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REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION

HEARINGS

BEFORE THE

SUBCOMMITTEE ON

GENERAL FARM COMMODITIES

AND RISK MANAGEMENT

OF THE

COMMITTEE ON AGRICULTURE

HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

MARCH 3 AND 9, 2005

Serial No. 109–2

(

Printed for the use of the Committee on Agriculture

agriculture.house.gov

COMMITTEE ON AGRICULTURE

BOB GOODLATTE, Virginia, Chairman

JOHN A. BOEHNER, Ohio,

Vice Chairman

RICHARD W. POMBO, California

TERRY EVERETT, Alabama

FRANK D. LUCAS, Oklahoma

JERRY MORAN, Kansas

WILLIAM L. JENKINS, Tennessee

GIL GUTKNECHT, Minnesota

ROBIN HAYES, North Carolina

TIMOTHY V. JOHNSON, Illinois

TOM OSBORNE, Nebraska

MIKE PENCE, Indiana

SAM GRAVES, Missouri

JO BONNER, Alabama

MIKE ROGERS, Alabama

STEVE KING, Iowa

MARILYN N. MUSGRAVE, Colorado

DEVIN NUNES, California

RANDY NEUGEBAUER, Texas

CHARLES W. BOUSTANY, JR., Louisiana

JOHN J.H. ‘‘JOE’’ SCHWARZ, Michigan

JOHN R. ‘‘RANDY’’ KUHL, JR., New York

VIRGINIA FOXX, North Carolina

K. MICHAEL CONAWAY, Texas

JEFF FORTENBERRY, Nebraska

COLLIN C. PETERSON, Minnesota,

Ranking Minority Member

TIM HOLDEN, Pennsylvania

MIKE MCINTYRE, North Carolina

BOB ETHERIDGE, North Carolina

JOE BACA, California

ED CASE, Hawaii

DENNIS A. CARDOZA, California

DAVID SCOTT, Georgia

JIM MARSHALL, Georgia

STEPHANIE HERSETH, South Dakota

G.K. BUTTERFIELD, North Carolina

HENRY CUELLAR, Texas

CHARLIE MELANCON, Louisiana

JIM COSTA, California

JOHN T. SALAZAR, Colorado

JOHN BARROW, Georgia

EARL POMEROY, North Dakota

LEONARD L. BOSWELL, Iowa

RICK LARSEN, Washington

LINCOLN DAVIS, Tennessee

BEN CHANDLER, Kentucky

PROFESSIONAL STAFF

WILLIAM E. O’CONNER, JR., Staff Director

KEVIN J. KRAMP, Chief Counsel

ROBERT L. LAREW, Minority Staff Director

SUBCOMMITTEE ON GENERAL FARM COMMODITIES AND RISK MANAGEMENT

JERRY MORAN, Kansas, Chairman

JOHN A. BOEHNER, Ohio,

TERRY EVERETT, Alabama

FRANK D. LUCAS, Oklahoma

WILLIAM L. JENKINS, Tennessee

TIMOTHY V. JOHNSON, Illinois

MIKE PENCE, Indiana

SAM GRAVES, Missouri

JO BONNER, Alabama

STEVE KING, Iowa

MARILYN N. MUSGRAVE, Colorado

RANDY NEUGEBAUER, Texas

CHARLES W. BOUSTANY, JR., Louisiana

K. MICHAEL CONWAY, Texas

JEFF FORTENBERRY, Nebraska

BOB ETHERIDGE, North Carolina,

Ranking Minority Member

JOHN T. SALAZAR, Colorado

JIM MARSHALL, Georgia

STEPHANIE HERSETH, South Dakota

G.K. BUTTERFIELD, North Carolina

CHARLIE MELANCON, Louisiana

JOHN BARROW, Georgia

EARL POMEROY, North Dakota

LEONARD L. BOSWELL, Iowa

RICK LARSEN, Washington

BEN CHANDLER, Kentucky

DAVID SCOTT, Georgia

JIM COSTA, California

TYLER WEGMEYER, Subcommittee Staff Director

(II)

(III)

C O N T E N T S

Page

Goodlatte, Hon. Bob, a Representative in Congress from the Commonwealth

of Virginia, prepared statement .......................................................................... 3

Etheridge, Hon. Bob, a Representative in Congress from the State of North

Carolina, opening statement ............................................................................... 2

Moran, Hon. Jerry, a Representative in Congress from the State of Kansas,

opening statement ................................................................................................ 1

MARCH 3, 2005

WITNESS

Brown-Hruska, Sharon, Acting Chairman, Commodity Futures Trading Commission .................................................................................................................. 4

Prepared statement .......................................................................................... 25

Answers to submitted questions ...................................................................... 28

MARCH 9, 2005

Etheridge, Hon. Bob, a Representative in Congress from the State of North

Carolina, opening statement ............................................................................... 2

Moran, Hon. Jerry, a Representative in Congress from the State of Kansas,

opening statement ................................................................................................ 1

WITNESSES

Carey, Charles, chairman, Chicago Board of Trade, Chicago, IL ........................ 42

Prepared statement .......................................................................................... 94

Coyle, Tom, general manager, Chicago and Illinois River Marketing LLC,

Chicago, IL, on behalf of the National Grain and Feed Association, Washington, DC ............................................................................................................. 84

Prepared statement .......................................................................................... 103

Damgard, John M., president, Futures Industry Association, Washington,

DC .......................................................................................................................... 63

Prepared statement .......................................................................................... 114

Attachement to testimony ................................................................................ 125

Doyle, Martin, president, OneChicago, LLC, Chicago, IL .................................... 87

Prepared statement .......................................................................................... 145

Duffy, Terrence A., chairman, Chicago Mercantile Exchange Holdings, Inc,

Chicago, IL ............................................................................................................ 40

Prepared statement .......................................................................................... 154

Gaine, John G., president, Managed Funds Association, Washington, DC ........ 69

Prepared statement .......................................................................................... 163

Green, Micah, president, the Bond Market Association, New York, NY ............ 67

Prepared statement .......................................................................................... 175

Hanley, George, president, Hanley Group, Chicago, IL, on behalf of the National Grain Trade Council, Washington, DC .................................................... 82

Prepared statement .......................................................................................... 170

Nandapurkar, Satish, chief executive officer, Eurex US, Chicago, IL ................ 47

Prepared statement .......................................................................................... 181

Newsome, James, president, New York Mercantile Exchange, Inc., New York,

NY ......................................................................................................................... 44

Prepared statement .......................................................................................... 186

Pickel, Robert G., executive director and chief executive officer, International

Swaps and Derivatives Association, Inc., New York, NY ................................. 70

Prepared statement .......................................................................................... 199

Page

IV

Roth, Daniel J., president and chief executive officer, National Futures Association, Chicago, IL .............................................................................................. 65

Prepared statement .......................................................................................... 213

Schoenhut, Frederick W., chairman, New York Board of Trade, New York,

NY ......................................................................................................................... 45

Prepared statement .......................................................................................... 219

Sprecher, Jeffrey C., chairman and chief executive officer,

IntercontinentalExchange, Inc., Atlanta, GA .................................................... 86

Prepared statement .......................................................................................... 225

SUBMITTED MATERIAL

‘‘Memorandum for ISDA Members’’ prepared by Craveth, Swaine and Moore,

submitted by Mr. Larsen ..................................................................................... 235

(1)

REAUTHORIZATION OF THE COMMODITY

FUTURE TRADING COMMISSION

WEDNESDAY, MARCH 3, 2005

HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON GENERAL FARM

COMMODITIES AND RISK MANAGEMENT, COMMITTEE ON AGRICULTURE, Washington, DC.

The subcommittee met, pursuant to call, at 10:00 a.m., in room

1300 of the Longworth House Office Building, Hon. Jerry Moran

(chairman of the subcommittee) presiding.

Present: Representatives Boehner, Lucas, Pence, Graves, Bonner,

King, Musgrave, Neugebauer, Boustany, Etheridge, Salazar, Marshall, Herseth, Butterfield, Pomeroy, Boswell, Larsen, Chandler,

Scott, Costa, and Peterson [ex officio].

Staff present: Brent Gattis, Dave Ebersole, Kevin Kramp, Tyler

Wegmeyer, Debbie Smith, Jennifer Daulby, Alise Kowalski, Matt

Smith, Rob Larew, John Riley, and April Dement.

OPENING STATEMENT OF HON. JERRY MORAN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF KANSAS

Mr. MORAN. Good morning, everyone. This hearing of the Subcommittee on General Farm Commodities and Risk Management

will now come to order. We are here today to review the Commodities Futures Modernization Act, and to see what has worked well,

discuss what changes, if any, might need to be considered by our

subcommittee as we proceed to reauthorize that legislation.

I am delighted today to have our witness, Dr. Sharon BrownHruska, who is the acting chairman of the Commodities Futures

Trading Commission, and I am delighted that she is joining us.

Just a few opening thoughts, and then, we will hear from Chairman Hruska. The Commodities Futures Trading Commission and

the futures industry are an important part of the oversight of the

Committee on Agriculture. In 1974, when the CFTC was created,

virtually all trading was agriculturally oriented. Since then, every

reauthorization has been considered by our committee. Today, the

percentage of business that is agriculture is much smaller, yet the

number of agricultural futures traded has grown dramatically.

I am very pleased that the industry has grown and prospered

while providing an extremely important risk management tool that

the marketplace uses each and every day, and more and more

every day. It is my view that the Commodities Futures Modernization Act of the year 2000 may be one of the most successful pieces

of legislation that has passed out of our committee, certainly since

2

I came to Congress. Our subcommittee has held a series of hearings already on the implementation of CFMA in the last Congress.

We heard a number of folks on a number of topics, and the discussion about current issues from the regulatory perspective as well

as the view of the overall competitiveness of the industry. At that

time, during that series of hearings, it appeared that CFMA had

accomplished much of its intended purpose, regulatory relief to foster industry growth and a level playing field, while still protecting

market integrity and transparency for all participants.

Now, in the over 4 years since the passage of CFMA, the futures

markets have really developed. In fact, 1.6 billion contracts were

traded last year. With this rapid growth and development, there

are likely difficulties and challenges. Today, the subcommittee begins a review of the futures industry, starting with the principal

regulatory agency, the Commodities Futures Trading Commission.

It is my hope that this hearing will provide us and the committee

members with a good understanding of what work needs to be done

this year for reauthorization of CFMA.

I now recognize the gentleman from North Carolina, my ranking

member and friend, Mr. Etheridge.

OPENING STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NORTH

CAROLINA

Mr. ETHERIDGE. Thank you, Mr. Chairman, and I thank you for

calling this meeting, and I am particularly pleased that we will be

working together on this subcommittee, not only to address the

subject of today’s hearing, but also, other issues that may be confronting the subcommittee and Congress.

Four years ago, as you have indicated, Congress took a bold step

in dramatically amending the Commodity Exchange Act, and

changing a system of derivative markets regulations. As you will

recall, it wasn’t easy. Many of us here remember that. Congress

was faced with several different and often conflicting patterns toward changes that were offered by a wide range of industry participants. But boldness was necessary in the face of technological advantages within the industry, and increasing foreign competition in

the derivatives business, and in the Commodity Futures Modernization Act of 2000, Congress delivered.

And we have seen the results of Congress’ work. From 2000 to

2004, the volume of futures and options contracts traded on the

U.S. exchanges have almost tripled. The number of products on

these exchanges have more than doubled. And we have seen the

entry of several new participants into the U.S. marketplace.

Mr. Chairman, the testimony we will receive today and at subsequent hearings will sing the praises of the CFMA, and it should.

Nevertheless, we should not take this success story for granted.

While a strong case can certainly be made for leaving well enough

alone, and passing a simple 5 year extension of the CFMA, a strong

case can be made for addressing the potential problems that remain within the industry, if any, and determining what else can

be done to further strengthen the U.S. derivative markets, making

it more efficient, making it more liquid, and making it more competitive.

3

So I commend you, Mr. Chairman, for holding this series of hearings to examine comprehensively the effectiveness of the Commodity Exchange Act. It is my hope that over the course of these hearings, we will thoroughly air some of the concerns that have been

raised in the industry with regard to the adequacy of our regulation of energy derivatives, whether or not the regulatory regime related to the trading of single stock futures is hindering the health

of that market, and whether or not, in the light of recent court decisions, the CFTC has adequate tools to crack down on fraudulent

currency trading options.

So Mr. Chairman, I am grateful for you beginning this process

early. I want to add my welcome to the CFTC’s Acting Chairlady

for being here this morning. Thank you. And I look forward to

working together with all of the members of this subcommittee in

the process of the reauthorization of the Commodity Exchange Act.

Thank you.

Mr. MORAN. Mr. Etheridge, thank you very much. In the presence of the gentleman from Minnesota, Mr. Peterson, I would like

to take the opportunity to welcome you as the new ranking member of our subcommittee, and tell you what a pleasure it will be to

have you by my side, with all due deference to Mr. Peterson, really.

Any statements for the record will be accepted at this time.

[The prepared statement of Chairman Goodlatte follows:]

PREPARED STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN CONGRESS

FROM THE COMMONWEALTH OF VIRGINIA

Mr. Chairman, I want to commend you for holding this hearing today and getting

an early start on the Commodity Futures Trading Commission’s reauthorization.

The last reauthorization, which began in May 1999, resulted in three committees

working for more than a year to report legislation to amend the Commodity Exchange Act and Federal securities law. Hopefully this round of reauthorization will

be significantly less complicated and less controversial.

To be sure, areas of controversy still exist—in energy derivatives, in sales of offexchange forex instruments, in single stock futures regulation, and in the continuing globalization of electronic trading. I am hopeful we can sort these matters out

through the hearings in this subcommittee and the full committee will hold.

I am also confident in the CFTC’s ability to police our derivatives markets. I believe the amendments that were adopted in 2000 for the most part set a course for

wise use, by large and small businesses alike, of an array of risk management instruments. While forming the basis of sound business practices in different venues,

these instruments remained cost-effective.

Additionally, I am heartened by the steady rise in trading volumes at this Nation’s futures exchanges. These increased volumes provide evidence that our exchanges still offer a unique product that may be used efficiently and with reasonable safety. I also assume these rising volume numbers mean that financial service

firms, offering tailored over-the-counter products to their customers, are laying some

of their risk off on the organized exchanges. I believe that was the hoped-for outcome, and I would like to learn more about whether or not our exchange officials

and others believe that this is the case.

Thank you for the opportunity to offer some of my thoughts on this important legislative undertaking.

Mr. MORAN.We are delighted to begin oversight review and reauthorization of this act today, and we are delighted to have a very

important witness. Chairman Hruska, thank you for joining us,

and our attention now turns to you.

With unanimous consent of the subcommittee, I would request

that we allow the witness longer than the 5 minutes. In fact, I

have suggested that she can have 10 minutes to tell us her story.

And with no objection, we will proceed in that manner.

4

STATEMENT OF SHARON BROWN-HRUSKA, ACTING

CHAIRMAN, COMMODITY FUTURES TRADING COMMISSION

Ms. BROWN-HRUSKA. Thank you, Mr. Chairman. I appreciate

very much the opportunity to be here this morning. I would like

to also thank Ranking Member Etheridge and all the members of

the committee for coming. I am pleased to appear on behalf of the

Commodity Futures Trading Commission to discuss the important

issues that surround the reauthorization of the Commission. Before

I begin my testimony, I would like to recognize and introduce my

fellow colleagues on the Commission who join me here today. First

is Commissioner Walt Lukken, who is certainly no stranger to

many of you because of his experience working on the Hill. I joined

the Commission at the same time as Walt, and I have greatly enjoyed working with him over the past two and a half years.

I would also like to introduce the two newest members of the

Commission, Commissioner Fred Hatfield and Commissioner Mike

Dunn, both of whom I had the honor of swearing in this past December. In the short time that Commissioners Hatfield and Dunn

have been at the Commission, they have contributed greatly to our

efforts. I look forward to continuing to work with them and drawing on their considerable expertise and insights. I have solicited

input from all of the Commissioners in preparing this testimony,

and I would like to thank them for working hard with me, and

coming up with this testimony.

Finally, I would like to recognize and commend the staff of the

CFTC. There is a big crowd of them behind me here, and I actually, at one point, was on the staff of the Agency in the early ’90’s,

and I really was able to see firsthand the dedication they devote

to the Agency and to the industry that they regulate. I want to

thank them for their energy and the creativity that they bring to

the task. Without this energy and dedication, I am sure much of

the innovation that the Commodity Futures Modernization Act of

2000 enabled wouldn’t have been possible.

Well, it was just over 4 years ago that Congress passed the

CFMA. While this may seem like a short time, the amount of

change that has occurred in the futures and derivatives industry

over this period has really been extraordinary. Much of that change

has been facilitated by the flexibility and innovative foresight of

that legislation. I like Congressman Etheridge’s comment, when he

said boldness was necessary, and Congress showed boldness, it is

something to be very proud of, that you had a role to play in energizing this industry. Today, I would like to take the opportunity to

brief you on the CFMA, the progress that we have made in its implementation, what has worked well, and what issues Congress

may wish to consider during its deliberation on reauthorization this

year.

Overall, as you have mentioned before, the act, as amended by

the CFMA, has functioned very well. The CFMA has provided flexibility to the derivatives industry, and legal certainty to much of the

over-the-counter derivatives market. This flexibility has allowed

the industry to innovate with respect to the design of contracts, the

formation of new trading platforms, and the clearing of both on-exchange and off-exchange products. There has been a bounty of innovation. The industry is no longer overburdened with prescriptive

5

legal requirements, and it is able to operate using its best judgment, rather than that of its regulator. At the same time, economic

and financial integrity have been safeguarded, and the Commission

has been able to maintain its ability to take action against fraud

and abuse in the markets, here and everywhere that we have jurisdiction.

Prior to the CFMA, the market was regulated with a one size fits

all model. It didn’t matter whether a customer was commercially

sophisticated, whether the commodity was susceptible to manipulation, whether a customer needed the flexibility of an over-thecounter contract or the liquidity of an exchange-traded one, or

whether there was more than one way to deliver customer protection to the marketplace. This recognition by Congress of the differences represented a significant step forward in its design of the

regulatory oversight structure. When Congress adopted the CFMA,

it put in place a practical, principles-based model, and it gave the

CFTC the tools to regulate the markets that were challenged by

competition brought on by technology and an increasingly global

marketplace.

Since the passage of the CFMA, you have mentioned that the futures industry has experienced phenomenal growth and innovation.

We have designated new contract markets, we have seen the emergence of exempt commercial markets and boards of trade that have

filed notification with the Commission, and we have seen a flourishing of new contracts and new mechanisms to transfer risk.

Markets have also become more global. There is more access

than ever for U.S. customers who want to trade on foreign exchanges, as well as foreign customers wanting to come back and

trade in the U.S. markets. Last fall, the CFTC approved a clearing

link with a European futures exchange that now allows U.S. customers of a foreign exchange to carry those positions at a U.S.

clearinghouse, with all the protections that that entails. In short,

the CFMA has permitted a level of innovation in these markets not

seen since futures contracts were first traded in Chicago during the

19th century.

Well, one of the benefits that has come about from this innovation has been increased competition and the lowering of trading

costs. In response to the USFE proposal to list contracts, the Chicago Board of Trade dramatically reduced its execution fees on its

market. In addition, the Board of Trade reacted to USFE by offering, for the first time, contracts based on German securities that

were previously traded exclusively in Europe.

New product and rule amendment certification procedures in the

CFMA have also lowered regulatory barriers and fostered innovation by providing exchanges greater flexibility in listing contracts

and reacting to developments in the cash markets. One result of

the lowered barriers to entry is that different contract designs have

been offered as alternatives to using traditional futures and options. In short, innovation, competition, customer choice, all of

these things that were envisioned by Congress in passing the

CFMA are bearing fruit.

That said, we at the Commission are committed to ensuring that

our regulatory policies are similarly responsive, and that the implementation of the CFMA fulfills the intent of Congress. Competition

6

and innovation must be realized in such a way that customer protection is not compromised, that the financial and economic integrity of markets are preserved. In that regard, there remains more

that we can do as a regulatory agency, working with industry,

working with other domestic and foreign regulators, working with

Congress to move the ball forward even within the current statutory model.

With that in mind, let me highlight three areas of concern on

which Congress may wish to focus as it deliberates during the reauthorization process. First, Congress may wish to evaluate whether clarifications are necessary for the legal framework provided for

exempt markets. Second, Congress may wish to suggest ways that

we can more effectively avoid duplicative burdens on the markets,

and going forward, provide us with guidance and support as we

seek to work with other agencies and other jurisdictions. Finally,

we at the Commission are cognizant of Congress’ firm commitment

to ensuring that customers are protected from fraud and manipulation, and to that end, Congress may wish to review whether the

CFTC has clear and adequate authority to police retail forex fraud.

In the wake of the Enron collapse, and in response to recent runups in prices in natural gas and crude oil, there have been calls

to increase the CFTC’s regulatory authority in the energy sector.

Some have called for retrenchment and a return to prescriptive

forms of regulation, like the adoptions of federally determined price

limits and position limits. Others have called for more sweeping

legislative changes that would give the Commission greater reach

into proprietary and bilateral markets. As you consider the appropriateness of such proposals, I would ask that you keep in mind

that the CFTC has responded decisively to prosecute wrongdoing in

the energy markets.

The Commission has acted resolutely in the energy markets to

preserve integrity and protect market users, demonstrating that its

authority is significant and it intends to use it. I would note that

the CFTC successfully pursued a complaint against Enron for attempted manipulation of the natural gas markets. We subsequently

obtained a civil monetary penalty of $35 million. In addition, the

Commission has filed and continues to pursue various actions and

investigations in the energy sector against both companies and individuals. Our enforcement efforts thus far have resulted in the

prosecution of 46 entities and individuals and the assessment of

approximately $300 million in penalties. In addition, the CFTC has

recently promulgated regulations clarifying and detailing its authority regarding exempt markets, including certain energy transactions, to better ensure that these markets remain free from manipulation and fraud.

Now, we are aware that last year’s energy bill contained several

provisions that would have directly affected the CFTC’s oversight

responsibilities, and we believe that it is appropriate and timely for

our authorizing committees in Congress to consider and weigh in

on these proposed changes. The proposed changes sought to make

it clear that the Commission has the authority to bring anti-fraud

actions in off-exchange principal-to-principal transactions, such as

those that occurred in the Enron Online type of environment.

While the CFMA provided for the Commission’s fraud authority

7

over exempt markets, some have questioned whether its application to bilateral and multilateral transactions would hold up, given

that our fundamental fraud authority appears to pertain only to

intermediated transactions. It has been the Commission’s contention that Congress intended to give the Commission fraud authority under the CFMA. Nonetheless, if that was not Congress’ intent,

or if they feel that they need to make it clearer, Congress may wish

to provide us with additional guidance regarding this area of the

act.

The energy bill also contained some savings clauses to confirm

the Commission’s exclusive jurisdiction with respect to futures and

options on energy commodities, a provision to reaffirm the Commission’s civil authority, a provision affirming that these changes restate existing law and continue to apply to acts or omissions that

occurred prior to enactment. Since these provisions of the energy

bill do amount to clarifications, Congress may wish to consider the

necessity of these changes and its intent regarding Commission jurisdiction.

As you know, the CFMA was noteworthy, in part because of Congress’ decision to permit the trading of futures on single securities,

under the joint jurisdiction of the CFTC and the Securities and Exchange Commission. However, more than 4 years after the CFMA’s

passage, the growth of single stock futures continues to be modest

at best. In December 2004, the NQLX exchange, one of the two exchanges that had been offering single stock futures, suspended

trading.

It is of some concern to us that this sector has not been more

successful, and that despite the best efforts of the Commission, the

CFTC and the SEC have not fully achieved the goals of the CFMA

in this area. In particular, it is of particular concern that more

progress has not been made with respect to implementing portfolio

margining, that we have not avoided completely the double audit

and review of notice registered exchanges and brokers, and we

have not determined the appropriate treatment of foreign security

indices and foreign security futures products.

In many areas, however, I am pleased to say that the two agencies continue to work to establish regulatory approaches that avoid

duplicative registration and regulation. Beginning in January, the

staffs of the CFTC and the SEC have been meeting to discuss a

means whereby commodity pool operators and commodity trading

advisors, can be overseen without imposing duplicative regulatory

structures. As we move forward, the agencies have to take to heart

your instructions to avoid duplicative registration and regulatory

requirements.

The CFMA clarified the CFTC has jurisdictions over retail foreign currency futures and options contracts, whether transacted onexchange or over-the-counter, as long as they are not otherwise

regulated by another agency. However, as demonstrated in the recent adverse Zelener decision, a case litigated by the Commission,

the CFTC does continue to face challenges in its jurisdiction based

on how retail forex transactions are characterized. In this case and

others, defendants often argue that transactions allowing retail

customers to speculate on price fluctuations in foreign currency are

8

not futures contracts, but are spot or forward transactions outside

our jurisdiction, including outside our fraud authority.

We at the Commission have been and remain committed to protecting retail consumers against the kind of egregious fraud we see

in the forex area. It has been the subject of much discussion within

the industry and among the derivatives bar as to how to respond

to the Zelener case, whether we need additional authority or clarity

in our jurisdiction, or whether we simply need to prove up our

cases better. Since the passage of the CFMA, the Commission, on

behalf of more than 20,000 customers, has filed 70 cases. We have

prosecuted 267 companies and individuals for illegal activity in

forex. As a result of those efforts, we have thus far imposed over

$240 million in penalties and restitution. Of the 70 cases that have

been filed thus far, the Commission has lost only three.

As noted, it has only been 4 years since Congress enacted, and

the Commission began implementing the CFMA. Given the

progress made and the lessons learned, Congress may determine

that it is premature to open the act to significant changes. The

Commission has been able to effectively work within the current

structure of the act to police markets, to ensure the integrity of the

price discovery mechanism, and to maintain the financial integrity

of markets and to protect customers. Nonetheless, the Commission

stands ready to offer its assistance as Congress moves through the

reauthorization process and considers a range of potential options.

In conclusion, let me say that my fellow Commissioners and I

welcome this opportunity to work with you on the reauthorization

of the CFTC. I greatly appreciate the opportunity to testify before

you today on this important matter, and I would be pleased to answer any questions that the committee may have.

Thank you, Chairman Moran.

[The prepared statement of Ms. Brown-Hruska appears at the

conclusion of the hearing.]

Mr. MORAN. Chairman Brown-Hruska, thank you very much,

and welcome to the other Commissioners that are present with us

today. And I want to focus my initial questions on the forex and

the Zelener case.

It appears to me that the case has thrown a wrench into the

workings of CFTC’s enforcement authorities, and it seems to me

that the court has redefined what a futures contract is. In the

Zelener court case, it seems to say that a futures contract is a futures contract only if it is traded on an exchange. I would like your

impression of what you believe the court has said, and what do you

think that decision does to affect your ability to enforce boiler room

operations?

Ms. BROWN-HRUSKA. Well, thank you very much, Chairman

Moran, for asking that question. It is of great concern to the CFTC,

just looking in that case, we believe that Zelener does not limit futures contracts only to those contracts traded on an exchange. But

instead, it really shifts the emphasis regarding the evidence that

the Commission must offer in forex cases to prove the existence of

a futures contract. So at least in our reading of the case, it doesn’t

say it has to trade on an exchange for us to have jurisdiction. Instead, it focuses on the character of the contracts traded.

9

Zelener was decided on the facts before the court, and took issue

with some of the evidence we presented there, and have presented

in the past, to argue that a contract is a futures contract. The court

noted, for example, that ‘‘treating the absence of ‘delivery’ as a defining characteristic of a futures contract is implausible,’’ and that

‘‘using ’delivery’ to differentiate between forwards and futures contracts yields indeterminacy.’’ So ultimately, as I have been advised

by the staff, I think the court found that the customer’s ability to

exit a transaction by offset might mean that a given contract operates as if fungible, but that the evidence was insufficient in that

case to permit the court to determine whether such an obligation

existed in the contracts at issue in that particular case.

In short, while the Seventh Circuit has not been a hotbed of

forex boiler room activity to date, the Commission fully expects to

continue to prosecute any forex boiler rooms in this Circuit, offering evidence that the contracts were, in fact, fungible, were capable

of offset, and in fact, operated as if they were.

So we think that we do have significant authority, and that we

are—it is not an issue of where the contracts are traded.

Mr. MORAN. Chairman, do you have cases pending in other Circuits under similar circumstances and a factual basis?

Ms. BROWN-HRUSKA. I think yes, we do have some other cases

that we have brought, and I think you are right on a factual basis,

that is—in some sense, Zelener provides us with information as to

how we should bring up those facts and circumstances of the case,

to better win those cases.

Mr. MORAN. Was the factual circumstances surrounding the

Zelener case unusual, different, or that is—it is a factual case that

is typical of the kind of case you would bring in this setting? The

things that are unique about Zelener that make a court decide the

way it decided, such that we would expect to have this kind of decision elsewhere?

Ms. BROWN-HRUSKA. Well, actually, no. I think that we have—

as I mentioned before, most of the cases that we brought which

were similar in circumstances, in terms of what—they were boiler

rooms, as you mentioned, a bunch of crooks trying to get innocent

people to part with their money. I think a lot of those cases we

have won, so in some sense, we have seen a lot of cases where

there are similar circumstances, and we have been able to prevail.

And so we take it as some comfort that we may have made some

mistakes in the Zelener matter, that we may have not brought the

full force of the evidence we had, particularly with regard to the

offset provision, to that court.

Mr. MORAN. But there is now court proceedings pending in other

cases similar to Zelener, in which the outcome may or may not be

the same? Is that true?

Ms. BROWN-HRUSKA. Yes, sir.

Mr. MORAN. Thank you very much. I recognize the gentleman

from North Carolina.

Mr. ETHERIDGE. Thank you, Mr. Chairman, and thank you again,

Madam Chairwoman, for being here this morning and coming.

In a number of the sections in your testimony, you suggested

there are areas where Congress might wish to consider changes in

the Commodity Exchange Act. A big factor in considering, in deterVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
10

mining whether or not we make changes will be the—of course,

your point of view. The agency experts seem to be the best place

to get advice on these areas, so with that in mind, let me refer to

the areas that you mentioned in your testimony, and get your opinion.

Should the CEA be amended, as you have talked about? Number

one. It says make clarification for the legal framework provided for

exempt markets. Number two. Make effectively, avoiding duplicate

burdens on the market, and provide guidance and support with respect to CFTC interaction with other agencies. And third, ensure

that the CFTC has clear and adequate authority to police retail

fraud, particularly in the foreign exchange areas.

If you would share with us on those three areas.

Ms. BROWN-HRUSKA. Well, thank you very much, Congressman.

As I mentioned, the CFTC does stand ready to assist Congress as

it makes the law that governs the industry. It is true, we are the

regulators, and we are just one part of the process. I certainly appreciate that you do look to us for our position, and we will certainly provide that to you, but we believe that this is, in many respects, this is the first opportunity for us to bring these issues to

you, and we would suggest that you also need to have the benefit

of the industry input. You need to hear from firms. You need to

hear from end users, folks who use the market, folks who want to

use the market.

We have to understand their issues, the people who are in the

markets, who use the markets, who run the markets. Now, we at

the Commission, and I think all of the Commissioners will be

happy to share our views and our assessment of the need and the

effect of any change going forward. I brought the three particular

areas to your attention, because they are a source of concern to the

CFTC, to all, to myself and the other Commissioners, significantly.

We have talked at length about the exempt markets, and it is interesting you raise that issue. We raise that issue, and one reason

I put that out there for Congress, it actually turns out that there

is a lot of disagreement as to what Congress did intend in many

of the aspects of the energy markets and the statutory language involved. So I would say that how we interpreted it was that we had

authority in many of those areas, to bring cases where we see

wrongdoing, and that is how we see our marching orders. But if

Congress did not intend for us to have that authority or if there

is some conflict there, we need to hear from you.

I think, again, we want to avoid, in the case of the single security

futures, in avoiding duplicative burdens. I think it is a challenge

for two regulatory agencies to jointly regulate a product, and we

have worked very hard to try to establish good relationships with

the SEC, to get some of the job done there.

The last point that you asked was: do we have adequate authority to police retail fraud? Again, it is still an issue that I think the

industry is working on, and we also are working with the industry

to try to get potential solutions, to ensure that we can bring these

cases.

Mr. ETHERIDGE. Let me try to get one more question in my first,

and you might want to expand on that in writing a little later, if

you will. Let me be a little more specific on the duplicate burden

11

and guidance portion of your statement. Some have argued that the

overlapping jurisdiction of the CFTC and SEC is the source of failure of the security products to really take off. We haven’t seen a

whole lot of movement.

Your testimony speaks of the successful cooperation with the

SEC, which is, I think, fine and good and very appropriate. But I

would like to hear any disagreements or disputes that may have

cropped up. I think this committee would, between the two agencies, relating to the products, and hear about the areas where your

disagreements may have created some problems where we can’t get

movement, that we need to move, to create the trading.

Ms. BROWN-HRUSKA. From my perspective, there were three

issues that I outlined, and that I have had some difficulty with, in

understanding, or not understanding, but some difficulty moving

the ball forward with the SEC. I think the Commission has—my

predecessor as well—encountered some difficulty the area of margining. I think the intent was that the SEC and the CFTC would

get together and come forward with a margining system that

wouldn’t create regulatory arbitrage between, say, the regulated

options markets and the new security futures products.

The problem is that with security futures products, they set the

levels very high. Also they are inconsistent with the way futures

are margined. Futures are usually margined on a risk-based approach, whereas securities margins are a flat, fixed number, that

doesn’t change with respect to market conditions or interest rates,

or important aspects. So I think it is a fundamental, philosophical

difference as to how how we can reach agreement on margins when

the methodologies that we use in securities and futures are somewhat different? We tend to think that ours is more sophisticated

and more appropriate, but—and I am sure they think that theirs

is more appropriate. So I think that we have tried to reach agreement, we have tried to get them to consider and to move forward

on considering a portfolio of assets, and setting margins based on

the portfolio of offsetting assets, and we are still intending to try

to push them. But margins are important. The reason I have spent

some time on it, because that is the cost of trading. I mean, that

is the cost of using these products, and if it costs too much to take

a position, and to get in and out of it, and to manage your risks

that you face, or to diversify your portfolio, you just won’t use it.

So I think that margins are one of the key issues that we really

will work hard to try to get agreement on.

Mr. MORAN. The Chair recognizes the gentleman from Ohio, Mr.

Boehner.

Mr. BOEHNER. Thank you, Mr. Chairman, and Madam Chairman, we welcome you to the committee. And as Mr. Moran pointed

out in his opening remarks, the CFMA has been wildly successful,

and a lot of us have worked on a lot of bills during our tenure in

Congress, but when we look at the Commodity Futures—the Modernization Act, I think we did, in fact, get it right, and having been

through at least three of these reauthorizations of the Commodity

Exchange Act, I remember when we decided that we were going to

create all the regulations over what should happen in the exchanges, which may have stopped some potential abuse, but certainly limited the ability of the exchanges to grow and to modernVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
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ize, and to deal with, certainly, all the new types of contracts that

we have, and when we did the CFMA, in allowing a different regulatory scheme to into place, more self-regulation, we did, in fact,

open up the exchanges to great modernization, far more new, different, and innovative products, and as we go through with this reauthorization, I am hopeful that the overall model that we created

will not change. And frankly, from where I sit, I don’t see a great

need for it to change, and as we look at the tinkering that you and

others may suggest, I think we need to be somewhat cautious

about overreaching. Clarifying it would be one thing, but overreaching in terms of how far we go is something that I have some

concerns about. The simpler we keep this, the better off I think we

will all be in terms of getting the Commodity Exchange Act reauthorized this year.

Single stock futures. Mr. Etheridge was asking a number of

questions. You addressed it in your opening remarks, and it has

been 4 years. We are still—we are getting off to a very slow start.

I understand it is not the easiest thing in the world to work with

the SEC or, for that matter, to have two regulatory agencies trying

to come to some agreement. Having been involved in the Financial

Services Modernization Act, that involved half a dozen regulators

and dozens of industries, I thought the industries were a problem,

trying to get them to the table to come to some agreement, until

I got to the regulators, and if we in this Congress think the turf

is important, you have not seen anything until you have seen regulators try to come to some agreement on turf.

The market is out there, and I think that these are important

products that could serve to be very significant risk management

tools, and at least for one member that is sitting up here, I would

hope that we would find some way to work through the turf battles

and to come to some agreement on these products, and how we are

going to regulate these products, so that we, the government, can

get out of the way, and let the markets do what they are supposed

to do.

So can you give me some hope?

Ms. BROWN-HRUSKA. I enjoyed your comments immensely, sir.

Congressman, I think that you are absolutely right. These products

are offer great opportunity to market users. I have a lot of my

money in a Government retirement account and a professor’s retirement account, and it is just locked in these market indexes, and

a couple of years ago, I started to sweat, because I think man, the

technology is going down, and I sure would like to get out a little

piece of that, or soften that part of my portfolio. If I had had narrow based technology index, as an individual investor, I could go

to the futures markets and take a short position, and it is basically

a portfolio diversification tool that I think individual investors and

commercial market participants who want to hedge deserve to

have, at a low cost, and an efficient, liquid market, and I commend

the industry, NQLX and One Chicago for bringing forth and making the investment into these products, and I think we, as regulators, really have to commit to you, and I certainly do, that we will

do everything we can to come to agreement to lower the costs of

trading, and to offer—to ensure that these products do have an opportunity to succeed.

13

Mr. BOEHNER. Thank you.

Ms. BROWN-HRUSKA. Thank you.

Mr. MORAN. Thank you, Mr. Boehner, for your historic insight.

The gentleman from Minnesota, Mr. Peterson, the ranking member

of the full committee.

Mr. PETERSON. Thank you, Mr. Chairman, and thank you for

holding this hearing, and welcome, Madam Chairman. Apparently,

the Zelener case that you mentioned in your testimony has important implications for the Commission’s jurisdiction and ability to

police these foreign currency trading scams, and the CFMA, as I

understand it, was intended to clarify the Commission’s jurisdiction

in this area, and you point out in your testimony the track record

of the Commission, where you have filed 70 cases, I guess, and

prosecuted 267 companies and individuals, recovered $240 million

in fines, and we commend you for that. Those are all good measures, but what we really want from an enforcement program is a

reduction in the amount of fraud that is committed. So in your

opinion, based on the Commission’s surveillance and enforcement

activities, has there been a reduction in fraudulent activities in

wake of all these successful enforcement cases, and can you demonstrate that?

Ms. BROWN-HRUSKA. I think yes. I think that what we see is that

this kind of fraud, I mean, I won’t say that—forex is kind of the

fraud du jour. It is the hucksters are out there saying the dollar

is low now, you can make money like the big guys, this amazing

profit potential, by going into trading forex in some sense, we have

seen this before, and in other areas. We see it in heating oil, for

example, almost every season, before the winter season. And we

have seen it in options, in the early 1970’s, before the Commodity

Futures Trading Commission was established. We have struggled

a lot with fraudsters. They will go from one commodity and one

asset to another, to try to get customers to part with their money.

I would qualify my answer, and say that, in fact, it may be the

case that we are seeing more forex fraud, it seems like with the

advent of the Internet, and there are more sort of avenues for

fraud in derivatives and in foreign exchange. It may be that just

that by virtue of the fact that the markets have grown, and that

the dollar has been weak, that we are seeing more fraud.

Mr. PETERSON. Thank you. Apparently what happens from some

of the time these firms that are committing this fraud, using these

Ponzi schemes or other methods for misleading investors. From

what I understand, they get shut down, and there are settlements

with you, and then they pop up in another form, in another place,

and run the same scams over again. Is that true, and do you think

that happens often? I have been informed that that is going on.

Ms. BROWN-HRUSKA. What we try to do in these cases is work

with criminal authorities to put these guys behind bars, and I

think we have had some success. In fact, we are just filing a case

right now for someone who—put behind bars for a number of years,

and as soon as he got out of jail, he immediately started doing it

again, and so we are shutting him down again, freezing his assets.

And we do try to work with state criminal authorities, and other

government agencies, like the Department of Justice, for example,

to try to use everything at our disposal to take these guys out of

14

the market. As you mentioned, they are very resourceful, they are

very clever, and they will move from to one commodity to another.

They will move from one state to another. They will change their

story. They will change their name. It is a real problem.

Mr. PETERSON. Well, and apparently, these activities violate

state laws, I guess, and Federal laws other than the Commodity

Exchange Act. Is that correct?

Ms. BROWN-HRUSKA. Yes.

Mr. PETERSON. What kind of cooperation do you have working

with these other enforcers, and do you think this is a good responsibility or mission for you guys, or would it be better off if the state

and other Federal agencies were given this task to do this?

Ms. BROWN-HRUSKA. Well, 3 years ago, we established the Office

of Cooperative Enforcement within the Division of Enforcement,

and the purpose of that office has been to educate state, local, and

fellow Federal authorities on how to prosecute this kind of illegal

conduct. As a result, we have been successful in getting these state

authorities to not only refer cases to us, but also, having them

bring criminal actions against off-exchange boiler rooms, specifically in the area of forex. This is an ongoing process, as we are in

the process of organizing a training conference in the near future,

in fact, to bring all states together to capitalize on coordination and

manpower. And I would even add that I have been talking with my

fellow Commissioners about this issue, thinking of ways that we

can increase our education of consumers that would fall prey to

this activity, and so we are kind of two-pronged. We want to try

to educate and work with other law enforcement authorities, and

we would also like to get the word out that we are serious about

shutting these guys down. Thank you.

Mr. PETERSON. Thank you. Thank you, Mr. Chairman.

Mr. MORAN. Thank you, Mr. Peterson. The gentlewoman from

Colorado, Ms. Musgrave.

Ms. MUSGRAVE. I don’t have any questions at this time, Mr.

Chairman. Thank you.

Mr. MORAN. Thank you very much. The gentleman from Georgia,

Mr. Marshall.

Mr. MARSHALL. Thank you, Mr. Chairman.

You have identified a number of issues that you think Congress

might want to weigh in on, but you have expressed no opinion

about how Congress might wish to actually weigh in?

Ms. BROWN-HRUSKA. Well, as I said before, and I appreciate your

raising this issue, because we are actually very anxious to consult

with you, and provide you with what we know.

Mr. MARSHALL. Since we have got such a brief period of time, it

would be helpful to me, and I think more helpful to the committee

and to Congress generally, if you and the other Commissioners

would—particularly, if you have all pretty much agreed with your

staff, your lawyers, if you would make recommendations, specific

recommendations to us, for how the CFMA ought to be modified in

order to address the issues that you have identified. Simply highlighting the issues, and doing no more than that is not nearly as

helpful as if you would give us your opinion, your expert opinion,

on how these issues should be addressed. Take the Zelener decision. I can’t imagine that you were happy with that decision.

15

Ms. BROWN-HRUSKA. Oh, no, we are not.

Mr. MARSHALL. I would imagine that those lawyers on your staff

who were prosecuting that case were pretty chagrined and surprised. They thought they had done their job, and you probably

haven’t told them that they weren’t doing their job, that they had

done it inappropriately. It may be a decision that you can live with,

and that you can work with in the future, in the sense that you

are going to have to change the way that you prosecute your cases,

but another way to address it is to suggest to us how we might

modify the CFMA so that you don’t have a Zelener type problem

in the future with addressing these kinds of fraud cases. And so

I guess what I would like to ask you to do, and if you could just

say yes, I will do it, or we will do it, that would be great. Is would

you, with regard to each one of these issues, make specific suggestions concerning what Congress might do to address the issue? You

all have in mind what you would like. You just haven’t suggested

what it is, and so if you could just give us the statutory language,

and the reasons why that statutory language would be appropriate

to adopt, it would be real helpful to me, and I think, to the balance

of us. How you would like to address the Zelener problem. You

would like to clarify your authority here, and that language that

you could use to do that. If you would just give us that language

and tell us what effect that language would have, and why you

need it, that would be helpful. The same with the other issues that

you are having. Are you willing to do that?

Ms. BROWN-HRUSKA. Oh, yes, sir. Absolutely.

Mr. MARSHALL. That would be great. Maybe the chairman can

suggest a date by which that might be done.

Ms. BROWN-HRUSKA. As I mentioned before, I really——

Mr. MARSHALL. We are going to hear from industry. You have already said that. We are going to hear from all kinds of other folks.

We need to hear from you as well. So we have started with you.

If you could give us your opinion, we view you as being unbiased

here. You don’t have an ax to grind. You just want to do a decent

job of enforcing and advancing these markets. And so if you could

do more than just identify the issues, if you could provide us with

your suggested solutions.

Ms. BROWN-HRUSKA. Well, thank you very much, sir.

Mr. MARSHALL. I will make one more observation. I have spent

years before being a mayor and being in Congress, as a lawyer and

a law professor, and the 70 and 3 record cuts two different ways.

I mean it sounds great, like you all do a wonderful job in prosecuting your cases. But a lot of lawyers would say that just means you

are not prosecuting enough cases. You should have more that you

lose. Now, I don’t know whether that is the case or not. I don’t

know enough about what you do, obviously, but this boiler room

problem is catching an awful lot of people. And I am sure you are

going after it as aggressively as you can, but just going—you just

prosecuting the winners exclusively means that there are a lot of

winners out there that you just didn’t put enough effort into. That

is what a lot of lawyers would say. I appreciate hearing from you,

receiving from you your specific suggestions, the statutory language, and the arguments that support adoption of that language

for each one of these issues.

16

Thank you.

Mr. MORAN. I thank the gentleman from Georgia. The gentleman

from Louisiana, Dr. Boustany.

Mr. BOUSTANY. Thank you, Mr. Chairman. I have one question,

and it really pertains to the energy markets, and some of the provisions you mentioned here in your testimony refer to, and you also

refer to last year’s energy bill. I want to know if everything you are

asking for, in terms of specifics, were in that energy bill, or is there

additional clarification of specific recommendations you are making

with regard to energy markets?

Ms. BROWN-HRUSKA. Yes we did, in fact, consult with the authorizing committees, for example, last year, when that energy bill was

being considered. I think there were some very overreaching and

significant changes to our authority that had been suggested. I

would say that we felt, and given our experience, that these

changes were sensible—and I can certainly outline them for Congress, we thought they were sensible, and would not send the industry into a tailspin, but it would increase the clarity with respect

to our jurisdiction. So we would be glad to discuss those further.

They are very limited. There were just, I think, four or five changes

that we thought would be worth considering.

Mr. BOUSTANY. And those were not considered overly prescriptive? You were satisfied, in other words, that it would meet your

needs?

Ms. BROWN-HRUSKA. Yes. Yes, sir.

Mr. BOUSTANY. Thank you. That is all I have, Mr. Chairman.

Thank you.

Mr. MORAN. Thank you very much, Mr. Boustany. The gentleman from Georgia, Mr. Scott.

Mr. SCOTT. Thank you, Mr. Chairman.

Chairman, it has been a little over 4 years since the last reauthorization Act was enacted, and a key modification of that law

was that the CFTC’s role of prescribing rules for exchanges, the follow was removed. And the exchanges were given the responsibility

to comply with core principles. While it is true that trading volumes have increased dramatically, they also increased large

amounts in periods before the CFMA was enacted. What tells you

that anything has really changes as a result of the change in the

statute?

Ms. BROWN-HRUSKA. I looked at a chart just yesterday. I asked

for a sort of an update on progress that our markets have made,

number of new contracts offered, and volume, and it is significantly

increased since the year 2000, or since the CFMA was passed,

which as an empirical matter, making that relationship, say, because of CFMA, if this, then volumes and contract innovation increase, it is a bit of a leap. But I believe just by observation, anecdotal as well, part of it is the speed with which we are able to approve, it is the flexibility that the industry has to think of new

ways to meet their customers’ needs and their demands, that the

CFMA really enabled, because it sort of takes the day to day, approval process away from the CFTC, and allows exchanges, when

they are not materially different changes, but significant concerns

from a regulatory perspective, but are innovative—it allows the exchanges to certify those changes, allows markets to set up different

17

market structures, that maybe weren’t contemplated when the exchanges developed. So we are actually seeing new, different types

of markets that offer different levels of—different ways of coalescing buys and sells, and different ways of satisfying customer demands. So we are literally seeing quite a flourishing of the markets.

Mr. SCOTT. We recently gave the CFTC pay parity authority,

that is, the right to set personnel pay levels outside the general

schedule for Federal employees. How has this authority been used,

and what effect has it had?

Ms. BROWN-HRUSKA. Well, thank you very much for asking that,

Congressman. It is one of those issues that has been very important to the CFTC. Prior to pay parity, and Congress did give us

that authority to offer pay parity, we had a terrible attrition rate.

We lost so many talented, smart people. You have got to realize,

futures and derivatives are—they are complicated transactions,

and you bring somebody along, and you develop their knowledge

and their skills, and then they run off to the private sector, or even

worse, they run off to another financial regulator, and so we really

needed to stop the flow of this high quality talent from the CFTC.

Part of the problem was that others were able to pay a lot more.

And so pay parity enabled us to at least bring our pay up to the

level that we were seeing in other financial regulatory agencies. We

evaluated how their pay systems worked, and we came forth with

a plan. In fact, we are still in the process of implementing certain

aspects of it, more performance based pay and the like. But it has

stopped the attrition. We are now down to, I think, a normal level

for a government agency, or a federal financial agency. We are consistent with those, and we have been able to build up a strong base

of staff, it has been a challenging experience from a resource management perspective, because pay parity, in essence, means that we

have to pay our people more to bring them up to the levels that

we saw in financial regulators, so we have to sometimes make sure

that we have to use every resource that we have at our disposal,

so that we are able to do that. But it has been a very big success

for the CFTC in improving our performance.

Mr. SCOTT. So you do feel that you have the adequate resources

to accomplish your mission.

Ms. BROWN-HRUSKA. Yes, we do. Thank you, sir.

Mr. SCOTT. OK. Thank you. Thank you, Mr. Chairman.

Mr. MORAN. Thank you, Mr. Scott. The gentleman from Texas.

Mr. NEUGEBAUER. Mr. Chairman, thank you. Chairman Hruska,

thank you for being here. Some have called for some price position

limits in—when it comes to trading some of the energy markets.

Others say that it is just a volatile market. It should be left to

trade on a fairly free basis. What is your position on that?

Ms. BROWN-HRUSKA. We have always had, from the exchanges’

perspective, we have always had, exchanges have had the ability

to set price and position limits, to curtail congestion, prior to the

delivery, or to ensure that there weren’t traders who were taking

unusually large positions, and moving the market unduly. And so

it has been one of those things where exchanges have had, in most

instances, a good bit of authority to put in these limits, and we

have seen, historically, we have worked very much with the exVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
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changes in their setting of those limits, and in their monitoring,

and they change them from time to time, to, for example, deal with

changing market conditions. I know we have seen a lot of growth,

for example, in the ag markets. A lot of grains still have federally

mandated speculative position limits. Because of all the growth in

the markets, and the new participants, and we have seen that they

have a desire, for example, to raise limits in those markets. So and

then, we hear in the natural gas markets that there are some people who think that those limits should be lowered. But what we

have done is we have relied on the exchanges to determine the limits based on their customers, that participate in those markets, and

their monitoring of the day to day changes in prices, and we have

had generally a very good, I think, experience. If we have a concern

about, for example, their levels that they have set, we will let them

know, but generally, I think that the exchanges have done a very

good job of administering those limits. So I guess my answer is

that we are satisfied and very comfortable with the current mechanism for setting limits.

Mr. NEUGEBAUER. So you think the exchanges are managing that

process effectively and efficiently?

Ms. BROWN-HRUSKA. I think that they are, yes.

Mr. NEUGEBAUER. Based on the Zelener case, it looks like somewhat of that case is over definition of what is a futures contract.

As we go back and maybe look at some tiny fixes or something like

that, is—would some language clarification in some of those areas

be helpful or not?

Ms. BROWN-HRUSKA. Well, I think one thing that we worry a little bit about when it comes to coming up with a definition and putting it in the statute is that we will give criminals a roadmap to

what they can do, so they can avoid our authority. So there is—

in some sense some advantage to allowing us, through our court

cases and through our actions, to provide signals, and to provide

guidance as to what we regard as illegal conduct and illegal activity. So we have had discretion. In the past, we have tried to utilize

that discretion appropriately by going after egregious fraud, all

fraud, in this area. We have tried not to expand our authority such

that we find ourselves regulating the currency inter-bank market,

populated by major banking institutions. We don’t have that authority. We don’t have that desire to get involved in that space. The

banking agencies take care of it. So that is one of our concerns,

that sweeping legislative changes or statutory language that might

bring forth some definition or some overspecificity may actually

create a difficulty for us.

Mr. NEUGEBAUER. And last question. This has been in effect for

4 years, and it is an impressive amount of activity that has increased in the markets and the new products, and of course, one

of the things I believe very strongly is that government not get into

the knee-jerk reaction of changing policy on a very frequent basis,

because what makes markets more efficient is once they understand what the rules are, they begin to operate effectively, and I

know we are going to hear from the industry themselves, but all

in all, do you feel like that the current structure that you are working under is working, and that we shouldn’t make any material

changes to it?

19

Ms. BROWN-HRUSKA. Yes. I think that the structure is working

remarkably well. Again, I kind of want to tell you why I qualify,

in my remarks, why we are not bringing forth specific changes.

First, because there is this concern that by doing statutory

changes, you will have these unintended consequences that could

quell some of this growth and vibrance that we are seeing in the

legitimate marketplace. So we are very cognizant of sort of the

costs and benefits of changing the act, and so I would say that we

are very comfortable with the act as it is now. We have found that

we have authority to bring a significant amount of cases in the energy and the forex area, and some of these issues really, in terms

of, like, the forex area, some of them are fine legal questions that

we could maybe do a better job of proving up our cases, or maybe

we could be more specific nailing those aspects that the court

seems to think we need to nail to bring—to succeed in those cases.

And we can do that without changing anything in the statute. So

thank you for raising that.

Mr. NEUGEBAUER. I think my time has expired, Mr. Chairman.

Thank you.

Mr. MORAN. Thank you, Mr. Neugebauer. The gentleman from

Washington, Mr. Larsen.

Mr. LARSEN. Thank you, Mr. Chairman, for a chance to ask some

questions. Quickly, on page 3 of your testimony, you outlined you

have taken prosecution of 46 entities to the tune of about $300 million in the energy market. Could you provide a list to the committee, which those entities are, and how much in each case?

Ms. BROWN-HRUSKA. Yes. It would be our pleasure. Thank you,

sir.

Mr. LARSEN. That would be great. Then, on page 4, you talked

about the, again, back to the energy markets. In your testimony,

proposed changes sought to make clear the Commission has the authority to bring any fraud actions in off-exchange principal-to-principal transactions. That was in the energy bill. It seems to me from

that paragraph in your testimony that you certainly believe, that

is, the Commission certainly believes it has the fraud authority

that it needs, but perhaps that consensus doesn’t exist in the energy industry. And so my concern is we will maybe create a situation where you use that authority, but if Congress does not clarify

that authority, that maybe there is some legal uncertainty in having that authority stand up. Is that your concern, or is there another, pardon me, another concern that you have about why we

should strengthen it? Because if it needs to be strengthened, we

ought to be foursquare behind it to do that.

Ms. BROWN-HRUSKA. Thank you, sir. I agree that there is disagreement, and there has been, this issue that has been debated

before I even came to the Commission of whether or not certain

parts of the act negate or conflict with other parts of the act. Our

approach has been to assume that the authority that is clearly

given in, say, for example, 2(h), which gives us fraud authority in

exempt markets, which are energy markets, our approach has said

you know, it says we have authority, we are going to exercise that

authority. Surely, clever attorneys for those companies that we go

after, or those individuals will argue that no, no, no, you don’t have

authority. But one thing that we have seen is that we have been

20

very successful in convincing those companies that they need to

come to the table, and that they need to cooperate with our investigations. A lot of them are still seeking to do business, and so it

has been a situation where we have—the kinds of activities that

we saw in energy, for example, we saw false price reporting. It was

a significant problem in that industry, and although, I think that

it is one of those problems that is part of the past, because we have

brought so many actions under that authority, which makes false

price reporting illegal under our Act. So we have been creative in

our use of the statute, to make sure that when we find wrongdoing,

we can bring—we can take an action, and so in general, I would

say that those changes that are—that we are suggesting Congress

might want to consider, are kind of, we are clear on what we think

Congress intended. Sometimes, it is more of a matter of Congress

saying OK, take that ball and run with it. And we would be delighted with that, and that may not result in any technical or marginal changes in the act. We are taking the ball if you tell us to.

Mr. LARSEN. Good. Well, we will—if you need another to ball to

take, I think Congress ought to do it, in the energy markets, certainly, we have had, obviously, our own experiences in Washington

State and the west coast, so I want to be clear about that. The

third thing I want to ask is about 2(g), Section 2(g), and there has

been some discussion, recommendations perhaps about repealing

2(g). Could you educate us on 2(g), and then some have suggested

that it serves as a loophole that trading entities can use to evade

CEA protections, that were otherwise preserved. Can you comment

both on 2(g), and then on does it act as a loophole, then, as well,

that we need to fix?

Ms. BROWN-HRUSKA. Yes, I am glad you asked that, because it

kind of is a good follow-on to your first question.

Mr. LARSEN. Sure.

Ms. BROWN-HRUSKA. Because that is kind of what was in the

back of my mind when I was answering. Two(g) is the swaps exclusion. It says that, and I think it was primarily to provide legal certainty for the over-the-counter swaps markets, that had suffered

under many years of legal uncertainty regarding whether or not

the CFTC would bring a case. There are some who felt early in the

development of the swaps markets that they were futures, and I

know, as a professor of derivatives markets and risk management

that they are different than futures. They have a lot of aspects that

are more customized. They are more—the cash flows are tailored

to individual consumers, or commercial participants’ needs, and so

swaps were provided an exclusion for one reason, from the CFTC’s

authority, because they were different transactions, and they were

more customized. And the other reason is that they were utilized

and offered, in most instances, by banking institutions, which are

regulated by the banking authorities. So the purpose of 2(g) was to

provide an exclusion from the CFTC’s jurisdiction, but not to let

these things out there in the wind, and have no supervision. They

are, certainly, I have friends who work for various banking agencies who go out and look at the portfolio of these entities that offer

swaps and ensure that their internal controls, and their representations, and their risk management practices are in order.

21

So in some sense, I think 2(g) is, was an important accomplishment of Congress. It did provide legal certainty, and it would be

very dangerous, I think, to send a signal that you would want to

repeal that, or you would want to—because that business is—it

serves an important risk management function to commercial market users, and those that do global business, and those that do

business in a variety of commodities, you depend on hedging their

use of, for example, those indexes, and those financial products. So

we see a development of those that has occurred. It is a healthy

development, a healthy market, and so even though I don’t think

that we have any demonstrated need to change that exclusion.

Mr. LARSEN. Just quickly—so you don’t see it as a loophole, because these swaps are regulated in another field, in banking, so

CFTC doesn’t necessarily need to have that authority, essentially

what you are saying?

Ms. BROWN-HRUSKA. Yes. And it is also the case that they are

commercial market users. They are sophisticated users that use

these, and often on a principal-to-principal basis, or they are intermediated by swaps, intermediaries that, again, are banking institutions or otherwise regulated financial institutions.

Mr. LARSEN. Thank you. Thank you, Mr. Chairman.

Mr. MORAN. The gentleman from Missouri.

Mr. GRAVES. Thank you, Mr. Chairman. I wanted to follow up on

a couple of questions. When it came to trading limits, particularly

for commodities like natural gas, and you have kind of touched on

that a little bit, and I know you are aggressively, and from your

testimony, you have said you are aggressively pursuing any problems that have come up in, particularly in energy trading, but

without trading limits for commodities like natural gas, I know you

can go after those folks for market manipulation after you see it,

but don’t you think that having trading limits would at least prevent some of that ahead of the game?

Ms. BROWN-HRUSKA. Well, what type of trading limits are you

talking about? Price limits, a lot of times, just stop trading.

Mr. GRAVES. It breaks it up, though.

Mr. GRAVES. It does break it up, though, or at least, attempts to

break it up.

Ms. BROWN-HRUSKA. Well, it stops trading in the regulated market, right. That is where a lot of people are advocating for us to

enact more draconian limits. It doesn’t necessarily stop trading in

the underlying cash markets, or in the, say, the voice-brokered

markets, or in some other market spaces, so what you might do is

if you have too tightly drawn limits, that you will constrain the

regulated market from sort of zeroing in on its fundamental value,

based on supply and demand. You will constrain that market, and

meanwhile, the underlying markets that are still free to operate,

in fact, it might cause volume to go to those unregulated markets,

because at least, you can accomplish trade when they are not shut

down waiting for a limit to be lifted, or for the time to expire. It

creates, actually, a fundamental inefficiency in the market if those

limits are too tightly drawn. What exchanges have seen fit to do

is to monitor the markets, to determine what the average size are

of transactions, and sort of optimal levels for limits, and as I mentioned before, our experience has been that the exchanges have

22

done a very good job of determining limits, and using limits in an

appropriate manner, to sort of still have levers of control, when

markets get highly jumpy and rather volatile, but not over controlling such that markets are disconnected from their underlying supply and demand fundamentals.

Mr. MORAN. Mr. Graves. The gentleman from North Dakota.

Mr. POMEROY. Thank you, Mr. Chairman. I want to say how

much I have enjoyed this hearing, and the chairperson’s testimony.

You follow much the spirit of your predecessor, Mr. Newsome, who

we enjoyed working with in the Agriculture Committee, felt like he,

kind of a breath of fresh air, in terms of commonsense regulation

out of CFTC. I want to commend your new commissioner, Mike

Dunn. I have known Mike for better than a dozen years, to get a

good hand there.

Ms. BROWN-HRUSKA. I agree. Thank you, sir.

Mr. POMEROY. A couple of questions that I have. Did you find in

the energy prosecution, I see that you have got $35 million in civil

penalties against Enron specifically?

Ms. BROWN-HRUSKA. Yes.

Mr. POMEROY. Did you find that their conduct was particularly

egregious in its violation of your jurisdiction, or in violation of the

laws within your jurisdiction?

Ms. BROWN-HRUSKA. I think every regulator that has looked at

Enron found their conduct to be particularly egregious. I mean, it

was indicative, I think, of the time in some respects, because a

number of companies were, in some sense, sometimes cooking their

books, or were sometimes engaging in very aggressive trading

strategies, to try to take advantage of poorly designed markets, and

they seemed to lead the way in that aggressiveness.

Mr. POMEROY. They, on the one hand, were highly innovative, in

terms of futures trading in the energy sector, but then, they went

to the dark side in a very big way.

Ms. BROWN-HRUSKA. Yes.

Mr. POMEROY. While $35 million sounds like a lot of money, the

economic consequences of their market manipulation was far beyond that. Correct?

Ms. BROWN-HRUSKA. Well, I would say our action was specifically

for their activities in Enron online, they had a separate platform

that we brought an action against them. What we call a 2(h)(1)

market, a one-to-many platform and they had violated some of our

rules that we have in that market space. And so our specific action

was for a small piece of their activity. And I would note that we

are still investigating them for some other areas of activity that we

want to ensure that—so even though $35 million, you are right, in

the grand scheme of things, it sounds like a good number, but it

is really for their particular illegal activity in Enron Online.

Mr. POMEROY. As a regulator, you have got a bankrupt corporation on your hands, further fines may penalize only the other debtors that are going to be getting stiffed by them. So it is a tough

line to walk. I note that you also have the jurisdiction, some actions pending against them on individual liability. To what extent

are you pursuing individual liability from Ken Lay and company?

Ms. BROWN-HRUSKA. Is it the Enron Task Force? OK. That is

good. I had to check with my Division of Enforcement director. He

23

said that actually, because we still have some ongoing investigations with criminal authorities, the Department of Justice and others, that we can’t describe or discuss them specifically at this time,

but I think that we may be able to come and provide a private

briefing of some of the things that we have and we are working on.

Mr. POMEROY. We will want to pursue that. And I will have an

exchange with the chair in just a moment, relative to what this

subcommittee ought to do relative to the energy bill, and your role

in it. But I do think that is important that this committee exercise

oversight authority, and fully understand the dimensions to which

you continue to prosecute these violations. I would say that I think

there is strong congressional intent, probably right across the political aisle here, for vigorous, personal enforcement of individual liabilities that, relative to key operatives in this corporate structure

that engaged in and were responsible for the wrongdoing. I don’t

think there is anything we can do to really establish bright lines

about the energy sector conduct in these instruments, and this type

of trading, than to really put some teeth into this enforcement in

the most significant individual ways.

I know my time is now up, but Mr. Chairman, I would ask you,

we have had a long dance with the Commerce Committee relative

to this jurisdiction, and they have been rather openly covetous of

our jurisdiction over CFTC over all these years. I think it is terribly important that we stake out our claim to jurisdiction over any

portion of the energy bill that would relate to CFTC’s ability to

bring these types of actions, and I would ask whether you believe

the Ag Committee will assert itself as an energy bill comes forward.

Mr. MORAN. Well, the gentleman from North Dakota raises a

good point. I would obviously need to defer to the gentleman from

Virginia, the chairman of the full committee, but it would be my

thought that should CFTC issues be contained in any energy bill,

and it is my understanding to date the House version of that energy bill does not include those provisions. The Senate attempted

bill has, does, may, and should we get to conference, I would think

it would be appropriate for the committee to be engaged in all

CFTC jurisdictional issues in an energy bill. But it is obviously an

issue that we need to raise with Mr. Goodlatte.

Mr. POMEROY. And certainly understanding that, Mr. Chairman,

I would hope that if it is something that is likely to be encountered

in conference, that this subcommittee would have ongoing hearings

specifically tailored to the energy sector, so that we might appropriately advise our committee conferees, at the time they go in,

with appropriate background, that we could develop at the subcommittee level.

Mr. MORAN. And it is a good suggestion. Again, one that we

ought to raise with the chairman of the full committee, and see

how he wishes to proceed, along with the consulting with the ranking member, Mr. Peterson.

Mr. POMEROY. Thank you, Mr. Chairman. In conclusion, I would

just say that I very much enjoyed working on the Commodity Futures Modernization Act, and think of our former chairman, Tom

Ewing, and his role in getting this thing passed. I don’t know withVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
24

out his persistence, whether we would have actually concluded that

landmark legislation.

But we certainly did intend for what I believe, the congressional

intent behind that was to essentially let competition work its will,

where there weren’t regulatory issues, but to leave with CFTC

clear authority to police abuses and fraudulent or illegal conduct,

and to the extent that your subsequent litigation under the CFMA

raises any questions of your legal grounding to bring the kind of

prosecutions that we expect you to bring, we will certainly want to

tighten that language up in this reauthorization, and so as Mr.

Marshall asked, if we could have your very specific recommendations, as you have learned from legal arguments raised under the

initial version of the act, we would very much like to know that,

so we could include it in the reauthorization.

Ms. BROWN-HRUSKA. Well, thank you, Congressman. I appreciate

you.

Mr. POMEROY. Thank you, Madam Chair. Mr. Chair.

Mr. MORAN. Thank you, Mr. Pomeroy. I don’t intend to have another round of questions, other than the gentleman from Washington has indicated he has one additional question, and I recognize

the gentleman from Washington.

Mr. LARSEN. Thank you, Mr. Chairman. Back to 2(g), Section

2(g). You mentioned the financial services sectors where some of

these others, where the swaps are being regulated. Within the energy market, though, are there transactions that are not being regulated that ought to be regulated, with regards to 2(g), or is everything getting done that needs to be done? You focused, you took

your answer, and moved it over to the financial services, which I

appreciate, but coming back to the energy market generally, how

is 2(g) applied, and are some things not being regulated, or are we

taking care of everything? Is everything getting taken care of?

Ms. BROWN-HRUSKA. Well, I don’t want to oversimplify things. I

think that 2(h) is not 2(g), while it is specific to swaps. Whereas

2(h) is specific to energy markets.

Mr. LARSEN. OK.

Ms. BROWN-HRUSKA. And 2(h) is really provided, I think, it was

one, again, of the strong points of the CFMA, that it actually provided a means for new markets, electronic markets, like the Intercontinental Exchange, for example, out of Atlanta, to come into

being, and other markets, like NYMEX, are providing clearing for

over-the-counter markets, products. There are certain things that

CFMA enabled, but it is still within a regulatory framework. So in

my view, the 2(h) provides us with, still, significant fraud and manipulation authority, and we have an intent to act upon that authority, so again, I don’t want to oversimplify and say everything

is covered, but virtually everything we have seen, we have been,

again, we have been creative. We have brought actions. We have

also seen that, for example, where markets developed, areas where

we had a concern about, and we raised it with them, they changed

their rules to ensure that, for example, that type of activity wasn’t

occurring any more, and I think it has been a positive experience

for us, working with some of these fledgling markets that are trying to get started, and for them as well. So to a short answer long.

25

Mr. LARSEN. You would be a great Member of Congress. Thank

you, Mr. Chairman.

Mr. MORAN. Thank you, Mr. Larsen. Chairman, thank you very

much for your testimony and your response to our questions today.

I have a series of questions that I would like to submit to you in

writing, and would request your reply, in writing, and we want to

follow up with you to—in regard to the gentleman from Georgia’s

question about specifics, and try to work out a time frame in which

you can get that back to us. In addition to that, I hope that you

and others can see a strong interest in this subcommittee’s, the

membership of this subcommittee in this topic. I was pleased with

the discussion and the questions, and the high level of interest that

members of this subcommittee have. I think we take our task very

seriously, that this is not just about simply concluding that everything is working fine and move forward. We want to make certain

that is the case, and make intelligent decisions that not only are

useful in the economic sense to the markets and to their customers,

and I suppose the overriding of most members of this panel is to

make certain that the industry succeeds, but at the same time, its

customers are protected, the CFTC has the authority and ability to

do its job.

And we look forward to working with you and others to see that

that is accomplished. We will have a hearing, again, next Wednesday, in which the exchanges and the industry will be presenting

their testimony. I think some time shortly thereafter it would be

useful for us to have any specifics of suggested changes that you

have in legislative language, statutory language.

Anything else? Therefore, having said everything that at least at

the moment needs to be said, without objection, the record of today’s hearing will remain open for 10 days to receive additional

material and supplementary written responses from witnesses

posed by any member of this panel. And the hearing of this Subcommittee on General Farm Commodities and Risk Management is

now adjourned. Thank you.

[Whereupon, at 11:33 a.m., the subcommittee was adjourned.]

[Material submitted for inclusion in the record follows:]

STATEMENT OF SHARON BROWN-HRUSKA

Good morning Chairman Moran, Ranking Member Etheridge and members of the

committee. I am pleased to appear on behalf of the Commodity Futures Trading

Commission to discuss the important issues surrounding the reauthorization of the

Commission. Before I begin my testimony, I would like to recognize and introduce

my fellow colleagues on the Commission, who join me here today. First is Commissioner Walt Lukken, who is certainly no stranger to many of you because of his

years of experience working on the Hill. I had the pleasure of joining the Commission at the same time as Walt, and have greatly enjoyed working with him over the

past two and a half years. As we proceed through the reauthorization process I look

forward to drawing on his knowledge of the Commodity Exchange Act (Act).

I would also like to introduce the two newest members of the Commission—Commissioner Fred Hatfield and Commissioner Mike Dunn, both of whom I had the

honor of swearing in this past December. In the short time that Commissioners Hatfield and Dunn have been at the Commission, they have contributed greatly to our

efforts. I look forward to continuing to work with them and drawing on their considerable experience and insights. I have solicited input from all the Commissioners

in preparing this testimony.

Finally, I would like to recognize and commend the staff of the CFTC. Having

been on the staff of the agency during the early 1990’s I was able to see firsthand

26

the dedication they devote to the agency and industry they regulate. As the acting

chairman I continue to see not only this dedication, but the enormous energy and

creativity that they bring to their task. Without this energy and dedication, I am

sure that much of the innovation that the Commodity Futures Modernization Act

of 2000 (CFMA) enabled would not have been possible.

It was just over four years ago that Congress passed the CFMA. While this may

seem like a short time, the amount of change that has occurred in the futures and

derivatives industry over that period has been extraordinary. And much of that

change has been facilitated by the flexibility and innovative foresight of that legislation. Today I would like to take the opportunity to brief you on the CFMA—the

progress that the Commission has made in its implementation, what has worked

well and what issues Congress may wish to consider during its deliberation on reauthorization this year.

Overall, the act, as amended by the CFMA, functions exceptionally well. The

CFMA has provided flexibility to the derivatives industry and legal certainty to

much of the over-the-counter derivatives market. This flexibility has allowed the industry to innovate with respect to the design of contracts, the formation of trading

platforms and the clearing of both on-exchange and off-exchange products. The industry is no longer overburdened with prescriptive legal requirements and is able

to operate using its best business judgment, rather than that of its regulator. At

the same time, economic and financial integrity have been safeguarded and the

Commission has been able to maintain its ability to take action against fraud and

abuse in the markets it oversees.

Prior to the CFMA, the market was regulated with a one-size-fits-all model. It did

not matter whether a customer was commercially sophisticated; whether the underlying commodity was susceptible to manipulation; whether a customer needed the

flexibility of an over-the-counter contract or the liquidity of an exchange-traded one;

or whether there was more than one way to deliver customer protections in the marketplace. This recognition by Congress of these differences represented a significant

step forward in its design of the regulatory oversight structure. When Congress

adopted the CFMA, it put in place a practical, principles-based model and gave the

CFTC the tools to regulate markets that were challenged by competition brought

about by technology and an increasingly global, marketplace.

Since the passage of the CFMA, the futures industry has experienced phenomenal

growth and innovation. Between 2000 and 2004, the volume of futures and options

contracts traded on U.S. exchanges has increased from 600 million contracts a year

to over 1.6 billion contracts per year. The number of products traded on these exchanges has more than doubled from 266 to 556. Since enactment of the CFMA,

eight new Designated Contract Markets have been approved by the CFTC, and 11

Exempt Commercial Markets and three Exempt Boards of Trade have filed notifications with the Commission.

The markets have also become more global. There is more access than ever for

U.S customers wanting to trade on foreign exchanges as well as for foreign customers wanting to trade in U.S. markets. Last fall, the CFTC approved a clearing

link with a European futures exchange that allows U.S. customers of the foreign exchange to carry these positions at a U.S. clearinghouse. In short, the CFMA has permitted a level of innovation in these markets not seen since futures contracts were

first traded in Chicago during the 19th century.

One of the benefits that has come about from this innovation has been increased

competition and the lowering of trading costs. In response to the U.S. Futures Exchange’s (USFE) proposal to list competing contracts, the Chicago Board of Trade

(CBOT) dramatically reduced its execution fees on its market. In addition, the

CBOT reacted to USFE by offering, for the first time, contracts based on German

securities that were previously traded exclusively in Europe on Eurex.

New product and rule amendment certification procedures in the CFMA have also

lowered regulatory barriers and fostered innovation by providing exchanges greater

flexibility in listing contracts and reacting to developments in the cash markets.

One result of the lowered barriers to entry is that different contract designs, such

as binary options, have been offered as alternatives to using traditional futures and

options. In short, the innovation, competition, and customer choice envisioned by

Congress in passing the CFMA is bearing fruit.

That said, we at the Commission are committed to ensuring that our regulatory

policies are similarly responsive and that the implementation of the CFMA fulfils

the intent of Congress. Competition and innovation must be realized in such a way

that customer protection is not compromised and that the financial and economic

integrity of our markets is preserved. In that regard, there remains more that we

can do as a regulatory agency—working with industry and other domestic and foreign regulators—to move the ball forward even within the current statutory model.

27

As we begin the reauthorization process, any change should come with careful consideration of potential outcomes, as well as any unintended consequences that may

present themselves. The Commission and its staff stand ready to assist you in any

and every way possible as you consider possible actions at this time.

With that in mind, let me highlight three areas of concern on which Congress may

wish to focus as it deliberates during the reauthorization process. First, Congress

may wish to evaluate whether clarifications are necessary for the legal framework

provided for exempt markets. Second, Congress may wish to suggest ways that we

can more effectively avoid duplicative burdens on the markets and, going forward,

provide us with guidance and support as we seek to work with other agencies and

jurisdictions. Finally, we at the Commission are cognizant of Congress’s firm commitment to ensuring that customers are protected from fraud and manipulation and,

to that end, Congress may wish to review whether the CFTC has clear and adequate

authority to police retail fraud, particularly in the foreign exchange area.

ENERGY MARKETS

In the wake of the Enron collapse, and in response to recent run-ups in prices

of natural gas and crude oil, there have been calls to increase the CFTC’s regulatory

authority in the energy sector. Some have called for retrenchment and a return to

prescriptive forms of regulation like the adoptions of federally determined price limits and position limits. Others have called for more sweeping legislative changes

that would give the Commission greater reach into proprietary and bilateral markets. As you consider the appropriateness of such proposals, I would ask that you

keep in mind that the CFTC has responded decisively to prosecute wrongdoing in

the energy markets.

The Commission has acted resolutely in the energy markets to preserve market

integrity and protect market users, demonstrating that its authority is significant

and that it intends to use it. I would note that the CFTC successfully pursued a

complaint against Enron for attempted manipulation of the natural gas markets,

and subsequently attained a civil monetary penalty of $35 million. In addition, the

Commission has filed and continues to pursue various actions and investigations in

the energy sector against both companies and individuals. Our enforcement efforts

thus far have resulted in the prosecution of 46 entities and individuals and the assessment of approximately $300 million in penalties. In addition, the CFTC has recently promulgated regulations clarifying and detailing its authority regarding exempt markets, including certain energy transactions, to better ensure that these

markets remain free from manipulation and fraud.

We are aware that last year’s energy bill contained several provisions that would

have directly affected the CFTC’s oversight responsibilities, and we believe that it

is appropriate and timely for our authorizing committees in Congress to consider

and weigh in on these proposed changes. The proposed changes sought to make it

clear that the Commission has the authority to bring anti-fraud actions in off-exchange principal-to-principal transactions, such as those that occurred in the Enron

Online-type of environment. While the CFMA provided for the Commission’s fraud

authority over exempt markets, some have questioned whether its application to bilateral and multilateral transactions would hold up given that our fundamental

fraud authority appears to pertain only to intermediated transactions. It has been

the Commission’s contention that Congress intended to give the Commission fraud

authority under the CFMA. Nonetheless, Congress may wish to provide us with additional guidance regarding this area of the act.

The energy bill also contained savings clauses to confirm the Commission’s exclusive jurisdiction with respect to futures and options on energy commodities, a provision to reaffirm the Commission’s civil authority, and a provision affirming that

these changes restate existing law and continue to apply to acts or omissions that

occurred prior to enactment. Since these provisions of the energy bill amount to

clarifications, Congress may wish to consider the necessity of these changes and its

intent regarding Commission jurisdiction.

SECURITIES FUTURES PRODUCTS

As you know, the CFMA was noteworthy, in part because of Congress’s decision

to permit the trading of futures on single securities, under the joint jurisdiction of

the CFTC and the Securities and Exchange Commission (SEC). However, more than

four years after the CFMA’s passage, the growth of single-stock futures trading continues to be modest at best. In December 2004, the NQLX exchange, one of two exchanges that had been offering single stock futures, suspended trading.

It is of some concern that this sector has not been more successful and that despite the best efforts of the Commission, the CFTC and SEC have not fully achieved

28

the goals of the CFMA. In particular, it is of concern that more progress has not

been made with respect to implementing portfolio margining; that we have not

avoided the double audit and review of notice registered exchanges and brokers; and

that we have not determined the appropriate treatment of foreign security indices

and foreign security futures products.

In many areas, however, I am pleased to say that the two agencies continue to

work to establish regulatory approaches that avoid duplicative registration and regulation. Beginning in January, the staffs of the CFTC and SEC have been meeting

to discuss a means whereby commodity pool operators, commodity trading advisors

and hedge fund operators can be overseen without imposing duplicate regulatory

structures. As we move forward, the agencies must take to heart Congress’s instructions to avoid duplicative registration and regulatory requirements.

RETAIL FOREX FRAUD

The CFMA clarified that the CFTC has jurisdiction over retail foreign currency

futures and option contracts, whether transacted on exchanges or over-the-counter

as long as they are not otherwise regulated by another agency. However, as demonstrated in the recent adverse Zelener decision, a case litigated by the Commission,

the CFTC continues to face challenges to its jurisdiction based on how retail forex

transactions are characterized. In this case and others, defendants often argue that

transactions allowing retail customers to speculate on price fluctuations in foreign

currency are not futures contracts, but spot or forward transactions outside the

Commission’s jurisdiction, including its fraud authority.

We at the Commission have been and remain committed to protecting retail consumers against the kind of egregious fraud that we see in the forex area. It has

been the subject of much discussion within the industry and among the derivatives

bar as to how to respond to the Zelener decision—whether we need additional authority or clarity in our jurisdiction, or whether we simply need to prove up our

cases better. I would point out that our overall track record in the forex area is favorable. Since the passage of the CFMA, the Commission, on behalf of more than

20,000 customers, has filed 70 cases and prosecuted 267 companies and individuals

for illegal activity in forex. As a result of those efforts, we have thus far imposed

over $240 million in penalties and restitution. Of the 70 cases that have been filed

thus far, the Commission has lost only three.

As noted, it has only been just over 4 years since Congress enacted, and the Commission began implementing, the CFMA. Given the progress made and the lessons

learned, Congress may determine that it is premature to open the act to significant

changes. The Commission has been able to effectively work within the current structure of the act to police markets, to ensure the integrity of the price discovery mechanism, to maintain the financial integrity of the markets and to protect customers.

Nonetheless, the Commission stands ready to offer its assistance as Congress moves

through the reauthorization process and considers a range of potential options.

In conclusion, let me say that my fellow commissioners and I welcome this opportunity to work with you on the reauthorization of the CFTC. I greatly appreciate

the opportunity to testify before you today on this important matter and would be

pleased to answer any questions that the committee may have.

ANSWERS TO SUBMITTED QUESTIONS

During the 1980’s, the Commission, State attorneys general and State security administrators were constantly at odds about how to police off-exchange boiler rooms, especially when attorneys would argue in State court

that the Commodity Exchange Act preempted State laws. The CFTC, acting

with State authorities, clarified the law and helped prosecute boiler room

activity. Are State attorneys general now policing boiler room fraud using

State anti-fraud laws?

In recent years, several States have independently or in conjunction with the

Commission brought claims under State law and/or the Commodity Exchange Act

against commodity boiler rooms and other perpetrators of commodities fraud.

Through our cooperative enforcement efforts, the Commission works hard to educate

State regulators and prosecutors about the applicability of State law and the CEA

to commodities fraud that is committed in their jurisdictions, and frequently has

provided assistance to States pursuing these cases.

However, despite the substantial efforts of the CFTC’s Division of Enforcement to

educate States about the application of State and Federal law, the vast majority of

such cases are still brought by the CFTC. The handful of actions brought by States

against commodities boiler rooms have been either cease and desist proceedings

29

under State law, or joint Federal civil actions with the CFTC under section 6d of

the CEA. The cease and desist proceedings typically allege violations of State securities laws, and result in orders against the boiler room promoters (often by default)

that the respondents evade by avoiding future solicitations in that particular State.

In a civil action, a State can join the CFTC in alleging violations of the CEA and

can also assert pendent claims under State law. In recent years, the CFTC has participated in one such joint action specifically against a forex boiler room. However,

in any such actions in the future, a State alleging CEA violations will face the same

jurisdictional hurdles that have blocked the CFTC’s efforts in recent forex actions.

The best way a State can attack commodity boiler rooms is through use of its

criminal powers; however, State prosecutors face a number of practical and policyrelated hurdles in pursuing criminal prosecutions. For one thing, State authorities

typically have a broad mandate, and consumer protection is only one aspect of their

focus. In addition, State authorities, like other enforcement entities, balance their

resources against program goals, and in deciding whether to launch a criminal prosecution will consider the amount of losses by local customers, and the presence of

the potential defendants within the State for prosecution. Boiler room promoters

often structure their businesses precisely to avoid local prosecution; in its investigations of such boilers rooms, the CFTC has found boiler rooms that deliberately

choose to solicit customers outside of the State where the defendants are located.

Boiler rooms typically solicit customers nationwide from several locations, through

mass telemarketing or the Internet, and an agency that lacks the CFTC’s nationwide jurisdiction will often be limited in its ability to investigate this fraud. Finally,

State authorities are stretched for resources and often lack the expertise to pursue

commodities fraud. The CFTC is finding that States, and sometimes other Federal

authorities, will only consider pursuing a matter referred by the CFTC involving

commodities fraud if the agency lends to the State the staff and/or technical expertise to assist in their prosecution of cases.

Do you think the 7th circuit created a split amongst the circuits by ruling

the contracts in the Zelener case were forward contracts not futures?

The Seventh Circuit arguably departed from the precedent of other circuits, and

its own precedent, by rejecting the multi-factor inquiry that had traditionally been

used to distinguish between futures and forwards, and focusing instead on contractual fungibility and the availability of offset. But that departure relates more to the

methodology for determining whether a contract is a futures contract, than to

whether the contracts at issue are, indeed, futures.

While we disagree with the outcome, and believe that most other courts would

have ruled in a different way, there is no other court decision where the factual circumstances fit four square with the situation that the court faced in Zelener, such

that a circuit split could be said to exist. Most cases applying the multi-factor test

involve the interpretation of the forward exclusion rather than whether the contracts at issue are spot transactions, and even those cases resulting in a different

outcome involve contracts that, unlike Zelener, are not, in form, spot contracts, and

where the right to offset was found to exist.

Finally, however simplified the approach of the Seventh Circuit in Zelener may

be compared to the traditional multi-factor approach, the right to offset is nevertheless a necessary element of a futures contract under either approach. That common

element, therefore, provides the basis for our view that we can prevail in these types

of cases under either approach as long as we can establish that element through

extrinsic evidence. See CFTC v. Co Petro Mktg Group, Inc., 680 F.2d 573, 580 (9th

Cir. 1982) (contract that does not contain wholly standardized terms can still be considered a futures contract if the seller ‘‘implicitly guarantees’’ that it will provide

for offset).

What kind of enforcement problems does the Zelener decision pose for the

CFTC when going after deceitfully marketed contracts?

The Zelener decision reaffirms the concept that the right to offset an existing position is a distinguishing characteristic between futures contracts and spot contracts.

However, language in that decision could be interpreted to mean that only the written terms of contractual agreements control a court’s analysis of whether transactions are futures. We believe the correct approach is for a court to consider not

only the written terms of agreements signed by customers, but also whether there

are any statements or implicit representations that modify the written terms of an

agreement. Such an approach would be consistent with both existing precedent from

the 7th Circuit, as well as existing precedent from other circuits. Congress should,

therefore, consider clarifying the CFTC’s jurisdiction with respect to these types of

contracts.

30

Do you believe there can be a bright line statutorily drawn to distinguish

between a forward contract and a futures contract and if so, do you think

we should draw it?

It may be premature to drawn such a line at this time. The distinction between

forward and futures contracts has evolved as the Commission and the courts have

addressed the issue over the last three decades. In the law, a futures contract is

a legal term of art that obtains its current meaning through a series of administrative interpretations and judicial decisions. Although the CEA does not define ‘‘contract for future delivery,’’ it nevertheless provides a statutory foundation upon which

the Commission and the judiciary have developed a Federal common law on that

subject.

Although Congress could attempt to shorten this evolutionary process by drawing

a statutory bright line test to distinguish between forward and futures contracts,

there are significant policy reasons why such an approach might not be desirable.

First, the process by which common law develops over time tends to weed out those

legal doctrines that are unfit or out-of-step with prevailing consensus as inefficient

outcomes tend to be relitigated until the courts get it right. See e.g., Paul Rubin,

Why Is the Common Law Efficient?, 6 J. Legal Stud. 51 (1977); George Priest, The

Common Law Process and the Selection of Efficient Rules, 6 J. Legal Stud. 65

(1977). Although we believe that the court erred in Zelener, for example, the overall

approach of the Seventh Circuit in that matter and in the Nagel decision, in our

view, does not preclude a better outcome in the future under the right set of circumstances.

Second, the evolutionary character of this process may be better suited than a

fixed statutory definition to accommodate changes in marketplace as new financial

products are developed. Third, a statutory definition that is poorly drafted could stifle innovation or favor one segment of the financial industry over another and thus

hamper the growth and proper functioning of our commodity markets in the future.

While innovators need and deserve greater clarity so that they can determine the

boundaries between cash contracts (such as spot and forward contracts) that are

generally outside the CFTC’s jurisdiction and futures contracts that are subject to

the Commission’s exclusive jurisdiction, any attempt to draw a line by legislation

during a period of reauthorization is subject to considerable risk.

Both the Commission and the judiciary are well-positioned to provide appropriate

and ongoing guidance on the difference between forward contracts and futures contracts as the markets evolve. The problems that occur in the market for retail foreign exchange can be addressed separately by clarifying the CFTC’s antifraud authority with respect to such transactions. Such a remedy would properly target the

problem of fraud in that market without necessitating any statutory definitions of

the terms forwards or futures.

Is CFTC participating in what I understand is an industry effort to arrive

at an effective, consensus recommendation for language that would address the Zelener case?

Yes, the Commission is participating in discussions with representatives of various segments of the futures and derivatives industries and the National Futures

Association, as well as the members of the President’s Working Group on Financial

Markets, in an effort to arrive at a consensus recommendation for legislative language that would address the Zelener decision. As stated earlier, although Zelener

does not foreclose the possibility that the Commission may succeed in asserting jurisdiction over Zelener-type contracts by introducing evidence that the right to offset

was implied or guaranteed during the solicitation process, the Commission welcomes

any assistance that Congress may be able to provide to strengthen its authority to

prosecute unscrupulous purveyors of fraudulent futures and options schemes who

prey on the retail public.

The existence of boiler room operations that fraudulently guarantee large returns

on investments in commodities with little or no risk to the capital invested continues to be a serious national problem. Although State and other Federal authorities

have some ability to prosecute this activity, the CFTC is in the best position to track

the movements of boiler room operators from State to State, or abroad, and has the

broadest powers to find and freeze customer funds and to seek the assistance of foreign authorities when necessary.

The Commission recognizes that any amendment to the act must be carefully

drawn and considered to guard against any unintended consequences. We believe

that with the help of the industry, we will be able to submit a specific legislative

proposal that will appropriately clarify our enforcement powers in this area.

31

1 See CFTC v. NRG Energy, Inc., No. 04-cv–3090 MJD/JGL (D.Minn. filed July 1,

2004)(charged false reporting; litigation pending); In re Mirant, CFTC Docket No. 05–05 (CFTC

filed December 6, 2004)(charged false reporting and attempted manipulation; settled for

$12,500,000).

OTC AND EXCHANGE-TRADED ENERGY DERIVATIVES

You discussed the Commission’s success in settling the cases in the aftermath of Enron’s demise, but your statement is a little less clear to me about

the results of those cases. Could you please assess for me how those cases

affected—in a positive or negative way—the Commission’s authority, especially in light of section 2(g) dealing with excluded swap transactions and

2(h) dealing with exempt commodities? My interest is whether or not any

of the companies the CFTC sued argued that their activities were protected

by either of these two provisions of the act.

Since 2002, the Commission has prosecuted almost fifty entities and individuals

who committed illegal acts while operating in the energy sector. As a result of those

efforts, the Commission assessed close to $300 million in civil penalties. More importantly, the Commission’s actions helped uncover and reform industry-wide systemic

abuse of the trade press and natural gas markets.

Throughout our investigations into false reporting and attempted manipulation

with respect to natural gas, the Commission faced some jurisdictional opposition

from the targeted entities. Most companies understood that the Commission was not

attempting to interfere with their transactions in natural gas, but instead, was attempting to identify, sanction and stamp out the negative effects other illegal activities had on those transactions. To that end, several companies requested meetings

with the Commission to provide information relevant to the investigations and gain

a better understanding of how repetition of the violative conduct could be avoided

in the future.

The Commission charged 27 companies and nineteen individuals for wash trading,

false reporting, attempted manipulation, and/or manipulation. Of the individuals

and companies that challenged the Commission’s authority under the act, a handful

made the argument that the conduct in question was beyond our statutory grasp

by virtue of its relationship to transactions in exempt commodities that fall largely

outside the jurisdiction of the Commission by reason of exemptions and exclusions

under sections 2(g) and 2(h) of the act.1

As the factual scenarios in all energy matters the Commission pursued, and as

enunciated by Federal courts to have ruled on the subject, price reporting to industry publications and attempted manipulation are activities that do not further the

execution or completion of energy contracts, and in many instances, is conduct that

occurs even in the absence of actual contracts. Therefore, the exemptions and exclusions introduced by the CFMA do not seem to controvert the Commission’s ability

under the act to promote market integrity through enforcement actions.

When you talk about ‘‘additional guidance’’ regarding authority over

fraud in your testimony about the energy markets, I assume you mean the

‘‘for or on behalf’’ of language contained in section 4b? Is there a reason

the Commission has not specifically asked this Committee for that change,

especially since I believe it was in the Senate energy bill?

Senior staff at the Commission previously consulted with Senate staff on this

issue and reached a consensus on the language that was ultimately placed into the

energy bill. The Commission remains supportive of the changes and has consulted

with industry sources to assure that the language previously contained in the bill

remains relevant. We will indeed provide guidance on specific language that will

clarify the application of our fraud statute to non principal-agent relationships.

Without such changes, although certain sections of section 2h preserve authority to

bring fraud claims, the Commission could not pursue those claims as part of its

prosecution of illegal conduct in the energy sector, since the transactions that occur

in that sector do not embody a principal-agent relationship.

As you know, there has been some interest in the managed money activity on the New York Mercantile Exchange’s Henry Hub natural gas futures

market. The complaint has been that funds are taking excessive speculative positions that are causing market volatility and that there is no transparency in these markets. How would you respond to these complaints?

First, analysis by Commission staff has found that price volatility in natural gas

appears to have been principally caused by demand and supply characteristics inherent to the natural gas market—i.e., both demand and supply of natural gas are

32

2 Positions in all accounts carried through futures commission merchants, foreign brokers,

and clearing members that equal or exceed certain reporting levels (which vary by commodity

market) must be reported daily to the Commission. The current reporting level for natural gas

futures is 200 contracts.

highly price inelastic in the short run—rather than the activity of managed money

traders or other speculators in energy markets. During cold winter weather, demand

for natural gas for space heating remains high even in the face of sharply rising

prices, and very little additional supply can be made available in the short run even

in response to higher prices. Faced with these rigidities of supply and demand, large

price increases can occur during the winter as a result of demand spikes caused by

unusually cold weather. Both academic research and market observation have

shown that markets with very tight demand/supply balances tend to demonstrate

high price volatility.

Second, futures markets are in fact quite transparent, especially to the CFTC. All

trading activity is observable by the trading public, and prices, trading volume, and

open interest are widely disseminated to the public. It is true that the identity of

traders is not publicly disseminated, but it is know by the Commission. The Commission closely monitors trading activity in the natural gas futures market through

our market surveillance program. The primary purpose of this program is to detect

and prevent instances of possible price manipulation. The CFTC’s surveillance staff

receive daily reports from futures commission merchants identifying all large long

and short positions in natural gas futures and options-on-futures markets. 2

This reporting requirement, of course, includes positions held by professionally

managed money traders. Using these reports, CFTC economists monitor trading activity in the natural gas market, looking for large positions and large trading that

might be used to manipulate natural gas prices. In addition, our analysts monitor

prices and price relationships, looking for price distortions that might be evidence

of manipulation. They also maintain close awareness of supply and demand factors

and other developments in the natural gas market through review of trade publications, and through industry and exchange contacts. Our surveillance staff routinely

reports to the Commission on surveillance activities at regular weekly surveillance

meetings.

Third, based on our surveillance experience with managed money traders we have

not identified this trading as a source of concern. The Commission’s market surveillance staff, using its large-trader reporting system, closely monitors managed money

trading in natural gas, both individually by trader, and as a group. Individual managed money trader positions are generally not large compared to the size of the total

open interest in the market. We have had no manipulation or congestion concerns

with respect to managed money trading, since they normally roll their positions into

forward contract months well before expiration. Moreover, the net aggregate position of the group is usually not extremely large in comparison to the size of the market. In fact, a substantial portion of managed money trading in natural gas involves

spread trading, i.e., offsetting long and short positions in futures and/or options in

order to arbitrage price differentials. This type of trading tends to be neutral with

regard to the direction of prices and to price volatility.

Finally, it should be noted that speculators provide a valuable service to futures

markets by providing liquidity to hedgers in the market. Liquidity can generally be

described as a measure of the ability to buy and sell futures contracts quickly, and

without materially affecting the market price. Liquidity is important to hedgers who

need to establish hedge positions quickly and with little price slippage. Frequently,

a hedger with an opposite need is not available to provide a counterparty at that

moment. The participation of speculators willing to take the other side of hedgers’

trades adds liquidity and makes it easier for hedgers to hedge their exposure. The

Commission’s Office of Chief Economist has been studying the role of managed

money trading in a number of futures markets, including in natural gas. They have

found, and it corroborates our surveillance observation, that managed money traders as a group generally take positions in the opposite direction of commercial traders. This finding appears to be consistent with the classic view of speculators as providing a ready counterparty to commercial trader activity.

Could you explain or provide for the record a comparison of the Commission’s regulatory program for major amendments to an exchange’s rules

prior to CFMA and following enactment of the 2000 amendments.

Prior to the enactment of the CFMA, exchanges were required to obtain prior

Commission approval before implementing amendments to an exchange’s rules.

Commission staff reviewed all major amendments to exchange rules, frequently

worked with exchange staffs to ensure that rule amendments complied with the

33

3 The CFMA also provides for ‘‘notice registration’’ with the CFTC of national securities exchanges, and SEC-registered broker/dealers.

4 The CFMA lists specific exemptions from certain provisions of the Securities Exchange act

of 1934 relating to, among other things, requirements regarding exchange rules, registration

procedures for self-regulatory organizations, and trading by members of exchanges.

5 Section 17(b)(1)(B) of the Securities Exchange Act of 1934, 15 U.S.C. 78q(b)(1)(B).on noticeregistered exchanges. In addition, the CFMA requires that the SEC notify the CFTC of any examination of a notice-registered futures exchange, furnish reports to the CFTC upon request,

and, prior to conducting examinations of notice-registered exchanges, and use CFTC reports of

examinations if the information available is sufficient for the purposes of the examinations.

CEA and the Commission’s regulations and policies, and then recommended approval if the amendments were consistent with the CEA and the Commission’s regulations and policies.

The CFMA modified the act to permit exchanges, with one exception noted below,

to adopt major amendments to their rules without prior Commission approval. Instead, exchanges need only file a written notification with the Commission certifying

that the rule amendment complies with the act and the Commission’s regulations.

The notice must be filed no later than the day before the exchange plans to list the

contract for trading. In addition, the CEA provides that an exchange voluntarily

may request Commission approval of a rule amendment.

There is one exception to the certification provision noted above. Specifically, the

CEA specifies that exchanges must submit for the Commissions prior approval rule

changes that are to be applied to open positions and that materially change the

terms and conditions of futures and option contracts on certain agricultural commodities that are specifically enumerated in section 1a(4) of the act.

For rule changes filed under certification procedures, consistent with the Commission’s oversight role, Commission staff conducts due diligence reviews of the filings

to ensure that the rule changes meet the requirements of the act and the Commission’s regulations. If any deficiencies or potential violations are identified, Commission staff works with exchange staff to address these matters. For rule amendments

submitted for approval, staff conducts the same analysis that was performed prior

to enactment of the CFMA to ensure that the standards for approval are met.

Could you also provide to us for the record the CFTC’s authorities for

trade practice and rule enforcement reviews of the exchanges’ self-regulatory program?

Section 3(b) of the act provides, in part, that it is the purpose of the act to serve

the public interest through a system of self-regulation ‘‘under the oversight of the

Commission.’’ Section 5(d) states that an exchange must comply with the core principles enumerated in section 5(d) of the act to maintain its designation as a contract

market. Based on many years of experience, the Commission has found that trade

practice and rule enforcement reviews are very effective oversight tools to ensure

that the exchanges continue to comply with all statutory requirements, including

the core principles, as well as Commission regulations and policies applicable to futures exchanges.

SECURITIES FUTURES PRODUCTS

You mention in your statement the double regulation of notice registrants for purposes of security futures contracts. Didn’t the law specifically mandate that when a futures exchange provides a notice registration

to trade security futures and the registration is accepted by the SEC then

the futures exchange would be exempt from other regulatory provisions,

such as SEC audits?

It is correct that the CFMA provides for ‘‘notice registration’’ with the SEC of designated contract markets, derivatives transaction execution facilities and futures

market intermediaries that trade security futures products (SFPs).3

The intent of the notice registration provisions was to avoid unnecessary and

overly burdensome dual registration of exchanges and intermediaries. The CFMA

did not, in fact, exempt notice-registered futures exchanges from all SEC audits and

examinations.4

The CFMA provides that notice-registered futures exchanges shall not be subject

to ‘‘routine periodic examinations’’ by the SEC. It further requires cooperative efforts

by the SEC and CFTC to ‘‘avoid unnecessary regulatory duplication or undue regulatory burdens’’5

The SEC and CFTC entered into a Memorandum of Understanding (MOU) on

March 14, 2004 with respect to notice registrants and information sharing. The

MOU requires that the agencies notify each other regarding any planned examinaVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
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6 These examinations are not defined in securities statutes or regulations, but rather are developed by SEC staff practice, and may be changed as staff determines necessary.

tion, advise each other of the reasons for examinations, provide exam-related information to each other, and conduct joint examinations when feasible. Also, the MOU

provides that the agencies will keep each other apprised of significant issues in SFP

markets and share trading data and related SFP information.

SEC staff have identified seven types of examinations that it undertakes regarding exchanges and intermediaries, specifically: 6

• ‘‘routine periodic’’ examinations

• ‘‘for cause’’ examinations

• ‘‘oversight’’ examinations (review SROs to ensure that their routine periodic examination of broker/dealers is sufficient)

• ‘‘focused examinations’’ (focus on one area of SEC’s examination modules)

• ‘‘exam sweeps’’ (focus on a particular issue across a large number of firms)

• ‘‘series of examinations’’ (similar to sweeps, but with a smaller number of firms)

• ‘‘surveillance examinations’’ (review of a particular broker/dealer to survey activity)

While the last four listed examinations relate primarily to intermediaries, SEC

staff have indicated that they may do similar examinations for exchanges, and have

also stated that they may undertake ‘‘special purpose market examinations’’ of notice-registered futures exchanges. We believe Congress should clarify that the SEC’s

authority to examine CFTC-designated exchanges is specifically limited to ‘‘for

cause’’ situations only and none of the other examination categories. Such a change

would eliminate overlapping and unnecessary review of exchanges that are already

subject to primary oversight by the CFTC.

Another significant area of concern relating to dual market oversight relates to

the SEC’s unilateral ability to abrogate rules of notice-registered futures exchanges.

Abrogation means that the SEC staff can unilaterally void a notice-registered futures exchange’s rule. Abrogation of a notice-registered futures exchange’s rule, except in extraordinary situations, is inconsistent with the intent underlying the

CFMA to avoid prescriptive regulation. For example, the Chicago Mercantile Exchange had proposed rules to facilitate the listing and trading of SFPs, but chose

not to pursue this effort based on assertions by SEC staff that they would abrogate

a proposed rule unless it was changed pursuant to SEC staff instructions; SEC did

not consult with the CFTC in this process.

What are the margin requirements for security futures products and how

could portfolio margining provide some relief for current margin requirements? Before you answer that question, it might be good if you could describe the difference between futures margins and security margins.

Security margins serve as a down payment of the intended purchase of a security.

Typically, an investor is required to post at least 50 percent of the security’s value

in margin when purchasing a security. Futures margins, by contrast, serve as a performance bond on the contract and are set to ensure that the customer who has entered into the contract can meet potential short-run losses on the contract. Exchanges typically set futures margins to cover 99 percent of the daily price moves,

usually 3 percent to 7 percent of contract value, over a specified time period. In addition, as prices move against a customer’s position, they will be expected to post

additional margin to cover future potential losses.

The margin requirements imposed upon security futures products (SFPs) are by

law set in reference to margins on stock options. These margins, which are currently

set at 20 percent of contract value, function more like security margins in that they

are fixed and do not explicitly take into consideration the underlying financial risk

of the contract. While the margins are lower than that set for the purchase of securities, they are significantly higher than those on futures contracts or options on futures contracts, and greater than required to manage short-term financial risk.

The margin requirements imposed upon SFPs differ in two major respects from

those on other futures contracts. First, an individual security future is subject to

securities-style margin of 20 percent, rather than futures-style, risk-based margining of between 3 percent and 7 percent. Second, SFPs are denied portfolio margining

treatment available to other futures (and, which the SEC may soon make available

for security index options, but not security futures). Under risk-based portfolio margining, required margin depends on analysis of the risk of each position in a customer account and recognition of risk offsets among correlated positions. In the U.S.,

the SPAN (Standard Portfolio Analysis of Risk) portfolio margining system, develVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
35

7 Section 7(c)(2)(B) of the Securities Exchange Act of 1934, 15 U.S.C. 78(g).

oped by the CME and licensed around the world, is used to calculate margin for

futures contracts.

Unlike other futures, SFPs are restricted to a relatively limited set of ‘‘strategybased offsets’’ that are currently permitted for security options. These can ameliorate some of the economic imprecision inherent in fixed-percentage margining, but

do not reflect economic risk nearly as well as would risk-based portfolio margining.

The benefits of portfolio margining among different types of financial contracts on

different exchanges are widely recognized. Portfolio-margining allows much greater

capital efficiency for the businesses and investors that use derivatives to manage

risk. This, in turn, can encourage even better and more widespread use of derivative-based risk management. From a supervisory perspective, it is well recognized

that offsetting positions in an appropriate cross-margining arrangement often provide even better protection for firms and clearinghouses than traditional collateral.

Back in 2000 when we enacted the CFMA, the idea was to allow both futures exchanges and equity exchanges to sell single stock futures and to

basically look to their own respective primary regulator—the CFTC or

SEC—to govern their single stock trading. The two agencies were supposed

to coordinate their activity of single stock futures has been greeted with

only modest success, in some degree due to continuing regulatory uncertainties and regulatory duplication between the two relevant agencies. Can

you tell us what the state of play is on single stock futures with respect

to progress in working out the respective regulatory regimes applied by

CFTC and SEC?

We have had some success working cooperatively with the SEC regarding oversight of exchanges and intermediaries, however, issues remain. The agencies entered into an MOU on March 14, 2004, regarding sharing SFP examination-related

information, and intended the MOU to ensure effective supervision of these markets

and at the same time avoid duplicative and unnecessary oversight. As noted in a

previous answer, however, it may be appropriate for Congress to review the specific

types of examinations undertaken of notice-registered exchanges to ensure that they

do not result in unnecessary dual oversight. In addition, Congressional review of the

SEC’s unilateral rule abrogation authority may be appropriate.

Two other areas where further progress is necessary are SFP margins and futures

on foreign security indices. First, a legislative change to the SFP margin level

should be considered; currently the level of SFP margins is statutorily set to be

‘‘consistent with comparable options’’ and not ‘‘lower than the lowest level of margin

. . . required for any comparable option . . .’’7

Market participants have commented that the margin level is unnecessarily high,

does not reflect the amount of risk involved, and discourages trading in SFPs. Second, a more flexible risk-based, futures-style portfolio margining system is appropriate for these products. The implementation of portfolio margining could yield

more users and more liquidity for SFP products, and thus greater success for these

markets. Third, as required by Congress in the CFMA, the agencies must jointly

adopt rules that would permit U.S. customers to trade futures on foreign broadbased securities indices; and fourth, the agencies must engage in the same mandated undertaking regarding foreign narrow-based securities indices. To date the

CFTC has met with resistance on the issue of foreign-based security indicies and

no progress has been made.

We note that, to date, there have only been two exchanges notice-registered with

the SEC to trade SFPs, and one of them ceased trading operations in December

2004. Market participants have commented that dual regulatory burdens have contributed in large part to the low level of trading and interest in these products.

What are the remaining problems or impediments that you see or which

the industry has raised with regard to regulation of single stock futures?

Security Futures Products (SFPs) are denied the benefit of portfolio margining

that is available to other futures contracts. Moreover, recent initiatives being considered by SEC staff would extend portfolio margining to certain security index options

but not to security futures, which could create regulatory and competitive disparities against SFPs.

The act designates the Federal Reserve (Fed) as the agency responsible for setting

margin, which they have delegated to the CFTC and SEC. In delegating jointly to

the CFTC and SEC responsibility for developing appropriate margin rules for SFPs,

the Fed requested that ‘‘the Commissions provide an assessment of progress toward

adopting more risk-sensitive, portfolio-based approaches to margining security fuVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 F:\DOCS\109-2 HAGRI PsN: HAGRI
36

tures products’’ in furtherance of the Fed’s own actions, such as amending its Regulation T so that portfolio margining systems ‘‘can be used in lieu of the strategybased system .’’ The Fed also stated that it ‘‘anticipates that the creation of security

future products will provide another opportunity to develop more risk-sensitive,

portfolio based approaches for all securities, including security options and security

futures products.’’

The SEC publicly endorsed the Fed’s position, stating in the Federal Register release for the final customer margin rules, that ‘‘[t]he Commissions strongly encourage the efforts of market participants to develop a portfolio margining proposal for

security futures, and are committed to working with these participants to resolve

any outstanding issues as quickly as feasible. Such a portfolio margining system

would be in keeping with current practices in the futures industry and would be

responsive to the Fed’s desire to encourage the development of more risk-sensitive,

portfolio-based approaches to margining security futures products.’’

Nonetheless, there has been no real progress toward portfolio margining for SFPs,

only for certain security index options. In 2004, CFTC staff told the Fed that this

‘‘lack of progress is disappointing.’’ The Fed responded that it ‘‘recognizes that

progress in this area is outside the control of the [CFTC]’’] and that it ‘‘appreciates

the [CFTC’s] willingness to lend its expertise.’’

In sum, then, the SEC staff was apparently only willing to permit SFPs to trade

on terms that would deem them securities and futures, giving the SEC regulatory

authority over them and subjecting them to terms and conditions fitting the securities regulatory scheme. This framework, particularly the margin standards, has

made SFPs unattractive to many customers and severely limited the ability of SFP

markets to achieve critical mass.

And that intransigence is a cause for serious concern on related issues. Unless

the staffs of the CFTC and SEC both demonstrate a consistent and reciprocal willingness to work together to satisfy their respective supervisory concerns in a way

that does not stifle much-needed innovation and competition in the U.S. financial

markets, U.S. markets may fall behind in their efficiency, effectiveness, and safety.

For example, as it continues to review a proposed pilot program for portfolio margining and cross-margining of securities and traditional (non-SFP) futures that was initially filed by the Chicago Board Options Exchange more than three years ago, the

SEC staff is taking the position that a strictly securities-style framework must be

imposed upon this arrangement.

Although the existing limited cross-margining arrangement for CME stock index

futures and CBOE security index options has been operating successfully for many

years, and although market participants would like to see it expanded, SEC staff

have unilaterally indicated that they will not permit this unless significant changes

are imposed, such as requiring that all positions, both futures and options, be held

in a securities account instead of a segregated customer funds futures account, as

has been the case to date. This unilateral decision to impose a mandatory change

in the type of account utilized would impose substantial operational costs on market

participants, would disadvantage some market participants relative to others, and

could call into question key protections upon which CFTC relies for ensuring market

integrity and customer protection in the futures markets.

AGRICULTURAL PRODUCTS

In the spirit of the CFMA, the Commission has worked to move markets

toward greater self-regulation. Specifically, in agriculture, this movement

has been successful and has resulted in a stronger, more open and more

transparent marketplace. Despite this progress, agricultural commodities

continue to receive special consideration not given to other commodities.

While embracing the spirit of the CFMA, why does the Commission continue to support this distinction?

In enacting the CFMA, Congress continued to treat the agricultural sector differently in certain areas. Certainly, many of the advances of the regulatory approach of the CFMA play a role in the agricultural derivative markets, but there

is no denying that some of the most significant changes have not been applied to

agricultural commodities. The Commission stands ready to work with Congress and

the agricultural industry to examine further modifications of the statute that would

be beneficial for this important sector of our Nation’s economy.

The CFMA pushes the Commission to remove unnecessary regulatory obstacles to market operation. Over the last four years, the Commission has

worked toward this goal, but still producers are blocked from using the agricultural trade option pilot program. What are your thoughts on how the

37

Commission can make this program a commercially viable risk-management option for producers as we move forward under the CFMA?

After conducting a thorough review of the cost and benefits that the offer and sale

of agricultural trade options (ATOs) would provide to the agricultural sector, the

Commission lifted the ban on ATOs on June 15, 1998. The rules allow the offer and

sale of trade options on agricultural commodities which had been prohibited since

1936. In addition, the Commission sought out the guidance and opinions of various

segments of the agricultural community and the futures and options industry. This

was accomplished through various Commission hearings, roundtable discussions and

comment letters received in response to rulemaking notices.

The rules adopted by the Commission best represented the consensus of interested

parties with respect to lifting a ban that had existed for more than a half century.

In response to continuing concern regarding the workability of the rules, the Commission revised them in 1999 to streamline regulatory and paperwork burdens. In

addition, the Commission amended the rules to permit for the cash settlement and

offset or cancellation of ATOs. These changes were adopted after giving careful consideration to extensive comments received from all segments of the agricultural

community and the futures and options industry. Since the adoption of the rule

changes in 1999, however, only one company has registered as an Agricultural

Trade Option Merchant and offers ATOs subject to the ATO rules.

The topic of ATOs and the rules governing them was the subject of a CFTC Agricultural Advisory Committee meeting in March 2001. The Committee engaged in a

wide-ranging discussion regarding the current use of ATOs and desired changes in

the rules. A consensus in views regarding the rules and potential changes in them

did not exist among the participants. Clearly, we must satisfy the concerns of farmers and producer groups and ensure that regulations effectively protect their interests without stifling the offering of this important risk management product to the

agricultural market. The Commission remains committed to providing agricultural

producers with safe access to risk management tools and continues to monitor and

review the situation with respect to ATOs.

(39)

REAUTHORIZATION OF THE COMMODITY

FUTURES TRADING COMMISSION

WEDNESDAY, MARCH 9, 2005

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON GENERAL FARM

COMMODITIES AND RISK MANAGEMENT,

COMMITTEE ON AGRICULTURE,

Washington, DC.

The subcommittee met, pursuant to call, at 10:05 a.m., in room

1302 Longworth House Office Building, Hon. Jerry Moran (chairman of the subcommittee) presiding.

Members present: Representatives Boehner, Neugebauer, Goodlatte [ex officio], Etheridge, Salazar, Marshall, Melancon, Boswell,

Larsen, Chandler, Costa, and Peterson [ex officio].

Staff present: Dave Ebersole, Kevin Kramp, Tyler Wegmeyer,

Callista Gingrich, clerk; Matt Smith, and John Riley.

OPENING STATEMENT OF HON. JERRY MORAN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF KANSAS

Mr. MORAN. Good morning, everyone. Welcome to our Subcommittee on Farm Commodities and Risk Management. I apologize for the slightly less than accommodating meeting room. Normally, Members of Congress are troubled by a number of meetings

at the same time, but normally not the same committee meeting

at the same time—the Agriculture Committee is meeting in 1300

today regarding the WTO issues. We are here, again, to review the

Commodity Futures Modernization Act of 2000 to see what has

worked well and determine what changes, if any, might be recommended as we proceed to reauthorize this legislation.

Last week, in our first hearing on this topic, we heard from Dr.

Sharon Brown-Hruska, the acting chairman of the CFTC. Today, I

am pleased that we are going to hear from three panels of exchanges and associations who have a stake in the legislation that

this subcommittee will develop. It is my general practice that a

subcommittee hearing should not last more than an hour, an hourand-a-half. That would suggest that the first panel may consume

all of the time. We will try to avoid that, and I would ask that our

witnesses make their remarks within the 5-minute allotted time,

and I will try to give everyone an opportunity to speak and members of the subcommittee to respond and ask questions.

This hearing will last longer than my usual practice, but rather

than being here for 2 or 3 days, we thought we would confine this

meeting to this morning and perhaps early this afternoon.

40

Technological changes have allowed the futures industry and option market to grow and evolve into a round-the-clock, global industry. Past legislative changes have allowed new products, such as

single-stock futures, to be introduced, giving solid legal footing to

existing products, and reflected the regulatory requirements of

internationally competitive markets for risk-management products.

In the over 4 years since the passage of CFMA, futures markets

have grown and developed tremendously, as well as faced some difficulties and challenges. Today, the subcommittee continues its review of the futures industry by listening to the leaders of that industry. We have a relatively new number of members on this subcommittee, to whom these issues will be somewhat new, and it has

been quite some time since the rest of us have worked on these

issues as well, so we look forward to the education that the distinguished panel of witnesses will be able to provide to our subcommittee members today.

I now turn to the distinguished gentleman from North Carolina,

Mr. Etheridge.

OPENING STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NORTH

CAROLINA

Mr. ETHERIDGE. Thank you, Mr. Chairman, and let me thank

you for holding this hearing today. My numbers indicate we have

14 witnesses. If each one takes 5 minutes, that is 70 minutes, so

the less I say, the sooner we can get to the testimony, so let us get

going. Thank you.

Mr. MORAN. You have upstaged the chairman. We now, will hear

from those witnesses, and I would like to invite the panel that is

at the table to begin their testimony. Mr. Terrence A. Duffy, who

is the chairman of the Chicago Mercantile Exchange Holdings, Inc.

in Chicago, IL; Mr. Charles Carey, the chairman of the Chicago

Board of Trade, Chicago, IL; Dr. James Newsome, president of the

New York Mercantile Exchange, New York, NY; Mr. Frederick W.

Schoenhut, chairman of the New York Board of Trade, New York,

NY; and Satish Nandapurkar, chief executive officer of Eurex U.S.,

Chicago, IL. Mr. Duffy, we are ready to begin.

STATEMENT OF TERRENCE A. DUFFY, CHAIRMAN, CHICAGO

MERCANTILE EXHANGE HOLDINGS, INC., CHICAGO, IL

Mr. DUFFY. I am happy to appear before you, Chairman Moran,

to offer the subcommittee the CME’s view as to what the subcommittee should be considering as it undertakes reauthorization

of the CFTC. In the judgment of the CME, the Commodity Futures

Modernization Act of 2000 represents successful, landmark legislation that materially and beneficially transformed the nation’s futures markets. The CFMA facilitated reduction of high-cost regulation, and has been an unparalleled success, making futures trading

more efficient and useful to a wide range of customers.

Throughout its over 100-year history, and especially so in the

past three decades, the CME has earned a reputation as a premier

innovator and industry pacesetter. A very clear demonstration of

our leadership in the global derivatives industry is an historic

clearing link between the CME and the Chicago Board of Trade,

41

which has delivered on the efficiencies and $1.8 billion in savings

just as promised.

Within our organization, the initials ‘‘CME’’ stands for ‘‘Customer

Means Everything,’’ and I think that customer-driven perspective

explains much in terms of our success since the enactment of the

CFMA. While the CME enthusiastically applauds the success of the

CFMA and recommends that we retain its historic, statutory

framework, the upcoming congressional reauthorization process offers a valuable opportunity to fine tune that statutory regime based

on industry experience gained since the CFMA’s enactment in

2000.

The first area in need of fine tuning involves retail foreign exchange futures. There have been massive, continuing frauds

against retail customers in the OTC/FX market. A loophole in the

act permits unregistered, known offenders to sell foreign-currency

futures to naive retail customers. This loophole can and should be

closed.

Compounding this problem is the recent, unfortunate decision of

the 7th Circuit Court of Appeals. In CFTC v. Zelener, the court

adopted an extremely narrow definition of futures contracts.

Zelener held that a futures contracts stopped being a futures contract if the seller inserted a meaningless disclaimer. The ruling

permits OTC dealers to easily offer futures-like contracts to unsophisticated customers without CFTC jurisdiction or registration requirements.

As noted in recent testimony by Acting Chairman Brown-Hruska,

this retail fraud has spread from foreign-exchange scams to heating

oil and orange juice. This can and should be stopped by closing the

loophole created by Zelener. Unless the loophole is closed, the committee should be concerned with the very real prospect that before

long, the CFTC’s jurisdiction and its retail customer protections

may be reduced to irrelevance. The challenge for the committee

and the futures industry is to find an effective solution that will

politically survive the reauthorization process.

The second area in which the CFMA needs to be modified deals

with single-stock futures. Inter-exchange competitive concerns combined with regulatory and legislative turf contests ended the hope

for this product before it was launched. It is time to let futures exchanges trade the product as a pure futures contract and let securities exchanges trade it as a securities product. Let the relevant exchanges deal solely with their respective regulator, whether the

CFTC or the SEC, which is what I believe that Congress initially

intended in 2000 in authorizing single-stock futures. I would urge

the committee to prevail upon the respective regulative agencies to

eliminate all undue regulatory impediments.

Before concluding, Mr. Chairman, I noted that one of the witnesses called on Congress to force exchanges that innovate and pioneer new contracts, to freely give up the benefits of their investment in innovation to their competitors. That idea is utterly contrary to every viable economic principal that has made the U.S.

economy work. A number of other issues have been raised in written testimony. I will be pleased to explain why self-regulation in

the futures industry works, how our corporate governnance meets

the highest standards, and why the rule-making process under the

42

CFMA is not broken, in response to your questions or in supplemental testimony.

In conclusion, I want to thank you, Mr. Chairman, for allowing

me to participate in this hearing. The CME, its customers, and the

industry have greatly benefited under the CFMA. The CME looks

forward to participating in the reauthorization process, helping the

committee craft amendments that preserve the original intent of

the CEA, amendments that protect retail customers and that improve the efficiency, competitiveness, and fairness of futures trading for all market participants. I will be pleased to answer any of

your questions. Thank you, sir.

[The prepared statement of Mr. Duffy appears at the conclusion

of the hearing.]

Mr. MORAN. Mr. Duffy, thank you very much for being here

today. The Chair now recognizes Mr. Carey.

STATEMENT OF CHARLES CAREY, CHAIRMAN, CHICAGO

BOARD OF TRADE, CHICAGO, IL

Mr. CAREY. Mr. Chairman and members of the committee, my

name is Charles Carey, and I am chairman of the Chicago Board

of Trade. It is an honor for me to appear before you to present the

Board of Trade’s views. As you have requested, we have submitted

our written testimony for the record.

We commend Congress for its excellent work in passing the Commodity Futures Modernization Act and the careful and thoughtful

way in which the Commodities Futures Trading Commission has

implemented its provisions.

The CFMA gave the commission needed flexibility to deal with

innovation and brought legal certainty to many products while preserving regulatory concepts that are essential to our industry. The

commission and its staff have shown great insight in using this authority to reduce regulatory burdens without sacrificing vital customer protections.

In my written testimony, I call attention to several issues that

deserve discussion, but major changes to the law appear unnecessary at this time. For example, security futures, which were allowed for the first time by the 2000 act, have yet to reach their potential. Dual regulation by the CFTC and the Securities and Exchange Commission has created challenges. We hope two commissions work together to relieve these, such as the unfair and unnecessary margin inequities that inhibit the growth of stock futures

and their usefulness as risk-management tools. A Federal Court

decision holding that the CFTC has no anti-fraud jurisdiction over

retail foreign currency transactions could lead to increased opportunities for fraud.

The potential impact of this decision is a matter of concern

across the futures industry. Congress may find that this issue warrants a legislative response. If that is the case, the CBOT will, as

always, be happy to work with the committee, the commission, and

other industry representatives in creating a solution. Since the

CFMA, a major trend in the industry has emerged toward international expansion and cross-border business arrangements. This

trend presents interesting challenges for regulators at home and

abroad. In one such initiative, Eurex, soon, will ask the CFTC to

43

approve a plan to clear trades on its U.S. subsidiary contract market through a clearinghouse located in Frankfort, beyond the regulatory control of the CFTC. The CBOT believes that such a nondomestic clearinghouse should register with the CFTC as a designated clearing organization. The requirement that U.S. futures

should be cleared by DCOs is good regulatory policy and would preserve for U.S. citizens trading on Eurex U.S. the protections available under U.S. regulation and bankruptcy law in the event of a

default or insolvency.

Recent actions of a handful of traders in London, selling and buying bonds through a European electronic trading system, are being

investigated by four European governments for possible price manipulation. This incident illustrates the potentially destabilizing effect that market behavior can have across borders and between exchanges and marketplaces. Comparable regulation and information

collection among regulators of different countries is essential to

help detect and prevent systemic harm from such activities. The

CBOT is pleased that the CFTC recently began discussions with

the committee of European securities regulators and hopes those

discussions will be productive in resolving issues of regulatory disparities and gaps, in a manner consistent with the CFMA.

In addition to customer protection issues, unequal regulatory

treatment can also result in uneven regulatory costs, thereby creating unfair competitive advantages. Decisions being made now with

regard to policies and protocols for cross-border business are setting critically important precedentd that will impact the global derivatives industry for years to come.

The Chicago Board of Trade, the oldest and one of the largest futures exchanges in the world, had its best year ever last year, trading over 600 million contracts, a volume increase of over 31 percent

from the prior year. The success of the Chicago Board of Trade over

the years reflects the confidence that market participants have in

our commitment to vigorous, evenhanded self-regulation. Self-regulation with commission oversight continues to work well. There

have been questions raised concerning the move by exchanges to

become for-profit organizations and whether they can avoid conflicts of interest. A for-profit exchange has an even greater incentive to maintain and increase public confidence. Experience has

shown that investors prefer markets that have demonstrated integrity through self-regulation. The Chicago Board of Trade is presently going through the process of becoming a for-profit organization, and I assure the committee that this new status, while enabling us to compete more efficiently with other exchanges from

around the globe, will not lessen our dedication to fair and forceful

self-regulation.

We hope and expect that regulators will keep in mind the advantages of knowledgeable and experienced self-regulation and not impose rigid definition that, for example, may preclude a member of

an exchange with no other ties to the exchange from becoming an

independent director or a committee member. Again, thank you for

the opportunity to testify today. The Chicago Board of Trade is

pleased to respond to questions and provide any assistance the

committee may deem necessary. Thank you.

44

[The prepared statement of Mr. Carey appears at the conclusion

of the hearing.]

Mr. MORAN. Mr. Carey, thank you for your time. Dr. Newsome,

welcome back in a new capacity.

STATEMENT OF JAMES NEWSOME, PRESIDENT, NEW YORK

MERCANTILE EXCHANGE, INC., NEW YORK, NY

Mr. NEWSOME. Thank you Mr. Chairman. Members of the committee, it is an honor to be here this morning as president of the

New York Mercantile Exchange. NYMEX is the world’s largest

forum for trading and clearing physical commodity-based futures

contracts, primarily energy and metals. The CFMA of 2000 was

landmark legislation that provided critically needed legal certainly

and regulatory flexibility to U.S. futures exchanges and derivatives

markets. It is our view that the current structure is providing a

reasonable, workable, and effective oversight regime for the regulated exchanges. Prior to the CFMA, the CFTC operated under a

one-size-fits-all regulatory approach. Regulatory inequities, particularly buyer-approval requirements for rule and contract changes

imposed unreasonable constraints on domestic exchanges competing with both international and unregulated exchanges.

This committee and the Congress agreed that the orientation of

the CFTC should be shifted to a more flexible oversight role to address these issues. Congress established market tiers so that a

marketplace can now select a level of regulation according to the

product types offered, but more importantly, to the eligible participants for the facility. NYMEX operates, by choice, at the highest

level of regulation by CFTC and has been consistently been deemed

by CFTC staff reviews to have maintained adequate regulatory

oversight and programs.

Although NYMEX is largely a marketplace used by commercial

participants for hedging, the benefits also accrue more broadly to

consumers, who receive prices based on open and fair competition.

Prices for the commodities traded in U.S. futures markets are vital

to our national economy and are recognized as reliable global

benchmarks. As a note, the CFMA maintains the CFTC’s exclusive

jurisdiction over futures and options on futures. NYMEX supported

and continues to support this approach, which would be maintained by several savings clauses contained in last year’s energy

bill.

It is important to point out, contrary to what some have suggested, the CFMA did not diminish the regulatory oversight responsibilities of the CFTC. Although regulated exchanges may selfcertify new contracts and rule changes, CFTC retains the responsibility to ensure that all changes are in accordance with the guidelines of the act. In practice, there is always prior discussion with

the CFTC on any substantive change.

Regulatory flexibility was vital in responding to the financial failure of Enron. In the aftermath, other energy-trading companies

lost credit rating, stock prices plummeted, and liquidities crises

begin to develop because market participants lacked confidence in

each others’ abilities to perform transactions. In response, NYMEX

addressed these issues by rapidly implementing a number of important measures to migrate positions from over-the-counter marketVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00048 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
45

place to NYMEX and the protections provided by it is AA+-rated

clearinghouse.

NYMEX also began launching a slate of products appealing to

OTC participants, which are executed off the exchange, but brought

to NYMEX for clearing. In doing so, 130 products that are traditionally traded OTC have been brought under the umbrella of a

regulated exchange which establishes the identity of participants,

a transaction audit trail, daily precision surveillance, and security

credit, none of which would have been available prior to the CFMA.

We recently completed an analysis of hedge fund participation in

several NYMEX markets, during the year 2004, which is being submitted to this committee, Mr. Chairman, for the record. As you review this report, I believe that you will agree, as our research suggests, that hedge funds serve an overall, constructive role in our

marketplace. And while hedge fund participation has not made up

a large portion of our markets to date, we continue to monitor this

market segment closely. Market integrity continues to be effectively safeguarded on the regulated exchanges through stringent

adherence to the CFMA core-principles. As a self-regulatory organization, NYMEX devotes significant resources to the oversight of all

of its markets. With regard to CFTC oversight responsibilities, the

agency has been, by all accounts, quite vigorous at exercising the

scope of its current authority to police abuses in the OTC marketplace, including energy markets. Nonetheless, there remain open

issues respecting CFTC anti-fraud authority over principal-to-principal transactions involving exempt commodities executed bilaterally or in electric platform. Congress certainly may wish to consider whether clarification or guidance in this area is needed, and

NYMEX looks forward to working with the committee on that

topic.

In closing, Mr. Chairman, the regulated futures industry is more

robust and competitive as a result of the common-sense revisions

made by Congress in the year 2000. The CFMA regulatory scheme

has provided and continues to provide an orderly and secure framework for competitive risk management. Mr. Chairman, I may admit

that I am a little bit biased, but I do believe that the CFTC followed closely the intent of the Congress as they implemented the

CFMA. I think it is working; I think this committee should be commended for that legislation; and certainly look forward to participating and answering any questions.

[The prepared statement of Mr. Newsome appears at the conclusion of the hearing.]

Mr. MORAN. Mr. Newsome, thank you very much. Mr.

Schoenhut?

STATEMENT OF FREDERICK W. SCHOENHUT, CHAIRMAN, NEW

YORK BOARD OF TRADE, NEW YORK, NY

Mr. SCHOENHUT. Mr. Chairman and members of the committee,

thank you for this opportunity to testify on behalf of the New York

Board of Trade, regarding the reauthorization of the Commodity

Futures Trading Commission. My name is Fred Schoenhut, and I

am chairman of the Exchange.

In 2004, the Coffee, Sugar, and Cocoa Exchange, founded in

1882, and the New York Cotton Exchange, founded in 1870, forVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00049 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
46

mally became one exchange, the New York Board of Trade. Like its

predecessor exchanges, NYBOT is a not-for-profit membership organization, established under New York law. NYBOT is the premier world market for futures and options in cocoa, coffee, cotton,

orange juice, and sugar. The exchange also has markets in currency rates and equities indices. While the financial markets exhibit different underlying characteristics than the agricultural commodities that dominate the exchange, they all provide reliable tool

for price discovery, price risk management and investment.

In 1994, NYBOT established a trading floor in Dublin, which is

the first open-outcry trading facility in Europe owned by a U.S. exchange. The concept of self-regulation, long embodied in the CEA,

was strongly enforced and expanded by the Commodities Futures

Modernization Act of 2002. The CFMA was the culmination of 4

years of work by the Congress. It provided flexibility for exchanges

to decide how to best structure their business around a set of core

principals. The CFTC provides oversight rather than promulgating

prescriptive regulations and second-guessing exchanges decisions.

We believe the CFMA is working as intended, allowing markets to

be competitive and by modernizing and streamlining the regulatory

system.

We, therefore, support a reauthorization bill that continues this

current regulatory structure.

In this regard, we wish to point out three areas of exchange selfregulatory structure that are important to maintain. First, each exchange should continue to be allowed to determine the composition

of its governing board. Consistent with core principal 16, the

NYBOT board consists of 25 voting governors and one nonvoting

governor, the president, who is the sole staff-representative to the

board. NYBOT governors include members who represent the commercial industries associated with products traded on the exchange, members who trade for themselves and others on the trading floor, FCMs, and public governors. This diversification provides

the board with a level of expertise that can only be provided by

people who are actively engaged in the trading of the products and

also allows the board to take a range of views into consideration

before reaching a decision. How board members are chosen, whether to have such diversification, and how representation of various

communities should be allocated are matters for each designated

contract market to determine for itself in light of its own particular

circumstances.

Second, the structure for exchange compliance and disciplinary

function should also remain unchanged. Currently each exchange

is required to have procedures in place for monitoring and enforcing contract market rules. The CFTC conducts regular rule-enforcement review to determine whether an exchange is meeting this requirement. Most cases presented to our disciplinary committee are

very technical in nature and require a strong knowledge of our

rules and understanding of trading practices. With this system

changed by requiring majority of the disciplinary committees or

trial panels to be comprised of nonmembers, it would deprive the

system of needed expertise. Moreover, it would be difficult to attract regular panel participants without adequate compensation,

thereby placing smaller exchanges that cannot afford to pay public

47

members attractive sums for serving on such panels at a disadvantage.

While the NYBOT compliance has worked successfully for many

years, undoubtedly other systems might be employed at other exchanges to equally good effect and should be decision of each exchange as to what system to employ. We believe the current system

works well and additional requirements making the make-up of or

functions of the disciplinary committees are not needed.

Third, exchanges are required to establish and to enforce rules

that minimize conflicts of interest in the decision-making process.

There is a flexibility for each exchange to determine how to meet

this requirement, recognizing that each exchange has a different

governing structure. At NYBOT, we disqualify board members from

participating in a decision they have direct conflicts with; however,

a person with potential conflict, who has useful expertise—we may

ask that that person provide to the board to inform our deliberations.

In closing, Mr. Chairman, on behalf of the Exchange, its trading

community, and users, I would like to thank the CFTC, this committee, and Congress for the support they gave after 9/11. NYBOT

was the only exchange completely destroyed in the World Trade

Center terrorist attack. Fortunately, we had a back-up site in Long

Island City, and using this site, we were able to trade 6 days later.

And thanks to the assistance that Congress provided, we were able

to rebuild in lower Manhattan and move to our new facilities in

September 2003. In 2004, we hit new trading volume records of approximately 32 million contracts, representing a 32-percent increase from the 2003 year.

Mr. Chairman, I would be happy to answer any other questions

you may have.

[The prepared statement of Mr. Schoenhut appears at the conclusion of the hearing.]

Mr. MORAN. Thank you very much. Mr. Nandapurkar.

STATEMENT OF SATISH NANDAPURKAR, CHIEF EXECUTIVE

OFFICER, EUREX U.S., CHICAGO, IL

Mr. NANDAPURKAR. Chairman Moran, members of the committee,

thank you for the opportunity to testify. I am Satish Nandapurkar,

CEO of Eurex U.S. Eurex U.S. is very grateful for invitation to participate in these hearing and be able to present our views as a relatively new entrant in these markets.

I share the opinion of others on this panel that the CFMA has

been a tremendous success. We believe it is working as Congress

intended, namely by allowing exchanges more freedom to innovate

and making it more attractive to operate here, on the ground, in

the United States, as a U.S. regulated futures exchange.

The CFMA has facilitated a degree of competition in the U.S.

markets that has never been seen before, resulting in greater innovation, greater efficiency, and greater choice for market participants. The numbers speak for themselves. Volume in the year

2000, across all U.S. futures exchanges, were 600 million contracts.

Last year, volume ballooned to 1.6 billion contracts.

We are also of the opinion that the CFTC has done an outstanding job in putting into practice this groundbreaking legislation.

48

Starting with former Chairman Newsome, and now continuing

with Acting Chairman Brown-Hruska, the CFTC has moved expeditiously, yet prudently, in implementing the new, streamline regulatory structure, while ensuring that participants are adequately

protected.

Since enactment of the CFMA, the CFTC has designated eight

new futures markets and eight new clearinghouses. And not surprisingly, this increase in competition has been accompanied by

new products, new services, lower cost and increased efficiency. 600

new products have been filed since enactment of the CMA, and as

exchanges compete, a beautiful thing happens; fees drop. When we

came into the marketplace for U.S. treasuries, the incumbent exchange, CBOT, dropped their fees 80 percent, and in some cases,

dropped their fees to zero, resulting in tremendous savings for the

industry, and especially for users.

Competition has also forced exchanges to finally respond to customers’ preferences for the transparency, immediacy, and efficiency

of electronic trading. Last year, most of the futures traded in the

United States were traded electronically. Back in 2000, that wasn’t

even close to the case. Thanks to electronic trading, a trader anywhere in the United States can be on the same footing and have

access to the same information as that which was once reserved for

a trader in the pits in Chicago.

We at Eurex U.S. are particularly indebted to the committee, for

without the committee, there would be no Eurex U.S. If I may, I

would like to tell you a little bit about Eurex U.S. We are a new

futures exchange registered with the CFTC and regulated by the

CFTC. We are headquartered in Chicago with a U.S. management

team based in Chicago. Our clearing is handled by the Clearing

Corporation, a 75-plus-year-old institution, again, based in Chicago.

Market surveillance and trade-practice surveillance is provided by

the NFA—the not-for-profit NFA in Chicago. We began trading in

February 2004 with futures on 2-, 5-, and 10- year Treasury notes

and on the 30-year Treasury bond as well as options on those futures. This year, we have expanded our product line into equity

index futures with the large-cap Russell 1000 index and the small

cap Russell 2000 index.

Our approach to markets is quite straightforward. We believe

customers are best served by an all-electronic trading system,

equal access to market information on a level playing field, and low

fees for all. And we believe that people should get all of this with

no membership purchase required. And our goal here is not just to

compete for the market in the United States, but to expand the

market in doing so. As markets continue to globalize, we plan to

be on the forefront of facilitating cross-border trade, making it easier for the European customer to access U.S. market and U.S. customer to access European markets.

We have had extensive discussions with the CFTC on the implementation of the next phase of our global business plans.

In enacting the CFMA, Congress placed great faith in competition, and that faith has been rewarded. Greater innovation and

greater efficiency have been the engine of growth in the futures industry in the last few years. In our own way, we are trying to realize the potential created by the CFMA. We offer the U.S. marketVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00052 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
49

place open and equal access, an all-electronic venue, competition in

existing products, new products, and low fees for all. Our course

forward is to build on this foundation to bring greater business into

the United States. The CFMA has greatly facilitated our ability to

do this. We urge Congress to stay the course. Continued reliance

on the benefits of competition will transform the futures industry

even future for the benefit of all and preserve the U.S.’s leadership

role in the global futures industry. Thank you.

[The prepared statement of Mr. Nandapurkar appears at the conclusion of the hearing.]

Mr. MORAN. I thank you very much. In light of Mr. Boehner’s

schedule, the Chair now recognizes the gentleman from Ohio.

Mr. BOEHNER. Let me thank the chairman for accommodating

my schedule. I have got a mark-up going on in my committee in

a few minutes, and as the chairman of the committee, I probably

ought to be there.

Let me suggest, as I did last week, that, having been through

several of these reauthorizations of the Commodities Exchange Act,

the CFMA clearly is a success, and for those of us who have sat

on this committee and been through this process several times, it

is probably one of the most significant achievements that members

of this committee have participated in.

But what I really failed to do last week when I made this point

was to thank those of you on this panel, those of you on the following panels, for your efforts in helping us achieve what has been a

great success. Because if it had not been for the CFMA, given the

continued globalization of the world economy, given the regulatory

structure we had prior to the CFMA, heavens only know where

that business would be located today. And I would suggest, clearly,

not in the United States. And so as we look at the reauthorization

of the Commodities Exchange Act, we are going to continue to need

your help in those areas where we believe we need fine tuning.

Now, fine tuning, I would point out, doesn’t mean legislating an advantage for your market versus someone else—or your exchange,

vis-a-vis, someone else. And I think that competition that has come

to the industry has kept the U.S. industry competitive, continued

to be a leader in the worldwide futures markets, and I want to see

that continue. Dr. Newsome, you have played a key role in helping

us put together the CFMA, and when it comes to reauthorization,

can you give us 1, 2, 3 points, in your opinion, sitting in your

unique position, as to what you think we need to do.

Mr. NEWSOME. Chairman Boehner, I would be more than happy

to do so. I think I would start with the ability of the commission

to bring charges against off-exchange forex bucket shops. In

myopinion it was clearly the intent of Congress to give the CFTC

that authority. That authority has been thrown into question

through the Zelener decision that many of you have discussed.

Certainly, I am not an attorney, so from the legal aspects of the

law, it would be very difficult for me to discuss. I would just say

this: the decision that the court faced was a very similar decision

that the commission faces on a weekly basis as we sit and listen

to appeals on cases that go before our Administrative Law Judges.

I don’t think there was any question about the fact that there was

fraud in the Zelener case. The question was whether it was a fuVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00053 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
50

tures contract. The commission viewed Zelener as a futures contract, and we were different than the court in the fact that we

looked at all of the components, not just the verbiage of the contract, but actually how it was implemented and used. And we do

that very regularly, so I think that is why you have a difference

in how the commission viewed the case versus how the court—who

just tended to look at the verbiage in the contract and declared it

was not a future.

I think, without going into trying to define exactly what a futures is, which is very, very difficult, I think guidance from the

Congress with regard to how the commission and how the courts

should view these scenarios, in terms of its entirety, would be very

helpful and could go a long way towards clarifying whether these

contracts do fall within the jurisdiction of the CFTC.

The second thing I would mention is the ability of the commission wto enforce fraud and manipulation in over-the-counter markets. Again, I think through 2(g) and 2(h), which were very important components of the CFMA—and they were important because

creating legal certainty in the over-the-counter markets was a key

component of the CFMA, and those two provisions go directly to

that. So those two provision—also, I think it is clear that Congress

intended the CFTC to have some enforcement authority in these

areas. That has been muddled a little bit by the language in 4b,

which is the general anti-fraud provisions of the act. I think instead of going into 2(g) and 2(h) and messing with the legal certainty issue of OTC, which none of us want to do, I think if we simply went to 4b and we looked at the intermediated language there,

and if the Congress decided to take out that language, that would

then clarify that the CFTC does and can use their anti-fraud/enforcement authority.

Mr. BOEHNER. I know my time is expired, but I will leave the

Sarbanes-Oxley question to the chairman because I would be interested in the effect at the CME, and now at the Board of Trade,

what that means in terms of governance and the challenges that

it brings.

Let me just thank all of you for being here, and it has been a

pleasure to work with you. I look forward to continuing to work

with you as we reauthorize the Commodities Exchange Act.

Mr. MORAN. Thank you, Mr. Boehner. The gentleman from

Washington, Mr. Larsen.

Mr. LARSEN. Thank you, Mr. Chairman, and thank the panel for

helping us out this morning. And my questions are really for Dr.

Newsome. Welcome back before the subcommittee. You mentioned

2(g) and 2(h), and I wanted to explore those a little bit, and then,

as well, get some of your thoughts on how, say, fixing or removing

4b would fix the 2(g)/2(h) question.

I understand that 2(h) provides exemptive relief for energy,

metal, and chemical contracts, subject to the applicability of the

specific provisions of the CEA. There is a memo that was provided

in 2001 that talks a little bit about 2(g). As well, it says a section

2(g) exclusion will be particularly relevant to transactions not executed on a trading facility that involves metals, chemicals, or energy products, so I am trying to understand if 2(h) provides exemptive relief for those products, and 2(g), perhaps, at least in one perVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00054 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
51

son’s opinion, provides exemptive relief for those products, why the

necessity for both?

How often would 2(h) be used, or 2(g) be used, if they apply to

the same set of contracts. And then, third, you introduced the question of 4b or modifying or removing that would solve some of the

questions surrounding the use of 2(h) and 2(g). Is that enough for

you? You have 4 minutes.

Mr. NEWSOME. OK. Let me attempt to do it very quickly.

Again, I think when the act was looked at, legal certainty primarily in the over-the-counter markets, was a priority. Energy

markets entered that discussion relatively early in the phase.

Quite frankly, the CFTC had great comfort in saying that the financial markets should be excluded; and therefore, the 2(g) exclusion. We had not done the due diligence with the energies and metals markets and therefore did not give a real answer to the Congress with regard to either energy or metals because we had not

done that due diligence. We had no reason to believe that they

couldn’t be included, but again, we didn’t have the study to back

it up, nor had the president’s working group looked at it in detail

as they had in the financial markets.

Mr. LARSEN. I am sorry. When you say included, you mean included in 2(g) or——

Mr. NEWSOME. You are getting a bit more technical than I am

prepared to comment on this morning. I guess, getting to the root

of the problem, which is what I tried to address a few moments

ago.

I think, clearly, through 2(g) and 2(h), Congress demonstrated

the desire for the CFTC to have some authority in these marketplaces with regard to enforcement. The only reason that is thrown

into question is because of the 4b, the general anti-fraud provisions

of the act. And 4b specifically talks about for or on behalf of. And

the commission’s ability to go after those, otherwise—in non-intermediated becomes a question mark because of the general fraud

language in 4b, of course in 2(g) and 2(h), you are talking about

bilateral.

And so that has raised the question of whether or not the CFTC

has the authority that Congress intended, because of the language

in 4b. My point is that if the language in 4b is clarified, or if the

‘‘for’’ or ‘‘on behalf of’’ language is taken out, then clearly the commission would have the authority to utilize its enforcement powers

in non-intermediated situations.

Mr. LARSEN. So then if 4b was removed, you are saying that the

commission would have the authority to use its anti-fraud authority to regulate 2(g) and 2(h) transactions for fraud.

Mr. NEWSOME. That would be my opinion, yes, sir.

Mr. LARSEN. Right.

Mr. NEWSOME. But I would also say that, as this committee

knows, it is very easy to come up with unintended consequences,

so I think the discussion about that should be inclusive of a number of market participants to make sure that through doing that

we don’t end up with some unintended, negative consequences.

But I certainly think it is worthy of the discussion of this committee.

Mr. LARSEN. Thank you, Mr. Chairman.

52

Mr. MORAN. Thank you, Mr. Larsen.

In follow up a bit to what Mr. Newsome said, does anyone believe, in light of the Zelener case, that it is time for Congress to

define what a futures contract is? And is there some industry effort

underway that would help us in that regard or head down this

path at all? Mr. Duffy?

Mr. DUFFY. Yes, Mr. Chairman, I think that to define a futures

contract and open up the act might be something that no one is

prepared to do, but I think that if we look at the original intent

of Congress—and there may be a quick fix that we can look at that

does not open the act—which is basically to say that a retail foreign exchange trader who uses these contracts for the shifting of

risk or speculation should be subject to CFTC regulation. I think

it is that simple. I don’t think that has to define a futures contract,

which then, in turn, would open up the act. So I think that simple

language fix could help solve some of this problem that we have

today.

Mr. MORAN. Does any of the panel have anything contrary or addition of Mr. Duffy’s suggestion?

Mr. DUFFY. Thank you.

Mr. MORAN. Mr. Carey, you talk about the global clearing link

and co-mingling of funds. It is my understanding the CFTC approved such co-mingling in similar circumstances in the past. Is

that true, and are the benefits of a global clearing link completely

outweighed by protection issues?

Mr. CAREY. Well, I believe that the benefits of global competition

do not outweigh our responsibility to maintain integrity in the market place. Our No. 1 priority has to be the confidence that Dr.

Newsome referred in your marketplace. And the fact that these do

raise novel issues—secure funds versus segregated funds and crossborder bankruptcy laws—they raise questions that should be answered. So our position on that is that the priority has to be maintained, the customer protections, and the integrity of the marketplace. And when you are dealing with a cross-border link, it does

raise questions, so we would prioritize customer protection in this

case.

Mr. NANDAPURKAR. Mr. Chairman?

Mr. MORAN. Yes, sir.

Mr. NANDAPURKAR. I would like to just to step back and talk a

little bit about global trading in general and then talk a little bit

about global clearing for the committee. Today there are a lot of

traders here in the United States that trade European products;

there is a lot of traders in Europe that are trading U.S. products.

In fact, it is all our strategies to grow the U.S. business by expanding in Europe and Asia. What we are proposing with the global

clearing link is a mechanism that basically links our clearinghouse,

the Clearing Corporation, with Eurex’s clearinghouse, Eurex Clearing, to actually make it more efficient and more cost-effective for

people to do that global, cross-border trade.

The first phase of that is already approved, and it allows U.S.

traders that are trading overseas on Eurex to actually repatriate

their funds back into the United States. So today, before that went

into place, they would trade on Eurex in a European regulatory environment and leave their funds over there with a European clearVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00056 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
53

ing firm. Now, thanks to the first phase that has been approved,

they can trade over in Europe, but they can repatriate their fund

and use their existing relationship in the United States and hold

their positions in the U.S. and their funds in the United States.

Now, what we are seeking approval for is the second phase, and

that is what we are working on, and we hope that that second

phase will actually make it a lot more efficient for a lot of smalland medium-sized traders in Europe to start doing business in the

United States. And the way that we are hoping to do that is by allowing those traders to trade U.S. products on Eurex U.S., but then

hold their positions at their existing clearing relationships in Europe.

And the way we are structuring this link follows and builds on

precedence in other clearing links that have placed for over 20

years, such as the CME’s clearing link with the SGX, and more recently, the CME’s clearing link with MAF. We feel that the structure we are going to be proposing is in line with the precedence

that is already out there.

We have been in discussion with the CFTC. We plan to file an

application very soon, and the application, we expect, will be put

out for comment, and we have committed that we wouldn’t move

forward with this clearing link until we do get CFTC approval. And

I am confident that CFTC will be reviewing this thoroughly; it will

go out for public comment; and they will be very comfortable with

what we have proposed.

Mr. MORAN. Mr. Nandapurkar, are there issues that we ought to

keep in mind as—in consumer protection in this cross-border—

these cross-border transactions? Issues related to information enforcement? The bankruptcy laws? What concerns are legitimate?

Mr. NANDAPURKAR. Yes, one of the things that we have done in

implementing this is, when it comes to a U.S. customer—especially

a U.S. customer trading on a U.S. exchange, we have implemented

a structure where they are guaranteed the highest level of protection for their funds, and that was important for us to do in terms

of getting this first phase in place. I am sure you have heard terms

like segregated funds versus secured funds—and I am not a lawyer

nor a regulatory expert, but one of the things I know we had to

guarantee—and we wanted to guarantee—was that the U.S. customer got the highest level of protection in getting these funds in

place.

And whenever a U.S. customer, or any customer, is trading on

Eurex U.S., they are always subject to U.S. regulatory rules and

rules of our exchange.

Mr. CAREY. Mr. Chairman? Could I make one more point? One

of the things I would like to state to complete my comments earlier—it is a little bit hard to talk about the structure of phase 2

because there has been no application yet. And the CME-SIMEX

link, which was referred to, was established before the CFMA, before there was any such thing as a DCO. Now that there is a registration category for this business, every clearinghouse that clears

U.S. trades should register. We continue to believe that getting a

DCO approval is the best way to structure the link to ensure protection of the customers.

54

Mr. MORAN. I think one of the things you raise, Mr. Carey, in

your testimony, is a concern that we may level-down the level of

regulation.

Mr. CAREY. A race to the bottom?

Mr. MORAN. Bring us to the bottom. One of the goals of CFMA

was to create a more level playing field with international competitors, and it seems to me that we have had some success. Are there

examples of regulatory imbalances internationally that we should

be made aware of?

Mr. CAREY. To answer that, there is potential because these exchanges, when you start to link them, have different rules in their

domicile countries, and the customer protections do vary, and I

think it is important to have that dialogue and to work through

these issues. Again, it is about the integrity of the marketplace and

the customer protection. So without referencing any specific cases,

I would say that the comparisons have to be made to ensure that

the playing field is level and that the customers are protected in

the same way.

Mr. MORAN. Is there a benefit that accrues to U.S. exchanges because of consumer confidence in our regulatory scheme? Is the reality is that U.S. exchanges get international business because it

is less risky?

Mr. CAREY. Clearly. We have a 157-year history of no defaults.

We go through rule-enforcement reviews. The commission has

strong oversight, and you have oversight over the commissions, so

we clearly believe that the integrity in the U.S. markets has contributed to their success.

Mr. MORAN. The story would be that business accrues to the

United States’ exchanges because of the system we have, and there

are international customers who would choose to transact business

here because of that?

Mr. CAREY. Absolutely.

Mr. DUFFY. Can I add to that?

Mr. MORAN. Sure, Mr. Duffy.

Mr. DUFFY. I think there are some other points, to add to that.

I think it is because of the innovation that the U.S. exchanges and

the people behind them have demonstrated that has created product for the world to participate in, also. So I think that cannot be

overlooked, and it goes to the point of exchanges who create product for the world to benefit—especially the U.S. citizens—that product should not be able to just be pillaged by any other exchange.

So it is the innovation factor, also, that makes U.S. exchanges attractive to international customers.

Mr. NANDAPURKAR. Could I add a follow-up? I think what we

have to remember is that the European exchanges—there are some

pretty large European exchanges, and in fact, by many measures,

Eurex is actually the larges exchange in the world. And about 20

percent of Eurex’s business is coming from the United States already, so we have already got a lot of this business going back and

forth. And with respect to Mr. Carey’s point about the precedent,

I believe the last clearing link that was put in place was CME

MAF, and that was done after the CFMA, so one of the precedents

we are looking at is the precedent of business that is done after the

CFMA.

55

In terms of trying to—regulatory impediments to going into Europe, I am actually aware of none, in terms of—or actually aware

of none that would stop the U.S. exchanges from doing what we

have done here. The way, traditionally, exchanges have moved

global is by putting remote terminals in the other countries, getting

an approval. The European exchange gets an approval to put their

remote terminals in the United States; a U.S. gets approval to put

their remote terminals in other counties in Europe; and then you

string lines back and forth across the Atlantic in trying to grow

your business.

What we have done here is we have taken much more of a longterm approach. Instead of coming in through the window, we are

coming in through the front door. We have set up a proper U.S. exchange that CTFC registered, CFTC regulated, and we are here on

the ground, and we are looking to actually move the business off

of this remote process, onto our main exchange, the European business, and that takes time to set up, and it takes a lot of investment. And I think the NYMEX is looking to do something like that.

NYBOT has set up an NA in Ireland, and I know Mr. Sprecher

from ICE, who you are going to hear from later, has bought the

IPEE, in trying an exchange on the ground in London in trying to

expand.

But we have done something a little different. We have set up for the long run here by making a $60 million-plus investment and

taken a lot of time to get the exchange set up right, as a proper

U.S. exchange, here.

Mr. MORAN. I would like to pursue this a little further, but my

time is expired.

The gentleman from North Carolina, Mr. Etheridge.

Mr. ETHERIDGE. Thank you, Mr. Chairman. I have a couple questions. If you will bear with me, I am going to ask those and then

ask each one of you to cover the areas that I have questioned, and

hopefully, that will save my time and yours, too. For you, Mr.

Duffy, in your testimony, when talking about securities futures

products, you say it is time to let futures exchanges trade the product as pure futures/securities products. ‘‘Let the relevant exchanges

deal solely with their respective regulator.’’ I want to explore exactly what you are looking for when you make this statement.

Should we allow the CFTC and SEC to regulate these products

independently and let the market determine whose regulator vision

for these products are better, or should we maintain the CFTC and

the ESEC’s collaboration on crafting regulation for these products,

but allow the exchanges to deal solely with their respective regulators. Or perhaps, you would prefer a single agency to have full

regulatory authority over these securities futures—or is that what

you are talking about?

Mr. DUFFY. Well, thank you, sir. What I am referring to—and I

think you did outline most of my testimony on single-stock futures—we do believe that the CFTC should be able to regulate the

futures—single-stock futures part of it. And if the securities exchanges want to trade single issues, they should go ahead and be

regulated by SEC. These contracts were doomed to fail from the beginning from margin and every other impediment that goes along

with it. The cost of regulation is very expensive. When you have

56

dual-regulation costs, it is a big, large deterrent for participants to

trade in these markets, so I think that you outlined exactly what

we are asking for, which is to have the CFTC regulate single-stock

futures that are traded on our exchange. And if a securities exchange wants to trade that product, let the regulator regulate

them, and we believe that will end the dual-regulation problem.

Mr. ETHERIDGE. OK. Anyone else have a comment?

Mr. NANDAPURKAR. Yes, sir. I would like to comment, Congressman. Having sat at a chair, negotiating with the SEC while we

were implementing the act, I think I have some insight into that

that no one else may have. I would say that I agree entirely with

Mr. Duffy’s evaluation and comments on how to move this forward.

Allowing the trading of single-stock futures was another large component of the act and a very big component. The Congress chose

to ask the CFTC and the SEC to cooperate from a regulatory

standpoint, moving forward. I will tell you that was tried; it was

tried diligently. I believe everyone was at the table in a good-faith

effort, but at the end of the day, it has failed.

There is a fundamental difference for why it has failed, and I

think it goes to the differences in the marketplaces. You have got

the securities business; it is about capital formation. The futures

business, that is about risk management. And because of that fundamental difference, the SEC has developed a regulatory scheme

based up on customer protection; the futures industry had developed a regulatory scheme based upon market integrity. And when

you try to meld those two together to regulate a single product, it

just has not worked.

So to me a logical solution is to allow both of the industries to

trade their own products on securities exchanges, on futures exchanges, regulated by the SEC and the CFTC and to allow the

marketplace to choose where they would like to do that business.

Mr. MORAN. Thank you.

Mr. ETHERIDGE. All right and this may give you a chance to comment, too, Mr. Nandapurkar. You have heard the concerns raised

about the second phase of your global trading link. Does the Eurex

German clearing-plan plan to register as a designated clearing organization, or do you believe that registration is not necessary or

required? And why would Eurex not want to register? And Mr.

Newsome, you have commented already, but you were CFTC Commissioner, the quote regarding Eurex having to register as a designated clearinghouse was attributed to you. Do you still believe

that?

Mr. NANDAPURKAR. The way we are structuring this link, the

way we set this link up, we believe follows and builds on precedence that have been in place with other clearing links for the last

20 years. Some of those clearing links were before the CFMA.

There is one that we picked up that was after the CFMA. But regardless—and again, I am not a lawyer or a regulatory expert, but

from what my lawyers tell me, the precedence still applies.

So our view, basically, is that there is precedence out there

where there have been clearing links in place. We are following

that precedence; we are building on it; and in none of those cases

was registration required. Now, I have a great deal of respect for

Dr. Newsome, and we would agree that with certain clearing-link

57

structures that registration as DCO could be appropriate. However,

we think our structure follows and builds on the precedence and

has a particular structure where it may not be appropriate. And in

those other cases, it was not appropriate. But again, we are going

to bring our application forward very soon. It will be put out for

public comment, and we have committed not to move forward until

the CFTC does approve it.

Mr. NEWSOME. Mr. Etheridge, I would make just a couple of comments. As I testified to this committee, I believe that the CFTC

should maintain that flexibility to make the determination of

whether DCO status is required.

I am not familiar with the application and certainly haven’t been

in contact with them, but I am very confident in the CFTC’s ability

to have that flexibility based upon the Eurex U.S. application to

make the appropriate judgment.

If that direction is not chosen, and say the CFTC decides that

there is no need for DCO registration or status, it is very difficult

looking at these kind of projects from the regulatory standpoint because at the end of the day, based upon the types of issues that

Chairman Moran mentioned, specifically bankruptcy, there is never

going to be a peg in every hole. It is just very difficult to make that

happen. So I think you have to rely upon disclosure. Disclosure is

something commonly used in the financial industry, and if at the

end of the day you can’t get a peg in every hole, I think you have

to disclose the differences to consumers about the regulatory functions in Europe, the regulatory functions in the United States, and

what that means to those customers.

Mr. ETHERIDGE. Thank you. Thank you, Mr. Chairman. I see my

time has expired.

Mr. MORAN. Thank you, Mr. Etheridge. To the panelist who continues to disclaim being a lawyer, please recognize the chairman is

one. I am assuming you are saying it in a way that suggests that

you would have more knowledge if you were.

Mr. NEWSOME. Lovingly, very lovingly.

Mr. MORAN. The gentleman from Louisiana, Mr. Melancon, welcome to the subcommittee. Any questions of our witnesses?

Mr. MELANCON. No, I don’t.

Mr. MORAN. Thank you very much.

The gentleman from Iowa, Mr. Boswell.

Mr. BOSWELL. Thank you, Mr. Chairman, and we don’t hold it

against you that you are a lawyer.

Mr. MORAN. The surprising thing is that I admitted it.

Mr. BOSWELL. Oh, I am not touching that. It is a good profession.

I am going to read what has taken place. I won’t take up your time,

but I appreciate my Chicago friends here and the rest of you as

well, but I know that you have made an effort to be here and be

a part of this, and thank you for it, and I will just have to talk to

you later. I was next door at the WTO meeting, so I just haven’t

figured out—they say I am big enough to be in two places if you

could split me, but I just haven’t figured it out yet. Thank you.

Mr. MORAN. Thank you, Mr. Boswell. Now, Mr. Boehner talked

about Sarbanes-Oxley, and both the Chicago Mercantile and the

Board of Trade are or are becoming publicly traded entities. I

didn’t say that correct. Publicly—a non—a for-profit organization.

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Mr. DUFFY. We already are.

Mr. MORAN. Tell me what regulatory environments SarbanesOxley adds to your circumstances?

Mr. DUFFY. First, the Chicago Mercantile Exchange has been a

public company since 2000, and it became a listed company in

2002. The Chicago Mercantile Exchange complies with all Sarbanes-Oxley requirements; it complies with all NYSE requirements

and all SEC-listed company requirements.

I think there is some confusion by the definition of independence

versus what is a conflict of interest. If there is a potential conflict

of interest by one of our board members, they have to abstain. So

right now, we understand all of the requirements of SarbanesOxley, and one of the things that we have, unique to anybody else

sitting up on this panel, being a listed company, we have shareholders, and they vote with their feet, obviously, and they vote with

their pocketbooks, and that is how they put their boards together.

When myself and others in this room took the Chicago Mercantile Exchange public, it was roughly a $600 to $700 million cap

company. Today we are roughly $7 billion market cap company. I

think our shareholders see the benefits of our board of directions

and what Sarbanes-Oxley has been able to provide for the CME.

The CME, also, is one of the most transparent listed companies on

the New York Stock Exchange. 80 percent of our revenue is derived

from transactions, so you can see on a daily basis exactly where we

are at.

So when it comes to a Sarbanes-Oxley, we have obviously complied with every requirement of every other listed company.

Mr. MORAN. Mr. Carey, anything to add?

Mr. CAREY. Well, I would like just to say that we are

transitioning to a for-profit company, and someday, we may be a

publicly traded company. I would like to compliment Chairman

Duffy on their success with the Chicago Mercantile Exchange. He

got into a little bit of the independent director definition, and I

would say that there is nothing to suggest that exchange members

that serve on our board are not independent. We disagree, strongly,

with the FIA on this point.

Both exchanges and the CFTC have recognized that having

knowledgeable and expert members on the board of directors has

served us well. In fact, SROs were granted flexibility in fulfilling

their obligations under the CFMA. The CFMA, itself, notes that

DCMs shall have reasonable discretion in establishing the manner

in which they comply with the core principals.

The CFTC conducts periodic reviews, rule-enforcement reviews,

so again, I think that a member’s interest, as far as the integrity

of the exchange and the decision-making process are in complete

alignment. And if we were a publicly traded company, we would

have to comply with Sarbanes-Oxley, also.

Mr. MORAN. Since the passage of CFMA, are there examples

where self-regulation has failed?

Mr. CAREY. Well, I am not aware of any. There may be, but I am

not aware.

Mr. MORAN. Mr. Newsome, this might be an appropriate question

for you.

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Mr. NEWSOME. Mr. Chairman, I am not aware of any, certainly

no major issues where the SRO function has failed during my tenure at the CFTC. I can’t recall that being the case. Certainly, there

are ongoing discussions between the CFTC and the SROs with regard to that responsibility and what that responsibility entails. The

CFTC consistently gives guidance to the exchanges with their

thoughts on how to maintain the strong SRO function.

In general, I was at the CFTC when we started the SRO review.

And I would remind the committee that we started that review before anything happened in the securities industry, so we were actually being proactive and simply not reacting to any kind of tragedies or major events within our business. I simply thought it was

prudent for the agency to review the responsibilities of the self-regulated organizations. I think everyone would agree that, in general,

that setup work very well, has worked very well over time, and I

think we are all anxious for the CFTC to issue their findings and

thoughts.

Mr. MORAN. Mr. Newsome, thank you. I call to the committee’s

attention NYMEX’s testimony and the summary and the comment

about the hedge fund participation. I think this energy sector will

be a topic of conversation in this committee, and perhaps even

more so in the Senate, and I think there are some findings that I

think are interesting in regard to that topic, and I appreciate that

information being available.

And then, finally, can any of you use your crystal ball and tell

me what you see happening in the futures industry into the future?

My guess is that many things that have transpired since the passage of CFMA, you may not have thought about when we were discussing CFMA 4 or 5 years ago. What kinds of things should be

concerned about? What should we foresee as we look to regulation

for the next 4 or 5 years?

Mr. DUFFY. I will be happy to start, if it is OK, Mr. Chairman.

Obviously, as far as projections, we are very careful, as a publicly

traded company, not to give any forward-looking projections, but on

regulation, I will just say that if you look at some of the problems

that we see—you know, again it is tied to my testimony with foreign exchange, and it may be spilling over to other difference products, such as heating oil and orange juice, which Chairman BrownHruska has testified to—so I think that the unregulated, retail customer is something that can be continually preyed on as this business continues to grow, which it is showing every evidence that it

is going to do so. The unsuspecting retail customer that thinks he

is trading on a regulated marketplace may be deceived, if we don’t

close a few of these loopholes, that problems could continue to get

bigger.

There was an investigation led by Dr. Newsome when he was

Chairman of the CFTC, called Wooden Nickel, which I believe is

one of the largest forex stings in the history of the agency, and they

did a wonderful job. I think we could be looking on more of an annual basis that an historic-type basis if loopholes are not closed. So

on the regulatory side, I would urge Congress to look very closely

at protecting its retail clients.

Mr. NANDAPURKAR. If I could? I think there are three basic

trends that are driving growth in the futures industry. One is the

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move toward electronic trading. And I think, from a regulatory perspective, there you are talking about distributing the potential to

real-time in these markets, throughout the country. So you have

got both the CFTC involved—but there may be issues in terms of

State and local governments that may get involved in terms of enforcing some of the regulations and how sales practices are done

from those distributed offices everywhere. Now, the electronic trading makes that a lot easier.

I think the second is just the trend towards globalization and the

fact that you are going to have more and more people around the

world trading each others’ products. Whether it is Asians trading

in the United States, whether it is people in the United States

trading in Europe, there is just going to be a trend towards more

globalization. I think the regulatory issue there is really about regulators cooperating, and think the CFTC is doing a very good job

there. But regulators cooperating around the world and realizing

that markets are interlinked, whether it is European interest-rate

markets and U.S. interest-rate markets, and how they move.

And then the third is we are probably at the early stages of a

secular trend, where business is moving from the OTC market back

into the listed market, and I think the CFMA has a lot to do with

that. I think we are starting to see where people do want a multilateral clearinghouse to be in the middle of the transaction. It is

a much greater capital efficiency to have a clearinghouse in the

middle of transactions, and people want the transparency of a

mark-to-marketed trade every day. So you know what the position

is. So I think we are in the middle of that trend, and I think we

need to be open to bridges from the OTC market into the listed

market so that trades, as they get done, OTC can be cleared more

in the listed market in a regulated clearinghouse.

Mr. NEWSOME. Mr. Chairman, just a couple of quick comments.

I think the globalization issue is one that certainly is going to be

on the forefront. I think the CFTC is taking appropriate steps with

regard to memorandums of understandings with foreign jurisdictions and information-sharing agreements; but I think the difference between different jurisdictions possibly limiting the ability

to do business globally is an issue that the committee may have to

consider over the next several years.

Second, as chairman of the CFTC, while I was very supportive

of the flexible nature of the act and allowing businesses to actually

conduct business and grow, at the same time, I was a very strict

believer in the strong enforcement authority of the CFTC, and very

used that authority very aggressively when I was chairman. I think

it is extremely important that the authority of the CFTC with regard to enforcement be very clear. And that goes to the comments

I made earlier to Mr. Larsen. So I think that is an issue that certainly can be addressed.

And then the other, which is a more difficult issue: I think as we

continued to have a growing world economy, more and more pressure will be put on commodities, particularly energy. We have to

come to the understanding that these markets are going to volatile.

That volatility is not created at the exchange. The volatility is in

the underlying cash market, and it becomes transparent at the exchange because the exchanges are the only place for that transVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00064 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
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parency to take place. It doesn’t happen in the underlying cash

market; it doesn’t happen in the OTC market.

I would just ask the committee to be careful not to shoot the

messenger of that price volatility because I expect it to continue.

Certainly, it is going to be a question, and issues are going to be

raised. But I look forward to working with this committee to address any issues that are raised, as well.

Mr. CAREY. I would like to add that I am in agreement with the

CEO of Eurex U.S. We have witnessed a recapturing of over-thecounter business that has now come to the regulated environment,

the exchange-traded environment, and between that and electronic

trading, we have seen tremendous growth in our products—as I

said 600 million contracts last year.

I think the challenge to the committee and the commission is

going to be the fact that these markets are all interlinked and

interrelated—over-the counter, foreign markets, and with electronic

trading they move swiftly, so it is going to be a challenge to regulate in that environment, also, but I think that were are looking

at a strong growth proposition.

Mr. DUFFY. Mr. Chairman, if I might add one final comment on

that.

I think that if you look back on Eurex’s testimony, when one

talks about the application of Eurex U.S. and regulatory

arbitrageurs that may come upon us, I think that we should not

get lulled to sleep believig that the potential for regulatory

arbitrageurs cannot still happen. And I think when we look back

at, maybe, some of the potential wrongdoing or the lack of discipline on some of the foreign markets, when there were definitely

some potential squeezes going on in their products, the regulator

didn’t act. So I think you have to look at potential regulatory arbitrage; though I don’t want to suggest either that inter-governmental memorandums of understandings are not useful or that the

world is such a beautiful place that we don’t need effective international regulation.

Mr. MORAN. I would welcome the panel and ask staff to provide

me with examples of where the regulators failed in foreign markets. I would be interested in seeing what those examples of that

would be. Anyone else?

Mr. SCHOENHUT. Thank you, Mr. Chairman. I would like to add

one, last thing. While I agree with much of what has been said,

with respect to this, I think there needs to be a great sensitivity

given to the financial climate that we are currently in.

In the advent of the stock market fall-out of 2000, commodity equity index and dead instruments have created a need for highly sophisticated investors and hedge participants in our markets. Other

similar users also recognize commodities in today’s world as a separate and distinct investment class. I think that is given rise to a

great deal of the volume increases that we have all been able to

share.

So I think that these factors and the investment-heading community, being given a new ability to mitigate risk, certainly opens up

the door for the CFTC and their reauthorization and people to have

the confidence to trade our markets, certainly, would be the theme

of the day.

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Mr. NANDAPURKAR. If I could make one, last comment, just on

the theme that I think is very important in this low-interest-rate

environment/low-return-environment, how much money is flowing

into hedge funds? And specifically, how much hedge funds are

starting to move into the listed world?

And when you combine the listed exchanges, the trend toward

electronic trading, that execution can take place so quickly, and

you have got these super-smart hedge funds out there hiring

Ph.D.’s in computer science and physics that are writing the models, now you are going to have exchanges around the world linked

anyway, and hedge funds figuring out with their models how to

maximize their capital usage, but pick up arbitrages. Those differences in markets and where people think real statistics

arbitrages, economic arbitrages—those things are going to go away

very quickly. And the hedge funds are moving their money, and the

biggest trend here is they are starting to move much more into the

listed world and onto the exchanges—define their edges to please

their customers. And I think you are going to see a lot faster movements in closing of the gap between markets globally.

Mr. MORAN. The chair recognizes the gentleman from Washington for a final question.

Mr. LARSEN. Thank you, Mr. Chairman.

Dr. Newsome, just 5 more minutes; that is all. You mentioned

transparency—don’t shoot the messenger that the market provides

a transparency—and I fully agree. The crux of my questions are,

then, does the CEA, then, provide proper authorization to the

CFTC that once that transparency shows there is a problem, then

is there an authority there to protect the players in the market

from fraud, from manipulation, and so on? And along those lines,

last week, Acting Chairman Brown-Hruska made it sound as

though—and this gets back to 2(h) and 2(g)—made it sound as

though 2(h) applies to 2(g) transactions as well. Is that how you

and your members understand the current statute, that there is no

great difference between the two?

Mr. NEWSOME. Well, I think when I was chairman, there was a

big discussion, and it happened to be in a Senate hearing with regard to whether or not the exclusion trumps the exemption.

I didn’t believe that to be the case, and I would just say that

from a practical standpoint, in the CFTC we were very aggressive

in bringing that enforcement action within the energy sector, and

we were not challenged on it. Now, we could be challenged at some

point, and my opinion could be found to be not true; but I think

with all of the legal-certainty issues, I would be hesitant to go in

and make changes to 2(h) and 2(g) when I think the enforcement

authority can be addressed through the 4b, through the general

fraud authority of the CFTC.

Mr. LARSEN. Mr. Chairman, with your consent—I have been citing the contents of a memo that may or may not be in the record;

I just want to ensure that it is in the record.

Mr. MORAN. Without objection, so ordered.

[The material appears at the conclusion of the hearing.]

Mr. LARSEN. That way, folks can know what I am reading from,

as well. I think that currently answers my questions. I am still

kind of exploring this, and I am sure we all be available as we conVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00066 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
63

tinue through this to—so I can come up with additional questions,

and I may have additional questions for the next panel, as well, on

this subject.

Mr. NEWSOME. I look forward to meeting with you anytime, Congressman.

Mr. LARSEN. Thank you.

Mr. MORAN. I thank the panel very much for their—taking the

time to educate our subcommittee, and I will dismiss this panel

and now call upon panel 2.

Mr. MORAN. Thank you. John Damgard, president of the Futures

Industry Association; Mr. Daniel J. Roth, president and chief executive officer of the National Futures Association; Mr. Micah S.

Green, president of the Bond Association; John Gaine, president of

the Managed Funds Association; and Mr. Robert Pickel, executive

director and chief executive officer, International Swaps and Derivatives.

[Recess.]

Mr. MORAN. The committee will resume and come to order. Mr.

Damgard, you may begin when you are ready.

STATEMENT OF JOHN M. DAMGARD, PRESIDENT, FUTURES

INDUSTRY ASSOCIATION, WASHINGTON, DC

Mr. DAMGARD. Thank you very much, Mr. Chairman.

Chairman Moran, Ranking Member Etheridge, and other members of the subcommittee, on behalf of the Futures Industry Association, I want to thank you for the opportunity to appear here

today.

I have an advantage over the others at the table in that I have

been involved in every CFTC reauthorization since the agency was

created in 1974—if that is an advantage. I think it just means that

I am old. I know, firsthand, the historic and vital role that the

House Agriculture Committee has played in periodically reviewing

the CFTC’s operations and reforming the Commodity Exchange

Act, when warranted. This subcommittee’s work on the Commodities Futures Modernization Act of 2000 is only the latest example

of your significant contribution to our mutual goals of strong, competitive, innovative, and honest futures and options market. Your

longstanding commitment is greatly appreciated by this futures industry, and I am very sincere when I say that a lot of the success

that we are enjoying right now is a direct result of the hard work

of this committee, and I might add, some of the staff members like

John Riley and David Ebersole and Tyler Wegmeyer have been extremely helpful in working to prepare for this hearing, and we appreciate that as well.

In light of that expertise, we would make a specific recommendation to the subcommittee. And that is, as you may know, the Senate’s version of last year’s energy bill contained amendments to the

Commodity Exchange Act. In light of your expertise, we were

pleased last week when the subcommittee indicated it would discuss with members of the Energy and Commerce Committee, efforts to amend the CEA in that committee. We believe that any

changes to the CEA this year should become part of the House Agriculture Committee’s consideration of CTFC reauthorization.

64

The CFMA was a piece of landmark legislation, which left the

commission with a very ambitious agenda. Under strong leadership, the commission has implemented the new regulatory design

authored by this by this subcommittee, and they are to be commended for their efforts.

CFTC reauthorization provides an opportunity to reconsider the

regulatory program for the futures markets, to see what is working

and what is not. In FIA’s view, the list of what is working is long,

and the list of what is not is quite short. My written testimony goes

over those lists in more detail, but let me just summarize the high

points.

The fundamental changes enacted in the CFMA have worked

well. We are not in favor of any change to the basic, statutory design. In particular, FIA would be concerned with any plan to expand dramatically the jurisdiction of the CFTC. In our view, when

the CFTC’s mission strays from its oversight of exchange-traded futures and options, it detracts from the commission’s ability to

achieve the act’s regulatory purposes of promoting competition and

responsible innovation.

That is why we have concerns about any proposal to expand the

CFTC’s jurisdiction as a response to the ongoing problems of fraud

against retail customers in the OTC/FX transactions. The CFTC

was not set up to become a national consumer protection agency for

commodity transactions, a fact this committee recognized in 1982,

when it endorsed the CFTC’s recommendation to amend the act to

include an open-season provision, which explicitly authorized the

application of any Federal or State law to persons that engaged in

unlawful commodity transactions. As the committee wrote, ‘‘the

States should be extensively involved in actions against those who

offer fraudulent off-exchange investments and in policing transactions outside those preserved exclusively for the jurisdiction of

the CFTC.’’

Consistent with the committee’s reasoning, our approach to retail

forex fraud would be twofold. First, give the CFTC specific targeted

authority to pursue fraud claims against otherwise-unregulated

persons. And second, encourage law enforcement officials to take

action against, and if need be put behind bars, those who con retail

customers in forex transactions. The only proven way to deter and

end retail forex fraud is a strong cooperative Federal, State, and

local law enforcement campaign to lock up those responsible and to

keep them from bouncing when caught from one jurisdiction to another.

Fair competition, transparency in exchange rulemaking, and true

SRO independence continue to be areas where FIA would support

improvements. The CFMA has sparked efforts to introduce more

direct competition among exchanges, as we had hoped. Thus far,

the challenger markets have not been successful in doing more

than chipping away at the entrenched market’s dominance. Further action by Congress and/or the commission may be needed to

accomplish the real promise of competition, by affording our customers a choice of efficient, low-cost market platforms from which

to select the best price available for any trade.

No one wants to go back to the days when all exchange rule

changes required costly and time-consuming CFTC approval. Our

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concern is if the current regime works to shut out our members

and their customers from both the exchange internal rule approval

process and any subsequent CFTC review. For example, a 3-day

private comment period is no substitute for the kind of due process

anyone would expect from fully-informed deliberation over an important exchange rule. We look forward to working with this subcommittee, the commission, and the exchanges to make exchange

rulemakings more open to public comment and input.

SROs have an important job to do, making sure that the public

has confidence in our markets. Independent directors signal to

markets users around the world that our SROs are serious about

self-policing and put the public interest above their business interests. While some exchanges, notably the Chicago Mercantile Exchanges, have made real strides in these areas, other have not. We

want to work with all interested parties to strengthen this aspect

of SRO operation.

And our last area of concern is product availability. Our members serve a sophisticated customer base that use futures markets

all over the world to manage price risk in their business or investment activity. When U.S. law or regulation prevents our customers

from obtaining access to exchange-traded products, either in the

country or overseas, it has the perverse effect of forcing our customers to use other, less transparently priced instruments to manage their risks, often without the clearing protection exchange trading affords. While those anomalies do not occur often, where they

do, we ask this subcommittee’s help in removing them.

In conclusion, Mr. Chairman, FIA looks forward to working with

the subcommittee and its staff. We believe that with handful of

changes, we can make an excellent regulatory system even better.

Thank you very much.

[The prepared statement of Mr. Damgard appears at the conclusion of the hearing.]

Mr. MORAN. Thank you, Mr. Damgard. Mr. Roth.

STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CHIEF EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, IL

Mr. ROTH. Thank you, Mr. Chairman. My name is Dan Roth, and

I am the president of National Futures Association. NFA is the industry-wide self-regulatory body for the futures industry. And the

process of self-regulation has received a fair amount of criticism

over the last couple of years, and I think the problems in the securities industry and the self-regulatory process in the securities industry have been well publicized.

What hasn’t been so well publicized is the success of self-regulation in the futures industry. Since 1982, when NFA began operations, futures volume on U.S. exchanges has gone up by over

1,200 percent. During that same time, customer complaints have

actually dropped by 75 percent. That is a fairly dramatic achievement, and it hasn’t been an accident.

That reduction in customer complaints has been the result of a

lot of hard work and a very close-working partnership between the

CFTC and NFA to shut down those boiler rooms and those bucket

shops that generated so many of those complaints.

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As we sit here, today, though, that trend, that achievement in reducing those numbers of complaints—I think that trend is in some

jeopardy. And it is in some jeopardy because the CFMA, for all of

its success, failed to achieve one of its customer-protection objectives. The CFMA tried to clarify once and for all the CFTC’s authority to protect retail customers investing in foreign-currency futures. As we sit here today, I think the CFTC’s authority to protect

retail customers may be more uncertain now than it was then. And

the main problem, that you have all heard about and that everybody has talked about, is the Zelener decision.

That Zelener decision, in my view, basically did three things. No.

1, it made it much harder for the commission to prove that these

leveraged contracts sold to retail customers to speculate in commodities prices are, in fact, futures. No. 2, it made it much easier

for the boiler rooms to therefore set up their operations in a way

that they can remove themselves from CFTC regulation. And No.

3, it created an honest-to-God, real-life customer-protection issue.

And to make matters just a little bit worse, that customer-protection issue is not limited to foreign-currency products. The boiler

rooms that want to use the Zelener decision to self-warrant currency products could do the same thing for heating oil, unleaded

gas, agricultural products, metals—just about any commodity that

you can mention.

At NFA, we feel that the Zelener decision represents a real

threat to customers and a threat that Congress has to meet headon. I have heard four different reasons why maybe Congress

shouldn’t be aggressive in this area and shouldn’t act; and I don’t

find any of them particularly persuasive.

Number 1 is the notion that there is no reason to clarify the

CFTC’s authority to protect retail customers because the States

have that authority. Well, Mr. Chairman, I have spend over 20

years working with State regulators, and I can tell you firsthand

that they are dedicated; they are committed; they are intelligent;

and they are overwhelmed. Anybody that thinks that the States

have the resources and the expertise to protect retail customers

from futures-look-alike scams is just dreaming.

Number 2, there is a thought that maybe the CFTC can just litigate itself out of the Zelener decision by bringing different types of

enforcement cases in the future. And for all of the reasons I laid

out in my written testimony, I want you to know that I think that

proposition is a lot harder than it sounds. And to rely on future litigation, in my view, places an awful lot of chips on a bet that is no

sure thing.

Number 3, some people have felt that it is premature at this

point for Congress to Act because the Zelener decision, itself, was

just issued last August and that we should just let events unfurl.

But realistically, Mr. Chairman, it seems to me that waiting means

waiting until the next reauthorization, and that is 5 years away.

And an awful lot of people can get hurt in 5 years, and I don’t

think any of us finds that acceptable.

And No. 4, there is notion that whatever legislative solution Congress comes up with here, we should limit its application to foreigncurrency products. Well, Mr. Chairman, as I have just described,

the problem is not limited to foreign-currency products, and I don’t

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think the solution can be either. Now, that is not to say that there

aren’t some real, legitimate concerns about legislative action here.

There are, and I recognize them.

Certainly our goal here would be not to expand the CFTC’s jurisdiction, but to restore it. And our goal would be to protect retail

customers without having the types of unintended consequences

which can actually impair institutional business. That is not what

we are trying to do. And I know the problem is hard; I know it is

complicated; but just because it is hard doesn’t mean it can’t get

done. There is an awful lot of smart people at the commission;

there is a lot of smart people in the industry; and NFA is very committed to working with the commission, with the industry, with

this committee, and with just about anybody else on God’s green

earth that can help us find the right solution that will avoid the

types of problems that I have talked about earlier, but which will

ensure that the goal that we all share—that customer protection is

achieved.

Thank you, Mr. Chairman.

[The prepared statement of Mr. Roth appears at the conclusion

of the hearing.]

Mr. MORAN. Thank you very much. Mr. Green.

STATEMENT OF MICAH S. GREEN, PRESIDENT, THE BOND

MARKET ASSOCIATION, NEW YORK, NY

Mr. GREEN. Good morning, Mr. Chairman, thank you very much.

I thank Ranking Member Etheridge and other members of the subcommittee for asking me to be here today. My name is Micah

Green; I am president of the Bond Market Association. I thank you

for the opportunity to be here to present our views on the reauthorization of the CFMA, which is a law that we think was an outstanding achievement of the Congress.

Through our offices in New York, Washington, and London, the

association represents the $44 trillion global bond markets. Our

members include all major dealers in Federal agency bonds as well

as securitized products, corporate and municipal securities, in addition to all of the primary dealers of U.S. Government securities as

recognized by the Federal Reserve Bank of New York. Our members are also active in markets for over-the-counter financial contracts involving fuller payments and deliveries related to a variety

of fixed-income securities, interest-rate, and credit products.

The Bond Market Association participated actively in the debate

that led to the enactment of the Commodities Futures Modernization Act of 2000. At that time, we advocated changes in the CEA

that we view as critical to vibrant in OTC security, derivatives, and

foreign exchange. The CFMA has proved to be extremely successful

in that regard because it clarified the exclusion from the Commodities Exchange Act and the jurisdiction of the CFTC of OTC derivatives swaps and foreign-exchange transactions, a much needed certainty that the Treasury amendment and the CEA continues to

bring these important sectors of the capital markets, enables efficient markets for U.S. treasury securities in particular, which allows the Federal Government to borrow at a lower cost and saves

U.S. taxpayer money.

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I want to congratulate this subcommittee and this full committee

and your counterparts on the Senate side as well as the past and

current leadership and members of the CFTC for your foresight in

enacting the CFMA nearly 5 years ago. You clearly anticipated the

expansion of the markets around the globe and the need to facilitate liquid and efficient markets wherever they may exist, and to

particularly ensure that U.S. markets were not at a disadvantage.

You clearly sensed that prescriptive rules and regulation in an

economy that requires nimbleness and flexibility would make it

more difficult for markets to adjust to changing conditions and that

sound, principals-based rules ensure that the markets function

smoothly, even in times of stress. Finally, you clearly foresaw the

development of sophisticated risk-management techniques that permit institutional market participants to manage risk in an increasingly precise manner. Market participants can retain the risk they

wish to retain, and for a fee, transfer those risks they do not wish

to retain to another market participant. These improvements in

risk management, facilitated by the OTC derivatives markets and

the CFMA, have helped the United States and global economies to

weather recessions and interest-rate volatility. In other words, the

leadership you provided nearly 5 years ago was really quite extraordinary and has provided tangible benefits to the economy.

The Bond Market Association set up three fundamental policy

goals during the last reauthorization process that led to the CFMA.

We called for maintaining the OTC markets as a viable alternative

to traditional organized exchanges, preserving the enforceability of

contracts freely negotiated between market participants, and avoiding duplicative regulation. I am happy to report that for the benefit

of the broader national and global economy, the CFMA did, in fact,

meet these goals.

Clarifying the exclusions of commodities and swaps in the

CFTC’s jurisdictions and assuring contract enforceability, as the

CFMA does, have brought the OTC derivatives market the legal

certainty it needed to thrive.

In closing, Mr. Chairman, I would like to reiterate our support

for the CFMA. The law strikes a delicate balance between regulating a rapidly changing market and encouraging innovation and diversity. Prior to the CFMA, the OTC markets were restrained by

legal uncertainly. Again, thanks to the foresight of the Congress

and this committee in particular, the market is now thriving and

helping to save taxpayers monies by lowering the cost of borrowing

for the Federal Government. Improved risk management and lower

capital costs helped stimulate a broader economy.

In the context of the reauthorization process, the Association

strongly urges this subcommittee and the Congress not to alter any

of the fundamental elements of the CFMA that encourage an orderly and innovated OTC derivatives market. Thank you very

much, again, and I look forward to answering any questions that

you have.

[The prepared statement of Mr. Green appears at the conclusion

of the hearing.]

Mr. MORAN. Thank you, Mr. Green. Mr. Gaine.

69

STATEMENT OF JOHN G. GAINE, PRESIDENT, MANAGED

FUNDS ASSOCIATION, WASHINGTON, DC

Mr. GAINE. Thank you, Mr. Chairman, and members of the subcommittee. My name is Jack Gaine; I am president of the Managed

Funds Association, and we certainly appreciate the opportunity to

appear here today.

Before I get into my oral comments, which will be relatively

brief, I have a written statement which I would like to have included in the record, where we outline in more detail a number of

the issues that concern us. But I would like to point out, Mr. Chairman, that this is truly a historic day, not just because of the work

of this subcommittee and the CFMA and implementation by Jim

Newsome and Sharon Brown-Hruska and the amazing growth of

the industry, but I participated in the first reauthorization in 1978,

as did John Damgard and Leo Malamed—and if you told me in

1978 that they would outlast Dan Rather, I would be shocked. Particularly John, who doesn’t remember that it was here.

Anyway, if I can turn to the more serious side of this. Thank you.

This is a great time, obviously, for the hearing. We come before you

with no statutory changes to be recommended, but I will footnote

that in light of my friend Dan Roth’s statement about a gap in

fraud.

No one has more interest in the preservation of the integrity of

these markets than Managed Funds Association, which is the primary trade association representing professionals in the alternative

investment-management business, including hedge funds, funds of

funds, and managed futures funds. We are, as I told my children

years ago in front of Chairman English—we are pro-anti-fraud, and

if there is a gap, we would certainly want to work with the—anybody on God’s green earth or wherever else and get it fixed.

We are major customers of the futures exchanges, FCMs. Many

of our members are registered as CPOs and CTAs. Our involvement with the Commodity Exchange Act, with the NFA and the

CFTC is pervasive.

Increased interest in and use of alternative investments is a direct result of the growing demand from institutional and other sophisticated investors for investment vehicles that deliver true diversification and help them meet their future-funding obligations

and other investment objectives. Our members’ funds perform a

number of important roles in the global marketplace, including contributing to a decrease in overall market volatility, acting as shock

absorbers and liquidity providers by standing ready to take positions in volatile markets when other investors choose to remain on

the sidelines.

With respect to volatility, I commend to your interest, if you have

not seen it yet—is the very thorough study that Jim Newsome and

NYMEX prepared on the role of hedge funds in the natural gas and

crude oil futures contracts as traded on NYMEX. It is full of data

and numbers and not-so-full of opinion and speculation. I think you

will find it very useful in your deliberations.

I echo much of what has been said about the importance of the

CFMA, the genius that lay behind it, and the way it has been implemented. It has worked very well.

70

Let me talk briefly about two or three subjects. Hedge funds effects on energy markets, I commend to you again the NYMEX

study, and our position is that hedge funds decrease volatility. We

do not increase it by our participation in the market. There are a

couple of other issues I briefly want to touch on. The clear congressional intent underlying the CFMA was to either de-regulate, go to

core principals, or at worst, avoid duplicative regulation. And in

doing such, the CFMA amended both the Investment Advisers Act

and the Commodity Exchange Act, providing a carve-out so there

would not be duplicative regulation of investment advisers at the

SEC and commodity trading advisors at the CFTC. We encourage

this committee, in its oversight role, to urge those agencies to get

on with it, give some definition to what primarily engaged means—

this is more fully set forth in the testimony—so that counsel and

industry participants can effectively use the exemptions that were

clearly designed by Congress.

Speculative limits: there are several petitions pending before the

CFTC to relax or liberalize the speculative position limits on certain commodities. We, again, urge the CFTC to take a look at

this—I know their plate is full—and we urge this subcommittee, in

its oversight role, to keep track of that. It is extremely important

to promoting the liquidity and the functioning and price discovery

of the markets.

We also urge the committee in its oversight role to encourage the

SEC and the CFTC to harmonize their regulatory structures. There

is wasted cost. We are the end user—we are sort of in a different

part of the food chain than most everyone else here, who either

provide you a service or sell a service or provide a market. We are

users, and the costs get passed on. And if the costs are not necessary, they ought to be removed. It hurts us in a competitive situation, vis-a-vis, our competition here in the United States as well

as globally.

On that note, Mr. Chairman, my time has expired, and I apologize to Mr. Damgard and Mr. Malomed.

[The prepared statement of Mr. Gaine appears at the conclusion

of the hearing.]

Mr. MORAN. Mr. Gaine, thank you very much for your commentary as well as your testimony. Mr. Pickel.

STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR

AND CHIEF EXECUTIVE OFFICER, INTERNATIONAL SWAPS

AND DERIVATIVES ASSOCIATION, INC., NEW YORK, NY

Mr. PICKEL. Mr. Chairman and members of the subcommittee, I

appreciate your invitation to testify here today on behalf of ISDA.

We have appeared frequently before the subcommittee in prior

years, and we welcome the opportunity to be with you today as you

continue your important hearings with respect to legislation to reauthorize the Commodity Futures Trading Commission.

ISDA is an international organization, and its more than 600

members include the world’s leading dealers in swaps and other

off-exchange derivatives transactions, commonly referred to as OTC

derivative. ISDA’s membership also includes many of the businesses, financial institutions, governmental entities, and other end

71

users that rely on OTC derivatives to manage risks inherent in

their core economic activities affectively and efficiently.

The CFTC administers the CEA, which was revised comprehensively in 2002 by the Commodity Futures Modernization Act. That

legislation was adopted, as you know, by Congress with broad bipartisan support after careful consideration over several years by

four congressional committees and with the support of the President’s working group. The CFMA extended much needed regulatory

relief for the futures exchanges, provided legal certainly and regulatory clarity for OTC derivatives and removed the ban on the trading of single-stock futures. It is this principal interest in CFMA

was and remains with those provisions intended to provide legal

certainty for OTC derivatives. The phrase legal certainty means

simply that the parties to an OTC derivative transaction must be

certain that their contracts will be enforceable in accordance with

their terms.

The CFMA framework for providing legal certainty it based on

a longstanding consensus among Congress, the CFTC, and other

that OTC derivatives transactions are not appropriated regulated

as futures under the CEA. The legal certainty provisions of the

CFMA were intended by Congress to reduce systemic risk and promote financial innovation. Our experience since 2000 confirms that

both of these objectives have been achieved. The use of OTC derivatives for risk management purposes has continued to grow, both in

periods of economic downturn and uncertainty and in times of economic expansion.

The reductions in systemic risk resulting from enactment of the

legal certainty provisions have not come at the expense of financial

innovation. New types of OTC derivatives have gained increased

market acceptance since the enactment of the CFMA. For example,

the significant growth in credit default swaps to manage risk in

times of volatility and uncertainty has been greatly enhanced by

the legal certainty provision of the CFMA. Similarly, the legal certainty provisions have encouraged dealers to develop and businesses to use an increasing range of new of kinds of OTC derivatives, such as weather derivatives, to manage additional types of

risk.

Finally, the CFMA removed the regulatory barriers to clearing of

OTC derivatives, and while collateralized transactions remain more

prevalent, the emergence of alternative clearing proposals attest to

the positive effects of the CFMA on financial innovation.

For these reasons, we share the views expressed by Acting Chairman Sharon Brown-Hruska last week before this committee that

the CFMA functions extremely well. In our view, this is attributable to the care with which Congress constructed the legislation

to the even-handed manner in which the CFTC has interpreted and

administered the CFMA in accordance with congressional intent,

and to the CFTC’s vigorous enforcement program following the collapse of Enron and the California energy situation.

ISDA believes that the experience that its members and other

have had under the CFMA demonstrates that there is no fundamental need for Congress to make substantive changes to those

portions of legislation governing OTC derivatives. We are aware

that others have advocated substantive changes to the legislation,

72

including changes with respect to OTC derivatives. In our view,

however, the case for such changes simply has not been made.

We understand that you and your colleagues will want to have

the benefit of a full range of views concerning the CFMA. We think

this is highly desirable and welcome the opportunity to participate

constructively in the debate and discussion of possible changes. We

do, however, urge you and your colleagues to proceed cautiously in

reopening the CFMA. The legislation, although carefully crafted, is

complex, and the potential for unintended and undesirable consequences from selective changes is great. We also urge you and

your colleagues to ensure that your subcommittee asserts fully its

right and responsibility to review and approve any substantive

changes to the CEA. Our experience in recent years has confirmed

that the use of freestanding amendments offered to separate legislation without your committee’s review, scrutiny, and public comment is an undesirable method of considering changes to a legislation as complex and as important as the CEA.

Let me conclude, Mr. Chairman, with three observations. First,

by providing legal certainty and regulatory clarity for OTC derivatives in a manner consistent with the longstanding policies of Congress and the CFTC, the CFMA materially reduces systemic risk

and encourages financial innovation. Second, the regulatory relief

provided to the futures exchanges has, likewise, provided substantial benefits to the capital markets. Together, these two factors confirm that the policy judgments Congress made in 2000 were sound

then and remain so today. Finally, ISDA has had a long tradition

of working cooperatively and constructively with this subcommittee, and we look forward to the opportunity to continue to do so in

the coming months.

I would be happy to take any questions you or the committee

may have.

[The prepared statement of Mr. Pickel appears at the conclusion

of the hearing.]

Mr. MORAN. Thank you very much. Just a general question to all

of the panelists: what will the future of this industry look like, and

what regulatory challenges does that present? What things should

we be looking at as we try to figure out what happens in the next

5 years, 10 years? Mr. Damgard?

Mr. DAMGARD. Well if the past is any indication of where we are

going, we will see continued growth because the world is a riskier

place, and I think more and more institutions—medium-sized and

even smaller institutions are recognizing how valuable futures contracts are for managing their risk. In addition, I think the competitive aspects of what the members of this committee achieved when

they wrote the CFMA has allowed more exchanges into the mix,

and I hope we will continue to see that, and I believe we have to

guard against any efforts to eliminate or curtail the arrival of new

entities. Also, I think futures markets are becoming more and more

efficient. One of the reasons why we have supported the clearing

link is because it reduces the amount of capital required from

clearing firms. As an industry, we have benefited dramatically

from the two Chicago exchanges using the same clearinghouse because the offsets make it less important for the clearinghouse to

hold as much money as they do if you are margining every position.

73

And to the extent of somewhere around 25 percent of the business

coming into Eurex is from U.S. customers. These are from great,

big institutional users who are looking for ways in which to make

these markets more capital efficient.

So I suspect if we avoid any major scandals, we are going to continue to see our markets grow quite dramatically.

There are issues out there that we haven’t talked about, like the

potential shortage of front-end providers for order entry into the

exchanges, and there are some controversial patents right now that

are being challenged by the industry that could have a deleterious

effect, but I don’t think those are matters that the committee need

to worry about at this stage.

Mr. ROTH. From the self-regulatory point of view, I think one

issue that is going to bear watching over the next couple of years

is just the continued evolution of the self-regulatory process. I have

mentioned in my oral testimony and in my written testimony that,

obviously, NFA is a huge believer in self-regulation, but the fact is

that that as the markets become more globalized and more competitive, the types of conflicts of interest inherent in the self-regulatory process start changing too, and there is going to be a great

need over the next couple of years to ensure that the regulatory

process always remains above the competitive fray. I don’t think

there is any need for legislation, but I think the CFTC—its job in

overseeing the self-regulatory process and its job in making sure

that it is managing those conflicts of interest becomes more complex. I am sure that the CFTC is up to that job, but I think managing the changing nature of the conflicts of interest inherent in the

self-regulatory process is something that the commission is going

to have to spend some resources on in the years ahead.

Mr. GREEN. Mr. Chairman, for me, it revolves around three concepts: convergence of markets, globalization of markets, and the

impact of technology on markets. And really, all three of those factors bring down barriers for entry for those who need to raise capital and those who need to invest capital. And as I look around, the

providers of the service—the intermediaries—they are recognizing

that and realizing that the power has begun to shift to the client,

the capital-raising client or the large, institutional investor client,

and frankly, away from the intermediary, because technology has

brought down the cost of transactions, globalization has brought

about many different choices, and convergences has taken down the

barriers between different types of products to let clients decide

how they are going to follow those things. And I think that the

principal-based approach that was adopted in the CFMA is an approach that is becoming catchy around the world. I think that you

are going to see more unleashing of creativity to continue to bring

down those barriers so the intermediary doesn’t define what the client’s needs are; the client defines what their needs are.

Mr. GAINE. Mr. Chairman, speaking on behalf of the alternative

investment-management industry, in the last 10 years, that industry has grown from $50 billion assets under management to $1.2

trillion. This is a reflection of the recognition by institutional investors, primarily, and high-net-worth individuals that long-only equity doesn’t get the job done, that there are risks associate there.

There are alternative vehicles that can actually be less risky with

74

a higher promise of return. If you chart $50 billion to $1.2 trillion

over 10 years, there is no reason to believe that endowments and

pension plans and high-net-worth individual will not continue to diversify their portfolios from just fixed-income-long, or equity-long

into the diversified benefits that can be derived from the alternative investment industry. So I see tremendous continued growth,

which would be reflected in all of the other associations and exchanges and parties that have appeared before you—an increase in

volume with them because the hedge fund is a counter-party. It is

involved in all of the activities of witnesses who appeared before

you, so I would say it would a very rosy picture for the industry.

And one last thing: the primary investors, the bulk of investment

in the alternative investment industry, by far, comes from sophisticated, institutional, high-net-worth individuals. We do not see the

kind for foreign exchange fraud, for example that Mr. Roth alluded

to, because of the nature of the investor. If you have a pension plan

with $50 billion in assets or $20 in assets, they are well able to do

due diligence on a hedge fund, and they do it; I assure you. So we

have a tremendous, growing industry, and I don’t think it is going

to be accompanied by some of the fraudulent activities that accompany large-growth industries. Thank you.

Mr. PICKEL. Mr. Chairman, I would just echo the comments

made, but also emphasize the electronic. I think in the same way

that over the last 5 years or so you have seen a transformation on

the exchange-traded side of the business, we are already seeing—

and I think this process will only accelerate over the next 5 years—

of use of electronic systems to facilitate the trading of OTC derivatives as well as the settlements and confirmation of trades that are

done, whether on the phone or in some electronic manner. So that

is a trend that we are certainly going to see.

Mr. MORAN. I thank you. Mr. Etheridge?

Mr. ETHERIDGE. Thank you, Mr. Chairman. Mr. Roth, exactly

how would you amend the CEA to ensure that you and the CFTC

have adequate enforcement authority? And can you tell us how the

industry is coming together to proffer a sort of a solution to the

problems?

Mr. ROTH. Watching the industry come together is always an interesting process. We have a special committee that our board appointed to deal with retail foreign exchange issues. Part of their

mission was to sort of tighten up our own rules, and part of their

mission was to see if there was a legislative proposal that all of

NFA could support, the exchanges, the FCMs, the managed money,

that they could all support.

We have been kicking around a couple of different drafts of alternative language at a staff level. Within the next couple of weeks,

we are going to be showing that to different members of our constituent groups and get those alternatives in front of our committee

to try to come up with a proposal. I am confident that we can do

it; we have done this kind of thing before. It is hard, but I am pretty sure that if we get enough smart people talking about the issue

that we will come up with an solution that everybody can live with.

I can just mention one more thing? In my oral testimony, I

talked about the Zelener decision. There is another aspect to the

statute that is a weakness in customer protection. You know, the

75

gist of the CFMA was that otherwise-regulated entities could do

business with the retail public, and I don’t have any problem with

that idea at all. If you are an otherwise-regulated entity, if you are

on somebody else’s radar screen, well, then, by all means, your can

do business with the retail public. The way the statute got worded

is that it provides that if the otherwise-regulated party or entity

is the counter-party to the transaction, then the transaction is outside the act.

Well, that leaves open the possibility that counter-party might be

otherwise regulation, but the people actually selling the product,

the people doing the telemarketing that have direct contact with

customers, soliciting customers—they are completely unregulated.

And as long as the counter-party is an otherwise-regulated entity,

all that activity is unregulated, and I don’t think that is what Congress meant. I don’t think that is what you were trying to get at,

and I think we need to develop language to address that issue as

well, and we are in the process of doing that as well.

Mr. ETHERIDGE. Thank you. Mr. Gaine, I am going to ask you the

same question, if I may, that I asked Mr. Duffy earlier. As greater

CFTC or SEC cooperation a solution or do we need to let the regulators set rules for the securities between products as they see fit?

Do you understand the question?

Mr. GAINE. I didn’t quite hear it. Are you asking about the coordination between the SEC and CFTC?

Mr. ETHERIDGE. Yes.

Mr. GAINE. Well, it crops up in a number of areas. The people

prior to me have discussed the single-stock futures, which have not

worked very well. As you probably know, the SEC recently adopted

a rule mandating investment advisor registration for hedge fund

managers. This was something that we opposed but lost in a 3 to

2 vote back in October. We are, hopefully, working with the SEC

now to make it the most efficient process, and I think the jury is

still out on that, but they have represented that we would be able

to sit down and work those things out.

There are other issues like the offering of public commodity

funds which are both registered under the Securities Act of 1933

and the pervasively regulated by the NFA and the CFTC—and

through the years, we, historically, had a lot of problems because

the SEC, quite frankly, didn’t have the expertise about commodity

exchanges domestically and worldwide. But we are hopefully going

to make some progress, and I would like to feel free to come back

to this subcommittee if we don’t really get it done.

Mr. ETHERIDGE. Well, this may be the time.

Mr. GAINE. Well, I have the address, sir, and I thank you. In

fact, I am making a note right now, sir.

Mr. ETHERIDGE. Thank you, and I yield back.

Mr. MORAN. Mr. Etheridge, thank you. The gentleman from

Washington, Mr. Larsen.

Mr. LARSEN. Thank you, Mr. Chairman. Mr. Pickel, a few questions about swaps derivatives and the application—you probably

were here earlier—the application of 2(g) and 2(h). Why would

someone choose, say, the legal certainty of 2(h) over the legal certainty of 2(g) to complete an exchange? I am trying to understand

why these two exist given that there doesn’t seem to be much difVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00079 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
76

ference—but I am trying to sort out those differences, as well. Can

you walk through that with me a little bit?

Mr. PICKEL. Certainly. I will try and do that. 2(g) is intended to

codify a longstanding policy of CFTC and Congress, what we kind

of shorthand-call OTC derivatives that are not appropriately regulated as futures. We often, in describing those contracts—instead

of saying OTC derivatives, we talk about bilateral, privately-negotiated, custom-tailored transactions that two parties enter into negotiation; they document that trade. They typically document

under an ISDA contract, and that is the world of what people refer

to as OTC derivatives.

Now, 2(g), I think, was very specifically and narrowly tailored to

focus on that individualized negotiation, and it provides a great

deal of legal certainty for a wide range of transactions. As far as

the 2(g)/2(h) divide, I think that a party entering into—because of

the potential for anti-fraud and anti-manipulation provisions to

apply if a transaction is considered to be 2(h), I think parties need

to be very careful in those type of transactions and how they enter

into negotiations and how they structure them.

I think the traditional way in which parties interact by phone,

typically confirming is the way we have dealt in this business for

20 years. As we move to electronic, much of what is done electronically is just in the same way as what is done telephonically, but

you do move into the potential for being more of a trading facility

or potentially even a quasi-type exchange. So I think in those situations you need to proceed cautiously on your reliance on 2(g).

But 2(g) is, in our view, there where transactions, say, between

Goldman Sachs and Exxon-Mobil on oil, which they negotiate and

enter into pursuant to an ISDA contract, which provides a number

of protections for the two sophisticated parties to the contract.

Mr. LARSEN. So 2(h) applies to an electronic-trading facility. Is

that right?

Mr. PICKEL. There is an exclusion there for it if it is not done

on a trading facility. It must not be done on a trading facility. I

think if you look at the definition of trading facility, there is an exception there that says if you are doing it essentially on an electronic transaction what you would do telephonically, then you are

not a trading facility for that purpose.

Mr. PICKEL. But once you get beyond that, I think——

Mr. LARSEN. Right, but then 2(h) would apply with legal certainty?

Mr. PICKEL. If it is done in a way—electronically that is inconsistent with the way traditionally it has been done, telephonically.

Mr. LARSEN. As I understand, as well, trading under 2(h), there

are specific exceptions that ensure the application of—I understand

as the application of anti-fraud and anti-manipulation. Does that

necessarily apply to 2(g) transactions as well?

Mr. PICKEL. Two G is stated to be an exclusion for these individually-negotiated transactions——

Mr. LARSEN. Yes.

Mr. PICKEL. And with the exceptions of a couple of very limited

revisions of the CEA, those relation to derivatives clearing organization and the provisions of the CEA do not apply to a 2(g) individually-negotiated transaction. The provisions of the CEA have antiVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00080 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
77

fraud and anti-manipulations, any provision of the CEA, other than

the two specifically allowed addressed in the legislation, derivatives

clearing organization and preemption. In our view, those provisions

of the CEA would not apply to those transactions.

I think the reason for that is if you look at—again, two sophisticated parties entering into a contract they negotiate—there are

many protects under an ISDA contract for that relationship. There

may be protections under State concepts of State law, fraud law.

And also, it is just the two parties to that transaction who know

the details of that transaction, with the possible exception of a

broker who put the parties together. And they are the only ones

who know those terms, and there is not that effect on the marketplace that I think would be a significant concern for the CFTC and

where I think they would clearly have authority.

Mr. LARSEN. So you believe if there was a concern in the marketplace, the CFTC, then, could be able to step in; there is authority

to step in if that 2(g) transaction had that—had some negative impact on the market?

Mr. PICKEL. I think what would be the case is that if there was

an effect in the marketplace, it would not be related to the transaction—that individual transaction, itself, but perhaps related to

other activity that one or the other party is engaged in, either on

a trading facility or on an exchange or something like that, where

the CFTC authority would kick in.

Mr. LARSEN. Mr. Chairman, just one more, if I may. Dr.

Newsome suggested that the issue wasn’t 2(g) and 2(h); the issue

might be the 4b provision, the language that says ‘‘for or on behalf.’’ If you remove that, that might help settle any issue that exists. Are you in agreement with that or——

Mr. PICKEL. I think, regarding 4b—and that is a provision that

has been discussed in connection with some legislation over the

last 5 years. And I would urge this committee to take that back

into this committee for consideration and not have it dealt with

through an energy bill. There are some other provisions there. I

think that is a worthy topic of discussion. I would say, however,

that, at least in our view, if it is a 2(g), individually-negotiated

transaction, whether you make a change to 4b or not, isn’t going

to affect the fact that that transaction is excluded from the provisions of the act, including anti-fraud and the anti-manipulation,

with those exceptions, derivatives clearing organizations and preemption of State law.

Mr. LARSEN. It seems a pretty broad exclusion, 2(g). That is an

opinion I am coming to. I don’t want to ask you to agree with me

on not; I won’t put you on the spot there. But it just seems like

a pretty broad exclusion, the 2(g) exclusion, so I am having trouble

sorting out why it would be there from a consumer’s perspective or

the users perspective. If there is legal certainty for the traders, the

folks who are doing the trading under 2(h)—why you would need

2(g) if you can get legal certainty under 2(h) and ensure that if

there are any problems with either individual, the CFTC could use

2(h) to deal with those problems.

Mr. PICKEL. I would just say that you are talking about two parties aho are eligible contract participants which I translate as sophisticated parties who are in a position to negotiate with their

78

counterparty, who might be another energy company, who might be

a Wall Street firm, and they can negotiate and negotiate hard for

the terms that are relevant to their particular transaction, and

they will, again, have the protections of a comprehensive, contractual framework largely developed by ISDA, available to them, as

well as, potentially—you know, other concepts of contract fraud if

that should be the case.

Mr. LARSEN. Thank you for the extra time, Mr. Chairman. I

would like to follow-up with you on this a little future as I get a

chance to think about your answers, and I will get back to you, as

well.

Mr. PICKEL. I look forward to it.

Mr. LARSEN. Thank you so much.

Mr. MORAN. Mr. Damgard, it is always useful for me to hear or

see examples. You talk about a potential need for re-regulating, I

guess, some of the rulemaking process for exchange rules.

Mr. DAMGARD. Yes.

Mr. MORAN. What is an example of a rule that would be implemented that would be onerous or a restrain on trade, one that

raises concern with you and your industry?

Mr. DAMGARD. Well, I think this is one of the reasons why we

are discussion how best to manage the boards of the exchanges.

Some of the rules of the exchange could conceivably be anti-competitive if they passed, particularly in a new world where the customer may have the opportunity to use more than one market. And

even when that customer may be an investment bank, that sometimes takes the customer’s order and decided that it is in the best

interest of the customer not necessarily to go to the central market

because they are worried that the size of the order would have the

effect of depressing the price by time that the order was fully executed.

If an exchange passes a rule based on the business people at the

exchange that punishes that particular market participant, in my

view, that would be a very, very bad step. One of the things that

we have suggested that would, I think, counter that is to have the

independent directors of the exchange responsible for all of the

SRO activity.

Also, in the punishment area, rules can be anti-competitive and

members of an exchange can be disciplined or punished by the exchange for anti-competitive reasons as well. There is one example

of a modification of an exchange rule that had to do with moving

positions from one clearinghouse to another after the order has

been executed, and the CFTC is looking at that right now. One

party believes that the rule was done for anticompetitive purposes.

The other party said, no; this is the equivalent of a wash trade;

simply broadening the definition of the existing rule. And these are

things, this is why you created an expert agency. The CFTC will

deal with such matters. I think.

Let me, at this moment, apologize to Mr. Gaine. I didn’t recognize him since he colored his hair, but it seems that his hearing

has deteriorated, he probably can’t hear this.

Mr. GAINE. As long as you limit it to the hair and don’t go to

weight, that would be fine.

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Mr. MORAN. Mr. Roth, I share your sentiments—at least my initial reaction to Zelener was—in fact, I am surprised by the lack of

folks taking the attitude or approach that you do when you say it

is important that Congress respond. I am very interested in that.

I throw that out for you and others, that my initial reaction is that

inability to enforce, as a result of the Zelener case, means that Congress has not only an option, but some responsibility to look at that

issue legislatively. And I know there will be lots of folks who tell

me the reasons that we should or you can’t open that can of worms,

so to speak; but again, I think that enforcement provision is awfully important. It is the basis for which the CFTC needs to be able

to operate.

Mr. ROTH. And obviously, I share that opinion very strong, and

I really am confident that the industry can come to a solution here

that all parts of the industry can support. I think it is not going

to be easy. We want to make sure that it is not over-broad; we

want to guard against unintended consequences; but gee, we got to

do this because if we don’t, there is just going to be an awful lot

of people get hurt, and there is going to be—and ultimately it is

going to be bad for the industry. So I think it is an issue that just

has to be addressed, and it just has to be addressed the right way.

Mr. MORAN. Mr. Etheridge and I commented upon your earlier

testimony, in which we thought your list was less than all-encompassing, in which you indicated there were smart people in the industry, smart people at the CFTC. We were waiting for the 3d. Although I agree with you, I was displeased by your testimony.

Mr. ROTH. One tries to avoid stating the obvious, Mr. Chairman.

Mr. MORAN. That was a well put and timely response. Let me

ask just a couple of questions, Mr. Roth. I don’t understand this

issue a lot or well. How do you characterize the firms that bring

foreign-currency business through NFA’s regulated members? Are

they owned by persons who can’t pass NFA’s fitness standards?

And how do you describe those firms?

Mr. ROTH. The situation I was trying to describe was one I alluded to in one of my answers. The way the statute is worded, if

the counterparty to the transaction is an otherwise-regulated entity, like an FCM, then the transaction is outside the act, and that

allows the possibility that the people working the phone and soliciting customers are unregulated and unregistered. And we have had

a number of instances in which these unregulated firms are bringing business to NFA member firms, and the people doing the solicitation, who are not required to be registered, have in fact, had previous disciplinary problems within the futures industry.

So we have this situation where people that have been subject

to disciplinary actions for sales-practice fraud and are out of the futures industry sort of come in through a backdoor by soliciting customers for these retail foreign exchange transactions to which and

FCM is the counterparty. And I don’t think that is what Congress

meant. I think the idea was that otherwise-regulated entities can

do business with the retail public, and I don’t think Congress

meant that that if the counterparty is the otherwise-regulated entity, we don’t really care who is soliciting the customer. I don’t

think that was what the idea was, and I think there is a way to

fix the statute. I think that would ensure that the people doing

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business with the public, that the people soliciting those customers,

are in fact, otherwise-regulated entities.

Mr. MORAN. Another topic that you raised that I don’t know a

lot about—you suggested, in fact, this program be eliminated—

CFTC’s reparations program. Tell me about that.

Mr. ROTH. You know, the CFTC is the only Federal financialoversight agency that I am aware of that is required by Congress

to have a dispute-resolution program for customers. And I think

when that was created by statute, back in about 1974, it probably

made a lot of sense. Back during that period, there were a couple

of things. No. 1, you had, frankly, a really bad situation with boiler

rooms all around the country that were taking advantage of retail

customers in the futures industry. Second, NFA hadn’t come into

existence yet, so there was no industry-wide arbitration forum that

was available, so the only way to give customers who had a beef

an alternative means of resolving that dispute was through the

reparations program.

Well, the reparations program was a big success; it did very well.

And back before NFA was created, they used to get 1,000 cases a

year. Last year, they got 93. That precipitous decline is, No. 1, because the CFTC and NFA have worked hard to try to get rid of

those bad firms that generated those complaints. And No. 2, NFA’s

arbitration program has become a little bit more popular forum for

customers that have disputes that want to resolve them without

going to court.

So the bottom line is that we kind of feel that the reparations

program was a good program that has perhaps outlived its usefulness and that it may be time for Congress to eliminate section—

I think it is section 14 of the act, that requires the commission to

maintain that program. All of us that are regulators—you are all

trying to spend your resources the smartest way you can. And to

require the commission to maintain a reparations program and

spend some resources on it to handle 93 cases a year, when they

used to handle 1,000. I just think maybe reparations has outlived

its usefulness.

Mr. MORAN. Let me ask a general question of the panel. Do any

of you hear any testimony from the earlier panel or you colleagues

on this panel that you would like to respond to? Mr. Green.

Mr. GREEN. I would not so much respond to, but just subscribe

to what Mr. Damgard and Mr. Pickel said about the process of

amending the act. The jurisdiction rests squarely in this committee’s hands, and floor amendments on energy bills is not the way

to craft that kind of careful legislation. The great history of this act

is because of the care that was taken in crafting it to make sure

that there was proper legal certainty and that exclusions and exemptions were well thought out, and we would just encourage you

to stand firm on your jurisdiction. And as it related to the issue of

the Zelener case, we, too, would look forward to working with the

committee in trying to carefully identify exactly what the problem

is, because that law of unintended consequences is very serious in

this regard. You know, the foreign-exchange market has grown tremendously in relevance to all of us as we see what happens with

the dollar on a day-to-day basis. It is a highly sophisticated market

that moves trillions of dollars regularly. If there a problem as a reVerDate 11-SEP-98 11:15 Apr 19, 2005 Jkt 020491 PO 00000 Frm 00084 Fmt 6601 Sfmt 6601 F:\DOCS\109-2 HAGRI PsN: HAGRI
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sult of the Zelener case, you need to narrowly identify what that

problem is and address it in a way that doesn’t contradict the ability of the marketplace to operate as a whole. And really, is that

fundamental basis, that principle basis that we support, so we

would want to work with you and urge caution to make sure that

the unintended consequences are fully thought out.

Mr. MORAN. Mr. Gaine.

Mr. GAINE. If I might just echo that. The reason there is this industry which—and the Alan Greenspans and John Snows and capital-markets people globally will sing the praises of it. The reason

this industry exists is because this committee, in 1974, put the exclusive jurisdiction over futures contracts in the hands of the

CFTC. I will debate that with anybody; it is absolutely, demonstrably true.

Micah’s point—I remember years ago—John Damgard may not

remember—but Pat Roberts was sitting up, around over in this corner, and we got into this same question about jurisdiction, and he

quoted from Genesis. I am Catholic, so we don’t read the Bible very

much—but he was quoting from Genesis about creation, and he

said ‘‘There is one chairman and one committee here in this body

that feels it has the birds that fly, the fish that swim and the animals that walk, et cetera’’ and that is their jurisdictional reach,

anything made under creation. I echo this. These are very complex,

difficult decisions that should be kept within the friendly and

knowledgeable confines of the House Committee on Agriculture.

Mr. MORAN. I have already complained to my colleagues that the

past continues—my predecessor continues to loom over my shoulder.

Mr. GAINE. Well, you couldn’t have a better person looming.

Mr. DAMGARD. I think the committee wisely differentiated between the cash markets and the futures markets. And many of the

issues today don’t clearly differentiate between what the mission of

the commission is, and I believe that Congress was very, very

smart in making sure that the CFTC’s mission was clear. It wasn’t

to deal with cash markets. It can’t be expected to be a national consumer-protection agency. And I agree with—and I think there are

ways in which to resolve this within the industry, but I remember

the grain scandals in New Orleans in the 1970’s, and that wasn’t

the CFTC’s problems. People painting lead bars with gold paint

and selling them. These are not issues that we think the commission or even the NFA ought to be wasting their resources on. But

I think a very narrow approach to fixing the forex problum is something that we can resolve.

And the other thing that I would like to say about Mr. Duffy’s

testimony, where he very proudly mentioned that their board was

meeting all of the requirements of the New York Stock Exchange

listed corporations—our point is not that they aren’t meeting the

listed corporation. They are an SRO, and if an SRO believes that

an independent director is independent, when in fact, that person

can be disciplined by the management of that organization, as I

said yesterday, that doesn’t pass the laugh test. That is not an

independent director. They have had some fine independent directors, including a former member of this committee, Dan Glickman

and Myron Scholes, who are legitimate, independent directors. And

82

I am sure that some of the directors who are not independent are

very, very strong supporters and fine directors. It is just that they

should not be able to count one of the local market-makers, who

sits on the floor every day and who can be disciplined by management for whatever reason, as independent.

Mr. MORAN. I thank the panel. Thank you very much for your

time and for the opportunity we had to learn from you.

I will call our third and final panel to the table: Mr. George Hanley, president of the Hanley Group, on behalf of the National Grain

Trade Council; Mr. Tom Coyle, general manager of Chicago and Illinois River Marketing LLC, on behalf of the National Grain and

Feed Association; Mr. Jeffrey Sprecher, chairman and chief executive officer of Intercontinental Exchange, Inc.; And Mr. Martin

Doyle, president of OneChicago, LLC. Mr. Hanley, you may begin

when you would like.

STATEMENT OF GEORGE HANLEY, PRESIDENT, HANLEY

GROUP, CHICAGO, IL, ON BEHALF OF THE NATIONAL GRAIN

TRADE COUNCIL, WASHINGTON, DC

Mr. HANLEY. Thank you. Mr. Chairman, good morning. My name

is George Hanley, and I am president of Hanley Group, an agricultural market-making group based at the Chicago Board of Trade.

I am also member of the National Grain Trade Council, on whose

behalf I appear before you this morning.

The Council is a North American Trade Association that brings

together grain exchanges, boards of trade, and national grain-marketing organizations with their grain industry counterparts, including grain companies, millers and processors, railroads, futures-commission merchants, and banks. We welcome the opportunity to

share our views with you today.

The National Grain Trade Council strongly supports a movement

from prescriptive regulation to the core principals of the Commodity Futures Modernization Act of 2000. We are very pleased with

how the CFMA has been implemented and how the industry has

prospered under it. In keeping with the spirit of the CFMA, the

Council believes that enumerating agricultural commodities under

the CFMA no longer serves to advance public policy.

Agricultural markets have matures, especially under the CFMA,

and the more prescriptive regulation is no longer necessary to protect the markets or the market participants. Modern U.S. agricultural futures and options markets are much deeper, draw significant representation from worldwide commercial hedging interests,

and offer greater trading opportunities for a speculative community, whose participation is as essential for the success of our markets as farmer and commercial hedging communities.

As the CFTC moves towards becoming more of an oversight authority under the CFMA, Congress may want to consider whether

the regulatory structure should recognize the maturity of the agricultural market and put them on a parity with the other physical

commodity markets. The Council strongly believes that price discovery, the fundamental goal of a regulatory structure, is best accomplished by vesting responsibility with exchanges and providing

the Commodity Futures Trading Commission with the necessary

tools for oversight authority and meaningful regulation. With that

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in mind, the council continues to believe that exchanges should be

responsible for setting speculative positions limits, subject to the

Commission’s oversight. We believe such action would result in a

reduction in duplication in regulatory oversight as well as greater

market transparency.

Currently, the exchanges must go through the self-regulatory

process to change their rules to allow for an increase in limits.

Then, they must petition the CFTC to modify its rules to permit

such an increase. Elimination of this regulatory redundancy would

fully implement the core principals of the CFMA for all agricultural

commodities and allow exchanges to respond quickly to the everchanging market conditions, while retaining CFTC oversight.

Furthermore, allowing exchanges to increase speculative position

limits would also increase activity in a transparent marketplace

and allow exchanges to compete more efficiently with over-thecounter markets.

We would also like to bring to your attention our concern that

funds are taking a position in agricultural indexes of significant

size to justify petitioning the CFTC for hedge exemption. In our

view, this has the potential to present a misleading perception of

commercial participation versus speculative participation in agricultural markets. As this issue moves forward, we believe the definition of a commercial participant should be carefully assessed.

Another issue that warrants further review by the CFTC is the

agricultural trade options pilot program. The Council supports the

comments of Acting Chairman Brown-Hruska on the need to make

viable risk-management tools, like ATOs, available for producers.

However, the program has not met the expectations of the producers industry or the CFTC. Over the years, the Council has watched

the CFTC and the industry wrestle with ideas on how to make the

ATO program more productive, but at this point, the Council believe that now is the time to consider a fresh start.

The Council suggests tapping into the innovation that we have

seen in the energy and metals markets and putting to work to deliver a risk-management tool for agricultural producers that is both

valuable and effective. In our view, before such tools can be developed, the CFTC and the industry must begin by defining the pool

of potential market participants, including examining who should

be a commercial participant and what is the appropriate level of

credit worthiness. The council, working in concert with you, the

CFTC, industry, and other affected parties, is eager to develop such

a program.

Another opportunity for meaningful regulation under the CFMA

involves application transparency for new exchanges. The CFMA

lowered many regulatory hurdles, making it easier for new entrants to participate in the marketplace, and we support this effort.

With 4 years of experience with the new regime, now is the time

to draw from those experiences and examine the application process for new exchanges to ensure that there is enough opportunity

for discussion and debate. The Council champions market competitiveness, but believes that the application process should ensure

that the CFTC, the marketplace, and public receive full and consistent information about new applicants. Though we understand

that financial accounting statements are outside of the jurisdiction

84

of CFTC, as part of our testimony today, we want to bring to your

attention the negative impact Financial Accounting Statement 133

is having on commodity markets. Under the current rules, grain

and food processors must either misrepresent their financial state

to comply with FAS 133 or opt to not participate in the market.

For example, FAS 133 requires a grain or food processor to report the in-term gain or losses from the futures hedge, but the firm

may not report the off-setting losses or gain from the change in the

price of the physical commodity, as though the movement in the

price of the hedge instrument has no relation to the movement of

the physical commodity that was hedged. This defeats the purpose

of hedging.

Under FAS 133, financial firms are allowed to hedge various

components that determine a financial assets price. Allowing the

agricultural commodity hedgers the same opportunity given to financial firms under FAS 133 would promote greater market participation and more accurate reporting of financial conditions.

The Council would welcome the opportunity to discuss this issue

with you in greater detail. In conclusion, Mr. Chairman, we compliment you for your effort. The Council supports the advances

made under the CFMA. We are very pleased with the direction in

which we are headed and look forward to working with you on solutions that continue to push the industry toward evermore efficient and meaningful regulation.

[The prepared statement of Mr. Hanley appears at the conclusion

of the hearing.]

Mr. MORAN. Thank you, Mr. Hanley. Mr. Coyle.

STATEMENT OF TOM COYLE, GENERAL MANAGER, CHICAGO

AND ILLINOIS RIVER MARKETING LLC, CHICAGO, IL, ON BEHALF OF THE NATIONAL GRAIN AND FEED ASSOCIATION

Mr. COYLE. Good afternoon, Mr. Chairman. We appreciate the

opportunity to present our view on reauthorization of the Commodity Futures Trading Commission and risk management issues confronting agriculture. I am Tom Coyle, general manager of Chicago

and Illinois River Marketing, LLC in Chicago, and I serve as chairman of the National Grain and Feed Risk Management Committee.

The NGFA’s more than 900 grain, feed, and processing firms operate over 5,000 facilities that handle more than two-thirds of all of

U.S. grains and oilseeds. Our industry, as a first purchaser of

grains and oilseeds from the producers has traditionally provided

both grain marketing and risk management services to farmers

through a variety of cash instruments. The NGFA’s membership

also represents a substantial portion of the hedge-business volume

on the grain exchanges, and so we have strong interest in the performance of both futures and cash markets.

The NGFA strongly supports reauthorization of the CFTC. The

agency performs an important oversight and regulatory role that

benefits the grain, feed, and processing industry as well as producers and consumers. Our organization maintains a strong, professional working relationship with the CFTC, and we have been generally pleased, in recent years, with the leadership and direction

taken by the agency.

85

The 2000 Commodity Futures Modernization Act provided additional regulatory flexibility in the CFTC’s regulation of exchanges

in all commodities except the enumerated commodities, grains and

other agricultural commodities. We are not going to argue that the

time has now come for enumerated commodity markets to be treated with the identical regulatory structure of all other markets;

however, there is no doubt that the greater regulation of enumerated commodity markets creates more hurdles in making rapid,

adaptive changes to respond to perceived customer needs and adds

to the cost of operating the exchanges.

We think it is to the advantage of the U.S. producer and consumer to have strong and liquid futures markets here in the

United States to maintain marketing and pricing efficiency. Given

the responsiveness of the exchanges to their customer base, we

would submit that that the agricultural markets should be candidates for a more flexible and less costly regulatory structure. The

increasing competition in the marketplace tends to provide additional discipline that should eliminate some of the need for regulations under the CFTC.

The Commodity Futures Modernization Act of 2000 addressed a

potentially major problem in nonagricultural off-exchange derivative markets. It provided legal certainty for such derivative contracts to be legally enforceable after both parties have executed the

contract. While agricultural markets are considerably smaller than

these financial derivative markets, cash agricultural contracts remain saddled with the risk that the CFTC or the court system may

review a particular contract and declare, after the fact, whether the

contract is viewed as legal, exempt from the CFTC jurisdiction, or

illegal and therefore not enforceable.

We think it is important that the marketplace have more direction from government as to the legal standing for agricultural cash

contracts. Increasingly, cash contracts that are offered to farmers

have features that provide the farmer and merchant with greater

flexibility. That flexibility has value to both parties. Unfortunately,

the flexible features that provide more value and utility are the

same contract features that potentially raise questions regarding

the contract’s legal standing. Contract features such as providing

for multiple rolling opportunities, allowing a contract to be rolled

forward, and offering the ability to cash in the contract, have real

economic value, but depending on the circumstances can raise legal

questions. The bottom line is that we think greater legal clarity

will provide the marketplace the ability to offer value through cash

contracting.

There are two potential ways to resolve the need for greater legal

clarity for these contracts that are exempt from CFTC jurisdiction.

One way is to amend section 1(a)–11 to more crisply define exempt

forward-cash commodities. The other method would be for the

CFTC to develop more specific guidance for the cash marketplace

that gives consideration to the most recent, relevant cases before

the CFTC and the Federal Circuit Courts. In our judgment, the latter approach, through a regulatory proceeding at the CFTC, holds

considerable promise, given the progress that recent court and

CFTC cases have made.

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As this subcommittee is keenly aware, government budget cuts

and the negotiations coming up in the next round of the WTO could

affect the level of government direct support to U.S. farmers. If this

occurs, producers may find that they have greater need for marketbased risk management tools. Given the situation, it seems timely

to at least review the market-based management tools now available and to make note of the regulatory barriers that are today restricting access to some producers.

Mr. Chairman, we appreciate the opportunity to resent our views

on the CFTC and related risk-management issues. I would be

happy to respond to any questions.

[The prepared statement of Mr. Coyle appears at the conclusion

of the hearing.]

Mr. MORAN. All right. You are welcome, Mr. Coyle. Mr. Sprecher.

STATEMENT OF JEFFREY C. SPRECHER, CHAIRMAN AND

CHIEF EXECUTIVE OFFICER,

INTERCONTINENTALEXCHANGE, INC., ATLANTA, GA

Mr. SPRECHER. I will be very brief in the interest of time, Mr.

Chairman. My name is Jeffrey Sprecher; I am the founder, the

chief executive officer, and the chairman of

IntercontinentalExchange, which is also known as ICE. We are

headquartered in Atlanta, and we operate a leading global-electronic platform for over-the-counter marketplace and for trading of

energy commodities and derivative contracts based on energy commodities. The energy commodities on our platform include oil, natural gas, and power. ICE also operates in energy commodities futures exchange through our wholly-owned, London-based subsidiary, the International Petroleum Exchange of London, which is also

known as the IPE.

I would like to thank the committee for its effective and farsighted work in developing and adopting the CFMA. The CFMA is

critical to my company’s success. ICE operates as an ECM under

the jurisdiction of the CFTC. As an ECM, ICE is required to comply with access, reporting, and recordkeeping requirements. With

respect to the issues affecting ECMs in particular, ICE is of the

view that the CFMA and the rules adopted by the CFTC provide

an effective framework for the oversight of commercial marketplaces and there is no need to amend the Commodity Exchange Act

in this area. The CFTC has promoted open, freely-accessible, and

transparent markets, including the permission of ECMs like me. I

believe restricting trading activity through additional regulation

would only adversely affect the market liquidity and price transparency and would not reduce price volatility in energy.

On behalf of ICE, I would like to thank this committee for the

excellent work that it has done in enacting the CFMA. It has been

a clear benefit to our company, and I submit to the producers and

the users of energy commodities around the world. ICE looks forward to working with this committee during the reauthorization

process, and I will be happy to take your question when appropriate. Thank you.

[The prepared statement of Mr. Sprecher appears at the conclusion of the hearing.]

Mr. MORAN. Thank you very much. Mr. Doyle.

87

STATEMENT OF MARTIN DOYLE, PRESIDENT, ONECHICAGO,

LLC, CHICAGO, IL

Mr. DOYLE. Thank you, Mr. Chairman. I am Martin Doyle, president of OneChicago LLC, the U.S. exchange for single-stock futures

and other securities futures products. On behalf of OneChicago, our

chairman, Peter Borsch, and our joint-venture owners, thank you

for inviting us to present our views today.

OneChicago is a true product of the Commodity Futures Modernization Act of 2000. In that Act, Congress authorized trading in

futures on securities by ending the almost 20-year statutory ban on

those instruments. It is no exaggeration to say that without this

subcommittee’s work on the CFMA, OneChicago would not be here.

We thank you and your predecessors for your work on that

groundbreaking legislation.

OneChicago is a joint venture of the Chicago Board Options Exchange, Chicago Mercantile Exchange, and the Chicago Board of

Trade. We provide an electronic trading facility for single-stock futures and other security-futures products. We are the only U.S.

market in these products. OneChicago began trading on November

8, 2002 with 34 listing, or 34 futures on individual stocks. Today,

OneChicago lists 136 single-stock futures contracts. All of the underlying stocks are included in the SMP–500, ranging from Apple

and Boeing to Starbucks and Wal-Mart.

Our progress has been steady. In 2003, OneChicago traded about

1.6 million contracts for an average daily volume of 6,425. Our

2004 volume increased to about 1.9 million contracts with average

daily volume of 7,630. While this does represent a 19-percent increase, our volumes in growth pale when compared to those in

overseas exchanges. In 2000, when the CFMA was being debated,

foreign markets had already announced their intention to trade security futures. We know this subcommittee and others in Congress

did not want to see U.S. markets fall behind overseas exchanges.

The U.S. is the home of financial innovation, the birthplace of financial futures trading. Having to play catch-up with foreign markets was not a desirable option.

A look at the volume numbers of foreign exchanges, contained at

page 3 of my written testimony as well as in the chart that I provided before the panel here—as this chart shows, even accounting

for their head start, our foreign counterparts are outpacing us in

terms of volume and growth. There are many possible explanations

for this, but the fact remains that some aspects of the CFMA, itself,

and its implementation have hindered our ability to grow our market. That is why I am here today.

We have started a new business with a new product under special restrictions imposed by both the CFTC and the SEC. We have

made a solid start, but we need some help. Our request falls into

two categories: non-statutory and statutory. My written testimony

describes these in more detail. Margin is a major area of concern.

We have asked the CFTC and SEC to allow us to apply portfolio

margining to securities futures products. This will save money and

promote financial integrity. We need this relief now. We also need

relief in the critical area of market-maker margin, where the rules

are too complicated and burdensome. Finally, we need a bright line

safe harbor so that CFTC-registered commodity trading advisors

88

can participate in our market in the same manner that they do in

every other futures markets without triggering registration with

the SEC as investment advisors.

In terms of statutory changes, margin, again, is the big issue.

First, current margin levels of 20 percents are too high and serve

as a disincentive for many new market users. We would ask Congress to change the statute to ensure margins in the range of 15

percent of notional value. Second, some firms have indicated that

securities-based suitability rules are an impediment to their use of

these new futures markets. The futures industry operates under

know-your-customer standards. Firms should be allowed to meet either form of customer protection rule in order to handle security

futures brokerage. Last, the tax treatment of securities futures

should be reformed to extend 60–40 treatment to all members of

a securities futures exchange.

Mr. Chairman, thank you for your consideration of these issues.

With your help and guidance, I am very hopeful that U.S. securities futures trading will be able to serve well the risk management

needs of our market participants and the national interest in making sure that the United States continues to lead the world in financial innovation. I look forward to answering any and all questions you may have.

[The prepared statement of Mr. Doyle appears at the conclusion

of the hearing.]

Mr. MORAN. I thank you, Mr. Doyle. Mr. Doyle, reiterate again

for me the suggestion you have for changes that would require congressional legislation.

Mr. DOYLE. The congressional or statutory changes that we

would recommend, Mr. Chairman, would include three things. First

of all, the reduction of the current 20 percent level of margin to a

more futures-style 15 percent. Second, we would ask that firms

that have accustomed to following the futures-style know-your-customer rule for customer protection purposes—be allowed to meet

that standard, as opposed to the new suitability rules, which they

have been forced to learn and learn to comply with as a result of

the CFMA. And third, we would ask that the 60–40 treatment be

applied to all of—members of any securities futures exchange, encourage market-making and so forth.

Mr. MORAN. If Congress and the CFTC followed your recommendation, what does that do to your ability to compete internationally? Does that eliminate what—I suggest your testimony—

what it suggests to me is that there is a disparity. Other exchanges

are growing at a faster rate than OneChicago, and I assume that

the issues you present to the committee are designed to level that

playing field?

Mr. DOYLE. That is correct.

Mr. MORAN. And would that be the case with—is that the distinction between what is happening in other countries and here in

the United States?

Mr. DOYLE. Well, I am not—I can follow up with certain information, Mr. Chairman, but I am not an expert on the tax situations

and the regulatory situations in all of the jurisdictions that would

be covered by that chart that I provided. However, I am aware that

in—I am generally aware that in the United Kingdom, where the

89

Life Exchange operates, the margin requirements in that jurisdiction are much more futures-style and lower than ours at

OneChicago; and therefore, a lowering of our margin to a more futures-style margin, I think, would allow us to compete and not fall

further behind.

Mr. MORAN. Mr. Doyle, what is a description—characteristics of

a person who uses your exchange? What does your customer look

like?

Mr. DOYLE. Well, we have an array of different types of customers at this point, from educated retail users to—all the way up

to the largest institutions. Right now—if I understand your question—our volumes and our growth are being driven more by professional trades and institutions who would appreciate things like

portfolio margining, 60–40 treatment for members, things like that.

Mr. MORAN. Mr. Sprecher, what is the characteristics of your

customer base? Who uses your exchange?

Mr. SPRECHER. We have about 900 companies that are registered

to trade on our platform, and it constitutes about 5,000 individuals.

The company is young; it is only 5 years old. When we started the

firm, the initial customer base were largely energy companies with

brand names that everyone would recognize. More recently, into

the energy space, you are seeing the emergence of investment

banks, commercial banks, and hedge funds whose names very few

of us would recognize.

I would say that the growth in energy trading is being driven by

the banking and financial community. At this point, I would submit

that today there are as many people who could tell you an approximate price of oil as there are that could tell you the Dow Jones industrial average. So it has become a geopolitical contract that has

wide implications in many markets, and you are seeing the effect

of new market entrants coming from the financial community.

Mr. MORAN. Are there others in your business out there? Who

are your competitors? People in other exchanges doing what you

are doing?

Mr. SPRECHER. No. We, really, somewhat stand alone. The

premise of the company when I founded it was to organize markets

that were traded outside of traditional exchanges. And those markets are either traded peer to peer by major oil companies, let us

say, or through voice brokers—and there is a large voice-brokerage

community out there that still handles that trade—so they are our

traditional competitors, and we are trying to bring those markets

into a more organized, transparency marketplace and then use the

efficiency of electronics.

Mr. MORAN. I assume that you are regulated differently than

NYMEX?

Mr. SPRECHER. That is correct.

Mr. MORAN. And what is the justification for that?

Mr. SPRECHER. NYMEX, as I am sure you are aware, is self-regulated organization. ICE, as an ECM, has direct oversight by the

CFTC under this category called ECMs. The rest of the marketplace, the voice brokers and the peer-to-peer business, is largely

unregulated, so there is sort of a—I guess a scale from black to

white to—with grey in between, as it now exists.

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Mr. MORAN. There will, I assume, be discussion about additional

regulations of the energy markets. Do you have an opinion?

Mr. SPRECHER. We think that the CFTC and the CFMA, as it

specifically relates to my company, is good, and we have a good relationship, and we have benefited by the CFTC’s enforcement action in the energy space to clean it up. We benefit by markets with

integrity. There is some talk in the halls, if you will, about possibly

giving the CFTC more enforcement capabilities as it relates to energy and other areas, and if the CFTC needs those, we would certainly support them in that and be prepared to work with people.

But specifically, as it relates to my company, I think the operation

of the CFMA is good.

Mr. MORAN. Mr. Hanley and maybe Mr. Coyle, we have heard

and know about the exponential growth of the futures industry,

and I know that there has been growth in the ag sectors of that

industry. How does that growth compare, ag versus other traded

instruments?

Mr. HANLEY. I would say ags probably fall behind financials in

stock-index trade and energy. The ags probably fall behind pretty

much everybody else.

Mr. MORAN. The other segments are growing faster?

Mr. HANLEY. Yes.

Mr. MORAN. And your explanation?

Mr. HANLEY. Well, my personal experience is when you open up

markets to electronic platforms or an side-by-side open-outcry electronic-platform choice that the trade grows, you will see more arbitrage between the two platforms which creates more liquidity,

which then creates more customer interest in the products. And I

also believe that ags are more regulated than financials are or energies are.

Mr. MORAN. Remind me. Is ag not traded on the electronic exchange?

Mr. HANLEY. No.

Mr. MORAN. It is only open outcry?

Mr. HANLEY. Yes.

Mr. COYLE. Except for—I think for except for in the evenings

where we do have electronic markets.

Mr. HANLEY. Except for——

Mr. COYLE. Except for in the evening, and we do—the Board of

Trade has an electronic platform. They have now done—the Winnipeg Exchange is now electronic, using the Board of Trade’s platform. Both the Kansas City and Minneapolis Grain Exchanges are

using night sessions using electronic format.

Mr. MORAN. And do you see growth in that sector of agriculture?

The electronic platform?

Mr. COYLE. I see growth in ag in general. I see growth in production, growth in consumption around the world, and new products

coming on stream. You know, the Board of Trade, in May, will offer

a contract on the South American soybean contract in the Chicago

market, so that should increase trading as well.

Mr. MORAN. Mr. Hanley indicated that the ag sector was more

heavily regulated. Is there a justification for that? Either one of

you?

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Mr. COYLE. We would say no. We would say that there certainly

is an history where there was a sense that the users of the agricultural markets were maybe less sophisticated and needed more protection. Today, as we have said in our testimony, we believe that

the exchanges have become much more responsive to their customers, and the customers themselves have become much more sophisticated. For that reason, we believe that it is time to consider

whether the enumerated commodities should be given the same

freedoms as other markets.

Mr. MORAN. Along that line, you do indicate in your testimony

that agricultural markets should be candidates for more flexible,

less costly regulation. What are the examples where that would

occur?

Mr. COYLE. I would say that Mr. Hanley might be able to better

answer that question. But the exchanges, themselves, as you have

heard in a number of cases earlier today, have taken advantage of

the CFMA to expand their markets. For instance, the example of

limits that I heard earlier that Mr. Hanley did mention, that there

is an approval process that is a bit cumbersome. That, frankly,

takes time, then to expand the ag markets, and it also takes up

energies and adds costs to the exchanges, but they can probably be

better used on growth initiatives.

Mr. HANLEY. I pretty much agree with Mr. Coyle. Whether it is

duplication in regulation, insofar as I think what Commissioner

Hruska is proposing is that the exchanges pretty much lead on the

position limit, but that the CFTC reserves the right to step in. It

would take away some of the regulation. I think the ag trade-option program has been pretty much just a program that didn’t

work, and I am sure that all of the work that was put into it, they

wanted to come out with a product that would be used, and widely

used. And I think that needs to be looked at again, and we would

be happy to give some suggestions on a product that would work.

In general, when you read about the growth of the over-thecounter trade in the energy markets—and my firm does not trade

energy products—I am somewhat envious of the energy markets,

that they have somewhat of a clear and open field to trade. And

what has happened with a lot of the over-the-counter energy trade

is it has gone and it has cleared at the NYMEX or at IPE, possibly,

or at intercontinental exchange. So you have this free and open

market, but then it is being guaranteed by the stability of the

clearinghouses—so that is a good thing.

I think a good example is mortgages. If you look at mortgages

and you look at financial markets and how the regulations have

been taken off financial markets, just look for the everyday man

how efficient mortgages are now. That is because they trade freely,

and there is a lot of competition. It seems like whenever you can

bring more competition in and usually there are some regulatory

reasons why there is less competition.

Mr. MORAN. Is there a distinction in the characteristics, the sophistication of those who are trading agricultural futures as compared to financials or single-stock? Who is now utilizing the exchanges in the agricultural world?

Mr. HANLEY. Well, I think the exchanges, I am an exchange guy,

so exchanges have their level of regulation. That is the first step,

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you have to conduct business with integrity, or you are going to

have problems. Not just problems with the CFTC, but you can have

problems from your customer. So most people will come to the exchanges. You have the clearinghouse that guarantees the trades.

You have the FCM community that also has their rules that are

in place, and so most of the trades come to the exchanges. You see

the farmers that will come to the exchanges. You see producers and

consumers and the professional market makers, and the—I will call

them professional—the hedge funds traders.

Mr. MORAN. And what volume of your business is related to the

cattleman in Dodge City, KS who has a 1,200-head feed yard? Are

those people utilizing the exchange?

Mr. HANLEY. My two companies—one is solely grain products,

mostly ag options, and the other company is a global market-making firm. So we don’t do any meats——

Mr. MORAN. Well, let me change it to the 1,000-acre grain farmer, then.

Mr. HANLEY. So we would be, hopefully, providing markets for

them in corn, soybeans, wheat or soybean meal and oil ag options

at the Chicago Board of Trade. And you know, we have seen the

explosion in the options volume as a percent of the trade, and you

know, that it is possibly an area, thought, we can bring more participants to. Ideally what I would like to see is the farmer be able

to take advantage of the liquidity of the markets to hedge their

risk.

Mr. MORAN. This subcommittee has an interest in pursing noncrop insurance risk management tools for farmers, and in part, my

interest—perhaps we can explore this further is who are using?

What are the characteristics of the kind of farmer or rancher that

is utilizing exchanges? Mr. Coyle.

Mr. COYLE. Yes, I can answer some of that. First, I can go back

to your cattle questions. I once worked for Continental Grain which

is the largest cattle feeder in the country, and I can tell you that

they hedged all of the corn that they used. They buy grain every

day from farmers, and other times they are buying from country

elevators, but they are using the Board of Trade. And in fact, they

have a desk, today, as just an animal company on the Board of

Trade floor.

In terms of farmers that use it, well, you do have some farmers

that use it; most of the farmers do not use it. There is a ceratin

amount of discomfort, I think, with the Board of Trade. Also, and

probably more importantly, is when a farmer wants to market their

grain, and not just manage the futures price risk, but they want

to be able to manage the logistics risk, the basis risk. There is also

the issue of margining. You know, today what happens and we

have seen a recent rally in prices, and the farmer is taking significant advantage of that, selling grain for next October, November,

and December. But when the farmer sells that to a commercial

grain company, the commercial grain company is the one that manages the margin on that. There is no cost to the farmer as the

prices go higher; it is the commercial grain company that has to

then provide the margin money. So there is a lot of comfort and

confidence in their local grain elevator and the fact that they can

manage these other risks as well as just the basis risk.

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You know, one of the things that we talked about earlier is now

as we get more clarity and give more flexibility to farmer, legal

clarity, then we can offer more flexibility to the farmers. That same

business ends up in the Chicago Board of Trade. If the farmer has

some of the newer contracts, which have more options embedded in

their contracts, not only are the futures hedged in the Chicago

Board of Trade, but so are the options. To the extent that the grain

industry, our members for instance, have more flexibility, more

comfort to provide more creative contracts to farmers, that directly

relates to an increase in volume and a stronger Board of Trade.

The other thing that we are noticing in the markets, which I

think one of the gentlemen mentioned is there is more index-fund

participation in the grain markets. it is adding a lot of liquidity to

markets. They have asked for an increase in limits in the Board

of Trade you have pension fund that wants to invest, you know,

$20 million. Well, the limits in the Board of Trade today, may simply not be big enough for how they manage their funds, so they

have been lobbying for that increase.

Another way that I can tell you that we at the National Grain

and Feed have said, fine. We support, you know, these increasing

limits as long as there is oversight by the CFTC. So I don’t know

if that answers your questions.

Mr. MORAN. It does. Thank you very much. Any of you hear anything from your fellow panelists that you would like to respond to?

I thank you very much for your time. Thank you for spending at

least a portion of your afternoon with us. I appreciate the education that you have provided. I thank you.

I would also like to thank our committee staff for their help in

organizing our subcommittee hearing today, Kevin Kramp and

Matt Smith and Dave Ebersole and Tyler Wegmeyer.

Without objection, the record of today’s hearing will remain open

for 10 days to receive additional material and supplemental written

responses from witnesses to any question proposed by a member of

the panel. The hearing of the Subcommittee on General Farm Commodities and Risk Management is now adjourned.

[Whereupon, at 1:09 p.m., the subcommittee was adjourned.]

[Material submitted for inclusion in the record follows:]

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