U.S. GOVERNMENT PRINTING OFFICE

65–907CC WASHINGTON : 2000

THE COMMODITY FUTURES

MODERNIZATION ACT OF 2000

HEARING

BEFORE THE

SUBCOMMITTEE ON

FINANCE AND HAZARDOUS MATERIALS

OF THE

COMMITTEE ON COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

SECOND SESSION

ON

H.R. 454

JULY 12, 2000

Serial No. 106–123

Printed for the use of the Committee on Commerce

(

2

COMMITTEE ON COMMERCE

TOM BLILEY, Virginia, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

MICHAEL G. OXLEY, Ohio

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

Vice Chairman

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

BRIAN P. BILBRAY, California

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

TOM A. COBURN, Oklahoma

RICK LAZIO, New York

BARBARA CUBIN, Wyoming

JAMES E. ROGAN, California

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

RON KLINK, Pennsylvania

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

TOM SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

JAMES E. DERDERIAN, Chief of Staff

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS

MICHAEL G. OXLEY, Ohio, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

Vice Chairman

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

STEVE LARGENT, Oklahoma

BRIAN P. BILBRAY, California

GREG GANSKE, Iowa

RICK LAZIO, New York

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ROBERT L. EHRLICH, Jr., Maryland

TOM BLILEY, Virginia,

(Ex Officio)

EDOLPHUS TOWNS, New York

PETER DEUTSCH, Florida

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

FRANK PALLONE, Jr., New Jersey

BOBBY L. RUSH, Illinois

JOHN D. DINGELL, Michigan,

(Ex Officio)

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C O N T E N T S

Page

Testimony of:

Levitt, Hon. Arthur, Chairman, Securities and Exchange Commission ...... 21

Parkinson, Patrick M., Associate Director, Division of Research and Statistics, Board of Governors, Federal Reserve System ................................ 43

Paul, C. Robert, General Counsel, Commodity Futures Trading Commission ................................................................................................................. 39

Sachs, Lewis A., Assistant Secretary for Financial Markets, Department

of the Treasury .............................................................................................. 47

Material submitted for the record by:

Bond Market Association, prepared statement of .......................................... 61

Chicago Board of Trade, prepared statement of ............................................ 56

Gordon, Scott, Chairman, Board of Directors, Chicago Mercantile Exchange, prepared statement of ..................................................................... 58

Parkinson, Patrick M., Associate Director, Division of Research and Statistics, Board of Governors, Federal Reserve System, letter dated July

19, 2000, to Hon. Tom Bliley, enclosing response for the record .............. 64

Sachs, Lewis A., Assistant Secretary for Financial Markets, Department

of the Treasury, letter dated August 8, 2000, to Hon. Thomas J. Bliley,

enclosing response for the record ................................................................ 66

Skolnik, Barry W., President, North American Securities Administrators

Association, letter dated July 12, 2000, providing comments for the

record ............................................................................................................. 60

(III)

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THE COMMODITY FUTURES MODERNIZATION

ACT OF 2000

WEDNESDAY, JULY 12, 2000

HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS, Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2123, Rayburn House Office Building, Hon. Michael G. Oxley

(chairman) presiding.

Members present: Representatives Oxley, Cox, Largent, Ganske,

Shimkus, Wilson, Fossella, Ehrlich, Bliley (ex officio), Towns, Stupak, Barrett, Luther, Markey, Rush, and Dingell (ex officio).

Also present: Representative Ewing.

Staff present: David Cavicke, majority counsel; Brian

McCullough, majority professional staff; Shannon Vildostigui, majority professional Staff; Robert Simison, legislative clerk; and

Consuela Washington, minority counsel.

Mr. OXLEY. The subcommittee will come to order.

Before my opening statement, I would like to recognize the gentleman from Illinois, Mr. Ewing, a refugee from the Agriculture

Committee, who has been kind enough to sit in on our hearing

since this is the legislation that he authored in the Agriculture

Committee and he Chairs the subcommittee of jurisdiction there.

Tom, welcome.

This subcommittee has dealt with many complex financial issues

over the years with a great deal of success. Last fall financial modernization was enacted into law after years of attempts to bring

meaning to an evolving financial services marketplace. Orders and

rules were established for the blurring lines between insurance, securities and banking. Our financial markets are not the best in the

world because they stand still. Instead constant developments and

new products derived from competition emerge to fill the needs of

customers.

Our financial markets have long since passed a time when their

role was limited to the purchase and sale of securities and futures

for investment purposes. Increasing need to minimize exposure to

fluctuating interest rates and uncertain financial markets provided

the impetus for valuable risk management tools such as financial

futures and other financial derivatives. This evolution has led to

futures on broad stock indices, and more recently narrow baskets

of stocks.

As with the financial services legislation, new products that

begin to look alike can cause regulatory and legal confusion. H.R.

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4541, the Commodity Futures Modernization Act of 2000, contains

several provisions that seek to eliminate confusion and create a defined regulatory structure. Most people are unaware of how important the derivative market is for our economy. The amounts involved are staggering, with trillions of dollars of contracts trading

annually. These are valuable products that should not be jeopardized with legal uncertainty. Because they rely on a regulatory exemption from the Commodity Exchange Act, they are subject to

changes or interpretations by future regulators. If we are agreed

that the policy of allowing this flourishing market to continue without being subject to the CEA, then we need to codify it in legislation and eliminate that uncertainty. H.R. 4541 addresses this problem in a fashion similar to the recommendations outlined in the

President’s Working Group report.

I am interested to hear the comments of our witnesses about

these provisions and further discussion regarding the legal uncertainty. Equally important is the repeal of the Shad-Johnson Accord,

which prohibits single-stock futures. Until now these products were

banned because an agreement on the regulatory regime between

the SEC and CFTC was never reached since the ban was implemented in 1982. The President’s Working Group on Financial Markets agreed last fall that the prohibition could be repealed if certain regulatory issues and the concerns about the integrity of the

underlying equity markets were addressed properly. I know disagreements remain between the agencies on this provision as reported, but failure to reach agreement now between the SEC and

the CFTC is simply not an option. We have waited 18 years for the

temporary ban to be lifted on a potentially useful financial product.

If we wait any longer, the activity will move offshore, and I am

confident agreement can be reached.

Requests were made of the SEC and the CFTC to work together

to find a compromise solution. I would request that each of these

agencies provide this subcommittee in writing with the status of

the negotiations to detail the specifics of what has been agreed to

and what remains unresolved. I look forward to the comments of

our witnesses and any suggestions they have for their suggestions

on improvements to the legislation. We have a distinguished group

of witnesses today and we look forward to hearing from them.

It is now my pleasure to recognize the gentleman from New

York, Mr. Towns, the ranking member.

Mr. TOWNS. Thank you, Mr. Chairman. I also thank you very

much for holding this hearing on this very important bill.

It is unfortunate that the committee has been given such a short

time to deal with this bill because it raises issues that go to the

heart of this committee’s jurisdiction. However, I hope that we

could work together to craft a good bill in the short time given to

us. As it has been described, the bill coming over to our committee

from the Agriculture Committee has three titles. Title I deals with

the legal certainty for the over-the-counter derivative transactions.

Title II provides regulatory relief to the U.S. Futures exchanges.

Title III attempts to address Shad-Johnson and the trading of single-stock futures.

I would like to focus my remarks on title I and III of the bill.

Title I of the bill is critically important to U.S. investment in comVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 65907.TXT HCOM2 PsN: HCOM2
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mercial banks and U.S. companies that use OTC derivatives to

manage risk. This title establishes the necessary legal certainty for

these OTC derivatives transactions. Specifically, the title insures

that no court or regulator can make a determination that could invalidate billions of dollars of legitimate derivative contracts. This

uncertainty is a cloud hanging over numerous types of transactions, such as OTC transactions, government securities and other

financial instruments. U.S. financial markets should not be forced

to tolerate the risk of such legal uncertainty.

Mr. Chairman, this is extremely important. However, let me add

we have what I see as a unique opportunity before us. As I understand it, the language coming out of the Agriculture Committee addressing legal certainty is strongly supported by the major financial trade associations, the major U.S. investment and commercial

banks, United States futures exchanges, all four members of the

President’s Working Group. I find this unanimity of agreement to

be almost unprecedented. We should seize this moment. Recognizing that no bill or title is perfect, there are obvious issues that

need to be resolved in title III. However, with title I receiving this

kind of broad support, it appears evident that we need to act on

this legislation and at a minimum provide OTC derivative transactions with the necessary legal certainty.

I do want to express my concerns about the portions of the Commodity Futures Modernization Act of 2000 dealing with singlestock futures. The bill would permit the trading of the single-stock

futures without the regulatory requirements imposed on securities.

Stock futures will act as a direct surrogate for individual stocks

and will be marketed to retail investors across this country. The

SEC is the expert regulator charged with oversight of the securities

markets. It is critical that the SEC be able to administer the security markets provisions it feels are necessary for stock futures.

The bill also would provide stock futures with regulatory advantages over competing securities products such as stock and stock

options. Customers of single-stock futures would be exempt from

Federal transaction fees imposed on securities and be subject to different margin levels than for stock options. This is unfair and

should be remedied, and we must find a way to do that.

For these reasons I believe that the stock futures provision of the

Commodity Futures Modernization Act should be modified to address the legitimate concerns of the SEC and securities markets regarding the regulatory and competitive disparities between futures

and securities arising from single-stock futures. If this cannot be

accomplished, if this cannot be accomplished, I repeat, within the

short time remaining in this congressional session, then the stock

futures provision should be removed from the bill so that Congress

can act on the important legal certainty provisions in the bill. I

strongly feel that under no circumstances should we delay a legal

certainty provision.

On that note, Mr. Chairman, I yield back the balance of my time.

I am anxious to hear the comments coming from our witnesses.

Mr. OXLEY. I thank the gentleman. The Chair now recognizes the

chairman of the full Commerce Committee, the gentleman from

Richmond, Mr. Bliley.

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Chairman BLILEY. Thank you, Mr. Chairman. Since 1982, when

the SEC and the CFTC could not agree on who was to regulate single-stock futures, they agreed to ban the product. Although the ban

was never intended to be permanent, they have yet to reach agreement on who should regulate them. Only in Washington do we ban

something when we can’t figure out who regulates it.

Last November, to assist Congress on issues addressing the commodities markets, the President’s Working Group on Financial

Markets issued a report and it detailed changes that should be

made in order that regulation keep pace with the rapidly evolving

marketplace. Among the suggested changes was the repeal of the

ban on single-stock futures. The President’s Working Group agreed

that the ban on single-stock futures could be repealed provided

issues of regulatory structure and integrity of the underlying cash

markets could be resolved.

On the basis of this report I, along with Chairman Larry Combest and Chairman Tom Ewing, wrote to the SEC and the CFTC

asking them to resolve this dispute. The response from the two

agencies was troubling, as they were once again unable to reach

any substantial agreement. Although single-stock futures may very

well turn out to be much fuss about little, their prohibition is based

on little more than an old-fashioned turf war. This is at odds with

the principles of capitalism and freedom. If the agencies cannot resolve this dispute, Congress will have to do it for them.

The President’s Working Group also stressed the importance of

providing greater legal certainty to over-the-counter derivatives.

Trillion dollar products are currently traded in reliance on a CFTC

exemption and a prayer that a court will not find the contract to

be a future. Systematic risk may exist so long as these products

trade without adequate legal certainty. That is precisely why the

President’s Working Group strongly urges certainty in this area.

We need to make sure that those investing in our markets have

confidence that the products in which they are trading are legally

binding. Doing so will continue the viability of the American market for these products.

Mr. Chairman, under your leadership, this subcommittee has

worked hard to ensure our financial markets are the envy of the

world. This bill before us today reflects a good starting point for

this committee to continue its work of shaping a framework which

will allow our markets to grow with a certainty that our investors

have come to expect. We don’t have a lot of time to consider this

important legislation, but we will do our best.

I yield back the balance of my time.

Mr. OXLEY. The gentleman yields back. The Chair is now pleased

to recognize the gentleman from Michigan, the ranking member of

the full committee, Mr. Dingell.

Mr. DINGELL. Mr. Chairman, I thank you for recognizing me and

I commend you for holding this important hearing, and I warmly

welcome our distinguished witnesses, especially our friend, the

Chairman of the SEC.

Mr. Chairman, I would begin by observing that this committee

has jurisdiction over the securities industry, and the securities

markets of this country. I note to you in the exercise of that jurisdiction, we have had a remarkable success going back to the origiVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 65907.TXT HCOM2 PsN: HCOM2
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nal 1933 and 1934 acts, and that the success of this has been to

see to it that our markets are the most trusted and respected in

the world, which is why everybody comes over here to invest in the

American securities industry.

I would note, however, that the same successes have not occurred

with regard to the futures markets, which at different times take

on the appearances and some of the characteristics of cesspools.

The protections which one would observe for the American securities markets are very clear. There are paper trails, protections

against fraud and, in addition to that, strong prohibitions against

insider trading. A market which has been disciplined by this kind

of oversight by the SEC and the kind of oversight that was crafted

by this committee in 1933 and 1934 has brought remarkable success and extraordinary trust.

As I have observed, the securities market everybody thinks runs

on money. It does not. It runs on public trust, and if the trust is

there, people make lots of money and that is people inside and outside of the market.

I would like now to be blunt. This committee has jurisdiction of

the securities industry. And while the Agriculture Committee may

have jurisdiction over the futures market, I should say that they

should exercise that with more diligence than they have done so in

the past. I intend to see that this committee exercises its jurisdiction over the securities market to protect the American investors

and to see to it that the integrity of that market system is carried

forward and protected.

I would ask to be forgiven for being blunt. This bill is a real turkey, and most of you know that I am a turkey hunter. If the bill’s

many defects are not fixed in this committee, I will do everything

within my power to put this legislation out of its misery at the earliest opportunity.

First, I support the effort to provide legal certainty for the OTC

derivatives. The Commerce Committee played an instrumental role

in crafting and passing the swaps exemption in the 1992 Futures

Trading Practices Act. I would like to be in a position to support

the legal certainty provisions of H.R. 4541. However, the bill before

us contains defective provisions on the regulation of clearinghouses

that must be fixed to assure appropriate regulation of the risks

that may be concentrated there. I am also concerned that the bill’s

definition of eligible contract participants includes retail investors

who have no business in these unregulated institutional markets.

I have other questions and concerns about this part of the bill,

but these are the principal ones.

Second, my general disdain for the quality of futures regulation

in this country has not improved after reading this bill. As I understand it, H.R. 4541 transforms the CFTC from a ‘‘front line regulatory agency’’ into an ‘‘oversight regulator’’ of what the bill calls

‘‘acceptable business practices under core principles’’ that will be

applicable to registered futures markets. I am still waiting to see

something that would fill that definition. If the CFTC believes that

a registered entity is violating these yet to be determined core principles, it must first notify the entity in writing, then recommend

an appropriate remedial action to remove the deficiency, but only

after first conducting a cost-benefit analysis of the remedial action;

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and finally, the burden of proof is shifted to the CFTC, which must

demonstrate the violation by a preponderance of the evidence.

Now it would go to several things. First of all, when events happen in the futures market, they happen very fast because it is a

very volatile market, and the ability to respond to a major scam or

serious misbehavior under these circumstances is virtually nonexistent. Certainly it is not possible under any expectation that it

might occur in a timely fashion. I am sure that every crook and

swindler in the country is hoping that these outrageous provisions

stay in the bill. I support reasonable regulatory relief for the futures exchanges, but H.R. 4541 is clearly contrary to the public interest.

Third, and I have saved the best for last, I see absolutely no redeeming value whatsoever in the provisions of this bill that would

lift the ban against single-stock futures and create a defective regulatory structure for these retail products under the Commodity Exchange Act and the CFTC, the same CFTC that this bill reduces

to a defanged oversight regulator of core principles.

This part of the bill, section 8, futures on securities, poses a serious threat to the integrity of the country’s capital markets and undercuts over 6 decades of unparalleled investor protection and investor confidence and makes a joke of fair competition between the

markets. These provisions are opposed by anybody who knows anything about securities. The Securities and Exchange Commission,

the American Stock Exchange, the Boston Stock Exchange, the

Chicago Board Options Exchange, the Chicago Stock Exchange, the

Cincinnati Stock Exchange, the Nasdaq Stock Market, the New

York Stock Exchange, the Pacific Stock Exchange, the Philadelphia

Stock Exchange, the Depository Trust and Clearing Corporation,

and the Options Clearing Corporation, among others.

Mr. Chairman, I ask unanimous consent to include in the record

a May 22, 2000 Business Week article entitled ‘‘The Case Against

Single-stock Futures’’ as well as copies of the June 27, 2000 letter

of the New York Stock Exchange and the July 11, 2000 memorandum of the United States Securities Markets Coalition setting

forth these entities’ detailed concerns with this bill.

Mr. OXLEY. Without objection, so ordered.

[The article follows:]

[Business Week—May 22, 2000]

THE CASE AGAINST SINGLE-STOCK FUTURES

Commentary By Joseph Weber

As if trading stocks wasn’t wild enough these days, the folks at the Chicago Mercantile Exchange and the Chicago Board of Trade want to give investors a chance

to take a real roller-coaster ride. Exchange officials are teaming up with friendly

legislators in Congress to revive an idea that some regulators in Washington

thought they had buried 18 years ago—futures contracts on individual stocks. ‘‘We

have all the necessary safeguards in 131ace to be able to trade single-stock futures,

and we see no reason why we shouldn’t be able to,’’ argues Scott Gordon, chairman

of the board of the Chicago Merc. ‘‘The public interest would be served.’’

And that may be so. But in fact, a strong argument can be made that single-stock

futures are a financial vehicle whose time has most definitely not come. While they

surely would be useful to institutional investors and a handful of speculators, they

pose a risk to small investors—and may even encourage stock manipulation.

To be sure, futures contracts have an honored place in the panoply of financial

instruments. They can be found for everything from Treasury bonds to pork bellies.

They are widely used as hedges against adverse price moves and are also popular

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speculations. In theory, both speculators and hedgers could make good use of singlestock futures. By selling futures contracts, money managers could hedge their portfolios against stock drops. By buying them, they could bet on stock-price rises when

they don’t want to—or can’t—commit immediately to the purchase of certain stocks.

True, you can do this already with options. But a futures contract would be cheaper than an option because it wouldn’t include a premium, as an option does. ‘‘We

want the widest possible array of choices,’’ says William P. Miller II, a Chicago Mercantile Exchange director who chairs the End Users of Derivatives Council for the

12,000-member Association for Financial Professionals.

But that cheapness comes at a cost. For one thing, the futures market is a

veritable lion’s den of risk, particularly for small investors, who can put up just

modest amounts of money and either win or, more often, lose big. If investors bet

wrong with options, their loss is capped at the premium they paid to buy them; with

futures, the potential loss is open-ended. To play the futures market, an investor

need put up as little as 5% of the value of a common futures contract—vs. the 50%

margin required for stocks. What’s more, futures players don’t have the same regulatory protections that investors in the stock market take for granted, such as comparable insider-trading rules. There is no prohibition of insider trading in the Commodity Exchange Act.

And fears abound that the high leverage connected with futures could tempt

would-be stock manipulators. An April report on single-stock futures by the General

Accounting Office warns that ‘‘even a small price movement in the underlying stock

could encourage attempts to manipulate stock prices.’’ Ordinarily, futures contracts

are far more volatile than the spot prices of the underlying securities. Thus, a

scamster could make large sums of money in futures by engineering even small

moves in the underlying stock. What’s more, there’s a potential feedback loop: If

they became popular, the futures ‘‘could spawn great volatility in stocks,’’ warns

Bruce I. Jacobs, a portfolio manager at Jacobs Levy Equity Management who has

written a book about derivatives and stock market crashes.

Because such issues have never been resolved, futures on single stocks have been

in limbo for nearly two decades. In 1981, the Securities & Exchange Commission

and the Commodity Futures Trading Commission promised to study all the issues

surrounding the idea. Meanwhile, they imposed a ‘‘temporary’’ ban. Now, the idea

has reared its head again.

And it has a real chance at success because of domestic and foreign competitive

concerns, such as the emergence of single-stock futures abroad and similar investment devices in the U.S., as well as the growth of electronic-trading technology, and

a good old-fashioned wish to end regulation. ‘‘We do have the stars aligned,’’ says

Senator Phil Gramm (R-Tex.), chairman of the Senate Banking Committee, who

held a hearing on the Shad-Johnson Accord and markets regulation on May 8 in

Chicago. Gramm and Senate Agriculture Committee Chairman Richard G. Lugar

(R-Ind.) plan to introduce a bill to legalize stork futures. They may tie the move to

reauthorization of the Commodity Exchange Act, which empowers the CFTC, and

which expires on Sept. 30.

Regulators have given the idea a mixed response. SEC Chairman Arthur Levitt

Jr. and CFTC Chairman William J. Rainer are still haggling over just how the new

products would be overseen. Rival markets are hardly enthusiastic. And no wonder—futures could pose a competitive threat. The head of the Mere’s archrival in

the Loop, William J. Brodsky of the Chicago Board Options Exchange, says singlestock futures must be treated the same as stocks—with the same aggressive SEC

oversight and stiffer margin requirements—or they ‘‘would worsen the competitive

inequities’’ among exchanges. CFTC Chief Rainer says the required margin would

be somewhere between the 50% minimum required for stocks and the 5% to 10%

generally required for commodity futures contracts.

Single-stock futures face an even more fundamental question: Is Congress rushing

to approve a product of limited appeal? The answer to that may well be yes. Singlestock futures are already offered on about nine European and Asian exchanges—

and they’ve proved to be anything but barnburners. They account for less than 1%

of the total trading volume of the foreign futures markets. ‘‘The anecdotal evidence

is that the marketplace doesn’t want these things,’’ adds Robert E. Whaley, a professor of finance at Duke University’s J.B. Fuqua School of Business. Similar products are already available in the U.S., but they, too, command fairly small

followings. On the over-the-counter market, for instance, financial professionals can

buy equity swaps. But these account for only a fraction of the value of OTC derivatives trading, says the GAO.

Certainly, single-stock futures contracts will be easier to understand than these

jury-rigged instruments. And that could raise a problem: They would also be simpler

to market to unsophisticated investors, who usually wind up behind the eight ball

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when they trade futures. ‘‘The vast majority of small investors in futures trading—

commodity futures—ultimately come out losing money,’’ warns John F. Marshall, a

professor of finance at St. John’s University. It is, in his view, ‘‘a zero-sum game.’’

Zero-sum or not, this new game has powerful friends on Capitol Hill, and that

alone means that single-stock futures may well be on the horizon. If they do not

turn out to be a flop, as they were overseas, their potential for abuse could make

them a risky innovation. Small investors may pay the price for the Street’s latest

big idea.

NEW YORK STOCK EXCHANGE

June 27, 2000

The Honorable TOM BLILEY

Chairman

Committee on Commerce

2125 Rayburn House Office Building

Washington, DC 20515

DEAR MR. CHAIRMAN: I am writing to share the views of the New York Stock Exchange, Inc. (NYSE) on H.R. 4541, the Commodities Futures Modernization Act of

2000. The NYSE is interested in two aspects of this important legislation—repeal

of the Shad-Johnson Accord and legal certainty for equity swaps. While we commend Chairman Tom Ewing of the Risk Management Subcommittee of the House

Agriculture Committee for his tireless efforts with regard to Commodity Futures

Trading Commission (CFTC) reauthorization, we are compelled to oppose H.R. 4541,

as reported by the Agriculture Committee.

Single Stock Futures

The NYSE agrees with the President’s Working Group on Financial Markets that

the ‘‘current prohibition on single stock futures can be repealed if issues about the

integrity of the underlying securities markets and regulatory arbitrage are resolved.’’ Over-the-Counter Derivatives Markets and the Commodity Exchange Act,

page 32 (1999)(emphasis added). Unfortunately, H.R. 4541 does not adequately address the issues raised by the Working Group.

For the last six months, the Securities and Exchange Commission (SEC) and the

Commodity Futures Trading Commission (CFTC), the two agencies with the expertise to address this complex issue, have been working diligently to develop a joint

regulatory framework applicable to single stock futures. Much progress has been

made. However, difficult issues remain to be resolved.

It is vital that regulatory issues relating to the SEC’s ability to adequately enforce

the insider trading and other anti-fraud laws, and to protect retail investors be resolved properly in the first instance. If the right balance is not struck, single stock

futures entail a high risk of great harm to retail investors and confidence in the

U.S. securities markets. The United States stock market is unique in the world because of its enormous size and its high level of individual investor protection. Today,

more than 70 million Americans participate in the stock market. Individuals and

institutions are willing to invest in the U.S. stock market because they believe in

the integrity of the market. Investor confidence is fragile. Once lost, it can be extremely difficult to regain.

H.R. 4541’s approach to single stock futures falls short in a number of important

areas. The SEC’s authority to enforce securities laws regarding insider trading, manipulation and fraud is too circumscribed and would leave the SEC unable to fully

protect retail investors and market integrity.

Further, the SEC must have the authority to inspect the surveillance programs

of futures exchanges that trade single stock futures because without direct access

to audit trail, coordinated market surveillance and inspection authority, the grant

of enforcement authority to the SEC is illusory. The SEC does not have the resources to detect and deter insider trading and other violations of the securities

laws alone. It depends on the surveillance programs of self-regulatory organizations

(SROs), i.e., the securities markets, to augment its efforts. The SEC regularly inspects the surveillance programs of the SROs to ensure that they are adequate. The

SEC must have the same authority with regard to futures exchange surveillance

programs applicable to single stock futures.

H.R. 4541 also provides that the SEC can obtain information from futures exchanges only with the permission of the CFTC. This subordinate role for the SEC

is unacceptable. To fully discharge its responsibilities under H.R. 4541, the SEC

must have the unfettered ability to obtain the information that it needs.

H.R. 4541 requires that margin levels for single stock futures be consistent with

the margin on comparable options listed on a securities exchange. Further work to

9

harmonize margins needs to be done. In determining whether margins are consistent, all rules governing margin, including the penalties for violating margin

rules, must be consistent. H.R. 4541 would permit the Federal Reserve Board to delegate its margin oversight authority to the CFTC alone. In the NYSE’s view, the

Fed should delegate its margin authority, not to the CFTC, but to the Intermarket

Margin Board described in H.R. 4541. This Board would consist of the Fed, SEC

and CFTC. Otherwise, margins on single stock futures, even if consistent at the outset, will not remain consistent with margins on stock options over time.

H.R. 4541’s recognition that a suitability rule must apply to single stock futures

is positive. However, the bill should mandate that such a suitability rule should be

at least as stringent as suitability rules applicable to stock options. Also, the fact

that suitability is a continuing requirement over the life of an account needs to be

clarified.

Finally, the provisions of H.R. 4541 are anti-competitive. H.R. 4541 provides that

single stock futures can only be traded on a futures exchange. Securities exchanges

should have the ability to trade this product as well. H.R. 4541 also fails to extend

the Section 31 transaction fee to single stock futures. This fee is applied to all stock

and stock options sales. Single stock futures will be direct substitutes for these products. Competitive fairness requires that single stock futures also be subject to this

transaction fee.

Legal Certainty for Equity Swaps

The NYSE’s interest in legal certainty for over-the-counter derivatives is limited

to equity swaps based on single stocks and narrow-based indexes. The NYSE is concerned about the legal status of these products because they are so closely linked

to out own market.

The NYSE supports legal certainty for equity swaps. However, we believe that exclusion from the CEA for equity swaps needs to be coupled with Congressional recognition that this type of OTC derivative is a security. Only by making it clear that

equity swaps are subject, at least, to certain investor protection provisions of the

securities laws can Congress and regulators assure that such products will not be

used to circumvent the insider trading, fraud and manipulation prohibitions of those

laws. It is also important that the proper margin, capital and sales practice standards apply to these instruments, and that they be integrated into the surveillance

systems currently applicable to equities and all other equity-based derivatives. H.R.

4541 falls to clarify that equity swaps are securities. Without this clarification, we

are concerned that the equity swap market may develop only for regulatory arbitrage, not to meet the legitimate risk management needs of investors.

The President’s Working Group recommended that an exclusion from the CEA for

OTC derivatives should only cover swaps between eligible swaps participants. The

Working Group agreed that consideration should be given to restricting the extent

to which individuals qualify for the exclusion by not making it available to natural

persons who own and invest, on a discretionary basis, less than $25 million in investments. H.R. 4541 defines eligible participant to include individuals with $10

million in total assets. This threshold would encompass a large number of individual

investors, and make it all the more pressing for Congress to clarify that excluded

equity swaps are securities. Without such clarification, these individual investors

would not have the benefit of the customer protections that all other individual investors in securities currently enjoy.

Thank you for considering the NYSE’s concerns about H.R. 4541. We look forward

to working with you and the Committee to address these issues.

Sincerely yours,

RICHARD A. GRASSO

Chairman and Chief Executive Officer

cc: Congressman John Dingell

Congressman Mike Oxley

Congressman Ed Towns

MEMORANDUM

TO: David Cavicke, Consuela Washington

FROM: The U.S. Securities Markets Coalition

RE: H.R. 4541 and Stock Futures

DATE: July 11, 2000

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1The members of the U.S. Securities Markets Coalition are the American Stock Exchange,

the Boston Stock Exchange, the Chicago Board Options Exchange, the Chicago Stock Exchange,

the Cincinnati Stock Exchange, The Depository Trust Clearing Corporation, the National Association of Securities Dealers, the Pacific Exchange, the Philadelphia Stock Exchange, and The

Options Clearing Corporation. 2Most of the attention in this controversy has been focused upon the regulation of trading

stock futures. Regulation of those that give investment advice with respect to stock futures and

the regulation of managed pools of stock futures outside of the established securities framework

raise a host of additional investor protection and competitive issues that have yet to be fully

considered.

This memo serves to provide comment from the U.S. Securities Markets Coalition 1 on H.R. 4541, particularly those aspects of the bill that would permit the trading of stock futures.

Stock futures will act as surrogates for stocks and stock options. They will trade

on public marketplaces, be.marketed to retail investors, become part of the price discovery process for stocks and derivatives based on stocks, and, unfortunately, be

used in schemes perpetrated by stock manipulators and scamsters. We therefore

find it quite unsettling that H.R. 4541, for the most part, rejects the notion of applying the securities laws framework to these products. Instead, it applies the commodities laws to these products and charges the CFTC to oversee them. The commodities laws are not designed to address retail trading of a stock-based product. Moreover, the CFTC, whose role in supervising the futures markets will be greatly reduced if H.R. 4541 were passed, has little experience in retail stock-based financial

product regulation. While the bill provides the SEC certain limited authority to

apply a handful of securities laws to stock futures, a number of important statutory

protections have been omitted. Moreover, SEC authority would be limited to mere

‘‘enforcement’’ authority. It would not, for example, have authority to conduct oversight examinations of futures exchanges or exercise its rulemaking authority to

adopt standards that would deter fraud and manipulation.

As acknowledged by the President’s Working Group, the issue of how to regulate

stock futures presents not only market integrity issues but also important regulatory arbitrage issues. Some of these arbitrage issues relate primarily to core investor protection concerns, such as how to address insider trading issues. Other issues,

arising from the similarity between stock futures, stock, and stock options, relate

primarily to fair competition concerns. Most of the issues involve a combination of

both concerns.

We remain stalwart in our view that the most effective and fairest approach is

to treat stock futures as securities. It is the only way to ensure that the panoply

of securities laws protections apply to a product that is security in all but technical

name.2 It is also the only way to ensure that the regulation of stock futures is consistent with the regulation of stocks and stock options. As a next best alternative,

we believe some form of joint SEC/CFTC regulation of stock futures could be possible, provided stock futures are treated as securities but are exempted from securities regulations where commodities regulation better serves the investing public.

The approach of the Ewing bill, to define stock futures as futures, then engraft several securities laws provisions onto the futures regulatory scheme, is the least favored approach, and the one that presents the greatest erosion of investor and market protections. It is also the approach that produces the greatest potential for competitive inequalities between futures and securities. We have identified below certain essential fixes to the most glaring deficiencies of the Ewing bill. Our points follow:

• Stock futures, including those that settle in stock, should be allowed to trade on

securities exchanges. The Ewing bill restricts the trading of stock futures to futures exchanges. S. 2697, by comparison, allows cash-settled stock futures to

trade both on futures exchanges and securities exchanges. The CFTC did not

object to the provisions of S. 2697 that would allow stock futures to trade on

securities exchanges. Allowing stock futures to trade on securities exchanges

can be accomplished by defining stock futures as securities under the securities

laws and deleting the exclusive jurisdiction provisions of the CEA. The exclusive

jurisdiction provisions of the CEA are anticompetitive. In addition to creating

legal certainty problems for swaps, these provisions have allowed the CFTC and

futures exchanges to block securities exchanges from offering a number of securities derivatives products, including certain securities hybrids and index participations. At the very least, however, any compromise that allows stock futures to trade on other than a securities exchange should allow this ‘‘new’’ product to trade both on securities and futures markets.

11

• If stock futures are permitted to trade under the CEA, then securities exchanges

should be allowed to trade futures on all financial instruments. The current bill

represents the futures exchanges’ view of how stock futures should be allowed

to trade—subject to a monopoly on their markets. If Congress is going to consider scrapping traditional jurisdictional boundaries for financial products, fairness dictates that the securities exchanges be provided with an adequate opportunity to make the case for being able to trade financial futures. This is also

consistent with Congressman Ewing’s stated view that H.R. 4541 should reflect

a comprehensive regulatory reform package. • Margin treatment must be ‘‘truly’’ equal between securities (particularly options)

and futures markets. The Ewing bill, notwithstanding its basic call for ‘‘consistent’’ margin levels between stock futures and stock options, does not create

a mechanism that will ensure this result. The Ewing bill would provide a tremendous amount of leeway and ambiguity in determining stock futures margin

levels. Its standards for consistent treatment are too loose and would allow separate regulators to arrive at significantly different margin levels. For example,

the CFTC would be able to decide stock futures margin levels and the SEC

would determine stock option margin levels. How can equal treatment be assured where separate regulators are applying an elastic standard? Even if the

margin board (Fed, SEC, and CFTC) were used as permitted, the Fed, in turn,

would be able to delegate the ultimate setting of margin levels back to the

CFTC and SEC, respectively. The bill also does not contain a legislative mandate for the Fed to ensure that the margin levels across securities and futures

markets are equal from a competitive perspective. Nor does the bill address important margin issues apart from margin levels, including who customer margin

levels should apply to, permitted margin offsets, and acceptable forms of collateral. For these reasons, we believe either the SEC or the Fed should singly determine margin policy for stock, stock options, and stock futures. If an intermarket margin board is used, once the board arrives at a margin policy it

should be the responsibility of the SEC to oversee and administer its implementation across all markets. • Stock futures must be subject to a sales practice program that is equivalent with

that which applies to stock options. The Ewing bill only requires the NFA to

adopt a suitability rule that is similar to the suitability rule currently applied

to exchange-listed options. Merely adopting such a rule does not ensure that

stock futures sales practices will be adequate, much less comparable to the high

standards established by the securities markets. For example, as you know, the

NASD administers a comprehensive sales practice program that applies to

stocks and stock options. Also, related issues such as disclosure (i.e, equivalent

of an Options Disclosure) and product advertising must be addressed. The SEC

should be provided broad rulemaking authority for sales practices across all

public markets for stock, stock options and stock futures products.

• The legislation must mandate a regulatory framework that will ensure futures exchanges trading stock futures adequately surveil their markets for market

abuses and share such information with other futures and securities exchanges.

Given that stock futures transactions will directly impact stock pricing and likely be used as part of stock fraud and stock manipulation strategies, the SEC

should be given authority to oversee the market surveillance programs of stock

futures markets. Related to this point, stock futures markets should be required

to maintain a real-time consolidated audit trail. While an audit trail requirement is contained in S. 2697, it is not made subject to SEC oversight and rulemaking. Congress should define the basic principles of such an audit trail and

provide the SEC with authority to oversee its operation.

• Full anti-fraud anti-manipulation authority of federal securities laws should apply

to stock futures. The Ewing bill only extends to stock futures a small fraction

of the anti-fraud and anti-manipulation provisions contained under the federal

securities laws. In addition, it does not provide the SEC with rulemaking and

exchange oversight authority, which are necessary to ensure that appropriate

market conduct is adequately defined and enforced.

• Stock futures must be traded in an environment that permits and fosters multiple

trading and adherence to best execution of customer orders. National Market

System principles, including the establishment of market linkages, the availability of realtime quote and trade information, and assuring the practicability

of brokers being able to execute investors’ orders in the best market must apply

to these instruments. The SEC has significant experience in this area. On the

other hand, the CFTC has little or no experience in applying these principles.

Moreover, application of these principles should be consistent with those applied

to securities markets. Accordingly, we believe the SEC should be vested with

12

the authority to apply NMS principles to stock futures, as it does to stocks and

stock options.

• Some form of centralized or linked clearing should be mandated for stock futures.

This is necessary to promote competition in stock futures across markets for

stock futures. For example, centralized clearing would help to ensure that positions opened on one exchange could be closed on another exchange.

• Tax treatment of stock futures must be made consistent with that which applies

to stock options. Unless the tax laws are changed, customer transactions in

stock futures (traded on either a futures exchange or securities exchange) would

be subject to favorable ‘‘60/40’’ treatment. Essentially, this means that customers of exchange-traded equity options would be subject to a higher tax rate

than customers of stock futures. This violates a longstanding congressional policy of providing equivalent tax treatment for competing products on the options

and futures exchanges. The disparity can be addressed either by extending 60/

40 tax treatment to equity options or denying 60/40 tax treatment to stock futures. The implementation of any stock futures legislation could also be made

contingent on achieving tax parity between stock options and stock futures.

• Section 31 fees should apply to stock futures. Imposing this fee on securities markets but not on futures markets would provide an unfair competitive advantage

to the futures exchanges. In addition, given that the Ewing bill essentially provides that the SEC shall police the stock futures markets against insider trading and enforce the handful of several other enumerated securities protections,

it seems appropriate that the futures markets help fund the SEC budget. Applying Section 31 fees would be appropriate in this regard.

• Unless equivalence of regulation between stock futures and other securities products can be assured, the securities exchanges would need certain regulatory relief in order to remain competitive. For example, the exchanges would need to

be freed from procedural requirements, such as SRO rule filings, that can cause

significant delays and roadblocks to changing business practices and creating

new products. Essentially, securities exchanges would be facing direct competitors operating in a deregulated environment (especially when compared to today’s securities exchange markets). They would need to be able act quickly to

respond to changing market conditions.

• There are numerous provisions in the Ewing bill that can be construed to expand

CFTC jurisdiction over instruments that are securities. For example, new Section 2(c)(2) on pages 18-19 gives the CFTC jurisdiction over options on a commodity (other than foreign currency or a security) traded on an organized exchange. The parenthetical does not include all securities options, specifically options on a group or index of securities. Second, the bill creates an entity under

CFTC jurisdiction called a derivatives transaction execution facility (‘‘DTEF’’)

which is a less-regulated version of a board of trade. New Section 5a(e) would

allow a DTEF to trade contracts or transactions involving excluded commodities

that would otherwise be excluded from the CEA under H.R. 4541. These excluded contracts or transactions would include many securities, such as government securities options, stock options, etc. The bill should be fixed to prohibit

a DTEF from trading any instruments excluded from the CEA. There are other

places in the bill that might impinge on SEC jurisdiction. The SEC and Commerce Committee should carefully review the bill and identify provisions that

affect the regulatory jurisdiction of the SEC.

• We will separately provide a line-by-line set of comments on the Ewing bill shortly.

Mr. DINGELL. I agree with many of their comments. I also ask

to include in the record a copy of the February 9, 2000 letter that

Mr. Towns, Mr. Markey and I sent to the SEC setting forth questions that we believed had to be satisfactorily addressed on this

matter. I would observe that the bill before us does not meet any

of the tests that we set forth for a good bill.

[The letter follows:]

13

U.S. HOUSE OF REPRESENTATIVES

COMMITTEE ON COMMERCE

February 9, 2000

The Honorable ARTHUR LEVITT

Chairman

Securities and Exchange Commission

450 5th Street, NW.

Washington, D.C. 20545

DEAR MR. CHAIRMAN: We are writing concerning the recommendations regarding

single stock futures that were made in the November 9, 1999, Report of the President’s Working Group on Financial Markets, entitled Over-the-Counter Derivatives

Markets and the Commodity Exchange Act.

As you will recall, the principal focus of the aforementioned report was to address

legal uncertainty and unnecessary regulatory burden questions arising from the

treatment of over-the-counter (‘‘OTC’’) derivatives under the Commodity Exchange

Act (‘‘CEA’’). The Working Group made recommendations with respect to broadening

the swaps exemption from futures regulation under the CEA, excluding certain electronic trading systems for swaps from CEA regulation, promoting development of

clearing systems for OTC derivatives, and providing authority to exempt certain exchange-traded derivatives from CFTC regulation. While we have a number of questions and concerns about these recommendations, we are writing you today to request information and assistance in understanding the far-reaching implications of

the Working Group’s recommendation regarding single stock futures.

The report states at page 32, in a section on Other Issues, that: ‘‘The Working

Group members agree that the current prohibitions on single-stock futures can be

repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved.’’ The report then goes on to note that:

‘‘From the perspective of the securities laws, the issues raised by trading of

single-stock futures include levels of margin, insider trading, sales practices,

real-time trade reporting, and activities of floor brokers, as well as the exclusive

jurisdiction of the CFTC over futures contract markets. From the perspective

of the commodity futures laws, the issues raised by these instruments include

clearing, segregation, large trader reporting, and direct surveillance.’’

The Working Group unanimously recommended that the SEC and the CFTC

‘‘work together and with Congress to determine whether the trading of single-stock

futures should be permitted and if so, under what conditions.’’ (emphasis added)

In light of the highly qualified and conditional natural of the Working Group’s

recommendation in this area, and the enormous complexities involved in satisfactorily resolving all of the issues raised by trading of single-stock futures, we note

with some concern the recent request by our colleagues, Representatives Combest,

Ewing, Bliley, and Stenholm, for the SEC and the CFTC to ‘‘create and present to

Congress a detailed legislative plan for repealing the current prohibition on single

stock futures’’ no later than February 21, 2000 so that ‘‘it may aid us as we consider

reauthorization of the Commodity Exchange Act this session.’’

This request appears to presume that all of the issues that were identified by the

Working Group regarding the integrity of the underlying securities market and regulatory arbitrage either are unimportant or can be successfully resolved in a short

period of time. We are not at all certain that these issues can be resolved consistent

with the public interest, the protection of investors, and the maintenance of fair and

orderly markets, especially if done in haste and within the confines of a regulatory

structure that bifurcates regulatory authority over certain financial derivatives between the SEC and the CFTC. As the Commission considers this matter, we believe

it absolutely imperative that the integrity of our nation’s securities markets and the

protections afforded to investors in these markets not be undermined in any way.

Accordingly, we respectfully request, before the Commission submits any detailed

legislative proposals to Congress relating to this matter, that it satisfactorily address the questions enclosed with this letter.

Thank you for your assistance and cooperation in responding to this inquiry.

Should you need additional information about this request, please have your staff

14

contact Mr. Jeffrey S. Duncan (Rep. Markey) at 202-225-2836 or Ms. Consuela

Washington (Rep. Dingell) at 202-225-3641.

Sincerely,

JOHN D. DINGELL,

Ranking Member, Committee on Commerce

EDWARD J. MARKEY

Ranking Member, Telecommunications, Trade and Consumer Protection

Subcommittee

EDOLPHUS TOWNS

Ranking Member, Finance and Hazardous Materials Subcommittee

cc: The Honorable Tom Bliley

The Honorable Michael G. Oxley

The Honorable Larry Combest

The Honorable Thomas W. Ewing

The Honorable Charles W. Stenholm

Enclosure

QUESTIONS FOR THE HONORABLE ARTHUR LEVITT, CHAIRMAN, SECURITIES AND

EXCHANGE COMMISSION

February 9, 2000

1. Single stock and narrow-based stock index futures (as well as options on those

products) would function as very close substitutes for stocks and stock options.

Would the availability of these products pursuant to a regulatory scheme that does

not contain all of the protections afforded under the federal securities. laws undermine the policy objectives of such laws?

2. If single stock and narrow-based stock index futures (as well as options on

those products) were to be permitted and regulated other than as securities, how

would the SEC be able to protect and ensure the integrity of the underlying securities?

3. Would the futures markets become the price discovery market for stocks? If so,

what protections should be in place to ensure prices are established in fair manner?

How important is it for the SEC to be able to establish and police such protections?

4. If single stock futures (or options on such futures) were permitted, would it be

beneficial to the public to be able to trade them on multiple exchanges and overthe-counter? If so, what market linkages would need to be in place to ensure investors get the best available price?

5. Should single stock futures (or options on such futures) be subject to centralized

clearing? If not, what competitive impediments are associated with issuing and

clearing such products through other clearing mechanisms, particularly if multiple

trading is permitted?

6. If single stock and narrow-based index futures (or options on such futures) were

not regulated as securities, how would insider trading be addressed? The futures exchanges have suggested empowering the SEC with the ability to apply insider trading rules to single stock futures to the same extent as it applies those rules to options traded on a securities exchange. Do you believe this would be an effective approach? How much responsibility does exchange surveillance play in this process of

deterring and detecting insider trading? Would the SEC need to have authority to

oversee futures exchange surveillance programs to ensure that insider trading was

being adequately policed? Would the SEC need to have the authority to establish

books and records requirements in order to enforce compliance with insider trading

restrictions?

7. In addition to insider trading, how would more general market manipulations

be addressed? Frontrunning? How much responsibility does exchange surveillance

play in this process of deterring and detecting market manipulation or

frontrunning? Would the SEC need to have authority to oversee futures exchange

surveillance programs to ensure that market manipulation and frontrunning prohibitions were being adequately policed? Would the SEC need to have the authority

to establish books and records requirements in order to enforce compliance with applicable market manipulation and frontrunning restrictions?

8. What is the appropriate margin scheme that should be applicable to single

stock and narrowbased stock index futures (or options on such futures)? Should

stock and stock index futures margin levels be harmonized with those applicable to

securities products? Should a single regulator set and administer the process? The

futures exchanges have suggested that they would be willing to apply stock options

15

margin treatment to single stock futures. Would this mean a margin of 20%? Who

would approve changes to this level?

9. We understand some trading of single-stock futures has taken place on markets

outside the U.S. Have you studied the impact that trading of such products has had

on the underlying stock markets? As a general matter, how are such products regulated? Is the regulation of futures, options, and stocks subject to a single regulator

in such markets? If so, do you believe this plays a significant role in any apparent

successful oversight of such products?

10. If single stock and narrow-based stock index futures (or options on such futures) were permitted and not regulated as securities, presumably the products

would be subject to either CFTC supervision or some type of dual Jurisdiction

shared between the SEC and CFTC. Either scheme, if designed to address the numerous existing regulatory disparities between securities and futures products,

would create an additional layer of regulation on the financial services community.

Would this result in excessive compliance costs for the financial community? Is it

preferable to link consideration of reform of the Shad-Johnson Accord with broader

regulatory reform, such as merging the SEC and CFTC, and harmonizing the laws

for all stock-based exchange traded products?

11. What expertise does the CFTC have that would justify it as being considered

as the sole or primary regulator for single stock and narrow-based stock index futures contracts? There is movement to convert the CFTC into a ‘‘supervisory’’ agency. How would any such reorganization affect the CFTC’s ability to adequately oversee stock-based futures trading?

12. Exchange-listed stocks and stock options are subject to listing standards that

help to ensure that adequate information about the underlying instrument is available (i.e., in compliance with securities registration provisions) and a base level of

market liquidity is present (i.e., minimum public float and holders). What standards

should apply to single stock and narrowbased stock index futures (or options on

such futures)?

13. What audit trail requirements should be applicable to single stock and narrow-based stock index futures (or options on such futures)? Should the futures exchanges be required to implement audit trails as precise and extensive as in the securities markets?

14. What securities market transparency provisions, such as quote dissemination

and transaction reporting requirements, should apply to single-stock and narrowbased index futures (or options on such futures)?

15. Narrow-based stock index futures are currently banned along with single stock

futures because they can act as surrogates for futures on individual securities. Do

you believe that any relaxation of the current ban on narrow-based stock index futures would undermine the policy objectives of the Shad-Johnson Accord?

16. Should consideration of modifying the Shad-Johnson Accord be linked with

consideration of whether the exclusive jurisdiction clause of the CEA should be removed? Would removal of the exclusive jurisdiction clause pave the way for securities exchanges to offer futures or futures-like products, such as index participations

and zero-strike options?

17. What is the appropriate disclosure regime for single stock and narrow-based

stock index futures (or options on such futures)? For example, should an equivalent

of the Options Disclosure Document apply? Should there exist enhanced risk disclosure requirements for stock futures as is required for penny stocks and day traders?

For uncovered options writing?

18. What regulatory requirements should apply to single stock futures (or options

on such futures) to address their possible use in connection with obtaining control

of publicly traded companies? For example, should Regulation 13D of the Exchange

Act or an equivalent provision apply to these products?

19. What regulatory requirements should apply to single stock futures to address

their use by entities engaged in distributing securities related to the futures products? For example, should Regulation M of the Exchange Act or an equivalent provision apply to these products?

20. The best execution standards applicable to securities brokers serve an important investor protection function in the equities and options markets. We are not

aware of any similar standards applicable in the futures markets. If single stock futures (or options on such futures) were traded on multiple markets, do you agree

that best execution standards would be critical to the fair operation of those markets? If such standards were applicable, how would they work, particularly if certain

key market transparency measures, such as real time quote availability (with size)

and market linkages, were not available?

21. Heightened sales practice and suitability requirements apply to securities options transactions. We are not aware of the existence of similar standards in the

16

futures markets. Do you believe such heightened standards should apply to single

stock and narrow-based stock index futures (or options on such futures)? What

would be the results if they did not apply?

22. Should the short swing profit restrictions contained in Section 16 of the Exchange Act apply to single stock futures (or options on such futures)? What would

be the results if they did not apply?

23. Assuming insider trading and other anti-manipulation provisions were applied

to single stock futures, how would issuer repurchase transactions through the use

of futures be addressed? Would an equivalent of Exchange Act Rule 10b-18 be warranted or necessary?

24. If single stock and narrow-based stock index futures (or options on such futures) were traded on futures exchanges, would additional intermarket coordination

mechanisms be necessary? For example, would trading halt policies need to be synchronized? Who would mandate and oversee this process? Would surveillance monitoring programs need to be coordinated? What regulator would oversee this process?

25. In addition to the disparities that exist between securities and futures products with regard to policies designed to protect the market and investors, a number

of competitive disparities also exist that might place securities markets in an unfavorable position vis-a`

-vis the futures markets unless addressed. For example, favorable ‘‘60/40’’ capital gains treatment is available to all futures products; however tax

code changes would need to be made to broadly extend such treatment to securities

markets. Also, securities markets are subject to Section 31 transaction fees. There

exists no equivalent under the futures regime. Should these and other competitive

disparities be fully addressed in connection with any revisit of the Shad Johnson

Accord?

26. Section 11A of the Exchange Act requires the securities markets to consolidate

last sale prices and quotations and make the data available on a real-time basis.

The CEA does not contain a similar requirement. If this situation persists and multiple futures markets trade single stock futures (or options on such futures), it

would be difficult for equity investors to accurately ascertain the price of any particular stock futures contract during the trading day. As part of any plan to permit

single stock futures, would it be desirable to require the futures markets to consolidate market data and make it available to all investors?

27. If single stock and narrow-based stock index futures are permitted, should the

regulation of all securities and securities-based derivatives be consolidated under

one regulator? How can the Shad-Johnson prohibition be lifted unless the SEC and

CFTC are merged?

28. The ability of investors to recover damages under the federal securities laws

exists for cases involving manipulation and fraud (as well as insider trading) associated with the purchase or sale of securities. Are identical protections afforded to investors under the commodities laws with regard to manipulation and fraud? If not,

should investors in single stock and narrow-based stock index futures (or options on

such futures) be afforded such protections?

29. The securities options exchanges maintain rules imposing limits on the aggregate number of options contracts that a member or customer may hold or exercise.

These rules are intended at least in part to prevent the establishment of options

positions that can be used to manipulate or disrupt the underlying market so as to

benefit the options position. Should similar limits be applied to single-stock and narrow-based stock index futures? Who would approve and oversee the enforcement of

such limits? Should any changes be coordinated between securities and futures markets?

30. The futures exchanges have informally suggested ways of addressing margin

and insider trading concerns associated with permitting stock index futures (or options on such futures). What are the complexities and limitations with their approach? Of course, margin and insider trading are but two of many protections afforded under the federal securities laws. How would these other protections be replicated for single stock and narrow-based stock index futures? If not replicated,

would the absence of such protections invite regulatory arbitrage, thereby undermining the federal securities laws?

31. Large trader reporting is a key requirement of the CEA. Large trader reports

are the linchpin of the CFTC’s and futures markets’ surveillance systems. The Government Securities Market Reform Act of 1993 gave the Treasury large position reporting authority for the Treasury securities markets, which it uses to monitor trading in Treasury bills, notes, and bonds. The Market Reform Act of 1990 gave the

SEC the authority to implement a large trader reporting system, but the SEC has

failed to do so. The trading of single stock futures would make the connections between the equities and futures markets even closer than they are today. Given this

close connection and the importance of large trader reporting system in preventing

17

futures markets manipulations, shouldn’t a large trader reporting system on the equities markets be a necessary precondition to permitting single stock futures?

32. If single stock and narrow-based index futures (or options on such futures)

were permitted, would-the SEC have adequate resources to police this additional

market for insider trading, market manipulation, frontrunning, or other abuses? If

not, please provide an estimate of what additional resources and personnel would

be needed?

Mr. DINGELL. Mr. Chairman, I am highly skeptical about the

wisdom of authorizing single-stock futures or futures on narrow

stock indices or narrow groups of stocks.

As the GAO warned in its April report, even a small price movement in the underlying stock could encourage attempts to manipulate stock prices. I would note to you at this time, Mr. Chairman,

that there is growing concern about the efforts of organized crime

to penetrate and to manipulate the markets. This certainly will assist that group in their nefarious attempts.

I would note that futures are a highly leveraged zero sum game.

A lot of people are going to get burned in this, and trust in the

market as well as volatility are going to be moved into dangerous

levels and dangerous areas. The stock markets have been the envy

of the world in this country, and they will be reduced to a commodity with futures markets being the price discovery point. This

concerns me. Nevertheless, if it is the judgment of my colleagues

that we should authorize these ill-advised instruments, it is absolutely imperative that the integrity of the Nation’s securities markets and the protections afforded investors not be undermined in

any way. At a minimum, we need to provide protections substantially similar to those that we have applied with respect to options

on stocks and narrow indices.

In closing, I want to assure my colleagues that I approach this

issue with an open mind given the general sorry character of the

legislation. I have a measure of skepticism about the merit of the

bill. I am happy to work with you to try to write a good bill. Barring that, I am committed to using this turkey for target practice.

I would observe that there is much that can be done to improve

this bill. Perhaps the best thing to do is kill it, but I am willing

to try to make a silk purse out of a sow’s ear if that is the wish

of the committee. I yield back the balance of my time.

Mr. OXLEY. The gentleman yields back. The gentlewoman from

New Mexico, Ms. Wilson.

Mrs. WILSON. I will enter any statement for the record.

Mr. OXLEY. Bless you.

Dr. Ganske.

Mr. GANSKE. Thank you, Mr. Chairman. I am looking forward to

the testimony today. This is how I see this issue now. If an investor

who owns stock in a company worth $50 a share and is worried

about a price drop so he can sell a futures contract, if the stock

dropped below $50 at a specified date, the contract’s purchaser

must either take delivery on the stock at $50 a share or pay the

investor the difference per share. If the stock climbs above $50 by

the specified date, the investor pays $50 per share to the contract’s

purchaser who profits from the rise in value.

I must say, Mr. Chairman, I haven’t had a single constituent

write me or phone me on this issue so I wonder why this is coming

up. What concerns me about this is the margin requirement for a

18

stock is 50 percent, while the requirement for a futures contract is

5 percent. I am worried that the introduction of single-stock futures

will increase speculation on individual issues.

This was something that was a problem back in 1929, and it

looks to me like the basic idea is back. The futures markets want

to trade single-stock futures which in economic terms are virtually

identical to stocks, and I think this enters a lot of volatility and

speculation into a market which already may have a lot of speculation and when investors like Warren Buffett, who lives on the edge

of my district, are having a hard time figuring out what the proper

valuation of a stock price is, I wonder whether the little guy is

going to have problems on that, too. So I will be looking forward

to your testimony today. I thank you.

Mr. OXLEY. The gentleman yields back. The gentleman from

Michigan, Mr. Stupak.

Mr. STUPAK. Thank you, Mr. Chairman. The piece of legislation

that we are examining today has potential to have a large impact

on our securities market. While there are portions of this bill which

will bring certainty to our financial markets, I have concern about

ending the prohibition on single-stock futures. This committee has

long ensured that the Nation’s securities market were fair to and

protected investors. While we have long understood that investors

and the securities market undertook risk and unlike bank deposits

were subject to the uncertainty of the market, we have always

made sure that the market was fair. We wisely banned insider

trading, created the Securities and Exchange Commission to police

unfair dealing, and we required that brokers sell products to investors only if suitable for that investor’s profile.

H.R. 4541 would allow for the trading of a new financial product,

a future based on a single stock. Like options, the value of the future would be directly related to the underlying exchange-traded

security. Like options, these products would affect the exchange

and the over-the-counter stocks owned by average retail investors.

However, unlike options in stocks, they would not be subject to the

insider trading prohibition. Brokers would not be held to the same

suitability standards for single-stock futures as for exchange-traded

securities. Single-stock futures would receive preferential tax treatment. They would be exempt from the SEC transaction fees. They

would have a separate margin requirement which could allow consumers to undertake dangerous levels of margin in their pursuit of

high-flying returns, only to find earth-crashing bankruptcy.

With so many retail investors in the market and with so many

already having problems with the current requirements, and with

the SEC continuing combatting stock fraud and market manipulation, with all of these events occurring, now is not the time to remove the rules on a new riskier product. Now is not the time to

return the retail investor to the Wild West, where ruthless

gunslingers live without rules while individual investors try to stay

alive.

Mr. Chairman, I am not opposed to the creation of a new financial product which may provide benefits to both institutional and

retail investors, I certainly support insuring that our financial markets continue to be the world leaders. However, allowing an exchange to sell a high-risk product to retail investors without the

19

protection of our Nation’s security laws will not improve our markets, it will harm our markets.

I look forward to this hearing and working with you to improve

this legislation to protect retail investors. I yield back the balance

of my time.

Mr. OXLEY. The gentleman yields back. The Chair recognizes Mr.

Markey.

Mr. MARKEY. Thank you, Mr. Chairman. In George Orwell’s

1984, one of the worst things you could do was to commit the offense of crime think. That was the act of even thinking bad

thoughts about Big Brother or the Party. It was a very serious offense. We are here today because Brooksley Born, the former chair

of the CFTC, committed an act of regulatory crime think. She

issued a notice to the world that the CFTC was thinking about

whether it should step up oversight for the OTC swaps market.

How shocking. How terrible. The swaps dealers went berserk. The

Fed and Treasury had conniptions. Congress passed a moratorium

on any CFTC’s consideration of Brooksley Born’s ideas and now we

are considering legislation aimed at making certain that no future

CFTC ever, ever, ever commits regulatory crime think again.

Now, those of us who served on the conference committee on the

Futures Trading Practices Act of 1992 thought we had already addressed the issue of the status of the OTC swaps under the Commodities Exchange Act. We included a provision aimed at providing

the swaps dealers legal certainty that swaps would not be regulated as futures. At the time the dealers hailed this as solving the

legal certainty problem. But now 8 years later, we are told we need

to fix the fix we made.

Now I have no objection to doing this, but it seems like a bit of

an overreaction. But more disturbingly, this bill contains a provision which would repeal the restrictions on single-stock futures.

Last year the President’s Working Group on Financial Markets

stated the Working Group members agree that the current prohibitions on single-stock futures can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved. The report goes on to note that from the perspective of the securities laws, the issues raised by trading of single-stock futures include levels of margin, inside trading, sale practices, real time trade reporting and activities of floor brokers as

well as the exclusive jurisdiction of the CFTC over futures contract

markets. From the perspective of the commodities futures laws, the

issues raised by these instruments include clearing, segregation,

large trader reporting and direct surveillance.

The Working Group unanimously recommended that the SEC

and CFTC work with Congress to determine whether the trading

of single-stock futures should be permitted and, if so, under what

conditions. In light of that highly qualified and conditional Working

Group recommendation in this area and the enormous complexities

involved in satisfactorily resolving all of the issues raised by the

trading of single-stock futures, I believe that this Congress is moving too quickly to approve legislation in this area. I believe it is absolutely imperative that the integrity of our Nation’s securities

markets and the protections afforded to investors in these markets

not be undermined in any way. Accordingly, I believe we must eiVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
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ther transfer jurisdiction over stock index and single-stock futures

to the SEC, or delete the bill’s provisions allowing for single-stock

futures.

I yield back the balance of my time.

[Additional statement submitted for the record follows:]

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, A REPRESENTATIVE IN

CONGRESS FROM THE STATE OF LOUISIANA

Thank you Mr. Chairman.

Mr. Chairman, I will keep my remarks this morning very brief as I am eager to

hear from Chairman Arthur Levitt of the SEC, as well as from our other distinguished witnesses here today. But let me take just a moment to frame the main

issue before us as I see it.

We are here today to discuss a bill, H.R. 4541, that attempts to do a good thing:

Modernize the Commodity Exchange Act (CEA). Modernization of the CEA, I think,

is needed considering that the ‘‘Shad-Johnson Accord,’’ which is codified in the CEA,

has left us with a great deal of legal uncertainty when it comes to regulating specific, complex financial products out there today.

Specifically, H.R. 4541, would, for the first time, permit the trading of ‘‘stock futures’’ despite that the CFTC and the SEC have never been able to reach an agreement on their respective jurisdiction over such futures as the Shad-Johnson Accord

contemplated they would.

While I am not opposed to the debut of stock futures trading on our exchanges,

I don’t believe that this bill, as reported out of the Agriculture Committee, adequately addresses the complex investor protection and competitive fairness issues

that need to be considered.

The bill as drafted does not treat stock futures as securities and does not provide

the SEC with the authority to supervise their trading. Consequently, H.R. 4541 does

not provide an appropriate regulatory framework for the trading of stock futures,

and herein lies the main problem with this bill.

Though it is an obvious point, ‘‘stocks,’’ or literally, units of equity ownership in

a corporate entity, are the most widely traded securities that we know of today. It

only stands to reason then that ‘‘stock futures’’—or agreements to buy or sell actual

SECURITIES for a fixed price, at a specified point in time—should be subject to at

least some oversight from the SECURITIES and EXCHANGE COMMISSION.

If we treat stock futures as commodities, and exempt them from the application

of the federal securities laws—as H.R. 4541 proposes to do—my fear is that these

futures will serve as surrogates for individual stocks and will be marketed to retail

investors across the country—free of basic disclosures... registration requirements... and other important investor protections that are the bedrock of securities

regulation in this country.

Now I have been a member of this Committee of sometime, and I need look no

further than our experience with H.R. 10 to realize that jurisdictional battles in the

context of financial services legislation are hard fought.

But in this case, I believe that Chairman Levitt, many members of this Subcommittee, and the vast majority of the securities industry participants probably

share my concerns about the stock futures provisions of this bill. In addition to the

SEC, the New York Stock Exchange (NYSE), the Securities Industry Assc. (SIA), the

Chicago Board of Options (CBOE), and the National Assc. of Securities Dealers

(NASD) all oppose H.R. 4541.

So, let me close by saying that I don’t think it would be wise for this Subcommittee, or this Full Committee, to adopt CEA modernization legislation without

addressing the concerns raised by these parties.

With that Mr. Chairman, I yield back the balance of my time.

Mr. OXLEY. The gentleman yields back. In deference to the distinguished Chairman of the SEC, we are going to go forward with

the hearing. The Chair will stay here and we will proceed.

Mr. LEVITT. Where has everybody gone?

Mr. OXLEY. This is a vote on the Journal. It is usually a device

of the leadership to find out how you are going to vote on a particular legislation. I prefer to keep the leadership in the dark as

far as my vote is concerned, and would rather hear from the distinVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
21

guished Chairman of the SEC. It is an honor to have you back

again to our committee and you may begin.

STATEMENT OF HON. ARTHUR LEVITT, CHAIRMAN,

SECURITIES AND EXCHANGE COMMISSION

Mr. LEVITT. Thank you very much, Chairman Oxley and thank

you for the opportunity to address this subcommittee concerning

H.R. 4541. This bill would provide legal certainty for over-thecounter derivatives and lift the ban on single-stock futures. As you

know, the Commission fully supports both of these objectives. In

some important respects, however, I firmly believe that the bill presents serious and unwarranted risks to the investing public as well

as to our securities markets.

As we consider the implications of the bill, it serves us well to

remember both the wisdom embodied in our securities regulatory

framework and the prosperity that it has fostered. Its wisdom I

think is quite simple: A recognition that protecting investors is not

just the right thing to do, but the smart thing to do; that it is investor confidence that ultimately fuels competition; that vibrant

markets rest on a foundation of integrity. I strongly believe that

the unequivocal commitment to protecting investors made by your

predecessors and mine has been critical to the success of the Nation’s securities markets.

The bill before you, consistent with the Working Group’s recommendations, goes a long way toward providing greater legal certainty for OTC derivatives by excluding certain products from the

CEA. In some important respects, however, the bill differs from the

Working Group’s recommendations. My staff and I would be glad

to go into detail and discuss with you the particulars of those differences. The bill would also lift the ban on single-stock futures

contained in the Shad-Johnson Accord. Now, I don’t have any particular interest in justifying the historical origins of the ban today.

I have made clear my view that market demand and not regulatory

fiat should determine the availability of investment vehicles. But

I do think we should squarely face the fact that single-stock futures

are an economic substitute for the underlying security. We must

not ignore the fabric of protections that retail securities investors

rely on and the confidence that these protections engender. Some

may dismiss this concern as kind of a guise for the protection of

turf. I assure you that the questions surrounding how best to ensure that regulatory disparities do not erode investor confidence

are profoundly serious and substantive.

Building upon the CFTC’s acknowledgment that we should jointly regulate these products, the SEC staff has crafted a plan under

which these products can trade. In my judgment, an enduring regulatory framework must have a number of salient elements. First,

single-stock futures are undeniably a proxy for stocks and stock options. Thus, the framework must recognize the legitimate interests

of both the SEC and the CFTC in determining how best to regulate

these products.

Second, the framework must encourage fair competition among

markets by, for example, including mechanisms to harmonize the

regulatory requirements across the securities and commodity markets, particularly with respect to margin. Competitive market

22

1 Report of the President’s Working Group on Financial Markets, Over-the-Counter Derivatives

Markets and the Commodity Exchange Act (Nov. 1999). 2 According to data from the Bank for International Settlements, at the end of June 1999, the

total estimated notional amount of outstanding OTC derivative contracts was $81.5 trillion. The

Global OTC Derivatives Market at end—June 1999, 45/1999E (Nov. 25, 1999) <http://

www.bis.org/press/index/htm>.

forces, rather than government regulation, should pick the winners

and pick the losers. Legislation also should facilitate the listing of

the same single-stock futures on multiple exchanges. This would

avoid any one market having an exclusive franchise by forcing all

markets to compete for investors’ business.

Third, the framework must acknowledge that single-stock futures

will be retail products. While complex derivative products might

not attract retail customers, a simple future on a share of a blue

chip stock is sure to do so. Investor protection therefore becomes

absolutely essential, as does clear and direct SEC authority over

market participants that trade single-stock futures.

Finally, the framework must avoid any harm to existing capital

markets. In lifting the ban on single-stock futures and reopening

jurisdictional issues, legislative changes should not take away existing SEC authority over financial products. The Shad-Johnson

Accord clarified the SEC’s jurisdiction over securities options. That

jurisdiction should not be diminished in any way, nor should legislation eliminate the SEC’s existing role in evaluating products such

as stock indices.

I firmly believe that the commitment to protecting investors embodied in these four principles is essential to maintaining the quality of our markets as well as our global competitive edge. Unfortunately, the bill in its current form simply fails to honor that commitment.

I would be happy to provide whatever assistance you may need

as you consider these important issues. Thank you very much.

[The prepared statement of Hon. Arthur Levitt follows:]

PREPARED STATEMENT OF HON. ARTHUR LEVITT, CHAIRMAN, U.S. SECURITIES AND

EXCHANGE COMMISSION

Chairman Oxley and Members of the Subcommittee: I am pleased to testify today

on behalf of the Securities and Exchange Commission (‘‘SEC’’ or ‘‘Commission’’) as

you consider H.R. 4541, the Commodity Futures Modernization Act of 2000. My testimony today focuses on two key topics. First, I address OTC derivatives markets.

Second, I address the competition, investor protection, and market integrity issues

raised by single stock and stock index futures.

I. LEGAL CERTAINTY FOR OTC DERIVATIVES MARKETS

As you know, the President’s Working Group on Financial Markets (‘‘Working

Group’’) issued a report last year on OTC Derivatives Markets and the Commodity

Exchange Act (‘‘OTC Derivatives Report’’).1 The OTC Derivatives Report contained

several recommendations related to legal certainty for OTC derivatives products.

The enormous size of the OTC derivatives markets 2 demonstrates their critical

role in our capital markets. Derivatives contracts play a crucial role in risk management for a vast array of businesses. Accordingly, I can think of few more important

issues for Congressional consideration than legislation to implement the recommendations by the Working Group to give legal certainty to the OTC derivatives

market. The Commission reiterates its strong support for implementation of the recommendations by the Working Group related to legal certainty for the markets that

trade these products.

The Working Group was given a fairly narrow task—to determine whether the

Commodity Exchange Act (‘‘CEA’’) provided an appropriate regulatory framework

for the OTC derivatives markets. The Working Group unanimously concluded that

23

3See Testimony of Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Concerning the Report to Congress on Over-the-Counter Derivatives Markets and the Commodity Exchange Act by the President’s Working Group on Financial

Markets, Before the Senate Comm. on Agriculture, Nutrition, and Forestry (Feb. 10, 2000). See

also Testimony of Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities

and Exchange Commission, Concerning Recent Recommendations by the President’s Working

Group on Financial Markets, Before the House Comm. on Banking and Financial Services (Apr.

11, 2000); Testimony of Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Concerning the Report to Congress on Over-the-Counter Derivatives Markets and the Commodity Exchange Act by the President’s Working Group on Financial Markets, Before the Subcomm. on Risk Management, Research and Specialty Crops,

House Comm. on Agriculture (Feb. 15, 2000). 4Letter from the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William

Rainer, Chairman, CFTC, to the Honorable Larry Combest, Chairman, House of Representatives

Committee on Agriculture, the Honorable Tom Bliley, Chairman, House of Representatives Committee on Commerce, the Honorable Tom Ewing, Chairman, Subcommittee on Risk Management, Research, and Specialty Crops, House of Representatives Committee on Agriculture, and

the Honorable Charles Stenholm, Ranking Member, House of Representatives Committee on Agriculture (March 2, 2000).

for certain OTC derivatives the CEA was not the appropriate framework. In addition, the Working Group determined that steps needed to be taken to ensure that

the CEA did not stifle the natural development of these markets. For a more detailed discussion of the Working Group’s recommendations, I refer you to earlier

Commission testimony.3

The consensus achieved by the Working Group was of historic significance. Four

of the leading U.S. financial regulators unanimously agreed that the Report’s recommendations, which reflected their combined regulatory expertise, urgently required implementation. The Commission strongly supports the efforts made in H.R.

4541 to further the goals of the Working Group. However, as we have stated in the

past, it is not necessary to link resolution of all of the issues raised in the bill to

the passage of the much needed provisions on legal certainty for OTC derivatives.

H.R. 4541 differs from the Working Group’s recommendations regarding legal certainty in several key respects. For example, the Bill does not fully adopt the Working Group’s recommendations on the regulation of clearing systems. By expressly

providing that clearing agencies registered with the SEC may voluntarily register

with the CFTC even though they are not required to do so, the Bill creates potential

issues as to which set of regulations would prevail in the event of a conflict. The

Working Group specifically recommended that a clearing system regulated by one

agency should not become subject to regulation by another agency as a result of

clearing OTC derivatives. The Commission staff would be happy to discuss those differences in detail with you or your staff and provide technical assistance to the Subcommittee.

The Commission continues to strongly support the implementation of the Working

Group’s recommendations that are designed to provide legal certainty for the OTC

derivatives markets. Those recommendations should be implemented immediately.

We appreciate the Subcommittee’s efforts in furtherance of this goal, and we are

committed to working with you as modifications are made to this bill.

II. LIFTING THE BAN ON SINGLE STOCK FUTURES

The Commission supports lifting the ban on single stock futures as soon as the

regulatory issues underlying that ban are resolved. This year, the Commission devoted tremendous staff resources to designing a legislative framework to permit the

trading of single stock and narrow-based stock index futures. Disparities between

futures and securities regulation made this a difficult task. As a result of our efforts, however, the Commission strongly believes that these products can trade

under the regulatory system that we have outlined below.the regulatory system that

I will outline for you today.

Among other things, the Commission staff focused on issues raised by the Working Group. In its OTC Derivatives Report, the Working Group identified several

issues that would have to be addressed before trading of single stock futures can

begin. Furthermore, the Working Group noted that these issues were best resolved

by the Commission and the CFTC.

The CFTC and the SEC engaged in extensive discussions on this topic. Chairman

Rainer and I have not agreed on all aspects of a regulatory framework for single

stock futures. However, we did reach agreement on fundamental principles for creating such a framework..4 Most important among these principles was that single

stock futures should be subject to joint regulation by the CFTC and the SEC. This

is a positive step forward from outdated notions of exclusive jurisdiction and the

24

view that because a product can be considered a ‘‘future’’ it should be solely regulated by the CFTC. It reflects movement towards truly modern financial regulation—regulation that recognizes the need for agencies with legitimate regulatory interests and expertise in a product to participate in that product’s oversight.

A. Requirements for a Legislative Framework

1. General Principles for Markets that are Competitive, Fair, and Free From Fraud

and Manipulation—The process of working through important issues with the

CFTC led the Commission staff to identify requirements for legislation to permit the

trading of single stock futures. Contrary to what some have suggested, this is not

a turf battle between the futures and options markets and the agencies that regulate them. Single stock futures would be nearly perfect surrogates for the underlying

securities. As a result, there are fundamental issues of market integrity and investor protection at stake. For this reason, we should move forward in a reasoned and

principled manner, as we consider how to permit an entirely new product to trade.

If legislation is crafted correctly, markets will compete and regulators will cooperate. I think it would be useful to review the components that we believe are critical

for an appropriate legislative framework.

Shared Jurisdiction

First, single stock futures are undeniably a substitute for stocks and stock options, and are fully expected to be a retail product. Therefore, the framework must

recognize the legitimate interests of both the SEC and the CFTC in regulating these

products. Single stock futures possess attributes of both securities and futures contracts. As a result, joint regulation of single stock futures is appropriate and exclusive jurisdiction is ill advised. Shared jurisdiction and joint regulation entail both

recognizing each agency as best qualified to apply the key components of the laws

that it administers and coordinating the agencies’ efforts to ensure efficient market

regulation that is not duplicative or overly burdensome.

At the practical level, this means ensuring that both agencies have the authority

to carry out core functions, and that both encounter no jurisdictional barriers in the

suppression of fraud and manipulation. Yet, at the same time, mechanisms should

be devised to coordinate on certain costly issues so that the traditional regulator

takes the lead.

Encourage Fair Competition

Second, the framework must encourage fair competition among markets. We do

not want a framework that lets differences in regulation determine winners and losers. Any legislation should allow both securities and futures markets to enter the

competitive fray, but should not give any type of market an artificial competitive

advantage.

For example, the SEC and the CFTC should have joint authority to harmonize

the margin requirements for single stock futures on an ongoing basis. Otherwise,

the market with the more lenient margin requirements will have an artificial competitive edge. Competition should be based on better products, services, and prices—

not on regulatory differences.

The legislation also should require coordinated clearing of single stock futures so

that a future purchased on one exchange could be offset on another exchange that

trades the same type of future. This would allow the same single stock future product to be listed on multiple exchanges. In the options markets, multiple listing has

narrowed spreads and reduced prices to investors. Coordinated clearing also makes

it more viable for new markets to enter the competitive arena over time. Without

coordinated clearing, new markets will not be able easily to offer the same products

as competitors.

Protect Investors

Third, the framework must acknowledge that single stock futures will be retail

products. Complex derivative products generally do not attract retail customers but

a simple future on a share of a blue chip stock will. Accordingly, legislation must

maintain the SEC’s ability to protect investors and to maintain integrity of the markets on which they trade. For this reason, the SEC should have clear and direct

authority over the markets and market participants that trade single stock futures.

I think it is important to explore a few examples of what might happen if the SEC

does not have such authority.

In the securities markets, recommendations that brokers make to investors are

governed by the suitability rules of self-regulatory organizations subject to SEC

oversight. The customer protection regime is quite different under the futures laws.

Investors receive a one-time disclosure document informing them that they can lose

money on futures. The implications of these differences are quite significant. If the

25

securities law principle of suitability is not applied to single stock futures, a broker

could recommend such a product to any customer with no liability under the securities laws, even if the recommendation was unsuitable for the customer. Moreover,

in many cases a broker who sells securities will also be licensed to sell single stock

futures. As a result, the SEC is very concerned that investors will not understand

that the protections they enjoy when they purchase one product from their broker

will not also apply to the other. Worse yet, brokers could have an incentive to offer

the riskier single stock futures to investors if they could do so without the suitability responsibilities that attach to the sale of securities. There is no public policy

reason to create a framework with such a disparity in investor protections.

Next, consider a corporate insider who learns that his company is about to receive

an unsolicited bid to be taken over. The insider buys a substantial amount of single

stock futures on a futures exchange and earns huge profits on the transaction. This

case involves insider trading that takes money out of the pockets of investors who

did not have this information. This is exactly the type of situation that the Commission needs its full authority to address. Without direct authority over the futures

exchange or a requirement for insider reporting, the SEC may have difficulty ever

learning of the futures purchase by the insider. Such activities could destroy years

of Commission efforts to protect investors from insider trading abuses.

Investors also currently rely on the Commission to protect them from unscrupulous, or even just sloppy, practices by investment advisers and mutual fund managers. A bill should not introduce single stock futures into the mix of investment

opportunities that investment advisers may recommend to their clients or that portfolio managers may purchase for the mutual funds they manage without regulation

by the SEC. This would leave investors in funds consisting of single stock futures

without the same protections that investors in mutual funds have enjoyed since

1940.

These are only a few examples, but I hope they illustrate why the investor protections contained in the securities laws should be extended to single stock and narrow-based stock index futures. Please recognize that the SEC’s instruments for investor protection are interlinked. Enforcement actions coupled with inspections and

the ability to promulgate new regulations are essential ingredients of ensuring the

integrity of America’s markets. Direct access to audit trails, coordinated market surveillance, inspection authority, as well as suitability and customer protection regulation are all necessary to the SEC’s ability to effectively regulate and protect investors. Although the SEC actively pursues people who violate the securities laws,

much of our success results from preventing problems before a single investor is

harmed.

The SEC has many decades of experience and legal precedent in protecting the

public—expertise that should be carried over to equity substitutes such as single

stock futures. Our securities markets are second to none because of the investor confidence that has flourished under this regulatory framework. It would be extremely

unwise to move ahead with legislation that lacks the elements necessary to ensure

the market integrity, suitability, and customer protections that investors have come

to expect under the securities laws.

Do Not Harm Existing Markets

Fourth, the framework must avoid any harm to existing capital markets. In lifting

the ban on single stock futures and reopening jurisdictional issues, legislative

changes should not take away existing SEC authority over financial products. For

instance, the Shad-Johnson Accord clarified the SEC’s jurisdiction over security options, and that jurisdiction should not be diminished in any way. Nor should legislation eliminate the SEC’s existing role in evaluating stock indexes for susceptibility

to manipulation and compliance with appropriate standards that assure they will

not become a surrogate for single stocks. Given the CFTC’s exclusive jurisdiction

over such futures, the standard put forward in any bill and the SEC’s role in applying it must be sufficient to deter insider trading through index futures. Investors

have strong expectations about the integrity of markets that the SEC regulates, and

the resulting investor confidence fuels the success of those markets. Accordingly,

legislation should not eliminate any existing SEC oversight of securities and related

markets.

Moreover, we cannot allow market integrity issues in new markets to migrate to

existing capital markets. Because there are times when problems in one market

may be identified and understood only by reference to another market, legislation

must provide for coordinated surveillance of all markets.

Adherence to these principles will leave U.S. markets for these products better positioned to compete against their foreign counterparts. When U.S. markets are

forced to compete against each other for investors’ business and to maintain the inVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6621 65907.TXT HCOM2 PsN: HCOM2
26

tegrity that promotes investor confidence and attracts additional business, those

markets should be leaders in the international arena. As markets around the world

compete for customers and capital, one overriding principle will serve as our competitive advantage: the quality of our markets.

2. Discussion Draft—The Commission staff has prepared a discussion draft that

incorporates these legislative goals into amendments to the federal securities laws

and the Commodity Exchange Act. The SEC’s proposal extends the protections of

the federal securities laws to single stock futures. However, much of the proposal

is devoted to ensuring that those laws do not unnecessarily burden the markets and

intermediaries that trade single stock futures. We look forward to comments from

the CFTC and to having a dialogue with your Subcommittee on our suggested approach. We are setting out below a brief summary of the principal elements of that

plan—a plan that presumes shared SEC and CFTC jurisdiction over these products.

First, this draft framework defines single and narrow-based stock index futures

as securities. This triggers SEC oversight and the application of the securities laws.

We then focus on detailed regulatory relief for some of these intermediaries and

markets as a means to avoid unnecessary or duplicative regulation.

For example, floor brokers on designated contract markets that are already registered with the CFTC would be completely exempt from SEC registration. We also

create a simple process of notice registration with the SEC for certain markets and

intermediaries that are already registered with the CFTC. Those markets and intermediaries would have to comply only with securities law provisions that are considered ‘‘core.’’ We clearly exempt these markets and intermediaries from the numerous

non-core provisions of the securities laws where the CEA and CFTC regulation sufficiently addresses the same public policy concerns.

For the core provisions of the securities laws that would still apply to these entities, we provide innovative ways to relieve their regulatory burdens and to coordinate our regulatory efforts with the CFTC. For example, for many of the proposed

rule changes that CFTC-regulated markets would submit to the SEC we have provided for immediate effectiveness of such changes and a limited scope of review. In

appropriate areas, such as examinations, we recognize that the CFTC should be the

lead regulator for such CFTC-regulated entities and limit our activities accordingly.

In addition to the detailed regulatory relief and coordination provisions, we provide minimum requirements to be incorporated into listing standards for these products. Such requirements, along with provisions related to coordinated clearing, are

aimed at promoting market integrity and intermarket competition.

Finally, we incorporate these products into other relevant securities laws, such as

the Securities Act of 1933, the Investment Company Act, and the Investment Advisers Act. In doing so, we avoid unnecessarily burdensome regulation under these acts

as well.

This discussion draft shows that the protections of the securities laws can be extended to single stock and narrow-based stock index futures while still permitting

the efficient operation of our markets. Our discussion draft would achieve the goals

of creating a new market for single stock and stock index futures that is competitive, fair, and free from fraud and manipulation. U.S. investors deserve nothing less.

U.S. capital markets provide the lifeblood of American business and are the place

where American families invest their hard-earned dollars with hopes of earning returns that will provide for everything from their children’s educations to their retirements. We cannot afford to put these markets at risk.

B. Comparison to H.R. 4541

Crafting our plan was not easy. Therefore, I appreciate your efforts in drafting

the bill. Moreover, I am heartened by the bill’s attempt to recognize some of the

principles that the Commission feels are so important in this area. Unfortunately,

the bill as written ultimately does not vindicate those principles and achieve the

goals of the legislative framework previously outlined. The bill does not sufficiently

extend the protections of the securities laws to single stock and narrow-based stock

index futures. The Commission therefore could not support the legislation in its current form.

As you continue to revise your legislation, I would hope your bill ultimately can

answer questions, such as the following, in the affirmative:

• Does the bill clarify in both the CEA and the securities laws that the SEC has

full authority over single stock and narrow-based stock index futures and that

the securities laws protections apply to these products?

• Does the bill provide for expedited registration of the intermediaries and exchanges that trade these products with both the SEC and the CFTC?

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• Does the bill provide real mechanisms for both the SEC and the CFTC to ensure

that the relevant securities and futures regulations, such as those related to

margin, remain harmonized on an ongoing basis?

• Are there provisions for coordinated clearing of these products?

• Are there provisions that enable the CFTC and SEC to work together to foster

competition in the markets for these products?

• Will both the CFTC and SEC be able to effectively prosecute frauds involving

these products?

III. CONCLUSION

Once again, the Commission appreciates the efforts that the Subcommittee has

made in bringing derivatives issues to the forefront. We believe that the regulatory

provisions that we have set forth can support the work of the Subcommittee in its

efforts to repeal the ban on single stock futures and eliminate uncertainty for the

OTC derivatives markets in a way that fosters competition, bolsters market integrity, and ensures that no harm befalls America’s capital markets or investors.

The Commission appreciates the Subcommittee’s efforts with respect to derivatives issues. Just as derivatives products themselves can be complex, so too are the

issues that surround these products. Having regulated securities derivative products

for decades, the Commission welcomes the opportunity to actively participate in the

dialogue about derivative products that your bill will engender. We look forward to

sharing our views with your Subcommittee, the Working Group, market participants, and other legislators as changes continue to be considered.

Thank you.

Mr. OXLEY. Thank you, Chairman Levitt. We accept your offer.

This is enormously difficult legislation for the committee, as you

know. It is very detailed and somewhat arcane, and so your staff

and your help would be most appreciated. As you know, we are

under a time constraint with the referral of the bill and essentially

have until the end of this month. Even though technically we have

until September, with the August recess, we are really faced with

3 weeks in which we have to act. The game plan is we have our

hearing today, we mark up the bill in our subcommittee next week,

and then the full committee the last week in July. So time is of

the essence. We are prepared to roll up our sleeves with you and

with our friends on the other side of the aisle to try to craft legislation that is in the best interests of the investing public. I think if

we all share that same goal, I am sure we do, we can make enormous progress.

Let me begin with some questions. Do you anticipate reaching

general agreement on regulation of single-stock futures in time for

the committee to reflect that agreement in this legislation?

Mr. LEVITT. I am not certain. The chairman of the CFTC and I

have been talking about this issue for a number of months, and I

think both of us are motivated by what we believe is in the best

interests of our markets and investors.

The issues are very difficult and complex. Our staffs are meeting

almost as we talk, and I am told some progress has been made. I

have advised our staff that I would be prepared to commit any

amount of time to accomplishing a meeting of the minds that would

avoid a legislative solution. I think that we are far better able to

craft this than anyone else, and, working with our colleagues in the

Treasury Department, I can promise you that progress has already

been made and more will be made. Whether we can meet the very

tight legislative timetable, I simply don’t know.

Mr. OXLEY. Is it your goal then, that if in fact everything were

to happen the way we would want it, for you to reach an agreeVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
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ment and then we would essentially codify that agreement in the

legislation?

Mr. LEVITT. I guess in the best of all worlds that is how it would

work. The Commission is motivated exclusively by what we regard

as being in the best interest of America’s investors. Putting a highly leveraged new product into the hands of America’s retail investors at a point in time when the market already has an abundance

of speculation is playing a very dangerous game. Because of that,

we are greatly concerned that the basic protections that have been

afforded retail investors in terms of equity investment be present

in allowing a product which is merely a proxy for a retail stock investment.

Mr. OXLEY. Some distinguished people, including Chairman

Greenspan, have said publicly they think that unless we lift the

Shad-Johnson Accord the business essentially will flow overseas;

that is, the traffic in single-stock futures. Does that cause you some

concern?

Mr. LEVITT. Let me give you kind of an unorthodox response to

that. As Chairman Greenspan knows, we both are passionate believers in free markets, but the notion that we would lose singlestock futures to any market, and that loss could be in any way a

danger to the United States economy or the United States markets,

I think, is an absurdity. If the world is crying for single-stock options—single-stock futures, let them have them in my judgment. It

is not our job to determine what products should or shouldn’t be

traded, but in my judgment in no way would the U.S. markets or

economy be impaired by the loss of that product to other markets.

The use of that product in Australia and other parts of the world

thus far has been a dismal failure.

My concern is that we are taking legitimate market products, the

futures market, which has been largely an institutional market,

transferring it to a retail incarnation and leaving it, according to

this bill, without the protections that we give investors in our equity markets.

Mr. OXLEY. Having said that, though, if all of us were able to

craft the necessary protections in the marketplace in a regulatory

scheme that we would envision, would you then feel comfortable

with lifting the accord?

Mr. LEVITT. Yes. You know, the Accord is kind of a jerry-built

structure to accommodate what I regard to be an irrational distribution of regulatory authority, but it is what it is, and if there

is a way of lifting it and protecting investors, I would enthusiastically support it, as I support other aspects of the bill in terms of

relieving the legal uncertainty from the trading of derivatives. I

think that is a very important and useful objective, although I fail

to see its relationship to this part of the bill. But my answer to

your question is very definitely yes.

Mr. OXLEY. If we were to start the world all over again, wouldn’t

it make sense to have single-stock futures regulated by the Securities and Exchange Commission as securities?

Mr. LEVITT. Absolutely.

Mr. OXLEY. Let me yield to my good friend from New York.

Mr. TOWNS. Thank you, Mr. Chairman.

29

Could you please give your views on the argument or statement

that has been made that markets are hindered by the application

of securities regulations? Haven’t the options markets thrived

under the securities law?

Mr. LEVITT. I remember full well how the options markets were

introduced to America’s investors. I was the head of the American

Stock Exchange at that time, and we were early participants in

that market. In those early years, there were all kinds of complaints and scams and scandals involving the use of that new product. We had the unfortunate experience of having to fine and censure 22 specialists on the floor of the American Stock Exchange in

connection with the trading of options.

Any new product involves a measure of uncertainty and a measure of risk. Options, because they are more leveraged than common

stock certainly represented that.

Now when you take the futures on single securities, they are

merely proxies for those securities; and one of the dangers, in my

judgment, in this bill is the amount of leverage that is entailed.

The amount of borrowing that a retail investor could now embark

upon is substantially greater. You are taking a new universe of retail investors, most of whom have never seen a down market, many

of whom in my judgment are more leveraged than they already

should be, and you are allowing them to use a new product, totally

new to them, a future on an individual stock, which will enable

them to buy that stock for a fraction of what they would have paid

had they bought either an option or the stock itself; and the risk

is unlimited in terms of what happens to that future.

And I suggest to you that, if we take that step, if the Congress

of the United States is prepared to take that step, we all have a

responsibility to America’s investors to see to it that they have the

same protections that they have when they purchase common stock

and common stock options.

Mr. TOWNS. Thank you very much.

According to my staff, you seem to have a plan for trading singlestock futures that could work. Could you please tell us about it? I

would like to know more about that.

Mr. LEVITT. We do have a series of recommendations with respect to how single-stock futures could work under the joint oversight of both the CFTC and the SEC. The plan is fairly detailed.

We have submitted it to the CFTC. They are considering the plan.

They have not yet responded to the plan in detail. It is my hope

and expectation that their response to this plan will enable us to

move forward together on a response to this legislation.

Mr. TOWNS. Mr. Chairman, I would like to ask that he submit

it for the record, submit the plan for the record.

Mr. OXLEY. Without objection.

Mr. LEVITT. We will submit the plan.

Mr. TOWNS. Thank you.

[No response was received by the subcommittee.]

Mr. TOWNS. I yield back the balance of my time.

Mr. OXLEY. The gentleman yields back.

Let me recognize the gentleman from Illinois, Mr. Shimkus.

Mr. SHIMKUS. Thank you, Mr. Chairman.

30

This is an interesting time. It is good to have Chairman Levitt

back. A couple of quick questions. I always like to boil it down.

Of course, in your opening statement you mention that this isn’t

a turf battle, but I would submit that turf battles are pretty important. Especially in our role in the Commerce Committee, we like

to protect our turf; and we think that we do so in the best interests

of the public as much as the Founding Fathers liked to protect the

turf of the executive and the judicial branch. That is not a bad

thing, especially if you feel that the turf you are protecting, you are

doing it based upon sound principles of protecting the interests of

the investors. That is my little opening statement.

Mr. Chairman, some of these questions may have been asked

when I went to the vote, but in H.R. 4541, it contemplates a role

for your agency in crafting a suitable rule for single-stock futures

along with the National Futures Association. You have addressed

some of the concerns you have with that. Do you have any additional ones that you may have left out?

Mr. LEVITT. Well, the problem with the aspect of the bill that I

think represents a serious risk for America’s investors and markets

deals with an assumption that the CFTC will oversee this product.

The bill really calls for exclusive CFTC jurisdiction. There really is

no assurance that there will be the same kind of oversight or regulation as far as the SEC is concerned. Whatever input we have

would have to be at the pleasure of the CFTC.

I have suggested before that in light of, again, what I think is

an artificial kind of overall regulatory structure, the best way to

proceed on this would be joint SEC/CFTC oversight. This bill does

not provide for that in any way, shape or form and leaves, in my

judgment, America’s investors very, very vulnerable.

Mr. SHIMKUS. Let me go on. The bill again states that margins

on single-stock futures could not be less than options on the same

underlying stock. Further, it gives the Federal Reserve margin authority and even allows it to designate that authority to intermarket margin boards made up of the Federal Reserve, CFTC and

the SEC. Do you think that this solution will work?

Mr. LEVITT. No, I think the solution is a contrived solution. I

think there is no assurance that the Federal Reserve board will indeed produce such a board; and I—going back to my experience in

running very complicated businesses, I reject the notion of boards

as a solution to very complicated underlying problems.

Mr. SHIMKUS. And I would just encourage you, we do value your

input and especially on this issue. The last thing that we want to

do is throw out a product that will put at risk the individual investors. I look forward to working with you and the chairman and, if

we move legislation, to move it with your support.

Mr. LEVITT. I appreciate that. Thank you.

Mr. OXLEY. Mr. Rush from Illinois.

Mr. RUSH. Chairman Levitt, I appreciate you being here this

morning. You had some insightful and cogent remarks as relates

to H.R. 4541. I do have a couple of questions. Are there any benefits to the small investor in the quest to regulate single-stock futures? Are there any benefits and, if so, what are those benefits?

31

Mr. LEVITT. Congressman Rush, are you asking me if I believe

there are significant benefits to the retail investor in the purchase

of futures and single-stock futures?

Mr. RUSH. Right. That is the question.

Mr. LEVITT. Again, this is a personal answer. It is based on my

experience with handling many, many investors through the years.

I think those benefits at best are marginal. I think I have expressed before my belief that this is not a product that America’s

investors are desperately crying for at this point in time. There are

other products I might say the same thing about, but it is everyone’s right to do with their money what they will. But I also think

it is our responsibility to see to it that we protect innocent investors from products that can be used unscrupulously and from products that represent levels of risk that call for a very specific kind

of regulatory oversight.

Mr. RUSH. Although some financial markets feel they would lose

business because of participation by the small investors, does the

single-stock futures market have enough opportunities to include

the small investors’ participation?

Mr. LEVITT. I think the experience of other markets with singlestock futures has not proven this to be a very successful undertaking. However, if it does have a potential for success with retail

investors in our markets, with the level of speculation that exists

today with investors being moved more by emotion than intellect,

I think we have to offer those investors the kinds of protections

that we have tried to outline in our testimony.

Mr. RUSH. Thank you, Mr. Chairman. I yield back the balance

of my time.

Mr. OXLEY. The gentleman yields back.

If I can just intervene. That was an interesting comment you

made in terms of the investors being driven more by emotion than

intellect. How would investor protection necessarily aid that individual who is overtaken by emotion?

Mr. LEVITT. Well, my concern about that kind of attitude in our

markets is that it does fuel speculation; and much of the Commission’s work has been dedicated, through a program of investor education in town meetings, in cautioning investors about scams in the

markets at a point in time. Today the emphasis in our town meetings, the emphasis in our brochures and on our website has been

to caution investors about borrowing, about margin. Therefore,

when we are thinking of introducing a product which will exacerbate the level of borrowing, I think it becomes even more important

for us to assure investors that we maintain the basic protections

that presently exist in our markets.

Mr. OXLEY. Thank you.

The gentleman from Oklahoma, Mr. Largent.

Mr. LARGENT. Thank you, Mr. Chairman.

I would like to ask you, Chairman Levitt, there really hasn’t

been a case made for additional CFTC regulation of the over-thecounter energy derivatives market. Why do you believe that additional regulatory jurisdiction is necessary?

Mr. LEVITT. You know, I don’t think that I have any feeling

about that. That is a CFTC matter, and I really am not familiar

with the issue.

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Mr. LARGENT. Okay. Are you looking to expand your oversight jurisdiction of the gasoline markets?

Mr. LEVITT. No.

Mr. LARGENT. I have no further questions.

Mr. OXLEY. The gentleman from Michigan, Mr. Dingell.

Mr. DINGELL. Welcome, Mr. Chairman.

Mr. LEVITT. Thank you.

Mr. DINGELL. I am glad to see you back here again. I have a series of questions I hope you will answer as briefly as you can because of the large amount of ground we have to cover.

What will be the impact of single-stock or narrow group index futures contracts on the underlying stock market, do we know?

Mr. LEVITT. I don’t think so.

Mr. DINGELL. If we lend additional volatility by reducing the

margin, by moving these into futures from the normal securities

market which has 50 percent margin, what would be the effect on

volatility of the market?

Mr. LEVITT. If there was substantial interest in such business, I

think it would increase the volatility.

Mr. DINGELL. By what order?

Mr. LEVITT. I don’t know.

Mr. DINGELL. Substantially?

Mr. LEVITT. Yes.

Mr. DINGELL. You have had some attempts lately by the Mafia

to enter into and manipulate the market in securities. You have

been devoting major efforts to addressing that question. What

would a 5 percent margin and reduced regulation of futures do to

the attempts of organizations like this to manipulate the market?

Mr. LEVITT. I think it would just give them additional opportunities to do their work.

Mr. DINGELL. What would be your ability to deal with those

kinds of attempts by Mafiosi and other groups to enter the market

for that purpose?

Mr. LEVITT. Under the provisions of this bill, practically nonexistent.

Mr. DINGELL. Have there been any studies of manipulation of the

markets?

Mr. LEVITT. With all due respect, I don’t think that we need

studies to understand the impact of the kind of leverage that we

are talking about in terms of manipulation.

Mr. DINGELL. You are talking about leverage because of reduced

regulation and——

Mr. LEVITT. And increased volatility.

Mr. DINGELL. Have there been any studies on increased

volatilities?

Mr. LEVITT. I am not certain.

Mr. DINGELL. Are there adequate protections and surveillance

mechanisms in the bill before us today of the level of magnitude

that you at the SEC would be able to apply to securities?

Mr. LEVITT. I don’t believe so, sir.

Mr. DINGELL. Is it fair to observe that a future on a single-stock

would be, for all intents and purposes, interchangeable with the

sale of the stock?

Mr. LEVITT. Absolutely.

33

Mr. DINGELL. So the investor should have the same protections

whether there is a sale of a future or a sale of the underlying security?

Mr. LEVITT. Yes.

Mr. DINGELL. Now, I want you to submit for the record the differences between your ability at the SEC to address insider trading

and those at CFTC. It is fair to say, however, that CFTC has much

reduced abilities to address the insider trading questions, does it

not? Much less than you have?

Mr. LEVITT. I am not precisely certain about the CFTC’s abilities

in this regard. I do know that we have seen more insider trading

today than ever in the history of our markets, and it is one of the

major areas of Commission concern.

Mr. DINGELL. If there is reduced authority to address insider

trading questions or reduced ability at the SEC to require paper

trails and things of that kind because of transference of your responsibilities to the SEC, what would be the impact on investors?

Mr. LEVITT. I think it leaves America’s investors extremely vulnerable.

Mr. DINGELL. Would you give us a short statement at your convenience on the differences between insider trading authorities and

paper trail requirements at the SEC and the CFTC?

Mr. LEVITT. Yes, sir.

Mr. DINGELL. Are you given adequate authority under this bill

to police the single-stock futures markets for insider trading?

Mr. LEVITT. No.

Mr. DINGELL. Why do you say that?

Mr. LEVITT. Because it gives exclusive jurisdiction to the CFTC.

Mr. DINGELL. It also reduces CFTC’s authority over insider trading, does it not?

Mr. LEVITT. You know, I don’t know the answer.

Mr. DINGELL. Would you, at your convenience, respond?

Mr. LEVITT. Yes.

Mr. DINGELL. So if there was to be some kind of major problem

in the market with regard to volatility, with regard to market drop,

let’s say something like happened in 1987 where the market fell

500 points, and let’s say there was some kind of insider trading or

manipulation going on, could the CFTC under the authorities it

has under this legislation or your agency under the authorities it

has under this legislation respond quickly enough to address the

problems that might exist there?

Mr. LEVITT. I don’t believe so.

Mr. DINGELL. Now, if we are to go forward in lifting the ban on

single-stock futures, what regulatory structures should we impose

and who should enforce it?

Mr. LEVITT. In my judgment, if we do that, we should recognize

and the bill should acknowledge that a single-stock future is a security; and all of the protections offered by the present securities

legislation should be available to investors in a single-stock future.

We should try to create a kind of regulatory scheme where there

is a joint regulation, shared regulation, by the CFTC and the SEC.

Mr. DINGELL. Does this legislation do that?

Mr. LEVITT. It does not do that.

34

Mr. DINGELL. It has been said that there is no difference between

an option and a single-stock future; is that true?

Mr. LEVITT. That is not true. An option has a limited amount of

risk. A single-stock future has an unlimited amount of risk. I would

suggest to you that a naked option is more closely aligned to a single-stock future.

Mr. DINGELL. So an option you can lose your money but your

loss—your potential loss on a single-stock future is unlimited, isn’t

that right?

Mr. LEVITT. Yes, sir.

Mr. OXLEY. The gentleman’s time has expired.

Mr. DINGELL. I thank the Chair. I look forward to continuing this

at a later time.

Mr. OXLEY. The Chair now recognizes the gentleman from Iowa,

Dr. Ganske.

Mr. GANSKE. Thank you, Mr. Chairman.

The idea that stocks are inherently risky and the government

should keep people from speculating with excessive leverage was

obvious in the 1930’s. Then people thought the 1929 crash had

been worsened because overleveraged investors were forced to sell.

Well, it is hard to remember that 70 years later; and free market

advocates claim, if we don’t allow such blatant gambling on stocks,

the action will go to some overseas market. That seems to be a recurrent theme. We shouldn’t let this go to some overseas market.

Mr. Chairman, would you comment on that, please?

Mr. LEVITT. Again, I preface that by saying that my response to

that may seem personal and impetuous, but my answer to your

question is, so be it. If insisting that single-stock futures for retail

investors have the same protections that investment in stocks do

means we lose that market, so be it. It is a price well worth paying

in terms of saving America’s investors from the kinds of dangers

that an unregulated market would represent.

Mr. DINGELL. Would the gentleman from Iowa yield?

Mr. GANSKE. I would be happy to yield.

Mr. DINGELL. I thank the gentleman.

Mr. Chairman, what has been the rush overseas into single-stock

futures where they are offered? It has not been moving fast. It is

something on the order of 1 percent?

Mr. LEVITT. That is correct. It has not been successful in Europe

or Australia.

Mr. DINGELL. So what they found is that no one really wants

these things overseas?

Mr. LEVITT. Thus far.

Mr. DINGELL. I thank the gentleman for yielding.

Mr. GANSKE. The futures market talk of single-stock futures as

providing ‘‘additional risk management tools,’’ as Scott Gordon,

chairman of the Chicago Mercantile Exchange, put it in an interview. They say you can already duplicate in a single-stock future

with a complicated trade in the options market, so why worry? Mr.

Chairman, would you comment on that?

Mr. LEVITT. You know, in general, some of the products that are

in our markets today are ones that I think individual investors

have to be very careful about. I think the proliferation of new products in our markets has been a benefit. Our markets are more liqVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
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uid today than ever before, and I think our futures markets have

been a vital part of managing risk. Our futures markets have been

largely institutional, and, while I applaud the growth and discipline of those markets and the inventiveness and creativity of

new products, when you translate what has been largely an institutional product to a retail product, that is a different ball of wax and

one, regardless of the benefits to our institutional markets, whose

benefits I think are largely nonexistent to the typical retail investor. And I want to be absolutely certain, and all of us should be

certain, that investors know what they are doing and are protected

from the kind of leverage that is involved and the opportunity for

scam that is created by subjecting investors to this product.

Mr. GANSKE. Mr. Chairman, can you tell us about any scams?

Mr. LEVITT. Well, I could tell you about so many scams, but since

America’s investors have not had the opportunity to invest in single-stock futures, I can’t go into any of those.

Mr. GANSKE. Are there scams overseas?

Mr. LEVITT. I don’t know the answer to that.

Mr. GANSKE. I thank you.

Thank you, Mr. Chairman.

Mr. OXLEY. The gentleman’s time has expired.

The gentleman from Michigan, Mr. Stupak.

Mr. STUPAK. Mr. Levitt, is there any reason to preclude securities exchanges from trading single-stock futures if they are allowed

to trade on futures exchanges?

Mr. LEVITT. No. We have had such extraordinary success at the

Commission by forcing our options markets to trade the same options to really let competition work. The impact of that has been

to reduce spreads by almost a third. The template is clear. It is

there. If we are going to go ahead with a program to introduce single-stock futures, they should be available to every market to compete to reduce the cost of that investment to the benefit of America’s investors.

Mr. STUPAK. With the rise in day trading, isn’t the potential for

increased leverage in the stock market a real concern?

Mr. LEVITT. It is a real concern, yes sir.

Mr. STUPAK. Do you believe that unless the tax treatment and

transaction fee treatment for these products traded on a futures exchange or securities exchanged are not rationalized, Congress

would be determining winners and losers in the marketplace?

Mr. LEVITT. I think to the extent there are disparities, regulatory

disparities and margin disparities, they absolutely would be.

Mr. STUPAK. Could an investor who decided that futures were too

risky and chose to invest in equities be harmed by single-stock futures? Specifically, would trading in futures affect the underlying

stock price?

Mr. LEVITT. I suppose trading in a single-stock future could affect the underlying stock price. I don’t really know what impact

that would have because, frankly, I don’t know the extent of interest that retail investors would have in this product in the United

States.

Mr. STUPAK. Would institutional interest really drive the harm

to the market? If you really get into the futures, if the institution

36

gets into the futures, could that not undermine the value of the

market as we know it now?

Mr. LEVITT. I don’t necessarily think so. I think that institutions

are very sophisticated; and if they choose to use futures as they

have used other derivative products to manage risk, I think that

is constructive for our markets. I have very few problems with the

use of futures as an institutional mechanism.

Mr. STUPAK. I yield back the balance of my time.

Mr. OXLEY. The gentleman yields back.

The gentleman from Maryland.

Mr. EHRLICH. I yield.

Mr. OXLEY. The gentleman yields.

The gentleman from Wisconsin, Mr. Barrett.

Mr. BARRETT. Thank you, Mr. Chairman.

Mr. Chairman, I want to thank you for coming to Milwaukee for

the town hall meeting. I am still getting many compliments for

your appearance.

Mr. LEVITT. Thank you.

Mr. BARRETT. I am learning as quickly as I can on this topic, and

my understanding is that the reason we are here is back in 1982

this was one of the areas where there was not agreement reached

between the SEC and the CFTC and that there still remains some

disagreement now.

What I would like you to do is perhaps help me understand

where the SEC is coming from on four issues if we have time: the

margin levels, the suitability requirements, the enforcement authority and the security transaction fees.

Maybe we can start with the margin levels. I know that was

something that Mr. Dingell alluded to in his questioning.

Mr. LEVITT. Well, in brief, the bill that is before us today provides for margin to be determined if—as I understand it, if the

Federal Reserve Board goes along with it, the creation of a board

that would adjudicate margin differences.

I think that that is a problematic, questionable solution that

could very well result in margin levels that are different based

upon the product rather than any kind of consistency, and I think

that could very well lead to arbitraging margin. And, as Congressman Stupak mentioned before, it represents government choosing

winners and losers by determining where the best deal may be; and

I don’t think that is our job.

Mr. BARRETT. What would be the response from the CFTC on

that, do you think?

Mr. LEVITT. You know, I am not certain. But I think the way to

respond to that——

Mr. OXLEY. If I can interject, the CFTC will have an opportunity

to testify and answer that question soon.

Mr. BARRETT. It is safe to say that is a disagreement between the

SEC and the CFTC?

Mr. LEVITT. I am not certain how the CFTC approaches that

issue. Our position has been that we have got to work together to

see to it that margins are harmonized. I think this bill misses the

point by creating what I regard to be a very complicated, problematic kind of solution involving a board. I think we should go directly to the mark and say margin will be harmonized and an inVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
37

vestor will not be able to take advantage of a product because it

is traded over there and they have to put up less money than if

it is traded over here.

Mr. BARRETT. The enforcement authority issue, obviously an area

where you have to have agreement. What is the issue that remains

unresolved there?

Mr. LEVITT. The real issue is the basis of CFTC enforcement,

which I think is really superb, is largely predicated on the institutional investor and lacks the kind of history that the SEC has in

terms of protecting individual American investors. It is almost a

cultural difference in that it lacks the self-regulatory organizations

that form the basis of a partnership between SEC regulation and

New York Stock Exchange and Nasdaq regulation. It lacks a history of inspection, examination, a history of cases predicated on

protecting individual investors, a surveillance mechanism, maybe

most importantly the whole question of suitability, where the

CFTC might say we place a warning up there for investors, warning them that there is great speculation involved in terms of a future.

The SEC requires much more with respect to suitability. Brokers

must determine whether a given investor really should be buying

a product. It is not enough that a broker tells your Aunt Sally that

this future is dangerous. If a broker tells her, yes, it is dangerous

Aunt Sally and she chooses to invest in it anyway and she loses

her money, under SEC regulation we can prosecute the broker because it is highly unsuitable for Aunt Sally to be buying a dangerous product. Futures regulation is a very different kind of oversight geared toward very different kinds of constituents.

Mr. BARRETT. Thank you.

Mr. OXLEY. The gentleman’s time has expired.

The gentleman from California, Mr. Cox.

Mr. COX. Thank you, Mr. Chairman.

I want to once again welcome Chairman Levitt; and because I

am tardy to this hearing, I am going to try to catch up on the testimony. Thank you.

Mr. OXLEY. Let me now turn to our guest panelist, Mr. Ewing,

who has a brief statement. The Chair would ask unanimous consent that Mr. Ewing be recognized for 5 minutes for a brief statement. The gentleman from Illinois.

Mr. EWING. Thank you, Mr. Chairman. I don’t think that I will

take the entire time. I want to thank you for holding the hearing.

And to Chairman Levitt, I have the greatest respect for your

knowledge and ability on these issues; and I think that there is—

I hope that there is opportunity for this committee working with

you to improve the legislation that was sent here dealing with this

important subject.

I just have maybe one question. The futures exchanges today are

trading stock indices, and I think that the courts have actually said

that they could trade narrow stock indices. How do you see the difference between that and the single-stock futures?

Mr. LEVITT. First let me say, Congressman Ewing, that I greatly

respect the work that you have done, the background that you have

brought to introducing this bill, the sincerity of your motives in

38

terms of doing something which you believe will be beneficial to

America’s markets.

I believe that our predecessors who came up with the agreement

between the CFTC and SEC and authorized the trading of futures

on broad indices felt that that would not have the retail impact

that trading a future on a narrow index might have. Now while the

courts ruled in that direction, I certainly stand behind the motivation that was displayed before. We need securities laws to apply to

indexes that can be manipulated. I think what is important is a

question of degree.

In my judgment, trading a broad index represents little or no

danger to a retail investor. Trading a narrow based index which

does create opportunities for manipulation represents a greater

danger to a retail investor. Trading a single-stock future, a future

on a single underlying stock, represents, in my judgment, the

greatest amount of risk to a retail investor unprotected by the oversight of securities laws.

Mr. EWING. Mr. Chairman, I appreciate your attitude of cooperation and the ability to work on this bill. I believe that we can find

a common ground that will protect our investors, protect our markets and make this legislation work; and I certainly look forward

to in the next few weeks working with you and with the other parties involved to try and arrange and come to those conclusions and

certainly with this committee and other committees of the Congress. Thank you very much.

Mr. OXLEY. Mr. Chairman, we again appreciate your participation in this and look forward to working with you and your staff

on these next couple of weeks to try to craft a compromise legislation. Again, thank you for your appearance.

Mr. LEVITT. Thank you.

Mr. OXLEY. The Chair would announce that we have three votes

on the floor of the House. I would propose that we introduce our

next panel. If they will come forward we will begin your testimony,

and then when we have to break we will take a break. Since we

have three votes, it will be probably somewhere in the nature of

a half hour by the time we get over and get back. The witnesses

and others may want to, during that break, have an opportunity

to have lunch or whatever; and we will just play it by ear.

Mr. OXLEY. Let me introduce our second panel of the day. C.

Robert Paul is General Counsel for the Commodity Futures Trading Commission; Mr. Lewis A. Sachs, Assistant Secretary for Financial Markets, Treasury Department; and Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics, at

the Federal Reserve.

I am sure that you heard my discussion with Chairman Levitt

in regard to the timetable that this committee faces on this important legislation, and we particularly appreciate your coming here

with short notice to help us understand this very difficult issue.

We will begin with Mr. Paul.

39

STATEMENTS OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION; PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH

AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL

RESERVE SYSTEM; AND LEWIS A. SACHS, ASSISTANT SECRETARY FOR FINANCIAL MARKETS, DEPARTMENT OF THE

TREASURY

Mr. PAUL. Thank you, Chairman Oxley, Chairman Towns and

members of the subcommittee. I am pleased to appear on behalf of

the Commodity Futures Trading Commission to discuss the important issues addressed in H.R. 4541.

The Commission commends the efforts of Chairman Combest,

Chairman Ewing and Congressman Stenholm to modernize the

Commodity Exchange Act by introducing H.R. 4541 to provide legal

certainty for over-the-counter derivatives, remove impediments to

innovation and reduce systemic risk. There are, however, two areas

of concern, the scope of the energy exemption and new burdens on

our enforcement authority, that preclude the Commission from supporting the legislation in its current form.

The Commission supports the provisions of H.R. 4541 which enhance legal certainty for over-the-counter derivatives by excluding

from the CEA certain bilateral transactions and electronic trading

facilities. This bill also permits clearing of OTC derivatives and authorizes a mechanism for the CFTC to regulate facilities that clear

OTC derivative contracts.

We support this recommendation with the following reservation:

The bill would allow securities clearing systems to clear a broader

range of contracts than futures clearing systems.

This bill would codify an exemption from most provisions of the

Commodity Exchange Act for transactions in energy commodities.

This is an area in which H.R. 4541 diverges from the recommendations of the President’s Working Group, and the Commission believes that these provisions raise concerns that have yet to be resolved.

The exemption for energy commodities is not governed by the

same considerations that form the basis of the Working Group’s

recommendations with respect to financial products. The President’s Working Group stated that the activities of most financial

derivatives dealers are already subject to direct or indirect Federal

oversight. The same cannot be said of trading in energy derivatives. The President’s Working Group also found that most financial OTC derivatives are not susceptible to manipulation. The case

has not been made for energy products.

Last month, the Commission published in the Federal Register

its comprehensive regulatory reform package, which alters fundamentally the Commission’s approach to regulation of markets

and participants under its jurisdiction. H.R. 4541 attempts to codify much of the Commission’s regulatory reform proposal, and we

welcome this support of the Commission’s initiative.

The Commission will be moving to oversight regulation in which

the agency will no longer act as a gatekeeper and will intervene

only when a problem arises. To succeed, however, the Commission

must be able to act quickly and effectively to address fraud and

40

manipulation, as well as to protect the financial integrity of the

markets.

Section 15 of the legislation erects several barriers to enforcement action by the Commission. When there is a violation of the

core principles, the Commission must delay any action until it provides an appropriate remedy to the violator. Moreover, the bill requires that the remedy be based upon a cost-benefit analysis. Thus,

the provision may allow registered entities to postpone and possibly

avoid responsibility for violation of core principles.

H.R. 4541 addresses the issue of equity futures contracts and reflects efforts to develop a plan to amend the Shad-Johnson Accord.

The Working Group recommended that the CFTC and the SEC

work together to determine whether and how the Accord should be

amended. The agencies agree in principle that equity futures

should be available to the marketplace. The agency staffs have

agreed on many specific conditions to lifting the ban, such as authorizing the SEC to prosecute insider trading, harmonizing margin requirements, notice registration of each other’s registrants, applying customer suitability rules to all intermediaries, testing personnel, establishing uniform listing standards for single-stock futures and providing SIPC coverage to customer accounts carried by

securities intermediaries and segregation to customer accounts carried by futures intermediaries. We acknowledge, however, a fundamental disagreement concerning the appropriate legislative approach.

The Commission has sought to avoid creating a framework that

potentially could result in overregulation of markets and intermediaries; and, therefore, the CFTC staff has advocated identifying

those core provisions from each regulatory regime necessary to ensure an appropriate level of oversight for trading these products.

While the agencies have agreed in principle that duplicative regulation must be avoided, the CFTC staff expressed concern that an

‘‘umbrella’’ approach imposing the panoply of securities regulation

to these products could result in overly burdensome regulation.

The CFTC believes that it is important to bring single-stock futures to the market in a way that does not result in the government favoring one market over another. Subjecting the futures exchanges to securities laws that address public policy concerns already addressed by the CEA creates a burden that may preclude

fair competition between futures and securities exchanges.

The Commission notes, however, that SEC’s belief that defining

equity futures products as securities is essential to fulfilling its regulatory functions. This fundamental difference in approach has led

to an apparent impasse, but the agencies have nonetheless continued to try to reach a resolution.

With respect to H.R. 4541, we have no objection to the ShadJohnson provisions as they bear on regulatory issues related to the

CFTC agency oversight of single-stock futures, but the CFTC continues to recommend a regulatory structure that would allow single-stock futures to trade on both securities and futures exchanges.

Again, the Commission appreciates the opportunity to present its

views. I would be happy to answer any questions you may have.

[The prepared statement of C. Robert Paul follows:]

41

PREPARED STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY

FUTURES TRADING COMMISSION

Thank you, Chairman Oxley and members of the Subcommittee. I am pleased to

appear on behalf of the Commodity Futures Trading Commission to discuss the important issues addressed in H.R. 4541.

The Commission commends the efforts of Chairman Combest, Chairman Ewing,

and Congressman Stenholm to modernize the Commodity Exchange Act by introducing H.R. 4541 to provide legal certainty for over-the-counter derivatives, remove

impediments to innovation, and reduce systemic risk. This bill responds to the

President’s Working Group’s request for urgent legislative action on its recommendations so that the U.S. may retain its leadership in rapidly developing financial markets. Implementation of the Working Group’s proposals is essential to

enable U.S. markets to keep pace with the technological and structural changes occurring in markets around the world, and reform of the Commodity Exchange Act

is a critical element of this process. The Commission recognizes the challenges involved in an undertaking of this complexity and appreciates the comprehensive approach to this task. The CFTC welcomes many of the provisions of H.R. 4541. There

are, however, two areas of concern—the scope of the energy exemption and new burdens on our enforcement authority—that preclude the Commission from supporting

the legislation in its current form.

The provisions of H.R. 4541 enhance legal certainty for over-the-counter derivatives by excluding from the CEA certain bilateral transactions entered into on a

principal-to-principal basis by eligible parties. Legal certainty is a crucial consideration when parties to OTC derivative contracts decide with whom and where to

transact business, and the President’s Working Group recognized that legal certainty for OTC derivatives is vital to the continued competitiveness of U.S. markets.

The Commission supports H.R. 4541’s exclusion for electronic trading facilities for

OTC financial derivatives to promote an environment in which innovative systems

can flourish without undue regulatory constraints. H.R. 4541 also permits clearing

of OTC derivatives and authorizes a mechanism for the CFTC to regulate facilities

that clear OTC derivative contracts. Again, the President’s Working Group specifically recommended removing legal obstacles to the development of appropriatelyregulated clearing systems to reduce systemic risk, and we support this recommendation with the following reservation. The bill would allow securities clearing

systems to clear a broader range of contracts than futures clearing systems. Futures

clearing facilities would have to register in a dual capacity—as futures and as securities clearing facilities—to clear the same mix of contracts available to securities

clearing facilities holding a single registration. By denying futures clearing systems

an equal opportunity to compete, the bill may inadvertently determine winners and

losers. We urge the Committee to avoid placing futures clearing facilities at a competitive disadvantage.

The Commission also supports the bill’s revision of the Treasury Amendment to

make clear our jurisdiction over transactions entered into between retail customers

and unregulated entities, including so-called ‘‘bucket shops.’’ We have long sought

legal clarity in this area to protect the public from foreign currency fraud, and the

President’s Working Group acknowledged the need for such a clarification.

H.R. 4541 would codify an exemption from most provisions of the Commodity Exchange Act for transactions in energy commodities. This is an area in which H.R.

4541 diverges from the recommendations of the President’s Working Group, and the

Commission believes that these provisions raise concerns that have yet to be resolved.

The Commission notes that this exemption for energy commodities, particularly

as it relates to electronic trading systems that approximate exchange environments,

is not governed by the same considerations that formed the basis of the Working

Group’s recommendations with respect to financial products. While there are some

similarities between the trading of financial products and non-financial products,

there are also significant differences. Most dealers in the swaps markets are financial institutions subject to supervision by bank regulatory agencies, affiliates of

broker-dealers regulated by the SEC, or affiliates of FCMs subject to CFTC oversight. ‘‘Accordingly, the activities of most derivatives dealers are already subject to

direct or indirect federal oversight.’’ (PWG at 16). The same cannot be said of trading in energy derivatives. The decision to extend the exclusion in H.R. 4541 to energy derivatives would leave these OTC products in a regulatory gap—neither directly regulated as financial products nor indirectly regulated by an agency with jurisdiction over commercial participants in the energy market. Thus, a principal argument warranting the exclusion of financial derivatives from the CEA—the fact

42

that derivatives trading in these products is subject to direct or indirect federal

oversight—does not fit OTC energy transactions.

The President’s Working Group also stated that most financial OTC derivatives

are not susceptible to manipulation. That case has not been made for energy products.

The CFTC has already exempted many types of energy trading from the provisions of the Commodity Exchange Act. But the exemption for energy commodities

included in H.R. 4541 expands the scope of the Commission’s existing exemptions

for such contracts. The Commission’s 1993 energy exemption is limited to those parties with the capacity to make or take delivery or the ability to contract to do so,

but H.R. 4541 would extend the exemption to encompass eligible contract participants as defined in the bill, not just those acting in a commercial capacity. The 1993

energy exemption is also limited to transactions in which the material economic

terms are subject to negotiation and that may not be cleared. H.R. 4541 specifically

permits clearing and places no limits on standardization of contract terms. In essence, unlike the Commission’s current energy exemption, H.R. 4541 would exempt

transactions that may be indistinguishable from those conducted in a traditional exchange environment. It is this multilateral trading aspect of the proposed statutory

exemption that gives rise to the Commission’s concerns.

The Commission recognizes that under the proposed exemption, energy transactions remain subject to the CEA’s antifraud and antimanipulation provisions and

to such transparency rules or regulations as the Commission may impose. We support the retention of these provisions. The Commission’s responsibility to police for

fraud and manipulation, however, can best be carried out if the Commission is also

granted the commensurate authority to promulgate regulations, where necessary, in

those areas.

Last month, the Commission published in the Federal Register its comprehensive

regulatory reform package, which alters fundamentally the Commission’s approach

to regulation of markets and participants under its jurisdiction. This proposal is

based on a comprehensive evaluation of the CFTC’s current regulatory structure

and represents an effort to streamline that structure and to relieve domestic exchanges from unnecessary regulatory requirements. The proposal also follows the

Congressional directive to transform the Commission from a frontline to an oversight regulator. The CFTC recently held two days of public meetings, with 23 witnesses representing a broad spectrum of interested parties, to maximize the input

the agency receives in crafting this new framework.

H.R. 4541 attempts to codify much of the Commission’s regulatory reform proposal, and we welcome the bill’s support of the Commission’s initiative to give registered entities the flexibility to determine the best way to structure their business

and to meet their self-regulatory obligations consistent with enumerated core principles.

In administering the new flexible structure envisioned by H.R. 4541 and the Commission’s regulatory reform proposal, the Commission will be moving to oversight

regulation in which the agency will no longer act as a gatekeeper and will intervene

only when a problem arises. To be successful in an oversight capacity, however, the

Commission must be able to act quickly and effectively to address fraud and manipulation, as well as to protect the financial integrity of the markets.

Section 15 of the legislation erects several barriers to enforcement action by the

Commission. When there is a violation of the core principles, the Commission must

delay any action until it provides an appropriate remedy to the violator. Moreover,

the bill requires that the remedy be based upon a cost/benefit analysis. Thus, the

provision may allow registered entities to postpone and possibly avoid responsibility

for violations of core principles by tying up the Commission in legal wrangling over

whether the agency successfully met the cost/benefit test. Another consequence is

that this section would essentially turn back the regulatory clock and force the

agency to revert to frontline regulation and issuance of prescriptive rules.

Section 15 also shifts the burden of proof to the Commission in making a determination that a registered entity is violating a core principle. This new obligation

would severely limit the Commission’s ability to take appropriate remedial action

outside the context of a formal enforcement proceeding. It is important for the Commission and regulated entities to be able to avail themselves of procedures designed

specifically to craft regulatory changes without the burden of proof and evidentiary

requirements characteristic of formal enforcement proceedings. These less formal

procedures have worked well in those situations in which the Commission has found

it necessary and appropriate to take remedial action involving a registered entity.

H.R. 4541 addresses the issue of equity futures contracts and reflects efforts to

develop a plan to amend the Shad-Johnson Accord. The Working Group recommended that the CFTC and the SEC work together to determine whether and

43

how the Accord should be amended. The agencies agree in principle that equity futures should be available to the marketplace. On March 2, the two agencies presented to Congress our areas of agreement and issues that remained unresolved

through that point, and on May 23, Chairman Levitt and Chairman Rainer met

with Senators Lugar and Gramm to discuss the issue further. The agency staffs

have agreed on many specific conditions to lifting the ban, such as harmonizing

margin requirements, restricting dual trading, testing for sales and supervisory personnel, and the establishment of uniform listing standards for single stock futures.

We acknowledge, however, a fundamental disagreement concerning the appropriate

legislative approach.

The Commission has sought to avoid creating a framework that potentially could

result in over-regulation of markets and intermediaries, and therefore the CFTC

staff has advocated identifying those core provisions from each regulatory regime

necessary to ensure an appropriate level of oversight for trading these products.

While the agencies have agreed in principle that duplicative regulation must be

avoided, the CFTC staff expressed concern that an ‘‘umbrella’’ approach imposing

the panoply of securities regulation to these products could result in overly burdensome regulation. The CFTC believes that it is important to bring single stock futures to the market in a way that does not result in the government favoring one

market over another, either by applying too light a touch or by being too heavyhanded. Subjecting the futures exchanges to securities laws that address public policy concerns already addressed by the CEA creates a burden that may preclude fair

competition between futures and securities exchanges. The Commission notes, however, the SEC’s belief that defining equity futures products as securities is essential

to its fulfillment of its regulatory functions.

This fundamental difference in approach has led to an apparent impasse, but the

agencies have nonetheless continued to try to reach a resolution. Last week, CFTC

and SEC staff met twice with Treasury Department staff to focus negotiations on

specific unresolved issues. We plan to continue these discussions.

With respect to H.R. 4541, we have no objection to the Shad-Johnson provisions

as they bear on regulatory issues related to the CFTC’s oversight of single stock futures. We wish to note, however, that we have stated from the outset of the discussion on repeal of the Accord that the CFTC believes a regulatory structure that

would allow single stock futures to trade on both securities and futures exchanges

is preferable to a structure that allows them to trade only on futures exchanges.

Again, the Commission appreciates the opportunity to present its views. I would

be happy to answer any questions you may have.

Mr. OXLEY. Thank you, Mr. Paul.

We have had the second bell; and I guess, in deference to the

members, we will suspend play here and recess the committee. The

committee will stand in recess until 12:30.

[Brief recess.]

Mr. OXLEY. The subcommittee will reconvene with our apologies.

Mr. Parkinson, please proceed.

STATEMENT OF PATRICK M. PARKINSON

Mr. PARKINSON. Thank you, Chairman Oxley. I am pleased to be

here today to present the Federal Reserve Board’s views on H.R.

4541, the Commodity Futures Modernization Act. My testimony

will be quite similar to testimony that Chairman Greenspan and I

presented last month to committees in the Senate and House, respectively. The Board continues to believe that such legislation

modernizing the CEA is essential. To be sure, the Commodity Futures Trading Commission has recently proposed issuing regulatory

exemptions that would reduce legal uncertainty about the enforceability of the over-the-counter derivatives, and would conform the

regulation of the futures exchanges to the realities of today’s marketplace. These administrative actions by no means obviate the

need for legislation, however.

I will focus on three areas that the legislation covers: First, overthe-counter derivatives; second, regulatory relief; and third, singleVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6602 65907.TXT HCOM2 PsN: HCOM2
44

stock futures. In its November 1999 report on over-the-counter derivatives, the President’s Working Group concluded that OTC

transactions should be subject to the CEA only if necessary to

achieve the public policy objectives of the act; that is, deterring

market manipulation and protecting investors against fraud and

other unfair practices.

In the case of financial derivative transactions involving professional counterparties, the Working Group concluded that regulation

was unnecessary for these purposes because financial derivatives

generally are not readily susceptible to manipulation and professional counterparties can protect themselves against fraud and unfair practices. Consequently, the Working Group recommended that

financial over-the-counter derivative transactions between professional counterparties be excluded from the coverage of the CEA.

The provisions of H.R. 4541 that address OTC derivatives are

generally consistent with the Working Group’s conclusions; therefore, the Federal Reserve Board believes it would be appropriate to

enact those provisions.

The Working Group did not make specific recommendations

about the regulation of traditional exchange-traded futures markets. Nonetheless, it called for the CFTC to review the existing regulatory structures, particularly those applicable to financial futures, to ensure they remain appropriate in light of the objectives

of the CEA. The Board supports the new approach to regulation

that was outlined in proposals issued by the CFTC last month. For

some time the Board has been arguing that the regulatory framework for futures trading, which was designed for the trading of

grains futures by the general public, is not appropriate for the

trading of financial futures by large institutions. The CFTC’s proposals recognize that the current one-size-fits-all approach to regulation of futures exchanges is inappropriate, and they generally incorporate sound judgments regarding the degree of regulation

needed to achieve the CEA’s purposes.

Similarly, the Federal Reserve Board generally supports the regulatory relief provisions of H.R. 4541. However, the CFTC has expressed concerns that the bill unduly restricts its authority to correct violations of the core principles of regulation. To facilitate expeditious passage of legislation, it thus may be prudent to address

the CFTC’s concerns about its enforcement authority. The Working

Group concluded that the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying

securities markets and regulatory arbitrage are resolved.

The Board believes that such instruments should be allowed to

trade on futures exchanges or on securities exchanges with primary

regulatory authority assigned to the CFTC or the SEC, respectively. However, the SEC should have authority over some aspects

of trading on these products on futures exchanges. The scope of the

SEC’s authority should be resolved through negotiations between

the CFTC and the SEC. Whatever agreement they reach should be

codified through amendments to H.R. 4541. In any event, the bill

should allow securities exchanges to compete with futures exchanges in listing single-stock futures.

H.R. 4541 reflects a remarkable consensus on the need for legal

certainty for OTC derivatives and regulatory relief for U.S. futures

45

exchanges, issues that have long eluded resolution. These provisions are vitally important to the soundness of our derivatives markets in what is an increasingly integrated and intensively competitive global economy. The Federal Reserve Board trusts the remaining differences regarding single-stock futures can be resolved quickly so that this important piece of legislation can be expedited

through this Congress.

Thank you. I am pleased to answer any questions you may have.

[The prepared statement of Patrick M. Parkinson follows:]

PREPARED STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION

OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE

SYSTEM

I am pleased to be here to present the Federal Reserve Board’s views on the Commodity Futures Modernization Act of 2000 (H.R. 4541). My testimony today will be

quite similar to testimony that Chairman Greenspan and I presented last month to

committees in the Senate and House, respectively. The Board continues to believe

that such legislation modernizing the Commodity Exchange Act (CEA) is essential.

To be sure, the Commodity Futures Trading Commission (CFTC) has recently proposed issuing regulatory exemptions that would reduce legal uncertainty about the

enforceability of over-the-counter (OTC) derivatives transactions and would conform

the regulation of futures exchanges to the realities of today’s marketplace. These administrative actions by no means obviate the need for legislation, however. The

greatest legal uncertainty affecting OTC derivatives is in the area of securitiesbased transactions, to which the CFTC’s exemptive authority does not extend. Furthermore, as events during the past few years have clearly demonstrated, regulatory

exemptions carry the risk of amendment by future commissions. If our derivatives

markets are to remain innovative and competitive internationally, they need the

legal and regulatory certainty that only legislation can provide.

In my remarks today I shall focus on three of the areas that the legislation covers:

(1) OTC derivatives; (2) regulatory relief for U.S. futures exchanges; and (3) repeal

of the Shad-Johnson prohibition of single-stock futures.

OTC DERIVATIVES

In its November 1999 report, Over-the-Counter Derivatives and the Commodity Exchange Act, the President’s Working Group on Financial Markets (PWG) concluded

that OTC derivatives transactions should be subject to the CEA only if necessary

to achieve the public policy objectives of the act—deterring market manipulation

and protecting investors against fraud and other unfair practices. In the case of financial derivatives transactions involving professional counterparties, the PWG concluded that regulation was unnecessary for these purposes because financial derivatives generally are not readily susceptible to manipulation and because professional

counterparties can protect themselves against fraud and unfair practices. Consequently, the PWG recommended that financial OTC derivatives transactions between professional counterparties be excluded from coverage of the CEA. Furthermore, it recommended that these transactions between professional counterparties

be excluded even if they are executed through electronic trading systems. Finally,

the PWG recommended that transactions that were otherwise excluded from the

CEA should not fall within the ambit of the act simply because they are cleared.

The PWG concluded that clearing should be subject to government oversight but

that such oversight need not be provided by the CFTC. Instead, for many types of

derivatives, oversight could be provided by the Securities and Exchange Commission

(SEC), the Office of the Comptroller of the Currency, the Federal Reserve, or a foreign financial regulator that the appropriate U.S. regulator determines to have satisfied its standards.

The provisions of H.R. 4541 that address OTC derivatives are generally consistent

with the PWG’s conclusions. At the margin, the provisions differ from those recommended by the PWG in terms of the range of counterparties covered by the exclusions. However, these differences reflect reasonable judgments regarding the types

of counterparties that can protect themselves against fraud and unfair practices.

Therefore, the Federal Reserve Board believes it would be appropriate to enact these

provisions.

46

REGULATORY RELIEF FOR U.S. FUTURES EXCHANGES

The PWG did not make specific recommendations about the regulation of traditional exchange-traded futures markets that use open outcry trading or that allow

trading by retail investors. Nevertheless, it called for the CFTC to review the existing regulatory structures, particularly those applicable to financial futures, to ensure that they remain appropriate in light of the objectives of the CEA. In February,

the CFTC published a report by a staff task force that provided a comprehensive

review of its regulatory framework and proposed sweeping changes to the existing

regulatory structure. Last month the CFTC issued a revised set of proposals for

public comment. With some exceptions, the regulatory relief provisions of H.R. 4541

are consistent with the CFTC’s proposals.

Using the same approach as the PWG, the CFTC has evaluated the regulation

of futures exchanges in light of the public policy objectives of deterring market manipulation and protecting investors. When contracts are not readily susceptible to

manipulation and access to the exchange is limited to sophisticated counterparties,

the CFTC has proposed alternative regulatory structures that would eliminate unnecessary regulatory burden and allow domestic exchanges to compete more effectively with exchanges abroad and with the OTC markets. More generally, the CFTC

proposes to transform itself from a frontline regulator, promulgating relatively rigid

rules for exchanges, to an oversight agency, assessing exchanges’ compliance with

more flexible core principles of regulation.

The Federal Reserve Board supports the general approach to regulation that was

outlined in the CFTC’s proposals. For some time the Board has been arguing that

the regulatory framework for futures trading, which was designed for the trading

of grain futures by the general public, is not appropriate for the trading of financial

futures by large institutions. The CFTC’s proposals recognize that the current ‘‘onesize-fits-all’’ approach to regulation of futures exchanges is inappropriate, and they

generally incorporate sound judgments regarding the degree of regulation needed to

achieve the CEA’s purposes.

Similarly, the Federal Reserve Board generally supports the regulatory relief provisions of H.R. 4541. However, the CFTC has expressed concerns that the bill unduly restricts its authority to correct violations of the core principles of regulation.

To facilitate expeditious passage of legislation, it thus may be prudent to address

the CFTC’s concerns about its enforcement authority.

SINGLE-STOCK FUTURES

The PWG concluded that the current prohibition on single-stock futures (part of

the Shad-Johnson Accord) can be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. The Board believes

that such instruments should be allowed to trade on futures exchanges or on securities exchanges, with primary regulatory authority assigned to the CFTC or the SEC,

respectively. However, the SEC should have authority over some aspects of trading

of these products on futures exchanges. The scope of the SEC’s authority can and

should be resolved through negotiations between the CFTC and the SEC. The Congress should continue to urge the two agencies to settle their remaining differences.

Whatever agreement they reach should then be incorporated through amendments

to H.R. 4541. In any event, the bill should allow securities exchanges to compete

with futures exchanges in listing single-stock futures.

If it would facilitate repeal of the prohibition, the Federal Reserve Board is willing

to accept regulatory authority over levels of margin on single-stock futures, as provided in H.R. 4541, so long as the Board can delegate that authority to the CFTC,

the SEC, or an Intermarket Margin Board consisting of representatives of the three

agencies. The Board understands that the purpose of such authority would be to

preserve the financial integrity of the contract market and thereby prevent systemic

risk and to ensure that levels of margins on single-stock futures and options are

consistent. The Board would note that, for purposes of preserving financial integrity

and preventing systemic risk, margin levels on futures and options should be considered consistent, even if they are not identical, if they provide similar levels of protection against defaults by counterparties, taking into account any differences in (1)

the price volatility of the contracts, (2) the frequency with which margin calls are

made, or (3) the period of time within which margin calls must be met.

CONCLUSION

H.R. 4541 reflects a remarkable consensus on the need for legal certainty for OTC

derivatives and regulatory relief for U.S. futures exchanges, issues that have long

eluded resolution. These provisions are vitally important to the soundness and comVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6621 65907.TXT HCOM2 PsN: HCOM2
47

petitiveness of our derivatives markets in what is an increasingly integrated and

intensely competitive global economy. The Federal Reserve Board trusts that the remaining differences regarding single-stock futures can be resolved quickly, so that

this important piece of legislation can be expedited through this Congress.

Mr. OXLEY. Thank you, Mr. Parkinson.

Mr. Sachs.

STATEMENT OF LEWIS A. SACHS

Mr. SACHS. Thank you, Mr. Chairman, and members of the subcommittee. I appreciate the opportunity to appear before you today

to discuss H.R. 4541, the Commodity Futures Modernization Act of

2000.

Mr. Chairman, the OTC derivatives markets provide a number

of benefits to our economy, enhancing the ability of businesses to

manage their risk profiles, to compete more effectively in the global

marketplace and to deliver more efficiently and at lower cost a

wide range of products and services to the American consumer. It

was with this in mind that last year the President’s Working

Group on Financial Markets, chaired by the Secretary of the Treasury, was requested to conduct a study of the OTC derivatives markets and the Commodity Exchange Act.

In response, the Working Group developed a set of unanimous

recommendations designed to reduce systemic risk, promote innovation, protect retail customers, maintain U.S. competitiveness in

these markets and protect the integrity of the underlying markets.

We believe that it is important to move forward with appropriate

legislation designed to accomplish these important objectives as

soon as possible. The legislation before you today largely incorporates the recommendations of the Working Group with respect to

OTC derivatives, and we support enactment of these provisions.

Let me touch upon a few of the specific objectives that the bill

addresses. First, H.R. 4541 would provide legal certainty. With regard to swap agreements, the Working Group sought to address an

area in which the need for change had been clearly demonstrated.

The Commodity Exchange Act was designed to address issues of

fraud, manipulation and price discovery. Therefore, the Working

Group unanimously recommended clarifying the legal status of

these instruments by creating a statutory exclusion from the CEA

only for transactions among large sophisticated parties involving

instruments not readily susceptible to manipulation and that do

not currently serve a price discovery function. This bill would establish such an exclusion and would permit the electronic trading

of these instruments, and we are supportive of these provisions.

Second, this bill would provide for the development of appropriately regulated clearinghouses. Well-designed clearinghouses

can help to reduce systemic risk. Consistent with the Working

Group’s recommendation, the bill provides for the development of

clearinghouses through clarification of their legal status and also

requires that they be regulated. We believe these provisions can

make an important contribution toward mitigating systemic risk.

Finally, this legislation takes an important step toward protecting retail customers by providing the CFTC with explicit authority to regulate foreign currency bucket shops. We are pleased

that the provisions have been included in this bill.

48

Let me discuss the bill’s provisions relating to the reform of the

Shad-Johnson Accord. We believe, as the Working Group report

states and has been quoted several times here today, that the current prohibition on single-stock and narrow based-stock index futures can be repealed if issues about the integrity of the underlying

securities markets and regulatory arbitrage are resolved. There are

a number of concerns, however, that the regulatory agencies consider important that have not yet been resolved.

As we have stated, it is important for the SEC and CFTC to

jointly address these issues. We are committed to making every effort to facilitate progress in resolving these issues. However, if

these issues cannot be resolved on a timely basis, we believe that

it is important to move forward with legislation designed to clarify

the legal certainty for OTC derivatives and to implement the other

recommendations of the Working Group.

Turning finally to the bill’s provisions regarding regulatory relief

for futures exchanges, we continue to support the view that it is

appropriate to review from time to time existing regulatory structures to determine whether they continue to serve valid public policy functions. Broadly, we are supportive of the CFTC efforts to

provide appropriate regulatory relief to the futures exchanges. We

recognize the need for competitive parity between the exchanges

and off-exchange markets, particularly as the status of off-exchange

markets is clarified.

Before concluding, Mr. Chairman, let me touch upon one issue

that is not part of the bill before you today but which is related

and vitally important to the smooth functioning of our markets

during periods of volatility. I would like to take this opportunity to

strongly urge Congress to adopt the Working Group recommendations regarding the treatment of OTC derivatives and certain other

financial contracts in cases of bankruptcy or insolvency. Rarely are

there tangible steps the government can take that can have a

meaningful impact on the mitigation of systemic risk, and this is

one such opportunity.

In conclusion, Mr. Chairman, we have an opportunity to advance

legislation that will create a modern legal and regulatory framework for OTC derivatives. We look forward to working with you

and the other members of this committee and our colleagues of the

Working Group to advance these important objectives.

That concludes my opening remarks. I would be happy to answer

any questions and ask that my prepared remarks be submitted for

the record.

[The prepared statement of Lewis A. Sachs follows:]

PREPARED STATEMENT OF LEWIS A. SACHS, ASSISTANT SECRETARY, DEPARTMENT OF

TREASURY

Chairman Oxley, Ranking Member Towns, members of this Subcommittee, I appreciate the opportunity to appear before you today to discuss H.R. 4541, the Commodity Futures Modernization Act of 2000.

In November 1999, the President’s Working Group on Financial Markets presented its report Over-the-Counter Derivatives Markets and the Commodity Exchange Act to the Congress. In this report, the Working Group, which is chaired by

Secretary Summers and includes the Chairmen of the Federal Reserve, the Commodity Futures Trading Commission and the Securities and Exchange Commission,

set forth a series of unanimous recommendations designed to reform the legal and

49

regulatory framework affecting the OTC derivatives market. The legislation before

you today would enact many of those important recommendations.

I would like to begin by providing some background on OTC derivatives and the

recommendations of the President’s Working Group on Financial Markets. I will

then turn to H.R. 4541 more specifically, including the bill’s treatment of OTC derivatives, regulatory relief for the futures exchanges, and the reform of the ShadJohnson restrictions on the trading of single stock and narrow-based stock index futures.

I. OTC DERIVATIVES AND THE PRESIDENT’S WORKING GROUP’S RECOMMENDATIONS

Mr. Chairman, our financial sector is the central nervous system of the American

economy. As our economy and our financial markets have evolved over the past two

decades, so too have the needs of the financial sector. Most notably, in an era of

globalization, volatility of interest rates, increased securitization and the growth of

the bond markets relative to the traditional loan markets, businesses and financial

institutions have required a more diverse and effective set of tools for managing

risk.

In that sense, the over-the-counter derivatives market has grown directly in response to the needs of the private sector. An OTC derivative is an instrument that

allows a party seeking to reduce its risk exposure to transfer that exposure to a

counterparty that wants and may be in a better position to assume the risk. This

is an important development that has significantly enhanced the ability of businesses to manage their risk profiles, to compete more effectively in the global marketplace, and to deliver more efficiently and at lower cost a wide range of services

and products to the American consumer.

Because of these rising demands, the notional value of global OTC derivatives has

risen more than five-fold over the past decade, to more than $80 trillion according

to estimates produced by the Bank for International Settlements.

The benefits to the American economy of OTC derivatives would continue to grow

within a proper and appropriate framework of legal certainty. For example:

• By helping businesses and financial institutions to hedge their risks more efficiently, OTC derivatives enable them to pass on the benefits of lower product

costs to American consumers and businesses.

• By allowing for the transfer of unwanted risk, OTC derivatives promote the more

efficient allocation of capital across the economy, further increasing American

productivity.

• By providing better pricing information, OTC derivatives can help promote greater efficiency and liquidity of the underlying cash markets that feed into a

stronger economy for all Americans.

• And, by enabling more sophisticated management of assets, including mortgages,

consumer loans and corporate debt, OTC derivatives can help lower mortgage

payments, insurance premiums, and other financing costs for American consumers and businesses.

Thus, OTC derivatives have the potential to bring important benefits to our economy. It was with the importance of OTC derivatives in mind that, last year, the

Congress requested that the Working Group conduct a study of the OTC derivatives

market and recommend changes required to ensure that we continue to reap such

benefits.

In response, the Working Group developed its set of unanimous recommendations

designed to achieve four objectives:

• First, to reduce systemic risk in the OTC derivatives market by removing legal

impediments to the development of clearing systems and ensuring that those

systems are appropriately regulated.

• Second, to promote innovation in the OTC derivatives market by providing

legal certainty for OTC derivatives and electronic trading systems. This would

strengthen the overall legal framework governing the OTC derivatives market

and, in turn, would stimulate greater competition, transparency, liquidity, and

efficiency and deliver stronger benefits to US consumers and businesses.

• Third, to protect retail customers by ensuring that appropriate regulations

are in place to deter unfair practices in all markets in which they participate

and by closing existing legal loopholes that allow unregulated entities to pursue

such unfair practices through foreign currency transactions.

• And fourth, to maintain US competitiveness by providing a modernized

framework that will lead those engaged in the financial services industry to continue the operations of their businesses in the United States, and thereby promote the continued leadership of American capital markets.

50

Given the scope of the bill before you today—providing legal certainty to OTC derivatives, reforming the Shad-Johnson Accord, and providing regulatory relief for futures exchanges—today I would add a fifth important objective:

• To protect the integrity of the markets underlying the derivatives in question—in particular, the securities markets.

While seeking to accomplish these objectives, we need to recall that the emergence

of the OTC derivatives market has come during an era of unprecedented economic

strength and prosperity.

It is to be expected that in times of distress some participants in these markets,

as in other financial markets, will be adversely affected. The recommendations we

have made, and the provisions in this bill, will not prevent these situations from

occurring, nor are they intended to do so. What needs to be protected, however, is

the financial system as a whole, and not individual institutions.

We believe that our recommendations with respect to clearing and those designed

to enhance transparency and legal certainty and to clarify the treatment of derivatives in the case of bankruptcy or insolvency can contribute to enhancing the stability of the system more broadly.

II. THE COMMODITY FUTURES MODERNIZATION ACT OF 2000

Let me now turn to the legislation before you today, H.R. 4541. Mr. Chairman,

we believe that this bill incorporates many of the recommendations of the Working

Group with respect to OTC derivatives which, if enacted, would promote greater

legal certainty for these instruments and help to advance the Working Group’s other

objectives. In particular, with respect to legal certainty, we believe that this bill,

with minor changes, would strike the appropriate balance between allowing the

economy to realize more fully the benefits of derivatives and, at the same time, ensuring the integrity of the underlying markets, providing appropriate protection for

retail customers, and where possible, taking steps to mitigate systemic risk.

Moreover, we believe that it is important to move forward with appropriate legislation as soon as possible. A failure to act in this area would risk a situation in

which the existing legal framework for our financial markets would lag significantly

behind the development of the markets themselves.

In the absence of an updated legal and regulatory environment, needless systemic

risk might jeopardize the broader vitality of the American capital markets; innovation might be stifled by the absence of legal certainty; and American consumers

might be deprived of the benefits that a more appropriate legal framework would

promote. We also risk an erosion of the competitiveness of American financial markets, with an increasing amount of business moving offshore to jurisdictions in

which the regulatory framework has kept up with the pace of change.

With this in mind, I would like to address the three major areas of the bill:

• First, the bill’s approach to OTC derivatives;

• Second, the provisions of the bill designed to provide regulatory relief for futures

exchanges; and

• Finally, the provisions of the bill providing for the repeal of the Shad-Johnson restrictions on the trading of single stock and narrow-based stock index futures.

OTC Derivatives

Let me first discuss the bill’s provisions regarding OTC derivatives. H.R. 4541

would take significant steps toward achieving the Working Group’s goals by enacting most of our recommendations regarding OTC derivatives. While there are a few

changes which we would like to see enacted, such as amendments to the definition

of eligible contract participants and of excluded commodity, we believe that the legislation takes an appropriate approach to OTC derivatives and encourage the Congress to adopt these provisions. Let me touch upon a few of the specific objectives

that this bill helps to accomplish.

First, H.R. 4541 would provide legal certainty. The Working Group members spent

several months studying and developing recommendations regarding the appropriate status of OTC derivatives under the Commodity Exchange Act. We focused

upon areas in which the need for change had been demonstrated in our markets.

With regard to swap agreements, the Working Group sought to remove the cloud

of legal uncertainty resulting from questions about the enforceability of certain swap

contracts in U.S. courts. This uncertainty resulted from a lack of clarity regarding

whether the CEA applies to certain OTC derivative transactions. The CEA was designed primarily to address issues of fraud, manipulation, and price discovery. Thus,

the Working Group unanimously recommended that the legal status of such contracts be clarified by creating a statutory exclusion from the CEA for certain OTC

derivative transactions which do not require regulation for these public policy reaVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6621 65907.TXT HCOM2 PsN: HCOM2
51

sons. The exclusion is limited to transactions involving qualified participants who

do not require the additional protections of the CEA, and the instruments subject

to the exclusion generally are not susceptible to manipulation, nor do they serve a

primary price discovery function at this time.

H.R. 4541 would establish such an exclusion for certain swap agreements and

thereby ensure that the U.S. OTC derivatives market can develop within the kind

of innovative and legally stable environment on which the continued competitiveness of our financial markets depend.

Second, H.R. 4541 would provide for the development of appropriately-regulated

clearinghouses. The Working Group’s report recommended that Congress enact legislation to provide a clear basis for the development of appropriately-regulated clearing systems for OTC derivatives. Well-designed clearinghouses can help to reduce

systemic risk: first, by diminishing the likelihood that the failure of a single market

participant can have a disproportionate effect on the market as a whole; and second,

by facilitating the offsetting and netting of contract obligations. In addition to these

benefits, however, clearing tends to concentrate risks and certain responsibilities for

risk management in a central counterparty or clearinghouse. Therefore, appropriate

regulation of clearing systems is essential to ensure that they indeed serve to mitigate systemic risk.

Under the Working Group framework, regulatory oversight could be provided by

the CFTC, SEC, a federal banking regulator, or by a recognized foreign regulatory

authority, depending on the structure of the clearinghouse and its activities.

H.R. 4541 provides for the development of clearinghouses, and requires that they

be regulated. It thereby can provide the beneficial effects of reducing systemic risk

by encouraging the development of such systems through the clarification of their

legal status and by subjecting them to appropriate supervision.

However, we believe that H.R. 4541 could be improved by clarifying the scope of

the SEC’s authority to regulate clearinghouses that clear securities and that also

wish to clear OTC derivatives.

Finally, H.R. 4541 takes important steps toward protecting retail customers. The

Working Group recommended that the CFTC be granted explicit authority to regulate foreign currency ‘‘bucket shops’’ and to prosecute such entities when they attempt to defraud retail customers. H.R. 4541 provides such authority to the CFTC,

thus strengthening protection for small investors. Again, this is an area in which

problems have arisen, and the need for appropriate oversight clearly has been demonstrated. We are pleased to see these provisions incorporated in the bill.

The Shad-Johnson Accord

Let me now turn to the section of the bill addressing reform of the Shad-Johnson

Accord. The members of the Working Group agreed that the current prohibition on

single-stock and narrow-based stock index futures could be repealed if issues about

the integrity of the underlying securities markets and regulatory arbitrage are resolved. Our view remains unchanged.

The provisions contained in this bill regarding futures on non-exempt securities

are a good starting point, although a number of issues remain unresolved. The bill

addresses some of the customer protection and enforcement concerns identified by

the CFTC, the SEC, and others as necessary conditions for repealing the prohibition

on single-stock futures. However, there are a number of concerns that the regulatory agencies consider important, but that have not been resolved in the legislation. We hope that the SEC and CFTC can provide specific comments on these

issues in the near future so that they can be incorporated into this bill.

In particular, certain issues related to the harmonization of margin requirements

will need to be clarified. While we do not see the need to establish margin requirements in statute, it will be important for regulatory authorities to establish margin

levels that do not encourage regulatory arbitrage or lead to a substantial increase

in leverage in our financial system.

While we have no objection to the introduction of single-stock or narrow-based

stock index futures, it is vitally important that the integrity of the underlying markets be preserved, and that these instruments not be used as a means to avoid the

regulations of the cash markets. Therefore, we continue to encourage efforts by the

SEC and CFTC to reach an agreement on a regulatory framework for these products

that preserves the integrity of the underlying securities markets. However, if these

issues cannot be resolved on a timely basis, we believe that it is important to move

forward with legislation designed to clarify the legal certainty for OTC derivatives

and to implement the other recommendations of the Working Group.

52

Regulatory Relief

The third component of this bill addresses regulatory relief for the futures exchanges. The Treasury Department continues to support the view that it is appropriate to review, from time to time, existing regulatory structures to determine

whether they continue to serve valid public policy functions. Like the OTC markets,

exchange trading of derivatives should not be subject to regulations that do not have

a public policy justification. Broadly, we are supportive of the CFTC’s efforts to provide appropriate regulatory relief to the futures exchanges, consistent with the public interest. To this end, the CFTC has recently released its regulatory relief proposal for public comment. We will be submitting a formal comment letter on this

proposal in the near future.

There may, however, be unforeseen consequences to legislating such regulatory relief. Once such provisions are written into law, the regulators will have no ability

to review and amend them should subsequent market developments warrant change

or should other problems arise. Again, we are supportive of appropriate regulatory

relief for futures exchanges, but suggest that certain aspects of that relief may be

more appropriately provided through administrative action.

III. THE IMPORTANCE OF CLARIFYING THE TREATMENT OF FINANCIAL CONTRACTS IN

BANKRUPTCY

Mr. Chairman, although not part of this bill, I would like to take this opportunity

to strongly urge Congress to adopt the President’s Working Group recommendations

regarding the treatment of OTC derivatives and certain other financial contracts in

cases of bankruptcy or insolvency. Rarely are there tangible steps the government

can take that could have a meaningful impact on the mitigation of systemic risk.

Enacting the recommendations of the Working Group designed to clarify the treatment of these instruments in bankruptcy is one of those steps. By establishing a

framework through which creditors and counterparties can work out a swift resolution in cases of bankruptcy or insolvency, enactment of these recommendations can

serve to reduce the impact of the failure of any one institution on the stability of

the system more broadly.

IV. CONCLUSION

In conclusion, Mr. Chairman, we have an opportunity to advance legislation that

will create a modern legal and regulatory framework for OTC derivatives designed

to promote innovation, protect retail customers, reduce systemic risk, maintain U.S.

competitiveness, and ensure the integrity of our markets. We look forward to working with the members of this Committee, other members of Congress, and our colleagues on the President’s Working Group in an effort to further advance these important objectives.

Thank you.

Mr. OXLEY. Thank you, Mr. Sachs. Let me begin my 5 minutes

with Mr. Parkinson. The provisions on legal certainty in the legislation, does that really solve all of the legal certainty problems that

OTC markets now face?

Mr. PARKINSON. I think it solves the most significant legal certainty problems; that is, those relating to eligible participants, that

is, institutions and wealthy individuals use of securities-based derivatives, electronic trading systems—other than perhaps those for

agricultural products—and clearing facilities. What it leaves unresolved is whether the CEA applies to retail swap transactions, but

I would note that we don’t believe that there is a significant

amount of retail activity at this time that is being imperiled by

that uncertainty.

Mr. OXLEY. Do the margin provisions in the bill adequately address concerns about consistent margins on single-stock futures

and options?

Mr. PARKINSON. Yes, in the sense that the bill empowers the

Federal Reserve to ensure that margins are consistent, and it

makes clear what is meant by consistency in this context. I think

we do have some technical comments regarding the provisions that

53

define what consistency means, which I think would be the major

source of potential confusion and conflict. But yes, I think in that

sense it does provide a solution.

Mr. OXLEY. Let me ask Mr. Paul, what is the overlap between

your regulatory relief proposal and this bill?

Mr. PAUL. Congressman, the bill attempts to codify very much of

our regulatory relief proposal as published in the Federal Reserve

last June. However, our proposal is out for public comment, and

the comment period extends until August 7. We anticipate getting

comments in response to those, perhaps making further refinements in our proposal, but we believe that the codification put

forth in the legislation is fundamentally close with our proposal

and we would expect where our proposal ends up that we would

support the legislation and would look forward to working with

congressional staffs to fine-tune any adjustments that would be required so that our regulatory proposal would match up with the

codification.

Mr. OXLEY. You heard some criticism from the dais earlier about

shifting from a front-line regulator to an oversight role. First of all,

your comments; and second, how would it impact this legislation?

Mr. PAUL. I will answer the second question first.

One way that it would impact, as I suggested in my remarks, my

opening remarks, is that because we are moving from prescriptive

rules to general core principles, we believe it is more important

than ever that we have enforcement authority that we can exercise

quickly and effectively. And we are concerned with the form of the

legislation currently, that may delay and hamstring us in administering or taking quick and decisive enforcement action. So we believe that if we modify that provision in the legislation, we would

be in a position to continue with our current enforcement efforts,

and I guess in connection with some of the comments made earlier

I just want to make the point that we believe that in our 25-year

history we have a very effective record of meaningful and diligent

enforcement in protecting the futures markets, both for institutional as well as retail investors.

Mr. OXLEY. Mr. Sachs, what has been the Treasury’s role in facilitating agreement between the SEC and CFTC on the regulation

of single-stock futures?

Mr. SACHS. Mr. Chairman, we have only in recent weeks been

asked to see if we can help facilitate those discussions. The CFTC

and SEC have had an extensive period of discussion on Shad-Johnson to see if they could resolve the remaining issues. We have held

several meetings. We have another one I believe this afternoon, to

see if we can’t move the process along further, to make clear to everyone where there is agreement and where there is disagreement

and to see if we might not be able to help bridge that gap.

Mr. OXLEY. Is it possible for CFTC and the SEC, with your help,

to reach an agreement before we start to mark up this vehicle?

Mr. SACHS. I don’t know the answer to that yet, Mr. Chairman.

It is still early in our involvement. The issues are, as everyone has

stated, quite complicated. The two different approaches that the

different agencies take to the way that they regulate their own

markets are quite different. We are going to make every effort to

54

try to get this done on a timely basis to be helpful to your committee. But I can’t provide any guarantees.

Mr. OXLEY. This is somewhat similar to operating subsidiaries

during the last session. I hate to reopen old wounds, but it struck

me as there are some similarities here. Other than the CFTC, who

I am sure watched from afar with fascination, but as far as the role

of the Fed and the Treasury and ultimately getting an agreement

from Mount Olympus on op subs which allowed us to go forward

and pass historic legislation, and perhaps Mr. Sachs we can make

history one more time in that regard.

Mr. SACHS. I hope to be able to come back in a few weeks and

say that everyone was able to learn from the experience of last

year and push this along. I can only—we will be happy to report

to you every several days.

Mr. OXLEY. We appreciate your working with our staff. As I say,

we are under a severe time constraint and we want to make every

effort to try to craft legislation. We appreciate your participation,

all of your participation.

The gentleman from Staten Island.

Mr. FOSSELLA. Thank you, Mr. Chairman. Just a brief question

for all members of the panel. Do you have any concern whatsoever—some opponents of the bill have raised concern about its impact on the margins and potential for insider trading and a concern

that there will be manipulation of stock. Do you have any opinion

on that? And if so, I would like to hear it.

Mr. PAUL. Let me take the first crack in answering that, Congressman.

From the very beginning in our negotiations with the SEC, the

CFTC has recognized the importance of harmonizing margins between the two markets. We have discussed a number of approaches

to that with the SEC. We are in general agreement that the margins should be harmonized. Whether we do that with the intervention of the Federal Reserve Board or whether we do it just between

our two agencies, we think either way would work and we would

be willing to take either approach.

With respect to insider trading, we have acknowledged and are

in full agreement with the SEC that it is absolutely essential that

any trading of single-stock futures or narrow-based indices on the

futures side would not provide a vehicle to circumvent the securities laws and the protections that currently exist. That is why we

have advocated and continue to support that the SEC be given authority to prosecute insider trading wherever it takes place, whether it be on the securities or futures side. We think that the bill does

that, but we are interested in continuing to work with the SEC on

any ways that we can make that stronger and make that clearer.

So I actually think that both agencies are in nearly full agreement on both those issues.

I will just add one other thing which has come up throughout the

conversation today, and that is customer suitability. We also agree

with the SEC for the need for customer suitability on the futures

side. We agree that to the extent that any futures registrants

should be trading these products, they should be subject to customer suitability rules on the futures side equivalent to the rules

on the securities side.

55

Mr. FOSSELLA. When was the last time you met with the SEC?

Mr. PAUL. On this matter was last Friday, and we are scheduled

to meet again this afternoon, which we may be postponing until tomorrow based on running over today. We continue to move closer

to full agreement.

Mr. PARKINSON. On the margin issue, I think this is being painted as much more difficult than it actually is. We hear again and

again that the margin for single stocks in the security markets is

50 percent and that margins in the futures markets are 5 percent.

In a sense, but only in a very misleading sense, that is true. The

50 percent margin is the initial margin on an individual stock. The

5 percent margin or 5.5 percent margin is the maintenance margin

on a stock index. Maintenance margins in the securities markets

are 25 percent, not 50 percent. Furthermore, if one used the same

methodology that the Chicago exchanges use in coming up with

their 5.5 percent on a stock index product, that would translate

into a significantly higher margin for a single stock. I think, depending on the volatility of the individual stock, that could be anywhere from 10 percent to 30 percent, with the 10 percent applying

to the lower volatility high-cap stocks, and the 30 percent applying

to the truly speculative issues of thinly capitalized firms.

Thus, I think framing the issue on terms of 50 percent versus 5

percent makes it look like the differences between the margining

systems used in the futures markets and the margining systems

that are in place in securities markets are much greater than they

in fact are.

Mr. SACHS. I have nothing further to add to either of these comments.

Mr. FOSSELLA. Mr. Sachs, are you concerned at all, or Mr. Parkinson, that there may be a competitive disadvantage between the

exchanges?

Mr. SACHS. With respect to single-stock futures?

Mr. FOSSELLA. Yes.

Mr. SACHS. Well, we hope that—we think that it is possible to

craft the legislation such that those advantages would not be—so

that there wouldn’t be those advantages and disadvantages. I think

if we can all come to agreement on how these instruments should

be regulated, that there would not be meaningful differences such

that one set of exchanges would have an advantage over the other.

And that is actually something that we need to keep in mind as

we work on this agreement and as you consider the legislation.

Mr. PARKINSON. One obvious point, the H.R. 4541 allows singlestock futures to be traded on futures exchanges, but does not permit securities exchanges to trade them, so that obviously is a severe competitive imbalance. I think we have urged, and I believe

Bob has urged, that as this legislation moves forward, it should be

modified so if we have trading of single-stock futures, as everyone

is urging, that stock exchanges and futures exchanges be able to

compete in listing the products.

Mr. FOSSELLA. Thank you, Mr. Chairman.

Mr. OXLEY. The gentleman’s time has expired. The gentleman

from New York, Mr. Towns.

Mr. TOWNS. Mr. Chairman, I am certain that every question has

been asked and every answer has been given. I think that what I

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would basically say is that I look forward to working with you to

try and resolve some of the problems that exist, and I think that

working together we can come up with a solution and be able to

move something forward.

I think that the time to do it is now. We don’t have a big turnaround time, but the point is if we work hard in some of the areas,

I think we can come up with a compromise. I look forward to working with you and of course, Mr. Chairman, working with you and

trying to resolve those issues to be able to move this legislation forward.

On that note I yield back the balance of my time.

Mr. OXLEY. I thank the gentleman for his comments. Indeed, I

share them as well. We want to thank all of you. This committee

does not want to stand in the way of the SEC and the CFTC meeting during this critical period of time. In that regard I would ask

unanimous consent that all opening statements be made part of the

record and the subcommittee stands adjourned.

[Whereupon, at 12:57 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

PREPARED STATEMENT OF BOARD OF TRADE OF THE CITY OF CHICAGO

The Chicago Board of Trade is pleased to submit for the record this testimony on

H.R. 4541. We strongly endorse this vital legislation. We appreciate this Subcommittee’s interest in the issues addressed in H.R. 4541 and welcome the opportunity to

summarize for you our views on the legislation.

All commerce involves price risk. Futures markets help to address that price risk

by offering a vehicle for shifting those risks to others or identifying a going market

rate. For many decades, agricultural futures contracts traded on U.S. futures exchanges were the only organized, centralized markets for managing price risk. Since

1975, that list of commodities has expanded to include precious metals, petroleum

products, foreign currency and interest rates. In 1982, the list was expanded again

to include stock indexes like the Dow Jones Industrial Average. All of those markets

are regulated under the Commodity Exchange Act, a statute administered since

1975 by the Commodity Futures Trading Commission.

In the last fifteen years this landscape has changed. Financial engineers on Wall

Street have invented swaps and other derivatives to replicate the risk-shifting benefits of futures trading. Swaps have become enormously popular and profitable, offering tailored, customized risk-shifting service to most facets of our economy. Swaps

are traded on interest rates, currency rates, commodity prices and equity securities.

Today, swaps are even offered in more standardized versions on electronic trading

platforms. And, swap transactions are not subject to any form of regulation that

even approaches the regulation of futures or securities markets.

This development triggered or exacerbated three problems.

First, the Commodity Exchange Act covers all futures contracts. All futures must

be traded on CFTC-regulated exchanges, absent an exemption. If a swap is a futures

contract, it is illegal and voidable by either party to the transaction. As a result,

swaps today are said to operate under a cloud of legal uncertainty caused by the

perceived lack of specificity in the Commodity Exchange Act’s coverage.

Second, as the President’s Working Group observed last year, the development

and maturation of the swaps market has blurred many of the traditional ways that

swaps were distinguished from futures contracts. Since swaps are largely unregulated and futures are heavily regulated, the Working Group unanimously agreed

that something should be done to rectify that competitive disparity without imposing additional burdens on swaps.

Third, despite the current legal uncertainty, equity swaps are being offered on

single equity securities. In 1982, however, Congress adopted what is known as the

Shad-Johnson Accord and imposed what it thought was a ‘‘temporary’’ moratorium

on trading in futures on single equity securities. (The moratorium was to be temporary while the SEC and CFTC figured out the best way to regulate single stock

futures. Congress is still awaiting that joint recommendation some 18 years later.)

If equity swaps are futures, they too are subject to that ‘‘temporary’’ ban. If swaps

are not futures, then the futures exchanges simply need to start offering equity

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swaps to avoid the ban. Since figuring out what transactions are futures and what

transactions are not has stymied Congress, the courts and commentators for many

years, the President’s Working Group recommended last year finding a way to simply lift the ban while addressing any major market integrity issues.

H.R. 4541 attempts to resolve each of these three challenges. It does so by promoting fair competition to strengthen U.S. markets while minimizing, but not eliminating, regulatory arbitrage. It treats the competitive interests of the swaps dealers,

futures exchanges and options exchanges in a fair and even-handed manner. It recognizes and tries to anticipate the role of technology in the markets of the future.

And it preserves important public and market integrity protections. H.R. 4541 is

comprehensive, balanced and responsible.

First, H.R. 4541 attempts to address the legal uncertainty issue by creating

bright-line tests defining what transactions are subject to the CEA and what are

not. The lines drawn are basically adapted from last year’s President’s Working

Group Report. Any transactions in financial commodities, called excluded commodities, not on a physical trading facility are excluded from the CEA unless they involve a retail customer. Special rules apply to these transactions when traded on

electronic trading facilities. In that context, the CEA does not apply to trades that

meet two tests: trades must be principal to principal (not on behalf of customers)

and limited only to sophisticated counterparties or institutions. Excluded transactions may be subject to clearing arrangements and still be excluded from regulation.

As a result of these provisions, many futures contracts traded today on CFTC-regulated exchanges, including futures on currencies, Eurodollars and stock indexes,

could be offered without any form of regulation, even if traded on the same centralized electronic systems the futures exchanges use. This regulatory arbitrage is even

more pronounced when one considers that over 95% of the market participants in

exchange-traded futures today are the same professional, sophisticated counter-parties that are eligible to trade in the excluded futures. The net result of these provisions: same contracts, same customers, same trading system, but very different regulatory treatment.

H.R. 4541’s second prong attempts to minimize this regulatory arbitrage by modernizing the regulatory burdens imposed on exchanges. Instead of current law’s innumerable rigid mandates that promote government micromanagement, H.R. 4541

requires exchanges to meet flexible performance standards, subject to the CFTC’s

oversight, in order to discharge their self-regulatory obligations. Exchanges could

tailor their systems for compliance with specific self-regulatory requirements to the

needs of different markets, rather than the current ‘‘one size fits all’’ brand of regulation. On balance, the message of H.R. 4541 to the futures exchanges is this—Congress will not shackle your over-the-counter competition; it wants you to compete

with them and is willing to give you many of the tools you believe you need to compete effectively on a fair, if not completely level, playing field.

The third prong of H.R. 4541 involves a similar message in the area of equitybased derivatives. The 1982 ban on single stock futures would be lifted subject to

special regulatory requirements that are designed to accommodate the areas of concern expressed by the Securities and Exchange Commission, and others. Specifically,

single stock futures must be: 1) cash-settled; 2) not susceptible to manipulation; 3)

traded at margin levels that are consistent with stock options margins; 4) traded

only on stocks that meet SEC eligibility requirements for stock options; 5) traded

without dual trading brokers; and 6) offered only on exchanges that agree to provide

the SEC such information as the SEC and CFTC jointly consider to be necessary

for the SEC to carry out its enforcement powers. Under those enforcement powers,

the SEC is free to bring actions to enforce core securities law protections in connection with single stock futures trading: insider trading, short swing profits, manipulation, front-running, tender offer pricing and integrity and trading in restricted securities. The SEC would be able to bring these actions unilaterally without seeking

cooperation or concurrence from the CFTC.

In addition, margins for single stock futures would ultimately be set and supervised by the Federal Reserve Board or an Intermarket Margin Board where the SEC

and CFTC would have an equal voice. And the futures industry-wide self-regulatory

body, the National Futures Association, would adopt and enforce a special suitability rule for any futures professional that recommended a single stock futures

trade to a customer. NFA must consult with the SEC and CFTC, and obtain CFTC

approval of this rule, within 9 months of the date of enactment.

H.R. 4541 responds to the three critical issues that the General Accounting Office,

in its April 2000 report, identified for single stock futures—insider trading, margin

and suitability—by, in effect, incorporating securities law concepts into the futures

regulatory apparatus. Through these special provisions, H.R. 4541 addresses the

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major areas of possible regulatory arbitrage between futures exchanges and options

exchanges. As in the area of off-exchange and on-exchange futures trading described

earlier, the bill minimizes, but does not eliminate entirely, regulatory arbitrage. Instead, H.R. 4541 promotes competition by finally allowing the futures exchanges to

offer equity-based derivatives that swaps dealers and options exchanges now may

offer in other guises.

Mr. Chairman, many observers believe that U.S futures exchanges are falling behind their competition both overseas and over-the-counter. Today, the Swiss-German electronic exchange, called EUREX, has replaced the Chicago Board of Trade

as the futures exchange with the highest trading volume. To address these threats,

the Board of Trade is restructuring and reorganizing its business operations to

maximize our chances of capturing the benefits of new technology and innovations.

We know we are in for a fight and we are willing to compete. Rationalizing regulation and removing competitive barriers imposed by statute, as contemplated by H.R.

4541, are critical elements in our competitive battle.

For these reasons, the Chicago Board of Trade strongly endorses H.R. 4541. It

tackles the difficult challenges of modern markets in a pro-competitive manner without sacrificing important regulatory interests. We urge you to join the House Agriculture Committee by giving H.R. 4541 favorable treatment in this Subcommittee

and the Full Committee. We look forward to working with you as your deliberations

progress.

PREPARED STATEMENT OF SCOTT GORDON, CHAIRMAN, BOARD OF DIRECTORS, CHICAGO MERCANTILE EXCHANGE

Chairman Oxley, members of the Subcommittee, I am Scott Gordon, Chairman of

the Board of Directors of the Chicago Mercantile Exchange (CME). The CME welcomes the opportunity to provide this testimony for the record. More than a year

ago, on May 19, 1999, the Exchange appeared before the Risk Management Subcommittee of the Agriculture Committee to offer its view of the reauthorization process and the important issues facing the industry and the Commission. Even at that

early stage of the process, the CME and the Chicago Board of Trade had taken the

lead and proposed a legislative framework for rationalizing the regulation of derivatives markets.

The CME and CBOT were joined by the New York Mercantile Exchange in our

effort to craft amendments to the Commodity Exchange Act to enhance competition

and customer opportunity. We proposed five principles and a long list of detailed

proposals. We proposed a means to rationalize the CEA and to restore internal consistency in concert with sound public policy. Within our framework, each segment

of the industry, other than securities exchanges, which seek protection from legitimate competition, got exactly what it had been publicly seeking. Our proposal went

farther than the OTC request for codification of the swaps exemption. We proposed

that swaps could be cleared without losing their exemption. We were diligently following advice of congressional leaders that we needed to gain sufficient support

from the derivatives industry to ensure passage of much needed reform legislation.

We proposed a five-part plan:

• Convert the CFTC to an oversight agency

• Reform the artificial competitive constraints imposed by the Shad/Johnson Accord • Expand access to futures markets

• Provide legal certainty to OTC markets

• Level the regulatory playing field

Since that testimony, most of the participants and regulators in the financial services industry have worked in good faith to find a compromise proposal. The President’s Working Group on Financial Markets issued an extensive report. On February 28, 2000, the Department of the Treasury submitted a draft amendment to

the Commodity Exchange Act that embodies the recommendations of the PWG.

Chairman Ewing held extensive hearings, listened to all views and concluded that

the time is ripe to alleviate the excessive regulatory burdens that have greatly disadvantaged U.S. futures exchanges in comparison to their global competition. Chairman Ewing sought a consensus-driven solution that balanced the interests of all

participants in the financial services industry.

This intensive effort by Chairman Ewing and the staff of his Subcommittee produced the bill that is the subject of today’s hearing. We are on record praising

H.R.4541 as providing a significant reform of financial services regulation and creating a more equitable regulatory environment for futures exchanges. By providing

a comprehensive approach to the inter-related goals of modernizing exchange regulation, reforming Shad-Johnson and establishing legal certainty for the OTC marVerDate 11-MAY-2000 13:38 Oct 10, 2000 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6621 65907.TXT HCOM2 PsN: HCOM2
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ket, this bill appropriately balances the interests of all participants in the financial

services industry while promoting the public interest.

We strongly support Chairman Ewing’s proposal to reform the Shad/Johnson Accord. Eighteen years ago, the Shad-Johnson Accord resolved a jurisdictional conflict

between the SEC and the CFTC. It included a temporary ban on most equity futures contracts. It was not intended as a permanent barrier to innovation and

growth. Futures exchanges were able to develop broad based stock index futures

under Shad/Johnson. Those products have matured into vital financial management

tools that enable pension funds, investment companies and others to manage their

risk of adverse stock price movements.

The CME’s long standing goal is freedom to list and trade futures contracts now

forbidden by the Shad/Johnson Accord without being subjected to multiple regulators and without changing the principles upon which futures trading has been conducted for more than 100 years. Remember, we created a tremendously useful product, equity indexes, in the face of overwhelming opposition. The SEC and its exchanges opposed futures on indexes with all of the same arguments that they now

raise against futures on individual securities. Nonetheless, equity indexes are

among the most popular contracts on securities exchanges as well as futures exchanges. Futures trading of equity indexes has enhanced customer opportunity with

none of the ill consequences predicted by the SEC or securities exchanges. In fact,

their business has directly benefited.

The options markets and swaps dealers offer customers risk management tools

and investment alternatives involving both sector indexes and single stock derivatives. Futures exchanges have been frozen out. Shad/Johnson’s ‘‘temporary’’ ban

lasted 18 years during which time single stock futures have thrived in the OTC

market in the form of equity swaps and on option exchanges in the form of synthetic

futures. Recently the President’s Working Group, the General Accounting Office and

congressional leaders have all called for an end to the ban.

On December 17, 1999, Chairman Lugar (Senate Agriculture Committee) and

Chairman Gramm (Senate Banking Committee) asked CFTC Chairmen Rainer and

SEC Chairman Levitt for a ‘‘detailed report addressing the desirability of lifting the

current prohibition on single stock futures together with any legislative proposals . . . no later than February 21, 2000.’’ On January 20, 2000, Commerce Committee Chairman Bliley along with Chairmen Combest and Ewing asked the SEC

and CFTC to create a ‘‘joint legislative plan for repealing the current prohibition on

single stock futures . . . no later than February 21, 2000.’’ On March 2d, Chairmen

Levitt and Rainer responded by presenting ‘‘the current views’’ of the agencies, but

failed to offer a specific legislative plan.

Of course, we are pleased that the CFTC and SEC have agreed that it is appropriate that U.S. exchanges be permitted to compete in world markets and offer U.S.

customers the opportunity to manage risks by means of equity futures contracts. We

are also pleased that they have found a way to accommodate their jurisdictional and

regulatory concerns on several important issues. But it is far too late in the game

to be satisfied with signs of progress. We share Senator Lugar’s ‘‘disappointment’’

that the agencies were unable to resolve all of their jurisdictional concerns within

the time frame requested.

Today, Shad-Johnson is a bar to useful competition. The SEC invoked Shad-Johnson to bar futures on the Dow Jones Utilities and Transportation Averages—because

that index did not ‘‘reflect’’ the utilities and transportation sectors. The United

States Court of Appeals overturned and vacated that SEC decision, Board of Trade

v. Securities and Exchange Commission, No. 98-2923 (7th Cir., August 10, 1999).

The court of appeals found: ‘‘The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves...The Securities and Exchange Commission, which regulates stock markets, has sided with its

clients.’’ Slip Op. at 4.

Congress intended the Shad-Johnson ban on single stock futures to be temporary.

The court of appeals found that the ban ‘‘was a political compromise; no one has

suggested an economic rationale for the distinction.’’ Slip Op. at 4. In the absence

of such a rationale, Congress should lift the single stock futures ban and allow the

marketplace to decide whether these instruments would be useful new risk management tools. Many exchanges around the world trade single stock futures; no reason

exists to deny U.S. customers and markets the same opportunity.

H.R. 4541 will enact an appropriate division of responsibility between the SEC

and CFTC for futures trading of contracts currently prohibited by the Shad/Johnson

Accord. It protects the SEC’s enforcement authority and forecloses avoidance of securities act proscriptions by means of futures contracts. It protects options exchanges from regulatory arbitrage arising out of disparate margin treatment. It

serves the public interest in fair competition and access to new products. It imposes

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1The oldest international organization devoted to investor protection, NASAA was organized

in 1919. Its membership consists of the securities administrators in the 50 states, the District

of Columbia, Canada, Mexico and Puerto Rico. NASAA is the voice of securities agencies responsible for investor protection and efficient capital formation.

more restrictions on futures exchanges than we had hoped for but not so many that

we will be unable to fairly test the market’s appetite for new products

Last year, the 106th Congress took dramatic action and modernized regulation of

most financial services firms by adopting the Gramm-Leach-Bliley Act. The consequences of excluding the derivatives industry from this progressive groundswell

would be disastrous. We hope that Congress will act expeditiously on H.R. 4541 to

ensure that complete financial regulatory reform becomes part of the legacy of this

Congressional Session. We pledge to work diligently with members of the House to

ensure that the all of the fundamental principles of this bill are enacted into law

this year.

Thank you again, Mr. Chairman, for the opportunity to include our written testimony in the record of this hearing.

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.

WASHINGTON, DC

July 12, 2000

DAVID CAVICKE, Majority Counsel

2125 RHOB

Washington, DC 20515

DEAR MR. CAVICKE: The North American Securities Administrators Association

(NASAA) 1 appreciates the opportunity to provide comments on H.R. 4541, the Commodity Futures Modernization Act of 2000. We support your effort to modernize our

futures laws and provide legal certainty for over-the-counter derivatives.

NASAA also supports lifting the Shad-Johnson ban on single stock futures once

the regulatory oversight concerns underlying the ban are addressed. Any regulatory

framework must recognize the expertise of both the SEC and the CFTC in regulating these products and the unique enforcement role played by the 20-plus states

that have adopted the Model Commodity Code. Both federal agencies and state securities agencies must have the authority to carry out their core functions; there

should be no barriers in their efforts to curtail fraud and manipulation.

In 1974, Congress preempted state securities agencies from applying their laws,

including enforcement, to persons and transactions within the Jurisdiction of the

Commodity Exchange Act (CEA). Not long after, there was a proliferation of off-exchange commodities fraud. In 1978, Congress passed Section 6(d) of the CEA to provide the states with the authority to enforce state laws of general criminal application and allowed the states to enforce the CEA in federal court.

It would be unwise at this time to move ahead with legislation that lacks the elements necessary to ensure the market integrity and customer protections that investors have come to expect under the securities laws.

It is important to recognize that single stock futures will be a substitute for stocks

and stock options and be sold as a retail product. While complex derivatives are sold

mostly to institutional customers, futures on a single stock are the type of product

that will be attractive to the retail investing public. Single stock futures must be

offered to retail investors with the same protections afforded to those who now buy

stocks and stock options. Americans are investing in our capital markets in record

numbers due largely to confidence in the markets instilled by our complementary

Federal/state/industry system of regulation.

Any legislation to lift the current ban on single stock futures must maintain the

SEC’s ability to protect investors and to maintain integrity of the markets on which

they trade. The SEC should have clear and direct authority over the markets and

market participants trading single stock futures.

SEC and CFTC Chairmen Arthur Levitt and Bill Rainer have made considerable

progress toward reaching agreement on a regulatory regime for single stock futures.

They should be given sufficient time to finalize the details of a plan to share regulation of single stock futures so each agency can utilize its expertise and create a

framework that allows for effective and efficient joint regulation of these products.

NASAA appreciates the efforts of your Subcommittee to consider H.R. 4541 under

a limited time frame. We urge you to amend the current version of the legislation

and extend the protections of the securities laws to single stock and narrow-based

stock index futures. American investors deserve no less.

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Please do not hesitate to contact me at 317-232-6695 or Deborah Fischione,

NASAA’s Director of Policy, at 202-737-0900.

Sincerely,

BRADLEY W. SKOLNIK

Indiana Securities Commissioner

NASAA President

PREPARED STATEMENT OF THE BOND MARKET ASSOCIATION

The Bond Market Association is pleased to comment on H.R. 4541, the Commodity

Futures Modernization Act of 2000. H.R. 4541 represents an important step in the

regulatory reform of the markets for derivative financial products. The bill includes

a number of proposals designed to streamline the regulatory environment for derivatives, and clarify several important areas of legal uncertainty which result in undue

systemic risk. For these reasons, we commend Chairman Oxley for focusing the subcommittee’s attention on H.R. 4541 and we support these aspects of the bill.

Reauthorization of the Commodity Exchange Act (CEA) presents an opportunity

to clarify the regulation of certain financial products and to eliminate any misconception regarding the scope of authority provided under the CEA. We concur

with the widely held belief that swaps are inappropriately regulated as futures, and

we believe that the CEA should codify the principle that swaps should not be regulated as futures by the Commodity Futures Trading Commission (CFTC). Such clarification would mitigate legal risk for market participants and would help maintain

over-the-counter markets as viable alternatives to traditional, organized exchanges.

It would also help avoid duplicative and unnecessary regulation. Congress has the

opportunity through the CEA reauthorization to help assure that the capital markets can continue to operate as efficiently as possible.

The Bond Market Association represents securities firms and banks that underwrite, trade and sell fixed-income securities in the U.S. and international markets.

Our interests in H.R. 4541 relate to how the bill would affect the efficient operation

and regulation of the markets for bonds and other fixed-income securities and related instruments, and our comments will focus on just those aspects of the bill.

The Financial Markets and the CEA

As the Subcommittee is aware, the financial markets have grown increasingly

complex in recent years. Issuers of securities and other market participants have

become accustomed to having a wide array of products available to meet very specific financing and hedging needs. Unfortunately, the United States regulatory system has not kept pace with the evolution of the marketplace. Issuers, underwriters

and dealers now find themselves laboring to decipher a web of overlapping and often

contradictory statutes and regulations that reduce efficiency and increase costs. Of

particular concern is the potential for private parties to exploit ambiguities in the

CEA to abandon responsibility for otherwise enforceable contracts—even if there is

no fraud or bad faith—by alleging that a transaction is an illegal off-exchange futures transaction. We know that this subcommittee, regulators and participants in

these markets have an interest in ensuring the finality of financial contracts and

thereby reducing potential risks to the financial system as a whole, and we commend Chairman Oxley for exploring ways to improve and update the Commodity

Exchange Act.

The Association takes an active interest in promoting and ensuring safe and efficient bond markets that allow governmental entities and corporations to raise debt

capital at the lowest possible cost. Toward that end, the basic policy positions we

seek to advance as Congress and the regulatory agencies deal with issues surrounding the CEA are:

• preserving the finality and enforceability of contracts freely negotiated between

market participants;

• maintaining the OTC markets as a viable alternative to traditional organized exchanges; and

• avoiding duplicative or unnecessary government regulation in the trading and

clearance of debt instruments.

Consistent with the above principles, we offer the following summary of our views

on certain issues that are integral to the current discussion of CEA reauthorization.

The Association:

• supports provisions of the bill which would reaffirm and clarify the Treasury

Amendment and recommends an additional change;

• supports the goals of other provisions of H.R. 4541 designed to provide ‘‘legal certainty’’ for over-the-counter derivatives; and

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• supports provisions of the bill related to derivatives clearing organizations;

• urges the adoption of legislation to reduce systemic risk in the financial markets

by reforming bankruptcy and insolvency law to clarify and enhance the ability

to close-out and net financial contracts.

Treasury Amendment

The market for government securities is well regulated under a structure tailored

to the unique qualities of the market. Under authority provided by the Government

Securities Act of 1986 and subsequent 1993 amendments, the Treasury Department

is a principal rulemaker for the government securities market. The Treasury Department, in consultation with other regulators, has published detailed rules regarding large position reporting and record-keeping. The National Association of Securities Dealers and bank regulators have published rules regarding sales practices. The

SEC has broad authority to enforce antifraud statutes on government securities

market participants. The CFTC and the organized exchanges, of course, regulate activity related to transactions in listed futures contracts on government securities.

This balanced arrangement ensures that the government securities market remains

safe and well-regulated in addition to serving as a model of market efficiency.

Efficient and sound regulation of the government securities market is important

because it helps ensure that taxpayers pay the lowest possible interest cost on the

government’s borrowing and that other U.S. borrowers whose debt is priced relative

to Treasury securities—corporations, financial institutions, homebuyers, consumers

and others—also enjoy efficiently determined borrowing costs. There are approximately $3.1 trillion of marketable Treasury securities outstanding, and over $200

billion of Treasury securities change hands every day. Any undue risk or uncertainty regarding the market’s regulatory structure can have significant effects on

the government’s interest cost and the interest rates faced by other borrowers.

When the CEA was first enacted in 1974, Congress included a provision precluding the CFTC from regulating ‘‘transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such

transactions involve the sale thereof for future delivery conducted on a board of

trade.’’ This provision has become known as ‘‘the Treasury Amendment.’’ The Treasury Amendment is important because it helps prevent duplicative or conflicting regulation.

Despite the plain meaning of existing statutory language, the Treasury Amendment does not explicitly address questions regarding the regulation of financial

products which involve government securities. These include, for example, instruments such as repurchase agreements, swap contracts and forward delivery contracts. This issue was addressed, albeit indirectly, by the U.S. Supreme Court in its

1997 decision in Dunn v. CFTC, where the Court generally held that ‘‘transactions

in’’ foreign currency encompass all transactions relating to foreign currency. Market

participants nevertheless widely believe that the same standard applies to other financial products covered under the Treasury Amendment, including government securities.

H.R. 4541 would generally maintain the current structure of the Treasury Amendment. The bill would specify that the CEA does not apply to transactions in government securities, foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase transactions in a financial commodity—a particularly important and welcome clarification—or mortgages or mortgage purchase

commitments. Futures contracts related to these products traded on an ‘‘organized

exchange’’ would still be subject to CFTC regulation under the bill. The bill retains

existing statutory language, implying Congress’ intent to embrace the Supreme

Court’s interpretation of such language. However, H.R. 4541 would not expressly

codify the Supreme Court’s interpretation of existing law regarding financial products involving the enumerated instruments. We, therefore, suggest amending H.R.

4541 to fully clarify the scope of the Treasury Amendment provisions and address

any remaining legal uncertainty regarding the scope of the Treasury Amendment’s

applicability. In particular, we suggest adding language to Section 4 of the bill specifying that the Treasury amendment exclusions apply to transactions ‘‘in or in any

way involving’’ the specified instruments.

Organized Exchanges

H.R. 4541 would also clarify the applicability of the Treasury Amendment by

specifying an exception to the general exclusion for contracts traded on an ‘‘organized exchange.’’ Current law provides an exception to the Treasury Amendment for

contracts traded on a ‘‘board of trade.’’ The definition of ‘‘board of trade’’ is somewhat vague with respect to both evolving electronic trading systems and the roles

63

of certain traditional market participants such as inter-dealer brokers. If ‘‘board of

trade’’ was defined under current law to include electronic trading facilities or situations where market participants conduct transactions in a screen-based format and

settle them through an independent clearing mechanism, significant market disruption would result. In particular, such a definition would subject already regulated

markets to a duplicative layer of government regulation.

We support the clarification of the Treasury Amendment exclusion from the CEA

through the ‘‘organized exchange’’ exception. The bill as introduced, however, included a vague definition of organized exchange that would have required that

transactions take place on a ‘‘bona fide principal-to-principal basis,’’ calling into

question the applicability of the exception to traditional ‘‘back-to-back’’ principal

transactions. The Agriculture Committee during its deliberations on H.R. 4541 clarified the definition of organized exchange by eliminating the confusing term ‘‘bona

fide.’’ We strongly support this change and we urge that it be retained in the legislation.

Legal Certainty for OTC Derivatives

Under current law, the CEA effectively gives a party the right to rescind a contract if the party is successful in its allegations that the transaction was actually

an illegal, off-exchange futures contract. Under the CEA, over-the-counter commodity futures transactions are per se illegal unless they are excluded by the Treasury Amendment or some other exclusion or exemption. Private parties have taken

the position that such transactions are subject to rescission. This harsh consequence

of voiding a contract is particularly troublesome in light of the difficult questions

associated with defining a future versus a forward transaction. We believe the financial markets should not be subject to the risks posed by the ability to abandon

contract obligations when the CEA status of a financial transaction is challenged.

H.R. 4541 includes two key provisions designed to address this problem.

First, the bill would specify that financial contracts may not be rescinded ‘‘solely

on the failure of the agreement, contract, or transaction to comply with the terms

or conditions of an exemption or exclusion from any provision of this Act or regulations of the Commission.’’ Second, the bill would specify that the CEA does not

apply to over-the-counter derivative contracts entered into between ‘‘eligible contract

participants’’ which are not conducted on a ‘‘trading facility’’ other than an ‘‘electronic trading facility.’’ Together, these two provisions represent a major step towards addressing the question of the ‘‘legal certainty’’ of over-the-counter derivative

contracts, a goal which we fully support.

Clearing Organizations

The process of clearing securities and derivatives transactions is vital to the efficient operation of the capital markets. Efficient clearing reduces risks and costs and

makes possible the smooth operation of the markets. Following a transaction, both

parties submit the details of the transaction to a clearing organization. The clearing

organization compares the transaction—ensures that details submitted by both parties are identical—and, once compared, usually guarantees the transaction in the

unlikely event that one party becomes insolvent before the transaction settles.

Clearing organizations also net outstanding transactions of individual participants

in order to minimize separate payments for offsetting trades or positions, and monitor margins or collateral required to be held against net positions.

H.R. 4541 includes a provision designed to streamline the regulation of derivatives clearing organizations. Specifically, Section 14 of the bill would generally make

it unlawful for derivatives clearing organizations to operate unless registered with

the CFTC. In order to prevent duplicative levels of regulation, the bill provides an

exemption from this requirement for clearing organizations which are regulated by

the SEC, a federal bank regulator or a foreign regulatory body. This exemption is

critical in helping to ensure that clearing organizations are not subject to superfluous, conflicting, multiple levels of regulation. For this reason, we support the exemption.

The bill as introduced contained a provision which would have mandated CFTC

regulation for clearing organizations which clear futures, options on futures or options on commodities which are not securities regardless of the above exception.

However, during its deliberations, the House Agriculture Committee included an exemption from this requirement for clearing organizations that clear instruments or

transactions which are generally exempted from regulation under the CEA. The

change adopted by the Agriculture Committee to Section 14 of the bill is extremely

important in ensuring that clearing organizations that clear both securities and

over-the-counter derivatives are not subject to multiple levels of regulation. We fully

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support the Agriculture Committee’s changes, and we are hopeful that the committee’s changes will remain in the bill.

Other Provisions of H.R. 4541

In addition to the provisions cited above, The Bond Market Association offers

these comments on other provisions of H.R. 4541:

• Shad-Johnson accord—Although presumably intended to permit single-stock futures, the bill expressly would allow futures on ‘‘non-exempt securities,’’ thereby

permitting futures on single debt instruments or on narrow debt indices. Key

aspects of the Shad-Johnson provisions in H.R. 4541 have apparently been

drafted to apply specifically to stock futures and in some cases are inconsistent

with the way the debt markets operate. They could result in confusion and uncertainty if applied to futures on single debt instruments. The subcommittee

may wish to review the Shad-Johnson provisions of the bill to ensure their consistency with debt market operations and with other provisions of the law. We

would be happy to consult with subcommittee members on this issue if requested.

• Bankruptcy—Although not part of H.R. 4541, the report of the President’s Working Group on the Financial Markets on financial derivatives recommended the

adoption of changes to the Bankruptcy Code and banking law designed to reduce systemic risk. The Working Group’s recommendations would streamline

the process by which financial contracts can be netted and resolved in cases of

bankruptcy or insolvency. We support these provisions and urge that they be

enacted.

Summary

In recent years, we have seen a rapid acceleration in the development of new and

sophisticated financial products designed to mitigate risk, reduce costs and enhance

efficiency. Unfortunately, the evolution of our regulatory structure for financial derivatives has lagged behind the evolution of the markets themselves. It is appropriate, therefore, for Congress to address the uncertainty and risk which has arisen

as a result of a system of regulation which never anticipated the market we have

today.

The Bond Market Association supports provisions in H.R. 4541 designed to enhance and clarify the Treasury Amendment. We also recommend an additional

change to the Treasury Amendment to clarify the treatment of products involving

excluded transactions. We also support the goal of key provisions of the bill to provide legal certainty with respect to the regulation of over-the-counter derivatives. In

addition, we support provisions in the bill adopted during Agriculture Committee

deliberations designed to prevent the duplicative regulation of clearing organizations. We raise questions regarding the application of the Shad-Johnson provisions

to single-debt futures, and we urge the adoption of bankruptcy and insolvency legislation designed to reduce systemic risk in the financial markets.

We appreciate the opportunity to present our views on H.R. 4541. We commend

Chairman Oxley and other members of the subcommittee for their quick action on

these important issues, and we look forward to working with subcommittee members and staff as the legislative process moves forward.

FEDERAL RESERVE SYSTEM

BOARD OF GOVERNORS

July 19, 2000

The Honorable TOM BLILEY

Chairman

Committee on Commerce

House of Representatives

Washington, D.C. 20515

DEAR MR. CHAIRMAN: Enclosed are my responses to your additional questions concerning H.R. 4541, the Commodity Futures Modernization Act of 2000.

Please let me know if I can be of further assistance.

Sincerely,

PATRICK M. PARKINSON

Associate Director, Division of Research and Statistics

Enclosure

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FOLLOW-UP QUESTIONS FOR PATRICK M. PARKINSON

Question 1. I Would an alternative approach to providing legal certainty under

which futures were defined as contracts on enumerated agricultural products and

any other derivatives product traded on a futures contract market provide greater

legal certainty than the approach in H.R. 4541? Would the Fed support such an approach?

Answer 1. Yes. Such an approach would provide greater legal certainty. But the

approach would need to be supplemented with provisions to address public policy

concerns about fraud and manipulation for those transactions that would be excluded from the CEA under this alternative approach but not under the working

group’s approach. Whether the Fed would support such an alternative approach

would depend on how those concerns are addressed.

Question 2. Do the margin provisions in the bill adequately address concerns

about consistent margins on single stock futures and options?

Answer 2. Yes. They empower the Federal Reserve to ensure that margins are

consistent and make clear what is meant by consistency. However, the language

clarifying what is meant by consistency should be moved from Section 8(g)(7)(D)(ii)

to Section 8(g)(4)(B)(v).

Question 3. Futures trading on a futures exchange could be regulated in one of

two ways: (1) as securities with SEC exemptions from non-core provisions or (2) as

futures with only core securities provisions applying. Which structure does the Fed

support?

Answer 3. The Federal Reserve does not have a position on this issue.

Question 4. Do you support the creation of the intermarket margin board as provided in the bill?

Answer 4. Yes. As I said in my testimony, the Board is willing to accept regulatory authority over levels of margin on single-stock futures, so long as the Board

can delegate that authority to the CFTC, the SEC, or an Intermarket Margin Board.

Question 5. Do you support enacting the legal certainty portions of the bill without removing the ban on single stock futures? Under this scenario will legal uncertainty still exist for OTC derivatives in securities based transactions.

Answer 5. Yes. We support enacting the legal certainty provisions of the bill, even

if the ban on single-stock futures is not removed. We would, however, prefer a comprehensive bill that allows U.S. investors to trade single-stock futures.

Under this scenario, legal certainty would still exist with respect to the enforceability of securities-based swaps between eligible participants. However, legal uncertainty would still exist on the question of whether securities-based swaps are subject to the securities laws.

Question 6. Do the clearing provisions in the bill place futures clearing systems

at a competitive disadvantage to securities clearing systems?

Answer 6. Yes. An SEC registered clearing organization could clear both securities

and securities-based derivatives, whereas a CFTC-registered clearing organization

could not. As a practical matter, this would allow an SEC clearing organization to

offer lower margins on securities-based derivatives when those positions were

hedged with securities, as they often are. Other things equal, this would place

CFTC-registered clearing systems at a competitive disadvantage.

Question 7. Are futures exchange’s ‘‘know your customer rules’’ and ‘‘risk acknowledgment’’ sufficient substitutions for suitability rules?

Answer 7. I have not studied these rules closely enough to permit me to answer

this question with any confidence.

Question 8. To what extent, if any, does the CFTC’s regulatory relief proposal reduce the need for legislation?

Answer 8. The CFTC’s regulatory relief proposal is no substitute for legislation.

It does not address the most serious legal certainty issue—the enforceability of securities-based swaps.

Question 9. The Working Group report concludes that electronic trading systems

should be permitted to develop unburdened by an anticipatory regulatory framework? How does H.R. 4541 achieve, or fail to achieve, this result?

Answer 9. H.R. 4541 achieves this for electronic trading systems for financial derivatives. For non-financial derivatives (other than derivatives based on agricultural

commodities and metals), it leaves some burdens (statutory prohibitions of fraud

and manipulation, possibly CFTC rules and regulations relating to data dissemination) but frees such systems from the kinds of burdens that would most concern the

PWG and market participants. For electronic trading systems for agricultural and

metals derivatives, achievement of a result consistent with the Working Group’s

conclusion would depend on CFTC regulatory exemptions for such systems.

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DEPARTMENT OF THE TREASURY

August 8, 2000

The Honorable THOMAS J. BLILEY

Chairman, Committee on Commerce

U.S. House of Representatives

Washington, D.C. 20515-6115

DEAR CHAIRMAN BLILEY: I am pleased to enclose responses to your questions submitted following the July 11, 2000 hearing held by the Subcommittee on Finance

and Hazardous Waste on H.R. 4541, ‘‘The Commodity Futures Modernization Act

of 2000.’’

Question 1: In your testimony you state that certain aspects of the regulatory relief may be more appropriately addressed through rule making than legislation.

With which provisions of the bill are you particularly concerned?

Answer 1: The Treasury Department continues to support the view that it is appropriate to periodically review existing regulatory structures to determine whether

they continue to serve valid public policy and regulatory functions. We are concerned, however, that there may be unforeseen consequences to legislating such regulatory relief as is contained in sections 12, 13, 14, 15, 16, 17, and 21 of H.R. 4541.

Once codified, regulators will no longer have the flexibility to review and amend

provisions when market developments necessitate change or problems arise. Such

aspects of regulatory relief may be more appropriately provided through administrative action. However, if Congress legislates regulatory relief, it is important that the

language is drafted carefully to ensure that futures on government securities are

not excluded from most of the provisions of the CEA that currently apply, as well

as from regulation under the securities laws, in a manner that would undermine

the regulatory framework for the government securities market established by the

Government Securities Act in 1986.

Question 2: Do you support the creation of the intermarket margin board as provided in the bill?

Answer 2: The Treasury Department generally supports the provisions in section

8 of H.R. 4541 to create an intermarket margin board, comprised of the Board of

Governors of the Federal Reserve System (‘‘Fed’’), Securities and Exchange Commission (‘‘SEC’’), and Commodity Futures Trading Commission (‘‘CFTC’’), to set and

maintain margin levels for single stock and narrow-based stock index futures. We

concur that such a board should endeavor to harmonize margin levels on single

stock futures and options, taking into consideration material differences in contract

size, price volatility, mark-to-market frequency, and the period of time within which

margin calls must be met. This provision should not supersede or limit the emergency powers of the CFTC contained in § 8a(9) of the Commodity Exchange Act

(‘‘CEA’’) regarding establishment of temporary emergency margin levels.

Question 3: Do you support enacting the legal certainty portions of the bill without removing the ban on single stock futures? Under this scenario will legal uncertainty still exist for OTC derivatives in security-based transactions?

Answer 3: The Working Group report recommended that legal certainty for swap

transactions be provided and that the prohibition against single stock futures could

be repealed if integrity and regulatory arbitrage issues could be resolved. However,

the recommendations were not contingent upon each other. The Treasury Department has been working diligently with the CFTC and SEC to resolve Issues related

to the Shad-Johnson Accord prohibition against single stock futures. We support enacting the legal certainty portions of the legislation as soon as possible. Failure to

clarify and resolve the legal certainty issue could result in a situation which the existing legal framework for U.S. financial markets significantly lags developments

and innovations in those markets.

If issues related to the Shad-Johnson Accord cannot be resolved on a timely basis,

we believe it is imperative to advance the other provisions of H.R. 4541 designed

to clarify legal certainty for OTC derivatives, provide for the development of appropriately-regulated clearinghouses, and protect retail customers from fraud and

abuse in foreign exchange futures and futures-options transactions with unregulated/unaffiliated entities.

With respect to legal certainty for securities-based OTC derivatives, because the

legal certainty provisions of H.R. 4541, as reported by the House Agriculture Committee, would exclude such derivatives from the CEA, these provisions would eliminate the concern about their enforceability that exists under current law. The legal

certainty provided to these instruments by sections 4, 5, 6, and 7 of H.R. 4541 is

not dependent upon the removal of the ban on exchange-traded futures on single

securities or narrow indexes.

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Question 4: Do the clearing provisions in the bill place futures clearing systems

at a competitive disadvantage to securities clearing systems?

Answer 4: The Treasury Department believes that the clearing provisions in section 14 of the bill will create a level playing field for clearing systems. Futures clearing organizations will be able to clear exchange-traded futures, futures-options, and

commodity options as well as non-security OTC derivative instruments. Securities

clearing organizations will be able to clear exchange-traded and OTC securities

transactions as well as OTC derivatives.

Question 5: Are futures exchanges’ ‘‘know-your-customer rules’’ and ‘‘risk acknowledgements’’ sufficient substitutions for suitability rules?

Answer 5: The CFTC and SEC currently are discussing customer suitability requirements for securities futures in the context of modifications to the Shad-Johnson

Accord. The Treasury Department feels that it is appropriate that the CFTC and

SEC should discuss and agree to the approach and specific requirements ultimately

mandated with respect to these instruments. The Working Group stated that the

current prohibition against single stock and narrow-based stock index futures could

be repealed if such issues regarding the integrity of the underlying securities markets and regulatory arbitrage could be resolved, but preferred that the CFTC and

SEC reach a mutually acceptable resolution. We recently have assumed a role in

these discussions as a facilitator between the two agencies, and we support actions

taken by Congress to urge progress in these discussions.

Question 6: To what extent, if any, does the CFTC’s regulatory relief proposal reduce the need for legislation?

Answer 6: The Treasury Department believes that it is imperative to provide for

legal certainty for OTC derivatives through legislation. The CFTC proposal to grant

regulatory relief to the futures exchanges does not reduce the need for the other provisions of the bill to clarify legal certainty for OTC derivatives, provide for the development of appropriately-regulated clearinghouses, and protect retail customers from

fraud and abuse in foreign exchange futures and futures-options transactions with

unregulated unaffiliated entities.

Question 7: The Working Group report concluded that electronic trading systems

should be permitted to develop unburdened by an anticipatory, regulatory framework. How does H.R. 4541 achieve, or fail to achieve, this result?

Answer 7: The Working Group recommended a broad exclusion from the CEA for

electronic trading systems (‘‘ETSs’’) that limit trading to eligible participants trading

on a principal-to-principal basis involving OTC financial commodities with non-finite

supplies. The group felt that development of such systems should be encouraged by

providing greater legal certainty, rather than burdening markets with a new anticipatory scheme of regulation that could inhibit innovation and prove to be inappropriate. Section 6 of H.R. 4541 amends the CEA to permit such ETSs consistent with

the Working Group’s recommendations.

I hope this information is helpful to you and your staff. Please feel free to contact

me if I can be of further assistance. We look forward to continuing to work with

you.

Sincerely,

LEE SACHS

Assistant Secretary, Financial Markets