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U.S. Securities and Exchange Commission

Testimony Concerning
H.R. 4541, The Commodity Futures Modernization Act of 2000

By Annette L. Nazareth
Director, Division Of Market Regulation
U.S. Securities & Exchange Commission

Before the Subommittee on Risk Management, Research and Specialty Crops
Committee on Agriculture
United States House of Representatives

June 4, 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 H.R. 4541, the Commodity Futures Modernization Act of 2000.

My testimony addresses two topics of significant interest to the Commission. First, the Commission reiterates its strong support for implementation of the recommendations by the President’s Working Group on Financial Markets ("Working Group") related to legal certainty for over-the-counter ("OTC") derivatives markets. Second, I will address the investor protection and market integrity issues raised by single stock and narrow-based stock index futures, the Commission staff’s suggested approach to address these issues, and why we believe H.R. 4541 fails to address our concerns.

I. Legal Certainty for OTC Derivatives Markets

As you know, last year the Working Group issued a report on OTC Derivatives Markets and the Commodity Exchange Act ("OTC Derivatives Report")1. That Report contained several recommendations related to legal certainty for OTC derivatives products. Given the critical role that these products play in our capital markets, I can think of few more important issues for Congressional consideration.

OTC derivatives markets are enormous in size2 because these contracts are critical to risk management for a vast array of businesses. In studying these markets, the Working Group’s task was fairly narrow – to determine whether the Commodity Exchange Act ("CEA") provided an appropriate regulatory framework for these markets. The Working Group unanimously concluded that for certain OTC derivatives the CEA was not the appropriate framework and 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 my earlier testimony.3

One cannot understate the historic significance of the consensus achieved by the Working Group. 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 is very supportive of this Subcommittee’s efforts to further the goals of the Working Group. Moreover, as we have stated in the past, it is not necessary to link resolution of all issues raised in the bill to pass the much needed provisions on legal certainty for OTC derivatives.

H.R. 4541, as introduced, differs from the Working Group’s recommendations in a few key respects. In particular, the Working Group recommended that certain OTC derivatives – products which typically have not attracted retail investors – be excluded from the CEA, provided that, among other things, they are entered into by sophisticated investors on a principal-to-principal basis. By contrast, the bill contemplates that certain agency transactions in OTC derivatives be excluded from the CEA. In addition, the definition of "eligible contract participant" in the bill would allow individuals that the Working Group did not consider to be sophisticated investors to enter into OTC derivatives transactions excluded from the CEA. Specifically, we do not believe that adequate consideration has been given to whether $10 million in total assets is a sufficient indication of sophistication for an individual investor. Moreover, the bill grants the CFTC broad discretion to declare anyone an eligible contract participant.

In addition, recognizing the significance of clearing systems to the management of systemic risk, the Working Group Report sought to clarify the regulation of clearing systems used for OTC derivatives. The bill does not adopt the Working Group recommendations on this issue, but rather introduces a notion of voluntary registration of clearing systems. Nor does the bill sufficiently clarify, as contemplated by the Working Group’s Report, that the clearance of an OTC derivatives transaction by clearing agencies regulated by other financial authorities, such as the SEC, will not trigger CFTC jurisdiction over the transaction.

Finally, in creating new types of deregulated futures facilities, the bill would attach exclusive CFTC jurisdiction over products traded on these facilities. Such products might include physically settled futures on government securities and other financial instruments. The Commission does not believe that there is a justification for eliminating the traditional role of other regulators including the SEC in regulating the markets and intermediaries that trade such government securities and other products, especially when these products would be traded on facilities subject to even fewer investor protections than exist today on futures exchanges.

The Commission continues to strongly support the implementation of the Working Group’s recommendations which are designed to provide legal certainty for the OTC derivatives markets. Those recommendations should be implemented immediately. We appreciate the efforts of this Subcommittee 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

This year the Commission devoted tremendous staff resources to designing a legislative framework under which single stock and narrow-based stock index futures could trade. Disparities between futures and securities regulation, as well as the ease with which single stock futures were expected to substitute for securities, made this a difficult task. However, the Commission strongly believes that these products could trade if certain regulatory issues are resolved. More importantly, I believe these issues are resolvable.

Our efforts in this area have not been undertaken alone. In its OTC Derivatives Report, the Working Group identified several issues that would need 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. Others, including this Subcommittee, also urged the SEC and CFTC to examine single stock futures. Accordingly, in pursuit of a resolution of these issues, the staffs of the CFTC and the SEC engaged in extensive discussions on this topic.

Although we were not able to craft joint legislation in this short period of time, we did reach agreement on fundamental principles for creating a framework for single stock futures. You will recall that Chairman Rainer and Chairman Levitt relayed these principles to you in a letter dated March 2.4 Most important among these principles was that, given the legitimate regulatory interests of both the SEC and CFTC in these products, single stock futures should be subject to joint regulation by both agencies. The significance of this agreement should not be understated. It reflects movement towards truly modern financial regulation – regulation that recognizes the interrelation between markets for different financial instruments and the need for all agencies with expertise and legitimate regulatory interests in a product to participate in that product’s regulation. 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. I believe these agreements by our two agencies are significant, and I appreciate the efforts by the CFTC staff in working to reach them.

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 minimum requirements for any legislation that permits the trading of single stock futures. Contrary to what some have suggested, this is not simply a turf battle between the futures and options markets and the agencies that regulate them. 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. I think it would be useful to review the components we believe are critical for any 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. Thus, 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. The nature of single stock futures makes joint regulation appropriate, and exclusive jurisdiction ill-advised. Shared jurisdiction and joint regulation entail both recognizing each agency as best qualified to apply the key components of the laws it administers, and coordinating the agencies’ efforts to ensure efficient market regulation that is not duplicative or overly burdensome.

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, mechanisms must be put in place to harmonize the margin requirements across markets 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. This would allow the multiple listing of the same single stock future product on multiple exchanges and promote price competition in ways that we have recently seen narrow spreads to the benefit of investors in the options markets. 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.

Of course, regulators themselves also must avoid burdensome duplication that would hinder efficient, competitive markets. Accordingly, any legislation, where appropriate, should carefully craft exemptions for regulated entities and provide for interagency coordination to achieve these goals.

Protect Retail Investors

Third, the framework must acknowledge that single stock futures will be retail products. While extremely complex derivative products might not attract retail customers, a simple future on a share of a blue chip stock or an interest in a pool of single stock futures is the type of product that is sure to do so. This especially is the case when the same sales force can offer customers the single stock future, the underlying blue chip stock, and pooled product that consists of either or both, which we believe will happen. Accordingly, legislation must maintain the SEC’s ability to protect retail 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.

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. The SEC should not be required to seek the permission of any other entity to protect investors. The SEC has over 65 years 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 clarifies the SEC’s jurisdiction over security options, and that jurisdiction should not be diminished in any way. Nor should legislation eliminate existing SEC functions related to evaluating products such as broad-based stock indexes for susceptibility to manipulation. Investors have strong expectations about the integrity of markets that the SEC regulates, and the resultant 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 problems in one market, at times, may be identified and understood only by reference to another market, legislation must provide for coordinated surveillance of all markets.

2. Discussion Draft

The Commission staff prepared a discussion draft that incorporates these legislative goals into amendments to the federal securities laws and the Commodity Exchange Act. Unfortunately, due to the brief time allowed, the CFTC has not had a chance to review or comment on our draft. 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. Then, having brought the markets and intermediaries that trade these products under the securities laws, we next focus on detailed regulatory relief for some of these intermediaries and markets as a means to avoid unnecessary or duplicative regulation.

For example, we exempt from registration those floor brokers on designated contract markets already registered with the CFTC. We also create a simple process of notice registration for certain markets and intermediaries already registered with the CFTC. And, such markets and intermediaries would only have to comply 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 provided for immediate effectiveness of such changes and a limited scope of review. Where appropriate, in 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 and the Investment Company Act.

* * *

Our discussion draft would achieve our 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. As a result, I appreciate the challenges that you faced in drafting your bill. Unfortunately, as written, the bill does not achieve the goals of the legislative framework previously outlined, and the Commission therefore could not support the legislation. Let me mention some of our general concerns with the bill.

First, rather than embracing shared jurisdiction and joint regulation of single stock futures, the bill would grant the CFTC exclusive jurisdiction over these products. Although the bill implicitly recognizes that single stock futures should be subject to certain securities laws and principles, any role for the SEC – the expert in administering such laws and principles – is not fully realized. SEC authority is illusory. For example, the bill calls for SEC participation in certain matters. If the CFTC or futures market participants totally ignore the SEC views, however, the SEC’s only recourse is to litigate the matter. We cannot support such an inefficient system of regulation by litigation in areas where the need to protect investors and the integrity of securities markets is so clear. The bill’s intention to prevent any reading of an appropriate role for the SEC under the bill is made clear in an unusual rule of construction (in Section 23 of the bill), which appears intentionally to limit SEC jurisdiction.

The bill also does not adequately harmonize securities and futures requirements related to single stock futures, in order to assure that single stock futures would not receive an artificial regulatory advantage over securities products with which they compete. This is particularly disconcerting in the area of margin, where the bill is, at best, ambiguous as to how, on a practical level, harmonized margin levels between securities and futures markets could efficiently be maintained. Markets should not compete for customers based on how much leverage they are allowed to provide those investors. Furthermore, it is unclear how securities exchanges might trade single stock futures under the bill. The bill also fails to provide for coordinated clearing that would allow for greater intermarket competition to the benefit of investors.

In addition, the bill fails to provide the Commission with the necessary authority to ensure the market integrity and customer protections that U.S. retail investors have come to expect for securities products. Although the bill provides that the SEC can enforce certain sections of the Securities Exchange Act of 1934 ("Exchange Act") for limited purposes, these provisions are so circumscribed as to promote minimal levels of market integrity. Section 10(b) of the Exchange Act, for instance, appears to apply only for the purposes of insider trading and frontrunning. We see no legitimate reason to preclude the Commission from prosecuting other frauds on U.S. investors involving single stock futures that would otherwise fall within Section 10(b) of the Exchange Act. U.S. investors deserve the anti-fraud and other protections included in other sections of the securities laws that do not make the bill’s short list.

Moreover, the bill fails to recognize that the SEC’s program of investor protection is comprehensive. Enforcement actions coupled with inspections and the ability to promulgate new regulations, when necessary, are essential ingredients of ensuring the integrity of America’s markets. Although the SEC actively pursues those who violate the securities laws, much of our success results from the violations that are prevented before a single investor is harmed.

Another example of where the bill recognizes the need for securities law principles for single stock futures, but does not adequately implement those principles, is in the area of recommendations to customers and suitability. The bill calls for the promulgation of rules governing recommendations by intermediaries to their customers, and contemplates that the SEC would be consulted about how those rules are formulated. The bill, however, provides neither clear standards for those rules’ content nor a mechanism to insure that these rules are truly harmonized with the well-developed suitability rules that apply to securities products today. For example, the bill could permit rules under which a salesperson could recommend a single stock future to a customer, even though suitability rules under the securities laws would preclude a recommendation to purchase the underlying security.

Similarly, investors rely on the Commission to protect them from unscrupulous, or even just sloppy practices, by investment advisers and mutual fund managers. The bill would introduce single stock futures into the mix of investment opportunities that an investment adviser may recommend to his or her clients or that an investment company manager may purchase for its affiliated investment company. It does so, however, without regulation by the SEC which would leave investors in funds consisting of single stock futures without the same protections that investors in mutual funds have enjoyed since 1940.

We would also point out that the bill fails to prevent disruption to existing securities markets. More specifically, language in the bill, such as the addition of definitions of "option" and "nonexempt security" to the CEA, makes it unclear whether CFTC exclusive jurisdiction over some products would be expanded, removing securities laws protections for those products that investors have come to expect. Moreover, the rule of construction in section 23 of the bill exacerbates this problem.

Other limitations on the SEC’s authority are also problematic. For instance, the SEC no longer will be able to prevent use of broad-based securities indexes that lend themselves to manipulation of the securities markets. Current SEC authority leaves little cause for concern as we exercise our discretion carefully. We have worked closely with the CFTC for many years on nearly 70 stock index futures proposals.

Moreover, trading in single stock futures would commence without clear, explicit provisions for coordinated surveillance across markets. Detecting schemes, for instance, where a fraud is perpetrated in one market and profits taken in another ultimately goes to the integrity of existing capital markets. This threat to the well-being of the financial markets cannot be tolerated.

III. Conclusion

Once again, the Commission appreciates the efforts that the Subcommittee has made in bringing derivatives issues to the forefront. Starting a dialogue is always an important first step. While we stand ready to review in more detail issues that the bill presents, we look forward to working with the Subcommittee to craft a modern legislative approach to these issues that fosters competition, bolsters market integrity, and ensures that no harm befalls America’s capital markets. Only then can the promise of these products to American investors be fulfilled.

The Commission appreciates this Subcommittee’s efforts with respect to derivatives issues. Just as derivatives products themselves can be complex, so to are the issues that surround these products. Having regulated 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.


1 Report of the President's Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (Nov. 1999).
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) <http://www.bis.org/press/index/htm>.
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 Subcomm. on Risk Management, Research and Specialty Crops, House Comm. on Agriculture (Feb. 15, 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 Senate Comm. on Agriculture, Nutrition, and Forestry (Feb. 10, 2000).
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).