oversight

The Commodity Exchange Act: Legal and Regulatory Issues Remain

Published by the Government Accountability Office on 1997-04-07.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to Congressional Committees




April 1997
                THE COMMODITY
                EXCHANGE ACT
                Legal and Regulatory
                Issues Remain




GAO/GGD-97-50
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division

      B-259983

      April 7, 1997

      The Honorable Richard G. Lugar
      Chairman
      The Honorable Tom Harkin
      Ranking Minority Member
      Committee on Agriculture, Nutrition
        and Forestry
      United States Senate

      The Honorable Thomas W. Ewing
      Chairman
      The Honorable Gary A. Condit
      Ranking Minority Member
      Subcommittee on Risk Management
        and Specialty Crops
      Committee on Agriculture
      House of Representatives

      In the past quarter century, technological advances and fundamental
      changes in the global financial markets have accelerated the development
      and use of financial products generically called derivatives.1 Derivatives
      include futures contracts2 that traditionally have been traded on organized
      exchanges and are regulated by the Commodity Futures Trading
      Commission (CFTC) under the Commodity Exchange Act (CEA).3 They also
      include swaps4 and other over-the-counter (OTC) derivatives contracts that
      resemble exchange-traded futures in their economic function but are
      privately negotiated between counterparties outside organized exchanges.
      As we and others have reported,5 derivatives can serve a useful
      risk-management function, but their use can pose risks to participants and
      the markets. The total notional/contract amount of derivatives contracts


      1
       Derivatives are contracts that have a market value determined by the value of an underlying asset,
      reference rate, or index (called the underlying). Underlyings include stocks, bonds, agricultural and
      other physical commodities, interest rates, foreign-currency rates, and stock indexes.
      2
       Futures contracts are derivatives that obligate the holder to buy or sell a specific amount or value of
      an underlying asset, reference rate, or index at a specified price on a specified future date.
      3
       7 U.S.C. 1 et seq.
      4
       Swaps are privately negotiated contracts that typically require counterparties to make periodic
      payments to each other for a specified period. The calculation of these payments is based on an
      agreed-upon amount, called the notional amount, that is not typically exchanged.
      5
       See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,
      1994) and the update to this report, Financial Derivatives: Actions Taken or Proposed Since May 1994
      (GAO/GGD/AIMD-97-8, Nov. 1, 1996).



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                   outstanding worldwide was an estimated $55.7 trillion as of March 31,
                   1995.6

                   Because of their resemblance to exchange-traded futures, swaps and other
                   OTC derivatives faced the possibility of falling within the judicially crafted
                   definition of a futures contract. As a result, they faced the legal risk of
                   being unenforceable under the CEA due to its requirement that futures be
                   traded on exchanges to be legal and thus enforceable. The Futures Trading
                   Practices Act of 1992 (P.L. 102-546) provided CFTC with authority to reduce
                   this legal risk, which the agency subsequently used. At the same time,
                   developments in the exchange-traded futures and OTC derivatives markets
                   brought regulated financial institutions into these markets, leading to a
                   greater array of derivatives contracts and greater competition among
                   those providing such contracts. Consequently, some of the distinctions
                   among market participants and between exchange-traded futures and OTC
                   derivatives have become blurred—raising questions about the appropriate
                   regulatory structure for these contracts, markets, and market participants.
                   Because of the Committees’ interest in the CEA and congressional interest
                   in the continued vitality and integrity of the U.S. exchange-traded futures
                   and OTC derivatives markets, we initiated this review to provide Congress a
                   context for addressing these questions. Specifically, we focused on (1) the
                   extent to which CFTC has reduced the legal risk surrounding the
                   enforceability of OTC derivatives under the CEA and (2) issues related to the
                   appropriate regulation for exchange-traded futures and OTC derivatives
                   contracts, including their markets and market participants.


                   Under the authority provided by the Futures Trading Practices Act of 1992,
Results in Brief   CFTC exempted most swaps and other OTC derivatives contracts from the
                   CEA’s exchange-trading requirement and, in doing so, reduced or
                   eliminated the legal risk that they could be unenforceable. The legal risk
                   arose from the possibility that CFTC or a court could find that swaps and
                   other OTC derivatives fell within the judicially crafted definition of a
                   futures contract, in part because, like futures, they served a risk-shifting
                   function. If determined to be futures, these contracts would have violated
                   the CEA’s requirement that futures be traded on an organized exchange,
                   making them illegal and thus unenforceable. In granting the exemptions,
                   CFTC was not required to, and did not, determine that OTC derivatives were
                   futures. As a result, a question has remained about whether OTC derivatives

                   6
                    This estimate was based on a comprehensive survey done by the Bank for International Settlements
                   and represents the most current data available. The notional amount of derivatives contracts is one
                   way that derivatives activity is measured. Because the notional amount is not exchanged in most OTC
                   derivatives transactions, it is not typically a measure of the amount at risk.



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are futures and can be regulated under the act. The possibility that swaps
are futures continues to be a source of legal risk for a narrow group of
swaps—so-called equity swaps—that are ineligible for exemption from the
act’s requirements. Legal risk also remains for certain agricultural
forwards7 that are becoming increasingly difficult to distinguish from
futures and that may not be eligible for the swaps exemption.

Although CFTC reduced or eliminated the legal risk of being unenforceable
for most swaps and other OTC derivatives, a broader policy question
remains about the appropriate regulation for OTC derivatives and
exchange-traded futures, including their markets and market participants.
We discuss three issues that are related to this policy question. The first
issue concerns the appropriate regulation for the OTC foreign-currency
market under the CEA. The act excludes from its regulation certain OTC
foreign-currency transactions, but the scope of the exclusion—called the
Treasury Amendment—has been the subject of disagreement among
federal regulators and the courts. A recent U.S. Supreme Court decision
resolved that the exclusion covers all transactions in foreign currency,
including foreign-currency options and futures.8 The Court did not,
however, address the meaning of language that saves from the exclusion
sales for future delivery conducted on a board of trade. As a result, the
extent to which the Treasury Amendment excludes transactions involving
unsophisticated market participants may still be subject to debate.

The second issue concerns the potential for the swaps market to evolve
beyond its exemption and raise additional regulatory concerns. CFTC
exempted swaps from virtually all CEA requirements but imposed
conditions on the exemption that restricted their design and trading
procedures. Although difficult to predict, the swaps market might develop
in ways that are inconsistent with these conditions. Should this occur,
CFTC could use its exemptive authority to accommodate market
developments and address any regulatory concerns, but such an approach
could introduce, among other things, jurisdictional questions involving




7
 Forwards are privately negotiated contracts in which the buyer and seller agree upon delivery of a
specified quality and quantity of goods at a specified future date. A price may be agreed upon in
advance or determined at the time of delivery. Delivery is typically expected, although it may not
occur.
8
 CFTC v. Dunn, 65 U.S.L.W. 4141 (U.S. Feb. 25, 1997), rev’g 58 F. 3d 50 (2d Cir. 1995).



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                          other federal regulators. The President’s Working Group on Financial
                          Markets provides one forum for addressing such questions.9

                          The third issue concerns the rationale for the regulatory differences
                          between the OTC derivatives and exchange-traded futures markets. The
                          types of contracts transacted in each market serve similar economic
                          functions but differ in other ways, including the way they are traded and
                          regulated. CFTC recently granted the exchanges an exemption to enable
                          them to better compete against the less regulated OTC derivatives market.
                          However, under the exemption, regulation of the two markets will
                          continue to differ substantially. While the exchange exemption represents
                          one approach to rationalizing the regulatory differences between the
                          markets, it also illustrates some of the challenges in doing so.

                          In attempting to address the appropriate regulation of the exchange-traded
                          futures and OTC derivatives markets, three fundamental questions arise
                          concerning the goals of federal policy. These questions are (1) what is the
                          current public interest in these markets that needs to be protected;
                          (2) what type of regulations are needed, if any; and (3) what is the most
                          efficient and effective way to implement and enforce any needed
                          regulations? Ultimately, maintaining globally competitive U.S. derivatives
                          markets will require balancing the goal of allowing the U.S. financial
                          services industry to innovate and grow with the goal of protecting
                          customers and the market, including its efficiency, fairness, and financial
                          integrity.



Background

The Futures Market Is     Futures contracts first appeared in the United States in the mid-1800s and
Regulated Under the CEA   were based on grains. They provided producers (farmers) and commodity
                          users with a means of reducing the risk of financial loss arising from
                          adverse fluctuations in commodity prices, called hedging. They also
                          provided a more efficient and transparent means of determining
                          commodity prices based on supply and demand factors, called price
                          discovery. Because of concerns about price manipulation and other
                          trading abuses in the futures market, including the operation of bucket


                          9
                           The President’s Working Group on Financial Markets was created following the October 1987 stock
                          market crash to address issues concerning the competitiveness, integrity, and efficiency of the
                          financial markets. The Secretary of the Treasury chairs the working group, and other members include
                          the chairs of CFTC, the Federal Reserve System, and the Securities and Exchange Commission.



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shops,10 Congress passed the CEA in 1936 to amend the Grain Futures Act
of 1922. Like its predecessor, the CEA required that futures trading in
specified commodities—such as corn, rye, and wheat—be conducted only
on federally designated markets. To receive such a designation, an
exchange had to meet certain self-regulatory requirements that included
providing for the prevention of manipulation and fraud. Congress
periodically amended the act to bring futures trading in additional
commodities under the CEA. For example, Congress amended the act in
1968 and brought futures trading in livestock, livestock products, and
frozen concentrated orange juice under federal regulation.

By the early 1970s, futures trading had expanded to include
nonagricultural commodities, such as precious metals and foreign
currencies. Although contracts on these commodities were traded on
futures exchanges, they were not covered by the act and, thus, were not
federally regulated. In 1974, Congress amended the CEA to ensure that all
futures contracts—whatever their underlying commodity—would be
federally regulated. It accomplished this goal by expanding the list of
commodities covered by the act to include virtually anything, tangible or
intangible.11 As a result, the class of instruments that could be defined as
futures and subject to the act’s exchange-trading requirement was
broadened. Any contract that was legally categorized as a futures contract
could be traded only on federally designated exchanges, making the
off-exchange trading of futures illegal.

The 1974 amendments to the CEA also created CFTC to administer the CEA.12
The CEA gives CFTC exclusive jurisdiction over futures and establishes a
comprehensive regulatory structure designed to protect the futures market
and its participants. Historically, CFTC’s regulatory structure was designed
to assure that all futures contracts were traded on self-regulated
exchanges and through regulated intermediaries, which were subject to
capital, examination, recordkeeping, registration, reporting, and customer
protection requirements. The CEA’s exchange-trading requirement was
intended to foster both market integrity and customer protection by
creating a centralized market that could be protected against excessive

10
  Bucket shops are firms that purport to conduct a legitimate business by accepting orders for futures
contracts, but that do not actually execute the orders in the futures market. When the price on the
futures market moves against the bucket shops, they often close their doors or file for bankruptcy
protection, leaving uncollectible debts.
11
  The list of specified commodities was expanded to include “all goods and articles . . . and all services,
rights, and interests in which contracts for future delivery are presently or in the future dealt in.”
12
  Before the 1974 amendments to the CEA, the Department of Agriculture administered the act and
regulated the futures market.



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    speculation, price manipulation,13 and other abusive trade practices.
    According to the act, regulation of the futures market was necessary to
    protect the public interest, because futures prices were susceptible to
    excessive speculation and could be manipulated to the detriment of
    producers, consumers, and others. Moreover, the act’s legislative history
    noted that the fundamental purposes of the act were to ensure fair
    practices and honest dealing in the futures market and to control those
    forms of speculative activity that demoralize the market to the detriment
    of producers, consumers, and the markets.

    While providing for their regulatory oversight, the CEA does not define the
    term futures contract. Instead, CFTC and the courts have identified certain
    elements as necessary, but not always sufficient, for defining a futures
    contract. These elements are

•   the obligation of each party to fulfill the contract at a specified price set at
    the contract’s initiation,
•   the use of the contract to shift or assume the risk of price changes, and
•   the ability to satisfy the contract by either delivering the underlying
    commodity or offsetting14 the original contract with another contract.

    CFTC and the courts have also identified additional elements of
    exchange-traded futures contracts, including standardized terms, margin
    requirements,15 use of clearinghouses,16 open and competitive trading in
    centralized markets (such as futures exchanges), and public price
    dissemination. These additional elements facilitate futures trading on
    exchanges but do not define what makes a contract a futures contract.
    Also, according to CFTC and the courts, the requirement that a futures
    contract be exchange-traded is what makes the contract legal, not what
    makes it a futures contract. Because CFTC and the courts have defined a
    futures contract in a way that reflects its risk-shifting function, the CEA

    13
     Manipulation is the distortion of market prices for economic gain. The distortion typically involves
    creating artificial prices that do not reflect supply and demand conditions, or creating a false picture of
    supply and demand conditions to cause a desired price movement and/or reaction by other market
    participants.
    14
     Offset for exchange-traded futures is the liquidation of a long (short) futures position through the
    sale (purchase) of an equal number of contracts of the same delivery month.
    15
      Margins are the cash or collateral deposited by customers with their agents for the purpose of
    insuring the agents and, ultimately, clearinghouses against loss on open exchange-traded futures
    contracts.
    16
      Clearinghouses are responsible for the daily clearance and settlement of all trades. Clearance is the
    process of capturing the trade data, comparing buyer and seller versions of the data, and guaranteeing
    that the trade will settle once the data are matched. Settlement is the process of fulfilling contractual
    requirements through cash payment or delivery.



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potentially covers a broad range of risk-shifting products that are not
exchange-traded.

The CEA also provides CFTC with jurisdiction over commodity options,17
except options on securities18 and options on foreign currencies traded on
a national securities exchange. CFTC’s options jurisdiction is further limited
by the recent U.S. Supreme Court decision in CFTC v. Dunn.19 Commodity
options include options to acquire futures contracts (called options on
futures) and options to acquire the actual commodity, excluding
securities. CFTC has issued regulations to allow futures exchanges, subject
to its approval, to trade options on futures in any commodity and options
on actual commodities other than domestic agricultural commodities.
Futures exchanges have been trading options since 1982, and virtually all
options traded on futures exchanges are options on futures. CFTC has also
issued regulations to allow certain options on commodities other than
domestic agricultural commodities (called trade options) to be traded
off-exchange. These OTC options are to be offered and sold to commercial
counterparties who enter into transactions for purposes related solely to
their business.

Since the 1974 amendments to the CEA and the creation of CFTC, the U.S.
futures market has evolved far beyond its agricultural origins and is now
dominated by futures based on financial products. In 1975, the largest
commodity group was domestic agricultural commodities, accounting for
nearly 80 percent of total trading volume. By 1996, the largest group was
interest rate contracts, accounting for 54 percent of total trading volume.
At the same time, agricultural commodities accounted for about
19 percent of total trading volume. According to the exchanges and others,
the participants in the futures market have changed as the market evolved.
They noted that the participants are now largely institutions and market
professionals, with retail customers representing a smaller proportion of
total market participants than they did when the act was amended in 1974.



17
  Commodity options give the purchaser the right, but not the obligation, to buy or sell a specified
quantity of the underlying commodity or financial asset at a particular price on or before a certain
future date.
18
 CEA section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional Accord, excludes options on
securities from CFTC’s jurisdiction. Options on securities are regulated by the Securities and
Exchange Commission under federal securities laws.
19
 In CFTC v. Dunn, CFTC brought an enforcement action against an investment fund that was allegedly
defrauding its investors through the purchase and sale of currency options, CFTC v. Dunn, 65 U.S.L.W.
4141 (U.S. Feb. 25, 1997), rev’g 58 F. 3d 50 (2d Cir. 1995). The impact of this decision is covered in our
discussion of the Treasury Amendment.



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                             During this period, the CEA has remained the primary statute specifically
                             created to regulate the trading of derivative products.


OTC Derivatives and          OTC derivatives and exchange-traded futures have similar characteristics
Exchange-Traded Futures      and economic functions but differ in other ways. The market values of
Can Be Used as Substitutes   both products are determined by the value of an underlying asset,
                             reference rate, or index. The economic uses of both products include
for and Complements to       hedging financial risk and investing with the intent of profiting from price
Each Other                   changes, called speculating. OTC derivatives and exchange-traded futures
                             differ in the way they are traded and cleared as well as in their degree of
                             standardization. OTC derivatives, which include forwards, options, and
                             swaps, are privately negotiated contracts. They are entered into between
                             counterparties, also called principals, outside centralized trading facilities20
                             such as futures exchanges. Counterparties negotiate contract terms—such
                             as price, maturity, and quantity—to customize the contracts to meet their
                             specific economic needs. Because OTC derivatives are entered into on a
                             principal-to-principal basis, each counterparty is exposed to credit
                             risk—the risk of loss resulting from the other party’s failure to meet its
                             financial obligation. In contrast, futures traditionally have been traded on
                             organized exchanges as well as cleared and settled through
                             clearinghouses. Clearinghouses manage counterparty credit risk, in part
                             by substituting themselves as the buyer to every seller and the seller to
                             every buyer. They also guarantee daily settlement of price changes,
                             thereby eliminating the need for the original counterparties to monitor
                             each other’s creditworthiness.21 Exchange-traded futures generally have
                             standardized terms—except for price, which the market determines.

                             The exchange-traded futures and OTC derivatives markets have followed
                             similar evolutionary paths. Exchange-traded futures developed from
                             forward grain contracts that were customized and traded on a
                             principal-to-principal basis. They evolved into contracts that have
                             standardized terms, except for price, and are traded on centralized
                             exchanges. Similarly, OTC derivatives originated as customized contracts
                             that involved brokers finding and matching counterparties. Today, almost


                             20
                              Centralized trading facilities are physical or electronic facilities in which all market participants are
                             able to execute transactions simultaneously and bind both parties by accepting offers that are made by
                             one participant but open to all market participants.
                             21
                               Counterparties still face credit risk from the potential failure of their clearinghouse and/or clearing
                             member (a member of the clearinghouse). Also, clearing members face credit risk from their exposure
                             to customers, and customers face credit risk from their exposure to other customers whose funds
                             have been segregated in the same account. In the United States, exchange rules and CFTC regulations
                             provide safeguards to minimize credit risk arising from such sources.



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              all OTC derivatives are traded through dealers.22 An industry association
              has developed standardized documentation for certain OTC derivatives,
              including swaps. However, each contract, including its material terms,
              continues to be privately negotiated between the two counterparties. The
              less complex interest rate and foreign-exchange swaps, called plain vanilla
              swaps, have become more homogeneous in terms of underlying reference
              rates or indexes and maturities. The majority of both swaps and
              exchange-traded futures are settled without delivery of the underlying
              commodity or financial asset.

              Because OTC derivatives and exchange-traded futures serve similar
              economic functions, they can be used as substitutes for one another and
              thus may compete in the marketplace. However, they are not perfect
              substitutes because of potential differences in their contract terms as well
              as transaction costs, regulations, and other factors. OTC derivatives and
              exchange-traded futures can also complement each other. For example,
              swaps dealers use exchange-traded futures to hedge the residual risk
              resulting from unmatched positions in their swaps portfolios. Similarly,
              food processors, grain elevators, and other commercial firms use
              exchange-traded futures to hedge their forward positions.


              To address our two objectives, we reviewed the CEA and its legislative
Scope and     history, Federal Register notices, comment letters, and other material
Methodology   related to CFTC’s exemptions for hybrid, OTC energy, swaps, and
              exchange-traded futures contracts. We also interviewed CFTC officials,
              including past commissioners, about the agency’s use of its exemptive
              authority for OTC derivatives and exchange-traded futures as well as the
              legal and regulatory issues raised by these markets. Furthermore, we
              interviewed officials of three futures exchanges (the Chicago Board of
              Trade, Chicago Mercantile Exchange, and New York Mercantile
              Exchange), the Federal Reserve Board, the Office of the Comptroller of
              the Currency, and the Securities and Exchange Commission (SEC) to
              obtain their views concerning legal and regulatory issues related to the
              exempted OTC derivatives. In addition, we attended conferences and
              congressional hearings as well as reviewed legal cases, journal articles,
              books, and reports pertaining to the CEA and the OTC derivatives and
              exchange-traded futures markets.




              22
               Dealers are typically banks and other financial institutions that stand ready to buy or sell OTC
              derivatives, providing both a bid and offer price to the market.



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Although OTC derivatives raise issues that extend beyond the CEA, we
limited our review to the legal and regulatory issues raised within the
context of the act. Given this focus, our discussion centered on futures,
forwards, and swaps and generally did not cover other financial products,
including securities options, asset-backed securities, and structured notes,
which are regulated under the federal securities laws.

We requested comments on a draft of this report from the heads, or their
designees, of CFTC, the Department of the Treasury, the Federal Reserve
Board, the Office of the Comptroller of the Currency, and SEC. We also
requested comments from three futures exchanges (the Chicago Board of
Trade, Chicago Mercantile Exchange, and New York Mercantile
Exchange), the New York Stock Exchange, and four industry associations
(the Futures Industry Association,23 International Swaps and Derivatives
Association,24 Managed Futures Association,25 and National Futures
Association26). CFTC, the Department of the Treasury, the Federal Reserve
Board, and SEC provided us with written comments under a joint response
as members of the President’s Working Group on Financial Markets. We
also obtained written comments from two futures exchanges (the Chicago
Mercantile Exchange and Chicago Board of Trade) and the four industry
associations. These comments are discussed at the end of this report and
are reprinted in appendixes I through VII. We did not receive written
comments from the Office of the Comptroller of the Currency, New York
Mercantile Exchange, or New York Stock Exchange. In addition, officials
from CFTC, the Department of the Treasury, the Federal Reserve Board, the
Office of the Comptroller of the Currency, SEC, the International Swaps
and Derivatives Association, and the Chicago Mercantile Exchange
provided us with technical comments that were incorporated into the
report as appropriate. We did our work in Chicago, New York, and
Washington, D.C., between August 1994 and February 1997 in accordance
with generally accepted government auditing standards.

23
  The Futures Industry Association is the national trade association of the futures industry.
24
 The International Swaps and Derivatives Association is a trade association that represents more than
150 financial institutions worldwide. Its members include investment, commercial, and merchant
banks that deal in OTC derivatives contracts.
25
  The Managed Futures Association is a national trade association that represents the managed futures
industry. Its members are primarily commodity pool operators and commodity trading advisors.
Commodity pool operators are individuals or firms that solicit or accept funds, securities, or property
for the purpose of trading commodity futures or options. Commodity trading advisors are individuals
or firms that are in the business of advising others, either directly or through publications, on the value
or advisability of trading commodity futures or options.
26
 The National Futures Association is a self-regulatory organization that is responsible, under CFTC
oversight, for qualifying commodity futures professionals and for regulating the sales practices,
business conduct, and financial condition of its member firms.



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                               Before 1993, swaps and other OTC derivatives contracts faced the legal risk
CFTC Used Its                  of being deemed illegal off-exchange futures and thus unenforceable under
Exemptive Authority            the CEA. To reduce this risk and promote innovation and fair competition,
to Reduce or                   Congress granted CFTC exemptive authority under the Futures Trading
                               Practices Act of 1992. CFTC used its authority in 1993 to exempt swaps and
Eliminate the Legal            other OTC derivatives from most CEA provisions (including the
Risk Surrounding the           exchange-trading requirement), thereby reducing or eliminating their legal
                               risk. However, a narrow group of swaps that are ineligible for the
Enforceability of Most         exemption continue to face the risk of being illegal futures. In addition,
OTC Derivatives                certain unregulated forwards have become increasingly difficult to
                               distinguish from regulated futures, resulting in legal risk.


Swaps and Other OTC            The CEA excludes forwards and certain other OTC derivatives from its
Derivatives Faced the Risk     regulation, but many swaps and other OTC derivatives could not qualify for
of Being Illegal and Thus      these exclusions. As a result, they faced the risk that CFTC or a court could
                               find them to be illegal and, thus, unenforceable futures under the CEA. To
Unenforceable Futures          reduce this legal risk, CFTC issued a policy statement in 1989 to clarify the
Under the CEA                  conditions under which it would not regulate swaps as futures. CFTC’s
                               policy statement, however, did not eliminate the risk of a court finding
                               swaps to be futures. In 1990, a court found certain OTC derivatives that
                               resembled unregulated forwards to be futures, which heightened the legal
                               risk for swaps and other OTC derivatives. Following the court decision,
                               CFTC issued a statutory interpretation holding that the OTC derivatives in
                               question were forwards, not futures.

Many Swaps Could Not Qualify   Due to their similarities to futures, swaps and other OTC derivatives faced
for an Exclusion From          the legal risk of being deemed futures under the CEA, making them illegal
Regulation Under the CEA       and, thus, unenforceable. These contracts were developed in the 1980s to
                               meet the risk-management, financing, and other needs of market
                               participants. Swaps evolved from parallel loans that involved two parties
                               making loans to each other in equal amounts but denominated in different
                               currencies. Over time, swaps were developed based not only on foreign
                               currencies but also on interest rates, commodities, and securities. These
                               contracts, like forwards, were entered into between two counterparties
                               outside an exchange and could be viewed as serving a similar economic
                               function as a series of forwards. However, swaps differed from forwards
                               in that they typically did not entail delivery of the specified underlying
                               commodity, a hallmark of traditional forwards. As such, swaps generally
                               were not considered forwards for regulatory purposes. Consequently, they




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                                  did not fall under the CEA’s forward exclusion27 (discussed below), which
                                  would have excluded them from regulation under the act. Nor did many
                                  swaps fall under the CEA’s Treasury Amendment28 (discussed below),
                                  which excludes certain OTC transactions in foreign currencies and other
                                  financial instruments from regulation under the act.

                                  Swaps that could not qualify for an exclusion from the CEA under its
                                  forward exclusion or Treasury Amendment faced the possibility of falling
                                  within the judicially crafted definition of a futures contract, because they,
                                  like futures, served a risk-shifting function. This possibility resulted in
                                  legal risk for such swaps by bringing into question their enforceability as
                                  futures under the act. If such swaps were found to be futures, they would
                                  be illegal and unenforceable, because they would have been traded
                                  off-exchange in violation of the CEA’s exchange-trading requirement. Given
                                  the legal uncertainty surrounding the status of swaps as futures, swaps
                                  counterparties faced legal risk from two sources. First, CFTC could take
                                  enforcement action and find swaps to be illegal, off-exchange futures
                                  contracts. Second, counterparties on the losing side of swaps could try to
                                  have a court invalidate the contracts as illegal, off-exchange futures
                                  contracts.

To Reduce Legal Risk for          To reduce the legal risk of unenforceability in the swaps market, CFTC
Swaps, CFTC Issued a Policy       issued a swaps policy statement in 1989 that clarified the conditions under
Statement                         which it would not regulate certain swaps as futures. In part, CFTC
                                  predicated its swaps policy statement on the rationale that swaps lacked
                                  certain elements that facilitated futures trading on exchanges, such as
                                  standardized terms and a clearinghouse. As such, swaps were not suitable
                                  for exchange trading and, in turn, not appropriately regulated as
                                  exchange-traded futures contracts. In this regard, CFTC identified
                                  conditions (collectively called a safe harbor) that swaps settled in cash
                                  could meet to avoid regulation under the CEA. These conditions were that
                                  the swaps

                              •   have individually tailored terms,
                              •   be used in conjunction with the counterparty’s line of business,
                              •   not be settled using exchange-style offset or a clearinghouse, and
                              •   not be marketed to the general public.




                                  27
                                   The forward exclusion is set forth in CEA section 2(a)(1)(A)(i). Originally enacted as part of the
                                  Grain Futures Act of 1922, it excludes forward contracts from CFTC regulation to facilitate the
                                  movement of agricultural commodities through the merchandizing chain.
                                  28
                                    The Treasury Amendment is set forth in CEA section 2(a)(1)(A)(ii).


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                                CFTC’s swaps policy statement did not eliminate all legal risk of
                                unenforceability. It removed the legal risk that CFTC would take
                                enforcement action against certain swaps, but it did not remove the legal
                                risk that a swaps counterparty might try to have a court invalidate a swap
                                as an illegal, off-exchange futures contract. A court finding that a swap
                                was a futures contract could call into question the legality of other
                                swaps—potentially threatening the market’s financial integrity and
                                potentially presenting a source of systemic risk.29


A Court Found That Certain      Following the issuance of CFTC’s swaps policy statement, a federal district
OTC Derivatives Were Futures,   court found that certain OTC energy contracts were futures. This finding
Causing CFTC to Issue a         heightened the legal risk of unenforceability for swaps and other OTC
Statutory Interpretation to     derivatives because of the possibility that a court could also find them to
Reduce Legal Risk               be futures and subject to the CEA’s exchange-trading requirement. Judicial
                                proceedings began in 1986 when commercial participants in the Brent oil
                                market30 were sued for violating, among other laws, the CEA’s
                                antimanipulation provisions. The participants responded by claiming that
                                the contracts were forwards and excluded from the CEA because no
                                contractual right existed to avoid delivery. In April 1990, a federal district
                                court rejected the claim and found that the contracts were futures, not
                                forwards.31 The court concluded that even though the contracts did not
                                include a contractual right of offset for avoiding delivery, both the
                                opportunity to offset the contracts and the common practice of doing so
                                were sufficient to determine that the contracts were futures. Furthermore,
                                the court found that the Brent oil contracts, like futures, were undertaken
                                mainly to assume or shift price risk without transferring the underlying
                                commodity. The contracts had highly standardized terms, which facilitated
                                their settlement without delivery and reflected their use for risk-shifting or
                                speculative purposes.

                                On September 25, 1990, CFTC issued a statutory interpretation for forwards
                                that adopted the view that the Brent oil contracts were forwards, not
                                futures. CFTC did not dispute the court’s findings that these contracts were
                                highly standardized and routinely settled by means other than delivery.
                                Rather, it found that the contracts fell under the CEA’s forward exclusion

                                29
                                 Systemic risk is the risk that a disruption—at a firm, in a market, or from another source—will cause
                                difficulties at other firms, in other market segments, or in the financial system as a whole.
                                30
                                 Brent oil contracts are for the future purchase or sale of Brent crude oil, which is a blend of oils
                                produced in various fields in the North Sea and delivered through pipelines for loading on cargo ships
                                at Sullem Voe in Scotland.
                                31
                                  Transnor (Bermuda) Limited v. BP North America Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990).



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                         because they required the commercial parties to make or take delivery,
                         even though the parties did not routinely do so. CFTC noted that the
                         contracts did not include any provisions that enabled the parties to settle
                         their contractual obligations through means other than delivery, and the
                         settlement of contracts without delivery was done through subsequent,
                         separately negotiated contracts. In that regard, CFTC noted that these
                         contracts served the same commercial function as forwards covered under
                         the CEA exclusion, notwithstanding the fact that many of the individual
                         contracts were settled routinely without delivery. One CFTC commissioner
                         dissented from the agency’s statutory interpretation, which, he said,
                         misinterpreted the CEA exclusion by broadening it to include transactions
                         that were, among other things, generally standardized, used for
                         noncommercial purposes, and offset.


Congress Granted CFTC    Following the court’s finding that certain OTC energy contracts were
Exemptive Authority to   futures and recognizing the broader implications of that decision for other
                         OTC derivatives, Congress granted CFTC exemptive authority under the
Reduce the Legal Risk
                         Futures Trading Practices Act of 1992. The 1992 act granted CFTC the
Facing Swaps and Other   authority to exempt any contract from almost all CEA provisions (including
OTC Derivatives          the exchange-trading requirement), provided the exemption was
                         consistent with the public interest32 and the contract was entered into
                         solely between appropriate persons, as defined in the act. In granting an
                         exemption, CFTC could impose any conditions on the exemption that it
                         deemed appropriate. The only provision from which CFTC could not
                         exempt a contract was section 2(a)(1)(B), which generally prohibits
                         futures contracts on individual stocks and narrowly based stock indexes.33


                         According to the 1992 act’s legislative history, Congress expected CFTC to
                         use its exemptive authority promptly to reduce legal risk for swaps,




                         32
                           According to the legislative history, the public interest was to include the national public interest
                         noted in the CEA (discussed in section 3 of the act), prevention of fraud, preservation of the financial
                         integrity of the markets, and promotion of responsible economic or financial innovation and fair
                         competition.
                         33
                           The section provides procedures under which CFTC, subject to SEC’s review, may permit exchanges
                         to trade futures contracts on stock indexes provided minimum criteria are met. These criteria include
                         that the contract is settled other than through delivery of the underlying securities and the underlying
                         index of securities is broadly based.



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                             forwards,34 and hybrids.35 The legislative history noted that the goal of
                             providing CFTC with broad exemptive authority was to give CFTC a means of
                             providing certainty and stability to existing and emerging markets so that
                             financial innovation and market development could proceed in an
                             effective and competitive manner. It also noted that CFTC could exempt a
                             contract without first determining that the contract was a futures contract
                             and subject to the act.


CFTC Used Its Authority to   Using its exemptive authority, CFTC exempted a broad group of swaps as
Exempt Most Swaps and        well as hybrids from virtually all CEA provisions—including the
Other OTC Derivatives        exchange-trading requirement—in January 1993. In response to a request
                             by a group of commercial firms in the energy market, CFTC granted a
From Most CEA Provisions     similar exemption in April 1993 to specified OTC energy contracts, which
                             included Brent oil contracts. These exemptions eliminated the legal risk
                             that the qualifying contracts could be deemed illegal, off-exchange futures
                             contracts. If CFTC or a court found an exempted contract to be a futures
                             contract, the contract would still be legal, because it would no longer need
                             to be traded on a designated market, or exchange. As a result, uncertainty
                             was reduced and with it, the potential for any related systemic risk. At that
                             time, CFTC noted that the exemptions should enhance U.S. market
                             participants’ ability to innovate by enabling them to structure OTC
                             contracts to best meet their economic needs, which should enable market
                             participants to compete more effectively in international markets. In
                             granting its exemptions, CFTC did not determine that the OTC derivatives
                             covered by the exemptions were or were not futures or otherwise
                             excluded from the act’s jurisdiction. CFTC noted that it had not made and
                             was not obligated to make such a determination.


A Narrow Group of Swaps      CFTC’s  swaps exemption does not extend to a narrow group of swaps,
Not Eligible for the         so-called equity swaps.36 Because of the possibility that swaps are futures,
Exemption Face the Risk      these nonexempted swaps continue to face the legal risk of being deemed
                             illegal and, thus, unenforceable futures. CFTC enforcement actions
of Being Illegal Futures     involving OTC derivatives can increase such legal risk for these swaps.


                             34
                               In elaborating on the forward exemption in the act’s legislative history, Congress encouraged CFTC
                             to determine whether exemptive or other action should be taken for Brent Oil contractsn.
                             35
                               Hybrids are financial instruments that possess, in varying combinations, characteristics of futures,
                             forwards, options, securities, and/or bank deposits. Unlike many other derivatives, hybrids generally
                             serve a capital-raising function.
                             36
                               In addition, CFTC’s exemption does not extend to swaps based on securities registered with
                             SEC—such    as swaps based on registered corporate debt. To the extent that such swaps exist, the
                             following discussion on equity swaps applies to them.


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CFTC’s Swaps Exemption Does   CFTC’s swaps exemption does not extend to equity swaps, whose returns
Not Cover All Swaps           are based on stocks or stock indexes. Even if these swaps met all of the
                              conditions of CFTC’s swaps exemption, they would not be exempt from CEA
                              section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional
                              Accord. Under the 1992 act, CFTC is allowed to exempt swaps from any CEA
                              provision, except section 2(a)(1)(B), which divides jurisdiction on
                              exchange-traded securities-related futures and options contracts between
                              CFTC and SEC and prohibits futures on individual stocks or narrowly based
                              stock indexes. Futures on broadly based stock indexes may be traded only
                              on CFTC-designated markets, provided CFTC determines that the contracts
                              are not settled through the delivery of the underlying stocks and are not
                              readily susceptible to manipulation. SEC must also agree with CFTC’s
                              determinations. According to market observers, if equity swaps were
                              found to be futures contracts, they could be in violation of section
                              2(a)(1)(B) and thus be illegal and unenforceable.

                              As long as the issue of whether swaps are futures is not definitively
                              addressed by CFTC, the courts, or Congress, the possibility exists that
                              equity swaps could be found to be futures and, thus, subject to the CEA.
                              CFTC has noted, however, that market participants using equity swaps may
                              continue to rely on its 1989 swaps policy statement. As discussed earlier,
                              the policy statement removed the legal risk that CFTC would take
                              enforcement action against certain swaps, but it did not remove the risk
                              that a court could invalidate such contracts by deeming them to be illegal
                              futures. In addition, the legal enforceability of equity swaps could be
                              jeopardized indirectly through a finding that an exempted swap is a
                              futures contract. For example, CFTC had proposed amending its swaps
                              exemption to include a stand-alone, antifraud rule that would apply to
                              exempted swaps.37 According to other federal regulators and market
                              participants commenting on the proposal, the rule would have suggested
                              that the exempted swaps were futures. This, in turn, would have suggested
                              that equity swaps were also futures. Following the comment period, CFTC
                              did not amend its swaps exemption to include the proposed change.

                              According to the International Swaps and Derivatives Association, a
                              finding that an exempted swap is a futures contract could increase legal
                              risk by prompting losing counterparties to equity swaps to rely on the
                              resulting legal uncertainty to avoid their performance obligations under
                              such contracts. It noted that this could result in substantial losses and a
                              market disruption. At a June 1996 hearing held by the Senate Committee

                              37
                               According to CFTC, questions had been raised about the applicability of the CEA’s antifraud
                              provisions to exempted swaps, and the proposed stand-alone, antifraud rule would have eliminated
                              such questions.



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                                 on Agriculture, Nutrition and Forestry, the association testified that the
                                 legal risk surrounding equity swaps has inhibited their evolution and that
                                 this uncertainty needs to be addressed. The Bank for International
                                 Settlements estimated that the worldwide market for equity swaps and
                                 forwards had a total notional value of $52 billion, as of March 31, 1995,
                                 which accounted for less than 1 percent of the total notional value of the
                                 OTC derivatives market.38


CFTC Enforcement Actions         CFTC’s enforcement actions involving OTC derivatives have highlighted the
Involving OTC Derivatives Have   potential for such action to increase legal risk in the equity swaps market.
Raised Questions About the       In December 1994, CFTC and SEC cooperated in an enforcement action
Enforceability of Equity Swaps   against BT Securities, a swaps dealer, for violating antifraud provisions of
                                 futures and securities laws in connection with swaps it sold.39 CFTC
                                 officials told us that swaps market participants did not want the agency to
                                 take any action against the swaps dealer that would suggest swaps were
                                 futures for fear of increasing legal risk for equity swaps. In its enforcement
                                 order, CFTC did not identify any of the swaps as futures. Rather, it found
                                 that BT Securities violated the CEA’s antifraud provisions in its role as a
                                 commodity trading advisor by providing the counterparty with misleading
                                 information about the swaps. According to market participants and
                                 observers, the finding implied that certain of the swaps sold by BT
                                 securities were futures or commodity options, which raised questions
                                 regarding the status of swaps under the CEA. Recognizing the potential
                                 legal and regulatory implications, CFTC issued a news release stating that
                                 its actions did not affect the legal enforceability of swaps or signal an
                                 intent to regulate them.

                                 According to some market participants and observers, CFTC’s enforcement
                                 order against MG Refining and Marketing—a commercial firm—resulted in
                                 greater legal risk for forwards and equity swaps. In 1995, CFTC took
                                 enforcement action against MG Refining and Marketing for selling illegal,
                                 off-exchange futures to commercial counterparties. The firm sold
                                 contracts that purportedly required the delivery of energy commodities in
                                 the future at a price established by the parties at initiation. These
                                 contracts provided counterparties with a contractual right to settle the
                                 contracts in cash without delivery of the underlying commodity. This right
                                 could be invoked if the price of the underlying commodity reached a
                                 preestablished level. Based largely on this provision, CFTC found these


                                 38
                                  The Bank for International Settlement reported the total notional amount outstanding of equity
                                 swaps and forwards together.
                                 39
                                  BT Securities is registered with SEC as a broker-dealer. SEC found that certain of the OTC
                                 derivatives that BT Securities sold were securities within the meaning of the federal securities laws.



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                           contracts to be illegal, off-exchange futures. CFTC’s conclusion was
                           consistent with prior court and CFTC decisions; it identified the contractual
                           right to offset as a critical feature distinguishing forwards from futures.
                           Nonetheless, some market participants and observers asserted that CFTC’s
                           order broadened the definition of a futures contract, creating legal
                           uncertainty over whether swaps and other OTC derivatives are futures and
                           resulting in greater legal risk for forwards and equity swaps.

                           In a letter sent to CFTC, two U.S. congressmen expressed their concern
                           about the potential for CFTC’s enforcement order to bring into question the
                           status of swaps as futures and to reflect a change in CFTC’s regulatory
                           position on swaps. In response to the congressional inquiry, the then CFTC
                           chairman wrote that the case had nothing to do with swaps. She noted
                           that, with regard to swaps generally, CFTC had not taken a position on
                           whether swaps were futures and continued to adhere to its 1989 swaps
                           policy statement. She also noted that in this case CFTC did not deviate from
                           its historical practice of looking at the totality of the
                           circumstances—including the nature of the contract and market—in
                           determining whether a particular transaction involved a futures contract.

                           On February 4, 1997, Senator Lugar, Chairman of the Senate Agriculture
                           Committee, Senator Harkin, Ranking Minority Member, and Senator Leahy
                           introduced a bill to amend the CEA. The bill is similar to the one that
                           Senators Lugar and Leahy introduced in the Fall of 1996, following the
                           June 1996 hearing. As noted in a discussion document prepared by
                           Senators Lugar and Harkin, the bill would provide greater legal certainty
                           for equity swaps by codifying the existing swaps exemption and extending
                           the exemption’s scope to include equity swaps.


Certain Forwards Have      Forwards have been distinguished from futures based on whether the
Evolved to Where It Has    parties intended to make or take delivery of the underlying commodity
Become Increasingly        when they entered into the contract. However, certain unregulated
                           forwards have evolved to where delivery of the underlying commodity
Difficult to Distinguish   may not routinely occur, making it increasingly difficult to distinguish
Them From Futures,         them from regulated futures and resulting in the legal risk that they could
Resulting in Legal Risk    be unenforceable. The CEA does not provide clear criteria for
                           distinguishing forwards from futures, but CFTC’s exemptions reduce the
                           need to do so for the purpose of addressing legal risk.




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Forwards Traditionally Differed   As discussed above, since its enactment in 1936, the CEA has excluded
From Futures in That They         forward contracts from its regulation to facilitate the movement of
Entailed Delivery                 commodities through the merchandizing chain.40 Absent a definition of a
                                  forward contract in the CEA, CFTC and the courts have generally defined
                                  these contracts in reference to futures contracts. Traditionally, they
                                  distinguished forwards from futures based on whether the parties
                                  intended to make or take delivery of the underlying commodity when they
                                  entered into the contract. Forwards served primarily a commercial
                                  function and, as such, entailed delivery of the underlying commodity in
                                  normal commercial channels, but delivery was to occur at a later date. In
                                  contrast, futures were used primarily to shift or assume price risk without
                                  transferring the underlying commodity; thus, actual delivery was not
                                  expected to occur. In short, CFTC and the courts defined a forward as a
                                  contract that bound one party to make delivery and the other to take
                                  delivery of the contract’s underlying physical commodity. Since forwards
                                  were commercial transactions that resulted in delivery, CFTC and the
                                  courts looked for evidence of the contracts’ use in commerce. In
                                  particular, they examined whether the parties were commercial entities
                                  that could make or take delivery and whether delivery routinely occurred.

Certain Forwards Face the         Besides the Brent oil market, other forward markets are evolving in
Legal Risk of Being               response to the risk-management and commercial needs of their
Unenforceable                     participants. For example, changes in U.S. farm policy, increased
                                  globalization of the agricultural markets, and other factors may have
                                  increased price volatility in the agricultural markets and created a demand
                                  for more innovative risk-management contracts. According to agricultural
                                  market participants, traditional forwards do not provide producers with
                                  sufficient flexibility because of their delivery requirement. In response to
                                  participants’ needs, the forward market for agricultural commodities has
                                  evolved to include variations of forwards that may not routinely result in
                                  delivery. Contracts that routinely allow parties to offset, cancel, or void
                                  delivery obligations rather than transfer the underlying commodity may be
                                  viewed as futures contracts or trade options, depending on their pricing
                                  structure. CFTC permits the sale of trade options on nonagricultural
                                  commodities, but prohibits the sale of such options on domestic




                                  40
                                    For example, a producer and grain elevator would enter into a forward contract under which the
                                  grain elevator would agree to buy the producer’s grain before it was harvested. The sale price was
                                  agreed to when the contract was initiated, and both parties expected that the grain would be delivered
                                  when harvested. In entering the forward contract, the producer would shift the price risk incident to
                                  the farming operation to the elevator.



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agricultural commodities.41 This prohibition was intended, in part, to
protect producers from unscrupulous parties who might try to take
advantage of their lack of knowledge about these options.

One variation of a forward experiencing increased use is the
hedge-to-arrive contract. Although varying in design, these are privately
negotiated contracts in which a producer agrees with an elevator to
deliver grain on a future date at an agreed-upon price,42 and the elevator
uses exchange-traded futures to hedge the sale on behalf of the producer.
Some of these contracts have allowed producers to defer the delivery
dates on their contracts beyond the current crop year, which has exposed
producers to significant price risk because their contracts were no longer
tied to the current crop year. According to market observers, unusual
factors, such as high grain prices and poor weather conditions, have
resulted in financial problems for some parties that deferred delivery into
future crop years. In May 1996, CFTC staff issued a policy statement for
hedge-to-arrive contracts to allow counterparties experiencing losses to
settle their contracts without delivery by entering into subsequent,
separately negotiated contracts. CFTC noted that it would not find
hedge-to-arrive contracts existing as of May 15, 1996, to be illegal based
solely on the cash settlement of such contracts for the purpose of
unwinding them, but may find them to be illegal based on other factors.43

CFTC or a court could find some hedge-to-arrive contracts or other
variations on agricultural forwards to be futures or agricultural trade
options. Either finding would make them illegal and unenforceable,
provided the contracts did not qualify for the swaps exemption. For
example, in November 1996, CFTC filed three administrative complaints,
two of which alleged, among other things, that two elevators had offered
and sold hedge-to-arrive contracts that were illegal, off-exchange futures.
In these two complaints, CFTC noted that the elevators sold the
hedge-to-arrive contracts to some producers who lacked the intent or
capacity to make delivery of the grain. CFTC also noted some producers did
not qualify as eligible participants under the swaps exemption. CFTC

41
  In December 1995, CFTC held a roundtable discussion to address the possibility of lifting its ban on
agricultural trade options to provide producers with a broader range of marketing and
risk-management tools. Based on this discussion, CFTC staff expected to advise the agency’s
commissioners of those issues that require further analysis.
42
 The final price received for the commodity being sold is determined by a formula that references the
current and future price of a specified exchange-traded futures contract as well as the future market
price of the commodity.
43
 According to CFTC, the actual delivery of the underlying physical commodity (as opposed to offset)
has been a hallmark of traditional agricultural forwards, but the failure to deliver on a contract alone
would not necessarily preclude the contract from qualifying for the forward exclusion.



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                                    further noted that the contracts contained a cancellation provision that
                                    permitted producers to effect an offset of their contracts.

The CEA Does Not Provide            While the CEA excludes forwards from its regulation because of their
Clear Criteria for Distinguishing   commercial merchandizing purpose, it does not provide clear criteria for
Forwards From Futures               distinguishing forwards from futures. In particular, the CEA does not
                                    specify what constitutes delivery under the forward exclusion and, thus,
                                    when a forward becomes a futures contract. Given the lack of clear
                                    criteria, the evolution of certain forwards to where delivery may not
                                    routinely occur has made it increasingly difficult to distinguish
                                    unregulated forwards from regulated futures. As illustrated by the Brent
                                    oil and hedge-to-arrive contracts, the difficulty in distinguishing between
                                    forwards and futures can result in legal risk. Under its 1990 statutory
                                    interpretation for forwards (discussed above), CFTC tried to reduce the
                                    legal risk and regulatory constraints that forwards face because of the
                                    delivery requirement, thereby permitting them to evolve to better meet the
                                    economic needs of end-users. However, its interpretation does not provide
                                    a clear basis for distinguishing forwards from futures in terms of their
                                    economic purpose. For example, it does not preclude forwards from being
                                    settled routinely without delivery and, in the process, being used primarily
                                    for risk-shifting or speculative purposes instead of a commercial
                                    merchandizing purpose.

CFTC’s Exemptions Reduce the        CFTC’s exemptions for OTC energy and swaps contracts reduce the need to
Need to Distinguish Forwards        distinguish unregulated forwards from regulated futures for the purpose of
From Futures for the Purpose        addressing the legal risk of being unenforceable. CFTC’s OTC energy
of Addressing Legal Risk            contract exemption reduces legal risk for certain forwards that routinely
                                    settle without delivery, but it is limited to OTC derivatives based on
                                    specified energy products. Although the exemption covers Brent oil
                                    contracts that CFTC determined earlier to be forwards under its 1990
                                    interpretation, CFTC noted that the exemption does not affect its
                                    interpretation. However, as with its 1989 swaps policy statement, CFTC’s
                                    forward interpretation does not eliminate all legal risk. It removes the legal
                                    risk of CFTC taking enforcement action against a contract that is consistent
                                    with its interpretation, but it does not eliminate the risk of a counterparty
                                    trying to have a court invalidate the contract as an illegal, off-exchange
                                    futures contract.

                                    CFTC’sswaps exemption further reduces the need to distinguish
                                    unregulated forwards from regulated futures to address legal risk.
                                    Contracts that resemble forwards but do not entail delivery may qualify for
                                    the swaps exemption. Qualifying contracts would not be illegal and



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                          unenforceable, even if CFTC or a court found them to be futures, because
                          they would be exempt from the exchange-trading requirement. The swaps
                          exemption is limited to “eligible” participants, which are largely
                          institutional and other sophisticated market participants. Consequently,
                          the exemption generally does not extend to contracts that involve
                          unsophisticated market participants.


                          Notwithstanding CFTC’s success in reducing or eliminating the legal risk of
Issues Remain             unenforceability that most OTC derivatives faced, issues remain that raise a
Related to the            broader policy question about the appropriate regulation for OTC
Appropriate               derivatives and exchange-traded futures, including their markets and
                          market participants. Congress alluded to this topic in the legislative
Regulation for the        history of the Futures Trading Practices Act of 1992 by noting that the
OTC Derivatives and       growth and proliferation of OTC derivatives raises questions of how best to
                          regulate the new market, adding that studies by us and others would be
Exchange-Traded           useful when Congress considers the broader question of regulatory policy.
Futures Markets           To that end, we discuss, but do not attempt to resolve, three issues that
                          are related to the question of how best to regulate the OTC derivatives and
                          exchange-traded futures markets. These issues concern the
                          (1) appropriate regulation for the OTC foreign-currency market under the
                          Treasury Amendment, (2) appropriate regulation for the evolving swaps
                          market,44 and (3) rationalization of regulatory differences between the OTC
                          derivatives and exchange-traded futures markets.


The Appropriate           The CEA excludes, among other things, certain OTC foreign-currency
Regulation for the OTC    transactions from CFTC regulation under its Treasury Amendment.
Foreign-Currency Market   However, the scope of the amendment has been difficult to interpret and
                          the subject of considerable debate and litigation. CFTC has interpreted the
Under the Treasury        amendment to exclude from the act’s regulation certain OTC
Amendment Is an           foreign-currency transactions between sophisticated participants, but not
Unresolved Issue          similar transactions involving unsophisticated participants. The Treasury
                          Department has disagreed with CFTC’s interpretation. While the federal
                          courts have differed in their interpretation of the Treasury Amendment,
                          they have recognized congressional intent to exclude the interdealer OTC
                          foreign-currency market from regulation under the CEA.




                          44
                            Our discussion focuses on the exempted swaps market, but the broader question of how best to
                          regulate the OTC derivatives market also applies to the equity swaps and evolving forwards markets
                          that are discussed above.



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The Treasury Amendment          The Treasury Amendment excludes from CFTC regulation certain OTC
Excludes Certain OTC            transactions in, among other things, foreign currencies and government
Foreign-Currency Transactions   securities.45 During the debate over the 1974 amendments to the CEA, the
From CFTC Regulation, but It    Treasury Department expressed concern that the proposed
Is Difficult to Interpret       changes—namely the expansion of the commodities covered under the act
                                coupled with the exchange-trading requirement—would prohibit banks
                                and other financial institutions from trading among themselves in foreign
                                currencies and certain financial instruments, including government
                                securities. The Treasury Department noted that futures trading in foreign
                                currencies was done through an informal network of banks and dealers
                                (called the interbank market),46 which serves the needs of international
                                business to hedge risk stemming from foreign-exchange rate movements.
                                The Treasury Department proposed the Treasury Amendment as a means
                                of clarifying that the CEA did not cover this market, and Congress adopted
                                the proposed amendment. According to the act’s legislative history,
                                Congress noted that the interbank market was more properly supervised
                                by the bank regulators and, therefore, regulation under the CEA was
                                unnecessary.

                                The Treasury Amendment has been difficult to interpret because its
                                language is ambiguous. Although the amendment was motivated primarily
                                by concern that the interbank foreign-currency market should be excluded
                                from regulation under the act, its language is not limited to the interbank
                                market. Rather, it excludes any transaction in, among other things, foreign
                                currencies, unless the transaction involves sale for future delivery
                                conducted on a board of trade.47 Before the recent U.S. Supreme Court
                                decision in Dunn v. CFTC, considerable debate occurred over the meaning
                                of the phrase “transactions in,” which defines the scope of the exclusion.
                                Arguments were made that the phrase could be interpreted narrowly to
                                mean only cash transactions in the subject commodity or broadly to
                                encompass derivatives transactions such as futures or option contracts. In

                                45
                                   The Treasury Amendment states: “Nothing in this Act shall be deemed to govern or in any way be
                                applicable to transactions in foreign currency, security warrants, security rights, resales of installment
                                loan contracts, repurchase options, government securities, or mortgages and mortgage purchase
                                commitments, unless such transactions involve the sale thereof for future delivery conducted on a
                                board of trade. (Emphasis added.) The CEA reference to “transactions involving the sale for future
                                delivery” refers to futures contracts and has been interpreted by the U.S. Supreme Court to also refer
                                to commodity options.
                                46
                                 The interbank market includes not only banks but also other financial institutions and industrial
                                corporations. Because the market is not limited to banks, some market observers, including the
                                Treasury Department, have noted that the market is more accurately characterized as an “institutional
                                market.”
                                47
                                 As noted above, the U.S. Supreme Court found that both futures and options involve sale for future
                                delivery within the meaning of the Treasury Amendment.



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                              Dunn, the U.S. Supreme Court endorsed the broader interpretation.
                              Furthermore, the CEA defines the term “board of trade,” which is used in
                              the “unless” clause, to “mean any exchange or association, whether
                              incorporated or unincorporated, of persons who shall be engaged in the
                              business of buying or selling any commodity.” Consequently, this clause
                              could be interpreted to save from the exclusion virtually any futures or
                              option contract sold by a dealer, a construction that would render the
                              amendment meaningless. The ambiguity of the statutory language has led
                              to disagreements among regulators and courts over how the amendment
                              ought to be interpreted.

CFTC and the Treasury         Because of its significant market impact, the activity that the Treasury
Department Have Interpreted   Amendment excludes from regulation under the CEA has been the subject
the Treasury Amendment        of considerable debate among federal regulators. Since at least 1985, CFTC
Differently                   has interpreted the Treasury Amendment to exclude from the act’s
                              regulation certain OTC transactions between banks and other sophisticated
                              institutions, drawing a distinction between sophisticated market
                              participants and unsophisticated market participants who may need to be
                              protected by government regulation.48 An OTC foreign-currency
                              transaction, such as a foreign-exchange swap, sold to a financial
                              institution would be excluded from the act’s regulation; a similar contract
                              sold to the general public would not be excluded. CFTC drew this
                              distinction to preserve its ability to protect the general public from, among
                              other things, bucket shops engaging in fraudulent futures
                              transactions—one of its missions under the CEA. According to CFTC, since
                              1990, the agency has brought 19 cases involving the sale of
                              foreign-currency futures or options contracts to the general public;49 in
                              those cases, more than 3,200 customers invested over $250 million, much
                              of which was lost. Whether foreign-currency contracts sold to the general
                              public are excluded by the Treasury Amendment, however, has remained a
                              source of legal uncertainty. According to CFTC, if the amendment were
                              interpreted to cover contracts sold to the general public, the agency’s
                              ability to prohibit the fraudulent activities of bucket shops dealing in
                              foreign-currency contracts would be effectively eliminated, creating a
                              regulatory gap.

                              The Treasury Department, however, has objected that CFTC’s approach to
                              the Treasury Amendment lacks a foundation in the language of the statute.
                              It has advocated the reading of the Treasury Amendment adopted by the

                              48
                                50 Fed. Reg. 42983.
                              49
                               One approach that CFTC uses to shut down bucket shops is to show that the contracts they sold
                              were illegal, off-exchange futures, thereby obviating the need to show fraud.



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                                U.S. Supreme Court in Dunn—that is, the Treasury Amendment excludes
                                from CFTC jurisdiction any transaction in which foreign currency is the
                                subject matter, including foreign-currency options, unless conducted on a
                                board of trade. Nevertheless, it has expressed sympathy with CFTC’s
                                concerns over fraudulent foreign-currency contracts marketed to the
                                general public. The Treasury Department has suggested that CFTC may be
                                able to interpret the term “board of trade” in a carefully circumscribed
                                manner that would allow appropriate enforcement action against fraud
                                without raising questions about the validity of established market
                                practices.

Federal Court Interpretations   The federal courts have differed in their interpretation of what activity the
of the Treasury Amendment       Treasury Amendment excludes from regulation under the CEA. In spite of
Have Differed                   these differences, the courts have recognized congressional intent to
                                exclude the interdealer foreign-currency market from regulation.
                                However, past court cases have highlighted the legal confusion over
                                whether the Treasury Amendment excludes from the act’s regulation
                                transactions in foreign currencies that involve the general public.

                                The Second Circuit Court of Appeals held in Dunn that option contracts
                                are not covered by the Treasury Amendment and, therefore, are subject to
                                CFTC jurisdiction. In doing so, it followed a precedent that it had
                                established in a case involving the sale of currency options to private
                                individuals. In that case, it reasoned that an option contract does not
                                become a transaction in foreign currency that is excluded under the
                                Treasury Amendment until the option holder exercises the contract.50

                                In February 1997, the U.S. Supreme Court reversed the Second Circuit’s
                                decision in Dunn. The Court interpreted the “transactions in” language of
                                the Treasury Amendment to exclude from CFTC regulation all transactions
                                relating to foreign currency, including foreign-currency options, unless
                                conducted on a board of trade. The Court noted that the public policy
                                issues raised by the various parties affected by the decision were best
                                addressed by Congress.

                                The Fourth Circuit Court, in Salomon Forex, Inc. v. Tauber,51 held that
                                sales of currency futures and options to a very wealthy individual are
                                transactions in foreign currency that the Treasury Amendment excludes
                                from regulation. The buyer of the contracts brought the action to avoid

                                50
                                 See CFTC v. The American Board of Trade, 803 F. 2d 1242 (2d Cir. 1986), cited in CFTC v. Dunn, 58 F.
                                3d 50 (2d Cir. 1995), rev’d 65 U.S.L.W. 4141 (U.S. Feb. 25, 1997).
                                51
                                  Salomon Forex, Inc. v. Tauber, 8 F. 3d 966 (4th Cir. 1993), cert. denied, 114 S. Ct. 1540 (1994).



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payment on transactions in which he had lost money. The court
interpreted the amendment to exclude from the CEA individually
negotiated foreign-currency option and futures transactions between
sophisticated, large-scale currency traders. The court observed that the
case did not involve mass marketing of contracts to small investors and
stated that its holding did not imply that such marketing was exempt from
the CEA.

The Ninth Circuit Court, in CFTC v. Frankwell Bullion Ltd.,52 affirmed a
lower court holding that the Treasury Amendment excludes the sale of
off-exchange foreign-currency futures and options from the CEA without
regard to whom the contracts are sold. CFTC brought action to stop the
seller of the contracts from allegedly selling illegal, off-exchange futures
contracts to the general public. The Ninth Circuit Court’s review focused
on the meaning of the clause “unless . . . conducted on a board of trade.”
The court interpreted the clause to carve out of the exclusion only
contracts sold on an organized exchange. The court acknowledged that
the plain meaning of a board of trade as defined by the act would include
more than exchanges. But the court rejected this interpretation in the
context of the Treasury Amendment because it would cause the “unless”
clause to encompass the entire exclusion and thereby render the
amendment meaningless. Turning to congressional reports accompanying
the 1974 legislation to explain the purpose of the Treasury Amendment,
the court concluded that Congress intended to exclude from the CEA all
transactions in the listed commodities except those conducted on an
organized exchange. In December 1996, CFTC filed a petition with the Ninth
Circuit Court requesting a rehearing, which was denied.

At the June 1996 hearing held by the Senate Committee on Agriculture,
Nutrition and Forestry, the then acting CFTC chairman testified that the
agency and Treasury Department were working to clarify the treatment of
foreign-currency transactions under the Treasury Amendment, but that
reaching an accord would take time. At the hearing, two futures exchanges
testified that congressional action was needed to clarify the Treasury
Amendment’s scope, particularly in view of the U.S. Supreme Court’s
decision to review the Dunn case. They said that a court finding that the
amendment excludes all off-exchange futures and options on foreign
currencies could shift such business away from the exchanges to the less
regulated OTC market and adversely affect their competitiveness.



52
  CFTC v. Frankwell Bullion Ltd., 99 F. 3d 299 (9th Cir. 1996).



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                              As mentioned earlier, Senators Lugar, Harkin, and Leahy introduced a bill
                              in February 1997 to amend the CEA. The bill includes a provision to clarify
                              the scope of the Treasury Amendment.53 According to a discussion
                              document prepared by Senators Lugar and Harkin, the bill reflects the
                              view that a federal role is needed in the market to protect retail investors
                              from abusive or fraudulent activity in connection with the sale of foreign
                              currency futures and options by unregulated entities. The discussion
                              document further notes that under the bill CFTC has no jurisdiction over
                              retail transactions that are subject to oversight by other federal regulators
                              or nonretail transactions.

                              On January 21, 1997, Congressman Ewing, Chairman of the House
                              Subcommittee on Risk Management and Specialty Crops, introduced a bill
                              to amend the CEA. The bill is identical to the one that he introduced in the
                              Fall of 1996. It proposes, among other things, to amend the Treasury
                              Amendment to clarify that CFTC has regulatory authority only over
                              standardized contracts sold to the general public and conducted on a
                              board of trade. The bill defines board of trade in the context of the
                              Treasury Amendment as “any facility whereby standardized contracts are
                              systematically marketed to retail investors.”


The Appropriate               The potential for the exempted swaps market to evolve beyond the
Regulation for the Evolving   conditions of the swaps exemption raises the issue of how to
Swaps Market Is an            accommodate market developments and address attendant risks and other
                              regulatory concerns. CFTC imposed conditions on exempted swaps that
Unresolved Issue              prohibited them from being traded and cleared in the same ways as
                              exchange-traded futures—on a centralized trading facility and through a
                              clearinghouse. Since then, the swaps market has continued to develop,
                              becoming more liquid54 and transparent.55 Among other alternatives, CFTC
                              could use its exemptive authority to accommodate any development that
                              is inconsistent with the conditions of the existing exemption—for
                              example, the development of a clearinghouse—and address any attendant

                              53
                                As discussed, Senators Lugar and Leahy introduced a bill to amend the CEA in the Fall of 1996.
                              Rather than addressing the Treasury Amendment in that bill, the senators asked CFTC and the
                              Treasury Department to reach an agreement by the end of 1996 on how the amendment should be
                              interpreted and, if necessary, amended. While the agencies were unable to reach an agreement by that
                              time, they have continued their discussions. In the meantime, each agency has provided the senators
                              with differing language to amend the Treasury Amendment. The bill that Senators Lugar, Harkin, and
                              Leahy recently introduced does not fully adopt either agency’s proposed language.
                              54
                               Liquidity is the extent to which market participants can buy and sell contracts without changing the
                              market’s price.
                              55
                               Transparency is the extent to which information about prices, trading volume, and trades is
                              disseminated to the public.



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                               risks to the market. However, such an approach could prompt legal
                               challenges and raise jurisdictional questions.

CFTC Exempted Certain Swaps    CFTC’s swaps exemption allows exempted swaps to trade legally outside
From the CEA Subject to Four   regulated exchanges—free from all CEA provisions, except certain
Conditions                     antifraud and antimanipulation provisions,56 and free from all CFTC
                               regulations. In granting the swaps exemption, CFTC did not take a position
                               on whether exempted swaps were futures contracts and subject to the
                               CEA’s jurisdiction. CFTC noted that it had not made and was not obligated to
                               make such a determination.

                               CFTC specified four conditions that swaps had to meet to qualify for an
                               exemption. First, they had to be entered into solely by eligible
                               participants, namely institutional and other sophisticated market
                               participants. Eligible participants include banks, securities firms,
                               insurance companies, commercial firms meeting minimum net worth
                               requirements, and individuals meeting minimum total asset requirements.
                               Second, they could not be fungible with standardized, material economic
                               terms. Third, the creditworthiness of the counterparties had to be a
                               material consideration. With this condition, exempted swaps could not be
                               cleared, like exchange-traded futures, through a clearinghouse.57 Fourth,
                               they could not be entered into and traded on or through a multilateral
                               execution facility, such as a futures exchange.

                               According to CFTC, these four conditions were intended to reflect the way
                               that swaps transactions occurred in 1993 when the exemption was granted
                               and to draw a line at which such transactions would not raise significant
                               regulatory concerns under the CEA. CFTC officials told us that Congress
                               directed the agency to exempt swaps as they were then transacted to
                               provide them with legal certainty. In addition, the four conditions
                               distinguished the exempted swaps from exchange-traded futures for
                               regulatory—not legal—purposes. That is, the exemption excluded from
                               regulation under the CEA swaps that did not possess certain characteristics
                               common to exchange-traded futures; it did not establish that exempted
                               swaps were not futures or otherwise excluded from the act’s jurisdiction.
                               The conditions generally reflected the elements that facilitate futures

                               56
                                 These antifraud and antimanipulation provisions are limited to specified types of conduct that
                               involve futures, options, or the cash market.
                               57
                                 According to the swaps exemptive release (58 Fed. Reg. 5591), “the exemption does not extend to
                               transactions subject to a clearing system where the credit risk of individual members of the system to
                               each other in a transaction to which each is a counterparty is effectively eliminated and replaced by a
                               system of mutualized risk of loss that binds members generally whether or not they are counterparties
                               to the original transaction.”



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                             trading on an exchange, including standardized units, a clearinghouse, and
                             open and competitive trading in a centralized market. As CFTC and the
                             courts have noted, these elements developed in conjunction with the
                             growth of the futures market to facilitate futures trading on exchanges;
                             however, their presence or absence does not necessarily determine
                             whether a contract is a futures contract.

                             CFTC  and others (including federal regulators and market observers) have
                             acknowledged that a centralized trading facility and/or clearinghouse
                             could benefit the swaps market and general public. For example, such
                             facilities could increase the market’s liquidity and transparency and
                             enhance the market’s financial integrity. In its 1993 exemptive release for
                             swaps, CFTC noted that such facilities did not yet exist and their existence
                             would present different regulatory issues than are raised under the current
                             swaps exemption. Recognizing the potential benefits of such facilities,
                             CFTC left open the opportunity for market participants to develop and use
                             such facilities, provided that such facilities receive CFTC’s prior approval.

                             As discussed, Senators Lugar, Harkin, and Leahy recently introduced a bill
                             to amend the CEA that includes a provision to codify the existing swaps
                             exemption. As noted in the discussion document prepared by Senators
                             Lugar and Harkin, the provision would not affect CFTC’s power to grant
                             additional exemptions or to amend the existing exemption to make it less
                             restrictive. However, the provision would require a statutory change to
                             make the existing swaps exemption more restrictive. According to market
                             observers, the provision addresses the concern of OTC market participants
                             that CFTC could modify the swaps exemption in a way that could disrupt
                             the market. At a February 11, 1997, hearing held by the Senate Committee
                             on Agriculture, Nutrition and Forestry, CFTC testified against the provision,
                             noting that it would eliminate the agency’s ability to modify the existing
                             swaps exemption in response to market developments.

The Swaps Market Has         Under the swaps exemption, the swaps market has become more liquid
Continued to Develop Under   and transparent. Swaps are traded primarily through dealers, some of
the Exemption                whom are linked through electronic communication networks that allow
                             them to exchange price information and negotiate transactions.58 Swaps
                             are commonly executed using standardized documentation, but each
                             contract—including its material terms—continues to be privately
                             negotiated between two counterparties. As mentioned above, plain vanilla
                             interest rate and foreign-exchange swaps have become more

                             58
                              Under the swaps exemption, swaps market participants may use electronic facilities “to
                             communicate simultaneously with other participants, so long as they do not use such facilities to enter
                             orders to execute transactions” (58 Fed. Reg. 5591).



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                               homogeneous, with dealers providing “indicative” (nonbinding) quotes for
                               such swaps. Market participants have noted that the market for plain
                               vanilla interest rate swaps has become very liquid and transparent, with
                               pricing information readily available from independent sources. Increased
                               liquidity and transparency can facilitate the use of offsetting contracts to
                               terminate open contracts.59

                               Some swaps market participants are increasingly using practices that are
                               similar, but not identical, to those used in the exchange-traded futures
                               market to reduce credit and other risks. These practices may reduce
                               systemic risk and encourage greater market efficiency. Some swaps
                               participants are using bilateral netting, which is the combining of payment
                               obligations arising from multiple transactions with one counterparty into
                               one net payment. In addition, some are periodically determining the value
                               of their swaps using market values, called marking-to-market. This
                               practice facilitates the movement of collateral, such as cash or U.S.
                               government securities, to reduce the financial exposure of counterparties
                               from open contracts.

                               In comparison, exchanges reduce credit risk by collecting margin
                               (payment required on open contracts that decline in value) on at least a
                               daily basis and by interposing a clearinghouse as the guarantor of all
                               contracts. As discussed above, in each exchange-traded futures
                               transaction, the clearinghouse is substituted for the original parties,
                               becoming the buyer to every seller and the seller to every buyer. Through
                               this process, the clearinghouse assumes the credit risk of each transaction
                               and mutualizes it among all clearing members. While swaps market
                               participants do not use clearinghouses, two futures exchanges are
                               developing collateral depositories to help manage swaps positions and
                               collateral for OTC market participants. Unlike a clearinghouse, they would
                               not guarantee contract performance. One exchange has reported that it is
                               developing exchange-traded swaps and plans for its depository to
                               ultimately guarantee their performance.

CFTC Could Use Its Exemptive   Although difficult to predict, the swaps market might develop in ways that
Authority to Accommodate       are inconsistent with the conditions of the existing swaps exemption. Such
Swaps Market Developments      developments could present risks to the market that warrant greater
                               federal regulation to protect the public interest. An example of such a

                               59
                                A swap can be offset by entering into an equal but opposite transaction with another counterparty.
                               Entering into an equal but opposite contract with the same counterparty eliminates the market and
                               credit risks associated with the contract. Doing so with a different counterparty eliminates market risk
                               but not credit and other risks associated with carrying two contracts. Alternatively, the counterparties
                               can negotiate a termination agreement that settles the contract or agree to assign the contractual
                               obligation to a third party.



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development would be the creation of a swaps clearinghouse. A
clearinghouse could provide benefits, such as reducing credit risk and
increasing market access, but it could also increase systemic risk by
concentrating credit risk in a single entity and thus might require federal
oversight.

CFTC’s swaps exemption does not bar a clearinghouse, but it does require
that a proposal for such a facility be submitted to CFTC for review. As noted
above, CFTC’s swaps exemption includes a condition that requires each
counterparty to consider the other’s creditworthiness. Because of this
requirement, swaps market participants may not be able to use a
clearinghouse without jeopardizing their exempt status and becoming
subject to the CEA’s regulatory requirements. According to CFTC, the
development of a swaps clearinghouse would not necessarily require CFTC
to amend the exemption. Instead, CFTC could exempt a swaps
clearinghouse from the CEA’s provisions (except section 2(a)(1)(B)) on
such conditions as it deemed appropriate. According to CFTC officials, the
extent to which CFTC would need to impose conditions on a clearinghouse
would depend on the facility’s design, applicability of other regulatory
regimes, and other factors.

Among other alternatives, CFTC could use its exemptive authority to
accommodate a swaps clearinghouse or any other market development
that is inconsistent with the conditions of the existing swaps exemption. In
accommodating such a swaps market development, CFTC may need to
include conditions in the exemption to ensure that the risks and other
regulatory concerns of the development are appropriately addressed.
Depending on the risks and concerns, such conditions may include
reporting, recordkeeping, disclosure, or other regulatory requirements that
are similar to the regulations that CFTC has imposed on the OTC derivatives
under its oversight—trade options, dealer options,60 and leverage
contracts.61




60
  Dealer options are off-exchange commodity options that are confined to a limited class of offerors
who were in the business of granting options on physical commodities and buying, selling, producing,
or otherwise using that commodity as of May 1, 1978, and who satisfy the requirements of CFTC
regulations. Dealer options are a retail product and are not currently being offered.
61
 Leverage contracts are long-term (10 years or longer) OTC contracts involving metals and foreign
currencies and are not currently being offered.



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CFTC’s Use of Its Exemptive      Imposing regulatory conditions on swaps participants might be an
Authority to Impose Regulatory   effective way for addressing potential risks to the market that could result
Conditions Could Prompt Legal    from a swaps market development. However, such an approach could
Challenges and Raise             prompt legal challenges and raise jurisdictional questions. First, as long as
Jurisdictional Questions         the issue of whether swaps are futures is not definitively addressed, the
                                 possibility remains that a court could find swaps to be outside the
                                 jurisdiction of the CEA if CFTC tried to use its exemptive authority to impose
                                 affirmative requirements on swaps. Second, imposing affirmative
                                 requirements on swaps might suggest that swaps are futures and subject
                                 to regulation under the CEA, even if CFTC did not explicitly make that
                                 determination. Any suggestion that swaps are futures and subject to
                                 regulation under the CEA could have policy ramifications for the swaps
                                 market because of CFTC’s exclusive jurisdiction over futures. Any such
                                 suggestion could also raise jurisdictional questions involving federal bank
                                 regulators and SEC because of their oversight or regulation of swaps
                                 participants or swaps. Tasked with considering new developments in the
                                 financial markets, including the increasing importance of the OTC
                                 derivatives market, the President’s Working Group on Financial Markets
                                 provides one forum through which CFTC and other federal regulators could
                                 address such issues.


The Rationalization of           The development of the swaps and exchange-traded futures markets has
Regulatory Differences           raised questions about the rationale for their regulatory
Between the OTC                  differences—recognizing that each market may not raise the same risks
                                 and, thus, warrant the same regulations. Swaps and exchange-traded
Derivatives and                  futures are similar in their characteristics and economic functions, but
Exchange-Traded Futures          differ in, among other ways, their trading environment and regulations. As
Markets Is an Unresolved         discussed above, CFTC exempted swaps and other OTC contracts from
Issue                            regulation under the CEA. In 1995, CFTC also granted the exchanges an
                                 exemption from certain regulations to enable them to compete more
                                 effectively against the less regulated OTC derivatives market.
                                 Notwithstanding the exemption, OTC derivatives and exchange-traded
                                 futures market regulations continue to differ substantially. The exchange
                                 exemption represents one approach to rationalizing regulations between
                                 the two markets but also illustrates some of the challenges in doing so.

Swaps and Exchange-Traded        Swaps and exchange-traded futures are similar in their characteristics and
Futures Have Similarities and    economic functions but differ in other ways, including the scope and focus
Differences, Including the       of their regulation. Swaps and exchange-traded futures have market values
Scope and Focus of Their         that are determined by the value of an underlying asset, reference rate, or
Regulation                       index. They also are used for hedging financial risk and investing with the



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intent of profiting from price changes by some of the same general types
of market participants, such as financial institutions, commercial firms,
and governmental entities. Given their similar economic functions, OTC
derivatives and exchange-traded futures can be used as substitutes for one
another, but they are not perfect substitutes because of differences in their
contract terms, transaction costs, regulations, and other factors. They also
can be used to complement each other. Some market
participants—primarily banks and other financial firms acting as
dealers—use exchange-traded futures to hedge the risk related to their OTC
derivatives positions. As a former CFTC chairman noted, the
exchange-traded futures market has grown closer to the swaps market as
it has expanded to remain competitive. The exchanges are offering more
flexible option contracts, whose terms can be customized to meet an
end-user’s particular risk-management needs. Moreover, they are working
on other proposals, such as collateral depositories, to address the needs of
participants using swaps and other OTC derivatives.

Notwithstanding their similar characteristics and economic functions,
differences between swaps and exchange-traded futures may result in
different risks that lead to differences in the types and/or levels of
oversight needed for each market. Swaps and exchange-traded futures
differ in ways that are reflected in CFTC’s swaps exemption. As discussed
above, unlike exchange-traded futures, swaps are not traded on a
multilateral execution facility, such as an exchange, or cleared through a
multilateral clearing facility, such as a clearinghouse. Rather, swaps are
entered into between two counterparties in consideration of each other’s
creditworthiness. Although plain vanilla swaps have become more
homogeneous in terms such as their underlying reference rates or indexes
and maturities, each contract continues to be privately negotiated.

Unlike exchange-traded futures, swaps and other OTC derivatives are not
regulated under a single, market-oriented structure or subject to a contract
approval process, because they are privately negotiated contracts. They
are regulated only to the extent that the institutions using or dealing in
them are regulated. As we noted in our May 1994 report, banks are major
OTC derivatives dealers. They are overseen by federal bank regulators and
subject to supervision and regulations—including minimum capital,
reporting, and examination requirements. These regulations are designed
to ensure the safety and soundness of banks but are not directly
concerned with protecting those doing business with them.62 Other major
dealers include affiliates of securities and insurance firms that are subject

62
  We are currently reviewing OTC derivatives sales practices and will report our findings separately.



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                                 to limited or no federal oversight. Since our 1994 report, CFTC, federal bank
                                 regulators, and SEC have taken several steps to improve their oversight of
                                 the major OTC derivatives dealers, including affiliates of securities firms.
                                 Also, a group of derivatives dealers, in coordination with SEC and CFTC, has
                                 developed a voluntary oversight framework for the OTC derivatives
                                 activities of unregulated affiliates of securities and futures firms. We
                                 discuss these and other actions taken by federal regulators and derivatives
                                 market participants in the November 1996 update to our 1994 report on
                                 financial derivatives.

                                 Traditionally, exchange-traded futures have been regulated as a market
                                 under a comprehensive regulatory structure, which is designed to protect
                                 customers and the market—including its efficiency, fairness, and financial
                                 integrity. This regulatory structure covers not only certain market
                                 participants but also the products and markets on which they trade.
                                 Unless exempted, futures must be traded on designated exchanges and
                                 through regulated intermediaries, subject to minimum capital, reporting,
                                 examination, and customer protection requirements. The CEA and CFTC
                                 specify certain self-regulatory duties—including providing for the
                                 prevention of manipulation, making reports and records on market
                                 activities, and enforcing exchange rules—that an exchange must perform
                                 to become and remain a designated exchange. The CEA also requires CFTC
                                 to review and approve products traded on a designated exchange.

CFTC’s Exchange Exemption Is     In 1993, two futures exchanges separately requested that CFTC exempt
One Approach to Rationalizing    from most of the CEA’s regulatory requirements certain exchange-traded
OTC and Exchange-Traded          futures that are traded solely by institutional and other sophisticated
Futures Market Regulations but   market participants. The exchanges indicated that they needed regulatory
Illustrates the Challenges in    relief to compete fairly with the less regulated OTC market. In response to
Doing So                         the exchange requests, CFTC provided the exchanges with regulatory relief
                                 under an exemption issued in November 1995. CFTC, however, did not
                                 provide the exchanges with the broad regulatory relief they requested.
                                 CFTC based its position, in part, on comments it received on the exchange
                                 requests from various government agencies, members of Congress, and
                                 the public, as well as on the 1992 act’s legislative history. In the latter,
                                 Congress cautioned CFTC to use its exemptive authority sparingly and not
                                 to prompt a wide-scale deregulation of markets falling under the act.

                                 The exchange exemption is to be implemented under a 3-year pilot
                                 program.63 It is intended to enable qualifying exchanges to list new
                                 contracts with greater ease and construct OTC-like trading procedures,

                                 63
                                   The 3-year pilot program will begin when the first contract is traded under the exchange exemption.



                                 Page 34                                GAO/GGD-97-50 Commodity Exchange Act Issues Remain
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permitting market participants to negotiate prices privately and execute
trades off of the exchange floor. The exchange exemption limits access to
the exempted futures market to specified participants, which are generally
the same institutional and sophisticated participants that may use
exempted swaps. In addition, the exemption is intended to streamline
requirements for registering brokers and disclosing risks when opening
new customer accounts. However, with the exception of these regulatory
changes, all other CEA provisions and CFTC regulations would continue to
apply to the exempted futures market. For example, the requirements
related to recordkeeping and audit trails as well as transaction reporting
would continue to apply.

According to CFTC, the exchange exemption would enable the exchanges
to compete more effectively with the OTC derivatives market, while
maintaining basic customer protection, financial integrity, and other
protections needed for trading in an exchange environment. Furthermore,
CFTC noted that the pilot program would provide it with an opportunity to
(1) test the operation of the exemption, (2) determine the effect of
exempted transactions on the integrity of the market as a whole, and
(3) determine whether continued trading under the exemption would be in
the public interest. To date, CFTC has not received any proposals under the
exchange exemption.

In a joint statement released at the June 1996 Senate Agriculture hearing
(discussed above), 10 futures exchanges noted that the exchange
exemption does not provide a level playing field for exempted
exchange-traded and OTC derivatives contracts. They noted that exempted
exchange-traded contracts would continue to be subject to the bulk of
CFTC regulations, even though such contracts, like exempted OTC
derivatives, would not be traded by public customers. The exchanges also
maintained that CFTC’s exchange exemption is not consistent with the 1992
act’s legislative history—noting that, among other things, Congress
intended CFTC, in consideration of fair competition, to use its exemptive
authority in a fair and even-handed manner to products and systems
sponsored by exchanges and nonexchanges.

As mentioned earlier, Senators Lugar, Harkin, and Leahy as well as
Congressman Ewing recently introduced bills to amend the CEA. Each bill
includes a provision that would largely exempt from regulation under the
act certain exchange-traded futures that are traded solely by institutional
and sophisticated market participants. In a joint statement released at the
February 11, 1997, hearing on reforming the CEA, 10 futures exchanges



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noted that the Senate bill “moves exchanges a long way toward achieving
a regulatory balance with the OTC markets.” They noted that the exempted
market would rely on market discipline and self-regulation, with the
exchanges having a business incentive to operate a fair, financially sound,
and competitive market. At the same hearing, CFTC testified that, if
enacted, the bill would likely cause a broad elimination of federal
regulation of the exchange-traded futures market and create significant
risks by doing so.

CFTC’s exchange exemption represents one approach to rationalizing
regulatory differences between the exchange-traded futures and swaps
markets but illustrates some of the challenges in doing so. The exchange
and swaps exemptions raised similar policy questions that CFTC
approached from opposite viewpoints, in part because of the existence of
a regulatory structure for one but not the other. For futures, the basic
question was: “What is the appropriate regulation for futures traded on
exchanges solely by institutional and other sophisticated market
participants?” In this regard, CFTC’s approach to exempting
exchange-traded futures focused on determining which CEA requirements
could be eliminated without compromising the public interest, as defined
in the CEA. Under this approach, the exchanges were tasked, in part, with
demonstrating which existing regulations were unnecessary. In
comparison, the basic question for swaps was: “Are swaps appropriately
regulated under the CEA?” In this regard, CFTC’s approach to exempting
swaps focused on determining whether CEA requirements needed to be
imposed on the market.

Another related challenge in rationalizing regulations between the two
markets arose from the similar nature of the participants.64 As required
under its exemptive authority, CFTC considered the nature of the market
participants in exempting swaps. It limited the swaps exemption to
participants it deemed sophisticated or financially able to bear the risks
associated with these transactions. Likewise, it considered the exclusion
of unsophisticated participants from the exempted exchange-traded
futures market as the most important factor supporting its exchange
exemption. However, CFTC noted that, unlike a dealer market, a centralized
market composed solely of sophisticated market participants did not
obviate the need to ensure market integrity, price dissemination, and
adequate protections against fraud, manipulation, and other trading
abuses. It further noted that CFTC regulations serve other vital functions,

64
  CFTC has characterized exchange-traded futures market participants as largely institutional, and a
former CFTC commissioner stated that the majority of users of regulated, exchange-traded futures
meet the eligibility requirements of the swaps exemption.



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              B-259983




              even where such markets include only sophisticated participants, in that
              the regulations substitute for individualized credit determinations and
              increase market access. The exchanges have disagreed with CFTC’s
              conclusions. They have stated that their safeguards—including
              clearinghouse guarantees and price transparency—provide greater
              protections than available in the OTC market but, at the same time, prevent
              them from obtaining regulatory relief comparable to that which CFTC
              provided to the OTC market.


              CFTC  has used its exemptive authority to reduce or eliminate legal risk in
Conclusions   the OTC derivatives market arising from the combination of the CEA’s
              judicially crafted futures definition and exchange-trading requirement.
              Through its efforts, CFTC has enhanced the legal enforceability of most OTC
              derivatives contracts and, in doing so, has enabled the OTC derivatives
              market to continue to grow and develop. Nonetheless, several legal and
              regulatory issues involving the CEA remain unresolved. These include the
              legal uncertainty facing equity swaps, the CEA’s lack of clear criteria for
              distinguishing unregulated forwards from regulated futures, the
              uncertainty surrounding the scope of the Treasury Amendment, and the
              extent to which CFTC should use its exemptive authority to provide greater
              regulatory relief to the futures exchanges. Ongoing congressional efforts
              to amend the CEA could provide specific solutions to these unresolved
              issues. Further, such efforts could provide a forum for addressing the
              broader policy question of what the appropriate regulation is for
              exchange-traded futures and OTC derivatives contracts, including their
              markets and market participants.

              The appropriate regulation for the exchange-traded and OTC derivatives
              markets should flow from the need to protect the public interest in these
              markets. The CEA identifies the public interest in the futures market as the
              need to protect the market’s price discovery and risk-shifting functions
              from market abuses, such as excessive speculation, manipulation, and
              fraud. However, articulating the public interest in this way may no longer
              provide a sufficient basis for regulating all aspects of the futures market,
              given market developments and regulatory changes. As discussed, the
              exchange-traded futures market is now dominated by financially based
              futures and institutional participants. Because of the greater liquidity of
              the underlying cash markets for financial products, the exchange-traded
              futures markets for these products may not serve the same price discovery
              function as exchange-traded futures based on agricultural and other
              physical commodities. Accordingly, they may not serve the price discovery



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    B-259983




    function that Congress intended to protect when crafting the CEA. In
    addition, CFTC now has the authority to allow futures to be traded
    off-exchange and free from the comprehensive regulatory structure
    applicable to exchange-traded futures. Because of the way they would be
    traded and other factors, off-exchange futures may not raise the same
    risks or regulatory concerns that exchange-traded futures raise and for
    which regulation under the CEA was deemed necessary to protect the
    public interest. Nonetheless, off-exchange futures may raise other risks,
    such as systemic risk, or regulatory concerns that warrant federal
    regulation.

    To address the broader policy question of the appropriate regulation for
    the exchange-traded futures and OTC derivatives markets, more
    fundamental questions concerning the goals of federal regulatory policy
    need to be answered. These questions include:

•   What is the current public interest in the exchange-traded futures and OTC
    derivatives markets that needs to be protected?
•   What type of regulations are needed, if any, and what is the most efficient
    and effective way to implement and enforce any needed regulations? To
    what extent are the answers to these questions affected by the nature of
    the market participants; trading environment; and products, including
    their function, type of underlying commodity, and degree of
    standardization?

    These fundamental questions provide a framework for systematically
    determining the appropriate regulation for exchange-traded futures and
    OTC derivatives, including their markets and market participants.
    Moreover, answers to these questions would also provide a basis for
    considering an array of options for amending the CEA. These options
    include (1) expanding the act’s jurisdiction to cover specified swaps and
    other OTC derivatives but tailoring their regulation to the circumstances
    under which they trade and other appropriate factors; (2) excluding swaps
    and other specified OTC derivatives from the act’s jurisdiction and
    providing for their oversight, as appropriate, by other federal regulators;
    and (3) tailoring the level of regulation for exchange-traded futures to the
    nature of the market participants and/or other appropriate factors.

    Swaps and other OTC derivatives involve institutions and activities in
    which federal bank regulators and SEC have traditionally had a supervisory
    or oversight role, while futures trading and futures market regulation have
    fallen under the CFTC’s exclusive jurisdiction. As a result, any policy



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                      B-259983




                      questions raised by the ongoing development of the OTC derivatives and
                      exchange-traded futures markets cross traditional jurisdictional lines and
                      involve not only CFTC but also federal bank regulators and SEC. The
                      cooperative efforts of these agencies, working with the Department of the
                      Treasury and the financial industry, will be required to address such
                      questions. As discussed, the President’s Working Group on Financial
                      Markets provides one forum through which to coordinate interagency
                      activities and address policy questions that cross jurisdictional lines.

                      As we concluded in our May 1994 OTC derivatives report, the U.S. financial
                      regulatory structure has not kept pace with the dramatic and rapid
                      changes in the domestic and global financial markets. We noted that one
                      issue needing to be addressed is how the U.S. regulatory system should be
                      restructured to better reflect the realities of today’s rapidly evolving global
                      financial markets. Our conclusion was based partly on the finding that the
                      development of new types of financial derivatives and their use by a
                      variety of once separate industries, such as banking, futures, insurance,
                      and securities, have made it more difficult to regulate them effectively
                      under the current U.S. regulatory structure. The potential legal and
                      regulatory issues raised by the evolving OTC derivatives and
                      exchange-traded futures markets under the CEA further illustrate such
                      difficulty and reinforce the need to examine the existing U.S. regulatory
                      structure. Ultimately, maintaining a globally competitive U.S. derivatives
                      market will require balancing the goal of allowing the U.S. financial
                      services industry to innovate and grow with the goal of protecting
                      customers and the market, including its efficiency, fairness, and financial
                      integrity.


                      We requested comments on a draft of this report from the heads, or their
Agency and Industry   designees, of CFTC, the Department of the Treasury, the Federal Reserve
Comments and Our      Board, the Office of the Comptroller of the Currency, and SEC. We also
Evaluation            requested comments from three futures exchanges (the Chicago Board of
                      Trade, Chicago Mercantile Exchange, and New York Mercantile
                      Exchange), the New York Stock Exchange, and four industry associations
                      (the Futures Industry Association, International Swaps and Derivatives
                      Association, Managed Futures Association, and National Futures
                      Association). CFTC, the Department of the Treasury, the Federal Reserve
                      Board, and SEC provided us with written comments under a joint response
                      as members of the President’s Working Group on Financial Markets. We
                      also obtained written comments from two futures exchanges (the Chicago
                      Mercantile Exchange and Chicago Board of Trade) and the four industry



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B-259983




associations. The written comments and our additional responses are
contained in appendixes I through VII. We did not receive written
comments from the Office of the Comptroller of the Currency, New York
Mercantile Exchange, or New York Stock Exchange. In addition, officials
from CFTC, the Department of the Treasury, the Federal Reserve Board, the
Office of the Comptroller of the Currency, SEC, the International Swaps
and Derivatives Association, and the Chicago Mercantile Exchange
provided us with technical comments that were incorporated into the
report as appropriate.

The President’s Working Group on Financial Markets commented that it
agreed with our conclusion that maintaining a globally competitive U.S.
derivatives market requires properly balancing the need to allow the U.S.
financial services industry to innovate and grow with the need to protect
the financial integrity of our markets. The Working Group noted that it is
effectively addressing intermarket financial coordination issues and that
further discussion in that forum of issues we identify would be useful.

The Futures Industry Association commented that the draft did not
adequately address the question of whether or to what extent additional
regulation of the OTC derivatives markets is warranted, and to the extent
warranted, whether the CEA is the appropriate vehicle for such regulation.
Similarly, the International Swaps and Derivatives Association stated that
there has been no demonstration that participants would benefit from
subjecting swaps to any form of regulation under the CEA. Our overall
objective was to provide Congress with information on the legal and
regulatory issues involving the CEA, not to determine the appropriate level
of regulation for the OTC derivatives market or the specific vehicle for any
such regulation. We identified regulatory gaps in this market in our
May 1994 report on OTC derivatives and recently issued a report that
discusses the actions taken by federal regulators and the industry since
that time. Nonetheless, the issues that we discuss lead to the broader
policy question of what the appropriate regulation is for the OTC
derivatives and exchange-traded futures markets. In our conclusions, we
provide a framework for addressing this policy question and, in turn,
related questions, such as whether the CEA is the appropriate vehicle for
regulating swaps and other OTC derivatives.

In a related comment, the Futures Industry Association noted that our
draft asserts that financial products serving a risk-shifting function should
be subject to similar regulatory treatment, even though the CEA has
recognized through its statutory exclusions that the regulation of such



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B-259983




products may appropriately differ depending on their nature and
underlying market. Correspondingly, the International Swaps and
Derivatives Association commented that risk-shifting activities related to
foreign exchange and other transactions were specifically excluded from
the CEA pursuant to the Treasury Amendment, demonstrating that
Congress did not intend for the CEA to govern all financial transactions
involving the transfer of risk. We do not assert that risk-shifting contracts
should be subject to similar regulation. Rather, we note that the CEA covers
futures contracts, which have been defined in a way that reflects their
risk-shifting function. As a result, OTC derivatives serving a similar
risk-shifting function as futures may fall within the definition of a futures
contract and be subject to the CEA. We agree that the CEA’s statutory
exclusions demonstrate that Congress did not intend for the CEA to govern
all risk-shifting contracts. However, these exclusions are not broad enough
to provide similar treatment for all OTC derivatives, many of which,
including swaps, did not exist when the exclusions were created. CFTC has
exempted most swaps and other OTC derivatives from virtually all the CEA’s
requirements to provide them with greater legal certainty, but a question
remains about whether swaps are futures and subject to the CEA. As we
discuss, the possibility that swaps are futures continues to be a source of
legal risk for equity swaps.

In another related comment, the Chicago Board of Trade, Futures Industry
Association, and Managed Futures Association noted that the CEA provides
CFTC with the authority and flexibility to address issues raised by the
evolving OTC derivatives and futures markets. We agree that the CEA, with
its exemptive authority provision, does not prevent CFTC from addressing
regulatory concerns raised by the OTC derivatives market, as needed. In
our report, we state that CFTC could use its exemptive authority to address
regulatory concerns raised by a swaps market development that is
inconsistent with the conditions of the existing swaps exemption.
However, we note that this approach could suggest that swaps are futures
and introduce jurisdictional questions. We also note that the President’s
Working Group on Financial Markets provides one forum through which
to address such questions.

The Chicago Board of Trade commented that, contrary to the impression
created in the draft, jurisdictional ambiguities in the act (the definition of a
futures contract and the Treasury Amendment) are not solely responsible
for the disparate regulatory treatment of exchange and OTC markets.
Instead, it cites the manner in which CFTC has chosen to use its authority
as leading to this disparity. According to the exchange, CFTC did not use its



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exemptive authority in a way that is consistent with the 1992 act’s
legislative history—that is, it did not use its authority in a fair and
even-handed manner to products and systems sponsored by exchanges
and nonexchanges. In a related comment, the Futures Industry
Association noted that it agrees with the draft report’s implicit assumption
that CFTC’s exchange exemption could be broadened. However, it stated
that the exchanges must provide CFTC with greater specificity as to the
nature of the products, trading mechanisms, and clearing structure that
would be subject to exemptive relief. We agree with the Chicago Board of
Trade that the act’s jurisdictional ambiguities are not solely responsible for
the regulatory differences between the OTC derivatives and futures
markets. Our report states that CFTC provided less regulatory relief under
its exchange exemption than it did under its OTC derivatives exemptions.
We also agree with the Futures Industry Association that greater
specificity could aid CFTC in the use of its exemptive authority to provide
additional regulatory relief to the exchanges. However, in granting the
exchange exemption, CFTC followed the congressional admonition to use
its exemptive authority sparingly and not to cause a wide-scale
deregulation of markets falling under the act. Given the different ways of
interpreting the 1992 act’s legislative history, we note in our conclusions
that one of the unresolved issues involving the CEA is the extent to which
CFTC should use its exemptive authority to provide greater regulatory relief
to the futures exchanges.


We are sending copies of this report to the Chairperson of CFTC, the
Comptroller of the Currency, the Chairman of the Federal Reserve Board,
the Chairman of SEC, the Secretary of the Treasury, and other interested
parties. We will also make copies available to others upon request.

Please contact me at (202) 512-8678 or Cecile O. Trop, Assistant Director,
at (312) 220-7600 if you or your staff have any questions. Major
contributors to this report are listed in appendix VIII.




Jean Gleason Stromberg
Director, Financial Institutions
  and Markets Issues




Page 42                       GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Page 43   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Contents



Letter                                                                          1


Appendix I                                                                     46

Comments From the
President’s Working
Group on Financial
Markets
Appendix II                                                                    47

Comments From the
Chicago Board of
Trade
Appendix III                                                                   53

Comments From the
Chicago Mercantile
Exchange
Appendix IV                                                                    56

Comments From the
Futures Industry
Association
Appendix V                                                                     64

Comments From the
International Swaps
and Derivatives
Association




                      Page 44   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                        Contents




Appendix VI                                                                                      75

Comments From the
Managed Futures
Association
Appendix VII                                                                                     78

Comments From the
National Futures
Association
Appendix VIII                                                                                    81

Major Contributors to
This Report




                        Abbreviations

                        CEA        Commodity Exchange Act
                        CFTC       Commodity Futures Trading Commission
                        OTC        over-the-counter
                        SEC        Securities and Exchange Commission


                        Page 45                   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix I

Comments From the President’s Working
Group on Financial Markets




See p. 40.




              Page 46   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II

Comments From the Chicago Board of
Trade




See pp. 41-42.




See pp. 41-42.




                 Page 47   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
             Appendix II
             Comments From the Chicago Board of
             Trade




See p. 35.




             Page 48                        GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix II
                 Comments From the Chicago Board of
                 Trade




See p. 41.




See p. 34.




See pp. 36-37.




See p. 36.




See pp. 36-37.




                 Page 49                        GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix II
                 Comments From the Chicago Board of
                 Trade




See p. 37.




See p. 36.




See pp. 37-38.




                 Page 50                        GAO/GGD-97-50 Commodity Exchange Act Issues Remain
             Appendix II
             Comments From the Chicago Board of
             Trade




See p. 41.




See p. 36.




See p. 32.




See p. 8.




See p. 42.




             Page 51                        GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II
Comments From the Chicago Board of
Trade




Page 52                        GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix III

Comments From the Chicago Mercantile
Exchange




See comment 1.




Now on p. 36.




See comment 1.




                 Page 53   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix III
                 Comments From the Chicago Mercantile
                 Exchange




Now on p. 39.




See p. 38.




See comment 1.




                 Page 54                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
               Appendix III
               Comments From the Chicago Mercantile
               Exchange




               The following are GAO’s comments on the Chicago Mercantile Exchange’s
               August 30, 1996, letter.


               1. The Chicago Mercantile Exchange commented that our use of the way
GAO Comments   that derivatives are traded (off-exchange versus on-exchange) as the basis
               for distinguishing OTC derivatives from futures for regulatory purposes is
               not an appropriate dichotomy. Rather, the exchange commented that the
               nature of the market participant (professional versus retail) is a better
               basis to use in determining the appropriate level of regulation needed for
               derivatives markets. We revised our report, and the referenced text no
               longer appears. In our conclusions, we provide a framework for
               determining the appropriate regulation for the OTC derivatives and
               exchange-traded futures markets, focusing on the current public interest
               in these markets that needs to be protected. As part of that framework, we
               note that the nature of the market participant, trading environment, and
               other factors should be considered in determining the regulations that are
               needed to protect the public interest.




               Page 55                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV

Comments From the Futures Industry
Association




See p. 7.




See p. 7.




              Page 56   GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix IV
                 Comments From the Futures Industry
                 Association




See comment 1.




See pp. 41-42.




See comment 2.




See pp. 40-41.




                 Page 57                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix IV
                 Comments From the Futures Industry
                 Association




See p. 38.




See comment 3.




See comment 4.




See comment 5.




                 Page 58                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
                 Appendix IV
                 Comments From the Futures Industry
                 Association




See comment 6.




See comment 7.




See comment 8.




See comment 7.




See comment 9.




                 Page 59                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
             Appendix IV
             Comments From the Futures Industry
             Association




See p. 40.




See p. 41.




             Page 60                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
               Appendix IV
               Comments From the Futures Industry
               Association




               The following are GAO’s comments on the Futures Industry Association’s
               September 18, 1996, letter.


               1. The association commented that the draft focused on the similar
GAO Comments   economic function served by OTC derivatives and exchange-traded futures
               but did not adequately address the policy implications arising from the
               important distinctions that exist between the two types of products. We
               focus on the similar risk-shifting function served by OTC derivatives and
               exchange-traded futures because the CEA covers futures, which have been
               defined in a way that reflects their risk-shifting function. As we discuss in
               our conclusions, Congress and federal regulators will need to consider the
               similarities and differences between the OTC derivatives and
               exchange-traded futures markets in addressing the broader policy
               question concerning the appropriate regulation for these markets. We
               agree that important distinctions exist between OTC derivatives and
               exchange-traded futures that have policy implications, and we amplified
               our discussion of these distinctions.

               2. The association commented that our draft cited the CEA as embracing
               the principle of functional regulation. We eliminated the term functional
               regulation because of the confusion over its meaning, but our message has
               not changed. That is, the CEA covers futures, which CFTC and the courts
               have defined in a way that reflects their risk-shifting function. As a result,
               contracts serving a similar risk-shifting function as futures may fall within
               the definition of a futures contract and be subject to the CEA.

               3. The association commented that our draft report listed the necessary
               elements of a futures contract without mentioning that such elements are
               not necessarily sufficient to define a futures contract. We modified the
               report accordingly.

               4. The association commented that section 3 of the CEA specifically
               identifies transactions in contracts for future delivery “commonly
               conducted on a board of trade” as the type of activity requiring regulation
               under the CEA. It further noted that this statement reflects a sensitivity to
               the regulatory significance of distinctions between exchange trading and
               private negotiation of contracts that is equally relevant today. We agree
               that the exchange-trading requirement is central to the CEA’s regulatory
               structure and recognize that differences exist between OTC derivatives and
               exchange-traded futures that may warrant differences in their regulation.
               In that regard, our conclusions provide a framework for determining the



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Appendix IV
Comments From the Futures Industry
Association




appropriate regulation for the OTC derivatives and exchange-traded futures
markets, focusing on the public interest in these markets that needs to be
protected. As part of that framework, we note that the nature of the
market participant, trading environment, and other factors should be
considered in determining the regulations needed to protect the public
interest.

5. The association noted that the draft report overstated the current level
of convergence between the OTC derivatives and futures market. We
revised the report to amplify our discussion of the similarities and
differences between the OTC derivatives and futures markets.

6. The association disagreed with the draft report’s observation that
participation of dealers in the OTC derivatives markets implies that such
markets are centralized. We did not intend to imply that the swaps market
is centralized and have revised the draft accordingly. We recognize that
swaps continue to be privately negotiated between counterparties and are
neither traded on a centralized facility nor cleared through a
clearinghouse. We note that swaps have followed a similar evolutionary
path as exchange-traded futures. However, we recognize that the extent to
which the swaps market, or some part thereof, will continue to evolve in
the same way as the exchange-traded futures market is unknown.

7. The association commented that, with respect to the distinction
between futures and forwards, our draft report sometimes fails to
distinguish between the nature of the obligation to make delivery and what
constitutes delivery. Our discussion of the disagreement between CFTC and
the federal district court on where to draw the line regarding the delivery
requirement for Brent Oil contracts was meant to illustrate this difference.
We also note in our conclusions that one of the unresolved issues is the
CEA’s lack of criteria for distinguishing unregulated forwards from
regulated futures.

8. The association commented that the losses associated with
hedge-to-arrive contracts do not appear to arise from the character of the
delivery obligations. We note that unusual factors, such as high grain
prices and poor weather conditions, have resulted in financial problems
for parties to these contracts. However, we also note that the legal risk
facing some hedge-to-arrive contracts due to the possibility that they could
be illegal futures or trade options has complicated matters. This legal risk
may persist, even in the absence of the factors contributing to financial
risk.



Page 62                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV
Comments From the Futures Industry
Association




9. The association commented that the Treasury Amendment’s scope was
broader than the restricted view presented in the draft report. Our
discussion of the Treasury Amendment was not intended to provide an
interpretation of the amendment’s scope but rather to describe the legal
confusion created by how others have interpreted its scope. We modified
the report accordingly.




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Appendix V

Comments From the International Swaps
and Derivatives Association




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 1.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 2.




See pp. 40-41.




See comment 3.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 3.




See comment 4.




See p. 33.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 5.




See p. 40.




See p. 6.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 6.




See comment 7.




See comment 8.




See comment 9.




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                  Comments From the International Swaps
                  and Derivatives Association




See comment 10.


See comment 11.




See comment 7.




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Comments From the International Swaps
and Derivatives Association




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               Appendix V
               Comments From the International Swaps
               and Derivatives Association




               The following are GAO’s comments on the International Swaps and
               Derivatives Association’s September 10, 1996, letter.


               1. The association commented that the draft painted a misleading picture
GAO Comments   of the similarities between exchange-traded futures and swaps by focusing
               on their risk-shifting function and failed to properly address the important
               differences between them that justify their disparate regulatory treatment.
               We focus on the similar risk-shifting function served by OTC derivatives
               and exchange-traded futures because the CEA covers futures, which have
               been defined in a way that reflects their risk-shifting function. As we
               discuss in our conclusions, Congress and federal regulators will need to
               consider the similarities and differences between the OTC derivatives and
               exchange-traded futures markets in addressing the broader policy
               question concerning the appropriate regulation for these markets. We
               agree that important distinctions exist between OTC derivatives and
               exchange-traded futures that have policy implications, and we amplified
               our discussion of these distinctions.

               2. The association commented that, although OTC derivatives and
               exchange-traded futures serve a similar risk-shifting function, many other
               financial transactions, including those involving securities, loans,
               guarantees, and various types of insurance contracts, can serve such a
               function. It further noted that attempting to implement a regulatory
               framework that would subject every form of financial or commercial
               activity that involves the transfer of risk to regulation under the CEA would
               clearly be inappropriate. We agree that it would be inappropriate to
               subject all instruments that can serve a risk-shifting function to the CEA.
               However, as CFTC and others have recognized, swaps and other OTC
               derivatives resemble futures not only in terms of their economic function
               but also in terms of their design. Given the market’s continued growth and
               development, questions remain about the extent to which additional
               regulation of the OTC derivatives market is needed. In our conclusions, we
               provide a framework for determining the appropriate regulation for the
               OTC derivatives and exchange-traded futures markets, focusing on the
               public interest in these markets that needs to be protected.

               3. The association commented that the draft report’s assertion that swaps
               are a centralized market is not true. We did not intend to imply that the
               swaps market is currently centralized and have revised the draft
               accordingly. We recognize that swaps continue to be privately negotiated
               between counterparties and are neither traded on a centralized facility nor



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Appendix V
Comments From the International Swaps
and Derivatives Association




cleared through a clearinghouse. We note that swaps have followed a
similar evolutionary path as exchange-traded futures. However, we
recognize that the extent to which the swaps market, or some part thereof,
will continue to evolve in the same way as the exchange-traded futures
market is unknown.

4. The association commented that the draft report portrayed swaps as a
centralized market by incorrectly asserting that swaps participants are
actively discussing the possibility of establishing a swaps clearinghouse.
We discuss the potential for a swaps clearinghouse to illustrate an
example of a development that could trigger a greater federal interest in
the market. It was not intended to suggest that the swaps market has
evolved into a centralized market, and we revised the draft accordingly.

5. The association noted that more corporations use swaps than
exchange-traded futures to meet their risk-management needs, disproving
the draft report’s assertion that swaps and exchange-traded futures share
the same general market participants. Our point was that swaps and
exchange-traded futures are used by many of the same general types of
market participants, not that swaps and exchange-traded futures are used
by all of the same market participants. We revised the report to clarify this
point. We still note that some of the same firms, namely banks and other
financial firms acting as dealers, use both swaps and exchange-traded
futures because of the complementary relationship of the contracts.

6. The association commented that few incidents exist where swaps
participants believed that they were treated unfairly by their
counterparties, which demonstrated both the ability of swaps participants
to protect their rights and the fact that such incidents represent bilateral
disputes with no implications for third parties. It added that the draft
report offers no evidence that additional regulatory protection is needed
or desired by swaps participants. We are currently reviewing OTC
derivatives sales practices and will report our findings separately.

7. The association commented that the swaps activities of institutions that
are thought to be subject to systemic risk and/or are supported by public
insurance are closely supervised by various regulatory agencies. As we
discussed in our May 1994 report on OTC derivatives, regulatory gaps
existed in the OTC derivatives market that could heighten the potential for
systemic risk. We have issued a report that updates our 1994 report and
discusses actions taken by federal regulators and the industry since that
time.



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Appendix V
Comments From the International Swaps
and Derivatives Association




8. The association disagreed with the draft report’s assertion that the CEA,
as amended in 1974, embraced the principle of functional regulation. While
we eliminated the term functional regulation because of the confusion
over its meaning, our message has not changed. That is, the CEA covers
futures, which CFTC and the courts have defined in a way that reflects their
risk-shifting function. As a result, contracts serving a similar risk-shifting
function as futures may fall within the definition of a futures contract and
be subject to the CEA.

9. The association commented that our draft report asserts
“uncategorically” and without direct evidence that the legislative history
surrounding the Treasury Amendment indicates that it was intended to
apply solely to the interbank market. Our discussion of the Treasury
Amendment was not intended to provide an interpretation of the
amendment’s scope but rather to describe the legal confusion created by
how others have interpreted its scope. We revised the report accordingly.

10. The association noted that our draft report listed the necessary
elements of a futures contract without mentioning that such elements are
not necessarily sufficient to define a futures contract. We modified the
report accordingly.

11. The association commented that our definition of offset is broader than
has been defined in regulatory and judicial contexts. We amended the
offset definition to make it consistent with CFTC’s definition and discussed
the way that OTC derivatives are terminated in a later section of the report.




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Appendix VI

Comments From the Managed Futures
Association




See comment 1.




See p. 41.




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             Comments From the Managed Futures
             Association




See p. 41.




See p. 41.




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               Appendix VI
               Comments From the Managed Futures
               Association




               The following are GAO’s comments on the Managed Futures Association’s
               October 15, 1996, letter.


               1. The association commented that it does not share some of our findings
GAO Comments   regarding the limitation of the Treasury Amendment’s carve-out of the
               interbank market, definition of a futures contract, and failure to recognize
               the continued noncentralized nature of the swaps market. We revised the
               report to clarify that we were not providing an interpretation of the
               Treasury Amendment’s scope, but rather were describing the legal
               confusion created by how others have interpreted its scope. We modified
               the report to clarify that no definitive list exists of all the elements of a
               futures contract. We also amplified our discussion of the differences
               between the OTC derivatives and exchange-traded futures markets.




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Appendix VII

Comments From the National Futures
Association




See comment 1.




See comment 1.




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                 Comments From the National Futures
                 Association




See comment 2.




See comment 1.




See comment 3.




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               Appendix VII
               Comments From the National Futures
               Association




               The following are GAO’s comments on the National Futures Association’s
               September 10, 1996, letter.


               1. The association commented that the draft report minimized the inherent
GAO Comments   tension between the equally important goals of limiting legal certainty
               while maximizing regulatory flexibility. We agree that tradeoffs exist in
               addressing the legal and regulatory issues raised by the ongoing
               development of the OTC derivatives market under the CEA. Such tradeoffs
               raise difficult and often competing policy concerns that can lead to more
               fundamental questions concerning the goals of federal regulatory policy.
               In our conclusions, we provide a framework for determining the
               appropriate regulation for the OTC derivatives and exchange-traded futures
               markets, focusing on the public interest in the markets that needs to be
               protected.

               2. The association noted that the swaps exemption must be periodically
               revisited to make sure that the conditions set by CFTC for the exemption
               continue to make sense. It also noted that CFTC must also reexamine the
               exemption granted to exchange-traded products. We agree that one
               alternative is to have CFTC revisit the exemptions, as needed, to address
               regulatory concerns raised by market changes and to ensure regulations
               do not impede market innovation and competition. However, we note that
               using such an approach for exempted swaps could suggest swaps are
               futures and introduce jurisdictional questions. Moreover, in our
               conclusions, we note that a remaining unresolved issue is the extent to
               which CFTC should use its exemptive authority to provide greater
               regulatory relief to the futures exchanges.

               3. The association commented that, with respect to the Treasury
               Amendment, it is inconceivable that Congress intended for futures
               contracts in foreign currencies to be mass marketed to the retail public
               without any of the protections afforded under the CEA. As we discuss,
               confusion exists as to the scope of the Treasury Amendment, and we note
               in our conclusions that such confusion remains an unresolved issue under
               the CEA.




               Page 80                         GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VIII

Major Contributors to This Report


                        Thomas J. McCool, Associate Director
General Government      Cecile O. Trop, Assistant Director
Division, Washington,
D.C.
                        Richard S. Tsuhara, Senior Evaluator
Chicago Field Office    Daniel K. Lee, Evaluator


                        Lorna J. MacLeod, Attorney
Office of General
Counsel, Washington,
D.C.
                        Desiree W. Whipple, Reports Analyst
Seattle Field Office




(233442)                Page 81                      GAO/GGD-97-50 Commodity Exchange Act Issues Remain
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