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U.S. Securities and Exchange Commission

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

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

Before the House Subcommittee on Finance and Hazardous Materials
Committee on Commerce

July 12, 2000

Chairman Oxley and Members of the Subcommittee:

I am pleased to testify today on behalf of the Securities and Exchange Commission ("SEC" or "Commission") as you consider H.R. 4541, the Commodity Futures Modernization Act of 2000. My testimony today focuses on two key topics. First, I address OTC derivatives markets. Second, I address the competition, investor protection, and market integrity issues raised by single stock and stock index futures.

I. Legal Certainty for OTC Derivatives Markets

As you know, the President's Working Group on Financial Markets ("Working Group") issued a report last year on OTC Derivatives Markets and the Commodity Exchange Act ("OTC Derivatives Report").1 The OTC Derivatives Report contained several recommendations related to legal certainty for OTC derivatives products.

The enormous size of the OTC derivatives markets2 demonstrates their critical role in our capital markets. Derivatives contracts play a crucial role in risk management for a vast array of businesses. Accordingly, I can think of few more important issues for Congressional consideration than legislation to implement the recommendations by the Working Group to give legal certainty to the OTC derivatives market. The Commission reiterates its strong support for implementation of the recommendations by the Working Group related to legal certainty for the markets that trade these products.

The Working Group was given a fairly narrow task - to determine whether the Commodity Exchange Act ("CEA") provided an appropriate regulatory framework for the OTC derivatives markets. The Working Group unanimously concluded that for certain OTC derivatives the CEA was not the appropriate framework. In addition, the Working Group determined that steps needed to be taken to ensure that the CEA did not stifle the natural development of these markets. For a more detailed discussion of the Working Group's recommendations, I refer you to earlier Commission testimony.3

The consensus achieved by the Working Group was of historic significance. Four of the leading U.S. financial regulators unanimously agreed that the Report's recommendations, which reflected their combined regulatory expertise, urgently required implementation. The Commission strongly supports the efforts made in H.R. 4541 to further the goals of the Working Group. However, as we have stated in the past, it is not necessary to link resolution of all of the issues raised in the bill to the passage of the much needed provisions on legal certainty for OTC derivatives.

H.R. 4541 differs from the Working Group's recommendations regarding legal certainty in several key respects. For example, the Bill does not fully adopt the Working Group's recommendations on the regulation of clearing systems. By expressly providing that clearing agencies registered with the SEC may voluntarily register with the CFTC even though they are not required to do so, the Bill creates potential issues as to which set of regulations would prevail in the event of a conflict. The Working Group specifically recommended that a clearing system regulated by one agency should not become subject to regulation by another agency as a result of clearing OTC derivatives. The Commission staff would be happy to discuss those differences in detail with you or your staff and provide technical assistance to the Subcommittee.

The Commission continues to strongly support the implementation of the Working Group's recommendations that are designed to provide legal certainty for the OTC derivatives markets. Those recommendations should be implemented immediately. We appreciate the Subcommittee's efforts in furtherance of this goal, and we are committed to working with you as modifications are made to this bill.

II. Lifting the Ban on Single Stock Futures

The Commission supports lifting the ban on single stock futures as soon as the regulatory issues underlying that ban are resolved. This year, the Commission devoted tremendous staff resources to designing a legislative framework to permit the trading of single stock and narrow-based stock index futures. Disparities between futures and securities regulation made this a difficult task. As a result of our efforts, however, the Commission strongly believes that these products can trade under the regulatory system that we have outlined below.

Among other things, the Commission staff focused on issues raised by the Working Group. In its OTC Derivatives Report, the Working Group identified several issues that would have to be addressed before trading of single stock futures can begin. Furthermore, the Working Group noted that these issues were best resolved by the Commission and the CFTC.

The CFTC and the SEC engaged in extensive discussions on this topic. Chairman Rainer and I have not agreed on all aspects of a regulatory framework for single stock futures. However, we did reach agreement on fundamental principles for creating such a framework.4 Most important among these principles was that single stock futures should be subject to joint regulation by the CFTC and the SEC. This is a positive step forward from outdated notions of exclusive jurisdiction and the view that because a product can be considered a "future" it should be solely regulated by the CFTC. It reflects movement towards truly modern financial regulation - regulation that recognizes the need for agencies with legitimate regulatory interests and expertise in a product to participate in that product's oversight.

A. Requirements for a Legislative Framework

1. General Principles for Markets that are Competitive, Fair, and Free From Fraud and Manipulation

The process of working through important issues with the CFTC led the Commission staff to identify requirements for legislation to permit the trading of single stock futures. Contrary to what some have suggested, this is not a turf battle between the futures and options markets and the agencies that regulate them. Single stock futures would be nearly perfect surrogates for the underlying securities. As a result, there are fundamental issues of market integrity and investor protection at stake. For this reason, we should move forward in a reasoned and principled manner, as we consider how to permit an entirely new product to trade. If legislation is crafted correctly, markets will compete and regulators will cooperate. I think it would be useful to review the components that we believe are critical for an appropriate legislative framework.

Shared Jurisdiction

First, single stock futures are undeniably a substitute for stocks and stock options, and are fully expected to be a retail product. Therefore, the framework must recognize the legitimate interests of both the SEC and the CFTC in regulating these products. Single stock futures possess attributes of both securities and futures contracts. As a result, joint regulation of single stock futures is appropriate and exclusive jurisdiction is ill advised. Shared jurisdiction and joint regulation entail both recognizing each agency as best qualified to apply the key components of the laws that it administers and coordinating the agencies' efforts to ensure efficient market regulation that is not duplicative or overly burdensome.

At the practical level, this means ensuring that both agencies have the authority to carry out core functions, and that both encounter no jurisdictional barriers in the suppression of fraud and manipulation. Yet, at the same time, mechanisms should be devised to coordinate on certain costly issues so that the traditional regulator takes the lead.

Encourage Fair Competition

Second, the framework must encourage fair competition among markets. We do not want a framework that lets differences in regulation determine winners and losers. Any legislation should allow both securities and futures markets to enter the competitive fray, but should not give any type of market an artificial competitive advantage.

For example, the SEC and the CFTC should have joint authority to harmonize the margin requirements for single stock futures on an ongoing basis. Otherwise, the market with the more lenient margin requirements will have an artificial competitive edge. Competition should be based on better products, services, and prices - not on regulatory differences.

The legislation also should require coordinated clearing of single stock futures so that a future purchased on one exchange could be offset on another exchange that trades the same type of future. This would allow the same single stock future product to be listed on multiple exchanges. In the options markets, multiple listing has narrowed spreads and reduced prices to investors. Coordinated clearing also makes it more viable for new markets to enter the competitive arena over time. Without coordinated clearing, new markets will not be able easily to offer the same products as competitors.

Protect Investors

Third, the framework must acknowledge that single stock futures will be retail products. Complex derivative products generally do not attract retail customers but a simple future on a share of a blue chip stock will. Accordingly, legislation must maintain the SEC's ability to protect investors and to maintain integrity of the markets on which they trade. For this reason, the SEC should have clear and direct authority over the markets and market participants that trade single stock futures. I think it is important to explore a few examples of what might happen if the SEC does not have such authority.

In the securities markets, recommendations that brokers make to investors are governed by the suitability rules of self-regulatory organizations subject to SEC oversight. The customer protection regime is quite different under the futures laws. Investors receive a one-time disclosure document informing them that they can lose money on futures. The implications of these differences are quite significant. If the securities law principle of suitability is not applied to single stock futures, a broker could recommend such a product to any customer with no liability under the securities laws, even if the recommendation was unsuitable for the customer. Moreover, in many cases a broker who sells securities will also be licensed to sell single stock futures. As a result, the SEC is very concerned that investors will not understand that the protections they enjoy when they purchase one product from their broker will not also apply to the other. Worse yet, brokers could have an incentive to offer the riskier single stock futures to investors if they could do so without the suitability responsibilities that attach to the sale of securities. There is no public policy reason to create a framework with such a disparity in investor protections.

Next, consider a corporate insider who learns that his company is about to receive an unsolicited bid to be taken over. The insider buys a substantial amount of single stock futures on a futures exchange and earns huge profits on the transaction. This case involves insider trading that takes money out of the pockets of investors who did not have this information. This is exactly the type of situation that the Commission needs its full authority to address. Without direct authority over the futures exchange or a requirement for insider reporting, the SEC may have difficulty ever learning of the futures purchase by the insider. Such activities could destroy years of Commission efforts to protect investors from insider trading abuses.

Investors also currently rely on the Commission to protect them from unscrupulous, or even just sloppy, practices by investment advisers and mutual fund managers. A bill should not introduce single stock futures into the mix of investment opportunities that investment advisers may recommend to their clients or that portfolio managers may purchase for the mutual funds they manage without regulation by the SEC. This would leave investors in funds consisting of single stock futures without the same protections that investors in mutual funds have enjoyed since 1940.

These are only a few examples, but I hope they illustrate why the investor protections contained in the securities laws should be extended to single stock and narrow-based stock index futures. Please recognize that the SEC's instruments for investor protection are interlinked. Enforcement actions coupled with inspections and the ability to promulgate new regulations are essential ingredients of ensuring the integrity of America's markets. Direct access to audit trails, coordinated market surveillance, inspection authority, as well as suitability and customer protection regulation are all necessary to the SEC's ability to effectively regulate and protect investors. Although the SEC actively pursues people who violate the securities laws, much of our success results from preventing problems before a single investor is harmed.

The SEC has many decades of experience and legal precedent in protecting the public - expertise that should be carried over to equity substitutes such as single stock futures. Our securities markets are second to none because of the investor confidence that has flourished under this regulatory framework. It would be extremely unwise to move ahead with legislation that lacks the elements necessary to ensure the market integrity, suitability, and customer protections that investors have come to expect under the securities laws.

Do Not Harm Existing Markets

Fourth, the framework must avoid any harm to existing capital markets. In lifting the ban on single stock futures and reopening jurisdictional issues, legislative changes should not take away existing SEC authority over financial products. For instance, the Shad-Johnson Accord clarified the SEC's jurisdiction over security options, and that jurisdiction should not be diminished in any way. Nor should legislation eliminate the SEC's existing role in evaluating stock indexes for susceptibility to manipulation and compliance with appropriate standards that assure they will not become a surrogate for single stocks. Given the CFTC's exclusive jurisdiction over such futures, the standard put forward in any bill and the SEC's role in applying it must be sufficient to deter insider trading through index futures. Investors have strong expectations about the integrity of markets that the SEC regulates, and the resulting investor confidence fuels the success of those markets. Accordingly, legislation should not eliminate any existing SEC oversight of securities and related markets.

Moreover, we cannot allow market integrity issues in new markets to migrate to existing capital markets. Because there are times when problems in one market may be identified and understood only by reference to another market, legislation must provide for coordinated surveillance of all markets.


Adherence to these principles will leave U.S. markets for these products better positioned to compete against their foreign counterparts. When U.S. markets are forced to compete against each other for investors' business and to maintain the integrity that promotes investor confidence and attracts additional business, those markets should be leaders in the international arena. As markets around the world compete for customers and capital, one overriding principle will serve as our competitive advantage: the quality of our markets.

2. Discussion Draft

The Commission staff has prepared a discussion draft that incorporates these legislative goals into amendments to the federal securities laws and the Commodity Exchange Act. The SEC's proposal extends the protections of the federal securities laws to single stock futures. However, much of the proposal is devoted to ensuring that those laws do not unnecessarily burden the markets and intermediaries that trade single stock futures. We look forward to comments from the CFTC and to having a dialogue with your Subcommittee on our suggested approach. We are setting out below a brief summary of the principal elements of that plan - a plan that presumes shared SEC and CFTC jurisdiction over these products.

First, this draft framework defines single and narrow-based stock index futures as securities. This triggers SEC oversight and the application of the securities laws. We then focus on detailed regulatory relief for some of these intermediaries and markets as a means to avoid unnecessary or duplicative regulation.

For example, floor brokers on designated contract markets that are already registered with the CFTC would be completely exempt from SEC registration. We also create a simple process of notice registration with the SEC for certain markets and intermediaries that are already registered with the CFTC. Those markets and intermediaries would have to comply only with securities law provisions that are considered "core." We clearly exempt these markets and intermediaries from the numerous non-core provisions of the securities laws where the CEA and CFTC regulation sufficiently addresses the same public policy concerns.

For the core provisions of the securities laws that would still apply to these entities, we provide innovative ways to relieve their regulatory burdens and to coordinate our regulatory efforts with the CFTC. For example, for many of the proposed rule changes that CFTC-regulated markets would submit to the SEC we have provided for immediate effectiveness of such changes and a limited scope of review. In appropriate areas, such as examinations, we recognize that the CFTC should be the lead regulator for such CFTC-regulated entities and limit our activities accordingly.

In addition to the detailed regulatory relief and coordination provisions, we provide minimum requirements to be incorporated into listing standards for these products. Such requirements, along with provisions related to coordinated clearing, are aimed at promoting market integrity and intermarket competition.

Finally, we incorporate these products into other relevant securities laws, such as the Securities Act of 1933, the Investment Company Act, and the Investment Advisers Act. In doing so, we avoid unnecessarily burdensome regulation under these acts as well.


This discussion draft shows that the protections of the securities laws can be extended to single stock and narrow-based stock index futures while still permitting the efficient operation of our markets. Our discussion draft would achieve the goals of creating a new market for single stock and stock index futures that is competitive, fair, and free from fraud and manipulation. U.S. investors deserve nothing less. U.S. capital markets provide the lifeblood of American business and are the place where American families invest their hard-earned dollars with hopes of earning returns that will provide for everything from their children's educations to their retirements. We cannot afford to put these markets at risk.

B. Comparison to H.R. 4541

Crafting our plan was not easy. Therefore, I appreciate your efforts in drafting the bill. Moreover, I am heartened by the bill's attempt to recognize some of the principles that the Commission feels are so important in this area. Unfortunately, the bill as written ultimately does not vindicate those principles and achieve the goals of the legislative framework previously outlined. The bill does not sufficiently extend the protections of the securities laws to single stock and narrow-based stock index futures. The Commission therefore could not support the legislation in its current form.

As you continue to revise your legislation, I would hope your bill ultimately can answer questions, such as the following, in the affirmative:

  • Does the bill clarify in both the CEA and the securities laws that the SEC has full authority over single stock and narrow-based stock index futures and that the securities laws protections apply to these products?

  • Does the bill provide for expedited registration of the intermediaries and exchanges that trade these products with both the SEC and the CFTC?

  • Does the bill provide real mechanisms for both the SEC and the CFTC to ensure that the relevant securities and futures regulations, such as those related to margin, remain harmonized on an ongoing basis?

  • Are there provisions for coordinated clearing of these products?

  • Are there provisions that enable the CFTC and SEC to work together to foster competition in the markets for these products?

  • Will both the CFTC and SEC be able to effectively prosecute frauds involving these products?

III. Conclusion

Once again, the Commission appreciates the efforts that the Subcommittee has made in bringing derivatives issues to the forefront. We believe that the regulatory provisions that we have set forth can support the work of the Subcommittee in its efforts to repeal the ban on single stock futures and eliminate uncertainty for the OTC derivatives markets in a way that fosters competition, bolsters market integrity, and ensures that no harm befalls America's capital markets or investors.

The Commission appreciates the Subcommittee's efforts with respect to derivatives issues. Just as derivatives products themselves can be complex, so too are the issues that surround these products. Having regulated securities derivative products for decades, the Commission welcomes the opportunity to actively participate in the dialogue about derivative products that your bill will engender. We look forward to sharing our views with your Subcommittee, the Working Group, market participants, and other legislators as changes continue to be considered.

Thank you.

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 Senate Comm. on Agriculture, Nutrition, and Forestry (Feb. 10, 2000). See also Testimony of Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Concerning Recent Recommendations by the President's Working Group on Financial Markets, Before the House Comm. on Banking and Financial Services (Apr. 11, 2000); Testimony of Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Concerning the Report to Congress on Over-the-Counter Derivatives Markets and the Commodity Exchange Act by the President's Working Group on Financial Markets, Before the Subcomm. on Risk Management, Research and Specialty Crops, House Comm. on Agriculture (Feb. 15, 2000).

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).