options on commodities which are not
securities regardless of the above exception. However, during its
deliberations, the House Agriculture Committee included an exemption
from this requirement for clearing organizations that clear instruments
or transactions which are generally exempted from regulation under the
CEA. The change adopted by the Agriculture Committee to Section 14 of
the bill is extremely important in ensuring that clearing organizations
that clear both securities and over-the-counter derivatives are not
subject to multiple levels of regulation. We fully support the
Agriculture Committee's changes, and we are hopeful that the
committee's changes will remain in the bill.
Other Provisions of H.R. 4541
In addition to the provisions cited above, The Bond Market
Association offers these comments on other provisions of H.R. 4541:
Shad-Johnson accord--Although presumably intended to permit
single-stock futures, the bill expressly would allow futures on
``non-exempt securities,'' thereby permitting futures on single
debt instruments or on narrow debt indices. Key aspects of the
Shad-Johnson provisions in H.R. 4541 have apparently been
drafted to apply specifically to stock futures and in some
cases are inconsistent with the way the debt markets operate.
They could result in confusion and uncertainty if applied to
futures on single debt instruments. The subcommittee may wish
to review the Shad-Johnson provisions of the bill to ensure
their consistency with debt market operations and with other
provisions of the law. We would be happy to consult with
subcommittee members on this issue if requested.
Bankruptcy--Although not part of H.R. 4541, the report of the
President's Working Group on the Financial Markets on financial
derivatives recommended the adoption of changes to the
Bankruptcy Code and banking law designed to reduce systemic
risk. The Working Group's recommendations would streamline the
process by which financial contracts can be netted and resolved
in cases of bankruptcy or insolvency. We support these
provisions and urge that they be enacted.
Summary
In recent years, we have seen a rapid acceleration in the
development of new and sophisticated financial products designed to
mitigate risk, reduce costs and enhance efficiency. Unfortunately, the
evolution of our regulatory structure for financial derivatives has
lagged behind the evolution of the markets themselves. It is
appropriate, therefore, for Congress to address the uncertainty and
risk which has arisen as a result of a system of regulation which never
anticipated the market we have today.
The Bond Market Association supports provisions in H.R. 4541
designed to enhance and clarify the Treasury Amendment. We also
recommend an additional change to the Treasury Amendment to clarify the
treatment of products involving excluded transactions. We also support
the goal of key provisions of the bill to provide legal certainty with
respect to the regulation of over-the-counter derivatives. In addition,
we support provisions in the bill adopted during Agriculture Committee
deliberations designed to prevent the duplicative regulation of
clearing organizations. We raise questions regarding the application of
the Shad-Johnson provisions to single-debt futures, and we urge the
adoption of bankruptcy and insolvency legislation designed to reduce
systemic risk in the financial markets.
We appreciate the opportunity to present our views on H.R. 4541. We
commend Chairman Oxley and other members of the subcommittee for their
quick action on these important issues, and we look forward to working
with subcommittee members and staff as the legislative process moves
forward.
______
Federal Reserve System
Board of Governors
July 19, 2000
The Honorable Tom Bliley
Chairman
Committee on Commerce
House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman: Enclosed are my responses to your additional
questions concerning H.R. 4541, the Commodity Futures Modernization Act
of 2000.
Please let me know if I can be of further assistance.
Sincerely,
Patrick M. Parkinson
Associate Director, Division of Research and Statistics
Enclosure
Follow-up Questions for Patrick M. Parkinson
Question 1. I Would an alternative approach to providing legal
certainty under which futures were defined as contracts on enumerated
agricultural products and any other derivatives product traded on a
futures contract market provide greater legal certainty than the
approach in H.R. 4541? Would the Fed support such an approach?
Answer 1. Yes. Such an approach would provide greater legal
certainty. But the approach would need to be supplemented with
provisions to address public policy concerns about fraud and
manipulation for those transactions that would be excluded from the CEA
under this alternative approach but not under the working group's
approach. Whether the Fed would support such an alternative approach
would depend on how those concerns are addressed.
Question 2. Do the margin provisions in the bill adequately address
concerns about consistent margins on single stock futures and options?
Answer 2. Yes. They empower the Federal Reserve to ensure that
margins are consistent and make clear what is meant by consistency.
However, the language clarifying what is meant by consistency should be
moved from Section 8(g)(7)(D)(ii) to Section 8(g)(4)(B)(v).
Question 3. Futures trading on a futures exchange could be
regulated in one of two ways: (1) as securities with SEC exemptions
from non-core provisions or (2) as futures with only core securities
provisions applying. Which structure does the Fed support?
Answer 3. The Federal Reserve does not have a position on this
issue.
Question 4. Do you support the creation of the intermarket margin
board as provided in the bill?
Answer 4. Yes. As I said in my testimony, the Board is willing to
accept regulatory authority over levels of margin on single-stock
futures, so long as the Board can delegate that authority to the CFTC,
the SEC, or an Intermarket Margin Board.
Question 5. Do you support enacting the legal certainty portions of
the bill without removing the ban on single stock futures? Under this
scenario will legal uncertainty still exist for OTC derivatives in
securities based transactions.
Answer 5. Yes. We support enacting the legal certainty provisions
of the bill, even if the ban on single-stock futures is not removed. We
would, however, prefer a comprehensive bill that allows U.S. investors
to trade single-stock futures.
Under this scenario, legal certainty would still exist with respect
to the enforceability of securities-based swaps between eligible
participants. However, legal uncertainty would still exist on the
question of whether securities-based swaps are subject to the
securities laws.
Question 6. Do the clearing provisions in the bill place futures
clearing systems at a competitive disadvantage to securities clearing
systems?
Answer 6. Yes. An SEC registered clearing organization could clear
both securities and securities-based derivatives, whereas a CFTC-
registered clearing organization could not. As a practical matter, this
would allow an SEC clearing organization to offer lower margins on
securities-based derivatives when those positions were hedged with
securities, as they often are. Other things equal, this would place
CFTC-registered clearing systems at a competitive disadvantage.
Question 7. Are futures exchange's ``know your customer rules'' and
``risk acknowledgment'' sufficient substitutions for suitability rules?
Answer 7. I have not studied these rules closely enough to permit
me to answer this question with any confidence.
Question 8. To what extent, if any, does the CFTC's regulatory
relief proposal reduce the need for legislation?
Answer 8. The CFTC's regulatory relief proposal is no substitute
for legislation. It does not address the most serious legal certainty
issue--the enforceability of securities-based swaps.
Question 9. The Working Group report concludes that electronic
trading systems should be permitted to develop unburdened by an
anticipatory regulatory framework? How does H.R. 4541 achieve, or fail
to achieve, this result?
Answer 9. H.R. 4541 achieves this for electronic trading systems
for financial derivatives. For non-financial derivatives (other than
derivatives based on agricultural commodities and metals), it leaves
some burdens (statutory prohibitions of fraud and manipulation,
possibly CFTC rules and regulations relating to data dissemination) but
frees such systems from the kinds of burdens that would most concern
the PWG and market participants. For electronic trading systems for
agricultural and metals derivatives, achievement of a result consistent
with the Working Group's conclusion would depend on CFTC regulatory
exemptions for such systems.
______
Department of the Treasury
August 8, 2000
The Honorable Thomas J. Bliley
Chairman, Committee on Commerce
U.S. House of Representatives
Washington, D.C. 20515-6115
Dear Chairman Bliley: I am pleased to enclose responses to your
questions submitted following the July 11, 2000 hearing held by the
Subcommittee on Finance and Hazardous Waste on H.R. 4541, ``The
Commodity Futures Modernization Act of 2000.''
Question 1: In your testimony you state that certain aspects of the
regulatory relief may be more appropriately addressed through rule
making than legislation. With which provisions of the bill are you
particularly concerned?
Answer 1: The Treasury Department continues to support the view
that it is appropriate to periodically review existing regulatory
structures to determine whether they continue to serve valid public
policy and regulatory functions. We are concerned, however, that there
may be unforeseen consequences to legislating such regulatory relief as
is contained in sections 12, 13, 14, 15, 16, 17, and 21 of H.R. 4541.
Once codified, regulators will no longer have the flexibility to review
and amend provisions when market developments necessitate change or
problems arise. Such aspects of regulatory relief may be more
appropriately provided through administrative action. However, if
Congress legislates regulatory relief, it is important that the
language is drafted carefully to ensure that futures on government
securities are not excluded from most of the provisions of the CEA that
currently apply, as well as from regulation under the securities laws,
in a manner that would undermine the regulatory framework for the
government securities market established by the Government Securities
Act in 1986.
Question 2: Do you support the creation of the intermarket margin
board as provided in the bill?
Answer 2: The Treasury Department generally supports the provisions
in section 8 of H.R. 4541 to create an intermarket margin board,
comprised of the Board of Governors of the Federal Reserve System
(``Fed''), Securities and Exchange Commission (``SEC''), and Commodity
Futures Trading Commission (``CFTC''), to set and maintain margin
levels for single stock and narrow-based stock index futures. We concur
that such a board should endeavor to harmonize margin levels on single
stock futures and options, taking into consideration material
differences in contract size, price volatility, mark-to-market
frequency, and the period of time within which margin calls must be
met. This provision should not supersede or limit the emergency powers
of the CFTC contained in Sec. 8a(9) of the Commodity Exchange Act
(``CEA'') regarding establishment of temporary emergency margin levels.
Question 3: Do you support enacting the legal certainty portions of
the bill without removing the ban on single stock futures? Under this
scenario will legal uncertainty still exist for OTC derivatives in
security-based transactions?
Answer 3: The Working Group report recommended that legal certainty
for swap transactions be provided and that the prohibition against
single stock futures could be repealed if integrity and regulatory
arbitrage issues could be resolved. However, the recommendations were
not contingent upon each other. The Treasury Department has been
working diligently with the CFTC and SEC to resolve Issues related to
the Shad-Johnson Accord prohibition against single stock futures. We
support enacting the legal certainty portions of the legislation as
soon as possible. Failure to clarify and resolve the legal certainty
issue could result in a situation which the existing legal framework
for U.S. financial markets significantly lags developments and
innovations in those markets.
If issues related to the Shad-Johnson Accord cannot be resolved on
a timely basis, we believe it is imperative to advance the other
provisions of H.R. 4541 designed to clarify legal certainty for OTC
derivatives, provide for the development of appropriately-regulated
clearinghouses, and protect retail customers from fraud and abuse in
foreign exchange futures and futures-options transactions with
unregulated/unaffiliated entities.
With respect to legal certainty for securities-based OTC
derivatives, because the legal certainty provisions of H.R. 4541, as
reported by the House Agriculture Committee, would exclude such
derivatives from the CEA, these provisions would eliminate the concern
about their enforceability that exists under current law. The legal
certainty provided to these instruments by sections 4, 5, 6, and 7 of
H.R. 4541 is not dependent upon the removal of the ban on exchange-
traded futures on single securities or narrow indexes.
Question 4: Do the clearing provisions in the bill place futures
clearing systems at a competitive disadvantage to securities clearing
systems?
Answer 4: The Treasury Department believes that the clearing
provisions in section 14 of the bill will create a level playing field
for clearing systems. Futures clearing organizations will be able to
clear exchange-traded futures, futures-options, and commodity options
as well as non-security OTC derivative instruments. Securities clearing
organizations will be able to clear exchange-traded and OTC securities
transactions as well as OTC derivatives.
Question 5: Are futures exchanges' ``know-your-customer rules'' and
``risk acknowledgements'' sufficient substitutions for suitability
rules?
Answer 5: The CFTC and SEC currently are discussing customer
suitability requirements for securities futures in the context of
modifications to the Shad-Johnson Accord. The Treasury Department feels
that it is appropriate that the CFTC and SEC should discuss and agree
to the approach and specific requirements ultimately mandated with
respect to these instruments. The Working Group stated that the current
prohibition against single stock and narrow-based stock index futures
could be repealed if such issues regarding the integrity of the
underlying securities markets and regulatory arbitrage could be
resolved, but preferred that the CFTC and SEC reach a mutually
acceptable resolution. We recently have assumed a role in these
discussions as a facilitator between the two agencies, and we support
actions taken by Congress to urge progress in these discussions.
Question 6: To what extent, if any, does the CFTC's regulatory
relief proposal reduce the need for legislation?
Answer 6: The Treasury Department believes that it is imperative to
provide for legal certainty for OTC derivatives through legislation.
The CFTC proposal to grant regulatory relief to the futures exchanges
does not reduce the need for the other provisions of the bill to
clarify legal certainty for OTC derivatives, provide for the
development of appropriately-regulated clearinghouses, and protect
retail customers from fraud and abuse in foreign exchange futures and
futures-options transactions with unregulated unaffiliated entities.
Question 7: The Working Group report concluded that electronic
trading systems should be permitted to develop unburdened by an
anticipatory, regulatory framework. How does H.R. 4541 achieve, or fail
to achieve, this result?
Answer 7: The Working Group recommended a broad exclusion from the
CEA for electronic trading systems (``ETSs'') that limit trading to
eligible participants trading on a principal-to-principal basis
involving OTC financial commodities with non-finite supplies. The group
felt that development of such systems should be encouraged by providing
greater legal certainty, rather than burdening markets with a new
anticipatory scheme of regulation that could inhibit innovation and
prove to be inappropriate. Section 6 of H.R. 4541 amends the CEA to
permit such ETSs consistent with the Working Group's recommendations.
I hope this information is helpful to you and your staff. Please
feel free to contact me if I can be of further assistance. We look
forward to continuing to work with you.
Sincerely,
Lee Sachs
Assistant Secretary, Financial Markets