TESTIMONY OF ANNETTE L. NAZARETH, DIRECTOR DIVISION OF MARKET REGULATION U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION BEFORE THE SUBCOMMITTEE ON RISK MANAGEMENT, RESEARCH, AND SPECIALTY CROPS COMMITTEE ON AGRICULTURE UNITED STATES HOUSE OF REPRESENTATIVES MAY 18, 1999 Chairman Ewing and Members of the Subcommittee: I am pleased to appear today to testify on behalf of the Securities and Exchange Commission ("SEC" or "Commission") concerning the reauthorization of the Commodity Futures Trading Commission ("CFTC") and related issues that affect the SEC. Since the CFTC began operating in 1975, Congress has used the reauthorization process as an opportunity to comprehensively review the Commodity Exchange Act and examine the role of the CFTC. We work closely and cooperatively with the CFTC on an ongoing basis, and support its rapid reauthorization. Although we have commented on many issues involving the oversight of derivatives and remain vitally interested in these issues, I will focus today on two subjects. I. Preservation of the Shad-Johnson Jurisdictional Accord One item that will likely receive attention during the current reauthorization process is the Shad-Johnson Jurisdictional Accord ("Accord") between the SEC and the CFTC. The Accord, which Congress codified in 1982, bans single stock futures and futures on narrow-based stock indexes. It also permits, under the CFTC's supervision, trading of broad-based stock index futures that meet certain criteria, subject to the Commodity Exchange Act. The Accord was designed to address uncertainties concerning the regulation of certain securities-based derivative products that stemmed from changes made to the commodity futures laws in 1974. Those changes gave the CFTC exclusive jurisdiction over all futures, whether the underlying commodity was a traditional commodity like pork bellies or a financial commodity like an interest rate. At the same time though, Congress provided that the jurisdiction of the SEC would not otherwise be limited or superseded. As a result, it was unclear whether the CFTC or the SEC had jurisdiction over futures on securities, a group of securities, or an index based on securities. This uncertainty, exacerbated by the "Ginnie Mae" options dispute,[1] created conflicts regarding each agency's jurisdiction over novel financial instruments that had elements of securities and futures products. To resolve the jurisdictional issues, the SEC and the CFTC agreed to clarify which financial instruments fell within each agency's jurisdiction. Under the terms of the Accord, the SEC would regulate options on: securities (including exempted securities), certificates of deposit, foreign currencies traded on a national securities exchange, and stock groups or indexes. The CFTC would regulate futures and options on futures on: exempted securities (except municipals), certificates of deposit, and "broad-based" indexes of securities. The CFTC also would oversee options on foreign currencies that are traded on a board of trade and not traded on a national securities exchange.[2] The SEC and the CFTC agreed that futures on individual securities (including equities, corporate bonds, and municipal securities) would be prohibited. In the 17 years since the Accord became effective, the SEC and CFTC have cooperated together to facilitate the introduction of innovative new futures products. Under the terms of the Accord, the SEC must review all proposed securities index futures contracts and determine whether they comply with the Accord's requirements. Among the securities index futures contracts reviewed by the SEC and approved by the CFTC for trading are industry sector stock indexes,[3] bond indexes,[4] and foreign stock indexes.[5] The futures exchanges now advocate repealing the Accord. This would lift the current ban on single stock and narrow-based stock index futures, permitting them to introduce a whole new series of securities-based products. While the Commission is sensitive to the futures markets' desire to expand the base of available futures products, the full consequences of repealing the Accord should not be oversimplified. There are some very complex issues that would need to be carefully addressed before the Accord is reconsidered by Congress. The delicate balance achieved by the Accord should not be disrupted absent the type of consultation and cooperation displayed by the SEC, CFTC, and their oversight committees in reaching the Accord in 1982. The repeal of the Accord would have significant consequences, not only for the SEC and CFTC, but also for the market participants subject to their oversight. Radical changes to the regulatory landscape should not be undertaken lightly; instead, the effect of any proposed changes should be subject to the scrutiny and careful review of Congress and both agencies. This review must take into account the major disparities between securities and futures regulation. The SEC believes that repealing the Accord in the face of these disparities will work to the detriment of our capital markets and investors in those markets. For this reason, the SEC is opposed to the repeal of the Accord and the trading of single stock and narrow-based index futures at this time. We believe the integrity of our securities markets would be jeopardized if disparities between securities and futures regulation were used to undermine the securities law provisions that serve to maintain fair and orderly markets for stocks and bonds. The Commission is particularly concerned that if futures on single stocks and narrow-based indexes are traded under the existing futures regulatory regime, buyers and sellers of such futures would not be afforded the same protections that are provided to buyers and sellers of stocks and stock options under the federal securities laws. For example, margin requirements are significantly lower, broad statutory prohibitions against insider trading do not apply, implied private rights of action for fraud are unavailable, and customer suitability determinations are not mandatory under existing futures regulation. The disparity in margin requirements alone could result in a shift of equities-based activity to the futures markets, entirely outside the scope of the securities laws and their important protections. As a result, it is possible that the cash markets could become less relevant, perhaps even serving only as the market for those seeking physical settlement.[6] This could have significant adverse consequences for issuers and others that access our securities markets to satisfy capital needs. Moreover, purchasers of single stock futures would be at risk of significant losses if they do not fully understand the concept of leverage and the magnification of price movements inherent in the futures markets. Retail investors recently have suffered sizable losses in volatile sectors of the equity and options markets, even though the leverage in those markets is considerably less than that which would be available to users of single stock futures. The disparate treatment of insider trading in the futures arena is another area that raises serious concerns. In contrast to the broad prohibitions against insider trading found in the securities laws, the CFTC's regulations contain a narrow provision that prohibits only a small class of futures industry insiders from trading on non-public material information.[7] Therefore, if trading in single stock futures were permitted, there is a very real risk that illicit profits could be reaped with impunity in the futures markets by exploiting insider information. Curbing insider trading helps maintain investors' strong confidence in the integrity of our securities markets. This high degree of confidence could deteriorate rapidly if users of equity-based futures are allowed to freely trade on non-public information. The futures exchanges have proposed to remedy this serious deficiency by giving the SEC insider trading authority over futures on single stocks and narrow-based stock indexes. Unfortunately, this attempt to strengthen the oversight of these futures is an ill-conceived quick-fix that would create more problems than it solves. For instance, to ensure truly effective surveillance and enforcement of our insider trading rules as applied to equity- based futures, the Commission would need the same type of authority over futures exchanges and market participants that it now has over their securities counterparts. This would include the ability to oversee futures exchange surveillance programs that are a critical component of efforts to detect and deter insider trading. If the Commission were provided this necessary oversight authority, the compliance costs for futures exchanges would increase significantly, as the exchanges would bear the burden of oversight by both the CFTC and SEC. It appears quite costly and inefficient to force these entities to incur significant additional compliance expenses to adhere to a single section of an entirely different regulatory scheme. Which leads me to my next point. A delegation of insider trading oversight would seem to represent the first step of an incremental merger of the SEC and CFTC. While the Commission has not taken a position in favor of, or against, such a merger, if after a thorough review Congress determines a merger is appropriate, it should complete the combination in a quick, efficient manner rather than in a piecemeal fashion. A step-by- step consolidation prolongs the process, complicates unnecessarily the regulatory scheme, and creates uncertainty among market participants. Finally, without an increase in resources, the SEC would be ill-equipped to monitor and detect insider trading in equity- based futures. Commission staff in the Divisions of Market Regulation and Enforcement do a remarkable job with the limited resources available now, especially in light of the recent surge in on-line trading and the accompanying concerns regarding Internet fraud. The Commission believes it would be difficult for the staff to effectively oversee trading in the futures markets without an increase in personnel. As Congress has previously recognized, the securities and futures markets are regulated differently owing to their different functions and purposes. The federal securities laws were designed to protect investors. This goal remains fundamental to the SEC's mission today. In contrast, the federal commodity futures laws were originally designed to regulate speculating and hedging in agricultural commodities. The landscape of the futures markets has changed substantially over the past several decades as the range of exchange-traded products has evolved from being entirely agricultural to primarily financial and non-agricultural.[8] The futures exchanges themselves have noted that the commodity futures laws are not designed to deal effectively with the increasingly sophisticated, non-agricultural products traded on the futures exchanges. However, any attempt at wholesale regulatory reform would produce enormous costs for all affected parties and their constituents.we cannot start anew -- we must work with Although at times the current regulatory scheme is the complicated, and sometimes burdensome, the SEC believes that, overall, the system works. regulatory structure that exists today. There arehowever ways to achievedevelop meaningful regulatory reform on less than a wholesale basis. Unfortunately, the approach taken by the futures exchanges does not bridge the existing regulatory divide for securities and futures products. Single stock and narrow-based stock index futures would be offered under a regulatory scheme that differs profoundly from the regulatory scheme governing the underlying stocks. Creating such a bifurcated regulatory scheme is not the solution that best addresses this issue. Furthermore, rather than attempt to narrow the regulatory disparities between futures and securities, the futures exchanges are advancing measures that would widen the regulatory chasm by cutting back the federal regulatory oversight of the futures markets. If this were to occur in conjunction with single stock futures, it would create tremendous pressure to deregulate the securities markets. This presents a recipe for disaster -- a race to the lowest level of regulation without regard for the negative consequences of eliminating important protections. It isYou might foreseeable that as competition for equity-based business intensified between securities and futures markets, exchanges would want to do away with safeguards simply to obtain a competitive advantage. and attract business from forum shopping market participants. While regulators should seek to encourage competition, they should be careful not to create incentives that would undermine their abilities to protect investors and oversee markets. The futures exchanges' proposal, in the name of deregulation, would shift significant authority from the regulator to market participants. If they prevail in scaling back the regulatory role of the CFTC, the futures markets will be free to establish their own rules, including rules governing trading and listing standards for new products, without receiving the approval of the CFTC. While the SEC believes that self- regulation plays an important role in maintaining fair and honest markets, it should be an adjunct to effective oversight -- not a substitute.[9] Our financial markets remain the envy of the world because of their depth and liquidity, innovative products, and the universal belief that they are fair. The Commission believes that strong -- but sensible -- regulation is the key to protecting the integrity of the markets. The Commission is concerned that the futures exchanges' proposal cannot ensure that this basic tenet is satisfied. In the following days of these hearings, certain witnesses are likely to criticize the Accord and the role of the SEC in reviewing proposed futures contracts on securities indexes. The Accord gives the SEC the authority to determine whether a proposed securities index futures contract satisfies the minimum requirements of the Accord. Specifically, the futures contract must: (1) be cash-settled; (2) not be readily susceptible to manipulation; and (3) measure and reflect a substantial segment of the securities market. If the SEC determines that a proposed futures contract fails to meet any one of these requirements, the CFTC may not permit trading in that contract. In December 1997, the Commission performed its statutorily- mandated review of two securities index futures contracts proposed by the Chicago Board of Trade that were based on the Dow Jones utility and transportation indexes. The Commission objected to the Chicago Board of Trade's proposal because we determined that the proposed Dow contracts did not satisfy the statutory criteria under the Accord. Specifically, the utilities and transportation indexes, both containing a small number of component stocks,[10] did not properly reflect a substantial segment of the U.S. equities market. The Chicago Board of Trade appealed our determination to the 7th Circuit Court of Appeals, where the matter is still pending. The futures exchanges believe that our Dow determination demonstrates that the SEC is a barrier to new products and shows that the Accord is "unworkable."[11] However, since the Accord was codified, we have worked with the futures exchanges and the CFTC on nearly 70 stock index futures proposals -- the Dow proposal is the only instance since November 1983 where we have formally objected to a proposal. The Commission believes that it has consistently cooperated and worked in good faith with the CFTC and the futures exchanges to facilitate the trading of new and innovative futures contracts. For example, since the Dow determination last July, the Commission worked with the Chicago Mercantile Exchange to introduce a new futures contract on a REIT index, and the Commission recently worked with the Kansas City Board of Trade to introduce a new Internet stock index futures contract. In both of these instances, SEC staff made suggestions and raised important questions regarding the structure of the indexes, and, in doing so, guided the exchanges in developing products that fit within the safeguards of the Accord. These examples demonstrate that the Accord permits the trading of industry sector products, and that the SEC remains flexible in interpreting the Accord to allow futures exchanges to offer novel equity-basedlinked products, provided they have adequately addressed the statute's anti-manipulation concerns. II. Providing Legal Certainty for OTC Derivatives Transactions The OTC derivatives market has experienced tremendous growth over the past two decades. In part, this growth can be attributed to the significant benefits OTC derivatives provide to corporations, financial institutions, and institutional investors by allowing them to isolate and manage risks associated with their business activities or financial assets. Although derivatives can be dangerous if misused, when market participants establish adequate internal controls, financial losses can be avoided, or at least minimized. In order for this market to continue to develop efficiently and effectively, it is essential to provide legal certainty for OTC swaps and other OTC derivative transactions effected between institutional counterparties. OTC transactions in securities- based swaps should be excluded from the CEA in order to provide such legal certainty for participants in this market. The market in these transactions has developed outside of the scope of CFTC regulation and does not affect, to any great extent, the price discovery or liquidity functions performed by regulated exchange markets. An exclusion from the CEA would preserve the interest of the SEC in securities-based products while providing the legal certainty that the products would not be deemed illegal futures. An exclusion would continue to uphold the Shad-Johnson ban against futures on individual securities, as well as the SEC's consultative role regarding securities index futures, while ensuring that the CEA would not be applied to institutional OTC transactions. In addition, this is the approach currently used to exclude transactions in government securities and foreign currency from the CEA by means of the Treasury Amendment. However, it is not appropriate to codify, and extend to Shad-Johnson, the exemptions from the CEA for swaps and other OTC derivative transactions.[12] These rules were adopted in 1993 pursuant to exemptive authority granted to the CFTC under the Futures Trading Practices Act of 1992.[13] Although most market participants did not consider swaps to be futures under the CEA,[14] these exemptive rules provided some assurance that a private litigant would not claim that a swap was an illegal future. The CFTC's exemptive authority does not extend to the Shad-Johnson Accord. As a result, some market participants believe that legal uncertainty continues to impair the development of equity swaps due to the risk that equity swaps would be deemed futures on single stocks in violation of the Shad-Johnson Accord. While it is important to ensure that securities-based swaps do not fall within the CEA, the Commission would be concerned by any proposed efforts to provide legal certainty through a broader exemptive approach. First, a broad exemptive approach would provide OTC transactions between institutional counterparties with an exemption from all provisions of the CEA, including the Shad-Johnson Accord. The SEC is concerned that this could lead to pressure for additional exemptions from Shad-Johnson for exchange-traded futures.[15] Second, an exemptive approach could allow some market participants to argue that because swaps are exempted from the CEA, they were presumed to be futures in the first place. Otherwise, no exemption would have been needed. Based on this presumption, some would argue that because the CFTC has exclusive jurisdiction over futures, exempted swap products would be free from oversight by other federal regulators.[16] Indeed, many of the jurisdictional problems that arise in the context of OTC and exchange-traded derivatives could be minimized if the CEA did not provide the CFTC with exclusive jurisdiction over financial product-based derivatives. Exclusive jurisdiction was largely designed to address issues associated with the pricing and efficiency of markets for physical commodity futures and to preempt state gambling laws. As applied in the context of securities regulation, the CFTC's exclusive jurisdiction has had the unintended consequence of impeding the SEC from fulfilling its statutory obligation to regulate the nation's securities markets. The Commission is participating in the President's Working Group on Financial Markets' study of the OTC derivatives market which should provide Congress with information on OTC derivative instruments, participants, negotiation and execution of transactions, and clearance and settlement. The study will evaluate whether additional regulatory safeguards for OTC derivatives are necessary. The goal of this study is to develop appropriate recommendations for additional changes in statutes, regulations, and policies to improve operation of the market; to enhance legal certainty for OTC derivative instruments; and to permit the development of new hybrid products. Among other things, the Working Group will need to assess whether additional steps should be taken to safeguard the increasingly sensitive and interconnected financial markets, where risks can become magnified by volume, technology, and complexity. III. Conclusion The Commission believes that the Accord continues to serve an important purpose and that overall it has operated quite well during the past 17 years. The repeal of the Accord and the offering of futures on single stocks and narrow-based stock indexes would have highly negative consequences for our capital markets. We urge Congress to protect the integrity of these vital markets by preserving the Accord. With respect to the regulation of the OTC derivatives market, we believe that, at a minimum, steps should be taken to improve the legal certainty of OTC derivative instruments. However, other issues should also be explored. To further analyze these issues, the Commission continues its work with fellow members of the President's Working Group to study the OTC derivatives market and develop a coordinated response in this area. That concludes my testimony. I would be happy to answer any questions you might have. **FOOTNOTES** [1]: In 1975, the CFTC approved a Chicago Board of Trade proposal to offer futures contracts on Government National Mortgage Association ("GNMA" or "Ginnie Mae") pass-through securities. The SEC asserted that the GNMA futures were securities within its jurisdiction, while the CFTC contended that the futures fell within their exclusive jurisdiction. The SEC later approved a Chicago Board Options Exchange proposal to trade GNMA options in 1981. The Chicago Board of Trade sued the SEC over that approval, and in the Ginnie Mae options case, the 7th Circuit Court of Appeals set aside the SEC's order approving the GNMA options, stating that GNMA options were not "securities" within the meaning of the Securities Exchange Act and that the SEC had no authority to regulate them. See Board of Trade of City of Chicago v. S.E.C., 677 F.2d 1137 (7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982). [2]: See Joint Explanatory Statement of SEC and CFTC, [1980- 1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) 21,332 (Feb. 2, 1982). [3]: See, e.g., Letter from Robert L.D. Colby, Deputy Director, Division of Market Regulation, SEC, to Steven Manaster, Director, Division of Economic Analysis, CFTC, dated March 12, 1999 (not objecting to the designation of the Kansas City Board of Trade as a contract market for futures and options on futures on the Internet Stock Price Index). [4]: See, e.g., Letter from Jonathan G. Katz, Secretary, SEC, to Dr. Paula Tosini, Director, Division of Economic Analysis, CFTC, dated August 24, 1987 (not objecting to the designation of the Chicago Board of Trade as a contract market for futures on the Long-Term Corporate Bond Index). [5]: See, e.g., Letter from Shirley E. Hollis, Assistant Secretary, SEC, to Dr. Paula Tosini, Director, Division of Economic Analysis, CFTC, dated October 11, 1988 (not objecting to the designation of the Chicago Mercantile Exchange as a contract market for futures on the Europe, Australia, Far East Index). [6]: Under the futures exchanges' proposal, all futures on non- exempt securities would be required to be cash-settled. [7]: CFTC Regulation 1.59, which was adopted to implement the insider trading provisions found in Section 9(f) of the Commodity Exchange Act ("CEA"), requires that each futures SRO (i.e., futures exchanges, National Futures Association, and clearing organizations) maintain rules that prohibit employees of the futures SROs (including members of the SROs' governing boards and committees) from trading in futures and options where the employees have access to material non-public information concerning such futures or options interest. Because this provision does not cover corporate insiders, it has been described as "a relatively narrow rule when compared with the broader prohibitions under the federal securities laws." 1 Philip McBride Johnson & Thomas Lee Hazen, Commodities Regulation 2.05[8] (3d ed. 1998). [8]: In 1951, for example, the Commodity Exchange Authority regulated futures trading on 20 commodities, all of which were agricultural. When the legislation creating the CFTC became effective on April 21, 1975, approximately 41 contract markets were already designated for futures trading by the Secretary of Agriculture. Each of the commodities underlying the 41 approved futures contracts was agricultural. By September 30, 1998, however, of the 706 contract markets designated for futures and futures options trading, 571 (81%) were for non-agricultural commodities (e.g., stock indexes, foreign currencies, interest rates, energy, metals, electricity, and insurance). [9]: In the Committee Report accompanying the legislation that codified the Accord, the House Committee on Energy and Commerce noted that the Government Accounting Office had described the limitations on futures industry self- regulation as follows: The limitations on self-regulation are traceable to the nature of commodity exchanges as voluntary organizations composed of members whose primary motivation is - understandably - profit making. The exchange member's profit motive and his role as an enforcer of rules against himself and other members (e.g., as an exchange board member or member of an exchange governing or disciplinary committee) can give rise to conflicts of interest. H.R. Rep. No. 565, 97th Cong., 2d Sess., pt. 2, at 13 (1982). [10]: The Dow Jones Utilities Average Index included 15 stocks and the Dow Jones Transportation Average Index included 20 stocks. [11]: The Chicago Board of Trade has claimed that the Accord has "unworkable and discriminatory product restrictions." See Letter from Thomas R. Donovan, President and Chief Executive, Chicago Board of Trade, to Senator Richard Lugar, Chairman, Committee on Agriculture, Nutrition, and Forestry, dated March 18, 1999. [12]: 17 C.F.R. Part 35. [13]: P.L. No. 102-546; 106 Stat. 3590 (1992). [14]: The views of market participants were based, in part, on guidance provided by the CFTC. In 1989, the CFTC issued a policy statement concerning swap transactions in which it expressed the view that "most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations." 54 FR 30694 (July 21, 1989). The CFTC provided additional guidance to OTC derivatives traders when it adopted its Part 35 rules in 1993. In the release adopting the rules, the CFTC stated that the issuance of the rule should not be construed as reflecting any determination that the swap agreements covered are subject to the CEA, "as the [CFTC] has not made and is not obligated to make any such determination." 58 FR 5588 (January 14, 1993). [15]: See Consolidated Testimony of the Futures Exchanges of the United States before the Committee on Agriculture, Nutrition and Forestry, United States Senate (February 11, 1997). [16]: See, e.g., Letter from Jean A. Webb, Secretary, CFTC, to Jonathan G. Katz, Secretary, SEC dated February 26, 1998. (Comment letter submitted in response to SEC's OTC derivative dealers proposed rulemaking, File No. S7-30- 97).