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 Committee on Banking and Financial Services
United States House of Representatives
July 19, 2000
Chairman Leach and Members of the Committee:
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 the desirability of legal certainty for the OTC derivatives markets and the need to assure that securities derivatives such as single stock futures do not undermine investor protection and market integrity.
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 market2 demonstrates its 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 OTC derivatives.
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. After studying the issues, the Working Group unanimously concluded that the CEA was not the appropriate framework for certain OTC derivatives. 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 my earlier 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.
In making its recommendations for the OTC derivatives market, the Working Group balanced the needs of users with the risk of abuses. The Working Group's recommendations for regulatory relief were limited to products traded by eligible contract participants. As a practical matter, institutional and other highly sophisticated investors are the main participants in the OTC derivatives market. The lines that the OTC Derivatives Report draws for exclusion from the CEA reflect the sophistication of market participants who will use the exclusion. The Working Group determined that these eligible contract participants do not have the same need for the protections of the CEA that retail investors do.
The Working Group also concluded that regulatory relief for electronic derivatives trading systems should be limited to systems on which participants trade on a principal-to-principal basis. The Working Group drew this distinction in order to avoid the concerns associated with fiduciary relationships and conflicts of interest that can arise with agency trading.
In addition, the Working Group made recommendations with respect to hybrid products - those derivative products that have characteristics of both futures and either deposits or securities. Again, care was taken to assure that the protections available under the banking and securities regulatory schemes would remain applicable to these products.
The Commission strongly supports the efforts made in H.R. 4541 to further these 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.
In addition, 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 Committee.
Moreover, the Working Group never suggested that achieving legal certainty entailed removing all regulation involving derivative products. Rather, the Working Group concluded only that the CEA was not the proper statute to govern certain swaps. Some have suggested that swap agreements should also be excluded from the coverage of the securities laws in order to eliminate all legal certainty concerns. However, concerns about the legal certainty of swaps have arisen only because swaps would be illegal and voidable under the CEA if they were construed as futures and were traded off of an exchange. 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.
The SEC does not have blanket authority over swaps or other derivatives. In fact, the SEC may not assert jurisdiction over any financial product unless the product meets well-established tests of what a security is. 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 they were documented as swaps. Nevertheless, the Commission by and large has taken action with respect to swaps only in enforcement cases involving clear instances of fraud. Providing legal certainty for swaps with respect to the CEA will have no impact whatsoever on the Commission's measured approach to these derivative products. Furthermore, when the industry has asked the SEC to take action in the OTC derivatives area, the Commission has responded promptly with creative initiatives, such as the flexible, voluntary regulatory framework for OTC derivatives dealers commonly referred to as "BD Lite".
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. The Commission also supports the Working Group's recommendation for improvements in the close-out netting regime for derivatives and other financial instruments under the Bankruptcy Code and bank insolvency law, which we discussed more fully in testimony on February 10, 2000. These recommendations for the OTC derivatives market should be implemented immediately. We appreciate the Committee's efforts in furtherance of this goal, and we are committed to working with you as modifications are made to this Bill.
II. Single Stock Futures
H.R. 4541 also would lift 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.
Because a single stock future would be a nearly perfect surrogate for the underlying security, the Commission believes that single stock futures should be jointly regulated by the SEC and the CFTC as both securities and futures. In addition, single stock futures are fully expected to be retail products. Accordingly, the Commission believes that purchasers of single stock futures should have the same legal protections that investors in other securities have. The SEC and the CFTC are working together to agree on a workable regulatory framework that will keep investor protection and market integrity in the forefront.
The Commission appreciates the Committee's efforts with respect to derivatives issues and single stock futures. Having regulated securities derivative products for decades, the Commission welcomes the opportunity to actively participate in the dialogue that H.R. 4541 has engendered about derivative products and single stock futures. We look forward to sharing our views with your Committee, the Working Group, market participants, and other legislators as changes continue to be considered.
1 Report 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 - 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 Recent Recommendations by the President's Working Group on Financial Markets, Before the House Comm. on Banking and Financial Services (Apr. 11, 2000). See also 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);
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).