Testimony Archives

TESTIMONY OF JANE CARLIN
CHAIRWOMAN, OVER-THE-COUNTER DERIVATIVE PRODUCTS COMMITTEE
SECURITIES INDUSTRY ASSOCIATION

HEARING ON COMMODITY FUTURES TRADING COMMISSION REAUTHORIZATION
BEFORE THE HOUSE AGRICULTURE COMMITTEE
SUBCOMMITTEE ON RISK MANAGEMENT, RESEARCH AND SPECIALTY CROPS
UNITED STATES HOUSE OF REPRESENTATIVES

MAY 20, 1999

I am Jane Carlin, a Managing Director at Morgan Stanley Dean Witter. I am appearing before the Subcommittee today in my role as Chairwoman of the Over-the-Counter Derivative Products Committee of the Securities Industry Association ("SIA").1 On behalf of the SIA, I want to express my appreciation for this opportunity to present the securities industry's views on the very important matter of the reauthorization of the Commodity Futures Trading Commission ("CFTC") and issues arising under the Commodity Exchange Act ("CEA").

With the rapid evolution and expansion of OTC derivatives and hybrid products over the last two decades, the issues involved in the reauthorization of the CFTC are now very important to SIA members and our customers. SIA is pleased that the current reauthorization process allows Congress the opportunity to reexamine the CEA in light of the changes that have characterized the financial markets during the last decade. As evidenced by our participation here today, SIA hopes to be actively involved with the Congress in shaping a modern and reinvigorated CEA that is responsive to the need for legal certainty for OTC derivatives and hybrid products as we enter the next century. My comments today will focus primarily on issues in the CEA that relate to securities and securities dealers.

While later in my testimony I will provide specific recommendations for the Subcommittee to consider, the SIA's chief concerns can be summarized as follows:

  • Over-the-counter derivatives and hybrid instruments have been a singular U.S. financial success story. OTC derivatives and hybrid instruments perform vital functions for corporations in all sectors of the economy. They facilitate risk management and investment opportunity. Congress has played an important role in contributing to these positive developments. Congress must take further steps at this time to ensure that the CEA does not stand as an obstacle to further progress in these areas.
  • The uncertain legal status of OTC derivatives and hybrids and the barriers to innovation inherent in current law present unacceptable problems for market participants that must be redressed by statutory revisions to the CEA. Clear and objective statutory exclusions for these OTC products must be codified to clarify the status of existing products and to reduce the risk of future uncertainty as new products are introduced.
  • Legal uncertainty is particularly acute in the context of OTC derivatives and hybrids based on non-exempt securities. These products should be expressly excluded from the CEA.
  • The CEA currently poses a significant obstacle to product and technological innovations concerning the execution, clearing and settlement of OTC derivatives and hybrid products, such as electronic trading, that could lower the cost of risk management, promote liquidity and reduce systemic risk.
  • Although reauthorization involves many complex problems without clear answers, one thing is certain: the solution is not to preserve the current state of legal uncertainty and intolerable barriers to innovation.

I. The CEA Must Reflect the Modern Competitive Global Market.

Looking back over the evolution of the CEA and its predecessors, Congressional policy has historically focused on the U.S. domestic market and primarily on exchange-based trading of physical commodities. However well that approach may have served the interests of the agricultural sector, that approach will not work for international financial markets. Globalization has led to worldwide competition in virtually every aspect of the financial services industry. Electronic trading has taken hold as a dominant force and international over-the-counter markets have proliferated to meet customer demand. The U.S. cannot afford the luxury of dealing with the CEA and affected domestic institutions in a parochial or protectionist manner as if isolated from the competitive realities of world markets.

The U.S. financial industry is the world leader and SIA's members are fiercely committed to continue to hold that premier place on the global stage. While SIA member firms are obliged daily to manage and mitigate a wide range of risks arising from their activities, the one risk that these firms cannot effectively manage is legal risk, including that arising from the CEA as it currently is written. To the extent that conducting business with U.S. financial institutions introduces such legal risk into a transaction that does not arise when doing business with European or Asian dealers, U.S. dealers face a substantial competitive disadvantage. Forcing U.S. financial institutions offshore to avoid legal risk deprives U.S. customers of the financial products they need to compete both domestically and internationally.

Moreover, moving global financial centers offshore seriously diminishes the United States' standing in the global financial markets and reduces America's influence on matters affecting international financial and monetary policy. None of these outcomes is in the best interests of the United States. These threats should be of grave concern to the Subcommittee. In our view, the challenge before Congress now is to remove these legal uncertainties and to eliminate the related barriers to innovation for all market participants, thereby creating incentives for U.S. financial institutions to continue at the vanguard of global market innovation while remaining based here in the U.S.

While these products and issues may seem esoteric and obscure – and, indeed, they are – the Subcommittee must not underestimate their economic significance.

II. OTC Derivatives and Hybrids

History. The development of OTC derivatives2 and hybrid instruments3 represents one of the great financial success stories of this century. Changes in the global financial architecture in the 1970s subjected all corporations to significant volatility in interest rates, foreign exchange rates and commodity prices. The commodity futures market responded with new financial futures contracts – in addition to their more traditional agriculture contracts. The financial markets also responded to these new risk management needs by offering custom tailored derivatives that were specifically designed to enable individual firms to manage their specific risks.

OTC derivatives – primarily swaps and hybrids – are powerful tools which enable businesses to unbundle and transfer risks, including by hedging, to other entities willing and able to accept them. They are extremely flexible and can be customized to address unique risk management needs and to meet new challenges presented by a rapidly evolving global economy.

Legal Uncertainty. As exchange trading of financial futures contracts grew, Congress recognized that the nature of the futures markets was changing. In order to modernize oversight of these markets, Congress enacted the Commodity Futures Trading Act of 1974. The new statute dramatically expanded the basic definition of a "commodity" to include, in addition to the traditional enumerated list of agricultural commodities, ". . . all other goods and articles, . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in . . . ." The intent of this definitional expansion was to clarify that the CEA applied to the new physical and financial futures contracts that were then being traded alongside traditional commodity futures on the exchanges. However, because of the potentially broad scope of the term "futures contract," confusion regarding the CEA's applicability to OTC swaps – and later hybrids – subjected these instruments to the risk of contract repudiation and allegations of illegality if they arguably violated the Act's strict off-exchange trading prohibition.

CFTC and Congressional Responses. The increasing importance of OTC derivatives and hybrids led to increased regulatory interest by the CFTC. The CFTC recognized the problem of the legal uncertainty associated with swaps and responded in 1989 by issuing the Swaps Policy Statement. 4 In effect, the policy statement created a regulatory safe harbor for qualifying swaps transactions by identifying those transactions which the CFTC would not take action to preclude or regulate as futures under the CEA.

The CFTC responded similarly to the problem of the legal uncertainty threatening hybrid instruments by issuing the Hybrid Statutory Interpretation.5 In the Statutory Interpretation, the CFTC indicated that it would not assert regulatory jurisdiction over certain categories of hybrid instruments.

While the Policy Statement and the Statutory Interpretation provided some degree of assurance that the CFTC would not take enforcement action against certain swaps and hybrids, it did not eliminate the legal risk that a counterparty might challenge the transaction or instrument in court.

Congress recognized the benefits of OTC derivatives and hybrid products and sought to encourage their development through the CEA by enacting the Futures Trading Practices Act of 1992 (FTPA).6 The FTPA for the first time vested the CFTC with the authority to grant broad exemptions from the provisions of the CEA other than from the requirements of the Shad-Johnson Accord (discussed below). In order to provide certainty and stability to the markets, Congress also directed the CFTC to create an exemption for swap transactions and hybrid instruments. In doing so, Congress demonstrated an appreciation that the public policy concerns which motivated the CEA are not raised by OTC derivatives.

Rationale for the Swaps and Hybrid Exemptions. The CEA and its predecessor statutes were enacted for a simple purpose: to require that futures contracts on agricultural commodities be traded on licensed boards of trade that had implemented adequate protections against price manipulation. Commodity futures contracts, by virtue of their standardization and physical delivery terms, were perceived to be susceptible to manipulation. Congress was concerned that manipulation of the futures markets in turn caused distortions in the prices for agricultural commodities, because the futures markets are the primary price discovery mechanism for these products.

By their nature OTC derivatives transactions do not present price discovery and manipulation concerns of the kind presented by standardized contracts requiring physical delivery.

Likewise, the principal regulatory challenge presented by hybrid instruments is not to prevent commodity price manipulation but, as is the case with more traditional securities, to ensure the adequacy of disclosure regarding the economic performance of and risks associated with the investment. The CEA was designed to protect markets against price manipulation and fraud, not to facilitate disclosure of material information to the capital markets. By contrast, disclosure is at the heart of the federal securities laws. Moreover, hybrid instruments, as with swaps, do not serve as the mechanism for discovering the price of the underlying, and thus do not present the same price manipulation concerns as do commodity futures.

Swaps and Hybrid Exemptions. Following the FTPA's Congressional mandate, the CFTC issued final rules in 1993 exempting certain qualifying OTC swaps agreements and hybrid instruments from regulation under the CEA. 7 While the swap and hybrid exemptions were helpful insofar as they provided needed practical relief to the markets, they were designed to reflect the way swaps and hybrids were transacted and designed at the time. SIA now believes the exemptions are too inflexible to appropriately accommodate innovative developments in the rapidly evolving financial marketplace and the global economy. Statements made by the CFTC over the past year have also raised concerns regarding the scope of and true protection afforded by these exemptions.

Barriers to Innovation. In its current form, the CEA impedes the development of new products designed to address changing risk management needs. Financial institutions must be free to respond to market changes and end user demands with innovative products – without having to confront costly, time-consuming and often insurmountable statutory and regulatory obstacles.

The CEA and its regulations also have hampered innovations associated with the trading, clearing and settlement of products. For instance, while clearing of swaps transactions would have the beneficial effect of mutualizing and reducing counterparty default risks, the swap exemption does not allow clearing of OTC swaps, unless a specific exemption is granted. These restrictions therefore can have the ironic result of actually increasing default risks in OTC swap transactions and, in turn systemic risks. There seems to be no public policy reason to limit the ability of the financial system to clear and settle transactions. Indeed, public policy should encourage development of clearing mechanisms wherever possible to reduce risk in the financial system.

The CFTC also has taken the view that the use of certain electronic trading mechanisms to execute OTC derivatives transactions implicates the agency's exclusive jurisdiction under the

CEA. An enormous variety of electronic trading mechanisms – ranging from relatively simple to extraordinarily complex -- are used throughout the financial system and around the world. One feature electronic trading systems generally have in common, however, is that they make trading more efficient, reduce costs and equalize market access. They also can offer benefits to the markets in terms of increased liquidity and price transparency. Unfortunately, the threat that simply using an electronic trading system might suddenly convert an otherwise exempt swap into a product which may be subject to CEA regulation has stifled useful and desirable electronic trading innovations here in the U.S. -- at the same time as electronic trading systems proliferate overseas. This situation again puts U.S. financial institutions at a competitive disadvantage.

The Current Situation Demands Congressional Action. The CFTC exacerbated the situation last year when it issued its Concept Release.8 By implying that swaps and hybrid instruments could be futures, the CFTC has cast additional doubt on their legal status. The result is a regulatory climate that subjects both newly developed and well-established products to legal uncertainty. No other class of financial instruments confronts this legal risk. This situation jeopardizes the availability and increases the cost of important risk management tools to companies throughout the U.S. economy. It also creates incentives for U.S. firms to conduct their transactions offshore beyond the jurisdictional reach of the CEA. Importantly, this threat reduces the leadership position of the U.S. financial sector in financial innovation and reduces the U.S. influence in world financial markets.

The history of the CEA evidences a repeated and counter-productive cycle wherein legal uncertainty arises and Congress eventually responds to individual issues, but not in a way which resolves the core structural problem with the CEA itself. There is something materially wrong with a regulatory scheme that continually and repeatedly jeopardizes otherwise lawful and socially desirable economic activity. Congress should restore the legal certainty that it intended to create both in 1974 and 1992 by enacting clear statutory exclusions for swaps and hybrids. These exclusions should be sufficiently flexible to accommodate innovations both in OTC products themselves and the manner in which the OTC business is conducted.

Recommendations:

  • Congress should specifically exclude swaps and hybrid instruments from the CEA.
  • Congress should provide flexibility in this exclusion to allow the evolution of new products.
  • Congress should clarify that clearing or electronic trading of swaps and hybrids do not subject the transactions or products to regulation under the CEA.

III. Swaps and Hybrids Based on Non-exempt Securities

OTC contracts based on or involving non-exempt debt or equity securities (also known as equity swaps or equity hybrids) allow parties to transfer the risk associated with changes in the price of an underlying security, basket of securities or securities index, without actually transferring ownership of the securities themselves. These products allow institutional investors and portfolio managers to hedge the risks associated with increasingly volatile securities markets. They provide means for institutional investors and portfolio managers to invest in new and emerging financial markets. They enable corporations to hedge the risks associated with direct investment in foreign markets. They allow firms to diversify their exposures to credit risk and, therefore, provide an important systemic risk management function. They enable corporations to reduce the cost of stock buybacks and employee stock option programs. They permit entrepreneurs to preserve assets by diversifying the risks associated with concentrating their wealth in a large block of a single stock. But many market participants have sought to enter into these types of transactions in jurisdictions outside the U.S., where their regulatory treatment is not subject to doubt.

Swaps and hybrids based on non-exempt debt and equity securities are subject to an even greater degree of legal uncertainty than other swap and hybrid transactions. The legal uncertainty surrounding these particular OTC products stems from a 1981 jurisdictional agreement, known as the Shad-Johnson Accord, between the CFTC and the SEC over transactions involving securities. Congress incorporated the Accord into the CEA in 1983.9 One provision of this agreement prohibits the CFTC from exempting contracts on non-exempt securities from regulation under the CEA. The effect of this legal uncertainty is that it increases the risks to parties engaging in such transactions, and encourages firms to execute such transactions outside the U.S. to the extent possible.

In this area, the CEA again serves to impede innovation in the marketplace, and drive valuable business outside the U.S. If there is one issue that SIA would have this Subcommittee address, it would be to correct this situation. No business should be subject to the risk that billions of dollars of legitimate contracts can be called into question by any regulator or by a judge. The systemic risk implications are obvious, and the current situation is not tolerable. This Committee understood the need to take urgent, interim action last year to prevent damage to a marketplace, action for which we are very grateful. SIA now asks Congress to address the problem permanently.

Recommendation:

  • Congress should amend the CEA to explicitly exclude swaps and hybrid instruments based on non-exempt securities.

IV. Congress Must Bring Legal Certainty to the CEA's "Treasury Amendment."

The term "Treasury Amendment" refers to an amendment to the CEA proposed by the Treasury Department in 1974, which specifically excluded various financial instruments –including transactions in OTC derivatives involving government securities and foreign exchange – from regulation under the CEA.10 The government securities and foreign exchange markets were then and continue to be the deepest, most liquid and most important financial markets in the world. These were and are off-exchange, inter-bank and inter-dealer markets which served a predominantly institutional and sophisticated client base. Congress agreed with the Treasury Department that the foreign currency and government securities markets did not present the concerns presented by the exchange-traded futures markets. In addition, Congress recognized that vibrant government securities and foreign exchange markets were vital to the national interest, and that potential application of the regulatory constraints of the CEA to these markets would be unnecessary and inappropriate.

The Treasury Amendment excludes transactions in government securities and foreign exchange from regulation under the CEA unless they are "conducted on a board of trade."11 While virtually every clause of the Treasury Amendment has been litigated, the phrase "board of trade" has been particularly problematic. Although standard usage and the legislative history suggest that Congress intended the term "board of trade" to mean "organized exchange," broad interpretations by the CFTC and some courts have subsequently caused a great deal of confusion over the meaning of the term.12 The Ninth Circuit recently held in CFTC v. Frankwell Bullion Ltd.,13 that the term "board of trade" in the Treasury Amendment means an "organized exchange," and that all off-exchange transactions were exempt. Similarly, the district court in Kwiatkowski v. Bear Stearns & Co., Inc.14 held that principal-to-principal, privately negotiated agreements for OTC purchases or sales of foreign currency were not conduced on a "board of trade" within the meaning of the Treasury Amendment.

More recently, the CFTC and others have suggested that electronic trading systems could be considered boards of trade for purposes of the Treasury Amendment. As a result, products that would otherwise be covered by the Treasury Amendment could be subject to CEA regulation merely because the parties transact their business through a computer system rather than over the telephone. As discussed above, electronic trading systems can vary widely in their characteristics, and it would be wholly inappropriate to subject every one to regulation or to CEA-style regulation. Electronic trading is widespread in the government securities market, and CFTC oversight of this market would clearly be inappropriate. The CFTC has also suggested that clearing of contracts may give rise to a board of trade, which as suggested above discourages the development of mechanisms that reduce systemic risk. The practical consequence of these CFTC positions is to deny services to U.S. businesses, because market participants are wary of operations that could cause them to be covered by the CEA.

Beyond the controversy over the meaning of the phrase "board of trade," the CFTC has also taken the position that the Treasury Amendment exclusion is limited to "sophisticated and informed institutions" and does not apply to transactions involving the general public, whether or not such transactions are conducted on an organized exchange. The CFTC has advocated this position notwithstanding the holding in the Frankwell Bullion case and the opposing view of the Treasury Department. Nonetheless, the potential application of the CEA has created potential legal uncertainty for OTC derivatives involving government securities.

Furthermore, the list of products excluded by the Treasury Amendment has not been amended since it was enacted. Changes are necessary to clarify that certain other appropriate products are included, such as government agency securities and securities issued by foreign governments.

Recommendations:

  • Congress should clarify that the term "board of trade" means "organized exchange."
  • Congress should clarify that all transactions in products covered by the Treasury Amendment are excluded from the CEA.
  • Congress should update the list of specific products excluded from the CEA under the Treasury Amendment.
  • Congress should clarify that electronic trading systems do not constitute a "board of trade" for purposes of the CEA.
  • Congress should clarify that the clearing of Treasury Amendment products does not mean that those transactions are "conducted on a board of trade" for purposes of the CEA.

V. OTC Derivatives Dealers Do Not Need Duplicative Regulation by the CFTC.

The CFTC has suggested in the Concept Release and in public statements15 (as have others) that OTC derivatives dealers should be subject to regulation under the CEA. SIA disagrees with the basic premise that OTC derivatives dealers require regulation. SIA further believes that even if public policy warranted such regulation, the CEA would clearly not be the appropriate statutory authority. First, well over 90 percent of the volume of OTC derivatives transactions are conducted with dealers who are regulated either as banks by the federal and state banking regulators, or as affiliates of broker-dealers that are subject to risk assessment requirements under the securities laws and internal control and reporting obligations under the Derivatives Policy Group voluntary oversight framework. Many of these firms must also comply with regulations of the Treasury Department. No case has been made that there is a need for additional regulation in this area. To add another layer of entity-level regulation would be unnecessary, duplicative and wasteful for both the dealers and U.S. taxpayers.

SIA also fundamentally disagrees that CEA regulation would be appropriate for dealers in derivatives if such regulation was deemed to be advisable. As discussed above, the CEA's regulatory design, while appropriate to organized exchanges, is ill-suited to oversee off-exchange products, markets, and entities. The issues posed in the regulation of derivatives dealers bear no resemblance to the issues addressed by CEA regulation. The CFTC has little or no experience with issues faced on a daily basis by derivatives dealers, and developing sufficient expertise would be a major distraction from the CFTC's primary mission: regulating and safeguarding the nation's commodity markets.

Recommendation:

  • Congress should not subject OTC derivatives dealers to regulation under the CEA.

VI. Conclusion

SIA believes this Committee must address these long overdue reforms of the CEA. We understand it is a complex and time consuming task and we applaud your willingness to undertake this effort. SIA believes that providing the U.S. financial markets with the flexibility to innovate is worth the effort to reform the CEA.

Mr. Chairman, as you know, these are not just issues involving the futures exchanges. The CEA presents unacceptable systemic risks to the financial markets that must be addressed. Statutes should be designed to reduce risk to society. Instead, the CEA creates risks and limits the availability of tools and market mechanisms to manage risk. This Subcommittee should not tolerate these risks. We strongly believe that the time has come to resolve issues which are over 20 years old. The global markets and international firms will not stand still while we sort out our anachronistic regulatory problems.

SIA is not prepared to insist that Congress vastly alter the current structure of the CEA to accommodate the concerns of the financial markets. However, the CEA simply does not work in the context of the OTC markets and is a barrier to progress. Therefore, we respectfully request that Congress provide clarification on the various issues discussed herein, so that the CEA does not continue to cloud our markets with uncertainty and impede innovation.

Footnotes:

1 SIA is the primary trade association representing the U.S. securities industry. SIA brings together the shared interests of more than 740 securities firms. SIA member firms (including investment banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all phases of corporate and public finance. The U.S. securities industry manages the accounts of more than 50 million investors directly and tens of millions of investors indirectly through corporate, thrift and pension plans. The industry generates more than $300 billion of revenues yearly in the U.S. economy and employs more than 600,000 individuals.

2 Derivatives are contracts that have a market value determined by the value of a stock, bond, commodity, interest rate, foreign currency or index (called the "underlying"). Derivatives typically include forwards, futures, options, and swaps contracts.

3 Generally, a hybrid is a financial instrument which combines the features of a debt instrument and a derivative and which links some portion of its return to changes in a particular commodity price, foreign exchange rate, interest rate, security price or index.

4 54 Fed. Reg. 30694 (July 21, 1989).

5 The CFTC originally published the Statutory interpretation in January, 1989, 54 Fed. Reg. 1139 (Jan. 11, 1989). Following further comments it had solicited, the CFTC subsequently published a revised Statutory Interpretation in April, 1990. 55 Fed. Reg. 13582 (Apr. 11, 1990).

6 Pub. L. No. 102-546, 106 Stat. 3590 (1992).

7 CFTC Regulations Part 34 (Hybrid Exemption), and CFTC Regulations Part 35 (Swap Exemption).

8 63 Fed.Reg. 26114 at 26122 (May 12, 1998).

9 The Futures Trading Act of 1982. Pub. L. No. 97-444, tit. I, 96 Stat. 2294 (1983). Codified at CEA § 2(a)(1)(B).

10 The Treasury Amendment provides that nothing in [the CEA] shall be deemed to govern or in any way be applicable to transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade with statutory citation. CEA § 2(a)(1)(A(ii).

11 In 1997, the Supreme Court ruled that the Treasury Amendment excluded from the CEA any transaction in which foreign currency is involved unless conducted on a "board of trade". Dunn v. CFTC, 519 U.S. 465 (1997).

12 For example, in CFTC v. Standard Forex, Inc., 1993 U.S. Dist. LEXIS 19909 (EDNY 1993), the district court determined that "board of trade" included sales of foreign currency futures to the general public by firms not otherwise regulated by a federal agency.

13 99 F.3d 299 (9th Cir., 1996)

14 1997 U.S. Dist. LEXIS 13078 (SDNY 1997).

15 See, e.g., testimony of Brooksley Born, Chairperson, CFTC, before the U.S. House of Representatives Banking and Financial Services Committee, July 24, 1998.

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