oversight

The Commodity Exchange Act: Issues Related to the Commodity Futures Trading Commission's Reauthorization

Published by the Government Accountability Office on 1999-05-05.

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

                United States General Accounting Office

GAO             Report to Congressional Committees




May 1999
                THE COMMODITY
                EXCHANGE ACT
                Issues Related to the
                Commodity Futures
                Trading Commission’s
                Reauthorization




GAO/GGD-99-74
GAO                United States General Accounting Office
                   Washington, D.C. 20548
                   General Government Division



                   B-281936

                   May 5, 1999

                   The Honorable Richard G. Lugar
                   Chairman
                   Committee on Agriculture, Nutrition
                    and Forestry
                   United States Senate

                   The Honorable Larry Combest
                   Chairman
                   Committee on Agriculture
                   House of Representatives

                   The Honorable Thomas W. Ewing
                   Chairman
                   Subcommittee on Risk Management,
                    Research, and Specialty Crops
                   Committee on Agriculture
                   House of Representatives


                   As part of your deliberations on the Commodity Futures Trading
                   Commission’s (CFTC) upcoming reauthorization, you have expressed an
                                                                      1
                   interest in exploring issues related to derivatives that are traded on-
                   exchange as well as those that are privately negotiated off-exchange, or
                   over-the-counter (OTC). This effort builds on your previous proposals to
                   revise the Commodity Exchange Act (CEA) to help ensure that the U.S.
                   derivatives markets are appropriately regulated and remain competitive. In
                   your December 18, 1998, letter, you requested that we provide information
                   on several topics that your committees plan to cover during the
                   reauthorization process. We briefed your offices on these topics in
                   preparation for the CFTC reauthorization roundtable discussion that you
                   sponsored in February 1999. This report presents information on the
                   requested topics in appendixes I through VIII. Additionally, a summary of
                   the CEA’s legislative history is provided in appendix IX, and a glossary and
                   list of GAO-related products are provided at the end of the report.

                   Agreement exists on the basic objectives of financial market regulation—
Results in Brief   to protect financial system integrity, market integrity and efficiency, and

                   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.




                   Page 1                                                      GAO/GGD-99-74 CFTC Reauthorization
             B-281936




             customers. However, the most appropriate means of meeting these
             objectives has been subject to debate by Congress, federal regulators, and
             market participants as the markets have grown, new products have been
             introduced, and competition has increased. As reflected in appendixes I
             through VIII of this report, the debate has encompassed questions about
             the appropriate U.S. regulatory structure for exchange and OTC derivative
             contracts, markets, and market participants. The appendixes address the
             following eight topics:

             •     CFTC exemptive authority for OTC derivatives,
             •     regulatory reform efforts for exchange-traded derivatives,
             •     the Shad-Johnson Jurisdictional Accord,
             •     the Treasury Amendment,
             •     the forward exclusion,
             •     agricultural trade options,
             •     electronic trading systems, and
             •     international regulatory coordination.

             Generally, each appendix discusses the issues related to the topic;
             captures the views of interested parties, including those expressed at the
                                    2
             roundtable discussion; and closes with public policy questions related to
             the topic.

             In the context of CFTC’s reauthorization, at least two significant questions
             surface from a discussion of these topics: (1) what types of derivative
             transactions and market participants should be covered by or excluded
             from CFTC regulation under the CEA and (2) how should the various types
             of transactions and market participants covered by the CEA be regulated?
             Reaching agreement among interested parties—OTC and exchange-traded
             market participants, federal financial regulators, and Congress—on actions
             needed to address these questions has proven difficult. Recognizing that in
             an increasingly global and competitive marketplace the cost of not
             reaching agreement could be high, congressional and industry leaders have
             begun discussions that could lead to a consensus.

             Derivatives provide users a means of shifting the risk of price changes in
Background   the underlying to those more willing or able to assume this risk.
             Derivatives include exchange-traded and OTC contracts. Exchange-traded
             derivatives generally have fixed terms—except for price, which the market
             determines. OTC derivatives generally have negotiable terms, including
             terms such as price, quality and quantity of the underlying, and method of
             2
                 See appendix X for a list of roundtable participants.




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                                                        3           4            5                6
payment. Derivatives include forwards, futures, options, and swaps
contracts. Traditionally, futures have been exchange-traded, while
forwards and swaps have been negotiated OTC. Options are traded on
exchanges as well as negotiated OTC.

The increased demand for risk-shifting products, along with technological
advances, has fueled the development of innovative exchange-traded and
OTC derivative products as well as the growth of these markets. Driven by
the introduction of financial futures, such as interest rate and currency
contracts, the U.S. exchange-traded futures market has experienced
substantial growth. Between 1986 and 1998, annual trading volume on U.S.
futures exchanges increased by about 227 percent, from 216.1 million to
707.4 million contracts. Following the U.S. lead, foreign futures exchanges
have introduced new products and increased their share of the worldwide
exchange-trading volume from 21 to 58 percent over this period.
Additionally, the development of swaps and other OTC derivatives has led
to the rapid growth and globalization of the OTC derivatives market. As of
                                      7
June 1998, the total notional amount of the OTC derivatives market
worldwide was estimated at $69.9 trillion, up from $47.5 trillion as of
             8
March 1995.

CFTC, an independent agency created by Congress in 1974, administers
the CEA. The act gives CFTC exclusive jurisdiction over all futures and
certain option contracts. It also establishes a regulatory structure that was
historically designed to ensure that all futures were traded on self-

3
 Forward contracts, according to CFTC, are privately negotiated, cash transactions in which
commercial buyers and sellers agree upon the delivery of a specified quantity and quality 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.
4
 Futures contracts are agreements 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 date. These contracts
may be satisfied by delivery or offset.
5
 Option contracts (American style) give the purchaser the right, but not the obligation, to buy (call
option) or sell (put option) a specified quantity of a commodity or financial asset at a specified price
(the exercise or strike price) on or before a specified future date.
6
 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 that is not typically exchanged.
7
 The notional amount is the amount upon which payments between parties to certain types of
derivatives contracts are based. Because this amount is not typically exchanged, the total notional
amount shown is not an aggregate measure of the amount at risk.
8
 Due to differences in the methodology used, the estimates of notional amounts are not directly
comparable.




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                  B-281936




                  regulated exchanges and through regulated intermediaries. In addition to
                  providing a means for shifting price risk, the exchange-traded futures
                  market has traditionally been a mechanism for discovering price.

                  To provide information on the various topics concerning the exchange-
Scope and         traded and OTC derivatives markets, we reviewed the CEA and its
Methodology       legislative history, Federal Register notices, and comment letters on CFTC
                  concept releases and rule proposals. In addition, we reviewed
                  congressional hearings, legal cases, journal articles, and reports on the
                  CEA and the exchange-traded and OTC derivatives markets. We
                  interviewed CFTC officials about the various topics covered in our report.
                  We also attended the February 1999 CFTC reauthorization roundtable
                  discussion, recent congressional hearings on the exchange-traded and OTC
                  derivatives markets, and a futures industry conference.

                  We requested comments on a draft of this report from the Chairperson,
                  CFTC, and Chairman, SEC, or their designees. In separate meetings held
                  on April 16, 1999, the Director of the Office of Legislative and
                  Intergovernmental Affairs, CFTC, and the Chief Counsel of the Division of
                  Market Regulation, SEC, provided us with oral comments. These
                  comments are discussed below. Additionally, we discussed the contents of
                  a draft of this report with officials of the Department of the Treasury and
                                                                                 9
                  Federal Reserve Board; self-regulatory organizations (SRO), including two
                  futures exchanges and a securities exchange; and four industry trade
                  associations. They provided technical clarification that we incorporated
                  into the report where appropriate. We did our work in Chicago, IL, and
                  Washington, D.C., between January and April 1999 in accordance with
                  generally accepted government auditing standards.

                  CFTC and SEC generally agreed with the accuracy of the information
Agency Comments   presented in this report and provided technical clarification that we
                  incorporated into the report where appropriate.

                  We are sending a copy of this report to Senator Tom Harkin, Ranking
                  Minority Member, Senate Committee on Agriculture, Nutrition and
                  Forestry; Representative Charles Stenholm, Ranking Minority Member,
                  House Committee on Agriculture; Representative Gary A. Condit, Ranking
                  Minority Member, Subcommittee on Risk Management, Research, and
                  Specialty Crops, House Committee on Agriculture; the Honorable
                  9
                   SROs are private membership organizations given the power and responsibility under federal law and
                  regulations to adopt and enforce rules of member conduct. They include all of the U.S. commodities
                  and securities exchanges, the National Futures Association, the National Association of Securities
                  Dealers, and the Municipal Securities Rulemaking Board.




                  Page 4                                                   GAO/GGD-99-74 CFTC Reauthorization
B-281936




Brooksley Born, Chairperson, CFTC; the Honorable Arthur Levitt,
Chairman, SEC; and other interested parties. We will also make copies
available to others upon request.

Major contributors are listed in appendix XI of this report. 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.




Thomas J. McCool
Director, Financial Institutions
 and Markets Issues




Page 5                                      GAO/GGD-99-74 CFTC Reauthorization
Contents



Letter                                                                                           1


Appendix I                                                                                      10
                        Rationale for CFTC Exemptive Authority                                  10
CFTC Exemptive          Limitations of CFTC Exemptions                                          11
Authority for OTC       Efforts to Address OTC Market Issues                                    12
                        The Long-Term Capital Management Recapitalization Has                   14
Derivatives               Raised Regulatory Concerns
                        CFTC Left Open the Opportunity for the Development of                   15
                          an OTC Clearinghouse
                        Public Policy Questions Raised By CFTC Exemptive                        16
                          Authority For OTC Derivatives


Appendix II                                                                                     18
                        U.S. Futures Market Regulation                                          18
Regulatory Reform       Derivatives Market Growth and Competition                               19
Efforts for Exchange-   CFTC Exemptive Authority                                                20
                        CFTC and Congressional Efforts to Provide Regulatory                    20
Traded Derivatives        Relief
                        Proposals for Revising Market Oversight                                 22
                        Costs and Benefits of Futures Market Regulation Are                     24
                          Difficult to Measure
                        Public Policy Questions Raised by Regulatory Reform                     26
                          Efforts for Exchange-Traded Derivatives


Appendix III                                                                                    27
                        Rationale for the Accord                                                27
The Shad-Johnson        Evidence of Continued Uncertainty                                       28
Jurisdictional Accord   Addressing the Prohibition on Stock-Based Futures                       29
                        Public Policy Questions Raised by the Accord                            31


Appendix IV                                                                                     32
                        Rationale for the Treasury Amendment                                    32
The Treasury            Problems Interpreting the Treasury Amendment                            32
Amendment               Proposals to Clarify the Scope of the Treasury                          36
                          Amendment
                        Public Policy Questions Raised by the Treasury                          37
                          Amendment




                        Page 6                                   GAO/GGD-99-74 CFTC Reauthorization
                         Contents




Appendix V                                                                                        38
                         Historical Definition of a Forward Contract                              38
The Forward              Problems Differentiating Forwards From Futures                           38
Exclusion                Public Policy Questions Raised by the Forward Exclusion                  40


Appendix VI                                                                                       41
                         History of the Ban on Commodity Options                                  41
Agricultural Trade       Narrowing of the Commodity Option Trading Ban                            41
Options                  CFTC Pilot Program on Agricultural Trade Options                         42
                         Status of the Pilot Program                                              43
                         Public Policy Question Raised by Agricultural Trade                      43
                           Options


Appendix VII                                                                                      44
                         CFTC Role in Facilitating the Development of Electronic                  44
Electronic Trading         Systems
Systems                  Expansion of Electronic Trading Systems                                  45
                         Foreign Futures Exchanges’ Placement of Terminals in                     46
                           the United States
                         Novel Electronic Futures Trading Systems                                 47
                         Industry Views on Electronic Trading                                     48
                         Public Policy Questions Raised by Electronic Futures                     49
                           Trading Systems


Appendix VIII                                                                                     51
                         Use of CFTC Expanded Authority and Limits to Its                         51
International              Authority
Regulatory               CFTC’s Additional Focus on International Concerns                        51
                         Industry Observations                                                    52
Coordination             Public Policy Questions Related to International                         52
                           Regulatory Coordination


Appendix IX                                                                                       53
                         Grain Futures Act of 1922 (42 Stat. 998)                                 53
Legislative History of   Commodity Exchange Act of 1936 (49 Stat. 1491)                           53
the Commodity            Amendments to the CEA Between 1936 and 1968                              54
                         1968 Amendments to the CEA (Pub. L. No. 90-258)                          54
Exchange Act             Commodity Futures Trading Commission Act of 1974                         55
                           (Pub. L. No. 93-463)
                         Futures Trading Act of 1978 (Pub. L. No. 95-405)                         56
                         Futures Trading Act of 1982 (Pub. L. No. 97-444)                         57



                         Page 7                                    GAO/GGD-99-74 CFTC Reauthorization
                        Contents




                        Futures Trading Act of 1986 (Pub. L. No. 99-641)                         58
                        Futures Trading Practices Act of 1992 (Pub. L. No. 102-                  58
                          546)
                        CFTC Reauthorization Act of 1995 (Pub. L. No. 104-9)                     59
                        Omnibus Appropriations Act of 1998 (Pub. No. 105-277)                    59


Appendix X                                                                                       60
                        Moderators                                                               60
Participants at CFTC    Panelists                                                                60
Reauthorization
Roundtable Discussion
Held in Washington,
D.C., on February 25
and 26, 1999
Appendix XI                                                                                      61

Major Contributors to
This Report
Glossary                                                                                         62


Related GAO Products                                                                             72




                        Page 8                                    GAO/GGD-99-74 CFTC Reauthorization
Contents




Abbreviations

CFTC        Commodity Futures Exchange Commission
FSA         Financial Services Authority
BIS         Bank for International Settlements
CBT         Chicago Board of Trade
CEA         Commodity Exchange Act
CFFE        Cantor Financial Futures Exchange
CME         Chicago Mercantile Exchange
DTB         Deutsche Terminborse
FCM         futures commission merchant
HTA         hedge-to-arrive
LTCM        Long-Term Capital Management
NFA         National Futures Association
NYMEX       New York Mercantile Exchange
OTC         over-the-counter
SEC         Securities and Exchange Commission
SRO         self-regulatory organization


Page 9                                   GAO/GGD-99-74 CFTC Reauthorization
Appendix I

CFTC Exemptive Authority for OTC
Derivatives

                      Because of their similarities to exchange-traded futures, swaps and other
Rationale for CFTC    over-the-counter (OTC) derivatives have faced the possibility of falling
Exemptive Authority                                                                  1
                      within the judicially crafted definition of a futures contract. This
                      possibility posed a legal risk for many OTC derivatives because of the
                      Commodity Exchange Act (CEA) requirement that futures be traded on an
                      exchange to be legal and, thus, enforceable. In 1989, to reduce the legal
                      risk facing swaps, the Commodity Futures Trading Commission (CFTC)
                      issued a swaps policy statement to clarify the conditions under which it
                      would not regulate certain swaps as futures. In part, CFTC predicated its
                      policy statement on the rationale that swaps lacked certain elements that
                      facilitated futures trading on exchanges, such as standardized terms and a
                      clearinghouse. CFTC’s policy statement 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. (See the
                      glossary at the end of the report for definitions.)

                      Under the Futures Trading Practices Act of 1992, Congress gave CFTC
                      broad authority to exempt any contract from all but one of the CEA
                      provisions, provided the exemption was consistent with the public interest
                      and the contract was entered into solely between eligible participants, as
                      defined in the act. According to the 1992 act’s legislative history, Congress
                      expected CFTC to use its exemptive authority promptly to reduce legal
                      risk for swaps, forwards, and hybrids. It further noted that CFTC could
                      exempt a contract without first determining that it was a futures contract.
                      Finally, the legislative history stated that the goal of providing CFTC with
                      broad exemptive authority was to give CFTC a means of providing
                      certainty and stability to the markets. Under its exemptive authority, CFTC
                      could impose any conditions on an exemption that it deemed appropriate
                      and could exempt contracts from any provisions of the CEA, except
                      section 2(a)(1)(B) (discussed below).

                      In January 1993, CFTC exempted a broad group of swaps from virtually all
                      CEA provisions, including the exchange-trading requirement. Under this
                      exemption, CFTC retained the CEA’s antimanipulation and antifraud
                      provisions for swaps but only to the extent they were futures. It also
                      imposed four conditions that swaps had to meet to qualify for an
                      exemption. First, they had to be entered into solely by eligible participants,
                      including banks; securities firms; insurance companies; commercial firms
                      meeting minimum financial requirements (e.g., net worth exceeding $1
                      million); and individuals with total assets exceeding $10 million. Second,
                      1
                          The CEA does not define the term futures contract.




                      Page 10                                                  GAO/GGD-99-74 CFTC Reauthorization
                      Appendix I
                      CFTC Exemptive Authority for OTC Derivatives




                      they could not be standardized as to their material economic terms. Third,
                      the creditworthiness of the counterparties had to be a material
                      consideration. Under this condition, exempted swaps could not be cleared
                      through clearinghouses that are similar to those used to clear exchange-
                      traded futures. However, CFTC noted that it would consider the terms and
                      conditions of an exemption for a swaps clearinghouse in the context of a
                      specific proposal. Fourth, exempted swaps 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 when the exemption was
                      granted and to describe when such transactions would not raise significant
                      regulatory concerns under the CEA.

                      In January 1993, CFTC also exempted hybrids from virtually all CEA
                      provisions, including the exchange-trading requirement; it granted a
                      similar exemption to specified OTC energy contracts in April 1993. CFTC’s
                      hybrid exemption was designed to exempt instruments that were
                      predominantly bank deposits or securities and included a condition to
                      ensure that they would be covered under banking or securities regulations.
                      CFTC’s energy exemption responded to congressional encouragement that
                      CFTC determine whether exemptive or other action should be taken for
                      certain OTC energy contracts. In response to a request by a group of
                      commercial firms in the energy market, CFTC granted an exemption to
                      specified OTC energy contracts, which included Brent oil contracts. CFTC
                      retained the CEA’s antimanipulation provisions, but not the act’s antifraud
                      provisions under this exemption.

                      CFTC’s swaps, hybrid, and energy exemptions eliminated the legal risk
Limitations of CFTC   that qualifying contracts could be deemed illegal, off-exchange futures. If
Exemptions            CFTC or a court found an exempted contract to be a futures contract, the
                      contract would still be legal because the CEA exchange-trading
                      requirement would not apply. In granting the exemptions, CFTC was not
                      required to, nor did it, determine that the OTC derivatives covered by the
                      exemptions were futures. According to an industry association, no swaps
                      have been found to be futures contracts. However, a question has
                      remained about the extent to which CFTC can subject OTC derivatives to
                      additional regulation under the CEA, such as by amending the conditions
                      of the exemptions.

                      CFTC’s swaps exemption did not provide the same legal certainty to
                      securities-based swaps, contracts whose returns are based on prices of
                      securities and securities indexes, as it did for interest rate, currency, and
                      other swaps. Even if a securities-based swap met all the conditions of the



                      Page 11                                        GAO/GGD-99-74 CFTC Reauthorization
                              Appendix I
                              CFTC Exemptive Authority for OTC Derivatives




                              swaps exemption, it would not be exempt from CEA section 2(a)(1)(B),
                              which codified the Shad-Johnson Jurisdictional Accord. (See app. III on
                              the accord.) According to market observers, if securities-based swaps
                              were found to be futures contracts, they could be in violation of CEA
                              section 2(a)(1)(B) and, thus, be illegal and unenforceable. In issuing its
                              swaps exemption, CFTC noted that counterparties to securities-based
                              swaps could continue to rely on its 1989 swaps policy statement, which
                              sets forth the conditions under which CFTC would not regulate certain
                              swaps as futures. According to an industry association, counterparties to
                              securities-based swaps have continued to rely on this policy statement to
                              address their legal concerns under CEA section 2(a)(1)(B).


Efforts to Address
OTC Market Issues
Congress Proposed             In 1997, a Senate bill (S. 257) was introduced that included provisions
                              intended to provide greater legal certainty for securities-based swaps by
Legislation to Reduce Legal   codifying the existing swaps exemption and extending its scope to include
Uncertainty                   securities-based swaps. As noted in an accompanying discussion
                              document, the provision would not have affected CFTC’s power to grant
                              additional exemptions or to amend the existing exemption to make it less
                              restrictive. However, the provision would have required a statutory change
                              to make the existing swaps exemption more restrictive. According to
                              market observers, the provision would have addressed the concern of OTC
                              market participants that CFTC could modify the swaps exemption in a way
                              that could disrupt the market. In related hearings, 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. In a
                              February 1997 letter to Chairman Lugar, SEC expressed concern about the
                              provision and stated that legal certainty for securities-based swaps could
                              be better achieved by excluding from the CEA these products and all
                              hybrid securities that are not predominantly futures.

CFTC Issued a Concept         In May 1998, CFTC issued a concept release on OTC derivatives that
                              sought public comment on whether the swaps and hybrid exemptions
Release on OTC Derivatives    continued to be appropriate in light of market changes. In the concept
                              release, CFTC asked, among other questions, whether additional oversight
                              of the OTC markets was required, including whether current fraud and
                              manipulation prohibitions were sufficient. CFTC indicated that it was
                              receptive to broadening its exemptions or imposing additional safeguards,
                              if warranted. Additionally, CFTC noted that the release did not alter the
                              current status of any instrument or product under the CEA and that all of



                              Page 12                                        GAO/GGD-99-74 CFTC Reauthorization
                             Appendix I
                             CFTC Exemptive Authority for OTC Derivatives




                             its currently applicable exemptions, interpretations, and policy statements
                             remained in effect.

                             The Treasury Department, Federal Reserve, and Securities and Exchange
                             Commission (SEC), as well as some market participants, have expressed
                             concern that CFTC’s concept release raises legal and regulatory
                             uncertainty in the OTC derivatives markets. First, concern exists that the
                             release creates legal uncertainty by suggesting that exempted swaps may
                             be futures, thereby calling into question the legality of securities-based
                             swaps and other OTC derivatives potentially subject to CEA section
                             2(a)(1)(B). Second, concern exists that the release creates regulatory
                             uncertainty by raising the possibility that CFTC might amend the
                             conditions of its exemptions to subject exempted OTC derivatives to
                             additional regulation under the CEA.

                             Opponents of the concept release have stated that it is unnecessary to
                             extend the CEA to OTC derivatives. They assert that the OTC derivatives
                             markets generally do not serve a price discovery function and are not
                             readily susceptible to manipulation. They further assert that counterparties
                             to OTC derivatives are capable of protecting themselves from losses
                             arising from counterparty defaults and fraud using remedies outside the
                             CEA, such as those provided under state statutory or common law. They
                             also maintain that the regulatory uncertainty resulting from the release
                             threatens the competitiveness of the U.S. financial markets. In addressing
                             these concerns, Congress directed CFTC, via the Omnibus Appropriations
                             Act (P.L. 105-277), not to issue or propose new regulations affecting swaps
                             and hybrids before March 31, 1999. As of April 20, 1999, CFTC had not
                             proposed or issued any new regulations affecting swaps or hybrids.

Industry Views on the Need   At a February 1999 roundtable discussion on CFTC reauthorization issues,
                             the participants discussed the desirability of resolving legal uncertainty in
to Address Legal             the OTC derivatives market. Five of the participants characterized it as the
Uncertainty                  most important issue that Congress needs to address during CFTC’s
                             upcoming reauthorization. According to one of these participants,
                             following the issuance of CFTC’s concept release, his firm was inundated
                             with calls from clients and counterparties, asking about the legal
                             enforceability of their OTC derivatives. Another roundtable participant
                             commented that SEC is also a source of legal uncertainty. He said that SEC
                             has indicated that some swaps are options and within the agency’s
                             jurisdiction. He added that SEC will need to be involved in the discussion
                             to fully resolve the legal status of OTC derivatives.




                             Page 13                                        GAO/GGD-99-74 CFTC Reauthorization
                            Appendix I
                            CFTC Exemptive Authority for OTC Derivatives




                            In a joint statement submitted to the Senate and House Agriculture
                                                                                                     2
                            Committees on March 19, 1999, the U.S. Securities Market Coalition stated
                            that clarifying that equity swaps, types of securities-based swaps, do not
                            fall under the CEA would reduce unnecessary legal risk for U.S. financial
                            markets. The Coalition further stated that, if Congress decides to provide
                            greater legal certainty for equity swaps, it should make it clear that SEC
                            has the authority to exercise appropriate regulatory oversight over them.
                            The Coalition opposed granting CFTC exemptive authority for equity
                            swaps because the Coalition believes that doing so could affect SEC’s
                            ability to react to issues in this market. Finally, the Coalition stated that
                            Congress should work with SEC to resolve the legal uncertainty issue.

The President’s Working     In a June 1998 letter, the Treasury Department, Federal Reserve, and SEC
                            told Congress that CFTC’s concept release raised important questions.
Group Is Studying the OTC   However, they indicated that these questions were most appropriately
Derivatives Markets         addressed by the President’s Working Group on Financial Markets because
                            they raised jurisdictional issues among the federal regulators. Accordingly,
                            in September 1998, Senator Lugar and Representative Smith requested that
                            the Working Group study the OTC derivatives market and develop
                            legislative recommendations by the spring of 1999. According to the
                            Federal Reserve, the Working Group’s study will address the following
                            policy objectives: (1) deterring market manipulation, (2) deterring fraud
                            and protecting certain counterparties to transactions, (3) promoting the
                            financial integrity of markets by limiting potential losses from
                            counterparty defaults, (4) providing legal certainty with respect to the
                            enforceability of contracts, (5) avoiding significant competitive disparities
                            across financial markets and institutions, (6) appropriately limiting
                            systemic risk, and (7) harmonizing regulations internationally.

                            In September 1998, the Federal Reserve Bank of New York organized a
The Long-Term Capital       meeting that led to a private sector recapitalization of Long-Term Capital
Management                  Management (LTCM), a hedge fund that traded in OTC and exchange-
Recapitalization Has        traded derivatives. Although the Federal Reserve Bank had no regulatory
                            authority over LTCM, officials were concerned that the firm’s financial
Raised Regulatory           problems, if not immediately addressed, could adversely affect the markets
Concerns                    and market participants not directly involved with LTCM.

                            Although LTCM was not subject to federal banking or securities
                            regulations, it was subject to CFTC regulation as a commodity pool
                            2
                             The U.S. Securities Market Coalition includes the American Stock Exchange, Boston Stock Exchange,
                            Chicago Board Options Exchange, Chicago Stock Exchange, Cincinnati Stock Exchange, NASDAQ
                            Stock Market, National Securities Clearing Corporation, New York Stock Exchange, Pacific Exchange,
                            Philadelphia Stock Exchange, and The Options Clearing Corporation.




                            Page 14                                                 GAO/GGD-99-74 CFTC Reauthorization
                      Appendix I
                      CFTC Exemptive Authority for OTC Derivatives




                      operator because it had U.S. investors and traded on futures exchanges. As
                      a commodity pool operator, LTCM was subject to registration,
                      recordkeeping, and limited reporting requirements as well as the antifraud
                      provisions of the CEA. In March 1998, CFTC staff received LTCM’s 1997
                      audited annual financial statements and found them to be in compliance
                      with its reporting requirements. According to CFTC, nothing in these
                      statements indicated a reason for concern about the firm’s financial
                      condition; thus, it did not share them with other regulators. CFTC’s ability
                      to share any concerns that it may have had was governed by section 8(e)
                      of the CEA, which permits CFTC to share information with other federal
                      agencies only upon their request. According to CFTC, this requirement
                      would not have impeded its ability to share LTCM’s financial statements
                      because CFTC could have solicited a request from an agency, if needed.

                      In response to the LTCM recapitalization, the Secretary of the Treasury
                      asked the President’s Working Group in September 1998 to study the
                      potential implications of hedge funds and their relationship with creditors.
                      In March 1999, Treasury testified that the Working Group was evaluating
                      the costs and benefits of potential policy options, including relying on
                      market discipline enhanced by greater regulatory scrutiny of and guidance
                      for regulated suppliers of credit; resorting to more direct forms of
                      regulation, such as expanded use of margin requirements; and imposing
                      direct regulation on some currently unregulated market participants.
                      According to the Federal Reserve, the central policy issue raised by LTCM
                      is how financial leverage—which LTCM achieved through a number of
                      means, including the use of OTC derivatives—can be constrained most
                      effectively in a market-based economy. It added that the Working Group’s
                      hedge fund study is separate from its OTC derivatives study because the
                      issues are distinct—regulation of OTC derivatives raises a wider range of
                      issues, many of which are unrelated to LTCM. According to CFTC, the near
                      failure of LTCM demonstrates the unknown risks that OTC derivatives may
                      pose to the U.S. economy and to financial stability around the world—
                      including the risk arising from lack of transparency—thereby highlighting
                      the need to address the questions raised in its concept release.

                      Recognizing the potential benefits of a clearinghouse—including reducing
CFTC Left Open the    counterparty credit risk and increasing market liquidity and
Opportunity for the   transparency—CFTC’s swap exemption left open the opportunity for the
Development of an     development and use of a swaps clearinghouse, subject to CFTC’s prior
                      approval. In its concept release, CFTC noted that a clearinghouse’s
OTC Clearinghouse     benefits are obtained at the cost of concentrating risk in the clearinghouse;
                      thus, federal oversight of the clearinghouse might be necessary. According
                      to CFTC, the extent to which it would need to impose conditions on a



                      Page 15                                        GAO/GGD-99-74 CFTC Reauthorization
                      Appendix I
                      CFTC Exemptive Authority for OTC Derivatives




                      clearinghouse would depend on, among other things, the design of the
                      facility and the applicability of other regulatory regimes.

                      In June 1998, the London Clearing House petitioned CFTC for an
                      exemption from most of the provisions of the CEA for its swaps
                      clearinghouse, called SwapClear. The London Clearing House sought
                      exemptive relief to alleviate the legal and regulatory uncertainty that U.S.
                      entities using SwapClear would face under the CEA. That is, because
                      CFTC’s swap exemption does not extend to swaps cleared through a
                      clearinghouse, the status of otherwise exempted swaps could be
                      jeopardized if cleared through SwapClear. In March 1999, CFTC approved
                      the London Clearing House’s petition, exempting from most CEA
                      provisions and CFTC regulations certain swaps cleared through
                      SwapClear. CFTC exempted SwapClear, in part, because the clearinghouse
                      and its participants will be subject to a comprehensive regulatory regime
                      in the United Kingdom, including oversight by the Financial Services
                      Authority (FSA). The exemption will not take effect until CFTC and FSA
                      have executed an addendum to their information-sharing agreement (see
                      app. VIII on international regulatory coordination), and FSA has notified
                      CFTC that it has approved SwapClear.

                      At the roundtable discussion on CFTC reauthorization issues, one
                      participant advocated that Congress mandate the creation of a national
                      clearinghouse for OTC derivatives. He asserted that such a clearinghouse
                      would reduce systemic risk and increase market efficiency through the use
                      of multilateral netting and other mechanisms. Other roundtable
                      participants said that an OTC derivatives clearinghouse is not needed. Still
                      others said that the competitive advantage associated with the higher
                      credit ratings of most major OTC derivative market participants reduces
                      their incentive to support a clearinghouse that would enable entities with
                      lower credit ratings to compete against them.

                      Financial Integrity/Systemic Risk and Market Integrity/Efficiency:
Public Policy
Questions Raised By   1. What financial integrity/systemic risk or market integrity/efficiency
CFTC Exemptive           issues do the OTC derivatives market raise, if any, and what role
                         should CFTC and/or other federal financial regulators play in
Authority For OTC        addressing them?
Derivatives
                      2. To what extent, if any, does the lack of legal certainty for securities-
                         based swaps pose systemic risk or introduce competitive concerns for
                         the U.S. markets?




                      Page 16                                        GAO/GGD-99-74 CFTC Reauthorization
Appendix I
CFTC Exemptive Authority for OTC Derivatives




3. What lessons does the LTCM recapitalization provide about the need to
   enhance federal regulations, private market mechanisms, and/or
   domestic and international coordination and cooperation to protect
   market stability?

4. Under what conditions would it be appropriate to subject an OTC
   derivatives clearinghouse to U.S. regulation, and what role should
   CFTC and/or other federal financial regulators play in providing any
   such regulation?

Customer Protection:

5. What customer protection issues do the OTC derivatives market raise,
   if any, and what role should CFTC and/or other federal financial
   regulators play in addressing them?




Page 17                                        GAO/GGD-99-74 CFTC Reauthorization
Appendix II

Regulatory Reform Efforts for Exchange-
Traded Derivatives

                      The traditional function of the exchange markets has been to provide a
U.S. Futures Market   mechanism for discovering price and a means for users to shift the risk of
Regulation            price changes in the underlying to those more willing or able to assume
                      this risk. Federal regulation of the U.S. futures market stems from a need
                      to ensure the market’s economic utility by encouraging its competitiveness
                      and efficiency; ensuring its integrity; and protecting market participants
                      against manipulation, abusive trade practices, and fraud. The market’s
                      regulatory structure consists of federal oversight provided by CFTC and
                      industry oversight provided by self-regulatory organizations (SRO)—the
                      futures exchanges and the National Futures Association (NFA). (See the
                      glossary at the end of the report for definitions.)

                      Reliance on the futures SROs is based on a belief that they should be able
                      to act more quickly and effectively than the federal government. Futures
                      SROs are responsible for establishing and enforcing rules governing
                      member conduct and trading; providing for the prevention of market
                      manipulation, including monitoring trading activity; setting qualifications
                      for futures industry professionals; and examining members for financial
                      strength and other regulatory purposes. Their operations are funded by the
                      futures industry through transaction fees and other charges.

                      In regulating the futures market, CFTC independently monitors, among
                      other things, exchange trading activity, large trader positions, and certain
                      market participants’ financial condition. CFTC also investigates potential
                      violations of the CEA and CFTC regulations and prosecutes alleged
                      violators. Additionally, CFTC oversees the SROs to ensure that each has an
                      effective self-regulatory program. In this regard, CFTC designates and
                      supervises exchanges as contract markets and NFA as a registered futures
                      association, audits SROs for compliance with their regulatory
                      responsibilities, and reviews and approves SRO rules and products that are
                      traded on designated exchanges. CFTC is funded through congressional
                      appropriations but also collects fees from the industry to recover the costs
                      of certain services and activities.

                      Traditionally, futures have been exchange-traded; as such, they have been
                      regulated under a structure designed to protect customers and the market.
                      The regulatory structure covers not only certain market participants but
                      also the products and markets on which they trade. Unless exempted or
                      excluded from the CEA, futures must be traded on designated exchanges
                      and through regulated intermediaries that are subject to minimum capital,
                      reporting, examination, and customer protection requirements.




                      Page 18                                    GAO/GGD-99-74 CFTC Reauthorization
                     Appendix II
                     Regulatory Reform Efforts for Exchange-Traded Derivatives




                     In the past two decades, technological advances and fundamental changes
Derivatives Market   in the global financial markets have accelerated the development and use
Growth and           of exchange-traded and OTC derivatives. Such advances and changes have
Competition          led to tremendous growth in not only the U.S. futures market but also the
                     foreign futures and OTC derivatives markets. Between 1986 and 1998,
                     annual trading volume on U.S. futures exchanges increased from 216.1 to
                     707.4 million contracts, or about 227 percent; annual trading volume on
                     foreign futures exchanges in the same products increased from 55.9 to
                     966.4 million contracts, or about 1,629 percent. As a result, foreign
                     exchanges’ share of worldwide trading volume increased from 21 percent
                     in 1986 to 58 percent in 1998. Around this period, the OTC derivatives
                     market also experienced tremendous growth, in part from the
                     development of swaps and other innovative products. As of June 1998, the
                     Bank for International Settlements (BIS) estimated that the total notional
                     amount of the OTC derivatives market worldwide was $69.9 trillion, up
                                                                        1
                     from an estimated $47.5 trillion as of March 1995. Swaps accounted for
                     about 50 percent of the 1998 total.

                     While the U.S. futures market has experienced substantial growth, it has
                     also evolved far beyond its agricultural origins. In 1975, agricultural
                     commodities accounted for nearly 80 percent of the total U.S. exchange
                     trading volume. In 1998, financial instruments and currencies accounted
                     for nearly 70 percent of the total U.S. exchange trading volume, with
                     agricultural commodities accounting for about 15 percent of the trading
                     volume and other commodities, such as energy and metals, accounting for
                     the remaining volume. According to futures exchanges and others, the
                     participants in the exchange-traded futures market have changed as the
                     market evolved. They have noted that the participants are largely
                     institutions and market professionals, with retail customers representing
                     about 5 percent of the total market participants. However, some of these
                     sources have said that advances in electronic trading could bring new
                     retail customers into this market.

                     The growth of the foreign futures markets has provided competition for
                     the U.S. markets, although the extent of competition varies by type of
                     product, transaction costs, and other factors. U.S. and foreign exchanges
                     compete directly with each other when they trade futures based on the
                     same or similar underlying commodities. For example, the Coffee, Sugar,
                     and Cocoa Exchange competes directly with foreign exchanges that trade
                     1
                      Due to differences in the methodology used, the estimates of notional amounts are not directly
                     comparable.




                     Page 19                                                   GAO/GGD-99-74 CFTC Reauthorization
                        Appendix II
                        Regulatory Reform Efforts for Exchange-Traded Derivatives




                        coffee, sugar, and cocoa futures. According to market observers, the
                        continued expansion of electronic trading systems has increased
                        competition between U.S. and foreign exchanges. (See app. VII on
                        electronic trading systems.)

                        In addition, the U.S. exchange-traded futures and OTC derivatives markets
                        compete with and complement each other. Although exchange-traded and
                        OTC derivatives serve similar economic functions and can, thus, compete
                        with each other, they differ by, among other things, their contract terms,
                        liquidity, transparency, transaction costs, and regulation. In addition, the
                        markets complement each other to the extent that OTC derivatives activity
                        generates hedging demand in the futures markets. For example, swaps
                        dealers use exchange-traded futures to hedge the residual risk resulting
                        from unmatched positions in their swaps portfolios.

                        The Futures Trading Practices Act of 1992 gave CFTC authority to exempt
CFTC Exemptive          both exchange-traded and OTC derivative contracts from all but one
Authority               provision of the CEA, including the exchange-trading requirement. (See
                        app. I on CFTC exemptive authority for OTC derivatives and app. III on the
                        Shad-Johnson Jurisdictional Accord.) The act stipulated, among other
                        things, that exemptions must be consistent with the public interest.
                        According to the act’s legislative history, the public interest was to include
                        protecting the futures market’s price discovery and risk-shifting functions
                        from market abuses, such as excessive speculation and manipulation;
                        preventing fraud; preserving the financial integrity of the markets; and
                        promoting innovation and fair competition. The legislative history directed
                        CFTC to be fair and even-handed in providing regulatory relief for both
                        exchanges and nonexchanges. However, it also cautioned CFTC to use its
                        exemptive authority sparingly and not to prompt a wide-scale deregulation
                        of markets falling under the CEA.

                        Although the competitiveness of the U.S. futures market is affected by a
CFTC and                number of factors, U.S. futures exchanges have asserted that regulations
Congressional Efforts   imposed by CFTC have stunted their growth and impeded their ability to
to Provide Regulatory   compete fairly with the less regulated foreign futures and OTC derivatives
                        markets. According to the exchanges, regulatory costs—not the quality of
Relief                  their services and products—have handicapped their industry and crippled
                        their growth and innovation. As discussed below, in 1993, two exchanges
                        separately requested that CFTC exempt from most CEA provisions
                        exchange-traded futures traded solely by institutional and other
                        sophisticated market participants. In addition, exchanges and other
                        market participants have expressed concerns that certain aspects of the
                        regulatory structure make U.S. exchanges less competitive than their



                        Page 20                                           GAO/GGD-99-74 CFTC Reauthorization
Appendix II
Regulatory Reform Efforts for Exchange-Traded Derivatives




foreign and OTC market counterparts. These concerns relate to audit trail
requirements, restrictions on certain trade execution procedures, risk
disclosure requirements, approval of new contracts, speculative position
limits, and capital requirements.

In response to the exchange requests, CFTC issued an exemption in
November 1995, which is to be implemented under a 3-year pilot program
that begins when the first contract trades under the exemption. The
exemption does not provide the exchanges with regulatory relief that is as
broad as they requested, and it applies only to proposals to trade new
contracts. The exemption would allow for the creation of a two-tier market
differentiated by the sophistication of market participants. CFTC
considered the exclusion of nonsophisticated market participants as the
most important factor supporting its exemption. Nonetheless, it noted that
a centralized market limited to sophisticated market participants did not
obviate the need to ensure market integrity and adequate protections
against fraud and other trading abuses. To date, no exchange has applied
for an exemption because, according to the exchanges, the rules provide
insufficient regulatory relief. The exchanges have indicated that they
expected to receive the same level of relief that CFTC provided under the
swaps exemption, because the 1992 act’s legislative history directed CFTC
to be fair and even-handed in using its exemptive authority.

According to CFTC, the agency has taken other actions that are responsive
to the competitive challenges faced by the U.S. futures industry and its
customers, while at the same time preserving important customer
protections and market safeguards that make U.S. markets attractive.
CFTC describes its regulatory reform efforts as intending to update,
modernize, and streamline regulations to improve market integrity and
protect market participants. These efforts include approving new
procedures for expediting approval of contract market designations and
exchange rules, piloting a program to permit trading of agricultural trade
options (see app. VI on the agricultural trade option pilot program),
improving the fairness and efficiency of the administrative process, and
permitting the use of electronic technology to reduce paperwork. Market
participants and others have supported these efforts but do not believe
that they go far enough.

The 1997 Senate (S. 257) and House (H.R. 467) bills to amend the CEA
included numerous provisions that were intended to provide regulatory
relief to the U.S. exchanges. First, both bills would have provided futures
exchanges with professional market exemptions that would largely
exempt from regulation under the act certain exchange-traded futures that



Page 21                                           GAO/GGD-99-74 CFTC Reauthorization
                         Appendix II
                         Regulatory Reform Efforts for Exchange-Traded Derivatives




                         were limited to institutional and sophisticated market participants.
                         Second, both bills would have allowed exchanges previously designated by
                         CFTC as contract markets to trade new contracts without CFTC approval.
                         Third, both bills would have expedited CFTC approval of exchange rules.
                         Fourth, the House bill would have required CFTC to issue an objective
                         standard or methodology for testing exchange audit trails, and both bills
                         stated that no particular technology was needed to meet the audit trail
                         requirements. Finally, both bills would have required CFTC to consider the
                         costs and benefits of its proposed actions before adopting rules,
                         regulations, and orders. The House bill, however, would have prohibited
                         CFTC from taking regulatory action if the benefits did not exceed costs.

                         The exchanges were supportive of the regulatory relief that the bills would
                         have provided. According to the exchanges, they were particularly
                         supportive of the bills’ professional market exemptions, because they
                         would have moved the exchanges a long way toward achieving a
                         regulatory balance with the OTC derivatives market. The exchanges noted
                         that the exempted market would have relied on market discipline and self-
                         regulation, with the exchanges having a business incentive to operate a
                         fair, financially sound, and competitive market.

                         In contrast, CFTC and SEC expressed concerns about the bills because of
                         the increased risks to the market and its participants that could have
                         resulted from them. CFTC stated that it opposed the professional market
                         exemptions, because they would eliminate federal power to protect
                         against manipulation, fraud, financial instability and other dangers. SEC
                         expressed concern about the House bill’s professional market exemption,
                         because it would have eliminated the applicability of the Shad-Johnson
                         Jurisdictional Accord to these markets. (See app. III on the accord.)

                         Participants at the CFTC reauthorization roundtable discussion
Proposals for Revising   recommended various ways that federal oversight could be revised for the
Market Oversight         benefit of the markets. These recommendations were similar in that they
                         focused on (1) providing regulatory parity between the exchange and OTC
                         markets and (2) differentiating regulation on the basis of the sophistication
                         of market participants. In addition, a former CFTC chairperson has
                         supported considerable deregulation of exchange-traded financial futures.

                         One recommendation made during the roundtable discussion was to base
                         the level of regulation—regardless of what agency provided it—on the
                         sophistication of the market participant, not on the market in which the
                         transaction occurred. Under this approach, unsophisticated market
                         participants would be subject to greater regulatory protections than



                         Page 22                                           GAO/GGD-99-74 CFTC Reauthorization
Appendix II
Regulatory Reform Efforts for Exchange-Traded Derivatives




sophisticated market participants; however, regulation within each group
would be consistent, regardless of whether trading occurred on or off of an
exchange.

A second recommendation was for CFTC to assume a supervisory role
similar to that of the U.S. banking regulators or the U.K. single financial
services regulator, FSA. U.S. banking regulators focus on safety and
soundness issues—rather than regulations. Under this approach, CFTC
would rely more on the SROs to regulate the markets. The U.K.’s FSA,
created in 1997, plans to adopt a flexible, risk-based approach to regulation
that distinguishes between the varying levels of consumer expertise. It is
to use cost-benefit analysis to ensure that the burdens imposed are
proportionate to their intended benefits. Also, FSA is to recognize the
desirability of maintaining the U.K.’s competitive position in an
international market.

A third recommendation was for regulation to be based on the activity
rather than on the institution or product. Activities would be categorized
according to the three basic goals of market regulation—protecting
financial system integrity, market integrity, and customers. Under this
proposal, the sophistication of the market participant would dictate the
regulatory approach. Sophisticated market participants would be subject
to the U.S. supervisory approach for banks, and unsophisticated market
participants would be subject to more traditional market regulation.

A fourth recommendation was to replace the existing financial market
regulatory structure with a set of meaningful and verifiable best practices
whose guiding principle would be transparency. These best practices
would be applicable to all significant market participants worldwide,
including institutional end-users, such as hedge funds, and would be
designed to reduce risks to participants and the financial system. They
would address internal controls, including risk management and credit
assessments; sales practices; documentation; information availability;
senior management accountability; and audit and compliance. Rather than
acting as a regulator, the federal government would monitor systemic risk.
Although existing financial laws and regulations would be abandoned, best
practices would remain subject to antifraud and contract law. The
participant who made this recommendation was critical of the U.S.
regulatory system, in which different rules exist to address the same risks
in products that are indistinguishable. That is, to the extent that the
products are indistinguishable and the risks are the same, he said that the
rules addressing the risks should be the same.




Page 23                                           GAO/GGD-99-74 CFTC Reauthorization
                        Appendix II
                        Regulatory Reform Efforts for Exchange-Traded Derivatives




                        Additionally, a former CFTC chairperson testified in December 1998 that
                        differences between physical and financial futures justify different
                        regulatory approaches. First, she asserted that financial futures, unlike
                        futures on physical commodities, generally do not serve a price discovery
                        function. Second, she noted that although exchanges facilitate the actual
                        delivery of physical commodities, this function is less necessary for cash
                        settled financial futures and requires less federal oversight. Third, she said
                        that financial futures are much less susceptible to manipulation or supply
                        distortions. Fourth, she noted that participants in the financial futures
                        market are often supervised by bank or securities regulators. In a 1999
                        journal article, she reiterated these views and noted that given the rapid
                        improvement in trading technology, the globalization of markets, and
                        increasingly open avenues of international trade, care must be taken to
                        ensure that a domestic regulatory structure does not chase business
                        offshore. Similarly, the Chairman of the Federal Reserve Board observed
                        that the OTC derivatives market functions effectively without the benefits
                        of CEA regulation, providing a strong argument for less regulation of
                        exchange-traded financial derivatives.

                        Federal regulations applicable to U.S. futures exchanges and other
Costs and Benefits of   regulated market participants are identifiable and impose costs. However,
Futures Market          our previous work has shown that difficulties exist in measuring the
Regulation Are          incremental costs of regulation. One measurement difficulty is
                        distinguishing actual compliance costs from those costs that would have
Difficult to Measure    been incurred as a normal business expense in the absence of federal
                        regulation. Futures exchanges have noted that certain regulations provide
                        benefits and would be retained in exchange rules regardless of whether
                        they were required by CFTC. The exchanges, however, have not specified
                        which regulations would be maintained in the absence of CFTC
                        requirements, making it difficult to measure actual compliance costs.
                        Similar measurement difficulties exist for other regulated market
                        participants. For example, in the absence of CFTC regulation, futures
                        commission merchants (FCM) could still be subject to regulations imposed
                        on them by exchanges and, if registered as broker-dealers, by SEC.
                        Additionally, measuring indirect costs, such as lost productivity or income
                        resulting from regulations, is more difficult than measuring direct costs.

                        Even if the incremental costs of regulation could be accurately measured,
                        such information would be of limited usefulness without corresponding
                        information on the benefits of regulation. Measuring the benefits of
                        regulation can be more difficult than measuring costs—particularly for
                        regulatory agencies like CFTC whose regulations are intended to prevent
                        or deter violations, such as manipulation and fraud. Moreover, although



                        Page 24                                           GAO/GGD-99-74 CFTC Reauthorization
Appendix II
Regulatory Reform Efforts for Exchange-Traded Derivatives




costs are typically measured in dollars, benefits cannot always be
measured quantitatively. For example, futures industry representatives and
other market participants have indicated that federal regulation enhances
market integrity and customer protection and promotes the perception
that the market and the financial intermediaries through which users gain
access are fair.

CFTC has noted that it considers the costs and benefits that may result
from the rules that it adopts relying, in part, on public comments. The
futures exchanges have supported the use of cost-benefit analysis, noting
that excessive regulation jeopardizes their competitiveness relative to
foreign futures and OTC derivatives markets. Other market participants
and observers have stressed the importance of ensuring that regulatory
costs do not exceed benefits, citing CFTC’s contract approval requirement
and federal audit trail standards, both required by statute, as examples of
regulations whose costs appear to outweigh benefits.

At the CFTC reauthorization roundtable discussion, one participant
commented that it is extremely difficult to analyze the costs and benefits
of futures regulation. He said that costs are measured in dollars and
benefits are measured qualitatively, making the comparison between them
subjective. Another participant agreed that measuring regulatory costs and
benefits is difficult, but he also said that attempts should be made to do so.
He indicated that cost-benefit analysis should be used to task CFTC with
proving that regulatory benefits exceed costs. Also, as discussed above,
one participant recommended that CFTC assume a supervisory role similar
to that of the U.S. banking regulators or the U.K. single regulator. The
latter plans to use cost-benefit analysis in deciding whether to issue new
regulations.

Finally, roundtable participants warned that overly burdensome
regulations could be avoided by moving transactions to other markets. For
example, OTC derivatives could be used instead of exchange-traded
futures to avoid triggering CFTC’s registration or large trader reporting
requirements. Also, market participants that seek access to markets closed
to U.S. citizens could transact through offshore foreign entities. One
roundtable participant indicated that entities seeking such access were
typically large, sophisticated institutions that did not need the protections
offered by the CEA.




Page 25                                           GAO/GGD-99-74 CFTC Reauthorization
                        Appendix II
                        Regulatory Reform Efforts for Exchange-Traded Derivatives




                        Financial Integrity/Systemic Risk:
Public Policy
Questions Raised by     1. How do the financial integrity/systemic risk issues posed by the
Regulatory Reform          exchange-traded derivatives markets differ from those of the OTC
                           derivatives markets, and what are the regulatory implications?
Efforts for Exchange-
Traded Derivatives      Market Integrity/Efficiency:

                        2. How are the risks posed by financial futures and options different from
                           those of physical commodities (e.g., as they relate to price discovery
                           and market manipulation); and what are the regulatory implications?

                        3. What are the implications of a regulated and unregulated exchange
                           market operating side-by-side for the same or different contracts?

                        4. What are the major risks, if any, that threaten the integrity and
                           efficiency of a futures market limited to sophisticated market
                           participants, and what are the regulatory implications of any such
                           risks?

                        5. To what extent can the costs and benefits of futures market
                           regulations be measured in an objective, consistent, and reliable
                           manner that allows for a meaningful comparison between them?

                        6. How should the terms futures contract and board-of-trade be defined,
                           if at all, in the CEA?

                        7. What is the appropriate role for CFTC in approving new contracts
                           proposed for trading by a futures exchange?

                        Customer Protection:

                        8. How do the customer protection issues posed by the exchange-traded
                           derivatives markets differ from those of the OTC derivatives markets,
                           and what are the regulatory implications?

                        9. How do the customer protection issues differ between tiers in a market
                           differentiated by the sophistication of market participants, and what
                           are the regulatory implications?

                        10. Absent CFTC regulations, what protections exist or should exist for
                            OTC market participants?




                        Page 26                                           GAO/GGD-99-74 CFTC Reauthorization
Appendix III

The Shad-Johnson Jurisdictional Accord


                    The Shad-Johnson Jurisdictional Accord is an agreement reached between
Rationale for the   the Chairmen of SEC and CFTC in 1981 to resolve a dispute concerning
Accord              jurisdiction over securities-based derivatives. The dispute was precipitated
                    by CFTC’s 1975 approval of a Chicago Board of Trade (CBT) futures
                    contract on Government National Mortgage Association pass-through
                    mortgage-backed certificates. SEC challenged CFTC’s decision, asserting
                    that the contracts for future delivery of these certificates were securities
                    falling within its regulatory jurisdiction. SEC later approved an option on
                    the certificates for trading on a securities exchange. CBT subsequently
                    prevailed in a court challenge of SEC’s approval, arguing that the option
                    was subject to CFTC’s exclusive jurisdiction. In 1981, the SEC and CFTC
                    Chairmen entered into an agreement to clarify each agency’s jurisdiction.
                    This agreement was codified in the Securities Acts Amendments of 1982
                    and in the Futures Trading Practices Act of 1982 that amended the CEA by,
                    among other things, adding section 2(a)(1)(B). (See the glossary at the end
                    of the report for definitions.)

                    Under the accord, CFTC retained exclusive jurisdiction over all futures
                    contracts, including futures on securities-based indexes and options on
                    futures and physical commodities. CFTC was also given jurisdiction over
                    options on foreign currencies not traded on a national securities exchange
                    (subject to the limitations imposed by the Treasury Amendment). (See
                    app. IV on the Treasury Amendment.) Futures and options on futures on
                    securities indexes were allowed only for contracts settled in cash, not
                    readily susceptible to manipulation, and derived from a substantial
                    segment of a publicly traded group or index of equity or debt securities,
                    called broad-based indexes. Such contracts were also subject to initial SEC
                    review for compliance with these requirements. If SEC determined that a
                    proposal did not meet these requirements, CFTC could not approve the
                                         1
                    contract for trading. Under the accord, SEC retained jurisdiction over
                    securities, including options on securities, options on certificates of
                    deposit, options on securities indexes, and options on foreign currency
                    traded on a national securities exchange.

                    Futures contracts on individual securities, other than exempted securities
                    (such as U.S. Treasuries), were prohibited by the accord. The CFTC
                    chairman who negotiated the accord stated at the CFTC reauthorization
                    roundtable that the accord was intended to ban certain stock-based
                    futures until issues of concern to SEC could be addressed. According to
                    the legislative history, SEC was concerned that the regulatory scheme

                    1
                     Under the accord, SEC authority applied only to contracts proposed on or after December 9, 1982.
                    The accord provided that CFTC was to consult with SEC on proposals made before that date.




                    Page 27                                                  GAO/GGD-99-74 CFTC Reauthorization
                        Appendix III
                        The Shad-Johnson Jurisdictional Accord




                        governing futures trading did not mirror securities regulation in important
                        areas such as insider trading prohibitions, customer protections, floor
                        trading rules, and margin requirements. The former CFTC chairman said
                        that at the time the accord was negotiated, CFTC had been willing to
                        address these concerns but the two agencies could not reach agreement on
                        jurisdiction over the prohibited products.

                        Questions have remained about how to regulate products covered by the
Evidence of Continued   accord. In 1987, after the stock market crash, SEC and the New York Stock
Uncertainty             Exchange cited trading in stock index futures for exacerbating stock
                        volatility during the crash and threatening the future stability of the stock
                        market. As a result, SEC requested that Congress shift oversight
                        responsibility for stock index futures from CFTC to SEC. No action was
                        taken on this request; however, Congress granted oversight authority for
                        setting margins on stock index futures to the Federal Reserve under the
                        Futures Trading Practices Act of 1992.

                        In 1989, several stock exchanges introduced contracts, called index
                        participations, to provide investors with a relatively low-cost way to obtain
                        an index-equivalent portfolio. The courts subsequently ruled, in response
                        to a suit by Chicago futures exchanges, that the index participations were
                        futures contracts and thus could be offered only on CFTC-regulated
                        futures exchanges. As a result, these contracts ceased trading. The
                        American Stock Exchange subsequently developed a securities product
                        that offered investors a benefit similar to these contracts by providing
                        them an interest in the holdings of a trust.

                        The Futures Trading Practices Act of 1992 gave CFTC broad authority to
                        exempt swaps and other OTC derivatives from all CEA provisions except
                        section 2(a)(1)(B), which codified the accord. Because of their similarities
                        to exchange-traded futures, certain OTC derivatives faced the possibility of
                        falling within the judicially crafted definition of a futures contract. This
                        possibility posed a legal risk for such contracts because of the CEA
                        requirement that futures be traded on an exchange to be legal and, thus,
                        enforceable. CFTC’s 1993 swaps exemption eliminated this legal risk for
                        qualifying contracts. However, the exemption did not eliminate the legal
                        risk for securities-based swaps, contracts whose returns are based on the
                        prices of securities or securities indexes, because these contracts might be
                        prohibited by or subject to CEA section 2(a)(1)(B).

                        According to market observers, if securities-based swaps were found to be
                        futures contracts, they could be in violation of section 2(a)(1)(B) and,
                        thus, be illegal and unenforceable. First, swaps on individual securities



                        Page 28                                     GAO/GGD-99-74 CFTC Reauthorization
                        Appendix III
                        The Shad-Johnson Jurisdictional Accord




                        that were deemed futures would violate section 2(a)(1)(B), which
                        prohibits futures on individual securities. Second, swaps on securities
                        indexes that were deemed futures would violate the CEA requirement that
                        futures trade on an exchange. However, swaps counterparties can still rely
                        on CFTC’s swaps policy statement, which sets forth the conditions under
                        which CFTC would not regulate certain swaps as futures, to address their
                        legal concerns under section 2(a)(1)(B). Provisions of a 1997 Senate bill to
                        amend the CEA (S. 257) were intended to provide greater legal certainty
                        for all swaps by codifying the existing swaps exemption and, for securities-
                        based swaps, by extending the scope of the exemption to include section
                        2(a)(1)(B). (See app. I on CFTC’s exemptive authority for OTC
                        derivatives.)

                        In July 1998, SEC exercised its authority under section 2(a)(1)(B) and
                        objected to a CBT application to trade futures based on the Dow Jones
                        utility and transportation indexes. According to SEC’s written decision,
                        this was the first time SEC had objected to a proposed stock-index futures
                        contract since 1984. Under the securities laws, SEC had approved options
                        on these same indexes for trading on the Chicago Board Options Exchange
                        in 1997. SEC determined that the CBT-proposed contracts on the Dow
                        Jones utility and transportation indexes did not satisfy the substantial
                        segment requirement of the accord. In July 1998, CBT challenged SEC’s
                        determination in federal court. In November 1998, CFTC filed a brief in
                        support of CBT, asserting that SEC had not accurately interpreted the
                        provisions of the accord. In January 1999, the New York Stock Exchange
                        and Chicago Board Options Exchange filed a brief in support of SEC,
                        asserting SEC’s determination was necessary to protect against injury to
                        the securities markets. The case is pending.

                        Finally, although the accord generally divided jurisdiction between CFTC
                        and SEC, the accord allowed options on foreign currency to be traded on
                        exchanges under either jurisdiction. Currently, foreign currency options
                        exist on both futures and securities exchanges, but the futures exchange
                        options are dormant.

                        The 1997 House bill (H.R. 467) to amend the CEA would have established
Addressing the          unregulated professional markets exempt from CEA section 2(a)(1)(B).
Prohibition on Stock-   One result would have been to legalize exchange-trading of futures on
Based Futures           individual stocks or on narrowly based stock indexes. In testifying on the
                        House bill, SEC expressed concern that by stripping it of its oversight
                        authority under the accord, the bill would eliminate an important tool for
                        overseeing the markets for equities and equity derivatives. SEC was also
                        concerned that because the futures and securities markets were linked,



                        Page 29                                    GAO/GGD-99-74 CFTC Reauthorization
Appendix III
The Shad-Johnson Jurisdictional Accord




undetected fraud and manipulation in futures markets caused by a lack of
audit trails, books and records, and trade reporting requirements would
inevitably spill over into the securities markets.

At the CFTC reauthorization roundtable discussion, several participants
questioned the rationale for banning futures on individual stocks. They
stated that concerns about the risks associated with allowing exchange-
trading of these contracts ignore the fact that equivalent products are
already being traded in the United States. Currently, market participants
can create the equivalents to futures on individual stocks, called synthetic
instruments, by taking positions in the options and stock markets. Also,
swaps based on stocks are traded in the OTC market. Although not
discussed at the roundtable, futures based on stocks are traded on some
foreign futures exchanges. For example, exchanges in Australia and Hong
Kong trade futures on individual domestic stocks and have considered
trading futures on major U.S. stocks.

A roundtable participant who worked at SEC when the accord was
negotiated identified several issues that he believed should be addressed
before futures on individual stocks and narrowly based stock indexes are
allowed to trade on exchanges and before a regulator for these products is
determined. These issues are similar to those that were of concern to SEC
when the accord was negotiated and relate to insider trading, customer
protection, market manipulation, and leverage limits. Additionally, one
participant said that rules limiting the sale of borrowed stocks when the
stock is declining in price, called short-sale rules, would also need to be
examined. The current CFTC chairperson stated at a March 1999 futures
conference that if Congress excluded equity swaps from the CEA it should
also consider permitting futures on equities to be traded on futures
exchanges, subject to an appropriate regulatory framework.

In a joint statement submitted to the Senate and House Agriculture
Committees on March 19, 1999, the U.S. Securities Market Coalition
expressed its opposition to lifting the ban. Citing the issues that were of
concern when the accord was negotiated, the statement concluded that
lifting the ban could disrupt the securities markets and undermine investor
confidence in these markets. An SEC official also expressed these views to
us, emphasizing the agency’s concern that if the ban were lifted, the
futures markets could become the pricing mechanism for securities. The
official said the agency was concerned that if price discovery for securities
occurred on the futures markets, the goals of the federal securities law
could be undermined, regulatory disparities could be exploited to the




Page 30                                     GAO/GGD-99-74 CFTC Reauthorization
                      Appendix III
                      The Shad-Johnson Jurisdictional Accord




                      detriment of securities investors, and liquidity in the securities markets
                      could be dissipated.

                      Financial Integrity/Systemic Risk and Market Integrity/Efficiency:
Public Policy
Questions Raised by   1. To what extent do futures on individual stocks and narrowly based
the Accord               stock indexes raise financial integrity/systemic risk or market integrity
                         risks that are different from those raised by options on such stocks and
                         stock indexes?

                      2. What are the implications, if any, to the efficiency and integrity of the
                         U.S. securities markets of separating the regulation of stock and stock
                         index futures from the regulation of the underlying stocks?

                      3. What are the implications should foreign exchanges trade futures on
                         individual U.S. stocks and narrowly based U.S. stock indexes?




                      Page 31                                     GAO/GGD-99-74 CFTC Reauthorization
Appendix IV

The Treasury Amendment


                        Before 1974, the CEA provided for CFTC’s predecessor to regulate futures
Rationale for the       trading in those commodities specifically listed in the act. Futures trading
Treasury Amendment      in other commodities was not subject to the act, including its exchange-
                        trading requirement. In 1974, Congress proposed amending the CEA to
                        expand the list of commodities covered by the act to include not only
                        physical commodities but also intangibles, such as interest and foreign
                        exchange rates. The proposed amendments would have significantly
                        broadened the transactions that would be subject to regulation under the
                        act. Under the CEA, any contracts that were defined as futures but traded
                        off-exchange, or OTC, would be illegal. (See the glossary at the end of the
                        report for definitions.)

                        The Department of the Treasury expressed concern that the proposed
                        expansion of the CEA’s commodity definition, when coupled with the act’s
                        exchange-trading and other provisions, would prohibit banks and other
                        financial institutions from trading among themselves in foreign currencies
                        and certain financial instruments, including government securities.
                        According to Treasury, virtually all U.S. futures trading in foreign
                        currencies was conducted off-exchange through an informal network of
                        banks and dealers (called the interbank market), which served the needs
                        of international business to hedge risk stemming from foreign exchange
                        rate movements. Treasury asserted that unlike some participants in the
                        exchange-traded markets who might need the protection provided by
                        government regulation, foreign exchange market participants were
                        sophisticated and informed institutions not requiring such protection. In
                        response to Treasury’s concern, Congress adopted the Treasury
                        Amendment to exclude from CFTC regulation certain transactions in,
                        among other things, foreign currency and government securities, unless
                        conducted on a board of trade. As part of the legislative history
                        accompanying the 1974 amendments to the CEA, which included the
                        Treasury Amendment, Congress noted that the interbank market was more
                        properly supervised by bank regulators and, thus, regulation by CFTC
                        under the CEA was unnecessary.

                        The Treasury Amendment has been difficult to interpret because its
Problems Interpreting   language is ambiguous. Although the amendment was motivated primarily
the Treasury            by concern that the interbank foreign currency market should be excluded
Amendment               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 and government securities, unless the transaction involves a
                        sale for future delivery conducted on a board of trade. Before the February
                        1997 U.S. Supreme Court decision in Dunn v. CFTC, considerable debate
                        occurred over the meaning of the phrase “transactions in,” which partly



                        Page 32                                     GAO/GGD-99-74 CFTC Reauthorization
                           Appendix IV
                           The Treasury Amendment




                           defines the scope of the exclusion. In Dunn, the U.S. Supreme Court
                           interpreted the phrase “transactions in” to include futures and options
                           contracts, but it did not address the meaning of the term board of trade as
                           used in the “unless” clause. The CEA defines the term board of trade 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.” 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
                           Amendment excludes from regulation under the CEA has been the subject
Department Have            of considerable debate among federal regulators. Since at least 1985, CFTC
Interpreted the Treasury   has interpreted the Treasury Amendment to exclude from the act’s
Amendment Differently      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. An OTC foreign currency
                           transaction 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.
                           Consistent with this philosophy, CFTC brought 33 cases involving the
                           illegal sale of foreign currency futures or option contracts to the general
                           public since its inception through 1998. These cases involved more than
                           3,800 customers who invested over $260 million. 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. According to some market observers, other
                           federal agencies, such as the Federal Trade Commission, and state
                           agencies can also protect retail customers from investment fraud.

                           In contrast to CFTC, Treasury has advocated the reading of the Treasury
                           Amendment adopted by the U.S. Supreme Court in Dunn—that is, the
                           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. It has objected to CFTC’s approach
                           to the Treasury Amendment, noting that it lacks a foundation in the
                           language of the statute. According to Treasury, CFTC enforcement actions



                           Page 33                                    GAO/GGD-99-74 CFTC Reauthorization
                          Appendix IV
                          The Treasury Amendment




                          involving OTC foreign currency derivative transactions have raised
                          significant issues about the scope of the amendment. Although CFTC
                          actions have been aimed at protecting unsophisticated market participants
                          from fraud, Treasury noted that such actions have created uncertainty over
                          which OTC transactions the amendment excludes from CEA coverage and,
                          in turn, have generated legal uncertainty in the financial markets.
                          Nevertheless, it has expressed sympathy with CFTC’s concerns over
                          fraudulent foreign currency contracts marketed to the general public.
                          Treasury has agreed 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.

                          The Foreign Exchange Committee—which represents major U.S. and
                          foreign banks and brokers—and other market participants have expressed
                          concerns similar to those of Treasury. Market participants have noted that
                          uncertainty regarding the amendment’s scope raises questions about the
                          legal enforceability of OTC foreign currency contracts involving U.S.
                          parties. They believe that such uncertainty needs to be addressed, given
                          the foreign currency market’s size and significance to the U.S. economy.
                          According to CFTC staff, the agency has been taking enforcement actions
                          involving OTC foreign currency derivatives since at least 1985, and
                          available evidence does not indicate that these actions have resulted in
                          legal uncertainty.

                          Market participants have noted that larger scale participants in OTC
                          foreign currency transactions could respond to legal uncertainty by
                          shifting trading to their overseas offices. These market participants have
                          argued that if a sufficiently large shift in trading were to occur, liquidity in
                          the U.S. foreign currency markets would be reduced to the detriment of
                          U.S. businesses engaged in foreign trade. According to a BIS survey, the
                          average daily turnover in the traditional foreign exchange market was
                          about $1.49 trillion as of April 1998. The U.S. share of this market was 18
                          percent, ranking it second behind the United Kingdom, whose share was
                          32 percent.

Federal Court             The federal courts have differed in their interpretation of what activity the
                          Treasury Amendment excludes from regulation under the CEA. In spite of
Interpretations of the    these differences, the courts have recognized congressional intent to
Treasury Amendment Have   exclude the inter-dealer foreign currency market from regulation.
Differed                  However, past court cases have highlighted the difficulty in interpreting
                          the meaning of a board of trade as used in the Treasury Amendment and
                          the legal confusion over whether the amendment excludes from the act’s



                          Page 34                                       GAO/GGD-99-74 CFTC Reauthorization
Appendix IV
The Treasury Amendment




regulation transactions in foreign currencies that involve the general
       1
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.

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 Supreme Court, however, did not
address the definition of a board of trade.

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

1
 While we refer in the text to decisions by federal circuit courts of appeal, two decisions by the federal
district court in New York (CFTC v. Standard Forex, Inc. (1993) and CFTC v. Rosner (1998))
interpreted “board of trade” in the context of the Treasury Amendment to include sales to the general
public of futures based on foreign currency by firms not otherwise subject to government regulation.
The Standard Forex interpretation was expressly rejected by the Ninth Circuit in the Frankwell Bullion
decision (1996) discussed in the text.




Page 35                                                     GAO/GGD-99-74 CFTC Reauthorization
                       Appendix IV
                       The Treasury Amendment




                       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.

                       The 1997 Senate bill (S. 257) to amend the CEA included a provision to
Proposals to Clarify   clarify the scope of the Treasury Amendment. According to an
the Scope of the       accompanying discussion document, the bill reflected the view that a
Treasury Amendment     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 document further noted
                       that the bill intended that CFTC would have no jurisdiction over nonretail
                       transactions conducted off-exchange or retail transactions that were
                       subject to oversight by other federal regulators. CFTC stated that it
                       opposed the provision because it would have (1) extended the
                       amendment’s exemption to certain exchange-traded futures and (2)
                       eliminated CEA protections afforded to retail investors in OTC
                       transactions. Treasury did not take a position on the provision. However,
                       the agency supported providing CFTC with authority to prosecute
                       unregulated firms defrauding retail customers but without burdening
                       successful, efficient markets. The Foreign Exchange Committee supported
                       the provision’s intent of providing legal certainty to OTC transactions but
                       suggested modifying it to limit CFTC’s jurisdiction to policing fraud. The
                       futures exchanges supported the provision because it would have clarified
                       that CFTC has jurisdiction over unregulated entities offering foreign
                       currency futures to retail investors but not over markets that exclude the
                       general public.

                       The 1997 House bill (H.R. 467) to amend the CEA proposed, 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 would have defined
                       board of trade in the context of the Treasury Amendment as “any facility
                       whereby standardized contracts are systematically marketed to retail
                       investors.” CFTC opposed the provision, in part, because it would have



                       Page 36                                     GAO/GGD-99-74 CFTC Reauthorization
                      Appendix IV
                      The Treasury Amendment




                      permitted exchanges to trade certain futures free from CFTC regulation.
                      Treasury did not take a position on the provision but supported providing
                      CFTC with authority over unregulated entities that defraud retail investors.
                      The Foreign Exchange Committee supported the provision but suggested
                      modifying it to limit CFTC’s jurisdiction to unregulated entities and to
                      preserve federal oversight of the futures exchanges.

                      Participants in the CFTC reauthorization roundtable discussion noted the
                      importance of the Treasury Amendment in providing legal certainty to
                      OTC foreign currency and other covered transactions. At the same time,
                      however, some recognized the need to protect unsophisticated retail
                      investors from unregulated firms fraudulently marketing OTC foreign
                      currency derivatives. Although one participant advocated abolishing the
                      Treasury Amendment, his goal was to provide equal regulatory treatment
                      to exchange-traded and OTC derivatives. He objected to market
                      participants being excluded from regulation under the CEA when
                      transacting in OTC instruments covered by the amendment, but being
                      regulated when trading similar instruments on an exchange. He supported
                      regulation based on the sophistication of the market participant. (See app.
                      II on regulatory reform efforts for exchange-traded derivatives.)

                      Market Integrity/Efficiency:
Public Policy
Questions Raised by   1. To what extent does the legal uncertainty faced by market participants
the Treasury             under the Treasury Amendment adversely affect the efficiency of the
                         market?
Amendment
                      Customer Protection:

                      2. How should the Treasury Amendment be changed, if at all, to clarify
                         whether unsophisticated market participants are covered by the CEA
                         when transacting in foreign currency or other enumerated
                         instruments?

                      3. To what extent should unregulated entities be allowed to engage in
                         OTC transactions with unsophisticated market participants?




                      Page 37                                    GAO/GGD-99-74 CFTC Reauthorization
Appendix V

The Forward Exclusion


                           Congress excluded forward contracts from the CEA to facilitate the
Historical Definition of   movement of commodities through the merchandizing chain. Absent a
a Forward Contract         statutory definition of a forward, CFTC and the courts have defined
                           forwards in reference to futures. Consistent with the CEA reference to
                           forwards as involving the sale of cash commodities for deferred delivery,
                           forwards have been distinguished from futures on the basis of whether the
                           contract served primarily as a vehicle for deferred delivery or risk shifting.
                           Because forwards primarily serve a merchandizing purpose, they are
                           expected to entail delivery, but delivery is expected to occur at a later
                           date. In contrast, futures primarily serve a risk-transferring function, and
                           actual delivery is not generally expected to occur. (See the glossary at the
                           end of the report for definitions.)

                           Although the CEA excludes forwards from its regulation because of their
Problems                   merchandizing purpose, the act does not specify what constitutes delivery
Differentiating            under the exclusion and, thus, does not clearly differentiate forwards from
Forwards From              futures. The evolution of certain contracts in which delivery may not
                           routinely occur has made it increasingly difficult to distinguish unregulated
Futures                    forwards from regulated futures and, as discussed below, can result in
                           legal risk regarding the enforceability of such contracts.

                           A 1986 lawsuit focused on whether Brent oil contracts—OTC contracts for
                           the future purchase or sale of Brent oil—were forwards or futures. A firm
                           had sued its counterparties to Brent oil contracts for violating the CEA’s
                           antimanipulation provisions. The counterparties responded that the
                           contracts were forwards and thus excluded from the CEA because no
                           contractual right existed to avoid delivery. In 1990, a federal district court
                           rejected the claim and found that the contracts were futures. The court
                           concluded that even though the contracts did not include a contractual
                           right of offset to avoid delivery, the opportunity to offset contracts and the
                           common practice of doing so were sufficient to determine that the
                           contracts were futures. Because the court’s decision created the possibility
                           that Brent oil contracts could be illegal, off-exchange futures, market
                           participants urged CFTC to issue an interpretation to clarify the status of
                           these contracts under the CEA. According to market observers, as a result
                           of the court decision, many participants in the Brent oil market
                           permanently stopped entering these contracts in the United States.

                           In a subsequent 1990 statutory interpretation on forwards, CFTC adopted
                           the view that Brent oil contracts were forwards, because they required the
                           commercial parties to make or take delivery, even though they did not
                           routinely do so. CFTC stated that the contracts did not include any
                           provisions that enabled the parties to settle their contractual obligations



                           Page 38                                      GAO/GGD-99-74 CFTC Reauthorization
Appendix V
The Forward Exclusion




through means other than delivery, and the settlement of contracts without
delivery was done through subsequent, separately negotiated contracts. In
1993, to provide the market with greater legal certainty, CFTC used its
newly granted authority to exempt Brent oil and other OTC energy
contracts from virtually all CEA provisions. (See app. I on CFTC exemptive
authority for OTC derivatives.) However, this exemption did not address
the legal risk faced by OTC derivatives that resembled both forwards and
futures but were not based on energy-related commodities, such as
agricultural commodities.

Although CFTC’s statutory interpretation on forwards was intended to
reduce the legal risk surrounding Brent oil contracts and allow that market
to evolve, it did not provide a clear basis for distinguishing forwards from
futures on the basis of their economic purpose. That is, it did not preclude
forwards from being settled routinely without delivery and, in the process,
being used primarily for risk-shifting or speculative purposes instead of
merchandizing purposes. In dissenting from the agency’s interpretation on
forwards, a CFTC commissioner stated that it broadened the CEA’s
forward exclusion to include transactions that were standardized, used for
noncommercial purposes, and offset.

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 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 pre-established level. Based largely on this
provision, a CFTC settlement order found these 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 action broadened the
definition of a futures contract and resulted in greater legal risk for
forwards and securities-based swaps.

In 1996, CFTC filed a complaint against a grain elevator, alleging that
certain of its hedge-to-arrive (HTA) contracts were illegal, off-exchange
futures. In 1997, before CFTC’s case was heard, a federal district court
held in a separate civil case involving the same grain elevator and its
producers that the elevator’s HTA contracts were forwards and excluded
from the CEA. The court found that the contracts were grain marketing



Page 39                                    GAO/GGD-99-74 CFTC Reauthorization
                        Appendix V
                        The Forward Exclusion




                        instruments, noting that the parties were in the business of growing and
                        merchandizing grain and had the ability to make or take delivery. Given the
                        court’s decision, the grain elevator requested that the court dismiss CFTC’s
                        case, but the request was denied. The federal district court also refused to
                        block CFTC’s case. In 1998, a CFTC administrative law judge found that
                        the grain elevator’s HTA contracts at issue in the case were futures and not
                        forwards. The administrative law judge found that the contractual terms of
                        the elevator’s HTA contracts readily allowed producers to unilaterally and
                        unequivocally avoid delivery for any reason.

                        In January 1999, CFTC filed administrative complaints against two other
                        grain elevators alleging, among other things that their HTA contracts were
                        illegal, off-exchange futures. Although the facts and circumstances differed
                        between the two cases, CFTC found in one case and charged in the other
                        that the contracts were futures, in part, because they could be terminated
                        without delivery. Dissenting against both complaints, a CFTC
                        commissioner maintained that the elevators’ HTA contracts were
                        forwards, noting that the contracts were limited to commercial parties and
                        included a contractual obligation to deliver.

                        Market Integrity/Efficiency:
Public Policy
Questions Raised by     1. What types of OTC transactions should be covered by the CEA’s
the Forward Exclusion      forward exclusion?

                        2. To what extent should the forward exclusion turn on the nature of the
                           counterparty to a forward contract?




                        Page 40                                    GAO/GGD-99-74 CFTC Reauthorization
Appendix VI

Agricultural Trade Options


                        Under the CEA of 1936, Congress banned exchange-traded and OTC
History of the Ban on   options on regulated commodities because of their suspected role in
Commodity Options       disrupting the market. Regulated commodities were those commodities
                        specifically listed in the CEA and initially included corn, wheat, oats,
                        barley, rye, flax, and sorghum. As Congress periodically amended the CEA,
                        it added other agricultural commodities to the list, effectively extending
                        the scope of the act’s options ban. In aggregate, the regulated agricultural
                        commodities became known as the enumerated commodities; all others
                        became known as the nonenumerated commodities. (See the glossary at
                        the end of the report for definitions.)

                        In 1974, Congress amended the CEA to create CFTC and bring all
                        nonenumerated commodities under federal regulation. Rather than adding
                        new commodities to the act’s list, Congress amended the commodity
                        definition with a catchall phrase to include virtually anything, thereby
                        bringing futures and options trading on all commodities under the CEA.
                        This broadening of the act’s scope was meant, in part, to address abusive
                        practices and fraud in the marketing of options on nonenumerated
                        commodities. Under the act’s authority, CFTC promulgated a regulatory
                        framework for trading these previously unregulated commodities.

                        In 1978, responding to continued fraud and abuse, CFTC suspended OTC
                        options trading on the nonenumerated commodities, except for trade
                        options—off-exchange commodity options offered or sold to commercial
                        users of the underlying commodity solely for purposes related to their
                        business. Later in 1978, Congress codified CFTC’s ban but provided CFTC
                        with the authority to lift the prohibition on trading options on
                        nonenumerated commodities after notifying Congress. The 1936 statutory
                        ban and CFTC rule prohibiting options on the enumerated commodities
                        remained in effect.

                        Since 1978, CFTC and congressional actions have narrowed the scope of
Narrowing of the        the ban on commodity options to allow for exchange-trading of options.
Commodity Option        Under a 1981 pilot program, CFTC allowed exchanges to trade options on
Trading Ban             futures contracts on the nonenumerated commodities. On the basis of the
                        experience of the pilot program, the Futures Trading Act of 1982 lifted the
                        1936 statutory ban on options on the enumerated commodities. Under a
                        1983 pilot program, CFTC allowed exchange-trading of options on futures
                        contracts on the enumerated commodities but did not allow exchange-
                        trading of options on the underlying physical commodities. CFTC
                        permitted this limited exchange-trading of options because such trading
                        would be subject to the comprehensive regulation of an exchange.




                        Page 41                                    GAO/GGD-99-74 CFTC Reauthorization
                        Appendix VI
                        Agricultural Trade Options




                        On numerous occasions since 1984, CFTC has sought public comment or
                        facilitated public discussion on lifting the prohibition on trade options on
                        the enumerated commodities. Until recent changes in U.S. agricultural
                        programs, however, industry opposition impeded a lifting of the ban.
                        Through a 1985 interpretative letter on forwards, CFTC lessened the
                        debate by permitting producers to obtain certain of the benefits associated
                        with the use of agricultural trade options by using bona fide forward
                        contracts containing option-like features. (See app. V on the forward
                        exclusion.)

                        On the basis of the results of the pilot programs and a shifting of industry
CFTC Pilot Program      views, CFTC began to consider lifting the ban on trade options on the
on Agricultural Trade   enumerated commodities. In a 1997 study, CFTC concluded that the
Options                 elimination of certain U.S. agricultural programs (e.g., elimination of crop
                        deficiency payments) and changes in international markets (resulting in
                        part from changes in trade agreements) increased uncertainty and price
                        volatility in the agricultural markets, warranting new forms of risk-shifting
                        instruments. Accordingly, in April 1998, after two rounds of public
                        comment, CFTC published rules for a 3-year pilot program for trade
                        options on the enumerated commodities. To allow for competition by the
                        exchanges, CFTC also removed the prohibition on exchange-trading of
                        options on the commodities enumerated in the act.

                        The pilot program is limited to agricultural trade options on the
                        enumerated commodities and requires that the options result in delivery of
                        the commodity. Such options may not be resold, repurchased, or otherwise
                        cancelled, except through the exercise or natural expiration of the
                        contract. Also, the pilot program permits only those entities that handle
                        the commodity in normal cash market channels to solicit, offer to buy or
                        sell, or buy or sell such options. Vendors of such options, usually grain
                        elevators, are required to register as agricultural trade option merchants
                        with NFA, report transactions to CFTC, provide customers with disclosure
                        statements, keep books and records, and safeguard customers’ premiums.
                        Certain employees of these merchants are also required to register and
                        meet training requirements. The rules also include an exemption for
                        commercials with not less than $10 million in net worth. According to
                        CFTC, the program rules were designed to protect program participants
                        and to account for recent experience with agricultural marketing schemes;
                        for example, HTA contracts. CFTC reported that although the pilot
                        program is a 3-year test, it would consider changes to these rules, as
                        experience warrants, before the conclusion of the test.




                        Page 42                                     GAO/GGD-99-74 CFTC Reauthorization
                           Appendix VI
                           Agricultural Trade Options




                           According to CFTC, as of April 20, 1999, no firm had applied to NFA to
Status of the Pilot        become an agricultural trade option merchant. Some producers and
Program                    industry representatives have told CFTC that the rules of the pilot program
                           are too onerous. In particular, they said that the delivery requirement
                           reduced the potential benefit of the options, and the paperwork
                           requirements were too burdensome. Industry representatives compared
                           the proposed regulations to other trade options that are exempt from
                           regulation. They proposed, among other changes, lowering the net worth
                           exemption to $1 million, consistent with the swap exemption. According to
                           CFTC, the lack of interest in the program may be due to producers (1) not
                           wanting to lock into prevailing low commodity prices and (2) focusing on
                           production rather than marketing strategies at the time the program was
                           introduced. Additionally, CFTC identified a general lack of knowledge
                           about the program. CFTC officials told us that the agency has issued three
                           educational brochures that will also be available on the Internet. A
                           participant at the CFTC reauthorization roundtable discussion commented
                           that CFTC regulations were an overly conservative reaction to the HTA
                           controversy. Another suggested that CFTC grant trade options an
                           exemption from the CEA similar to that provided to swaps. (See app. I on
                           CFTC exemptive authority for OTC derivatives.)

                           Market Integrity/Efficiency:
Public Policy Question
Raised by Agricultural •   How can the rules of the agricultural trade options program be changed to
Trade Options              better address industry concerns and encourage participation, while also
                           providing sufficient market and customer protections?




                           Page 43                                    GAO/GGD-99-74 CFTC Reauthorization
Appendix VII

Electronic Trading Systems


                     The Futures Trading Practices Act of 1992 mandated that CFTC
CFTC Role in         (1) facilitate the development and operation of electronic trading as an
Facilitating the     adjunct to open outcry systems and (2) assess the benefits of U.S.
Development of       electronic trading systems. Under open outcry systems, futures are traded
                     by floor participants who verbally or through hand signals make bids and
Electronic Systems   offers to each other at centralized exchange locations. In contrast, under
                     electronic trading systems, bids and offers are entered into a host
                     computer through computer terminals and then electronically matched
                     and executed. (See the glossary at the end of the report for definitions.)

                     CFTC addressed the 1992 act’s mandates in a November 1994 report. First,
                     CFTC reported that the agency facilitated the development and operation
                     of electronic trading by reviewing and approving the Chicago Mercantile
                     Exchange (CME) and New York Mercantile Exchange (NYMEX) electronic
                     trading systems. The CME system, called Globex, and the New York
                     system, called NYMEX ACCESS, began operating in 1992 and 1993,
                     respectively. (The CBT electronic system, called Project A, was approved
                     by CFTC and began operating in 1994 but was not sufficiently advanced to
                     be addressed in CFTC’s report.) CFTC also reported that it entered into
                     information-sharing arrangements with foreign regulators to assist CBT
                     and NYMEX in placing in foreign countries computer terminals that would
                     provide access to their electronic trading systems. CFTC further reported
                     working through the International Organization of Securities Commissions
                     to develop international principles for regulatory review of electronic
                     trading systems that were published in 1990. According to CFTC, it has
                     adopted these general principles, uses them as part of its process for
                     reviewing electronic trading systems, and is working with foreign
                     regulators to assess the need to update them.

                     Second, CFTC reported the results of its assessment of the CME and
                     NYMEX electronic trading systems. CFTC found that these systems
                     (1) enhanced market access by extending exchange trading hours and
                     providing direct market access, (2) improved the agency’s audit ability by
                     providing precise and unalterable audit trails, and (3) appeared to reduce
                     the opportunity for trading abuse by electronically executing trades and
                     providing precise audit trails. CFTC concluded that it needed to clarify
                     exchange responsibilities for supervising such systems and would consider
                     establishing standards and procedures for technical reviews of electronic
                     trading systems. According to CFTC officials, the agency has not explicitly
                     established such standards or procedures but has implicitly defined them
                     in its review and approval of the Cantor Financial Futures Exchange
                     (CFFE) (discussed below).




                     Page 44                                    GAO/GGD-99-74 CFTC Reauthorization
                     Appendix VII
                     Electronic Trading Systems




                     Although CBT, CME, and NYMEX principally rely on open outcry systems
Expansion of         to trade futures, they have continued their efforts to expand the use of
Electronic Trading   electronic trading systems. These efforts include introducing new
Systems              contracts for electronic trading, extending the trading hours of their
                     electronic systems so that certain contracts can be simultaneously traded
                     on the exchange floor and electronically, and increasing the number of
                     computer terminals in domestic and foreign locations. Today, all three
                     electronic systems operate internationally: CBT has terminals in France,
                     Japan, and the United Kingdom; CME has terminals in Bermuda, France,
                     Hong Kong, Japan, and the United Kingdom; and NYMEX has terminals in
                     Australia, Hong Kong, and the United Kingdom. In response to the
                     exchanges’ expansion efforts, electronic trading volume at each exchange
                     has grown rapidly. For example, CBT, CME, and NYMEX electronic
                     trading volume in 1998 exceeded the prior year’s electronic trading volume
                     by 108, 123, and 51 percent, respectively. Nonetheless, the electronic
                     trading volume at each exchange accounted for less than 5 percent of each
                     exchange’s total trading volume in 1998.

                     Major foreign futures exchanges have expanded their electronic trading
                     systems in the same ways as have U.S. exchanges. However, they are
                     taking an additional step and moving away from open outcry to electronic
                     trading systems as a means of enhancing their competitiveness. Although
                     no single data source on electronic futures trading volume exists, it has
                     been estimated that such volume accounts for about 20 to 30 percent of
                     the total trading volume worldwide, with most of the volume occurring on
                     foreign exchanges. In 1998, in response to growing competition, the
                     Deutsche Terminborse (DTB) and Swiss Options and Financial Futures
                     Exchange merged to create Eurex, a fully electronic exchange. On the
                     basis of 1998 trading volume, Eurex was the world’s fourth largest futures
                     exchange; on the basis of first quarter 1999 trading volume, it had become
                     the world’s largest futures exchange. Other foreign exchanges, such as the
                     London Financial Futures and Options Exchange and Sydney Futures
                     Exchange, are also moving toward replacing their open outcry systems
                     with electronic trading systems to reduce trading costs and enhance their
                     competitiveness. The Marche a Terme International de France completed
                     this transition in 1998.

                     Finally, U.S. and foreign exchanges are increasingly seeking electronic
                     linkages to boost volume and cut costs. For example, CME and the Marche
                     a Terme International de France have an agreement that permits each
                     exchange to trade the contracts of the other under certain circumstances.
                     These exchanges and the Singapore International Monetary Exchange
                     announced on February 8, 1999, that they are taking the additional step of



                     Page 45                                   GAO/GGD-99-74 CFTC Reauthorization
                       Appendix VII
                       Electronic Trading Systems




                       creating a common electronic trading system that will allow them to trade
                       each other’s products in the North American, European, and Asian time
                       zones. The system is expected to be operational by the third quarter of
                       1999. Also, NYMEX has arrangements with the Sydney Futures Exchange
                       and Hong Kong Futures Exchange that permit the members of these
                       foreign exchanges to trade NYMEX products.

                       According to CFTC, technological advances raise a variety of issues
Foreign Futures        concerning the degree to which a foreign futures exchange’s trading
Exchanges’ Placement   activities in the United States are subject to CFTC regulation. These issues
of Terminals in the    arise because electronic trading systems make it possible for U.S. market
                       participants to use computer terminals located in the United States to
United States          execute trades on foreign exchanges. Also, electronic order routing
                       systems enable customers to submit orders electronically to FCMs and to
                       have such orders routed to foreign exchanges for execution with little or
                       no human intervention.

                       Before placing electronic trading terminals in another country, an
                       exchange must generally obtain some form of approval from that country’s
                       regulator. In 1989, CFTC staff issued a no-action letter on the trading of
                       foreign futures contracts through CME’s Globex electronic trading system.
                       The letter stated that CFTC staff would not recommend enforcement
                       action against a foreign board of trade that listed products on Globex
                       based solely on its failure to become designated as a domestic contract
                       market. In 1996, DTB, which later merged with another foreign exchange
                       to form Eurex, was the first foreign exchange to seek and receive a no-
                       action letter from CFTC allowing placement of DTB trading terminals in
                                                                                                1
                       the U.S. offices of its member firms for executing trades on its market.
                       CFTC staff concluded that the public interest would not be adversely
                       affected because (1) no customer trading would be allowed unless the
                       DTB member was also registered with CFTC as a FCM and (2) CFTC
                       would have access to books and records either on the DTB member’s
                       premises or via information-sharing agreements with DTB’s regulator.
                       CFTC’s position was also based on the premise that DTB was a “bona fide”
                       foreign futures exchange whose main business activities occur in
                       Germany.

                       Since 1996, CFTC has received additional no-action requests as well as
                       inquiries regarding CFTC’s position on placing foreign trading terminals in
                       the United States. In general, these inquiries sought CFTC’s position on

                       1
                        The CFTC no-action letter applies only to the placement of terminals at firms that were either DTB
                       members or had memberships pending at the time of the letter.




                       Page 46                                                   GAO/GGD-99-74 CFTC Reauthorization
                   Appendix VII
                   Electronic Trading Systems




                   whether locating terminals in the United States might subject a foreign
                   exchange to regulation as a domestic contract market. Rather than issue
                   separate no-action letters, CFTC decided to address the subject through its
                   rulemaking process. CFTC issued a concept release in July 1998 to gather
                   information for use in proposing a rule on placing foreign exchanges’
                   computer terminals in the United States.

                   In March 1999, CFTC issued a proposed rule that would establish a
                   procedure under which foreign exchanges could petition CFTC to permit
                   electronic access from within the United States without being designated
                   as a domestic contract market. The rule would allow U.S. customers to use
                   order routing systems, including Internet-based systems, to enter orders
                   and would establish minimum safety standards for operating these
                   systems. Although all of the four CFTC commissioners voted to release the
                   proposed rule for comment, three of the four have expressed concerns
                   that it is overly complex, imposes unnecessary burdens, could negatively
                   affect the competitiveness of U.S. exchanges, and/or may be illegal. Some
                   participants at a recent industry conference also expressed frustration
                   with the complexity of the rule, the effect of this complexity on the time
                   that will ultimately be required for approval of the rule, and the impact on
                   the competitiveness of foreign exchanges that are currently unable to
                   access U.S. customers in the absence of a rule.

                   A CFTC representative told us that the agency considered the numerous
                   comments it received on its concept release in formulating its proposed
                   rule and was interested in working with the industry to quickly address
                   remaining concerns. On April 20, 1999, CFTC sponsored a roundtable
                   discussion of the proposed rules that was attended by representatives of
                   U.S. and foreign exchanges, U.S. and foreign brokers, foreign regulators,
                   and technology experts. The comment period on the proposed rule was to
                   expire on April 30, 1999.

                   In September 1998, CFFE was approved by CFTC and began electronically
Novel Electronic   trading U.S. Treasury futures contracts. CFFE is jointly operated by the
Futures Trading    New York Cotton Exchange, a CFTC-designated exchange, and Cantor
Systems            Fitzgerald, an interdealer-broker in the U.S. Treasury securities market.
                   The New York Cotton Exchange is responsible for all of CFFE’s self-
                   regulatory responsibilities, and Cantor Fitzgerald provides the electronic
                   trading system that CFFE uses to match and execute trades. Certain
                   market participants, including FCMs and their approved customers, have
                   direct keyboard access to the electronic trading system. Others must
                   submit their orders to terminal operators, who are agents of the exchange
                   but employees of Cantor Fitzgerald. Although CFFE is subject to generally



                   Page 47                                    GAO/GGD-99-74 CFTC Reauthorization
                     Appendix VII
                     Electronic Trading Systems




                     the same CFTC regulations as open-outcry exchanges, as with other CFTC-
                     approved electronic trading systems, a number of regulations do not apply
                     because of the lack of a physical trading floor. For example, CFTC’s
                     regulation on collecting physical trading records is not applicable to CFFE,
                     because CFFE trade data are generated and recorded electronically.

                     In January 1997, FutureCom, a Texas limited partnership, applied to CFTC
                     for designation as an electronic exchange for trading cattle futures and
                     options over the Internet. Subsequently, it applied for designation as a
                     contract market for technology stock index futures and options. If
                     approved, FutureCom will be the first electronic futures exchange
                     available over the Internet. In March 1998, CFTC stayed FutureCom’s
                     application, pending the receipt of additional information. CFTC has
                     continued to work with FutureCom to resolve open issues.

                     Participants in the CFTC reauthorization roundtable generally agreed that
Industry Views on    electronic futures trading systems will likely replace open outcry, because
Electronic Trading   they are potentially less costly, can be expanded more easily, and provide
                     greater market access. Participants commented that U.S. exchanges need
                     to expand their electronic trading systems to remain competitive. One
                     participant noted that foreign futures exchanges have made more progress
                     than U.S. exchanges in moving toward electronic trading and that the trend
                     toward electronic trading has put competitive pressure on U.S. exchanges.
                     One participant said that U.S. exchanges could probably remain
                     competitive using open outcry for a few more years, because their higher
                     costs are allocated among a high volume of trades. Other participants said
                     that U.S. exchanges need to move much more quickly toward electronic
                     trading to remain competitive. Finally, one participant commented that
                     exchange members, not CFTC, have limited the progress of the U.S.
                     exchanges in moving toward electronic trading.

                     Some roundtable participants opined that the evolution toward electronic
                     trading could raise a number of regulatory issues. A former CFTC
                     chairman said that his review of the CEA revealed 122 requirements—55
                     percent of which did not apply to electronic trading. Other participants
                     commented that electronic trading could eventually lead to principal-to-
                     principal trades, thereby eliminating the need for intermediaries. Such a
                     possibility raises questions about who would need to be registered and
                     what customer protections would be needed. They added that the
                     elimination of intermediaries could call into question the meaning of an
                     exchange membership and lead to changes in the ownership structure of
                     exchanges.




                     Page 48                                    GAO/GGD-99-74 CFTC Reauthorization
                      Appendix VII
                      Electronic Trading Systems




                      The former CFTC chairman elaborated in a futures industry publication
                      that without an intermediary, CFTC’s principal antifraud provision, which
                      applies only when an agent is used, would no longer protect most traders
                      who deal directly with each other. He questioned the future of CFTC’s
                      customer protection programs when traders dealing directly with each
                      other are no longer considered to be customers. Finally, he suggested that
                      without either the traditional exchange structure and intermediaries, it
                      may be feasible to rely on the same consumer protection laws that apply to
                      other types of electronic commerce.

                      In March 1999, the CFTC chairperson testified that electronic trading
                      systems might diminish certain regulatory concerns relating to trading
                      abuses in open outcry trading. However, she noted that such systems raise
                      other regulatory issues concerning system capacity and security, which are
                      not applicable in an open outcry environment. Moreover, she added that
                      the need for fitness standards for intermediaries and customer protection
                      measures may become less important with the greater direct access
                      associated with electronic trading. Finally, the chairperson said that CFTC
                      has insufficient experience with electronic systems to identify all of the
                      risks they currently pose.

                      At a March 1999 futures industry conference, participants cited the need
                      for common rules and procedures to facilitate use of electronic systems,
                      including rules related to trading, cross-margining, cross-exchange access,
                      and resolving errors. The importance of preorder entry risk management
                      controls was cited as a means to control traders that exceed trading limits.
                      Establishing separate rules for retail and wholesale market participants
                      transacting electronically was also suggested.

                      Financial Integrity/Systemic Risk and Market Integrity/Efficiency:
Public Policy
Questions Raised by   1. What novel risks or other concerns do electronic trading systems raise;
Electronic Futures       and which, if any, CEA provisions need to be amended to address
                         them?
Trading Systems
                      2. What principles should guide CFTC’s regulatory treatment of foreign
                         futures exchanges that operate electronic trading systems in the
                         United States?




                      Page 49                                    GAO/GGD-99-74 CFTC Reauthorization
Appendix VII
Electronic Trading Systems




Consumer Protection:

3. To what extent have technological advances in electronic trading and
   related systems altered the nature of the relationship between
   customers and FCMs, including their rights and responsibilities?




Page 50                                  GAO/GGD-99-74 CFTC Reauthorization
Appendix VIII

International Regulatory Coordination


                         The Futures Trading Practices Act of 1992 provided CFTC authority to
Use of CFTC              protect confidential information received from foreign regulators and to
Expanded Authority       conduct investigations on their behalf. These enhanced powers were
and Limits to Its        intended to facilitate the signing of agreements between CFTC and foreign
                         regulatory authorities. According to the International Organization of
Authority                Securities Commissions, at the end of 1998, CFTC was a party to 36 of
                         these information-sharing and coordination agreements. Two key
                         agreements resulted from the 1995 collapse of Barings Plc. and the 1996
                         Sumitomo Corporation copper trading scandal. (See the glossary at the
                         end of the report for definitions.)

                         The 1995 Barings collapse—precipitated by losses on unauthorized futures
                         trades—led to the Windsor Declaration. The declaration proposed actions
                         that regulators and exchanges should take to address weaknesses in
                         international regulatory coordination and cooperation. In March 1996, 14
                         international futures regulators implemented the declaration by entering
                         into a multilateral agreement, called the Boca Declaration. A companion
                         memorandum of understanding was signed by 49 international futures
                         exchanges and clearing organizations. Both the declaration and the
                         memorandum of understanding authorized the signatories to share
                         information on common members’ or affiliates’ financial resources or
                         market exposure after certain triggering events occurred. To date, the
                         declaration has been signed by 25 regulators and the memorandum of
                         understanding by 65 exchanges and clearing organizations.

                         Trading by a Sumitomo employee in the United Kingdom, disclosed
                         publicly in 1996, disrupted the U.S. and U.K. copper markets. As a result of
                         this episode, in October 1997, CFTC and 16 foreign regulators signed the
                         Tokyo Communiqué. This agreement established international standards
                         for contract design, market surveillance, and information sharing in
                         markets where physical delivery is made. The Sumitomo case also raised
                         questions about the adequacy of CFTC authority to monitor and regulate
                         delivery locations in the United States for contracts listed on foreign
                         exchanges. The 1997 Senate bill (S. 257) to amend the CEA contained a
                         provision that would have required CFTC to consult with foreign
                         jurisdictions to obtain assurances that delivery locations specified in
                         foreign futures contracts would not create the potential for price
                         manipulation or any other disruption in U.S. markets.

                         In July 1997, CFTC created the Office of International Affairs to serve as
CFTC’s Additional        the focal point for the agency’s global regulatory coordination efforts.
Focus on International   According to CFTC, the office was created so that the agency could
Concerns                 respond quickly to market crises that have global systemic implications;



                         Page 51                                     GAO/GGD-99-74 CFTC Reauthorization
                        Appendix VIII
                        International Regulatory Coordination




                        remain an effective supervisor in a global marketplace where no one
                        regulator has all of the information or resources to regulate its markets or
                        firms; and eliminate unnecessary impediments to global business, while
                        preserving core protections for markets and customers.

                        In March 1998, CFTC established the Global Markets Advisory Committee,
                        an industry forum for discussing issues raised by the globalization of the
                        futures markets. Committee members include representatives of U.S.
                        exchanges, futures firms, and market users most directly involved in and
                        affected by global operations.

                        Market observers have emphasized the need for CFTC to continue its
Industry Observations   efforts to coordinate with foreign regulators as the trend towards global
                        electronic trading accelerates. Participants at a March 1999 futures
                        industry conference also emphasized the importance of coordination to
                        harmonize international trading and clearing rules and international
                        bankruptcy laws. In the absence of a global clearinghouse, the need for
                        standardized clearing software to reduce costs was suggested. One
                        industry official expressed the view that a network of information sharing
                        among global regulators was needed to address market abuse. Another
                        industry official suggested that recent events affecting the futures markets
                        suggest that financial integrity, clearing, and systemic risk are the most
                        important international issues. (Also, see app. I on CFTC exemptive
                        authority for OTC derivatives and app. VII on electronic trading systems.)

                        Financial Integrity/Systemic Risk:
Public Policy
Questions Related to    1. What financial integrity/systemic risk issues, if any, are raised by
International              differences in international regulations, and what steps are being taken
                           to address them?
Regulatory
Coordination            2. What changes, if any, are needed in CFTC’s authority over U.S. delivery
                           points for contracts listed on foreign futures exchanges?

                        Customer Protection:

                        3. What customer protection issues, if any, do differences in international
                           regulations raise for U.S. market participants, and what steps are being
                           taken to address them?




                        Page 52                                     GAO/GGD-99-74 CFTC Reauthorization
Appendix IX

Legislative History of the Commodity
Exchange Act

                          The Grain Futures Act of 1922 was enacted in response to speculative
Grain Futures Act of      excesses and price manipulation on the grain exchanges during a period of
1922 (42 Stat. 998)                                                              1
                          declining commodity prices and a farming depression. The regulatory
                          framework established by the act relied primarily on exchange self-
                          governance, subject to the Secretary of Agriculture’s oversight. Among its
                          major provisions, the 1922 act

                        • prohibited off-exchange trading of futures on an enumerated commodity
                          (corn, wheat, oats, barley, rye, flax, and sorghum) if a futures contract on
                          that enumerated commodity is traded on a board of trade designated as a
                          contract market by the Secretary of Agriculture;
                        • imposed conditions for designation as a contract market, including
                          requiring boards of trade to adopt rules for (1) disseminating market
                          information, (2) preventing dissemination of false information, (3)
                          preventing manipulations, and (4) maintaining records and providing
                          reports;
                        • excluded contracts for deferred shipment or delivery—forwards—from
                          regulation under the act;
                        • authorized the Secretary of Agriculture to investigate the operations of
                          boards of trade;
                        • established a commission composed of the Secretary of Agriculture,
                          Secretary of Commerce, and the Attorney General to (1) suspend a board
                          of trade’s designation as a contract market if the board failed to comply
                          with or enforce conditions of designation; (2) review a denial of
                          designation by the Secretary of Agriculture; and (3) suspend any person’s
                          trading privileges on the basis of evidence presented by the Secretary of
                          Agriculture that the person violated the act, attempted a manipulation, or
                          violated antimanipulation rules; and
                        • imposed criminal (misdemeanor) sanctions for off-exchange trading in the
                          enumerated commodities and the dissemination of false information that
                          could affect grain prices.

                          The Commodity Exchange Act (CEA) of 1936 was passed after the grain
Commodity Exchange        price collapse of 1933—believed to be a result of continued market
Act of 1936 (49 Stat.     manipulation and the failure of a large brokerage house. The act provided
1491)                     for more extensive regulation of the markets and their participants. Among
                          its major provisions, the 1936 act


                          1
                           In 1921 Congress enacted the Futures Trading Act, which imposed a tax on grain futures transactions
                          that were not consummated on an exchange designated as a contract market by the Secretary of
                          Agriculture. The statute was held unconstitutional as an improper exercise of the taxing power
                          provided in the Constitution. The Grain Futures Act of 1922 reenacted the statute’s regulatory
                          provisions, but omitted its unlawful taxing power provisions.




                          Page 53                                                  GAO/GGD-99-74 CFTC Reauthorization
                         Appendix IX
                         Legislative History of the Commodity Exchange Act




                       • added cotton, rice, mill feeds, butter, eggs, and Irish potatoes to the
                         enumerated commodities subject to the act;
                       • expanded the prohibition against off-exchange trading to any futures
                         contract on an enumerated commodity;
                       • prohibited options on the enumerated commodities;
                       • provided for the Secretary of Agriculture to (1) impose limits on
                         speculative trading in futures or in the underlying commodity (speculative
                         position limits) and (2) specify thresholds for the mandatory reporting of
                         large positions in futures or in the underlying commodity (large trader
                         reporting);
                       • specifically outlawed fraudulent conduct in connection with futures trades
                         by members of contract markets and certain affiliated persons; prohibited
                         specific forms of sham trading and any transaction used to cause an
                         artificial price; and required registration of futures commission merchants
                         (FCM) and floor brokers;
                       • authorized the Secretary of Agriculture to suspend the trading privileges of
                         any person who violated the act or related regulations and to suspend or
                         revoke the registrations of FCMs and floor brokers;
                       • expanded the activities subject to criminal (misdemeanor) sanctions to
                         include fraud, manipulation, off-exchange trading, and violations of
                         speculative trading limits and registration requirements;
                       • designated the commission established under the Grain Futures Act as the
                         Commodity Exchange Commission and authorized it to (1) establish and
                         enforce the speculative trading limits and (2) issue a cease and desist
                         order (rather than withdrawal of designation) to contract markets that
                         violated the act or related rules and regulations; and
                       • changed the name of the Grain Futures Act of 1922 to the “Commodity
                         Exchange Act.”

                         In 1938, wool tops were added to the commodities subject to the act; and
Amendments to the        in 1940, fats and oils, cottonseed, cottonseed meal, peanuts, soybeans, and
CEA Between 1936 and     soybean meal were added. Wool (as distinguished from wool tops) was
1968                     added in 1954, and the act was made applicable to onions in 1955. In 1958,
                         the act was amended to prohibit futures trading in onions but did not
                         remove onions from the list of commodities covered by the act.

                         As the futures markets grew, additional measures were considered
1968 Amendments to       necessary to protect the public interest and enhance regulatory
the CEA (Pub. L. No.     effectiveness. Among their major provisions, the 1968 amendments
90-258)
                       • expanded the prohibition against fraudulent conduct to apply to any
                         person acting in connection with an exchange-traded futures contract;




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                         Appendix IX
                         Legislative History of the Commodity Exchange Act




                       • required FCMs to satisfy minimum net financial requirements pursuant to
                         regulations of the Secretary of Agriculture or rules of a designated contract
                         market;
                       • enhanced enforcement under the act by (1) requiring registrants (FCMs
                         and floor brokers) to make required reports and maintain and grant access
                         to books and records, (2) requiring designated contract markets to enforce
                         their bylaws and rules related to the terms and conditions of futures
                         contracts and member FCM minimum financial standards, (3) authorizing
                         the Commodity Exchange Commission to suspend the designation of a
                         board of trade that failed to enforce its rules, (4) authorizing the Secretary
                         of Agriculture to use cease and desist orders, and (5) increasing criminal
                         penalties (from misdemeanor to felony) for defalcation of customer funds
                         and manipulation and distribution of false information to affect commodity
                         prices; and
                       • added livestock, livestock products, and frozen concentrated orange juice
                         to the commodities enumerated for regulation under the act.

                         After the enactment of the 1968 amendments to the CEA, the federal
Commodity Futures        government stopped using stockpiles of commodities to stabilize prices,
Trading Commission       thereby allowing prices to fluctuate freely on the basis of market supply
Act of 1974 (Pub. L.     and demand factors. The greater price volatility brought commercials into
                         the market who sought to protect themselves from the risks associated
No. 93-463)              with wide price swings as well as the general public, including speculators,
                         who hoped to profit from them. As a result, the futures market began to
                         play an increasingly important role in the pricing of the nation’s
                         commodities. In passing the Commodity Futures Trading Commission
                         (CFTC) Act of 1974, Congress concluded that the economic significance of
                         futures trading had reached a level that warranted expanding the scope of
                         regulation to cover unregulated commodities as well as creating an
                         independent agency to regulate the market. Among its major provisions,
                         the 1974 act

                       • expanded CEA coverage from the statutory list of enumerated physical
                         commodities to include futures contracts on all goods, articles (except
                         onions), services, and rights and interests, thereby defining the term
                         commodity to include anything on which a contract is traded (except
                         onions);
                       • created an independent regulatory agency, CFTC, and provided it with,
                         among other things,




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                             Appendix IX
                             Legislative History of the Commodity Exchange Act




                             • exclusive jurisdiction over all transactions involving futures contracts,
                                        2
                                options, and leverage transactions on gold and silver bullions and coins;
                             • enhanced enforcement and oversight powers, including authority to
                                impose civil money penalties for certain violations;
                             • reparations authority; and
                             • authority to order exchanges to act in a market emergency;
                         •   included the Treasury Amendment, which excluded certain transactions
                             from coverage under the act, including transactions involving foreign
                                                                         3
                             currencies and U.S. government securities;
                         •   created three new classes of registrants--(1) commodity trading advisors,
                             (2) commodity pool operators, and (3) associated persons of FCMs;
                         •   provided for the creation and registration of registered futures
                             associations to enhance industry self-regulation and facilitate increased
                             public and commercial participation in the futures markets;
                         •   increased criminal penalties for violations of the antifraud,
                             antimanipulation, and certain other provisions of the act; and
                         •   authorized appropriations for fiscal years 1975 through 1978.

                             During hearings on the Futures Trading Act of 1978, CFTC was criticized
Futures Trading Act of       for ineffective management and failure to fully implement the 1974 act.
1978 (Pub. L. No. 95-        Transferring some or all of CFTC’s functions to the U.S. Department of
405)                         Agriculture, Department of the Treasury, the Securities and Exchange
                             Commission (SEC), or any combination of these agencies was discussed,
                             but related action was not taken. Among its major provisions, the 1978 act

                         • required CFTC to consult with the Department of the Treasury, the Board
                           of Governors of the Federal Reserve System, and SEC about (1) CFTC
                           activities that relate to the responsibilities of these agencies; and (2) the
                           relationships among futures trading, securities, and other financial
                           instruments;
                         • provided CFTC authority to develop a user-fee system to offset the costs of
                           regulation;
                         • authorized states to bring judicial actions against persons other than
                           contract markets, clearinghouses, and floor brokers to enforce the CEA or
                           CFTC regulations;
                         • increased criminal penalties for certain violations;
                         • imposed restrictions on options trading until CFTC reported to Congress
                           on its ability to regulate such trading;
                             2
                              The 1974 amendments preserved the prohibition on options on commodities listed in the act before
                             the 1974 amendments—the enumerated commodities.
                             3
                              The amendment clarified that the CEA did not prohibit off-exchange trading in foreign currencies and
                             certain other financial instruments.




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                           Appendix IX
                           Legislative History of the Commodity Exchange Act




                         • authorized CFTC to prohibit or regulate leverage transactions in non-
                           agricultural commodities; and
                         • authorized appropriations for fiscal years 1979 through 1982.

                           The Futures Trading Act of 1982 addressed issues arising from the
Futures Trading Act of     continued expansion of the financial futures markets and increased
1982 (Pub. L. No. 97-      commercial and public participation in the futures markets, including the
444)                       silver market crisis of 1979 and 1980. Among its major provisions, the 1982
                           act

                         • codified the Shad-Johnson Jurisdictional Accord, a 1981 agreement
                           between CFTC and SEC that clarified their jurisdictions with respect to
                           securities-related instruments by
                           • granting CFTC exclusive jurisdiction over futures on a group or an index
                              of securities as well as options on such futures, subject to certain
                              conditions, including (1) cash settlement or some other means of
                              settlement not calling for transfer of a covered security, (2) adequate
                              antimanipulation safeguards, and (3) a general prohibition on over
                                                                                         4
                              concentration of a covered index or group of securities;
                           • excluding from CFTC jurisdiction options on any security or group or
                                                  5
                              index of securities; and
                           • prohibiting futures contracts on individual securities that are subject to
                              SEC regulatory oversight;
                         • removed the ban on options on the enumerated commodities and
                           authorized CFTC to establish a pilot program for trading such options;
                         • established a 1 year time limit for CFTC decisions on applications for
                           contract market designation;
                         • provided for judicial review of a CFTC determination that a market
                           emergency exists;
                         • required CFTC to regulate leverage transactions in nonagricultural
                           commodities, subject to a public interest consideration;
                         • enhanced CFTC registration authority and provided for statutory
                           disqualification;
                         • authorized registered futures associations to perform CFTC registration
                           functions and required them to establish CFTC-approved member
                           standards for training, solicitations, and financial integrity;
                         • authorized the states to enforce CEA antifraud provisions in state courts
                           against all registrants, except floor brokers and registered futures

                           4
                             These contracts were also subject to initial SEC review for compliance with the three requirements
                           listed in the text.
                           5
                               Separate legislation granted SEC jurisdiction over these instruments.




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                           Appendix IX
                           Legislative History of the Commodity Exchange Act




                           associations, and provided for state regulation of off-exchange
                           instruments;
                         • ordered federal financial regulators (the Federal Reserve, CFTC, and SEC,
                           with assistance from the Department of the Treasury) to study the effects
                           of trading futures and options on the U.S. economy;
                         • authorized private rights of action against most registrants for violation of
                           the act; and
                         • authorized CFTC appropriations through fiscal year 1986.

                           Among its major provisions, the Futures Trading Act of 1986
Futures Trading Act of
1986 (Pub. L. No. 99-    • enhanced CFTC enforcement powers by (1) clarifying that CEA antifraud
641)                       provisions apply to off-exchange instruments and not just exchange-traded
                           instruments and (2) authorizing extraterritorial service of administrative
                           subpoenas;
                         • removed pilot status from exchange-traded agricultural options and
                           authorized permanent, general regulation of such options by CFTC;
                         • prohibited leverage transactions in commodities other than silver, gold,
                           and platinum and required CFTC to coordinate a study of leverage
                           transactions; and
                         • authorized appropriations through fiscal year 1989.

                           By authorizing CFTC to grant exemptions from most provisions of the
Futures Trading            CEA, the Futures Trading Act of 1992 provided a means of alleviating (1)
Practices Act of 1992      the legal uncertainty for the multitrillion-dollar over-the-counter
(Pub. L. No. 102-546)      derivatives market and (2) the regulatory burden on futures exchanges.
                           The act also addressed trade practice, recordkeeping, and corporate
                           governance issues that surfaced in 1989 as a result of (1) Federal Bureau of
                           Investigation undercover sting operations at selected futures exchanges
                           and (2) the declaration of an emergency in the soybean market. In
                           addition, the act addressed concerns that surfaced during the market crash
                           of 1987 about the need for greater international cooperation and
                           coordination and for more information on material affiliated persons—
                           those entities with a relationship to an FCM such that their business
                           activities were reasonably likely to have a material impact on the financial
                           and operational condition of the FCM. Among its major provisions, the
                           1992 act

                         • authorized CFTC to exempt any contract from almost all provisions of the
                           CEA, including the exchange-trading requirement;
                         • established stringent exchange audit trail requirements;
                         • established trading restrictions and disclosure requirements for associated
                           floor brokers;


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                          Appendix IX
                          Legislative History of the Commodity Exchange Act




                        • required registered futures associations and boards of trade to provide for
                          fair representation of interests in self-governance and disciplinary
                          proceedings and public disclosure of major violations of pertinent rules;
                        • required exchanges to adopt conflict-of-interest rules;
                        • required registered futures associations to establish supervisory guidelines
                          to curb telemarketing fraud;
                        • granted oversight authority for setting margins on stock-index futures and
                          options thereon to the Federal Reserve;
                        • enhanced registration fitness and disqualification criteria, strengthened
                          enforcement powers and sanctions, increased criminal penalties for
                          certain violations of the act, and added criminal sanctions for insider
                          trading;
                        • directed CFTC to facilitate the development and operation of
                          computerized trading as an adjunct to open outcry;
                        • required ethics training for registrants;
                        • required CFTC to study the effects of CFTC-imposed penalties, the
                          competitiveness of domestic boards of trade with foreign boards of trade,
                          and the potential for computerized trading;
                        • encouraged CFTC cooperation with and participation in actions by foreign
                          futures authorities;
                        • authorized CFTC to collect information from FCMs about the activities
                          and financial condition of material affiliated persons for use in assessing
                          the risks that they pose to the FCM;
                        • prohibited insider trading by self-regulatory organization employees or
                          officials; and
                        • authorized appropriations through fiscal year 1994.

                          The CFTC Reauthorization Act of 1995 authorized appropriations through
CFTC Reauthorization      fiscal year 2000.
Act of 1995 (Pub. L.
No. 104-9)
                          In response to concerns of Congress, federal financial market regulators,
Omnibus                   and market participants that CFTC intended to propose or issue new
Appropriations Act of     regulations covering swaps and hybrid financial instruments, the Omnibus
1998 (Pub. No. 105-       Appropriations Act of 1998 prohibited CFTC from taking such action until
                          March 31, 1999.
277)




                          Page 59                                             GAO/GGD-99-74 CFTC Reauthorization
Appendix X

Participants at CFTC Reauthorization
Roundtable Discussion Held in Washington,
D.C., on February 25 and 26, 1999
              Philip McBride Johnson—Skadden, Arps, Slate, Meagher & Flom LLP
Moderators
              Robert K. Wilmouth—National Futures Association



              John C. Coffee, Jr.—Columbia University School of Law
Panelists
              George E. Crapple—Millburn Ridgefield Corp.

              David G. Downey—Timber Hill LLC

              Gerald Gulke—Strategic Marketing Services, Inc.

              Robert W. Kohlmeyer—World Perspectives, Inc.

              Howard Kramer—Schiff, Hardin & Waite

              Robert J. Mackay—National Economic Research Associates, Inc.

              Leo Melamed—Sakura Dellsher, Inc.

              Merton H. Miller—University of Chicago

              Ernest Patrikis—American International Group

              Todd E. Petzel—The Common Fund

              David M. Pryde—J.P. Morgan Futures, Inc.

              Thomas A. Russo—Lehman Brothers Inc.

              Richard L. Sandor—Environmental Financial Products

              Charles W. Smithson—CIBC World Markets

              Steven Spence—Merrill Lynch & Company

              John A. Wing—Illinois Institute of Technology

              Note: The roundtable is also referred to as the “House and Senate Agriculture Committees’ Futures,
              Derivatives, and Public Policy Roundtable.”




              Page 60                                                  GAO/GGD-99-74 CFTC Reauthorization
Appendix XI

Major Contributors to This Report


                        Richard J. Hillman, Associate Director
General Government
Division, Washington,
D.C.

                        Cecile O. Trop, Assistant Director
Chicago Field Office    Roger E. Kolar, Senior Evaluator
                        Richard S. Tsuhara, Senior Evaluator
                        Angela Pun, Evaluator

                        Paul G. Thompson, Senior Attorney
Office of the General
Counsel




                        Page 61                                  GAO/GGD-99-74 CFTC Reauthorization
Glossary


Agricultural trade option    Agricultural trade option merchants are eligible vendors under the
                             Commodity Futures Trading Commission (CFTC) agricultural trade option
merchants                    pilot program for off-exchange trade options on commodities enumerated
                             in the Commodity Exchange Act (CEA). Eligible vendors are entities that
                             handle the commodity in normal cash market channels. They are required
                             to register with the National Futures Association, report transactions to
                             CFTC, provide customers with disclosure statements, keep books and
                             records, and safeguard customers’ premiums.

Associated person            An associated person is a person associated with any futures commission
                             merchant, introducing broker, commodity trading advisor, commodity
                             pool operator, or leverage transaction merchant as a partner, officer,
                             employee, consultant, or agent, or any person occupying a similar status or
                             performing similar functions, in any capacity that involves (1) the
                             solicitation or acceptance of customer orders, discretionary accounts, or
                             participation in a commodity pool (other than in a clerical capacity); or (2)
                             the supervision of any person or persons so engaged.

Audit trails                 Audit trails are the records of the price and time of each trade; they
                             generally consist of customer order tickets and timestamps, trading cards,
                             trade execution times, and exchange records of price changes.

Bank for International       The Bank for International Settlements was established in 1930 in Basle,
                             Switzerland, by six Western European central banks and a U.S. financial
Settlements                  institution. One of its functions is to provide a forum for cooperative
                             efforts by the central banks of major industrial countries.

Basis                        Basis is the difference between the current cash price of a commodity and
                             the futures price of the same commodity.

Board of trade               A board of trade is any exchange or association, whether incorporated or
                             unincorporated, of persons who are engaged in the business of buying or
                             selling any commodity or receiving the same for sale on consignment.

Brent oil energy contracts   Brent oil energy contracts are over-the-counter (OTC) transactions 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.

Call option                  Call option (See option.)




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                             Glossary




Cantor Financial Futures     Cantor Financial Futures Exchange is an electronic exchange jointly
                             operated by the New York Cotton Exchange, a CFTC-designated exchange,
Exchange                     and Cantor Fitzgerald, an interdealer-broker in the U.S. Treasury securities
                             market. The New York Cotton Exchange is responsible for self-regulatory
                             responsibilities, and Cantor Fitzgerald provides the electronic trading
                             system that the Cantor Financial Futures Exchange uses to match and
                             execute trades.

Capital requirements         Capital requirements are requirements, regulatory or self-imposed, to hold
                             a specific amount of capital to cushion against potential losses.

Clearance                    Clearance is the process of capturing the trade data, comparing buyer and
                             seller versions of the data, and—in traditional exchange-style clearing—
                             guaranteeing that the trade will settle once the data are matched.

Clearinghouse                A clearinghouse is responsible for the daily clearance and settlement of
                             trades.

Commercials                  Commercials (buyers/sellers) are entities involved in the production,
                             processing, or merchandising of a commodity.

Commodities                  Commodities, as defined in the CEA, are all agricultural goods listed in the
                             act; and all other goods and articles, except onions; and all services, rights,
                             and interests in which contracts for future delivery are presently or in the
                             future dealt in.

Commodity pool operators     Commodity pool operators are individuals or firms in businesses similar to
                             investment trusts or syndicates that solicit or accept funds, securities, or
                             property for the purpose of trading futures or commodity options.

Commodity trading advisors   Commodity trading advisors are individuals or firms that, for pay, issue
                             analyses or reports concerning commodities, including the advisability of
                             trading futures or commodity options.

Contract markets             Contract markets are boards of trade or exchanges designated by CFTC to
                             trade specified futures or options under the CEA.

Credit risk                  Credit risk is the risk of counterparty default.

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




                             Page 63                                      GAO/GGD-99-74 CFTC Reauthorization
                          Glossary




Derivatives               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.

Enumerated commodities    Enumerated commodities are specifically identified in the CEA as being
                          regulated under the act. These include wheat, cotton, rice, corn, oats,
                          barley, rye, flaxseed, grain sorghums, mill feeds, butter, and eggs.

Equity swap               A swap whose return is based on the price of a stock or stock index. (See
                          securities-based swap.)

Exercise of an option     Exercise of an option is to elect, if a call option, to purchase the underlying
                          commodity or financial asset at the option exercise (strike) price or, if a
                          put option, to sell the underlying commodity or financial asset at the
                          option exercise (strike) price.

Exercise (strike) price   Exercise (strike) price is the price specified in the option contract at
                          which the buyer of a call option can purchase the underlying commodity
                          or financial asset during the life of the option, and the price specified in the
                          option contact at which the buyer of a put option can sell the underlying
                          commodity or financial asset during the life of the option.

Federal Housing           The Federal Housing Administration is a wholly owned government
                          corporation, established under the National Housing Act of 1934, to
Administration            improve housing standards and conditions; to provide an adequate home
                          financing system through insurance of mortgages; and to stabilize the
                          mortgage market. The Federal Housing Administration was consolidated
                          into the newly established Department of Housing and Urban Development
                          in 1965.

Floor brokers             Floor brokers execute trades for customers and may also execute trades
                          for their personal or employer accounts in any pit, ring, post, or other
                          place provided by a contract market for the meeting of persons similarly
                          engaged.

Floor traders             Floor traders (also called locals) execute trades for their own accounts in
                          any pit, ring, post, or other place provided by a contract market for the
                          meeting of persons similarly engaged.

Forward contracts         Forward contracts, according to CFTC, are privately negotiated cash
                          transactions in which commercial buyers and sellers agree upon the
                          delivery of a specified quantity and quality of goods at a specified future



                          Page 64                                      GAO/GGD-99-74 CFTC Reauthorization
                             Glossary




                             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.

Futures commission           Futures commission merchants are individuals, corporations, associations,
                             partnerships, and trusts that solicit or accept orders to buy or sell futures
merchants                    contracts and accept payment from or extend credit to those whose orders
                             are accepted.

Futures contracts            Futures contracts are agreements 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 date. These contracts may be satisfied by
                             delivery or offset.

Globex                       Globex is an electronic trading system developed by the Chicago
                             Mercantile Exchange that allows exchange members to trade futures and
                             options products.

Government National          The Government National Mortgage Association (also known as GNMA or
                             Ginnie Mae) is a government agency within the Department of Housing
Mortgage Association         and Urban Development that, among other things, guarantees payment on
                             mortgage-backed certificates.

Government National          Government National Mortgage Association pass-through mortgage-
                             backed certificates are backed by pools of Federal Housing
Mortgage Association pass-   Administration-insured and/or Veterans Administration-guaranteed
through mortgage-backed      residential mortgages, with the mortgage and note held in safekeeping by a
certificates                 custodial financial institution. The certificates are guaranteed by the
                             Government National Mortgage Association (also known as GNMA or
                             Ginnie Mae).

Hedge                        Hedge is to protect against adverse changes in the value of assets or
                             liabilities.

Hedge fund                   Hedge fund is a term that is commonly used to describe private investment
                             vehicles that engage in active trading of various types of securities and
                             commodities, employing investment techniques, such as arbitrage,
                             leveraging, and hedging.

Hedge-to-arrive contracts    Hedge-to-arrive contracts are OTC transactions in agricultural
                             commodities in which the basis, which makes up part of the contract
                             price, is not set at the time that the parties enter into the contract.




                             Page 65                                     GAO/GGD-99-74 CFTC Reauthorization
                             Glossary




Hybrids                      Hybrids are financial instruments that possess, in varying combinations,
                             characteristics of forwards, futures, options, securities, and/or bank
                             deposits.

Interbank market             The interbank market is an informal network of banks and dealers that
                             serves the needs of international business to hedge risk stemming from
                             foreign exchange rate movements. It includes not only banks but also
                             other financial institutions and industrial corporations.

Index participations         Index participations were contracts introduced by certain securities
                             exchanges in 1989 to allow investors to buy a portfolio position in an index
                             of stocks without buying the individual stocks. The contracts stopped
                             trading when a federal court ruled that these were futures contracts and
                             thus could be offered only on CFTC-regulated futures exchanges.

International Organization   The International Organization of Securities Commissions includes
                             securities administrators from over 60 countries and facilitates efforts to
of Securities Commissions    coordinate international securities regulation.

International Swaps and      The International Swaps and Derivatives Association is a trade association
                             that represents more than 150 financial institutions worldwide. Its
Derivatives Association      members include investment, commercial, and merchant banks that deal in
                             OTC derivatives contracts.

Introducing broker           An introducing broker is any person (other than a person registered as an
                             associated person of a futures commission merchant) who is engaged in
                             soliciting or accepting orders for the purchase or sale of any commodity
                             for future delivery on an exchange who does not accept any money,
                             securities, or property to margin, guarantee, or secure any trades or
                             contracts that result therefrom.

Large trader reporting       Large trader reporting is required when a trader holds or controls a
                             position in any one future or in any one option expiration series of a
                             commodity on any one contract market equaling or exceeding the
                             exchange or CFTC-specified reporting level.

Legal risk                   Legal risk is the possibility of financial loss resulting from an action by a
                             court, regulatory authority, or legislative body that invalidates a contract.

Leverage contract or         A leverage contract or transaction is a standardized OTC agreement for the
                             delivery of a commodity with payments on the contract spread out over a
transaction                  period of time.




                             Page 66                                      GAO/GGD-99-74 CFTC Reauthorization
                              Glossary




Leverage transaction          A leverage transaction merchant is any individual, association, partnership,
                              corporation, or trust that is engaged in the business of offering to enter
merchant                      into, entering into, or confirming the execution of leverage contracts, or
                              soliciting or accepting orders for leverage contracts, and who accepts
                              leverage customer funds or extends credit in lieu of those funds.

Liquidity                     Liquidity is the extent to which market participants can buy and sell
                              contracts in a timely manner without changing the market price.

Locals                        Locals (See floor traders.)

Long                          Long is one who has bought a futures contract to establish a market
                              position; a market position that obligates the holder to take delivery; or
                              one who owns an inventory of commodities. (See short.)

Margins                       Margins, in the futures markets, are the cash or collateral deposited by
                              market participants with their futures commission merchants for the
                              purpose of protecting the futures commission merchants and, ultimately,
                              clearinghouses against loss on open exchange-traded futures contracts.

Market risk                   Market risk, also called price risk, is the exposure to the possibility of
                              financial loss caused by adverse changes in the value of assets or
                              liabilities.

Manipulation                  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.

Material affiliated persons   Material affiliated persons have a relationship to another entity such that
                              their business activities are reasonably likely to have a material impact on
                              the financial and operational condition of that entity.

Multilateral transaction      A multilateral execution facility is a physical or electronic facility in which
                              all market participants that are members simultaneously have the ability to
execution facility            execute transactions and bind both parties by accepting offers, which are
                              made by one member and open to all members of the facility.

National Futures              The National Futures Association is a self-regulatory organization that is
                              responsible, under CFTC oversight, for qualifying commodity futures
Association                   professionals and for regulating the sales practices, business conduct, and
                              financial condition of its member firms.



                              Page 67                                      GAO/GGD-99-74 CFTC Reauthorization
                             Glossary




No-action letters            No-action letters are issued by CFTC staff to indicate that they will not
                             recommend enforcement action for violation of law or regulation if certain
                             conditions are met. These letters do not reflect official Commission views.

Nonenumerated                Nonenumerated commodities are all commodities meeting the definition
                             of a commodity under the CEA but not specifically listed in the act.
commodities
Notional amount              The notional amount is the amount upon which payments between parties
                             to certain types of derivatives contracts are based. When this amount is
                             not exchanged, it is not a measure of the amount at risk in a transaction.

NYMEX ACCESS                 NYMEX ACCESS is an electronic trading system developed by the New
                             York Mercantile Exchange that allows market participants to trade the
                             exchange’s futures and options products.

Offset for exchange-traded   Offset for exchange-traded futures contracts is the liquidation of a long
                             (short) futures position through the sale (purchase) of an equal number of
futures contracts            contracts of the same delivery month.

Offset for OTC derivatives   Offset for OTC derivatives contracts occurs when a market participant
                             enters into another contract with equal but opposite terms.
contracts
Open outcry                  Open outcry is a method of public auction under which futures are traded
                             by floor participants who verbally or through hand signals make bids and
                             offers to each other at centralized exchange locations.

Option contracts             Option contracts (American style) give the purchaser the right, but not the
                             obligation, to buy (call option) or sell (put option) a specified quantity of
                             the underlying commodity or financial asset at a specified price (the
                             exercise or strike price) on or before a specified future date. For this right,
                             the purchaser pays the seller (writer) an amount called the option
                             premium. The seller of the option has the obligation to sell (call) or buy
                             (put) the commodity or financial asset at the exercise price if the option is
                             exercised. A European-style option can be exercised only on its expiration
                             date.

Option premium               Option premium (See option.)

Over-the-counter contracts   Over-the-counter contracts are privately negotiated, off of an exchange.

Position                     Position is an interest in the market, either long or short, in the form of one
                             or more open contracts.




                             Page 68                                      GAO/GGD-99-74 CFTC Reauthorization
                            Glossary




Position limit              A position limit is the maximum position, either net long or net short, in
                            one commodity future (or option) or in all futures (or options) of one
                            commodity combined that may be held or controlled by one person as
                            prescribed by an exchange and/or by CFTC.

President’s Working Group   The President’s Working Group on the Financial Markets was created
                            following the October 1987 market crash to address issues concerning the
on the Financial Markets    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 SEC.

Price discovery             Price discovery is the process of determining price on the basis of supply
                            and demand factors.

Price risk                  Price risk (See market risk.)

Project A                   Project A is an electronic trading system developed by the Chicago Board
                            of Trade that allows market participants to trade the exchange’s financial
                            futures and options products.

Put option                  Put option (See option.)

Reparations                 Reparations is compensation payable to a wronged party in a futures or
                            options transaction under CFTC’s customer claims procedure for recovery
                            of civil damages.

Risk shifting               Risk shifting is the transference of risk arising from price or rate
                            movements from entities less willing or able to manage it to those more
                            willing or able to do so.

Securities-based swap       A swap whose return is based on the price of a security or securities index.
                            (See swap.)

Segregation of customer     Segregation of customer funds is to separate customer assets from those
                            of the broker or firm (including the futures commission merchant and
funds                       clearing organization) and is required by the CEA.

Self-regulatory             Self-regulatory organizations are private membership organizations given
                            the power and responsibility under federal law and regulations to adopt
organizations               and enforce rules of member conduct. They play an extensive role in the
                            regulation of the U.S. futures and securities industries and include all of
                            the U.S. futures and securities exchanges, the National Futures




                            Page 69                                     GAO/GGD-99-74 CFTC Reauthorization
                              Glossary




                              Association, the National Association of Securities Dealers, and the
                              Municipal Securities Rulemaking Board.

Settlement                    Settlement is the process of fulfilling contractual requirements through
                              cash payment or delivery.

Short                         Short is the selling side of an open futures contract, or a trader whose net
                              position in the futures market shows an excess of open sales over open
                              purchases. (See long.)

Speculation                   Speculation is to assume risk in attempting to profit from anticipating
                              changes in market rates or prices.

Speculative position limits   Speculative position limits (See position limits.)

Stock indexes                 Stock indexes are used to measure and report value changes in
                              representative stock groupings.

Strike price                  Strike price (See exercise price.)

Swaps                         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 typically not exchanged.

Systemic risk                 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.

Trade options                 Trade options are off-exchange commodity options offered or sold to
                              commercial users of the underlying commodity solely for purposes related
                              to their business.

Transparency                  Transparency is the extent to which information about prices, trading
                              volume, and trades is available to the public.

Underlyings                   Underlyings (See derivatives.)

U.S. Securities Market        The U.S. Securities Market Coalition includes the American Stock
                              Exchange, Boston Stock Exchange, Chicago Board Options Exchange,
Coalition                     Chicago Stock Exchange, Cincinnati Stock Exchange, NASDAQ Stock
                              Market, National Securities Clearing Corporation, New York Stock




                              Page 70                                      GAO/GGD-99-74 CFTC Reauthorization
             Glossary




             Exchange, Pacific Exchange, Philadelphia Stock Exchange, and Options
             Clearing Corporation.

Volatility   Volatility is a characteristic of a security, commodity, or market to rise
             and/or fall sharply in price within a short time period.




             Page 71                                      GAO/GGD-99-74 CFTC Reauthorization
Related GAO Products


             OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice
             Disputes (GAO/GGD-98-5, Oct. 2, 1997).

             The Commodity Exchange Act: Legal and Regulatory Issues Remain
             (GAO/GGD-97-50, Apr. 7, 1997).

             Regulatory Burden: Measurement Challenges and Concerns Raised by
             Selected Companies (GAO/GGD-92-2, Nov. 18, 1996).

             Financial Derivatives: Actions Taken or Proposed Since May 1994
             (GAO/GGD/AIMD-97-8, Nov. 1, 1996).

             Financial Market Regulation: Benefits and Risks of Merging SEC and CFTC
             (GAO/GGD-95-153, May 3, 1995).

             Financial Derivatives: Actions Needed to Protect the Financial System
             (GAO/GGD-94-133, May 18, 1994).

             Regulatory Burden: Recent Studies, Industry Issues, and Agency Initiatives
             (GAO/GGD-94-28, Dec. 13, 1993).




             Page 72                                   GAO/GGD-99-74 CFTC Reauthorization
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