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U.S. Securities and Exchange Commission

Testimony Concerning
S. 2697, The Commodity Futures Modernization Act of 2000

By Chairman Arthur Levitt
U.S. Securities & Exchange Commission

Before the Committee on Agriculture, Nutrition, and Forestry
Committee on Banking, Housing, and Urban Affairs
United States Senate

June 21, 2000

Chairman Lugar, Chairman Gramm, and Members of the Committees:

I am pleased to testify today on behalf of the Securities and Exchange Commission ("SEC" or "Commission") as you consider S. 2697, the Commodity Futures Modernization Act of 2000. The billís principal focus is on lifting the ban on single stock futures and the much needed modernization of our futures laws as well as the provision for legal certainty for over-the-counter ("OTC") derivatives. One of its core provisions, however, potentially could result in fundamental and counterproductive deregulation of our securities markets.

For over six decades, our securities laws have defined the Commissionís mission: To insure integrity and competition in our markets and to protect investors. Today, Americans invest in our capital markets in greater numbers than anywhere else in the world, a testament to the confidence that the securities laws have helped instill.

I can appreciate that to some our securities laws may appear to be just more government regulation. But to study our securities laws is to discover the rich history of U.S. financial markets. Your predecessors did not write these laws in a vacuum. They enacted these statutes in response to significant problems that cried out for practical solutions.

History proves that these laws have worked for the securities markets. Not only our securities markets, but also our derivatives markets, such as the options markets, have thrived under this framework. To me, the question posed by this bill is whether the benefits of the securities laws that investors have come to expect should continue to apply to these markets. Unequivocally, the Commissionís answer to that question is yes.

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, last year the Presidentís Working Group on Financial Markets ("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. These products play a critical role in our capital markets. 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. Accordingly, 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.

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 Groupís task was fairly narrow Ė to determine whether the Commodity Exchange Act ("CEA"), which had introduced substantial risk that such contracts could be voided, 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 Groupís recommendations, I refer you to prior Commission testimony.3

It is worth underscoring the significance of the consensus achieved by the Working Group. Four of the leading U.S. financial regulators unanimously agreed that the Reportís recommendations, which reflected their combined regulatory expertise, urgently required implementation. The Commission is very supportive of the Committeesí efforts 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 issues raised in the bill to passage of the much needed provisions on legal certainty for OTC derivatives.

S.2697, as introduced, differs from the Working Groupís recommendations regarding legal certainty in several key respects. The Commission staff would be happy to discuss those differences in detail with you or your staff and provide technical assistance to the Committees. But today, I want to focus on a provision in the bill that would have significant implications for the integrity of the market for a wide-range of securities-based derivatives. Section 23 of the bill would exclude from the securities laws Ė and their widely enjoyed protections Ė any swap agreement. We see no public policy justification for this far-reaching provision.

Concerns about legal uncertainty regarding swaps arose only because, if swaps contracts were construed as futures under the CEA, they would be illegal and voidable if they were traded off of an exchange. This unique structure of the CEA, coupled with the issuance by the CFTC of a concept release suggesting a new regulatory framework for swaps, were what brought the legality of these transactions into question. This is what prompted the other members of the Working Group to call for a moratorium on CFTC rulemaking in this area and led to the Working Groupís study of OTC derivatives markets and the CEA.

By contrast, similar issues of legal certainty do not arise under the securities laws. Nothing in the securities laws has impaired the growth of the $80 trillion swap business. The marketplace has structured these products to comply with the securities laws with no adverse impact on their economic structure.

In addition, the SEC has taken a measured approach in the swaps area. In part, this is because the SEC does not have blanket authority over swaps or other derivatives. Generally, for the SEC to assert jurisdiction over a financial product, that product must meet well-established tests of what is a security. Under these tests, it has been recognized from the earliest days of the securities laws that over-the-counter options on securities were themselves securities, even if documented as swaps. Moreover, the Commission by and large has brought enforcement actions related to swaps only in clear cases of fraud. The exclusion of swaps from the CEA will have no impact whatsoever on the Commissionís measured approach to these derivative products.

Furthermore, when the industry has asked the SEC to take action in the OTC derivatives area, we have responded promptly with creative initiatives, such as the flexible, voluntary regulatory framework for OTC derivatives dealers Ė commonly referred to as BD Lite. The Working Group never suggested that achieving legal certainty entailed removing all regulation involving derivative products. The Working Group concluded only that the CEA was not the proper statute to govern certain swaps. The real issue was removing these products from a law that called their validity into question. Nothing in the Report called for the elimination of other existing financial regulations, and the protections they provide.

The billís language in Section 23 on what products are defined as swaps and therefore excluded from the securities laws is expansive and vague. OTC options on securities could be characterized as swaps. Indeed, any exchange of cash for a security could be drawn up as a swap and therefore arguably excluded from the securities laws. Therefore, this provision of the bill would result in a wholesale removal of SEC oversight over a wide array of securities products. The risks to this approach could not be more clear. Those seeking to avoid long-established investor and market integrity protections of the securities laws could do so by merely labeling the transactions as "swaps." The potential consequences of this gaping loophole in the application of our long established securities law protections could be significant.

Because of the breadth of related provisions in Section 23, the legislation, as currently drafted, also threatens important aspects of the Commission's enforcement program. In its apparent effort to ensure that swaps would be excluded from SEC jurisdiction, the legislation includes a "catch-all" limitation on SEC authority. The language of this catch-all provision could be interpreted to curtail Commission authority in areas where it traditionally has acted to protect investors. In particular, the catch-all could undermine SEC authority to act against perpetrators of Ponzi schemes, who frequently target the kinds of novice investors recently drawn into the markets in great numbers. It also could be applied to inhibit the SEC's effort to combat a troubling resurgence in insider trading.

Thus, while the SEC strongly supports the Working Groupís recommendations to provide legal certainty for OTC derivatives regarding the CEA, we cannot support the billís attempt to go beyond the carefully considered recommendations of the Working Group.

The Commission continues to strongly support the implementation of the Working Groupís recommendations that are designed to provide legal certainty for the OTC derivatives markets. Those recommendations should be implemented immediately. We appreciate the efforts of these Committees 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 Shad-Johnson ban on single stock futures, once the regulatory issues underlying that ban are resolved. 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. As a result of our efforts, the Commission strongly believes that these products can trade under the regulatory system that I will outline for you today. That is not to say that it was easy to formulate this system. 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.

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 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 the Chairmen of these Committees, also urged the SEC and CFTC to determine cooperatively how to regulate single stock futures.

I want to highlight that, although Chairman Rainer and I did not reach agreement on all aspects of a regulatory framework for single stock futures, we did reach agreement on fundamental principles for creating such a framework. We 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 point should not be understated. 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 Ė regulation that recognizes the need for agencies with legitimate regulatory interests, and expertise, in a product to participate in that productís oversight.

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 at base 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. If legislation is crafted correctly, markets will compete and regulators will cooperate. I think it would be useful to review the components 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. 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 agenciesí 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. This involves not only stating that some specific regulations should be harmonized, but providing a mechanism for the CFTC and SEC to do so on an ongoing basis as the markets evolve.

For example, mechanisms must be put in place so that both the SEC and the CFTC can act 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. Markets should not compete for customers based on how much leverage they are allowed to provide those investors. Competition should be based on better products, services, and prices Ė 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 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 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.

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 is the type of product that is sure to do so. Accordingly, legislation must maintain the SECís 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. If the securities law principle of suitability is not applied to single stock futures, a broker could recommend such a product to a retiree with no liability under the securities laws. 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. What are the implications of these differences? I believe they are quite significant. Consider that in the vast majority of cases the same broker who sells the retiree securities will also be licensed to sell single stock futures. Does anyone believe that investors will understand that the protections they enjoy when they purchase one product from their broker will not also apply to the other? And worse yet, could brokers 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? I see no public policy reason to create a framework with such an inexplicable 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, which he plans to send to an offshore bank. 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. Even if the SEC were notified of the suspicious futures transactions, if we have to seek CFTC permission to proceed with an investigation or enforcement action, the SEC loses precious time and could likely lose the ability to freeze the insiderís U.S. assets. Such activities could destroy years of Commission efforts to protect investors from insider trading abuses. Indeed, I think back to some of our most celebrated insider trading cases. Would we want a system that would risk the successful prosecution of such cases merely because they involved single stock futures?

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 an investment adviser may recommend to his or her clients or that a portfolio manager may purchase for the mutual fund he or she manages 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 SECís instruments for investor protection are interlinked. Enforcement actions coupled with inspections and the ability to promulgate new regulations, when necessary, are essential ingredients of ensuring the integrity of Americaís markets. Direct access to audit trails, coordinated market surveillance, inspection authority, as well as suitability and customer protection regulation, are all necessary to the SECís ability to effectively regulate and protect investors. Although the SEC actively pursues those who violate the securities laws, much of our success results from preventing problems before a single investor is harmed.

The SEC should not be required to seek the permission of any other entity to protect investors. The SEC has many decades of experience and legal precedent in protecting the public Ė 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 SECís jurisdiction over security options, and that jurisdiction should not be diminished in any way. Nor should legislation eliminate the SECís 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 CFTCís exclusive jurisdiction over such futures, the standard put forward in any bill and the SECís 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 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.


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 investorsí 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 prepared a discussion draft that incorporates these legislative goals into amendments to the federal securities laws and the Commodity Exchange Act. Unfortunately, given the pendency of this bill as well as bills in the House, the CFTC has not apparently had a chance to review or comment on our draft in detail. In addition to the extension of securities law protections to covered products, much of the proposal is devoted to ensuring that those laws do not unnecessarily burden the markets and intermediaries that trade those products. We continue to look forward to comments from the CFTC and to having a dialogue with your Committees on our suggested approach. We are setting out below a brief summary of the principal elements of that plan Ė 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 with the Commission for certain markets and intermediaries already registered with the CFTC. And, such 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 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, 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 childrenís educations to their retirements. We cannot afford to put these markets at risk.

B. Comparison to S. 2697

Crafting our plan was not easy. Therefore, I appreciate your efforts in drafting the bill. Moreover, I am heartened by the billís attempt to recognize some of the principles that the Commission feels are so important in this area. Unfortunately, as written, the bill 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?

The staff and I look forward to providing additional technical assistance to help you reach the right answers for our markets.


Once again, the Commission appreciates the efforts that the Committees have made in bringing derivatives issues to the forefront. We believe the regulatory provisions that we have set forth can support the work of the Committees in their 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 Americaís capital markets or investors. Only then can the promise of these products to American investors be fulfilled. And only then will U.S. markets, tested under the rigors of true competition, be ready to vie effectively with foreign markets.

The Commission appreciates the Committeesí 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 Committees, the Working Group, market participants, and other legislators as changes continue to be considered.

Thank you.

1Report of the President's Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (Nov. 1999).

2According 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 Ė June 1999, 45/1999E (Nov. 25, 1999) <http://www.bis.org/press/index/htm>.

3See 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 Presidentís 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 Presidentís 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 Presidentís Working Group on Financial Markets, Before the Senate Comm. on Agriculture, Nutrition, and Forestry (Feb. 10, 2000).

4Letter 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).