The Report to Congress on Over-the-Counter Derivatives Markets and The Commodity Exchange Act by The President's Working Group on Financial Markets
By Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities & Exchange Commission
Before the House Subcommittee on Risk Management, Research,
and Specialty Crops, Committee on Agriculture
February 15, 2000
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") as you consider issues pertaining to the reauthorization of the Commodity Futures Trading Commission ("CFTC"). My testimony focuses on the Report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act1 ("OTC Derivatives Report"), which the President's Working Group on Financial Markets ("Working Group") submitted to Congress last November.2
As you know, the application of the Commodity Exchange Act ("CEA") to transactions involving over-the-counter ("OTC") derivative instruments raises significant questions of public policy. The Commission has welcomed the opportunity to study some of these questions in coordination with other members of the Working Group. The rapid evolution of OTC derivatives markets requires a regulatory approach that promotes greater legal certainty as well as innovative financial instruments. The Working Group's Report and its recommendations represent an important step toward this goal.
I. The Growth of OTC Derivatives Market
It is widely recognized that OTC derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets. Indeed, U.S. markets and market professionals have been global leaders in derivatives technology and development.
OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to isolate and manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates. Because of the range of benefits these products offer, the OTC derivatives market has grown tremendously during the past two decades. 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.3
II. Findings and Recommendations of the OTC Derivatives Report
In preparing the OTC Derivatives Report, the Working Group's task was fairly specific: to focus on how a particular piece of legislation, the CEA, might be modified to address issues related to OTC derivatives markets. Accordingly, the Report makes recommendations in several areas.
A. Swap Agreements
Regulators have focused on the treatment of swaps for over a decade. In 1989, the CFTC issued a Policy Statement, noting that "most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the CEA and regulations."4 After receiving exemptive authority under the Futures Trading Practices Act of 1992,5 the CFTC followed up with its 1993 Swap Exemption.6 Notwithstanding the Exemption's relief for some transactions, concerns arose about its scope. Because Congress did not explicitly determine whether swaps fell under the CEA absent such an exemption, the status of swaps remains unclear.
In light of this legal uncertainty, the OTC Derivatives Report recommends that Congress amend the CEA to exclude bilateral swap agreements (other than transactions involving non- financial commodities with finite supplies) between eligible swap participants, acting on a principal-to-principal basis, provided that the transactions are not conducted on a multilateral transaction execution facility ("MTEF").7 The Commission believes that excluding qualifying instruments from the CEA should create greater legal certainty than the current approach that merely provides for the possibility of exemption, thus leaving open the question of whether such instruments are futures.
B. Electronic Trading Systems
In addition to focusing on the regulatory treatment of particular instruments, the OTC Derivatives Report explores questions raised when electronic systems facilitate the trading of OTC derivatives. It is worrisome that legal uncertainty might hinder technological development in the OTC derivatives market since technological innovation could promote transparency and efficiency. Moreover, the use of technology could help firms to apply more reliable internal controls on traders and to reduce risk.
The OTC Derivatives Report therefore recommends that Congress amend the CEA to exclude certain types of electronic trading systems for derivatives, provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts that involve non-financial commodities with finite supplies. Systems clearly not covered by the definition of MTEF in the current Swap Exemption would be covered by this exclusion. The exclusion would also cover systems that assist eligible swap participants communicating about or negotiating bilateral agreements. In addition, the exclusion would cover systems (including ones where bids and offers are open to all participants) where: first, the system only allows participants to act solely for their own account, and, second, the system is not used to enter into agreements requiring a party to make physical delivery of a non- financial commodity with a finite supply.
Moreover, to avoid disadvantaging existing futures and commodities exchanges, those exchanges designated by the CFTC as contract markets also would be permitted to establish these kinds of electronic trading systems for swaps.
C. Clearing Systems
Like electronic trading systems, clearance systems for OTC derivatives transactions are subject to legal uncertainty. Because of their importance, the OTC Derivatives Report recommends that Congress enact legislation to regulate clearing systems used for OTC derivatives. More specifically, the SEC, the CFTC, another federal regulator, or a foreign financial regulator satisfying appropriate standards would regulate clearing systems for OTC derivatives.
Clearing systems that clear futures, commodity options, and options on futures could also clear OTC derivatives (other than OTC derivatives that are securities), subject to CFTC oversight. In addition, clearing agencies subject to SEC oversight could clear OTC derivatives other than instruments involving non- financial commodities with a finite supply. Under the Working Group proposal, legislation would authorize the CFTC to develop rules for the establishment and regulation of clearing systems for OTC derivatives involving non-financial commodities with a finite supply (to the extent they are exempted by the CFTC in a manner allowing clearing). All other OTC derivative clearing systems would need to organize as a bank, bank subsidiary or affiliate, or Edge Act corporation that would be subject to the supervisory jurisdiction of the Federal Reserve or the Office of the Comptroller of the Currency.
The OTC Derivatives Report also recommends that a clearing system subject to regulation by one agency should not become subject to regulation by another agency by virtue of clearing OTC derivatives. Finally, the Report recommends allowing clearing through foreign clearing systems supervised by foreign financial regulators that the appropriate U.S. regulator has determined satisfy appropriate standards.
Hopefully, this framework will encourage the development of clearing systems for OTC derivatives products.
D. The Treasury Amendment
The OTC Derivatives Report also focuses on providing greater certainty for instruments covered by the Treasury Amendment. The Treasury proposed this amendment in 1974 out of concern that the broad statutory definition of "commodity" would subject OTC markets in government securities and foreign currency to CEA regulation. Accordingly, the amendment excludes a list of instruments from the definition of commodity. These listed instruments, however, still may be subject to CEA regulation when traded on a "board of trade." By proposing to replace "board of trade" with "organized exchange," the OTC Derivatives Report seeks to more clearly delineate the parameters of the limitation on the exclusion.
The OTC Derivatives Report further recommends that the Treasury Amendment be clarified to allow the CFTC to address problems associated with foreign currency "bucket shops." Transactions in foreign currency futures and options would be subject to the CEA if entered into between a retail customer and an entity that is neither regulated or supervised by the SEC or a federal banking regulator nor affiliated with such a regulated or supervised entity.
E. Hybrid Instruments and CFTC Exclusive Jurisdiction
Although the members of the Working Group did not reach consensus in the OTC Derivatives Report that all hybrid instruments should be entirely excluded from the CEA or that a hybrid instruments rule needs to be codified at this time, the CFTC has agreed that it will not propose any new rule about hybrid instruments without the concurrence of the other Working Group members. This decision reflects recognition of the interests of the SEC and bank regulatory agencies in this area. These interests arise because hybrid instruments possess characteristics of securities and bank products.
The OTC Derivatives Report, however, urges Congress to clarify that the Shad-Johnson Accord should not be construed as applying to hybrid instruments that have been exempted from the CEA.
Finally, over the years, the clause in the CEA granting the CFTC "exclusive jurisdiction" over certain matters has caused confusion. Questions have been raised over the appropriate regulator and regulatory scheme for complex derivative instruments possessing attributes of securities and futures contracts. All Working Group members agreed to recommend amending the CEA to explicitly clarify that insofar as hybrid instruments may be subject to the CEA, the exclusive jurisdiction clause shall not be construed to limit the authority of the SEC and the bank regulatory agencies with respect to such instruments.8
F. Other Issues
1. Single Stock Futures
The unanimous findings of the OTC Derivatives Report reiterate the Commission's position that although single stock futures may possess elements of traditional futures contracts, they also have the characteristics of traditional securities. Accordingly, when considering the Shad-Johnson Accord's9 ban on single stock futures, one must recognize that regulatory issues associated with the introduction of such products would be complex. Indeed, the members of the Working Group agree that numerous issues including but not limited to margin levels, insider trading, sales practices, real-time trade reporting, floor broker activities, and CFTC exclusive jurisdiction over futures contract markets would have to be resolved before the ban could be reconsidered.
As you know, Chairmen Combest, Congressman Bliley, and Congressman Ewing asked that the SEC and the CFTC report back to their respective committees and subcommittees later this month on issues associated with modifying the Shad-Johnson Accord.10 The Commission staff has been working diligently with their counterparts at the CFTC to review the relevant issues. We look forward to sharing our views with the Committee on these issues when our Report is submitted.
2. Regulatory and Tax Arbitrage
The Report recognizes that derivative products may be tailored to circumvent regulation or tax consequences that would apply to other financial products. The Commission endorses the Working Group's view that, in most instances, the way to address regulatory arbitrage is to amend underlying statutes and regulations that most closely pertain to the regulatory goal to be achieved.
With respect to netting, the Commission supports the Working Group's reiteration of the need for improvements in the close-out netting regime for derivatives and other financial instruments under the Bankruptcy Code and bank insolvency law. The Working Group's April 1999 report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management ("Hedge Fund Report"),11 previously recommended this course.
4. Derivatives Dealers
The OTC Derivatives Report also reiterates a recommendation from the Hedge Fund Report regarding certain derivative dealers. Generally, derivatives dealers enter into derivatives contracts with end users and other dealers. Such dealers may use OTC derivative instruments to hedge their own financial risk, and most in the U.S. are banks or bank affiliates or affiliates of broker-dealers or futures commission merchants ("FCMs"). Although banking regulators supervise the banks and their affiliates, most affiliates of broker-dealers and FCMs remain unregulated.12
For OTC derivatives dealers, private counterparty discipline is now the primary mechanism for limiting potential losses from counterparty defaults and reducing systemic risk. The OTC Derivatives Report calls for government regulation to supplement, but not substitute for, private market discipline. Both regulated and unregulated OTC derivatives dealers have employed private counterparty credit risk management, and some tools exist for federal regulators. As the Hedge Fund Report noted, however, limitations on SEC and CFTC access to information about the activities of unregulated affiliates of broker-dealers and FCMs create a gap in financial market oversight. Thus, the Hedge Fund Report called for Congress to provide the SEC and CFTC with enhanced authority to obtain risk assessment information. The OTC Derivatives Report reiterates this recommendation.13
The OTC Derivatives Report only represents a beginning. In addition to implementing the Report's recommendations, we must continue to study the OTC derivatives market as it develops. With input from Congress and industry participants, I feel confident that we can meet any regulatory challenges while allowing the efficient development of this market.
The rapid evolution of OTC derivatives markets requires a regulatory approach that promotes greater legal certainty as well as innovative financial instruments. The OTC Derivatives Report represents a balanced approach. The Commission appreciates the opportunity to consider these issues, and looks forward to interacting with the Working Group, your Committee, and other legislators as they consider implementation of changes recommended in the OTC Derivatives Report.
I would be happy to answer any questions you might have.
1Report of the President's Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (Nov. 1999).
2The Working Group includes the Secretary of the Department of the Treasury ("Treasury") and the Chairmen of the Federal Reserve Board, the SEC, and the CFTC.
3The Global OTC Derivatives Market at end June 1999, 45/1999E (Nov. 25, 1999) .
4Policy Statement Concerning Swap Transactions, 54 FR 30694 (July 21, 1989).
5Futures Trading Practices Act of 1992, Pub. L. No. 102-546, 106 Stat. 3590.
6Exemption for Certain Swap Agreements, 58 FR 5587 (Jan. 22, 1993) (codified at 17 C.F.R. pt. 35).
7The CFTC has explained that an MTEF "is a physical or electronic facility in which all market makers and other participants have the ability to execute transactions and bind both parties by accepting offers which are made by one member and open to all members of the facility." Exemption for Certain Swap Agreements, 58 FR 5587 (Jan. 22, 1993).
8The Commission, Treasury, and the Federal Reserve Board believe that the exclusive jurisdiction clause should apply only to transactions in futures contracts or options on futures contracts effected on designated contract markets, and that the clause should be clarified by providing that the CFTC's jurisdiction over such transactions is not exclusive in instances where the CEA or some other federal statute specifically grants another agency authority.
9Futures Trading Act of 1982, Public Law No. 97-444, 96 Stat. 2294-97.
10Letter from the Honorable Larry Combest, Chairman, House of Representatives Committee on Agriculture, the Honorable Tom Bliley, Chairman, House of Representatives Committee on Commerce, and Chairman Tom Ewing, Subcommittee on Risk Management, Research, and Specialty Crops, House of Representatives Committee on Agriculture, to the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC (January 20, 2000).
11Report of the President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (Apr. 1999).
12The SEC and CFTC possess limited authority to obtain information about such affiliates' activities, and the SEC has instituted a special regulatory scheme for derivatives dealers conducting a limited securities business. Some U.S. derivatives dealers are affiliated with entities, such as insurance companies, finance companies, and public utilities, that are not subject to banking or securities regulation.
13The OTC Derivatives Report also notes the need to continue monitoring the development of derivatives dealers that are unaffiliated with banks, broker-dealers, or FCMs.