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35–904 PDF 2007

S. HRG. 109–910

THE COMMODITY FUTURES

MODERNIZATION ACT OF 2000 AND

RECENT MARKET DEVELOPMENTS

HEARING

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

EXAMINING THE PROPOSED REAUTHORIZATION OF THE COMMODITY 

FUTURES TRADING COMMISSION, FOCUSING ON THE COMMODITY FUTURES MODERNIZATION ACT OF 2000 AND RECENT MARKET DEVELOPMENTS

SEPTEMBER 8, 2005

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

RICK SANTORUM, Pennsylvania 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

PAUL S. SARBANES, Maryland 

CHRISTOPHER J. DODD, Connecticut 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

DEBBIE STABENOW, Michigan 

ROBERT MENENDEZ, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel 

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel 

MARK OESTERLE, Counsel 

JUSTIN DALY, Counsel 

DEAN V. SHAHINIAN, Democratic Counsel 

ALEX STERNHELL, Democratic Professional Staff 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

GEORGE E. WHITTLE, Editor

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(III)

CONTENTS

THURSDAY, SEPTEMBER 8, 2005

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of: 

Senator Sarbanes .............................................................................................. 3

Senator Allard ................................................................................................... 4

Senator Crapo ................................................................................................... 4

Senator Martinez .............................................................................................. 6

Prepared statement ................................................................................... 42

Senator Bunning ............................................................................................... 7

Senator Hagel ................................................................................................... 7

WITNESSES 

Randy K. Quarles, Under Secretary for Domestic Finance, U.S. Department 

of the Treasury ..................................................................................................... 8

Prepared statement .......................................................................................... 42

Response to written question of Senator Shelby ............................................ 118

Robert L.D. Colby, Deputy Director, Division of Market Regulation, U.S. 

Securities and Exchange Commission ................................................................ 10

Prepared statement .......................................................................................... 44

Patrick J. McCarty, General Counsel, Commodity Futures Trading Commission ........................................................................................................................ 11

Prepared statement .......................................................................................... 50

Patrick M. Parkinson, Deputy Director, Division of Research and Statistics, 

Board of Governors of the Federal Reserve System .......................................... 13

Prepared statement .......................................................................................... 69

Response to written question of Senator Crapo ............................................. 119

Charles P. Carey, Chairman of the Board, Chicago Board of Trade ................... 22

Prepared statement .......................................................................................... 71

Response to written question of Senator Bennett ......................................... 119

John M. Damgard, President, Futures Industry Association .............................. 24

Prepared statement .......................................................................................... 74

Terrence A. Duffy, Chairman, Chicago Mercantile Exchange Holdings, Inc. ..... 25

Prepared statement .......................................................................................... 83

Meyer S. Frucher, Chairman and Chief Executive Officer, Philadelphia Stock 

Exchange On Behalf of The U.S. Options Exchange Coalition: American 

Stock Exchange, Boston Options Exchange, Chicago Board Options Exchange, International Securities Exchange, Pacific Exchange, Philadelphia 

Stock Exchange, and the Options Clearing Corporation .................................. 27

Prepared statement .......................................................................................... 100

Mark Lackritz, President, Securities Industry Association ................................. 29

Prepared statement .......................................................................................... 105

Response to written question of Senator Bennett ......................................... 120

Robert G. Pickel, Executive Director and Chief Executive Officer, International Swaps and Derivatives Association, Inc. ............................................. 31

Prepared statement .......................................................................................... 109

Response to written question of Senator Bennett ......................................... 121

Daniel J. Roth, President and Chief Executive Officer, National Futures 

Association ............................................................................................................ 32

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

Response to written question of Senator Bennett ......................................... 122

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THE COMMODITY FUTURES 

MODERNIZATION ACT OF 2000 AND 

RECENT MARKET DEVELOPMENTS 

THURSDAY, SEPTEMBER 8, 2005

U.S. SENATE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC.

The Committee met at 10:05 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the 

Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY 

Chairman SHELBY. The hearing will come to order. This morning, 

the Committee will examine the impact of the Commodity Futures 

Modernization Act of 2000 and recent market developments. Five 

years ago, Congress passed the Commodity Futures Modernization 

Act, making significant changes to the Commodity Exchange Act 

and the regulation of derivatives. The CFMA was the product of a 

comprehensive hearing process involving the Banking Committee 

and the Agriculture Committee. The Act provided for legal certainty and regulatory clarity for over-the-counter derivatives, modernized the regulatory regime for futures trading, and established 

a framework for trading security futures products. The CFMA recognized that certain financial products have attributes of securities 

and futures and provided for a regulatory regime intended to assure that the purposes of the Commodity Exchange Act and the 

Federal securities laws are carried out. 

As the CFTC’s 5-year reauthorization approaches, it is time to 

revisit and to evaluate some of the provisions contained in the 

CFMA. Since passage of the CFMA, the futures markets have continued to evolve as innovative products, and new market participants now define the marketplace. Although futures contracts were 

originally tied to agricultural and other physical commodities, the 

vast majority of trading now involves financial instruments such as 

foreign currencies, stock indexes and government securities. Given 

that certain futures contracts based on financial instruments can 

function as a proxy for that financial instrument, this Committee 

has a significant role to play in examining any proposed changes 

to the regulatory lines established in the CFMA. 

During the current reauthorization process, several issues have 

arisen that are indicative of the changing nature of the futures 

markets. Specifically, we will examine security futures and consider how portfolio margining could apply to these products and seVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
2

curities options. Given the hybrid nature of certain futures, it is 

important to appreciate the joint regulatory regime overlaying 

these products. We will also consider proposed definitional changes 

to the term ‘‘narrow-based security index’’ that are intended to expand the scope of future products that can be based on debt and 

foreign securities. These changes are significant because they govern regulatory jurisdiction. We are mindful of the investor protection concerns regarding investor protection, insider trading, and 

market manipulation underlying the current statutory definition. 

Finally, we will consider several issues related to the sale of foreign 

exchange contracts to retail investors. Some have raised concerns 

regarding the scope of foreign exchange products subject to the 

CFTC’s authority, and some have also proposed new registration 

requirements for certain counterparties involved in the sale of retail foreign exchange products. 

While considering legislative proposals to amend the Commodity 

Exchange Act, it is important to ensure that any resulting amendments do not capture financial products specifically excluded from 

the regulatory regime created by the CFMA. Expanding the CFTC’s 

jurisdiction to include new products and market participants must 

be carefully examined to guard against unintended consequences 

that could undermine the legal certainty, grant competitive advantages or leave investors without necessary protections. 

The Committee’s examination of the CFTC’s reauthorization is 

consistent with the Senate’s approach to these complex issues in 

the year 2000. As the Senate considers reauthorization of CFTC, I 

look forward to working with Chairman Chambliss and the other 

Members of the Committee of the Agriculture Committee. We all 

share an interest in ensuring a fair, efficient, and competitive marketplace for financial products. 

We will have two panels here this morning. First, we will hear 

from the members of the President’s Working Group on Financial 

Markets. During consideration of the Modernization Act in 2000, 5 

years ago, the Working Group’s recommendations were invaluable 

and served as a roadmap for reform. I once again expect the Working Group’s recommendations to inform and guide the current

reauthorization process. Any legislative proposals to redraw the 

regulatory lines should receive a complete examination and endorsement by the Working Group. 

Representing the Working Group this morning we have Mr. 

Randal Quarles, Under Secretary for Domestic Finance, U.S. Department of the Treasury; Mr. Robert Colby, Deputy Director of the 

Division of Market Regulation, the Securities and Exchange Commission; Mr. Patrick McCarty, General Counsel, Commodity Futures Trading Commission; and Mr. Pat Parkinson, Deputy Director of the Division of Research and Statistics, the Federal Reserve. 

On the second panel today, we will hear from a range of market 

participants. The witnesses on the second panel will be Mr. Charles 

Carey, Chairman of the Chicago Board of Trade; Mr. John 

Damgard, President, Futures Industry Association; Mr. Terrence 

Duffy, Chairman, Chicago Mercantile Exchange; Mr. Sandy 

Frucher, Chairman and Chief Executive Officer of the Philadelphia 

Stock Exchange, and Mr. Mark Lackritz, President, Securities Industry Association; Mr. Robert Pickel, Executive Director and Chief 

3

Executive Officer, International Swaps and Derivatives Association; 

and Mr. Daniel Roth, President, National Futures Association. 

I thank each of you for appearing here this morning, and we look 

forward to your testimony and your participation. 

Senator Sarbanes. 

STATEMENT OF SENATOR PAUL S. SARBANES 

Senator SARBANES. Thank you very much, Mr. Chairman. I want 

to commend you for holding this hearing, and for your leadership 

in asserting the Committee’s role with respect to some of the issues 

that are raised with respect to this matter. 

Chairman SHELBY. Thank you. 

Senator SARBANES. And I also want to acknowledge the work 

that Senator Crapo’s been doing on this issue. We very much appreciate it. 

Five years ago this Committee, working closely with the Agriculture Committee, in a joint deliberative process—it was a very 

cooperative working effort at that time—produced the Commodities 

Futures Modernization Act of 2000, the CFMA. Some of us will recall that process included a joint hearing of the two Committees to 

receive testimony from the agencies which comprise the President’s 

Working Group on Financial Markets. Those agencies are actually 

represented again today here at the witness table. 

An important part of the CFMA was the authorizing of trading 

of security futures, ending the prohibition that had been established by the Shad-Johnson Accord. The CFMA permits trading of 

security futures subject to joint regulation by the SEC and the 

Commodities Futures Trading Commission. The Act requires that 

the SEC and the CFTC, ‘‘jointly prescribe regulations to establish 

margin requirements,’’ and that ‘‘the margin requirements for a security futures product be consistent with the margin requirements 

for comparable options contracts.’’

It is obviously appropriate for this Committee to review the impact of the earlier law, especially, in light of legislation that the 

Agriculture Committee marked up in late July. Fed Chairman Alan 

Greenspan wrote on July 20 of this year that legislative provisions 

which were adopted by the Agriculture Committee ‘‘include novel 

terms and approaches,’’ and that the ‘‘issues are complex and the 

potential for legislation to have unintended consequences is considerable.’’ He went on to say, ‘‘I believe it would be a mistake to 

enact legislation that has not been thoroughly evaluated by the 

PWG’’—the President’s Working Group—‘‘and by market participants that may be affected.’’ I think this is an observation to which 

we need to pay close attention. 

One provision of the bill, S. 1566, the one marked up in the Agriculture Committee, would implement a pilot program for single 

stock futures that would remove certain regulatory authority from 

the SEC. The seven U.S. options exchanges stated in a letter date 

July 20 of this year that they oppose this because it is ‘‘not consistent with the regulatory and competitive parity between security 

futures and security options established in the CFMA.’’ That was 

an issue that we really worked very hard on back when we did that 

earlier legislation. 

4

There are also other issues and provisions of the S. 1566 which 

merit our attention and which the witnesses will be addressing. 

The Chairman of the Agriculture Committee said in the markup 

that his Committee was passing the bill to move the legislative 

process along and to stimulate discussion, which is of course what 

is happening here today. 

[Laughter.] 

And he also said that he was committed to working over the next 

few months with the Senate Banking Committee. I look forward to 

working closely, as we have on so many issues, with Chairman 

Shelby and Senator Crapo, who has played an important role in all 

of this, as we try to resolve this matter. 

We have a very collaborative working relationship the last time 

around, and I hope that we will be able to achieve that this time 

around as well. I think it is very important in ending up with a 

constructive resolution of some of these issues. 

Mr. Chairman, I join with you in welcoming the panels that are 

before us. I have another engagement this morning, and I am not 

quite sure how long I will be able to stay. I do want to say with 

respect to the first panel that both Bob Colby at the SEC and Pat 

Parkinson of the Fed have each served a quarter of a century with 

distinction at their respective agencies, and I want to acknowledge 

that here this morning. And Pat McCarty has served for more than 

15 years with a number of agencies and on House staff before that. 

And, Mr. Quarles, we welcome you to the panel, and you are a new 

started, so to speak, but we wish you the very best as you move 

ahead in your responsibilities. 

Thank you very much, Mr. Chairman. 

Chairman SHELBY. Senator Allard. 

COMMENTS OF SENATOR WAYNE ALLARD 

Senator ALLARD. Mr. Chairman, thank you. I am not going to 

make any opening comments. 

Chairman SHELBY. Senator Crapo. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Thank you very much, Mr. Chairman, and I 

want to say at the outset I appreciate both you and Senator Sarbanes and the efforts that you have made to put this hearing together to work on this year. 

Chairman SHELBY. Thank you for the work you did. 

Senator CRAPO. Thank you very much. 

Mr. Chairman, I strongly believe that we need to reauthorize the 

Commodity Futures Trading Commission, and frankly, I think we 

need to act promptly. But it is more important that we do not undo 

the excellent work that is already based largely on the President’s 

Working Group back in 1999. Many individuals and groups have 

referred to the subsequent legislation, the Commodities Futures 

Modernization Act of 2000, as a landmark in futures regulation. 

The end result, measured in substantial increase in market volume, has been show to work well and to work very well. 

The careful balance that was struck in the CFMA established a 

tiered system of regulation depending upon the market participant’s decision to trade on a registerd futures exchange or on a deVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
5

rivatives transaction execution facility, and depending on the sophistication of the parties involved. The CFMA also created legal 

certainty for swaps, prohibiting the CFTC from regulating them as 

futures contracts and prohibiting the SEC from regulating them as 

securities. The CFMA rightly recognized that swaps are banking 

products. The issues addressed in the CFMA were very complex 

and required a substantial amount of time to negotiate and to 

draft. 

The Banking Committee played a key role in creating legal certainty for swaps in its work, together with the cooperation of the 

Agriculture Committee, as evident in Titles III and IV of the 

CFMA. 

The CFMA was adopted with broad bipartisan support, after 

careful consideration over a period of years by four Congressional 

Committees and with the active support of the Secretary of the 

Treasury, the Chair of the Board of Governors of the Federal Reserve, the Chair of the Commodity Futures Trading Commission, 

and the Chair of the Securities and Exchange Commission. 

I am very concerned that we not undo the significant achievement of the CFMA that was largely based on the President’s Working Group report entitled ‘‘Over-the-Counter Derivatives Market 

and the Commodities Exchange Act.’’ That product was an excellent report produced during the Clinton Administration. 

That is why on July 19 I sent a letter to the PWG requesting its 

new views on the draft Commodity Futures Trading Commission 

reauthorization bill that was being worked on by the Senate Agriculture Committee. Chairman Greenspan replied, as Senator Sarbanes has already indicated that, ‘‘the issues are complex and the 

potential for legislation to have unintended consequences, including 

uncertainty about the enforceability of legitimate transactions that 

do not involve fraud, is considerable.’’ He went on to say, ‘‘Consequently, I believe it would be a mistake to enact legislation that 

has not been thoroughly evaluated by the PWG and by market participants that may be affected.’’ 

I am in complete agreement with that statement and would like 

to thank you, Mr. Chairman, for starting this process today, and 

Senator Sarbanes, for your long history of involvement and work 

with this. This is a very technical subject matter and we need to 

get it right. 

It is my understanding that the PWG staff devoted much time 

and effort during the month of August to address these concerns. 

It is my hope that the PWG principals can come together in agreement on this important issue and I look forward to the witnesses’ 

testimony today. If the PWG principals cannot reach agreement, 

then I will be very hesitant to make very significant changes to the 

CFMA during reauthorization. If the PWG principals reach consensus but still have reservations, then I think we need to think 

long and hard about how we proceed. 

I am also very concerned that over the last 3 to 4 years there 

have been proposals for additional regulation of energy derivatives 

that is not warranted and would have changed the CFMA balance 

in reaction to certain market events. Fortunately, we were able to 

turn them back here in the Senate, but had they succeeded, I am 

concerned that those efforts would have unraveled the delicate and 

6

highly negotiated balance, and frankly, would have adversely impacted our economy. 

In fact, in several hearings, Chairman Greenspan, commenting 

on some of these proposals and their potential impact, indicated 

that they could have had a serious dampening impacts on the ability of our economy to respond in a timely and appropriate fashion 

to significant events. So we are dealing with very critical issues 

here. 

No doubt we must make sure that those who would commit fraud 

in financial transactions are subject to very aggressive and effective 

regulation, and that they are capable of being identified, stopped, 

and punished, and I do not believe that there is anybody who 

would disagree with that. 

But in our zeal to make sure that we accomplish that objective, 

I do not think that we want to create a disincentive for financial 

markets in this country to work, and to work in the smoothness 

and the effectiveness that they have been shown to be able to do 

in the past. We want to have financial tools available that will 

allow our economy to react swiftly and well, to allocate risk properly, and basically to keep us on the cutting edge of international 

competition. 

Mr. Chairman, as we have discussed, it is my intention to hold 

a hearing in the Subcommittee on the International Trade and Finance on the regulation of futures based on financial instruments 

and other financial products. In recent years, trading in futures 

contracts has expanded rapidly beyond the traditional physical and 

agricultural commodities into a vast array of financial instruments, 

including foreign currencies, U.S. and foreign government securities, and U.S. and foreign stock indices. 

I appreciate the Chairman’s willingness to facilitate and support 

the Subcommittee’s interest in this and look forward to holding 

that hearing. 

Again, Mr. Chairman, I appreciate your attention to this issue 

and look forward to working with you as we move forward. 

Chairman SHELBY. Thank you. 

Senator Martinez. 

COMMENTS OF SENATOR MEL MARTINEZ 

Senator MARTINEZ. Mr. Chairman, Thank you very much. I want 

to thank you and Senator Sarbanes for this important hearing. I 

have a brief statement. 

Chairman SHELBY. We all want to call you ‘‘Mr. Secretary,’’ but 

we are getting used to you being up here. 

[Laughter.] 

Senator MARTINEZ. I have changed now. I am pleased to be here 

in this role, and I just want to submit a brief statement for the 

record. 

Chairman SHELBY. Without objection, it will be made part of the 

record. 

Senator MARTINEZ. Thank you, Mr. Chairman. 

Chairman SHELBY. Senator Bunning. 

7

STATEMENT OF SENATOR JIM BUNNING 

Senator BUNNING. Thank you, Mr. Chairman. I have a short 

statement. I would like to just thank you for holding this hearing 

today, and Senator Sarbanes also, on the Commodity Futures Modernization Act, the CFMA reauthorization. 

In 2000, we enacted the CFMA after a joint Committee hearings 

process involving the Banking Committee and the Agriculture 

Committee. The CFMA enacted the most significant amendment to 

the CEA and derivatives trading in 25 years. The CFMA provided 

for legal certainty and regulatory clarity for over-the-counter derivatives and a framework for trading security futures products. 

The provisions in the CFMA generally followed the recommendations contained in the report by the President’s Working Group on 

Financial Markets. The CFMA worked because the two Committees 

worked together. Unfortunately, that is not the case this time. 

I know the Chairman and Ranking Member have made their concerns well-known to the Agriculture Committee. I wish the Ag 

Committee would have worked with us to solve these problems. 

But the Ag Committee chose to go ahead and report their bill, despite this Committee’s concerns. I believe that was a mistake. Now, 

we find ourselves with serious jurisdictional problems, problems I 

believe could have been worked out to both Committees’ satisfaction. 

I understand the Ag Committee’s frustration with the lack of action by the SEC on many of the issues they tried to fix in S. 1566. 

Many of us on this Committee have felt similar frustrations with 

the SEC on other issues. It seems like no issue becomes a priority 

to the SEC unless a State official starts making headlines. I am 

confident this will change with Chris Cox as the new Chairman. 

I hope this hearing and this process has gotten the SEC’s attention. I hope these issues that have sat around for 5 years-plus now, 

will become priorities. I hope the SEC and the CFTC and the rest 

of the President’s Working Group will continue to work together, 

I commend the staff of the group for coming up with an agreement 

to clarify the Zelener decision problems and allow the CFTC to protect retail investors. And finally, I hope, going forward, that the Ag 

Committee will work with this Committee, as we did in 2000 and 

pass a good bill that protects investors and help markets. 

Thank you, Mr. Chairman. 

Chairman SHELBY. Thank all of you. 

The panel’s written testimony will be made part of the hearing 

record. If you would, sum up your strongest parts and your recommendations and observations. We will start with Secretary 

Quarles. Welcome to the Committee. 

Oh, excuse me. Senator Hagel. 

COMMENTS OF SENATOR CHUCK HAGEL 

Senator HAGEL. Mr. Chairman, I thank you for holding this hearing today on such a timely topic. I just want to welcome all of the 

witnesses today and thank them for coming. I am sure we will benefit from their knowledge. 

Chairman SHELBY. Okay. He wants to go to the panel. Thank 

you. Go ahead, Mr. Secretary. 

8

STATEMENT OF RANDY K. QUARLES

UNDER SECRETARY FOR DOMESTIC FINANCE

U.S. DEPARTMENT OF THE TREASURY 

Mr. QUARLES. Thank you, Chairman Shelby, Ranking Member 

Sarbanes, and other Members of the Committee. I will be very brief 

given that my written remarks will be included in the record. 

As you know, the Secretary of the Treasury is the Chair of the 

President’s Working Group. The other members of the President’s 

Working Group are here with us. In recent weeks, the Working 

Group and members of the senior staff have met to discuss the effect of last year’s Seventh Circuit Court of Appeals decision in 

CFTC v. Zelener, and the effect of that decision on the CFTC’s antifraud authority, and in particular, the ability to address certain retail foreign exchange contracts. 

We have produced a proposal that addresses the issues that were 

raised by the Zelener case, reflecting a consensus of the President’s 

Working Group, while being very sensitive to preserve the careful 

compromises of the CFMA of 2000. 

Let me just say at the outset that one of the important elements 

of this consensus is that we do not think that the modification that 

this proposal would produce should extend beyond retail foreign exchange to any other commodities. We think that major changes to 

the significant modernizations of the CFMA are not warranted. But 

one change that the CFMA did make was to modify the Commodity 

Exchange Act so that certain provisions of the Act, including antifraud provisions, did apply to foreign exchange futures and certain 

options with retail customers if the counterparty was not otherwise 

regulated. 

Those changes were intended to provide the CFTC with tools to 

pursue fraud against retail customers by bucket shops offering certain foreign exchange contracts. What the Zelener case showed was 

that there were some weaknesses in the CFTC’s ability to pursue 

this type of bucket shop fraud, but we think that with the work 

that we have done over the course of August, the proposal that we 

currently have here, that those weaknesses can be addressed without upsetting the compromises of the CFMA. They can be addressed in a very narrow way. 

The changes that we are proposing would be, as I said, limited 

to cover only certain retail foreign exchange contracts that have 

been the subject of abuse. They would apply the CEA or its antifraud provisions to certain retail foreign currency futures and certain options and their sales chains when an FCM is involved. And 

they would apply the antifraud provisions to certain retail foreign 

exchange contracts that are not securities, that are not contracts 

that result in actual delivery within 2 days or certain contracts in 

connection with a line of business, as well as to their sales chains. 

Our proposal makes futures transactions and certain options on 

foreign currency between a retail participant and a counterparty 

that is not an otherwise regulated entity, such as a financial institution, a broker-dealer, or an insurance company, subject to the 

CEA. It would provide the CFTC with antifraud jurisdiction over 

those retail foreign exchange contracts and the persons who engage 

in sales activity in connection with those contracts if the 

counterparty is an FCM. And any person who participated in the 

9

solicitation or recommendation of such a contract within the FCM 

sales chain would register with the CFTC and be a member of a 

registered futures association. The PWG proposal would preserve 

the exclusion for otherwise regulated entities that was crafted by 

the CFMA. 

This proposal would make certain foreign currency contracts between a retail participant and counterparty that is not otherwise 

regulated subject to CFTC antifraud jurisdiction if the contracts 

were leveraged, margined, or financed, except that they would not 

apply to, as I said, securities, contracts that result in actual delivery within 2 days, or certain contracts in connection with a line of 

business. It would make such retail foreign exchange contracts and 

the persons who engage in activity in connection with them subject 

to the antifraud provisions, and any person who participated in the 

solicitation or recommendation of such a contract would have to 

register with the CFTC and be a member of the NFA. 

Let me move on and say just a few words then about the issues 

of portfolio-style margin systems and contracts and products based 

on narrow-based indices. The CFMA granted to the Board of Governors of the Federal Reserve System the authority to establish 

margin requirements for security futures products. The Board delegated that authority to the SEC and the CFTC jointly. The SEC 

and the CFTC are continuing to work toward permitting portfoliostyle margin models. At the Treasury Department, we support the 

concept of portfolio-style margining systems. They increase the efficiency of capital allocation. They encourage risk management activities. We note some progress has been made very recently, and 

we remain hopeful that the SEC and the CFTC can work together 

to facilitate the implementation of these margining systems soon. 

The CFMA also created a distinction between broad-based security indices, which have been regulated solely by the CFTC, and 

narrow-based security indices, which are regulated by the SEC and 

the CFTC jointly. The definition of ‘‘narrow-based security index’’ 

seems to have been formulated using criteria that are appropriate 

for equity securities as opposed to debt securities. And so in that 

context, the Treasury Department can support reviewing the appropriateness of certain criteria in this definition of ‘‘narrow-based 

security index’’ in the context of debt and foreign security index futures given that the nature of the underlying securities differs from 

domestic equities, which seems to have been what was the context 

of the development of the definition. And so we are supportive of 

that review. 

In conclusion, I very much appreciate the opportunity to appear 

today to discuss these issues, present the consensus proposal of the 

President’s Working Group. The proposal does provide the CFTC 

with the statutory enforcement authority that is necessary to combat fraud against retail customers while preserving what we think 

are the very important provisions of the CFMA and avoiding unintended consequences of overly broad changes. 

I look forward to continuing to work with my colleagues from the 

President’s Working Group and with Members of Congress on these 

issues, and I look forward to your questions. 

Chairman SHELBY. Thank you, Secretary Quarles. 

Mr. Colby. 

10

STATEMENT OF ROBERT L.D. COLBY

DEPUTY DIRECTOR, DIVISION OF MARKET REGULATION

U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. COLBY. Chairman Shelby, Ranking Member Sarbanes, and 

Members of the Committee, I am pleased to be here today to testify 

on behalf of the Securities and Exchange Commission. I will briefly 

summarize the Commission’s views on the Commodity Exchange 

Reauthorization Act of 2005, which are more completely set forth 

in my written testimony. 

There are three changes proposed by S. 1566 that I will discuss: 

First, the changes to the margin requirements for securities futures; second, the directive to change the definition of ‘‘narrowbased security index’’; and, finally, the changes to the Commodity 

Exchange Act designed to address the Seventh Circuit decision’s in 

CFTC v. Zelener.

The Commission supports the expansion portfolio margining to 

all equity products. We believe, however, that it can, and should, 

be accomplished without undermining the current requirements regarding comparability between security futures margin and options 

margin. Section 7 of S. 1566 would permit security futures margin 

to be calculated using a portfolio margining methodology, but 

would do so by removing the current requirements regarding comparability between security future margin and exchange-traded options margin. It would also eliminate the SEC’s role in establishing 

margin requirements for security futures. The Commission strongly 

opposes these changes to the joint regulatory framework for security futures and believes that these changes would provide security 

futures a regulatory advantage over security options, products that 

are economic equivalents. The SEC believes that competition 

should be based on better products, services, and prices, not on regulatory differences. 

We acknowledge that implementing portfolio margining has not 

been the Commission’s top priority over the past few years and 

that it is time for more concrete action to implement portfolio margining. In this regard, Chairman Cox met recently with CFTC 

Chairman Jeffery and committed to make the expansion of portfolio 

margining a Commission priority. Already, on July 14, 2005, the 

SEC approved companion proposals by the New York Stock Exchange and the Chicago Board Options Exchange that permit their 

members, on a pilot basis, to compute certain customers’ margin requirements using a portfolio margin methodology. These portfolio 

margin rules are limited, but the Commission staff has been actively discussing with the securities industry, CBOE, and New 

York Stock Exchange an approach to portfolio margining, including 

single stock futures, narrow-based securities index futures, and 

other equity securities. 

The self-regulatory organizations, too, have reinvigorated their 

efforts to allow for risk-based portfolio margining, and we anticipate that the New York Stock Exchange and CBOE will propose to 

expand their portfolio margining pilot drawing from recommendations of a committee of representatives of securities firms. 

Finally, we believe it would be helpful for legislation to make certain changes to the Securities Interview Protection Act of 1970, or 

SIPA. Such amendments could be targeted to provide that futures 

11

held in a portfolio margin account to offset positions in related securities would receive SIPA protection in the event of bankruptcy. 

This type of change to SIPA would encourage customers to take full 

advantage of portfolio margining rules. 

The Commission also has serious concerns about the amendments in Section 8 of S. 1566. These changes would potentially remove products currently considered securities from Commission 

oversight and eliminate key protections currently provided by the 

Federal securities laws to investors in futures based on such excluded indices. Also, if these indices were excluded from the definition, it would give the CFTC exclusive jurisdiction over futures on 

such indexes, and give futures exchanges the exclusive right to 

trade these products. Securities exchanges would be precluded from 

trading such instruments. 

I would also like to note that Section 8 of S. 1566 introduces a 

subjective standard that the SEC and CFTC would be required to 

consider in assessing whether an index should be considered broadbased. One of the significant achievements of the CFMA was to establish clear, objective standards for which indexes were narrow 

and which were broad. We urge Congress not to reintroduce uncertainty into this area by establishing standards for determining jurisdictional boundaries that are subjective and subject to differing 

interpretations. 

Finally, the Commission shares the concerns of this Committee’s 

Chairman and Ranking Member, as well as other members of the 

Working Group, regarding the potential adverse consequences of 

the provisions in S. 1566 designed to address the Seventh Circuit 

decision in CFTC v. Zelener. The Commission is concern that the 

changes proposed to be made to the CEA would compromise the 

legal certainty and regulatory clarity achieved by the CFMA. 

In addition, S. 1566 would curtail the foreign currency exclusions 

from the CEA for the securities industry that were established by 

the CFMA. The Commission believes these changes would undermine the competitive parity between broker-dealers and banks in 

foreign currency transactions. There is no evidence of involvement 

in the retail foreign currency fraud by these currently excluded 

broker-dealer affiliates that would justify elimination of their exclusion. Instead, we think the Zelener decision just calls for fine-tuning of the Treasury Amendment. We stand with what Under

Secretary Quarles has said, and we look forward to finalizing legislative language. 

Thank you very much. I would be happy to answer any questions 

you may have. 

Chairman SHELBY. Thank you. 

Mr. McCarty. 

STATEMENT OF PATRICK J. McCARTY, GENERAL COUNSEL,

COMMODITY FUTURES TRADING COMMISSION 

Mr. MCCARTY. Mr. Chairman and Senator Sarbanes, good morning. I am pleased to testify today on behalf of the Commodity Futures Trading Commission regarding the reauthorization of the 

Commodity Exchange Act. 

The last such exercise by Congress resulted in the Commodity 

Futures Modernization Act of 2000, which truly was landmark legVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
12

islation. This Committee deserves credit for its role in the drafting 

of that law. The CFTC concurs with the widely held view that the 

current reauthorization should involve only incremental changes to 

the Commodity Exchange Act. 

Mr. Chairman, you asked us to comment on several issues, and 

I will begin with portfolio margining for security futures products. 

This is an important issue because we have heard from exchanges 

and market participants that the current margining scheme has 

been an impediment for traders to buy and sell SFP’s. They are 

being traded quite successfully in other jurisdictions, including in 

Europe, and in the vast majority of foreign SFP markets, margin 

requirements are risk based. 

I would note that the reauthorization bill reported by the Senate 

Ag Committee calls for a pilot program for risk-based portfolio margining of SFP’s. That SFP pilot program would be similar to the 

CBOE portfolio margining pilot program that was approved by the 

SEC on July 14. The CBOE pilot program does not include SFP’s. 

The CFTC strongly supports the concept of risk-based and portfolio 

margining for both security futures products and for security options. These types of margining, standard in the futures industry, 

are both efficient and effective from a regulatory point of view, and 

have been very successful in protecting customer funds. 

The use of risk-based portfolio margining for financial products 

has received support in the past from the Board of Governors of the 

Federal Reserve System and the Securities and Exchange Commission. Details are in my written testimony. 

Mr. Chairman, regarding definitional changes for narrow-based 

security indexes, the current statutory tests enacted in the CFMA 

were based on the U.S. equity market, the largest, deepest, and 

most liquid market in the world. They are inappropriate for the 

smaller size in trading volume that generally characterizes foreign 

markets and debt markets. The CFMA gave the CFTC and the 

SEC authority to exclude certain foreign indexes and instruments 

from this narrow-based category. However, the agencies have not 

acted, thus preventing these new products from being made available to U.S. customers. 

This is not a matter of altering the existing jurisdictional division 

between the SEC and the CFTC, but rather ensuring that foreign 

security indexes and debt security indexes may qualify to be traded 

in the United States under a test that more accurately takes into 

account the nature and size of these markets as the CFMA requires. The CFTC has developed specific definitions to achieve this 

end and they are set forth in my written testimony. 

Finally, the issue that has received the most public attention involves the Commission’s antifraud authority over retail foreign currency transactions in light of the recent Zelener court decision.

Retail forex fraud from sales pitches with false assurances of guaranteed profits to outright absconding with customer funds has 

posed a significant enforcement challenge to our agency. 

Since the CFMA was enacted, the CFTC has brought 79 enforcement actions in the retail forex sphere involving more than 23,000 

victims, and court-ordered restitution and penalties of approximately $267 million. I want to stress that the CFTC continues to 

believe the contracts at issue in Zelener were futures contracts. To 

13

protect customers from fraud, our Division of Enforcement will continue to litigate similar cases aggressively. 

As you are aware, there are a number of views as to how the 

Zelener decision should be addressed. Recognizing this, the President’s Working Group on Financial Markets, of which CFTC Chairman Reuben Jeffery is a member, set out to develop a consensus 

position to recommend to the Congress. As Under Secretary 

Quarles of the Treasury has testified, the PWG members have 

reached agreement in concept. Final details are being worked out. 

With respect to questions posed by the Committee, I can say the 

concept would be a narrow fix that applies only to futures and 

Zelener type contracts in foreign currency that are offered to retail 

customers. In addition, the concept retains the current otherwise 

regulated regime in which retail forex transactions by financial institutions, including banks, broker/dealers, and insurance companies, are excluded from the CFTC’s jurisdiction. 

We look forward to providing our authorizing committees and 

this Committee our recommendations when the detailed language 

has been finalized. 

Thank you again, Mr. Chairman, and I am prepared to answers 

your questions. 

Chairman SHELBY. Mr. Parkinson. 

STATEMENT OF PATRICK M. PARKINSON

DEPUTY DIRECTOR, DIVISION OF RESEARCH AND STATISTICS

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Mr. PARKINSON. Chairman Shelby, Senator Sarbanes, and Members of the Committee, thank you for the opportunity to testify on 

the CFMA and on regulatory issues that have arisen in the context 

of the reauthorization of the CFTC. 

The Federal Reserve Board believes the CFMA has unquestionably been a successful piece of legislation. The CFMA has made our 

financial system and our economy more flexible and resilient by facilitating the transfer and dispersion of risk. Consequently, the 

Board believes that major amendments to the regulatory framework established by the CFMA are unnecessary and unwise. 

Nonetheless, the Board supports some targeted amendments to 

the CEA to address persistent problems with fraud and retail foreign currency transactions and to facilitate the trading of security 

futures products and futures on security indexes. 

In its 1999 report, the PWG concluded that to address problems 

associated with foreign currency bucket shops, the CEA should be 

applied to transactions in foreign currency futures if they are entered into between a retail customer and an entity that is neither 

federally regulated nor affiliated with a federally regulated entity. 

The CFMA included provisions that were largely consistent with 

the PWG’s recommendation. 

The CFMA has allowed the CFTC to take numerous enforcement 

actions against retail foreign currency fraud. However, the CFTC 

has continued to encounter certain difficulties in this area. The 

Board supports targeted amendments to the CEA that address the 

specific difficulties that the CFTC has encountered. However, it is 

critical that those amendments be carefully crafted to avoid creating legal or regulatory uncertainty for legitimate businesses proVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
14

viding foreign exchange services to retail clients. The Board would 

be opposed to extending any new CFTC authority to retail transactions in other commodities without further careful consideration 

and demonstrated need. Provisions crafted to avoid creating uncertainty for legitimate foreign currency businesses are unlikely to 

provide the same protection to a much wider range of businesses. 

The agreement in principle that has been reached by the PWG 

appears to be fully consistent with the Board’s views and therefore 

deserving of its support. 

Turning to portfolio margins, the CFMA gave the Board authority to prescribe regulations establishing initial and maintenance 

margins for security futures products or to delegate that authority 

jointly to the CFTC and the SEC. The Board delegated its authority to the Commissions in a letter dated March 6, 2001. The Board 

has supported the use of portfolio margining for some time. For example, in 1998 the Board amended its Regulation T to allow securities exchanges to develop portfolio margining as an alternative to 

strategy-based margining subject to SEC approval. 

In its 2001 letter delegating its authority over margins for security futures jointly to the CFTC and SEC, the Board requested that 

the Commissions report to the Board annually on their experience, 

exercising the delegated authority, and in particular to include in 

those reports an assessment of progress toward portfolio margining 

for security futures products. 

Unfortunately, to date, no progress has been made toward portfolio margining of security futures products. Because the CFMA 

stipulates that margin requirements for security futures products 

must be consistent with margin requirements on comparable security options, progress for security futures requires progress on options. Although margin requirements for options have for many 

years been portfolio based at the clearing level, customer margins 

were, until very recently, strictly strategy based. 

However, in July the SEC approved rule changes that create a 

2-year pilot program that would permit portfolio margining of options and futures positions in broad-based stock indexes held by 

certain customers with very large accounts. If this pilot program 

were adopted as a margining system available to all customers for 

a broad range of products, significant progress toward portfolio 

margining security futures products would become possible. 

The Board believes that it is appropriate for the Congress to spur 

progress toward portfolio margining for security futures. For example, the Congress could spur progress for both security futures 

products and options by requiring the Commissions to jointly adopt 

regulations permitting the use of risk-based portfolio margining

requirements for securities futures products within a short reasonable time period, and requiring the SEC to approve risk-based portfolio margin requirements for options within the same period. 

Finally, some futures exchanges argue that the definition of a 

narrow-based index in the CFMA was drafted with reference to the 

U.S. equities markets, and that in any event the definition unnecessarily restricts the trading of futures on indexes of U.S. debt obligations and foreign securities. Although the Board has not had a 

strong interest in this issue, it favors taking another look at the 

15

appropriateness of applying the existing definition to indexes of foreign securities. 

First, for many years several futures on foreign equity indexes 

have been trading aborad and have been offered to customers in 

the United States. Although these indexes would be considered 

narrow-based indexes under the existing definition, we see no evidence that these indexes have been susceptible to manipulation. 

Second, the provision in the 2005 Reauthorization Act can be 

seen as simply reiterating an existing requirement in the CFMA 

that the CFTC and the SEC jointly adopt rules that define narrowbased indexes based on foreign securities. 

That concludes my prepared remarks. Thank you. 

Chairman SHELBY. I think I have about four questions. Other 

people have more. The futures markets continue to evolve, as we 

all know, as an increasing number of future contracts are based on 

financial instruments. It seems increasingly likely that exchanges 

will soon seek to trade both securities and future products. 

As a result of this market convergence, the differences between 

securities and futures becomes less clear. In light of these developments here, does the regulatory regime need to be modernized to 

reflect current market realities? Does the current regulatory 

scheme that draws a line between futures regulation and regulation for other financial products make sense? Secretary Quarles, do 

you want to comment first? 

Mr. QUARLES. That is a thoughtful question. The official sector 

always needs to be very mindful of changes that are happening in 

markets and in the structure of industries that affect changes in 

market——

Chairman SHELBY. Is the market getting ahead of the regulatory 

regime? 

Mr. QUARLES. We need to make sure that the regulatory framework is reflecting what is actually happening in practice. I think 

that that requires further reflection. I would not be prepared today 

to make specific recommendations in light of that, but having recently been sworn into this job, that theme is something that I am 

asking my people at the Treasury Department to be focused on, is 

ensuring that changes in the industry over the last 5, 10 years, 

changes and the effects on markets that those changes in the structure of the industry might be having, that we are thinking about 

appropriate policy responses. Today, I would not be prepared to 

recommend any particular ones, but that is a theme that we are 

definitely pursuing. 

Chairman SHELBY. Mr. Colby, you have any comment? 

Mr. COLBY. Chairman Shelby, this is an issue that has been of 

acute interest to the Commission over the years. We deal with the 

ramifications of this very important issue on a daily basis. Our new 

Chairman, however, has not had time to focus on this crucial issue, 

so I would like to defer answering the question. 

Chairman SHELBY. Mr. McCarty, you have a different view? 

[Laughter.] 

Mr. MCCARTY. No. I think I will have to defer to get an answer 

from our Chairman. 

But I think your observation is absolutely correct. There seems 

to be a convergence occurring over the last several years. The 

16

CFMA has worked extremely well, and I would say that the regulatory structure has seen the markets and helped them develop I 

think that convergence is a big issue that is coming. 

Chairman SHELBY. Mr. Parkinson, do you have a comment? 

Mr. PARKINSON. I think the distinctions between securities and 

futures have been blurring, and where they exist they are often arbitrary—based on legal distinctions rather than economic differences. But having encountered this question several times over 

the years, I do not think one should underestimate the difficulty 

of developing a new regulatory structure that improves on the existing one. 

For example, some seem to think that simply merging the CFTC 

and SEC would solve all these problems, but I think that, by itself, 

would not achieve consistent regulation of securities and futures. 

The fact is that the underlying statutes the CEA and the 34 Act, 

provide for quite different approaches to regulation. Moreover, if 

OTC derivatives come into the picture here, they are neither futures nor securities, and in our view are not appropriately regulated as either. In that case, private market discipline rather than 

Government regulation is really the critical mechanism ensuring 

that public policy objectives are met. 

Again, much as I can understand the frustrations with the existing regime, I think it is going to be difficult to come up with a better one. 

Chairman SHELBY. The product is not a security, per se, and it 

is not a futures, per se. Is it a hybrid? Is it something that man 

has invented and is very resourceful? 

Mr. PARKINSON. At the insistence of this Committee, the CFMA 

explicitly identifies a class of products called banking products that 

are neither securities nor futures nor regulated as either. So that 

is an example. 

Chairman SHELBY. It seems that there is agreement among the 

witnesses that portfolio margining is a positive step for not only security futures but also for security options. There seems to be consensus on this point. To date, the regulators have been unable to 

produce a rule adopting portfolio margining. Given this inaction, 

should Congress mandate that the regulators adopt portfolio margining for security futures and security options? If not, then what 

assurances does Congress have that it will be done in a timely 

manner? 

Mr. Colby. 

Mr. COLBY. I recognize first of all that this issue has been a long 

time in coming. I believe that we are on the cusp of moving much 

more quickly to address portolio margining. We have a framework 

now established in the pilot program that was set up by the CBOE 

and New York Stock Exchange. The NYSE and the CBOE, I believe, are reenergized in order to move this forward. 

We have a consensus in the industry about a way to move forward, and so I do not think the issue merits legislation. If there 

were legislation, I think it would remain important that the margin 

requirements be determined by the SRO’s who bring the expertise 

of the industry and the ability to work on the issues and find a 

workable and inexpensive way to do it, subject to the approval of 

the CFTC and the Commission. 

17

Chairman SHELBY. Secretary Quarles, you have a different view? 

Mr. QUARLES. No. I think, as I indicated in my testimony, I think 

we are beginning to see progress. 

Chairman SHELBY. What about you, Mr. McCarty, you have a 

different view than the SEC? 

Mr. MCCARTY. I think that it has been a long time coming, and 

I guess our point of view is we would like to work with the SEC 

to get this done as quickly as possible. I would note however that 

there is nothing like a statutory deadline to get one to move. 

Chairman SHELBY. Mr. Parkinson. 

Mr. PARKINSON. As I indicated in my testimony, the Board believes it is appropriate for Congress to spur progress here, both in 

the case of security futures and security options. The step that the 

SEC took recently was a very important one, but as you have indicated, it was a long time in coming, and I think the concern of

people in industry is that we not come to the next CFTC reauthorization and see that there still has not been meaningful progress. 

Chairman SHELBY. Some have proposed that Congress should direct the regulators to amend the definition of what we call narrowbased security indexes to account for debt and foreign securities. 

Do the SEC and the CFTC currently have the necessary statutory 

authority to modify this term or is legislation necessary? 

Mr. Colby. 

Mr. COLBY. We absolutely have the necessary authority to——

Chairman SHELBY. Without question? 

Mr. COLBY. Without question. And we have in the past excluded 

some indices from the definition narrow-based volatility indexes 

that are——

Chairman SHELBY. If you have the authority, what are you going 

to do about it? 

Mr. COLBY. Yes, that is a fair question. Our plan is to work closely with the CFTC to address each of these issues. Some of them 

are new to us. The debt issue has not previously been presented 

to us before this legislation. The foreign securities issue is familiar. 

The debt issue is new. 

Chairman SHELBY. Can you afford to let the market get ahead 

of you as a regulator? Both of you. In a sense you cannot, can you? 

Mr. COLBY. We never want the market to get ahead of us. I think 

we can work with the CFTC to make real progress here. 

Chairman SHELBY. Secretary Quarles and Mr. Parkinson, would 

you please comment briefly on changes to the definition of narrowbased security index? In other words, can the members of the 

Working Group here resolve this issue, or does Congress need to 

step in? What do you think, Secretary Quarles and Mr. Parkinson? 

The Treasury and the Fed play a role here. 

Mr. QUARLES. If you are asking is it appropriate for the Working 

Group to have on its agenda this issue. It is the issue that the 

Working Group can consider. I do think that the SEC and the 

CFTC obviously have the principal expertise here, and so I do not 

know that it is necessary that it become an agenda item. Certainly 

if it was the desire of this Committee that it become one——

Chairman SHELBY. If they have the expertise, which I do not 

question, if they have the statutory authority, they need acceleration perhaps in doing something? 

18

Mr. QUARLES. The Working Group has been in the past an accelerating device. 

[Laughter.] 

Chairman SHELBY. Senator Crapo, you spent a lot of time on 

these issues. 

Senator CRAPO. Thank you very much, Mr. Chairman. I have 

been checking off my questions as you asked them, but I still have 

a couple of others. 

I want to go into what I understand to be the consensus position 

that the Working Group is prepared to submit with regard to the 

Zelener decision. Let me clarify, it is my understanding that we 

have a consensus position in concept, but we do not have specific 

language; is that correct? 

Mr. QUARLES. That is correct, but there has been a very substantial element that remains to have final language done, so this is 

not just concept. 

Senator CRAPO. And the only area on which we have consensus 

at this point is the matter of dealing with the Zelener decision. I 

mean there are other issues that the Working Group is working on, 

I understand, and I understand there is not necessarily a consensus position on other issues. Is that correct? 

Mr. QUARLES. We have begun with the Zelener issue, so it is not 

as though we have been considering the other issues and have 

reached any impasse. It is that as a working procedure we began 

with the Zelener issue and completed that agreement, and the time 

that that took, took the time until this hearing. 

Senator CRAPO. That is a good clarification and I appreciate that. 

I know that each of you in your testimony have basically said this 

already, but I want to nail it down, and that is that my understanding is that the consensus that has been developed is that the 

fraud issues dealing with retail foreign currency transactions that 

were raised by the Zelener case can be handled with a narrow antifraud fix that does not expand the jurisdiction of the Act otherwise, 

a narrow antifraud fix dealing with retail foreign currency transactions specifically; is that correct? Everybody is nodding their 

head yes. 

Mr. QUARLES. Yes, it is. 

Senator CRAPO. So the record can reflect that at least the Working Group is in consensus, that a narrow fix is all that is necessary 

and can accomplish the objectives necessary to deal with the fraud 

issues? 

Mr. QUARLES. That is correct. 

Senator CRAPO. Let me ask a question then about the rest of the 

agenda. It is clear to me that the fraud issues were one that we 

needed to deal with. The Zelener case brought this to the forefront 

and the concern about the potential fraud, particularly in retail foreign currency transactions, required some action, and there is now 

consensus in terms of how we should approach that, at least from 

the Working Group. Are there other areas such as the Zelener case 

or the retail fraud issues that we just discussed, that Congress 

needs to talk about, or is the Zelener case really the area that we 

need to focus on? Are there other problem areas that require statutory solutions right now? 

19

Mr. COLBY. As I mentioned in my testimony, there is a small 

amendment to the Securities Investor Protection Act that we think 

would facilitate cross-margining, which we would be happy to 

transmit to you for your consideration. The aim of it is to protect 

futures that are in a cross-margin account under the Securities Investor Protection Act so you do not run the risk of insolvency where 

part of the account will be protected and part of it will not. 

Senator CRAPO. Any others? Yes, Mr. McCarty. 

Mr. MCCARTY. Senator Crapo, we had two other provisions in our 

testimony dealing with fraud authority. One is with respect to 

clarifying that we have principal-to-principal fraud authority under 

our Section 4(b) provision. This is a very important issue for us, 

and we can discuss it later on, but it is a very important part of 

the Senate bill. 

The second item is clarification of our civil and administrative 

authority to bring actions under Section 9 of our Act. Those two 

provisions are actually in the Senate bill and they are quite important to the Commission. 

Senator CRAPO. Any others? 

Mr. PARKINSON. As we indicated, we do support the Congress 

taking steps to spur progress on portfolio margining, and I think 

less strongly we would support doing something to move forward 

on the narrow-based index question as well. 

Senator CRAPO. But in that context you are talking about more 

deadline setting rather than Congress establishing those substantive changes? 

Mr. PARKINSON. That is correct. I think Congress would not want 

to take on the question of redrawing the narrow-based index definition, for example, which is extremely complex. 

Senator CRAPO. Mr. McCarty. 

Mr. MCCARTY. If I might come back to that issue just briefly. 

One, I think that we clearly have the statutory authority, as the 

Chairman suggested, the SEC and ourselves at the CFTC, to work 

out exceptions from the narrow-based index definition. We have 

some proposed definitions that we have supplied in our testimony. 

There may be a difference of opinion between the two staffs as to 

exactly where Congress—what their intentions were and were not 

about the scope of those exceptions that we might make from the 

narrow-based security index definition. That is one thing that we 

may need to talk to you or your staffs about to get a clear focus 

on exactly how to fulfill Congress’s intent in terms of what you 

would like to exclude. 

Senator CRAPO. Anything else? I am trying to just get the waterfront laid out here so we know what we want to look at. 

Just one last question of the panel, Mr. Chairman. 

Chairman SHELBY. Go ahead. 

Senator CRAPO. And that is, Mr. McCarty, you raised Section 9 

of the Agriculture Committee’s bill as a matter that you feel did 

address some important issues that you need to deal with. In the 

context of legal certainty for swaps, one of the issues that was addressed by this Committee was the creation of legal certainty for 

swaps in the legislation. Sections 2(g), 2(h), and 2(i) in the Act were 

included specifically to establish this legal certainty. 

20

As I read at least the report language and my understanding of 

the bill’s language itself that the Senate Agriculture Committee 

just put out, it would adversely affect these or significantly change 

these sections, in that the report states that the CFTC believes 

that Section 9 dealing with false reporting applies to excluded 

transactions, even though the statute currently specifically states 

that nothing in that section applies to these swap transactions. 

So the question I have is: If Section 9 applies to any excluded 

transactions, would this not cover securities and mortgage finance 

as well as OTC swaps, and does this not undermine the legal certainty for swaps that was established in the original Act? 

Mr. MCCARTY. Senator, I think what you are referring to here is 

the false reporting cases that we have brought. Our Section 9 authority actually has many aspects to it. One is where people supply 

knowingly false reports in an attempt to manipulate commodity indexes and prices. We have always taken the position that the 2(g) 

and 2(h) exclusion and exemption apply to the contracts themselves. We are not actually saying that our Section 9 authority 

brings those contacts back in. The distinction that we make is that 

those contacts are clearly excluded from our jurisdiction except 

when someone, like an energy company, would report falsely or 

make up transactions and report them to index providers, publishers, in an attempt to manipulate those commodity prices. 

We just had a very significant victory in the Northern District 

of Oklahoma in the Bradley case. In Bradley, the Federal District 

Court agreed with the CFTC that in fact while the 2(g) and 2(h) 

provisions exclude the contracts transactions and their legal certainty is assured, the act of false reporting those transactions is a 

separate act. No one is required, who engages in a transaction 

under 2(g) or 2(h), to report those transactions to anyone. 

Chairman SHELBY. That is correct. 

Mr. MCCARTY. What we found in the Bradley case is that hundreds of false reports were submitted to the index providers in an 

attempt to benefit positions that the energy traders had. 

Senator CRAPO. Have you been successful in asserting jurisdiction over that false reporting? 

Mr. MCCARTY. Yes, sir. August 1 of this year, the U.S. Federal 

District Court for the Northern District of Oklahoma in Bradley

agreed with our long-held position that false reporting is a separate 

act from the actual exclusion of the transactions under 2(g) and 

2(h). 

Senator CRAPO. Would there need to be any statutory change 

since you have already successfully asserted that? 

Mr. MCCARTY. Senator, yes, we still do need the change that has 

been agreed to with the industry. That language is in the Senate 

Ag bill. It is needed to clarify the language in Section 9 which looks 

as if it applies only to felonies. We want to make sure that it clearly applies to our civil and administrative actions. 

Senator CRAPO. But you are not seeking to extend the reach of 

the Act to anything beyond what you have already done I these enforcement actions? 

Mr. MCCARTY. That is absolutely correct, Senator. 

Senator CRAPO. Thank you. 

Thank you, Mr. Chairman. 

21

Chairman SHELBY. Thank you, Senator Crapo. 

I will direct this question to Secretary Quarles and Mr. Colby. It 

seems that the Working Group is developing a proposal regarding 

registration requirements for certain counterparties engaged in the 

sale of retail foreign exchange contracts. How would such registration requirements apply to broker/dealers and their affiliates? Secretary Quarles? 

Mr. QUARLES. They would not apply. 

Chairman SHELBY. Do you have the same opinion? 

Mr. COLBY. I certainly hope so. 

[Laughter.] 

Chairman SHELBY. You hope so. 

Mr. COLBY. My understanding is they would not apply, that is 

right. 

Chairman SHELBY. I want to thank the first panel here—we have 

another panel—for your appearance this morning. It seems to me 

here that the Working Group has developed a consensus position 

regarding the regulatory ambiguity arising from the Zelener case, 

as Senator Crapo referred to. If I am wrong, you tell me. 

While I am encouraged by this positive result, or seemingly so, 

I would request that the Working Group continue to meet, hopefully over the coming weeks, regarding portfolio margining and 

definitional changes to the term ‘‘narrow-based security indexes.’’ 

As in 2000, consensus from the President’s Working Group would 

be extremely constructive to this Committee, to our process, and I 

believe it is critical to advancing any CFTC reauthorization legislation through the Senate. I hope that the Working Group will report 

back to this Committee with recommendations and proposed legislative language regarding the issues that we have discussed here 

this morning. We know they are complex, but you deal with complex issues. 

I would also ask that you consult with the Committee staff here, 

as you have, as to when you might bring forth such recommendations. 

We would also look forward to working, as always, with our colleague Senator Crapo, who has put so much effort into this, as he 

considers the regulatory scheme for futures based on financial instruments and other financial products at an upcoming Subcommittee hearing that he mentioned earlier. Senator Crapo, as we 

have acknowledged here—I have and Senator Sarbanes—has been 

a leader on this issue, has spent a lot of time on this issue, and 

I think his upcoming hearing will further inform the Senate as we 

consider the CFTC reauthorization. I hope you all will be forthcoming soon. 

Thank you very much. 

Senator CRAPO. Mr. Chairman. 

Chairman SHELBY. Yes. 

Senator CRAPO. Could I ask one more real quick question? 

Chairman SHELBY. Go ahead. 

Senator CRAPO. I apologize for that. This is for everybody on the 

panel. As you know, in the past, the President’s Working Group 

has explained why proposals that we have faced in the last couple 

of years for additional regulation of energy derivatives were not 

warranted, and the panel has unanimously urged Congress to be 

22

aware of the potential unintended consequences of those proposals. 

Is that still true today? I have not heard anybody discuss bringing 

that issue back up today and I just wanted to be clear that there 

is agreement that that does not need to be addressed. 

Mr. QUARLES. That is correct. 

Mr. COLBY. Our view has not changed. 

Senator CRAPO. And one other aspect of that: Would that also 

apply to natural gas derivatives; any reason for us to try to start 

jumping into changing the dynamic for regulating derivatives in 

the energy markets of any kind? 

Mr. QUARLES. Not at this time. 

Mr. COLBY. We agree. 

Senator CRAPO. Thank you. I want the record to show that the 

answer was no from all members of the panel. 

Chairman SHELBY. The record will so show. 

Thank you very much. 

Our second panel—I introduced them earlier, but I will do it 

again for the record. Mr. Charles Carey, Chairman of the Chicago 

Board of Trade, Mr. John Damgard, President, Futures Industry 

Association; Mr. Terrence Duffy, Chairman, Chicago Mercantile Exchange; Mr. Meyer Frucher, Chairman and Chief Executive Officer 

of the Philadelphia Stock Exchange; Mr. Mark Lackritz, President, 

Securities Industry of America; Mr. Robert Pickel, Executive Director and Chief Executive Officer of the International Swaps and

Derivatives Association; and Mr. Daniel Roth, President, National 

Futures Association. 

If the second panel will make their way to the table. As I said 

before, your written testimony is made part of the record, the hearing record, without objection, and if I could ask you to sum up your 

pertinent points, your strongest points that you want to make, as 

brief as you can, we would be very appreciative. 

Mr. Carey, we will start with you if you are ready, and welcome 

to the Committee, all of you. 

STATEMENT OF CHARLES P. CAREY

CHAIRMAN OF THE BOARD, CHICAGO BOARD OF TRADE 

Mr. CAREY. Mr. Chairman and Members of the Committee, my 

name is Charlie Carey and I am Chairman of the Chicago Board 

of Trade, the oldest and one of the largest futures exchanges in the 

world. Thank you for allowing me to appear before you today. I 

have also submitted written testimony for the record for the consideration of the Committee. 

The CBOT thanks and congratulates the Congress for the passage of the Commodity Futures Modernization Act of 2000. The 

CFMA provided for increased competition and legal certainty in the 

derivatives industry, and reduced many unnecessary and costly 

regulatory burdens. Overall, it has been a great success. 

Unfortunately, some of the goals and promises of the CFMA have 

not been fully realized. Dual regulation and inefficient margining 

have contributed to an environment that has inhibited the development of a robust, single-stock futures industry. Regulatory confusion may be keeping other innovations from the market. And an 

unfortunate court decision has been issued, which if not addressed, 

raises the specter of increased fraud. The Seventh Circuit Court of 

23

Appeals in Chicago rendered an opinion in the recent CFTC v. 

Zelener case, which essentially does away with previously settled 

law setting out characteristics of a futures contract. By determining that the contracts in question were not futures because 

they did not include a guaranteed right of offset, this decision provides a road map for potential wrongdoers to offer fraudulent 

transactions outside the reach of the CFTC. 

Such fraud involving commodities has the potential of tarnishing 

the reputations of exchanges, firms, and individuals who engage in 

legitimate business activities in the futures and derivatives industry. 

When Congress passed the CFMA, it recognized that persons 

who did not meet the criteria for becoming eligible contract participants still needed the protection of Federal regulation by the CFTC 

if they dealt in commodity futures. Yet still, these retail investors 

are being solicited by telephone, Internet, and television pitches to 

invest in fraudulent deals involving foreign currency, heating oil, 

gold, and other commodities. CBOT urges Congress to enact an 

amendment giving the CFTC the authority to shut down fraudulent operators before this activity results in the loss of hard-earned 

savings of the investing public. 

We believe that a solution that only addresses foreign currency 

transactions will not solve the problems created by this decision 

but merely shift them to other commodities. 

In addition to clarifying law to protect the public from ongoing 

and future fraud due to the Court’s decision in the Zelener case, the 

CBOT hopes that Congress will also continue the goal of reducing 

regulatory barriers to innovation in two areas. First, the CBOT 

asks that Congress consider clarifying that the definition of ‘‘narrow-based security indexes’’ does not include indexes on fixed income securities, corporate bonds, and other nonequity securities. 

The present definition creates a series of tests to distinguish narrow-based indexes from broad-based indexes. These tests are only 

workable for indexes on U.S. equity securities. Index products 

based on nonequity securities do not implicate the same regulatory 

concerns that led to the creation of the definition and test. 

However, the possibility that the definition could be interpreted 

to cover nonequity products has hampered development of such 

products due to confusion as to what regulations may or may not 

apply. Clarification of this definition is an important issue that deserves to be addressed at this time. 

Second, the CBOT asks the Congress to address the present inefficient and noneconomic margin requirements which continue to 

stymie growth of single-stock futures in this country while they 

flourish overseas. The CBOT hopes Congress will take this opportunity to facilitate the margining of stock futures as futures contracts, recognizing that the economic function of a futures contract 

is not to acquire ownership of the stock, but rather to act as a 

hedging vehicle. 

The Chicago Board of Trade, along with all other U.S. exchanges, 

vigorously competes in the international marketplace. We ask Congress and this Committee to remain cognizant of the continued 

need to reduce unnecessary regulatory complexities that inhibit the 

24

ability of U.S. exchanges to compete effectively with their counterparts around the world. 

We also ask the Congress to give the CFTC the tools necessary 

to prevent peripheral scandals that have the potential of harming 

the U.S. derivatives industry. 

Once again, the CBOT thanks the Committee for this opportunity and I am happy to answer any questions the Committee 

may have. 

Chairman SHELBY. Thank you. 

Mr. Damgard. 

STATEMENT OF JOHN M. DAMGARD

PRESIDENT, FUTURES INDUSTRY ASSOCIATION 

Mr. DAMGARD. Good morning, Mr. Chairman. Thank you, Senator Crapo, for inviting me to testify. 

I am John Damgard, President of the Futures Industry Association. The FIA’s regular members comprise the largest futures brokerage firms, called Futures Commission Merchants, and its other 

members come from all segments of the futures industry. Thank 

you very much for the opportunity to present our views. 

Both the CFMA and the CFTC have worked well, and we believe 

the CFTC should be reauthorized. Only two areas of the CFMA 

need discussion: Retail FX transactions and security futures. For 

retail FX, the issue is sales fraud. In recent years, the CFTC has 

devoted considerable resources to prosecuting firms for defrauding 

the retail public in FX transactions. Some have sought a major 

change in this area, which would grant the CFTC general jurisdiction over nonfutures FX transactions. They argue that because the 

CFTC lost one case, the Zelener case, the CFTC needs general jurisdiction over nonfutures retail FX or even other commodities. 

FIA believes that would be a serious mistake. Just as the SEC 

was set up to regulate securities, the CFTC was set up to regulate 

futures. Expanding the CFTC’s regulatory mission to nonfutures 

would be unwise and unnecessary. A better approach would be to 

address the fraud problem head on. In my testimony last March, 

FIA recommended that Congress grant the CFTC special fraud authority to move against unregulated firms that purvey retail FX 

transactions even if not futures. We still support that reform. 

FIA also recommends making changes to CFMA’s provisions for 

retail FX futures. As detailed in my written statement, FIA supports prohibiting shell FCM’s from becoming qualifying 

counterparties to retail customers, registering those who solicit orders from retail customers, imposing special net capital levels on 

FCM’s whose affiliates seek to qualify as counterparties, subjecting 

those qualifying affiliates to CFTC recordkeeping and reporting 

rules, and expanding the CFTC’s enforcement powers to cover principal to principal fraud. 

These important measures should give the CFTC the tools to 

curb the retail fraud scams that we have seen in recent years. 

In security futures, FIA has one overriding goal. We want U.S. 

investors to have access to a full menu of innovative liquid and 

capital efficient markets for managing their security price risk. Allowing portfolio margining for U.S. security futures, that is, futures 

on individual stocks and narrow-based security indexes, would 

25

serve that goal. It is true that the U.S. securities futures markets 

are not as well-developed as foreign markets. But portfolio margining will help our markets grow through more efficient use of 

trading capital under well-tested systems long in use by the futures 

industry. 

We strongly urge the CFTC and the SEC to allow portfolio margining to be implemented without delay for security futures. 

FIA also would encourage the SEC to move quickly on similar 

systems for the cash and options markets that it regulates. Anything that this Committee could do to help bring about portfolio 

margining would be grately appreciated. 

Foreign security futures products is another area where congressional attention is warranted. Right now U.S. institutional investors are prohibited from trading foreign security futures products. 

CFTC and the SEC could lift this ban, but thus far no action has 

been taken. The result is that U.S. investors, including Federal 

Government employee pension funds, earn different and usually 

lower rates of return than their foreign counterparts who do have 

access to these foreign security products. Again, we ask for the 

Committee’s help to rectify this disparity. 

This handicap could also be reduced if the CFTC and the SEC 

adopted a targeted criteria for determining when foreign security 

indexes are narrow or broad. If an index is broad-based and the 

subject of a futures contract, it may be traded by U.S. investors; 

if narrow-based it may not be. Many diverse foreign security indexes, some with over 200 stocks, would not qualify under the 

CFMA’s narrow-based index criteria. Yet many of these foreign indexes pose no threat of being used as a surrogate for trading an 

individual stock. This Committee could encourage the CFTC and 

the SEC to address this issue so that U.S. investors will have access to more products for managing their foreign equity price risk. 

Thank you for your time and attention to these issues, and we 

look forward to working with the Committee on this legislation. 

Chairman SHELBY. Thank you. 

Mr. Duffy. 

STATEMENT OF TERRENCE A. DUFFY, CHAIRMAN,

CHICAGO MERCANTILE EXCHANGE HOLDINGS, INC. 

Mr. DUFFY. Thank you, Chairman Shelby and Senator Crapo. I 

am Terry Duffy. I am the Chairman of Chicago Mercantile Exchange Holdings, Incorporated, which owns and operates the largest U.S. futures exchange, and by most standards, the largest futures exchange in the world. 

This hearing permits the Committee to consider whether the 

Commodity Futures Modernization Act of 2000 has lived up to its 

promise. I want to use this time to explain the CME’s suggestions 

for extending the positive impact of CFMA. 

First, I urge this Committee to direct the SEC and the CFTC to 

exercise their statutory authority, to permit U.S. futures markets 

to implement genuine risk-based margining for securities futures 

products and to fully participate in the worldwide market for futures trading in broad-based indexes. 

Second, we urge that the Commodity Exchange Act be amended 

to stop the explosion of off-exchange, retail futures fraud, and to 

26

close the Zelener loophole, which is being exploited to avoid CFTC 

jurisdiction. I am confident that our solutions cause no harm, competitive or otherwise, to any customer or to the marketplace itself. 

In my Congressional testimony of June 2003, I characterized single-stock futures as the CFMA’s unfulfilled promise. I am sad to 

say what was true then remains so even today. The success of single-stock futures in European markets proves the value of the product. In this country, inter-exchange competitive concerns, combined 

with regulatory turf contests, largely mitigated the hope for this 

product long before it was launched. The regulatory system that 

has slowly evolved between the SEC and the CFTC has not addressed key issues. Several of the regulations that have been produced thus far are overly burdensome or inflexible. 

We are not asking to undo the CFMA. We are only asking that 

the CFTC and the SEC be directed to do exactly what was contemplated by Congress when the CFMA was enacted. That is to 

jointly issue regulations to permit risk-based portfolio margining. 

This will put U.S. markets on par with financially sophisticated 

markets throughout the world. No one disagrees that risk-based 

margining is the world standard. 

Any opposition to CME’s proposal is based on ill-conceived notions of competitive parity. This claim is baseless. The average 

daily trading volume on options exchanges is 5 to 6 million contracts per day. One single-stock futures exchange has already 

failed, and the other trades about 6,000 contracts per day. The opponents of relief want Congress to suppress a potential competitor 

because they have been unable to get regulatory relief. The CME 

does not oppose equivalent relief for the securities options exchanges. 

The CFMA defined one class of broad-based security indexes and 

left it to the agencies to jointly create an inclusive definition. The 

agencies have not done so. As a result, futures exchanges and U.S. 

Futures Commission Merchants have been unable to provide their 

customers with broad-based indexes on U.S. debt obligations, foreign debt obligations, and foreign equity securities. 

The CFTC, the futures exchanges, and FIA are in agreement in 

principle that this should be fixed now. Our proposal requires the 

agencies to adopt a broad-based index definition that will fill in the 

statutory void that the agencies left unattended for the past 5 

years. 

The last point I want to talk about is off-exchange, retail futures 

trading. Off-exchange promotion of futures contracts to retail customers is a continuing source of harm to consumers. Just over the 

last 4 years of the CFMA, the CFTC has brought 79 enforcement 

actions involving 267 companies and individuals for illegal retail 

foreign exchange trading. The CFTC estimates that these cases involve trading with over 20,000 customers, and resulted in over 

$260 million in penalties and restitution orders. This is just the tip 

of the iceberg. 

The massive continuing fraud committed against retail customers in the OTC foreign exchange market, and the recent unfortunate decision of the Seventh Circuit Court of Appeals in CFTC

v. Zelener, compel this industry to reexamine the public policy of 

how the CFMA addresses retail foreign exchange futures and the 

27

threshold definition of what transactions should be subject to CFTC 

jurisdiction. The Zelener case held that the CFTC jurisdiction is 

avoided if the contract does not guarantee a right of offset. This 

was a surprising result since futures contracts traded at our exchange do not guarantee a right of offset. 

The bucket shops have already figured out that the rationale of 

the Zelener opinion can apply to commodities other than FX. Heating oil and unleaded gas appear to be the hot targets as a result 

of the price run-ups in those commodities. How soon will it be before the CFTC’s jurisdiction and its retail consumer protections are 

reduced to irrelevance? 

Our Zelener fix puts the crooks out of business before they take 

the money and run, and it protects the public against the fraudulent oil and orange juice scams that will replace currency scams if 

the legislative response is limited to foreign exchange scams. It 

does not interfere with any legitimate business operation. CME believes that the law should be returned to its pre-Zelener status. A 

futures contract has always included leveraged, speculative contracts for future delivery sold to retail customers. All pertinent registration and other customer protection provisions should apply to 

such transactions. 

Congress faces the challenge of adapting the CEA to an everchanging world to assure the efficiency, competitiveness, and fairness of U.S. futures markets. 

The CME looks forward to working with the Banking Committee 

to produce legislation that meets that objective. I thank you very 

much for your time. 

Chairman SHELBY. Thank you, Mr. Duffy. 

Mr. Frucher. 

STATEMENT OF MEYER S. FRUCHER

CHAIRMAN AND CHIEF EXECUTIVE OFFICER,

PHILADELPHIA STOCK EXCHANGE 

Mr. FRUCHER. Thank you very much, Mr. Chairman, Senator 

Crapo. Thank you very much for having this hearing. This is very 

important to the industry. 

I testify today, not just on behalf of the Philadelphia Stock Exchange, but also on behalf of the five other U.S. securities markets 

that trade options, namely the American Stock Exchange, the Boston Options Exchange, the CBOE, ISE, and the Pacific Exchange, 

as well as on behalf of our clearinghouse, the Options Clearing Corporation. 

Securities options, that is, options on individual stocks and on 

broad-based stock indexes, play an important role in the U.S. financial system. U.S. options exchanges offer market participants a 

liquid, low-cost opportunity to hedge positions held in the cash 

markets. Market participants have been embracing exchange traded security options in record numbers in recent years, and daily 

trading volumes have roughly doubled from 2000 to 2005, and are 

up roughly 20 percent from 2004 to 2005 alone. 

U.S. options exchanges operate in a highly competitive marketplace. Unlike the market for trading stocks, no options exchange 

enjoys a dominant market share, let alone anything like the market share the New York Stock Exchange commands in its listed 

28

stocks. The markets for trading individual equity options have, for 

several years now, been characterized by cross-listing of products 

that are traded on multiple exchanges. The markets for trading futures, in contrast, are marked by monopoly products traded on single exchanges. Competition is a fact of life among the options

exchanges, and we accept it as a fact of life between the options 

exchanges and exchanges that trade other products. 

Since enactment of the Commodity Futures Modernization Act of 

2000, the options exchanges have faced competition from a new 

product, security futures, or futures on individual stocks and on 

narrow-based stock indexes. Prior to 2000, Congress had prohibited 

trading in these instruments, in large part due to the concerns 

about the adequacy of regulating them strictly as futures. 

The U.S. options exchanges did not object to the introduction of 

security futures. We are used to competition. But we did urge Congress to ensure that they are regulated in a manner that provides 

a level playing field for security options. So did the President’s 

Working Group. Congress agreed that security futures contain elements of both securities and futures and provided a role for the 

SEC and the principles of securities regulation in the oversight of 

these products. 

This was the right policy in 2000 and is the right policy today. 

It has allowed a new product to develop, facilitating a market participant’s ability to engage in hedging and other strategies. At the 

same time, it has prevented regulatory arbitrage. And the way you 

conducted your hearings in 2000 eliminated the need for legislative 

arbitrage, protected investors, reduced risk in the financial markets as a whole. 

The U.S. options exchanges urge Congress to maintain the parity 

of treatment for security options and security futures that was enacted in the CFMA. Any legislation should preserve parity, not just 

on day one, but going forward as well. It should not authorize any 

one exchange or regulator to end this parity in the future. 

The U.S. futures exchanges advocate ending that parity in the 

crucial area of customer margin. They propose allowing the futures 

exchanges total discretion to set margin requirements for security 

futures. This approach is contained in the bill reported by the Senate Agriculture Committee. Should this bill become law, it would 

put Congress in the position of picking winners and losers in the 

marketplace, exactly what Congress sought to avoid in 2000. 

The U.S. options exchanges have an alternative approach that 

would preserve the consistent treatment endorsed by Congress 

while ensuring appropriate margin levels for both products. Under 

this approach, Congress would direct the SEC and CFTC to adopt 

joint rules permitting the use of portfolio margin for securities futures and also to direct the SEC to adopt a consistent rule for securities options. I think as a consequence of today’s hearing, that position was endorsed today by the SEC. 

This would allow for more efficient margin treatment than the 

current approach used for the two products, while maintaining an 

adequate protection against risk. We have shared this approach 

with the SEC, the CFTC, and look forward to its consideration by 

the President’s Working Group as the process of reauthorization 

moves forward. 

29

I also would like to commend you, Mr. Chairman, and this Committee, for including the President’s Working Group in this very 

key and important dialogue on this product, and I think it is important that they be part of the process. 

I will conclude by noting that the SEC recently authorized portfolio margining for a narrow range of products and a narrow category of market participants. Even this relatively modest step

followed 3 years of consideration by the SEC following submission 

of a formal proposal. 

While I appreciate the need for careful review by the SEC of exchange rulemaking, that process must not move so slowly as to stifle innovation. I have said this to you before in another context. 

The 9-month period specified for rulemaking in our proposal is sufficient to ensure the legitimate regulatory concerns are addressed, 

while allowing the exchanges to move forward. The SEC testified 

on the first panel that the agency will move forward on this issue, 

and I believe they will. 

Thank you again, Mr. Chairman. I would be happy to answer 

questions. 

Chairman SHELBY. Mr. Lackritz. 

STATEMENT OF MARK LACKRITZ

PRESIDENT, SECURITIES INDUSTRY ASSOCIATION 

Mr. LACKRITZ. Thank you, Mr. Chairman and Senator Crapo. I 

appreciate the opportunity to testify today on S. 1566 and to articulate SIA’s concerns about a couple provisions in this bill. I would 

also like to thank you, Mr. Chairman, for convening this hearing 

and for taking the interest in these particular provisions that are 

of significant importance to the securities industry and to the capital markets. 

We strongly support reauthorization of the CFTC this year, but 

we do not support certain provisions that go beyond the CFTC reauthorization and would amend the Commodity Exchange Act and 

the recently enacted modifications to the CEA codified in the 

CFMA in 2000. 

We are deeply concerned with two principal areas in S. 1566: 

First, the provisions addressing portfolio margining; and, second, 

the scope of the language addressing the so-called Zelener decision 

and related foreign exchange issues, including the provisions to 

limit the scope of permissible activities of broker-dealers. 

We support the agency rulemakings and the SRO rule approvals 

under the CEA and the Securities Exchange Act of 1934 that would 

promote the adoption of portfolio margining. Any portfolio margining legislation, however, should ensure that all financial instruments—and here we are not talking about just futures or single 

stock futures or options, but all financial products—should be included in a manner so it does not result in margin-based competitive disparities. 

The conventional approach to margin setting is called strategybased, and its primary deficiency is that only certain precisely 

specified positions are treated as offsets. Combinations of financial 

instruments that act as hedges to reduce risk are just not recognized unless they appear on the list of acceptable offsets. But it is 

simply impossible for a strategy-based system to accurately capture 

30

all the different possible combinations of financial instruments that 

might change the risk of a given portfolio. That could only be done 

through a model to perform the necessary number crunching. So 

strategy-based margining creates two significant problems: First, it 

penalizes customers for failing to link their margin requirements to 

the true risk of loss in their portfolios; and, second, U.S. financial 

firms can and, unfortunately do lose business where customers are 

able to invest with financial services firms, often offshore, that are 

permitted to calculate margin on a portfolio basis. 

An ad hoc committee of the SIA has been working with the 

SRO’s and the SEC to expand the use of portfolio margining, really 

across the board, and we hope a proposal we recently submitted to 

the New York Stock Exchange will be approved in the near future. 

We, therefore, oppose the provisions that are in S. 1566 currently. 

They are addressed solely to portfolio margining for security futures. These provisions are way too narrowly drawn, creating the 

potential for inappropriate competitive disparities across competing 

product markets. We would support legislation, however, that the 

SEC and CFTC agree would facilitate adoption of SRO rules implementing portfolio margining. 

With respect to broker-dealer affiliates, we strongly oppose the 

provisions of S. 1566 that would cut back significantly existing provisions of the CFMA that permit SEC-registered broker-dealers 

and their material affiliates to conduct over-the-counter foreign exchange futures activities with counterparties that do not qualify as 

eligible contract participants. It is our understanding that these 

provisions are intended to deal with a practice in which firms establish and register shell FCM’s for the purpose of permitting 

under-capitalized and unregulated affiliates, also known as bucket 

shops, to engage in retail over-the-counter foreign exchange futures 

activities. 

We emphasize that affiliates of SEC-registered broker-dealers 

where most U.S. broker-dealer holding company groups conduct 

their over-the-counter foreign exchange activities are well-capitalized and regulated. Moreover, there is no history of foreign exchange-related abuse occurring in the context of SEC-registered 

broker-dealers, their affiliated entities, or the affiliated broker-dealer’s personnel. Nor is there any reason to believe or suspect that 

such a problem will arise in the future. Requiring reorganization 

of this business line and registration of personnel would be both 

costly, burdensome, and entirely unjustified by the record. 

With respect to retail foreign exchange fraud, Mr. Chairman, we 

understand that retail fraud in connection with speculative foreign 

exchange activities continues to be problematic, but we do not 

agree that there is a compelling need for modifications to the CEA 

to address these problems. We believe that the Zelener decision was 

correctly decided based on the facts that were in evidence, and we 

do not agree with claims that the Zelener decision will lead to a 

chamber of horrors or similar decisions in cases involving retail 

transactions in physical commodities that typically require costly, 

complex, and burdensome delivery mechanisms. We strongly support efforts to root out fraud against retail investors, but we believe 

the provisions of S. 1566 are overly broad and could well result in 

unintended adverse consequences. We are encouraged by the agreeVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
31

ment in principle by the President’s Working Group and look forward to seeing that specific language. 

Finally, we would add that CFMA resolved many significant 

issues in an innovative fashion and has enabled the U.S. derivatives market to provide important benefits for the U.S. economy. 

The products subject to the CEA, as well as those covered by the 

exclusions from the CEA are complex and extremely difficult to define. History has shown repeatedly that a lack of clarity under the 

CEA can produce significant adverse consequences. As such, we 

urge you to proceed cautiously in considering provisions that go beyond the CFTC reauthorization. We are eager to continue working 

with you, Mr. Chairman, your Committee, and staff to achieve your 

legislative objectives in a constructive manner that preserves the 

many benefits of the CFMA. 

Thank you very much. 

Chairman SHELBY. Mr. Pickel. 

STATEMENT OF ROBERT G. PICKEL

EXECUTIVE DIRECTOR AND CHIEF EXECUTIVE OFFICER,

INTERNATIONAL SWAPS AND DERIVATIVES ASSN., INC. 

Mr. PICKEL. Mr. Chairman and Senator Crapo, I am the Executive Director and Chief Executive Officer of the International 

Swaps and Derivatives Association. I appreciate the Committee’s 

invitation to appear today to present ISDA’s views on proposed legislation to reauthorize the Commodity Futures Trading Commission. 

ISDA is an international organization, and its more than 650 

members in 48 countries include the world’s leading dealers in and 

many users of OTC derivatives. We welcome this Committee’s interest in the CFTC reauthorization legislation. 

Throughout this reauthorization process, we have worked closely 

with three other financial services trade associations. Two of 

these—the SIA and the FIA—are on our panel this morning. The 

third—the Bond Market Association—has filed a written statement 

for the record and joins in my statement today. 

For the reasons explained in our written statement, our experience since 2000 confirms that Congress achieved its objectives of 

providing legal certainty and regulatory clarity for OTC derivatives 

transactions in a manner that has reduced systemic risk and encouraged financial innovation. The carefully crafted exclusions and 

exemptions in Section 2 of the CFMA are critical to that legal certainty. 

From all indications, the CFMA has been a broad-based success 

for the capital markets generally. ISDA commends the CFTC for 

the effective manner in which it has implemented the CFMA, and 

we will continue to actively support passage of the legislation to reauthorize the CFTC. 

As discussed in detail in our written statement, ISDA believes 

there is no compelling need to make substantive changes to those 

portions of the CFMA governing OTC derivatives. In considering 

any amendments, we urge the Committee to take a cautious approach. If any such amendments are agreed to, they should be narrowly targeted to specific policy problems requiring a legislative

response and carefully crafted to avoid unintended collateral conVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
32

sequences that could undermine the legal certainty provided for 

OTC derivatives by the CFMA. 

Let me illustrate our concerns by references to proposals to 

amend the so-called ‘‘Treasury Amendment,’’ which is the core provision of the CFMA intended to provide legal certainty for OTC derivatives based on foreign currency. All of these amendments seek 

to address the decision in Zelener. In that case, the U.S. Court of 

Appeals for the Seventh Circuit held that the foreign exchange contracts before it were not futures contracts and that the CEA’s antifraud rules were, therefore, not applicable. The proposed amendments, including that approved by the Agriculture Committee, seek 

to address the Zelener issue by giving the CFTC for the first time 

jurisdiction over certain off-exchange contracts that are neither futures nor options. In ISDA’s view, the Zelener case was correctly 

decided based on the facts before the court. It does not preclude the 

CFTC from successfully bringing similar cases in the future, and 

we heard this morning that the CFTC continues to pursue those 

cases. And it does not provide a road map for an end run around 

the CEA that can be exported to physical commodities such as 

heating oil and grain. 

ISDA does not believe that it has been demonstrated that legislation is necessary to address the so-called ‘‘Zelener problem.’’ Moreover, there is a significant problem that amendments will be so 

broad they will have collateral consequences that will undermine 

the legal certainty provided by Congress in 2000. Finally, Congress 

needs to carefully consider extension of the CFTC’s jurisdiction to 

new classes of contracts and how that could hamper the Commission’s ability to carry out its core mission of supervising the Nation’s futures exchanges. 

We stand ready to work with the relevant committees of Congress, including this Committee, and the members of the President’s Working Group as legislative proposals are developed and 

considered. We believe, however, that there should be a significant 

burden placed on those who seek to amend what all agree is a 

highly effective and successful piece of legislation—the CFMA. 

I thank you for this opportunity to present our views, and I am 

prepared to answer any questions you may have. 

Chairman SHELBY. Mr. Roth. 

STATEMENT OF DANIEL J. ROTH

PRESIDENT AND CHIEF EXECUTIVE OFFICER,

NATIONAL FUTURES ASSOCIATION 

Mr. ROTH. Thank you, Senator. My name is Dan Roth, and I am 

the President of the National Futures Association. NFA is the industry-wide self-regulatory body for the futures industry. Our only 

mission really is customer protection, and I appreciate the opportunity to appear here today to talk about an issue that is directly 

related to customer protection, and that is the Zelener issue. If possible, I would like to take a few minutes and discuss the Zelener

issue from a little bit of a historical perspective. 

When NFA began operations back in 1982, the futures industry, 

frankly, was plagued with a pretty large-scale sales practice problem. There were a lot of boiler rooms. They were very big, and they 

were very brazen in their fraud. 

33

Since 1982, when we began operations, volume on U.S. futures 

exchanges has grown by well over 1,200 percent. During that same 

period of time, customer complaints have actually dropped by over 

75 percent, and that dramatic drop was not an accident. It was the 

result of a lot of hard work and a very close working relationship 

between the CFTC and NFA to crack down on those boiler rooms. 

Unlike Mr. Pickel, I am concerned that the impact of the Zelener

decision could be to return us to the bad old days of the wild, wild 

West because I do think it provides something of a road map to the 

fraudsters on how to avoid CFTC jurisdiction. And let me see if I 

can explain that. 

Prior to Zelener, the main case dealing with the definition of ‘‘futures contracts’’ for retail customers was the Co Petro decision, 

which was decided in 1982, and there the court rejected the idea 

of any bright-line test or definition for ‘‘futures contract,’’ but they 

said we have to look at the underlying purpose of the transaction, 

and they found that where the contract for future delivery is being 

marketed to retail customers as a speculative investment vehicle 

and those retail customers have no expectation of delivery, then 

that was a futures contract subject to the CFTC’s jurisdiction. 

In Zelener, you basically had all of those elements present, but 

the court there found that the contracts were not futures contracts 

because, instead of focusing on the underlying purpose of the transaction, they focused primarily on the written contract between the 

parties. And because there was no guaranteed right of offset, the 

court found that they were not futures. 

Now, I understand that the President’s Working Group agrees 

that Congress should do something to address the Zelener issue, 

and that is good. I understand that their proposal will be limited 

in scope to the forex area, and I am sure that their reasoning is 

that the forex is where the problem is so that is where the solution 

should be. And that sounds pretty reasonable. But I think that reasoning ignores two important factors. 

First is the language of the decision itself because there is nothing in the Zelener decision which limits its application to forex 

products. If a fraudster can set up a Zelener-type contract for forex 

and avoid the CFTC’s jurisdiction, he can do the same thing with 

a Zelener contract for heating oil. 

Second, I think the narrow an approach ignores the history of 

sales practice problems in the futures industry because the fact is 

that in our 20 years of experience, frankly, what boiler rooms love 

to sell are products that retial customers have day-to-day experience with. So that for years, I mean, the problems tended to be 

sugar futures, and then it was orange juice, and then it was metals, and then it was unleaded gas, and then it was heating oil. But 

it was always something that the customers could relate to based 

on their day-to-day experience, and, frankly, forex does not fit that 

mold at all. Forex became the scam of choice only when it became 

recognized as an unregulated niche. And that really happened in 

a 1996 decision called Frankwell Bullion where the court found 

that CFTC had no jurisdiction over retail forex transactions. That 

is when forex became the unregulated niche. That is when the 

fraudsters started selling forex, and that is when our problems 

began to mushroom. Congress tried to address that in the CFMA, 

34

but I think their efforts were largely negated by the Zelener decision. 

I think the problem I have with the so-called ‘‘narrow fix’’ is that 

I do not think it is a fix at all. It does not really close the unregulated niche. It just shifts it. It seems to tell the fraudsters that they 

cannot sell Zelener contracts for forex, but it could suggest that 

they can sell those types of contracts for heating oil, unleaded gas, 

or any other product and do so outside the regulatory jurisdiction 

of the CFTC. That is basically an invitation to the fraudsters, and 

if some people feel that they will not take up that invitation, well, 

I respectfully disagree. 

The better approach, I think, is not to expand the CFTC’s jurisdiction, which is, frankly, what I think the Senate Ag Committee 

bill did. I do not think the right solution is to do anything new. I 

think the right solution is to do something old and tried and true 

and tested, and that is to codify the Co Petro decision, and that is 

what our proposal, which is attached to my testimony, would basically do. 

I see the red light is on, so let me wrap up by just saying that 

I believe that our proposal would not in any way impose a rigid 

definition of futures contract. It would not disturb jurisdictional 

boundaries between agencies. It would not implicate any forward 

contracts or spot contracts. It would not interfere with otherwise 

regulated entities and their ability to sell retail forex. It would simply codify the Co Petro decision, which stood for over 22 years and 

which gave the Commission ample authority to protect retail customers without inhibiting legitimate business activity. 

I know there is a fair number of people that disagree with me, 

Senator, and you heard from a lot of them today. And I kind of expect I will be getting fewer Christmas cards this year. But the fact 

is that——

Chairman SHELBY. You will have fewer to open, won’t you? 

[Laughter.] 

Mr. ROTH. The fact is that codifying the Co Petro decision I think 

is the right response to the Zelener issue, and if Congress does, in 

fact, adopt the narrow approach, I would at least hope that there 

would be a firm commitment that we would not have to wait 5 

years until the next reauthorization process to address this issue, 

to revisit this issue and to get it right, because I would hope that 

when the problems are discussed become more apparent, then we 

could revisit the issue—if, in fact, Congress takes the narrow approach, which I hope they will not. 

Thank you, Senator. I would be happy to answer any questions. 

Chairman SHELBY. Thank you. 

During the first panel of witnesses—most of you were here, I believe—they discussed whether the current regulatory regime fits 

the realities of the marketplace where futures and other financial 

products are virtually indistinguishable and are traded by affiliates 

of the same broker-dealers. I would like each of you briefly to address whether the current regulatory regime should be modernized 

to reflect market realities. Does the jurisdictional line between the 

SEC and the CFTC still make sense? This is central to all of this. 

Mr. Carey, just briefly. 

Mr. CAREY. In light of the——

35

Chairman SHELBY. Yes or no. 

Mr. CAREY. Yes or no? I guess——

Chairman SHELBY. Well, and a few more words. 

[Laughter.] 

Mr. CAREY. Well, I think while we are here to express frustration 

on certain parts of CFMA, the fact of the matter is I would be hard 

pressed to argue for a different regulatory scheme after the growth 

that we have witnessed over the last 5 years since its passage. So 

I would have a hard time supporting a wholesale change to the regulatory framework. 

Chairman SHELBY. Mr. Damgard. 

Mr. DAMGARD. I would agree with Mr. Carey. I think our markets globally have probably tripled in the last 3 years, and I think 

from the standpoint of modernization, thanks to this Committee 

and the Ag Committee, we did a lot of that work for you 5 years 

ago. 

I do think there is a difference. I mean, futures markets have 

historically been institutional markets, and the mission of the 

CFTC has been to protect the market. The regulatory regime has 

worked very well. And I think that there is a lot of credit to be 

spread around on the basis of the success of these two exchanges 

and other exchanges around the world. 

The SEC obviously has a different role; its regulatory regime is 

centered on customer protection rather than market protection. 

And those two missions are at least different enough so that I 

think the current regulatory scheme serves at least our market 

pretty well. We have seen other countries that have combined their 

regulators, particularly in Great Britain. It is awfully difficult to 

pass rules that are going to work across the board. One shoe really 

does not fit all. 

Chairman SHELBY. Mr. Duffy. 

Mr. DUFFY. I actually think that Mr. Damgard and Mr. Carey 

said it all. I definitely agree with their comments. I do not believe 

that these agencies at this time should even be remotely considered 

for being put together. I think that our industry has been able to 

prosper and grow. I think Mr. Roth cited some incredible growth 

numbers over the last several year. 

Chairman SHELBY. Is the market ahead of the regulatory regime? 

Mr. DUFFY. Is the market ahead of the regulatory regime? 

Chairman SHELBY. Yes. 

Mr. DUFFY. No. 

Chairman SHELBY. You do not think so? 

Mr. DUFFY. No. 

Chairman SHELBY. Mr. Frucher. 

Mr. FRUCHER. What an extraordinarily prescient question. I 

think it goes right to this question of regulatory arbitrage. What 

you see here is the futures industry trying to move into, legitimately, in a competitive way, a realm that had traditionally been 

on the securities side of the business. 

Chairman SHELBY. Eighty percent, more or less, of the futures 

financial products perhaps? 

Mr. FRUCHER. That is correct. And I think your point is certainly 

an open question that requires a look-see. We talk about the need 

36

for modernization here or change in the margin requirements because, ‘‘this product,’’ which is really a securities-related product, 

is not competitive. But the fact is this product has not been successful and it really has not been successful in Europe. It has been 

successful in parts of Europe—Spain, for example—and it has been 

successful in India where the securities markets are not particularly efficient. And what you have now is a world that is moving 

away from floor-based exchanges into electronic markets. Those 

electronic markets are going to be traded on one screen—equities, 

options, and equity futures. And you are going to trade Microscoft 

three different ways. And if you are going to have regulatory arbitrage between these products, I think you are opening up a serious 

Pandora’s box. Who knows? These people may be trading Pandora’s 

box futures in the future, because I think that this question that 

you have before you today opens up this question. 

Chairman SHELBY. Mr. Lackritz. 

Mr. LACKRITZ. Mr. Chairman, I would echo a lot of what Mr. 

Frucher has just said. I think we have a historical anomaly here 

where we have a futures market that began as an agricultural futures market evolving into basically a financial futures market that 

is inextricably linked with other financial markets. And I think 

there is no question about the fact that the technology is driving 

the products and the services into convergence. So, I think it clearly deserves a very careful look. 

I would suggest as well that as you look at other jurisdictions 

around the world, they do organize this differently in terms of their 

regulatory oversight. And some have been more successful, some 

have been less successful. But at the same time, this clearly deserves a careful look. It is a complicated area, and it is one of those 

areas that can absorb huge amounts of time and energy of the 

Committee. But at the same time, it is very important and I think 

very appropriate to take that look. 

Chairman SHELBY. Mr. Pickel. 

Mr. PICKEL. I think what we have focused on is the underlying 

risk and how it gets managed. We have developed, working with 

our membership——

Chairman SHELBY. That is central, is it not, the underlying risk? 

Mr. PICKEL. That is right. We have developed an extensive documentation structure, market practices, private discipline in the derivatives business, the OTC derivatives business, that has served 

the market extremely well. And so it manages the risks that you 

might manage in the cash markets or on the futures exchanges, 

but it does it through this private discipline that has been developed, and we think that is a very important feature of that particular product. 

Chairman SHELBY. Mr. Roth. 

Mr. ROTH. Senator, the only point I would make would be that 

it is an interesting question to consider, but in considering it, one 

should never underestimate the value of having a regulatory agency which is devoted to futures, which has deep expertise in understanding these markets and can be responsive to its regulatory 

challenges. 

Chairman SHELBY. But the regulatory regime has to understand 

the very complicated products as they evolve, doesn’t it? 

37

Mr. ROTH. That is exactly right, and I think that there is a real 

value to having that expertise reside in one agency that focuses on 

futures products, and it has been a tremendous benefit to the futures industry over the past—well, since the CFTC was created in 

1974. 

Chairman SHELBY. The representatives of the President’s Working Group that you heard recommended basically that Congress respond to the Zelener decision by adopting a narrow amendment 

that addresses only retail foreign exchange products. What about 

this? What is the merit of this recommendation? In your view. 

Mr. Carey. 

Mr. CAREY. Well, Mr. Chairman, I think that they want to keep 

it specific to forex only, but our concerns are that it will spread to 

other commodities, as was stated so well by Chairman Terry Duffy 

of the Mercantile Exchange, and Dan Roth. So these are our concerns. What is the merit of a forex fix? We think we will be back 

for other fixes afterwards. 

Chairman SHELBY. Mr. Duffy, do you have a different view? 

Mr. DUFFY. No, obviously not. We agree with the President’s 

Working Group, what they believe should be done, except that the 

fix does need to extend to other commodities because we really cannot draw that line like they can for some reason. We can see, like 

Mr. Roth clearly can see, that scamsters are certainly going to go 

to the product de jour. 

Chairman SHELBY. Any of you have a different opinion? 

Mr. Damgard. 

Mr. DAMGARD. I think the issue here is really the resources of 

the agency. If Congress wants to create another consumer fraud 

agency, they really should reflect on what kind of resources are 

necessary. The CFTC has done an excellent job over the last 25 or 

30 years nurturing the growth of futures markets. 

Chairman SHELBY. That has primarily been financial futures 

products, hasn’t it? 

Mr. DAMGARD. That has grown a lot, but there are also energy 

markets and agricultural markets. I mean, the mechanism itself 

has proved to work across the board on financial instruments just 

as easily, as Mark pointed out, originally agricultural products. 

Chairman SHELBY. Mr. Roth. 

Mr. ROTH. With respect to the CFTC’s resources, I would just 

point out that the day before the Zelener decision, the CFTC had 

precisely the authority that we are trying to restore, and their resources were just fine. In fact, the track record that I cited in the 

decline of customer complaints is largely a result of their enforcement efforts. So we are not talking about an expansion of CFTC 

responsibility. We are talking about restoring its responsibility. It 

had the resources necessary to do the job very well the day before 

the Zelener decision, and I think it would have the same resources 

and the same ability today. 

Chairman SHELBY. Mr. Lackritz. 

Mr. LACKRITZ. Mr. Chairman, with all due respect to my colleagues on the panel, I think that the Zelener case does not need 

to give rise to any new legislative fix. I mean, we used to have a 

saying in law school about bad cases making bad law, and this particular case I think was decided exactly right based on the facts 

38

that were presented by the litigants. The Solicitor General of the 

United States decided not to take it up further. So from that standpoint, I think the case on its facts before the court was rightly decided. 

In addition, the case is now over a year old, and we have no evidence whatsoever that there is a broad problem that has resulted 

as a result of this particular case. So, I do not think there is any 

need for it. 

Chairman SHELBY. Mr. Pickel. 

Mr. PICKEL. We have advocated the President’s Working Group 

getting engaged on this and certainly will take a serious look at the 

proposals that they have developed, but I would share Mr. 

Lackritz’s view. The court case basically said that they did not 

have other facts presented to them so that their only solution was 

to look at the written contract. I am sure that the CFTC in the 

cases that it is developing now and bringing in a similar fashion 

is developing that factual record so that if they truly believe that 

those are futures contracts, a court in another circuit will find 

them to be futures contracts. 

Also, the Zelener case did not overrule Co Petro as the test for 

what a futures contract is. It just interpreted based on the facts before it whether the elements of a futures contract applied in that 

case. 

Mr. ROTH. Senator? 

Chairman SHELBY. Go ahead. 

Mr. ROTH. Just that with respect to Mr. Pickel’s comments, the 

Zelener decision did not explicitly overturn the Co Petro decision, 

but it basically tore its guts out. It did so by saying that we are 

not going to look at the underlying purpose of the transaction, we 

are going to look at the written agreement and look and determine 

whether there is a guaranteed right of offset. The notion that the 

CFTC—God bless the CFTC if they can litigate their way out of 

this thing—but I think it is putting an awful lot of chips on a bet 

that is no sure thing, because the idea that they will be able to 

present testimony or evidence of oral representations made by a 

salesman concerning a guaranteed right of offset suggests that the 

salesman cannot be more evasive than the written contract. And I 

have dealt with these salesmen long enough to know that that is 

just not true. 

So, I think the idea of litigating our way out of this problem is 

a pretty difficult and tall order. 

Mr. FRUCHER. Mr. Chairman, I think your first question, interestingly enough, has some relevance here. I think the question may 

not be a single legislative fix on the Zelener situation but, rather, 

to look at the gaps between regulators. I think that is a bigger 

issue, and that is the one I think that really deserves to be looked 

at. There are gaps. 

Chairman SHELBY. I am going to defer to my Harvard Law graduate, Senator Crapo, right now and see what he says about all this. 

[Laughter.] 

Senator CRAPO. Mr. Chairman, frankly, the discussion that you 

just caused to happen here answered most of the questions that I 

was going to ask. But one question that I do want to get into which 

takes the current discussion another step further is, as I listen to 

39

this panel, I can see that Mr. Carey, Mr. Duffy, and Mr. Roth 

would like to have a broader solution for the Zelener case. And I 

am assuming that the others would support the more narrow solution. Is that correct? 

Mr. DAMGARD. That is correct. 

Senator CRAPO. I think that the question is, as Mr. Roth proposes, that we just go back to the Co Petro case. I think we probably all felt that that was the standard before the Zelener case was 

decided, and there is a little dispute among the panel members 

here as to whether the Zelener case is really going to be a broad 

case or not and create a big loophole or not. But this notion of a 

broader legislative solution to the Zelener case I think raises a 

question as to whether Congress will, intentionally or not, change 

that jurisdictional balance that the CFMA created. I think that is 

the real issue here that is behind the positions that people are taking. 

And so first I wanted to ask, if I am correct about that, if you 

believe that there is a risk here, that if Congress starts going down 

the road of trying to figure out a broader solution than the one that 

the President’s Working Group apparently is going to put forward, 

will that create an imbalance—or will that change the balance of 

jurisdiction that we now have that seems to be working so well as 

a result of the President’s Working Group conclusions and Congress’ actions in 1999 and 2000? 

Mr. DAMGARD. I think that is the danger, Senator. We think the 

problem is FX only. What we have proposed I think is a scalpel approach to the problem of fraud versus the sledge hammer approach. 

Firms have gotten into the business of doing legitimate FX business. Customers now have a choice between taking their business 

to an exchange or doing this business with a legitimate 

counterparty. The problem has been in the shell FCM’s go in and 

register without any qualifications at all and create an affiliate. We 

are proposing that we require $20 million capital to be an FCM 

and have the affiliate that is actually selling the product register 

with the CFTC. That gets at the FX problem. 

Congress did carve out a special role for the CFTC in the 2000 

CFMA for FX based on the Treasury Amendment, and that is why 

we have looked at this and decided that, from the CFTC’s standpoint, this grants them all the authority that they really need. 

Senator CRAPO. Mr. Duffy. 

Mr. DUFFY. Senator, right now I believe that the CME’s and the 

NFA’s approaches obviously are very similar, and we do not believe 

that this affects any legitimate business dealings. For anybody that 

has legitimate, bona fide business in any product, our solution does 

not impede them from doing business, and for us to go back to 

things pre-Zelener we think only makes sense. 

To think that we can fix it in FX and leave it alone in other products I think is a little bit naı ̈ve. In light of what is going on in this 

world, I actually believe exactly what Dan is saying, that it is insufficient to merely stop fraudsters from conning people for FX and 

ill-gotten gains. It is going to be very easy for these scamsters to 

pick up the phone and tell somebody how they can create 80-percent gains in heating oil in the next 3 weeks in light of what is 

40

going on. I mean, people are actually going to believe that type of 

sales pitch. 

So we are very concerned about this, and we do believe it needs 

to be a broader fix, and we do not believe our fix impedes any legitimate business dealings. 

Mr. ROTH. Senator, you are exactly right on what the problem is 

here. I am sick of talking about Zelener. I have been talking about 

it with everybody for a real long time, and I have not talked to anybody that disagreed with me that was in favor of fraud. No one, 

none of the people that disagree with us are on that point. The 

trick is trying to restore the CFTC’s jurisdiction in a way that does 

not disturb any of the jurisdictional agreements that were part of 

the CFMA. And it is not easy, and we have worked very hard to 

try to craft our proposal in a way that does precisely that. We are 

not aware of any way in which we would be infringing on another 

agency’s jurisdiction, not aware of any way in which we would be 

infringing on legitimate business activities. But for God’s sake, if 

there is something in our proposal that does that, let us know and 

we will find the right words in the English language to do it. But 

we should not have to settle for a narrow fix that I think it just 

shifts the unregulated niche and does not really address the underlying problem. 

Mr. LACKRITZ. Senator Crapo, if I can just address that question 

you raise, I think your concern is exactly right in terms of the risk 

of any kind of broad-based solution, or even a narrow-based solution here, which is to alter the balance that has worked so effectively as a result of the CFMA in 2000. I am pushed back to the 

old adage that physicians take the Hippocratic Oath, which is, 

‘‘First, do no harm.’’ And given the fact that this is one decision in 

one case where the facts were not presented very well in the 

record, to justify adding all of this other legislation and new law 

and new authority is a very slim reed to base that one. 

Mr. PICKEL. I think the balance that was struck in the CFMA 

is exactly why the President’s Working Group is looking at a narrow fix and the FIA has proposed a narrow fix, because there was 

a determination in the CFMA that as it relates to retail foreign exchange futures, there would be authority for the CFTC to take action. So, I think it is appropriate in that context if Congress wants 

to look at the Zelener case and whether it undermined that policy 

decision. But what we are hearing from some of the panelists is a 

broader opening up of that policy decision from 2000, and it does 

run the risk of upsetting some of the balance that you allude to. 

Senator CRAPO. Anybody else want to jump in? 

Mr. FRUCHER. There is only me, and I agree with that side. 

[Laughter.] 

Senator CRAPO. I figured that. 

All right. I know that our time is basically gone, and I appreciate, again, Mr. Chairman, you letting us do this, and I look forward to exploring a lot of this further as we conduct our hearing 

in the Subcommittee. 

Chairman SHELBY. Thank you, Senator Crapo. 

Senator CRAPO. Thank you. 

41

Chairman SHELBY. I want to thank all of you for appearing. We 

have had a spirited discussion. We think these are very important 

issues that we are dealing with and very complicated issues. 

Thank you very much. 

[Whereupon, at 12:13 p.m., the hearing was adjourned.] 

[Prepared statements, response to written questions, and additional material supplied for the record follow:] 

42

PREPARED STATEMENT OF SENATOR MEL MARTINEZ 

I would like to thank Chairman Shelby and Senator Sarbanes for holding this 

hearing and for their efforts to work in cooperation with the Senate Agriculture 

Committee on the Commodities Exchange Act Reauthorization legislation. 

Five years ago, when Congress reauthorized the CEA, the Banking and Agriculture Committees worked cooperatively with the input of the President’s Working 

Group and industry representatives to develop changes to the Commodities Exchange Act that revolutionized over-the-counter derivatives and security futures 

products. By providing a regulatory regime that recognized that certain financial 

products have attributes of securities and futures and giving the SEC and the CFTC 

shared regulatory authority, the Commodity Futures Modernization Act created parody among single-stock futures and options. Industry and the President’s Working 

Group agreed that the legislation that was passed 5 years ago has been very successful. However, the markets are very sophisticated and can change overnight. 

There have been numerous market developments, specifically changes in the traditional futures market, since Congress last reauthorized the CEA that this Committee needs to study and have input on before a final CEA reauthorization bill can 

go to the floor of the Senate. 

Our witnesses today are going to speak on several major issues that must be addressed and fully vetted by this Committee. These issues include portfolio margining, the definition of narrow-based securities, the jurisdiction the CFTC has over 

retail foreign exchange contracts, and broker-dealer registration requirements. 

Before the Senate can reauthorize the CEA for the next 5 years, the Agriculture 

and Banking Committees need to work together as they did 5 years ago to ensure 

that all of these issues have been fully explored and that parody in the markets is 

maintained. 

Thank you to our witnesses. I look forward to their testimonies. 

—————

PREPARED STATEMENT OF RANDY K. QUARLES

UNDER SECRETARY FOR DOMESTIC FINANCE, U.S. DEPARTMENT OF THE TREASURY

SEPTEMBER 8, 2005

Thank you Chairman Shelby, Ranking Member Sarbanes, and other Members of 

the Committee. I appreciate the opportunity to address certain issues that have 

arisen in the context of Congressional reauthorization of the Commodity Futures 

Trading Commission (CFTC). As you know, Treasury is a Member of the President’s 

Working Group on Financial Markets and the Secretary serves as the PWG’s Chairman. The other Members of the PWG are the Chairmen of the Federal Reserve 

Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. 

In recent weeks, the PWG Members and senior staff have met to discuss the effect 

of last year’s 7th Circuit Court of Appeals decision in CFTC v. Zelener on the 

CFTC’s antifraud authority, in particular the CFTC’s ability to address retail foreign exchange fraud by otherwise unregulated entities. The proposal that we have 

produced reflects a consensus of the President’s Working Group that would make 

narrow changes to the CFTC’s antifraud authority to provide the CFTC with enforcement tools to combat fraud against retail customers involving certain foreign 

exchange contracts, while preserving the complex and delicate compromises reached 

in the Commodity Futures Modernization Act of 2000 (CFMA). In this regard, the 

President’s Working Group opposes extension of such provisions beyond retail foreign exchange contracts to other commodities. 

The Importance of the Commodity Futures Modernization Act of 2000

The CFMA provided important legal certainty to risk management efforts. Businesses, financial institutions, and investors throughout the economy rely on derivatives products to protect them from market volatility and unexpected events. The 

ability to manage risks makes the economy more resilient to financial and economic 

events and imbalances, and its importance cannot be underestimated. Consequently, 

the President’s Working Group believes that major changes to the significant modernizations made by the CFMA are not warranted. 

The CFMA modified the Commodity Exchange Act (CEA) so that provisions of the 

Act (including antifraud provisions) apply to foreign exchange futures and certain 

options with retail customers if the counterparty is not an otherwise-regulated entity such as a financial institution, broker-dealer, Futures Commission Merchant 

(FCM), or insurance company. Those changes were intended to provide the CFTC 

43

with tools to pursue fraud against retail customers by bucket shops offering certain 

foreign exchange contracts. In the 2004 Zelener case, the CFTC’s jurisdiction over 

a retail foreign exchange contract was challenged, and the 7th Circuit found that 

the CFTC lacked jurisdiction over the specific contract in question. The President’s 

Working Group is supportive of narrow and tailored changes to the CEA that would 

address the Zelener issue. 

Pursuing Retail Foreign Exchange Fraud 

The changes we are proposing would be limited to cover only certain retail foreign 

exchange contracts that have been the subject of abuse. Any such changes must be 

very carefully formulated to avoid creating barriers or undue burdens for legitimate 

businesses, undermining legal certainty, and creating unintended consequences. As 

a consequence, the President’s Working Group opposes the extension of such provisions for retail foreign exchange contracts to other commodities, absent a clearly 

demonstrated need and thorough public policy debate. 

President’s Working Group Consensus on Pursuing Retail Foreign

Exchange Fraud 

At the direction of the President’s Working Group, senior staff of PWG member 

agencies have been meeting frequently to discuss and draft a legislative proposal to 

address fraud perpetrated against retail customers using futures or futures—like 

foreign exchange contracts. The staff group has drafted language that would accomplish that goal in two ways: (1) by applying the CEA or its antifraud provisions to 

certain retail foreign currency futures and certain options, and their sales chains, 

when an FCM is involved; and (2) by applying the antifraud provisions to certain 

retail foreign exchange contracts that are not securities, contracts that result in actual delivery within 2 days, or certain contracts in connection with a line of business, as well as to their sales chains. 

The PWG proposal makes futures transactions and certain options in foreign currency between a retail participant and a counterparty that is not an otherwise-regulated entity—such as a financial institution, broker-dealer, or insurance company—

subject to the CEA. It also would provide the CFTC with antifraud jurisdiction over 

such retail foreign exchange contracts, and the persons who engage in activity in 

connection with those contracts, if the counterparty is an FCM. Any person who participated in the solicitation or recommendation of any such contract within the FCM 

sales chain would have to register with the CFTC and be a member of a registered 

futures association, in this case the National Futures Association (NFA), the futures 

industry’s sole self-regulatory organization. The PWG proposal would preserve the 

exclusion for otherwise-regulated entities crafted by the CFMA. 

Retail Foreign Exchange Futures-Like Contracts 

The PWG proposal would make certain foreign currency contracts between a retail 

participant and a counterparty that is not an otherwise-regulated entity subject to 

CFTC antifraud jurisdiction if the contracts were leveraged, margined, or financed, 

except that they would not apply to securities, contracts that result in actual delivery within 2 days, or certain contracts in connection with a line of business. It also 

would make such retail foreign exchange contracts and the persons who engage in 

activity in connection with those contracts subject to the antifraud provisions of the 

CEA. Additionally, any person who participated in the solicitation or recommendation of any such contract would have to register with the CFTC and be a member 

of the NFA. Again, this proposal would preserve the previous carefully crafted 

CFMA exclusion for otherwise-regulated entities. 

Portfolio-Style Margining Systems 

The CFMA granted to the Board of Governors of the Federal Reserve System 

(Board) the authority to establish margin requirements for security futures products. The Board delegated that authority to the SEC and CFTC jointly. The SEC 

and CFTC continue to work toward permitting portfolio-style margining models. The 

Treasury Department generally supports the concept of portfolio-style margining 

systems, which increase the efficiency of capital allocation and encourage risk management activities. We note that some progress has been made very recently and 

we remain hopeful that the SEC and CFTC can work together to facilitate the implementation of such margining systems soon. 

Securities Futures Products and Narrow-Based Indexes 

The CFMA created a distinction between broad-based security indexes, which 

have been regulated solely by the CFTC, and narrow-based security indexes, which 

are regulated by the SEC and CFTC jointly. The definition of ‘‘narrow-based security index’’ seems to have been formulated using criteria appropriate for equity secuVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00047 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
44

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

Markets and the Commodity Exchange Act (Nov. 1999) (OTC Derivatives Report). 

rities, as opposed to debt securities. The Treasury Department generally supports 

reviewing the appropriateness of certain criteria in the definition of ‘‘narrow-based 

security index’’ in the context of debt and foreign security index futures given that 

the nature of the underlying securities differs from domestic equities. 

—————

PREPARED STATEMENT OF ROBERT L.D. COLBY

DEPUTY DIRECTOR OF THE DIVISION OF MARKET REGULATION

U.S. SECURITIES AND EXCHANGE COMMISSION

SEPTEMBER 8, 2005

Introduction 

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I 

am pleased to appear today to testify on behalf of the Securities and Exchange Commission (Commission) to express the Commission’s views on the Commodity Exchange Reauthorization Act of 2005, S. 1566, reported out of the Senate Agriculture 

Committee on July 29, 2005. My testimony will focus on those sections of S. 1566 

that would affect the regulatory framework for security futures products established 

by the Commodity Futures Modernization Act of 2000 (CFMA), which is administered jointly by the CFTC and the SEC. 

The Commission shares the concerns of this Committee’s Chairman and Ranking 

Member expressed in their letter of July 20 to the Chairman of the Senate Committee on Agriculture, Nutrition, and Forestry regarding Section 7 of S. 1566. The 

Commission supports the expansion of portfolio margining to all equity products but 

believes it should be accomplished without undermining the current requirements 

regarding comparability between security futures margin and options margin. The 

Commission also has serious concerns about the amendments in Section 8 of 

S. 1566. These changes would remove products currently considered securities from 

Commission oversight, thereby compromising both investor protection and market 

integrity and prohibiting securities exchanges from trading such instruments. 

Finally, the President’s Working Group on Financial Markets (Working Group) 

has reached an agreement in principle on how to address the questions raised in 

the 7th Circuit’s decision in CFTC v. Zelener. Commission staff has been working 

diligently with staff of the other members of the Working Group and has reached 

agreement on how to grant the CFTC targeted, additional antifraud authority, and 

an appropriate registration requirement for solicitors of retail foreign exchange contracts, that they believe would address Zelener without compromising legal certainty 

or competitive parity. 

On this point, the Commission would especially like to thank the CFTC and its 

staff for their significant contribution to this effort. We fully support the CFTC in 

its efforts to combat retail foreign currency fraud. 

Security Futures 

CURRENT REGULATORY FRAMEWORK

The Commodity Futures Modernization Act of 2000 (CFMA) was a significant legislative achievement. Among other things, it lifted the ban on the trading of futures 

on single stocks and narrow-based indexes and established a framework for trading 

security futures products over which the CFTC and the SEC share regulatory authority. Its enactment was the product of much effort by Congress, the members of 

the Working Group, and participants in the securities and futures industries. The 

SEC has a significant and legitimate interest in any legislative changes that affect 

the consensus achieved in the CFMA. 

The ban on single stock futures was considered as part of the Working Group’s 

1999 report on OTC derivatives and the Commodity Exchange Act.1 The report identified several important issues to be resolved before trading of single stock futures 

should be permitted, including issues about the integrity of the securities market 

and regulatory arbitrage. In December 1999, various Members of Congress requested that the Chairmen of the SEC and CFTC formulate a legislative plan for 

lifting the ban on single stock futures. The legislative proposal negotiated by the 

Chairmen of the two agencies to eliminate the ban on single stock futures was 

transmitted to Congress by the Working Group in September 2000. Much of this 

proposal was incorporated into the bill that was enacted by Congress as the CFMA. 

45

2See Section 2(a)(3) of the Securities Act, 15 U.S.C. 77b(a)(3). 3Section 7 of S. 1566 would relieve certain markets trading security futures from the requirement to comply with the rules jointly adopted by the Commission and CFTC under Section 

Continued

Under the joint regulatory framework established by the CFMA, security futures 

may trade on both futures and securities exchanges, as well as derivatives transaction execution facilities and alternative trading systems. Moreover, broker-dealers 

and futures commission merchants are both permitted to trade these products and 

offer them to their customers. While both agencies have enforcement and examination authority, it is clear that the CFTC is the lead regulator for futures markets 

and futures commission merchants and that the SEC is the lead regulator for securities broker-dealers and securities markets. Consultation between the two agencies 

generally is required when examinations or enforcement actions are undertaken, 

and examination reports of the lead regulator are to be used whenever possible. 

The SEC staff has worked cooperatively with the CFTC in overseeing the market 

for security futures products. For example, our coordinated efforts to fulfill the objectives of the CFMA led to the establishment of a memorandum of understanding 

between the SEC and CFTC under which the two agencies agreed to share examination and trading-related information, coordinate examinations involving security futures activities, and notify each other concerning significant regulatory issues in the 

oversight of security futures products. 

The SEC shares regulatory authority over security futures products because such 

products are surrogates for their underlying securities and therefore can be used to 

engage in frontrunning and manipulation in the underlying securities markets. For 

example, an investor who has agreed to sell a block of stock at the closing price 

could buy futures on that stock with the expectation of causing the stock’s price to 

tick up at the close. In the same fashion, single stock futures and narrow-based security index futures have the potential to be used for insider trading and intermarket trading abuses, such as frontrunning and market manipulation. Because

security futures are a substitute for their underlying securities and, therefore, have 

the potential to impact those underlying securities markets, the CFMA applies the 

securities laws to these products. 

In addition, unlike many OTC derivative products, which are complex and relatively inaccessible to retail investors, security futures are readily available to retail 

investors. An intermediary can offer an investor either a security futures product 

or the securities underlying that product, or both. The CFMA recognizes that direct 

access to audit trails, coordinated market surveillance, and inspection authority, as 

well as suitability and customer protection regulation, are all necessary to the SEC’s 

ability to regulate effectively and protect investors. Finally, the CFMA clearly provided that security futures could not be used to avoid the registration and disclosure 

provisions of the Securities Act of 1933 (Securities Act).2

CHANGES TO REGULATORY FRAMEWORK FOR SECURITY FUTURES PRODUCTS IN S. 1566

The SEC believes that, if enacted, the changes to the current SEC-CFTC regulatory framework that are provided for in Sections 7 and 8 of the Commodity Exchange Reauthorization Act of 2005 would disrupt the jurisdictional balance and 

regulatory interaction that Congress, the members of the Working Group, and participants in the securities and futures industries have worked so hard to achieve, 

undermining both the accomplishments of the CFMA and our ability to protect investors and maintain market integrity. The SEC’s specific concerns are discussed 

below. 

Portfolio Margining 

Importance of Comparability of Margin Requirements. The SEC supports the implementation of risk-based portfolio margining for all equity products. Under such 

a methodology, customer margin levels are determined by assessing the market risk 

of a ‘‘portfolio’’ of financial instruments taken as a whole. The advocates of this approach stress portfolio margining results in customer margin requirements that 

more realistically reflect the risk to the broker-dealer of financing the customer’s securities positions better than the current strategy-based methodology, which computes margin requirements for each individual position or strategy in a portfolio. Of 

course, this result depends on the accuracy of the models used to calculate risk, 

under normal and extreme market circumstances. While Section 7 of S. 1566 would 

permit security futures margin to be calculated using a portfolio margining methodology, it would do so by removing the current requirements regarding comparability 

between security futures margin and exchange-traded options margin, and eliminate 

the SEC’s role in establishing margin requirements for security futures.3

46

7(c)(2)(B) of the Exchange Act or any SRO rules pertaining to the levels of initial and maintenance margin that would preclude the implementation of portfolio margining. 4Section 7(c)(2) of the Exchange Act directs the Board of Governors of the Federal Reserve 

System (Federal Reserve Board) to prescribe rules establishing initial and maintenance customer margin requirements imposed by brokers, dealers, and members of national securities exchanges for security futures products. The Federal Reserve Board may delegate this rulemaking 

authority jointly to the Commission and the CFTC, which it did on March 6, 2001. The Commission and the CFTC adopted customer margin requirements for security futures on July 31, 2002. 

See Securities Exchange Act Release No. 46292, 67 FR 53416 (August 14, 2002) (File No. S7–

16–01). 5SEC, Federal Reserve Board, and CFTC staff have also been invited to participate as observers in meetings of this committee. 

Because of the balancing that is required to ensure equivalent margin treatment 

among related instruments, the SEC strongly believes that it would not be advisable 

for Congress to effect these changes to the joint regulatory framework for security 

futures through legislation. In fact, the SEC fears that these changes might lead 

to regulatory arbitrage between security futures and options. The amendments in 

Section 7 of S. 1566 would, for example, permit futures markets to establish portfolio 

margin requirements that treat unfavorably instruments held in a portfolio that 

were traded on a competing market. The SEC firmly believes that margin requirements should not be permitted to be used to gain a competitive advantage for securities futures over options. 

The SEC believes that competition should be based on better products, services, 

and prices—not on regulatory differences. To avoid this possibility, the CFMA established that the margin requirements for security futures shall be no lower than 

margin requirements for comparable options contracts and that margin requirements would be set jointly by the SEC and CFTC.4 These requirements were included to ensure that security futures were not provided a regulatory advantage 

over options and that exchanges would not compete on the basis of margin requirements. The changes in Section 7 of S. 1566 violate this principle and would provide 

security futures a regulatory advantage over securities options—products that are 

economic equivalents. 

SEC Action. Importantly, if done imprudently, risk-based margining involves risks 

to the firms providing the margin, the investors, and the markets as a whole. For 

this reason, risk-based margining must be done carefully by the entity with the 

greatest familiarity with the issues involved. Therefore, other than initial margin 

requirements for stock, margin requirements in the securities markets are proposed, 

in the first instance, by the self-regulatory organizations, or SRO’s. The SRO’s are 

best able to draw on the expertise of their members in developing such proposals. 

The SEC believes this is a more prudent approach to implementing risk-based portfolio margining, but acknowledges that this has not been our top priority over the 

past few years. However, on July 14, 2005, the SEC approved companion proposals 

by the NYSE and the CBOE that permit their members, on a pilot basis, to compute 

certain customers’ margin requirements using a portfolio margin methodology. 

These portfolio margin rules are limited to portfolios of financial instruments based 

on broad-based security indexes such as the S&P 500, Nasdaq 100, and the Russell 

2000. Moreover, Chairman Cox has met recently with CFTC Chairman Jeffery and 

has committed to making the expansion of portfolio margining a priority. 

In taking steps to expand portfolio margining to a broader array of financial instruments, including single stock futures, narrow-based securities index futures and 

other equity securities, and a wider range of customer accounts, the SEC staff has 

been actively discussing with the securities industry and the NYSE an approach to 

portfolio margining that would both lower margin requirements and protect against 

systemic risk in the event of extreme market movements. The SRO’s have reinvigorated their efforts to allow for risk-based portfolio margining, and we anticipate that 

the NYSE and CBOE will propose to expand their portfolio margining pilot based 

on recommendations of a committee composed of representatives of the securities 

firms, the NYSE and CBOE.5 Recently, this committee reached agreement on an approach to portfolio margining that allows its full benefits to be realized, while retaining the prudential benefits of margin requirements. Accordingly, we expect the 

SRO’s to file a proposal that would expand portfolio margining to include equity 

products. 

Amendments to SIPA. The SEC believes that Congress can promote portfolio margining by targeted legislative changes to the Securities Investor Protection Act of 

1970 (SIPA), which will encourage customers to take full advantage of new portfolio 

margining rules. The NYSE and CBOE portfolio margin rules necessarily have a 

cross-margin component under which futures and futures options can be combined 

with related securities to make up a portfolio, provided the futures positions offset 

47

6Specifically, an index is considered narrow-based if its lowest weighted component securities, 

in the aggregate, have average daily trading volume below $50 million ($30 million if the index 

has at least 15 securities). This requirement was intended to ensure that indexes of equity securities that are composed disproportionately of illiquid, and therefore more manipulable, securities are covered by the definition of ‘‘narrow-based security index.’’ Individual debt securities do 

Continued

securities positions. For example, a portfolio made up of securities based on the S&P 

500 could include futures and futures options based on the S&P 500 as well. Losses 

on the securities positions could be offset by gains on the futures positions to arrive 

at the customer’s margin requirement. 

Under the NYSE’s and CBOE’s rules, the securities and futures positions must 

be carried in a securities account to provide the customer with the protections of 

the securities laws and regulations. This raises an issue as to how the futures positions would be treated in a liquidation of the broker-dealer under the SIPA. 

SIPA was enacted to protect customers of a failed broker-dealer. In general, it operates as a short-cut through the bankruptcy process, thereby providing the failed 

broker-dealer’s customers with quicker access to their cash and securities. Part of 

this protection includes provisions for the trustee in the SIPA proceeding to make 

advances to customers up to $500,000 per customer to be used to return securities 

or cash that are missing or otherwise not available to be returned. Consistent with 

FDIC protection, only $100,000 of the $500,000 maximum can be used to return 

cash. The advances and the other costs of a SIPA liquidation are financed through 

a fund maintained by the Securities Investor Protection Corporation (SIPC). If the 

trustee does not recover the amounts advanced from the estate of the failed brokerdealer, the SIPC fund incurs the loss (rather than the customer who received the 

advance). 

The SIPA protections apply to cash and securities held at a broker-dealer, but not 

to futures positions. This result is a function of the SIPA definition of ‘‘security,’’ 

which specifically excludes futures. Moreover, there is no corresponding statutory 

protection for futures customers under which they would receive advances if futures 

assets are missing. Because, as noted above, the NYSE and CBOE rules permit

futures and futures options to be included in a portfolio where they will hedge offsetting positions in related securities, the question is raised as to how the futures 

positions should be treated in a SIPA liquidation of the broker-dealer. The SEC believes they should be protected under SIPA because their inclusion lowers the risk 

of the portfolio as a whole. 

To assure SIPA protection to all products in these accounts, the SEC recommends 

that Congress amend certain definitions in SIPA. Such amendments could be very 

narrowly tailored to, in effect, provide that futures (including options on futures) 

held in a portfolio margin account under a SEC approved portfolio margin rule 

would receive SIPA protection. Thus, the amendments would extend SIPC protection to those products that are permitted to be deposited into a portfolio margin account that are hedging offsetting securities positions and, therefore, lowering the 

broker-dealer’s risk of carrying the financed customer positions. 

Proposed Amendments Affecting the Definition of ‘‘Narrow-Based Security Index’’

The SEC is concerned that the proposal in Section 8 of S. 1566 to amend the definition of narrow-based index would remove the SEC’s jurisdiction over futures on 

certain security indexes, which we believe would negatively impact investor protection and market integrity. Specifically, Section 8 of S. 1566 would direct the SEC 

and CFTC to exclude from the definition of ‘‘narrow-based security index’’ indexes 

based on specified types of instruments: (a) indexes based on foreign and U.S. debt 

securities; (b) indexes based on foreign equity securities; and (c) other U.S. securities. The blanket exclusion in Section 8 would eliminate key protections currently 

provided by the Federal securities laws, such as the registration and disclosure provisions of the Securities Act, to investors in futures based on the indexes (or the 

underlying securities) that this provision would exclude. Also, by excluding these indexes from the definition and giving the CFTC exclusive jurisdiction over futures 

on such indexes, futures exchanges would have the exclusive right to trade these 

products, and securities exchanges would be precluded from trading such instruments. The impact of this proposal is described further below. 

Indexes Based on Foreign and U.S. Debt. Prior to the proposal of legislation to 

exclude debt indexes from the definition of ‘‘narrow-based security index,’’ no parties 

had expressed interest to the SEC in trading futures based on debt indexes. That 

said, we agree that the current statutory definition of ‘‘narrow-based security index’’ 

does not appropriately distinguish between broad-based and narrow-based indexes 

of debt instruments.6 However, we do not believe that legislative changes are necVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00051 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
48

not trade with the same regularity as equity securities. Therefore, it would be very difficult to 

create a debt index that does not fall within the definition of ‘‘narrow-based security index’’—

even if that index would be widely considered broadly based. Moreover, the frequency with 

which a particular debt securities trades is not a good indicator of whether it is susceptible to 

manipulation. 7See Section 3(a)(55)(C)(vi) of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(vi). 8 15 U.S.C. 78l. 9The jurisdictional agreement, commonly referred to as the ‘‘Shad-Johnson Accord,’’ was 

passed into law as part of both the Securities Acts Amendments of 1982 and the Futures Trading Act of 1982. See P.L. No. 97–303; 96 Stat. 1409 (1982) and 97–444; 96 Stat. 2294 (1982). 

Under the Shad-Johnson Accord, the CFTC retained exclusive jurisdiction over all futures contracts on broad-based security indexes. The agreement prohibited the trading of single stock futures and futures on narrow-based security indexes. 

essary to address this issue. In Section 3 of the Exchange Act, the limitations of 

the definition were contemplated by Congress, and joint authority was provided to 

the SEC and the CFTC to make determinations with respect to security indexes 

that do not meet the specific statutory criteria without regard to the types of securities that comprise the index.7 The SEC and CFTC already have the tools necessary 

to exclude indexes composed of debt

securities (United States or foreign), and we look forward to working with the CFTC 

to expeditiously address the trading of futures on debt indexes through joint action. 

To legislate such a change would make an unwarranted jurisdictional shift while 

limiting the flexibility of the two agencies to respond to interest in developing and 

trading new security futures products relating to debt indexes. 

Foreign Security Indexes. Section 8 of S. 1566 would require the SEC and the 

CFTC to exclude from the definition of ‘‘narrow-based security index’’ indexes on foreign equities consistent with the capitalization, trading patterns, and trade reporting conditions in the foreign market. The SEC believes that it is important for the 

securities laws to apply to any index future that can be a surrogate for the index’s 

component securities. A future on a narrow-based index composed of foreign securities can be a surrogate for underlying securities in the same way that a narrowbased index composed of domestic securities can be. Whether or not an index is a 

surrogate of its component securities depends on the number, concentration, and liquidity of the securities composing the index. The capitalization, trading patterns, 

or trade reporting conditions in a particular foreign market are not determinative 

of whether a future on a particular index could be a surrogate for the index’s component securities. 

Currently, the principal impediment to trading security futures on narrow-based 

indexes composed of foreign securities is the statutory requirement that all the securities underlying a security future be registered under Section 12 of the Exchange 

Act.8 Because today all foreign stock indexes include unregistered securities, this requirement precludes U.S. exchanges from trading futures on such indexes if the indexes are ‘‘narrow-based.’’ By moving the jurisdictional line to deem such indexes 

‘‘broad-based,’’ the requirement that underlying securities be registered under Section 12 would be removed. Thus, none of the protections of the securities laws would 

apply, including the prohibition on insider trading, raising market integrity, and investor protection concerns. Moreover, redefining an index as broad-based would 

grant futures exchanges a monopoly to trade futures on such indexes because broadbased index futures may only trade on futures exchanges. 

The SEC believes that there is an alternative way to address the impediments 

to trading these products as security futures (that is, the Section 12 registration requirement), and SEC staff has shared this approach with CFTC staff. Specifically, 

the SEC and the CFTC have the authority to exempt security futures from the requirement that underlying securities be registered under Section 12 of the Exchange 

Act. The SEC believes such an exemption would be appropriate under certain circumstances, including where such products are only available to sophisticated investors. The SEC and its staff would welcome the opportunity to work with the CFTC 

to resolve this issue. 

Other U.S. Securities. Finally, Section 8 of S. 1566 would require the SEC and the 

CFTC to exclude from the definition of ‘‘narrow-based security index’’ indexes on 

other U.S. securities. It is unclear what this provision contemplates; yet it directs 

the two agencies to agree to change the jurisdictional line established by the CFMA. 

Prior to the enactment of the CFMA, futures exchanges were permitted to offer 

a futures contract on a securities index only if the futures contract satisfied certain 

statutory criteria, including a requirement that the underlying securities index 

measure and reflect the entire market or a substantial segment of the market.9 In 

addition to lifting the ban on trading of futures contracts if they did not satisfy 

these criteria, the CFMA’s definition of ‘‘narrow-based security index’’ established a 

49

10See Board of Trade of City of Chicago v. SEC, 677 F.2d 1137 (7th Cir. 1982), vacated as 

moot, 459 U.S. 1026 (1982); and Chicago Mercantile Exchange v. SEC, 883 F.2d (7th Cir. 1989); 

Board of Trade of the City of Chicago v. SEC, 187 F.3d 713 (7th Cir. 1999). 11 373 F.3d 861 (7th Cir. 2004). 

clear, objective standard for which indexes were narrow and which were broad. The 

SEC urges Congress not to reintroduce uncertainty into this area by establishing 

standards for determining jurisdictional boundaries that are subjective and subject 

to differing interpretations.10 The SEC believes the current definition of ‘‘narrowbased security index’’ reasonably identifies those indexes of U.S. securities that are 

so small, highly concentrated, or illiquid that a future on such an index would be 

a surrogate for the underlying securities. 

Application of CEA to Foreign Currency Transactions 

LEGAL CERTAINTY FOR OTC DERIVATIVES MARKETS

It is widely recognized that OTC derivative instruments are important financial 

management tools that, in many respects, reflect the unique strength and innovation of U.S. capital markets. Indeed, U.S. markets and market professionals have 

been global leaders in derivatives technology and development. The enormous size 

of the OTC derivatives market demonstrates its critical role in our capital markets. 

OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to isolate and manage risks 

associated with their business activities or their financial assets. These instruments, 

for example, can be used by corporations and local governments to lower funding 

costs, or by multinational corporations to reduce exposure to fluctuating exchange 

rates. 

Legal certainty and regulatory clarity are essential to ensure that the United 

States continues to play a leading role with regard to innovation and growth in the 

OTC derivative market. An environment that lacks legal certainty could undermine 

the flexibility and competitiveness of the U.S. financial markets. The OTC Derivatives Report issued by the Working Group prior to the enactment of the CFMA contained several recommendations designed to address legal uncertainty regarding the 

application of the CEA to the execution and clearance of OTC derivatives products. 

In response, Congress sought in the CFMA to provide legal certainty and regulatory 

clarity in the OTC derivatives market. The SEC believes it is critical that these 

achievements be retained. 

PROPOSED AMENDMENTS TO ADDRESS RETAIL FOREIGN CURRENCY FRAUD

The SEC has worked closely with staff of the other members of the Working 

Group on issues related to the sale of foreign currency products to retail customers. 

The goal has been to give the CFTC clear authority to take action against foreignexchange boiler rooms without undermining the so-called Treasury Amendment, 

which excludes certain transactions in foreign currency from CFTC jurisdiction. 

This effort is a response to the Seventh Circuit’s decision in CFTC v. Zelener,11

upholding the dismissal of a CFTC fraud action on the grounds that certain leveraged contracts of sale for foreign currency marketed to retail customers were spot 

transactions, not futures contracts, and thus not subject to the CEA. As others have 

noted, the decision raised questions about the scope of the CFTC’s jurisdiction under 

the Treasury Amendment. S. 1566 would address the Zelener decision by significantly expanding the jurisdiction of the CFTC. 

The SEC believes that any change to the CEA should not be so broad as to affect 

the securities markets or the SEC’s ability to effectively oversee those markets. In 

its current form, S. 1566 could do both by generating legal uncertainty regarding 

whether the CFTC would have jurisdiction over options on foreign currency that are 

traded on national securities exchanges and certain other securities, such as structured notes that reflect currency values. In addition, S. 1566 would undermine the 

competitive parity between broker-dealers and banks in foreign currency transactions that Congress established in 2000 with the CFMA. The securities and banking industries rely on parallel exclusions from the CEA that were fashioned by the 

CFMA for foreign currency transactions. However, S. 1566 would substantially curtail those exclusions for the securities industry by eliminating the exclusion for certain affiliates of broker-dealers. Because we have not seen evidence of involvement 

in retail foreign currency transaction fraud by these unregistered affiliates of 

broker-dealers, we do not believe it is appropriate to eliminate the exclusion. 

The Working Group principals created a staff-level working group and directed 

their staff to work together to craft a legislative solution that would address the 

Zelener decision in a more targeted way than does S. 1566. The Working Group has 

reached agreement in principle on how to address the issues raised by this decision. 

50

1 Risk-based margining, as opposed to strategy-based margining, establishes margin levels 

based upon an analysis of the historical performance and expected price volatility of individual 

products. Risk-based margin requirements are designed to cover the expected one-day price 

movement with an established level of statistical confidence (generally 99 percent). Risk-based 

portfolio margining establishes margin levels by assessing the net market risk of a portfolio of 

positions in an account. Portfolio margining is based upon the premise that combinations of positions can have offsetting risk characteristics due to historic or expected correlations in their 

price movements. Under a risk-based portfolio margining system, the minimum level of margin 

is determined by (1) analyzing the risk of each component position in an account and (2) recognizing any risk offsets in an overall portfolio of positions. Portfolio margining, as opposed to 

strategy-based margining, more accurately evaluates the economic risks of open positions, thereby minimizing the chance of over-margining or under-margining. In addition, portfolio marThe staff have met regularly over the past several weeks and is crafting legislative 

language that would grant the CFTC additional antifraud authority over a narrow 

category of leveraged transactions in foreign currency with retail customers by unregulated foreign exchange bucket shops, and a registration requirement for solicitors of such transactions. Important to the Commission is that this agreement would 

preserve the existing exclusion from the CEA for foreign currency transactions by 

certain broker-dealer affiliates, as well as other regulated financial institutions. 

Conclusion 

The SEC appreciates the opportunity to participate in the dialogue that S. 1566 

has engendered regarding security futures products and derivative products. We 

look forward to working closely with this Committee, the Working Group, market 

participants, and other legislators as these issues continue to be considered. 

—————

PREPARED STATEMENT OF PATRICK J. McCARTY

GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION

SEPTEMBER 8, 2005

Mr. Chairman, Senator Sarbanes, and Members of the Committee, I appreciate 

the opportunity to appear on behalf of the Commodity Futures Trading Commission 

(CFTC) at this hearing on the reauthorization of the Commodity Exchange Act 

(CEA). 

Congress’s most recent exercise in reauthorizing the CEA resulted in the Commodity Futures Modernization Act of 2000 (CFMA). It was, most assuredly, landmark legislation under which the futures industry has flourished. This Committee 

deserves credit for its role in the CFMA’s development. The CFTC concurs with the 

widely held view that this reauthorization—unlike the sweeping nature of the 

CFMA—should involve only incremental changes to the CEA. 

The issue in this legislative round that has received the most public attention involves the CFTC’s antifraud authority with respect to retail foreign currency transactions in light of the Zelener decision. CFTC v. Zelener, 373 F.3d 861 (7th Cir.), 

rehearing denied en banc, 387 F.3d 624 (7th Cir. 2004) (Zelener). I am pleased to 

note that the staff of the President’s Working Group on Financial Markets (PWG) 

has reached an agreement in concept on a legislative recommendation to address 

the post-Zelener situation, though the final details are being worked out for approval by the PWG Principals. 

I will cover today the issues the Committee specifically asked us to address, as 

well as two others of importance to the CFTC: (1) risk-based and portfolio margining 

for both security futures products (SFP’s) and for security options; (2) clarification 

of exclusions from the CEA’s definition of narrow-based security index; (3) the 

Zelener/retail foreign currency fraud consensus proposal endorsed by the PWG; (4) 

amendments to Section 4b of the CEA providing the Commission with clear ‘‘principal-to-principal’’ antifraud authority over off-exchange futures transactions; and 

(5) amendments to Section 9 of the CEA clarifying the Commission’s authority to 

bring administrative and civil actions as well as increasing civil and criminal penalties. 

Risk-Based Portfolio Margining of Security Futures Products and Security

Options 

Section 7 of the Senate Agriculture Committee bill as reported, S. 1566, provides 

for the institution of a pilot program for risk-based portfolio margining of SFP’s. The 

CFTC supports risk-based and portfolio margining for both SFP’s and security options.1 Risk-based margining and portfolio margining, standard in the futures indusVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00054 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
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gining acknowledges the reality that an offsetting position can be a better risk mitigant than 

deposited collateral. 2 Cross-margining is a type of risk-based margining that jointly margins related products (securities, options, and futures contracts) that are traded in different markets and generally 

cleared by different clearing entities. 3See CEA Section 1a(25)(C) and Securities Exchange Act Section 3a(55)(D)(joint broad-based 

rulemaking), and CEA Section 2(a)(1)(E)(i) and Securities Exchange Act Section 6(k)(1)(joint 

narrow-based rulemaking). CEA Section 2(a)(1)(E)(ii) and Securities Exchange Act Section 6k(2) 

specifically require that, in promulgating rules pursuant to Sections 2(a)(1)(E)(i) and 6(k)(1), the 

agencies shall take into account the nature and size of the markets underlying the foreign security index. 4 CEA Section 1a(25)(B)(vi). 

5See Appendix A. 

try, are both efficient and effective from a regulatory point of view, and have been 

remarkably successful in protecting customer funds. 

The use of a more risk-sensitive, portfolio-based approach to margining for financial products has received wide support. For example, the Federal Reserve Board 

of Governors expressed support for risk-based and portfolio margining in its March 

2001 letter to the Securities and Exchange Commission (SEC) and CFTC delegating 

margin authority over SFP’s. The Board specifically noted its expectation that the 

creation of this new product would promote opportunities for portfolio margining for 

all securities, including security options and SFP’s. 

The SEC has also taken steps that show support for risk-based and portfolio margining. On July 14, 2005, the SEC approved a Chicago Board Options Exchange 

(CBOE) 2-year pilot program for portfolio margining and cross margining 2 with respect to certain products. On the same date, the SEC also approved New York Stock 

Exchange (NYSE) rule changes that would enable NYSE members to participate in 

the CBOE pilot program. However, SFP’s are not included in the portfolio margining provisions of the pilot program, and therefore it would not directly facilitate 

the use of portfolio margining for these products. In addition, while broad-based securities index futures and broad-based equity options are included in the cross-margining provisions of the pilot program, they must be held in a securities account in 

order to receive the benefit of cross-margining; market participants should have the 

choice to have margin held in a futures account if they so desire. 

The CBOE pilot program has similarities to the pilot program for SFP’s found in 

Section 7 of the Senate Agriculture Committee bill insofar as the CBOE program 

permits portfolio margining. The CFTC urges Congress to enact legislation that will 

allow firms and their customers to benefit from the use of risk-based portfolio margining systems. 

Clarification of Narrow-Based Security Indexes 

Section 8 of S. 1566 as reported by the Senate Agriculture Committee directs the 

SEC and the CFTC to undertake a joint rulemaking that would exclude certain 

types of indexes from the definition of ‘‘narrow-based security index.’’ In the CFMA, 

Congress determined that SFP’s, which include ‘‘narrow-based security indexes,’’ 

would be subject to joint regulation by the SEC and the CFTC. At the same time, 

Congress directed the SEC and the CFTC to issue rules defining both broad- and 

narrow-based security indexes for foreign securities markets.3 Neither set of rules 

has yet been promulgated. Further, Congress, in the CFMA, provided the SEC and 

CFTC with the authority to exclude certain other types of indexes and instruments 

from the definition of ‘‘narrow-based security index.’’ 4 The agencies have not acted 

to exclude certain types of indexes which we believe Congress did not intend to be 

regulated as SFP’s. Legislation to compel a joint SEC/CFTC rulemaking in this area 

would be appropriate to provide legal certainty to market participants, and to give 

effect to the intent of Congress when it enacted the CFMA, which we understand 

was to make these products available to U.S. investors. 

The Senate Agriculture Committee bill would not cause the SEC to lose jurisdiction or alter the prior jurisdictional division between the agencies but, rather, would 

add needed clarification regarding the classification of these products. The CFTC 

has had exclusive jurisdiction over futures on broad-based security indexes, and

options on such futures, for well over 20 years. These markets have operated effectively under CFTC oversight. Prior to enactment of the CFMA in 2000, approximately 100 futures contracts on broad-based security indexes—both domestic and 

foreign—were approved for trading by the CFTC in coordination with the SEC.5 In 

the CFMA, Congress preserved the CFTC’s exclusive jurisdiction over futures on 

broad-based security indexes. Congress provided joint jurisdiction with the SEC only 

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6The SEC has explicitly acknowledged the CFTC’s exclusive jurisdiction over futures on 

broad-based security indexes on many occasions. In 1983, an SEC no-action letter stated, ‘‘The 

Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over . . . futures contracts on broad-based indices of any securities.’’ See Granite Fund, SEC No-Action Letter, October 31, 1983. The SEC again acknowledged the CFTC’s exclusive jurisdiction more recently, in 

2002, in the joint order issued by the SEC and the CFTC excluding certain security indexes from 

the definition of ‘‘narrow-based security index’’ under the CEA and the Federal securities laws. 

The CFTC/SEC Joint Order on Grandfathered Security Indexes stated, ‘‘[t]o distinguish between 

security futures on narrow-based security indexes, which are jointly regulated by the Commissions, and futures contracts on broad-based security indexes, which are under the exclusive jurisdiction of the CFTC . . . .) (emphasis added). 67 Fed. Reg. 38,941 (June 6, 2002). 7The statutory test for ‘‘narrow-based security indexes’’ provides that an index will be considered ‘‘narrow-based’’ if: (1) it has nine or fewer components; (2) one of the component securities 

comprises more than 30 percent of the index’s weighting; (3) the five highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting; or (4) 

the value of average daily trading volume of the bottom quartile of the index, by weight, falls 

below $50 million (or below $30 million in the case of indexes with 15 or more component securities). CEA Section 1a(25)(A), Securities Exchange Act Section 3a(55)(B). 8The statutory test for a ‘‘nonnarrow-based security index’’ provides that a security index will 

be considered ‘‘nonnarrow’’ if: (1) it has at least nine component securities; (2) no component 

security comprises more than 30 percent of the index’s weighting; and (3) each component security is registered under Section 12 of the Securities Exchange Act, is one of 750 securities with 

the largest market capitalization, and is one of 675 securities with the largest dollar value of 

average daily trading volume. CEA Section 1a(25)(B), Securities Exchange Act Section 3a(55)(C). 9 Application of the current narrow-based security index definition almost certainly means 

that all foreign industry and sector indexes will be considered to be narrow-based. 10 CEA Section 2(a)(1)(E)(ii), Securities Exchange Act Section 6(k)(2). 

over futures on single stock and narrow-based security indexes—CEA § 2(a)(1)(D)—

not with respect to futures on broad-based security indexes.6

It has been 5 years since enactment of the CFMA. The agencies have not adopted 

rules for foreign security indexes and debt security indexes because of divergent 

views over whether the current narrow-based security index test applies to those 

markets and indexes. It is appropriate at this time to provide more statutory clarity 

regarding what constitutes a broad-based security index. Congress should act to provide legal certainty to market participants and to regulators, and at the same time 

allow for innovation and competition in these markets. 

Further, we believe that the four broad-based security index definitions that we 

have developed are reasonable and consistent both with past CFTC practice in approving futures on broad-based security indexes, and with Congressional intent in 

enacting the CFMA. In brief, these definitions relate to: (1) foreign security indexes; 

(2) U.S. debt security indexes; (3) foreign debt security indexes; and (4) a general 

broad-based security index definition. These four definitions are more fully described in Appendix B. 

The current statutory test for ‘‘narrow-based security indexes’’ is quite detailed 

and was tailored to fit the U.S. equity market.7 In addition, the CFMA included a 

‘‘nonnarrow-based’’ security index test.8 These current statutory tests for narrowand nonnarrow-based security indexes are appropriate for the U.S. equity market, 

which is the largest, deepest, and most liquid securities market in the world by far. 

These tests were not designed to apply to foreign markets, as most of these countries do not list even 200 equity securities—let alone 675 securities as contemplated 

by the ‘‘nonnarrow-based’’ test. In addition, foreign equities generally are not registered under Section 12 of the Securities Exchange Act of 1934, and so it is difficult, if not impossible, to meet the current nonnarrow-based security index test. 

With regard to indexes that are currently not being offered in the United States 

(due in large part to the barrier to entry created by the current narrow-based security index test), CFTC economists have identified numerous well-established foreign 

indexes that would not meet the current test, but which should be considered broadbased under a test that more accurately takes into account the nature, size, and 

character of foreign markets (as required by the CFMA).9 (See Appendix C.) This 

point is evidenced by the clear language of the CFMA, which mandated that in developing joint foreign narrow-based security index product rules, the Agencies 

should consider the size and nature of the markets underlying the foreign indexes.10

In addition, application of the current narrow-based security index test in foreign 

markets results in strange anomalies. Several well-known foreign security indexes 

that are currently trading as broad-based indexes pursuant to the ‘‘grandfather’’ 

provision in the CFMA—the IBEX–35 (Spain); the Hang Seng (Hong Kong); the 

MSCI Singapore Free; and the MSCI Hong Kong—would not meet the current statutory test. This results in a situation in which existing indexes may continue to 

trade, but an identical new index that is required to meet the current ‘‘narrow-based 

security index’’ test could not qualify to trade. These anomalous results, and the 

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11There is a long history of futures being offered on U.S. Treasury bonds, notes, and bills at 

the Chicago Board of Trade (CBOT). The same can be said for futures on German Government 

bund, bobl, and schatz, first at the London Stock Exchange, then Eurex, and most recently at 

Eurex US and the CBOT. There is no evidence that Congress, in enacting the CFMA, had any 

intention of requiring futures on these government debt instruments to be SFP’s subject to joint 

CFTC/SEC jurisdiction, as opposed to being solely subject to the CFTC’s exclusive jurisdiction. 

It may be appropriate at this time to consider statutory or regulatory revisions to broaden the 

list of exempted securities that may appropriately underlie futures contracts and be included 

as component securities in debt security index contracts. 12See Appendix B. 

clear language of the statute, evidence that Congress did not intend to apply the 

narrow-based security index test to foreign markets. 

Similar difficulties occur in attempting to apply the current statutory definition 

to domestic debt securities. Additionally, it is very clear that Congress intended U.S. 

Government debt to be excluded from the definition of SFP’s. And the language of 

the CFMA indicates that Congress did not intend for foreign government debt or 

agency debt to be traded under the dual SFP regulatory scheme.11 The market capitalization and quartile tests, and particularly the trading volume measures, in the 

narrow-based security index test are not appropriate for these markets. To illustrate 

this point, after passage of the CFMA, the agencies were contacted by the Chicago 

Board of Trade (CBOT), which wanted to increase the number of component securities (from 40 securities to 200 securities) in its existing municipal debt security 

index. However, the data was not available to evaluate the volume requirement of 

the test, and so the new (200-security) index could not pass the statutory test. This 

would seem to defy common sense. If the old (40-security) index contract was considered broad-based, then there is something wrong with the current definition if it 

will not accommodate as broad-based the same index with 200 underlying securities. 

The result has been a barrier to entry, such that exchanges simply do not attempt 

to offer futures on broad-based debt security index contracts to the marketplace. 

Accordingly, a separate test is needed for domestic debt securities. And because 

foreign debt markets are significantly different from U.S. debt and equity markets, 

there also needs to be an appropriately crafted test developed specifically for foreign 

debt security indexes. 

The Senate Agriculture Committee bill would promote clarity in this area by requiring the CFTC and the SEC to jointly promulgate final rules within 180 days. 

It also provides criteria that the CFTC and the SEC are to use in excluding indexes 

on U.S. debt instruments, foreign equities, foreign debt instruments, and other U.S. 

securities from the definition of ‘‘narrow-based security index.’’ As noted above, the 

CFTC has developed specific definitions to address each area 12 that would tailor the 

rules for foreign equity markets (which are significantly smaller than U.S. equity 

markets) and debt instruments (which are inherently unable to meet the current 

volume and market capitalization tests in the statute) based on the size and nature 

of those markets, and on the potential for insider trading and market manipulation. 

Either these definitions should be codified, or joint regulations adopting such definitions should be issued. These definitions would address a significant problem, and 

are consistent with the language in the CFMA. 

The Zelener Decision/Foreign Currency Fraud 

With regard to the adverse impact of the Seventh Circuit Court of Appeals decision in the Zelener case on the CFTC’s ability to combat retail foreign currency 

(forex) fraud, the CFTC continues to believe that the Zelener case was wrongly decided and that the contracts at issue in that case were futures contracts. We therefore urge Congress to restore legal certainty by clarifying the CFTC’s jurisdiction 

in this area. 

Retail forex fraud is a significant concern for the CFTC. In the last 4 years, the 

CFTC has brought 79 enforcement actions involving forex fraud against 

unsuspecting retail customers. In these 79 cases, there were 23,000 victims who invested approximately $350 million. Courts have awarded approximately $267 million in customer restitution and civil penalties in these cases. The Commission has 

been able to recover some funds for distribution to customers, but the total amount 

of funds frozen and/or distributed is less than $15 million. 

There are divergent views over whether Congress should address the Zelener decision broadly with respect to all commodities, or narrowly with a ‘‘forex-only’’ solution. The Commission transmitted legislative language limited to forex to the Senate 

Agriculture Committee on May 20, 2005, and noted at the time that the legislative 

package ‘‘represents a consensus among the Commissioners and the minimum 

which the Commission believes it needs in terms of change to the Commodity Exchange Act during reauthorization.’’

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As you may know, the staff of the PWG members met at least weekly during the 

month of August with respect to the Zelener issue. As noted in the introduction, 

PWG staff has reached agreement in concept on a Zelener solution that it believes 

will give the CFTC adequate authority to address the significant retail forex fraud 

problem. 

The final details of the language are being worked out for approval by the PWG 

Principals. I would note, though, that the staff believes the concept would provide 

the CFTC with fraud authority over retail forex ‘‘futures look-alike’’ contracts, and 

thus specifically address the problem raised by the Zelener decision. It would address the significant problem that our enforcement staff has faced in the investigation and prosecution of fraudulent bucket shops and solicitors who prey upon retail 

customers in the forex arena. 

The proposed language, however, would apply only to certain retail foreign currency transactions—futures and ‘‘futures look-alike’’ contracts as were involved in 

the Zelener case. Its scope is narrow, as it also makes clear that legitimate spot 

transactions (such as the purchase of foreign currency at a currency exchange) are 

not included within the jurisdiction of the CFTC. 

The proposal also would retain the current ‘‘otherwise regulated’’ scheme established in the CFMA, whereby retail foreign currency transactions by financial institutions such as banks, broker-dealers, and insurance companies are excluded from 

the CFTC’s jurisdiction. The CFMA excluded these ‘‘otherwise regulated’’ financial 

institutions based on the premise that their regulators will oversee, examine, and 

bring fraud actions if there are problems. SEC-registered broker-dealers will not be 

required to register with the CFTC in order to engage in off-exchange forex transactions with retail customers. They will still be able to rely upon the ‘‘otherwise regulated’’ exclusion in the statute, subject to the review and oversight of the SEC. 

Finally, it is important to reiterate that the CFTC continues to believe that 

Zelener was wrongly decided. We believe that the foreign currency contracts that 

were the subject of that controversy were futures contracts, and that they were not 

excluded spot contracts because no deliveries of foreign currency were ever made to 

any customers under any of the contracts. We also note that the court in Zelener

determined that there clearly was fraud involved. The CFTC will continue to litigate 

this issue vigorously to protect customers against precisely this type of fraud and 

abuse. 

Principal-to-Principal Antifraud Authority 

Section 2 of S. 1566 amends Section 4b of the CEA to address an important issue 

relating to the CFTC’s antifraud authority. Section 4b, the CFTC’s main antifraud 

provision, has been amended in this bill to clarify that the CFTC has the authority 

to bring fraud actions in off-exchange ‘‘principal-to-principal’’ futures transactions. 

These changes are necessary to eliminate significant obstacles to the use of the 

CFTC’s antifraud authority in today’s nonintermediated markets. 

In late November 2000, the Seventh Circuit Court of Appeals ruled that the CFTC 

could use Section 4b only in ‘‘intermediated’’ transactions—those involving a brokercustomer relationship. Commodity Trend Service, Inc. v. CFTC, 233 F.3d 981, 991–

992 (7th Cir. 2000)(CTS). In other words, the court ruled that the CFTC cannot use 

its Section 4b antifraud authority in ‘‘principal-to-principal’’ transactions. Meanwhile, at about the same time, the CFMA amended the CEA to permit off-exchange 

futures and options transactions that are done on a principal-to-principal basis, such 

as energy transactions pursuant to CEA Sections 2(h)(1) and 2(h)(3). Congress specifically reserved the CFTC’s Section 4b antifraud authority in Section 2(h) so that 

the CFTC could prosecute fraud involving transactions conducted under that Section 

of the CEA. Since all Section 2(h) transactions must be done on a principal-to-principal basis to qualify for the exemption, it is important to clarify that Section 4b 

antifraud authority applies to nonintermediated transactions. Without this clarification, the work of Congress in 2000 to protect energy markets from fraud could be 

rendered meaningless. 

Accordingly, the Senate Agriculture Committee’s reported bill amends subsection 

4b(a)(2) by adding the words ‘‘or with’’ to address off-exchange principal-to-principal 

transactions. This new language would make it clear that the CFTC has the authority to bring antifraud actions in off-exchange principal-to-principal futures transactions, including exempt commodity transactions in energy under Section 2(h) as 

well as all transactions conducted on derivatives transaction execution facilities. 

This amendment to Section 4b would implement Congressional intent to reserve the 

CFTC’s antifraud authority with regard to principal-to-principal transactions. 

In addition, the amended Section 4b would clarify that market participants in 

these transactions are not required to disclose information that may be material to 

the market price, rate, or level of the commodity in such off-exchange transactions. 

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It also would codify, however, existing law that prohibits market participants from 

using ‘‘half-truths’’ in negotiations and solicitations by requiring necessary disclosures to protect against materially misleading statements. 

I note that the Section 4b language is supported by the Futures Industry Association, the National Futures Association, the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, Eurex U.S., and others. 

Civil and Administrative Actions under Section 9

Section 3 of S. 1566 amends CEA Section 9 by adding a new subsection 9(f) that 

would clarify the CFTC’s authority to bring civil and administrative actions. Under 

Section 9 of the CEA, it is a felony for any person to knowingly make false, misleading, or inaccurate reports regarding the price of any commodity—including electricity and natural gas. Most of the other provisions of Section 9 similarly identify 

types of misconduct that constitute felonies. The CFTC lacks criminal powers, but 

it has brought civil enforcement proceedings under Section 9 throughout its history. 

In fact, in the last 25 years the CFTC has brought over 70 civil injunctive or administrative enforcement actions under Section 9. 

In the last 3 years, the CFTC has used Section 9 to achieve approximately 30 significant monetary settlements, totaling nearly $300 million in civil monetary penalties, for ‘‘false reporting’’ by energy trading firms or their traders in violation of 

CEA Section 9. In many of these cases, the energy trading firms or their traders 

reported a very large number of fictitious transactions, or reported significantly altered data about transactions, to publications that compile and publish natural gas 

price indexes. The reporting was done in an attempt to manipulate index prices. 

Energy firms and traders have argued that the reporting of fictitious transactions 

and significantly altered data about transactions is excluded from the CFTC’s jurisdiction by Section 2(g) of the CEA. The CFTC has consistently taken the position 

that, even if a transaction is excluded from CFTC jurisdiction under Section 2(g), 

the false reporting of such a transaction is a separate act that remains a violation 

of Section 9 that the CFTC has authority to prosecute. On August 1, 2005 the 

CFTC’s position regarding false reporting and the scope of the exclusion under Section 2(g) (and the related exemption under CEA Section 2(h)) were upheld in CFTC

v. Bradley, Case No. 05–CV–00062–JHP–FHM (N.D. OK August 1, 2005). This is 

the first reported decision in this area, and an extremely important one that affirms 

the CFTC’s authority and ability to prosecute false reporting cases under CEA Section 9. 

Even with the Bradley decision, we feel a legislative change to Section 9 is still 

necessary because it would clarify the CFTC’s authority to bring civil and administrative actions, and would ensure that the CFTC can continue to bring false reporting cases in the energy arena for acts or omissions that occurred prior to enactment. 

The Senate Agriculture Committee bill expressly provides that these amendments 

restate, without substantive change, existing CFTC civil enforcement authority. 

This clarifying change does not grant any new statutory authority, and provisions 

of Section 9, as restated, continue to apply to any action for any alleged violation 

occurring before, on, or after the date of enactment. 

Section 3 of S. 1566 also amends CEA Section 9 to double the civil and criminal 

penalties available for certain criminal violations of the CEA such as manipulation, 

false reporting, and conversion. The maximum fines under Section 9 would be increased from $500,000 to $1 million, and the maximum prison sentence would be 

increased from 5 to 10 years. In a similar vein, Section 3 of S. 1566 includes conforming amendments to the procedural enforcement provisions in Sections 6(c), 6b, 

and 6c of the CEA to effectuate this increase in civil monetary penalties. 

I note that the Section 9(f) statutory language is consensus language that has 

been agreed to by the Futures Industry Association, the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, Eurex 

U.S., and others. 

Conclusion 

The CFTC’s reauthorization is a unique opportunity to address the five areas that 

I have mentioned: Portfolio margining for security futures products and security options; clarification of definitions applicable to broad-based foreign security indexes 

and debt indexes; the Zelener/forex fraud provision; the CEA’s principal-to-principal 

antifraud authority; and increased penalties and clarification of civil and administrative authority. The CFTC is eager to work with the Congress to successfully complete reauthorization of the CFTC this year. Thank you for the opportunity to testify 

on these important matters.

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1President’s Working Group on Financial Markets (1999), Over-the-Counter Derivatives Markets and the Commodity Exchange Act (Washington, DC: November). www.ustreas.gov/press/releases/reports/otcact.pdf.

PREPARED STATEMENT OF PATRICK M. PARKINSON

DEPUTY DIRECTOR, DIVISION OF RESEARCH AND STATISTICS

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

SEPTEMBER 8, 2005

Chairman Shelby, Senator Sarbanes, and Members of the Committee, thank you 

for the opportunity to testify on the Commodity Futures Modernization Act of 2000 

(CFMA) and on regulatory issues that have arisen in the context of the reauthorization of the Commodity Futures Trading Commission (CFTC). The Chairman’s invitation letter requested that the testimony and written statement provide an overall 

evaluation of the CFMA and address three specific regulatory issues: (1) legislative 

measures to address fraud in certain retail foreign currency transactions; (2) portfolio margining for security futures products; and (3) futures on narrow-based securities indexes. 

Overall Evaluation of the CFMA 

The Federal Reserve Board believes that the CFMA has unquestionably been a 

successful piece of legislation. Most important, as recommended by the President’s 

Working Group on Financial Markets in its 1999 report, it excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act 

(CEA).1 As the Working Group argued, regulation of such transactions under the 

CEA was unnecessary to achieve the act’s principal objectives of deterring market 

manipulation and protecting investors. Such transactions are not readily susceptible 

to manipulation and eligible counterparties can and should be expected to protect 

themselves against fraud and counterparty credit losses. Exclusion of these transactions resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable. At the same 

time, the CFMA modernized the regulation of U.S. futures exchanges, replacing a 

one-size-fits-all approach to regulation with an approach that recognizes that the 

regulatory regime necessary and appropriate to achieve the objectives of the CEA 

depends on the nature of the underlying assets traded and the capabilities of market participants. Together, these provisions of the CFMA have made our financial 

system and our economy more flexible and resilient by facilitating the transfer and 

dispersion of risk. Consequently, the Board believes that major amendments to the 

regulatory framework established by the CFMA are unnecessary and unwise. 

Nonetheless, the Board supports some targeted amendments to the CEA to address persistent problems with fraud in retail foreign currency transactions and to 

facilitate the trading of security futures products and futures on security indexes. 

Fraud in Retail Foreign Currency Transactions 

In its 1999 report, the President’s Working Group concluded that, to address problems associated with foreign currency ‘‘bucket shops,’’ the CEA should be applied to 

transactions in foreign currency futures if they are entered into between a retail 

customer (an individual or business that does not meet the definition of an eligible 

counterparty) and an entity that is neither federally regulated nor affiliated with 

a federally regulated entity. The CFMA included provisions that were largely consistent with the Working Group’s recommendation. 

The CFMA has allowed the CFTC to take numerous enforcement actions against 

retail foreign currency fraud. However, the CFTC has continued to encounter certain difficulties in this area. These difficulties have stemmed from two sources. 

First, the CFTC’s authority is limited to foreign currency futures, and some entities 

have fraudulently marketed contracts that, although similar to futures, have characteristics that have led some courts to conclude that they are not futures and that 

the CFTC has no jurisdiction. Second, some perpetrators of fraud have taken advantage of the CFMA’s exclusion from CFTC jurisdiction of retail foreign currency futures offered by futures commission merchants (FCM’s) and their affiliates. These 

perpetrators have set up thinly capitalized FCM’s and used affiliates of those FCM’s 

or unregulated unaffiliated entities to fraudulently solicit retail customers. 

The Board believes that fraud undermines the functioning of financial markets 

and that some governmental entity must have the authority to protect retail investors in foreign currencies by taking enforcement action against entities that are defrauding them. Although the States have an important role to play in combating 

70

fraud, the President’s Working Group concluded in 1999 that the CFTC is the appropriate Federal regulator and should have clear authority to pursue retail fraud 

by foreign currency bucket shops. Consequently, the Board supports targeted 

amendments to the CEA that address the specific difficulties that the CFTC has

encountered in taking enforcement action in this area. It is critical that those 

amendments be carefully crafted to avoid creating legal or regulatory uncertainty 

for legitimate businesses providing foreign exchange services to retail clients. The 

Board would be opposed to extending any new CFTC authority to retail transactions 

in other commodities without further careful consideration and demonstrated need. 

Provisions crafted to avoid creating uncertainty for legitimate foreign currency businesses are unlikely to provide the same protection to a much wider range of businesses. 

Portfolio Margining for Security Futures 

The CFMA gave the Board authority to prescribe regulations establishing initial 

and maintenance margins for security futures products or to delegate that authority 

jointly to the CFTC and the Securities and Exchange Commission (SEC). The Board 

delegated its authority to the commissions in a letter dated March 6, 2001. The letter indicated that the Board concluded that delegation is appropriate because it believes that the most important function of margin regulations is prudential—that 

is, to protect margin lenders from credit losses. In the case of security futures, the 

lenders are broker-dealers and FCM’s, and the commissions are responsible for all 

other aspects of prudential regulation of those firms. 

Portfolio margining is a method for setting margin requirements that evaluates 

positions as a group or portfolio and takes into account the potential for losses on 

some positions to be offset by gains on others. Specifically, the margin requirement 

for a portfolio is typically set equal to an estimate of the largest possible decline 

in the net value of the portfolio that could occur under assumed changes in market 

conditions. Portfolio margining is an alternative to ‘‘strategy-based’’ margining. With 

strategy-based margining, the potential for gains on one position in a portfolio to 

offset losses on another position is taken into account only if the portfolio implements one of a designated set of recognized trading strategies. The margin requirements for recognized strategies are set out in the rules of self-regulatory organizations. Each strategy is viewed in isolation; the remainder of the portfolio and other 

strategies are not taken into account. 

The Board has supported the use of portfolio margining for some time. For example, in 1998 the Board amended Regulation T to allow securities exchanges to develop portfolio margining as an alternative to strategy-based margining, subject to 

SEC approval. In its 2001 letter delegating its authority over margins for security 

futures products jointly to the CFTC and the SEC, the Board requested that the 

commissions, either jointly or individually, report to the Board annually on their experience exercising the delegated authority and to include in those reports an assessment of progress toward portfolio margining for securities futures products. The 

Board continues to believe that portfolio margining is both more risk-sensitive and 

more efficient than strategy-based margining. 

Unfortunately, to date no progress has been made toward portfolio margining of 

security futures products. Because the CFMA stipulates that margin requirements 

for security futures products must be consistent with margin requirements on comparable securities options, progress for security futures requires progress on options. 

Although margin requirements for options have for many years been portfolio-based 

at the clearing level, customer margins were until very recently strictly strategybased. However, in July the SEC approved rule changes that create a 2-year pilot 

program that would permit portfolio margining of options and futures positions in 

broad-based stock indexes held by customers with a minimum account equity of $5 

million or more. If this pilot program were adopted as a margining system available 

to all customers for a broader range of products, significant progress toward portfolio margining of securities futures products would become possible. 

The Commodity Exchange Reauthorization Act of 2005, which the Senate Agriculture Committee approved in July, proposes to make progress on portfolio margining (1) by eliminating the need for margins required on security futures to be 

consistent with those required on comparable options and (2) by substituting CFTC 

oversight of security futures margins for joint regulation by the CFTC and the SEC 

under delegation from the Board. This approach would be a marked departure from 

the regulatory regime for security futures that was established by the CFMA. The 

Board believes that it is appropriate for the Congress to spur progress toward portfolio margining for security futures but that this can be accomplished without 

changing so fundamentally the regulatory regime for security futures margins. For 

example, the Congress could spur more rapid progress toward portfolio margining 

71

for both security futures products and options by requiring the commissions to jointly adopt regulations permitting the use of risk-based portfolio margin requirements 

for security futures products within a short but reasonable time period and requiring the SEC to approve risk-based portfolio margin requirements for options within 

the same period. 

Futures on Narrow-Based Securities Indexes 

The CFMA distinguished between futures on broad-based security indexes, which 

are subject to the exclusive jurisdiction of the CFTC, and futures on narrow-based 

securities indexes, which are considered security futures products and, as such, are 

subject to joint CFTC and SEC jurisdiction. Some futures exchanges argue that the 

definition of a narrow-based index in the CFMA was drafted with reference to the 

U.S. equities markets and that, in any event, the definition unnecessarily restricts 

the trading of futures on indexes of U.S. debt obligations and foreign securities. 

The 2005 Reauthorization Act would address those concerns by requiring the 

CFTC and the SEC to jointly promulgate a revised definition of a narrow-based securities index that would better reflect capitalization, trading patterns, and trade 

reporting in the underlying markets. Such a definition would permit futures on indexes of U.S. debt obligations and foreign securities to trade as broad-based indexes 

if the indexes are not readily susceptible to manipulation. 

Although the Board does not have a strong interest in this issue, it favors taking 

another look at the appropriateness of applying the existing definition of a narrowbased index to indexes of foreign securities. First, for many years several futures 

on foreign equity indexes have been trading abroad and have been offered to customers in the United States. Although these indexes would be considered narrowbased indexes under the existing definition, we see no evidence that these indexes 

have been susceptible to manipulation. Second, the provision in the 2005 Reauthorization Act can be seen as simply reiterating an existing requirement in the CFMA 

that the CFTC and the SEC jointly adopt rules that define narrow-based indexes 

based on foreign securities. 

—————

PREPARED STATEMENT OF CHARLES P. CAREY

CHAIRMAN OF THE BOARD, CHICAGO BOARD OF TRADE

SEPTEMBER 8, 2005

Mr. Chairman and Members of the Committee, thank you for the opportunity to 

submit this written testimony on behalf of the Chicago Board of Trade (CBOT) for 

the record and for the consideration of the Committee. The CBOT also thanks and 

congratulates the Congress for the passage in 2000 of the Commodity Futures Modernization Act (CFMA). The CFMA provided for increased competition and legal

certainty in the derivatives industry and reduced many unnecessary regulatory burdens that served only to increase costs for the investing and hedging participants 

in U.S. financial markets. Some of the goals and promises of the CFMA have not 

been fully realized, however. Dual regulation and inefficient margining have contributed to an environment that has inhibited the development of a robust single stock 

futures industry. Regulatory confusion may be keeping other innovations from the 

market. And an unfortunate court decision has been issued which, if not overturned, 

raises the specter of increased fraud. 

Fraud by Unregistered Persons Offering Leveraged Futures ‘‘Look-a-Like’’

Contracts Should be Addressed 

The influential Seventh Circuit Court of Appeals in Chicago has rendered an opinion which essentially does away with previously settled law setting out determining 

characteristics of a futures contract. Commodity Futures Trading Commission v. 

Zelener 373 F.3d. 861 (7th Cir. 2004). This decision provides a road map for unregulated commodity transactions that can be used to defraud those least able to defend 

against it. 

The CFMA excluded from the coverage of the Act certain over-the-counter transactions that involve highly capitalized, sophisticated persons—defined in the CFMA 

as ‘‘eligible contract participants.’’ These persons were deemed by the Congress to 

possess, or at least to be able to obtain, the acumen or expertise to engage in margined or leveraged transactions in commodities without the protection of Commission regulation. Congress continued to believe that persons who did not meet the 

criteria for becoming eligible contract participants still needed the protection of Federal regulation by the Commodity Futures Trading Commission (CFTC) if they dealt 

in commodity futures. 

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1See, Remarks of Stephen M. Cutler, Director, Division of Enforcement, Securities and Exchange Commission, at Washington University School of Law, February 21, 2003, on SEC 

website found at http://www.sec.gov/news/speech/spch022103smc.htm#footnotel5, citing 

Hearing on the Federal Securities Act, 73rd Congress, First Session, A Study of the Economic 

and Legal Aspects of the Proposed Federal Securities Act (submitted for the record by the Department of Commerce) pp. 99, 101. 

When the CFMA was enacted and for 4 years after that, there was relative certainty as to what constituted a futures contract. For 22 years, the decision in CFTC

v. Co Petro Marketing Group, Inc., 680 F.2d 573, 577 (9th Cir.1982) provided the 

means for the Commission, the industry, and the courts to determine whether a financial transaction that could be used for leveraged or margined speculation on the 

prices of commodities was a futures contract. Using a ‘‘totality of the circumstances’’ 

test, the Commission and the courts could effectively deal with persons who offered 

speculative contracts involving commodities without proper registration. 

Registration and the capital requirements found in Commission regulations acted 

to ensure persons who offered futures contracts to the public had a large enough 

financial stake that they would not simply close up shop and disappear with their 

customers’ money. Commission regulation and capital requirements essentially provided a credit and background check on such firms, which individuals and smaller 

entities, that is, persons who are not eligible contract participants, lack the resources or ability to carry out for themselves. 

When fraudulent dealings in commodities came to the attention of the Commission, typically the perpetrator was not a Commission registrant. The CFTC could 

immediately shut the operation down because the unregistered person was not permitted to offer or solicit orders for futures contracts because of the lack of registration. By moving quickly, and without first having to show all the requisites of fraud, 

the CFTC frequently could catch wrongdoers off guard and prevent them from hiding or otherwise further dissipating the assets of those who had been defrauded. 

These Federal protections for persons who are not eligible contract participants, 

along with the ability of the Commission to bring enforcement actions in appropriate 

cases, are no longer available against those who commit fraud using the form contract deemed not to be a futures contract in Zelener. Persons who are not eligible 

contract participants, that is, those who Congress believed in 2000 still needed the 

protection of Federal regulatory jurisdiction, are now protected only by the threat 

of after-the-fact legal actions by local prosecutors under the laws of the individual 

States. 

The fundamental weakness of this approach was clearly demonstrated in the early 

part of the 2000’s and lead to the enactment of the Federal securities laws. In that 

era, persons who defrauded others in connection with the sale of securities were relatively safe from prosecution if they took care to cheat only persons located in another State. Local prosecutors in the State in which the criminal was located may 

have had little incentive to use their resources if the bulk of the victims were in 

other States, having more immediate and pressing needs in other areas; and prosecutors in States where the victims were located did not have jurisdiction over the 

person committing the fraud from another State. The Congress, according to Stephen M. Cutler, a former Director of Enforcement for the Securities and Exchange 

Commission, addressed this problem by making investor protection one of the goals 

of Federal securities legislation in 1933 and 1934. Congress, recognizing ‘‘the ability 

of scammers to ‘take advantage of State boundaries,’ ’’ saw fit to establish the Securities and Exchange Commission as a Federal presence to deal with the interstate 

nature of securities fraud.1

To further quote Mr. Cutler, but in the similar context of commodity fraud, ‘‘these 

concerns have a surprisingly contemporary sound to them.’’ Current day wrongdoers 

use telephone, internet, and television appeals to showcase their fraudulent 

‘‘pitches’’ involving heating oil, gold, and other commodities. The National Futures 

Association and the Commodity Futures Trading Commission try to monitor these 

websites and infomercials, but the advent of the Zelener opinion may leave them impotent in the face of flagrant fraud. 

The Zelener case is not about only foreign exchange products. The contract the 

Zelener Court found to be outside the jurisdiction of the CFTC may just as easily 

be utilized by scammers to induce the unsuspecting to invest in other commodities. 

Unless checked by an amendment to the CEA overturning the Zelener opinion, such 

fraudulent operators could cause a scandal similar to those involving options on 

sugar and other commodities in the mid-1970’s. Such a scandal could, as then, reflect adversely on the legitimate financial services and derivatives industry here in 

the United States. 

73

The Chicago Board of Trade hopes that Congress will enact an amendment giving 

the CFTC the power to shut these fraudulent operators down by showing that they 

are dealing in futures contracts without the required registration, before this activity results in the loss of hard-earned savings of citizens. We favor an amendment 

that would cover all margined or leveraged speculative commodities transactions entered into with persons who are not eligible contract participants. Merely providing 

enhanced antifraud authority that can be used only after a fraud has been foisted 

on the public is insufficient to effectively address the problem. 

Some have questioned whether anything at all should be done, raising the possibility that someone’s legitimate business may be somehow affected. A properly 

drawn amendment that restricts only those who deal with persons who are not eligible contract participants, along with the forward exclusion, the Treasury Amendment and the other provisions enacted as part of the CFMA, should not adversely 

impact the operations of any legitimate person or firm. Indeed, the industry carried 

out its business for years when the Co Petro standard was in place, including the 

4 years between the passage of the CFMA and the issuance of the Zelener opinion, 

and a return to the regulatory landscape of that period should not further restrict 

any legitimate firm. To the extent, however, that persons may believe that proposed 

language may infringe on their legitimate operations, we would hope that they 

would provide specific examples so that language can be crafted to alleviate those 

concerns while giving the CFTC the necessary tools to protect the investing public. 

Dual Regulation Poses Barriers to Innovation 

The CFMA provided much-needed regulatory relief to entities regulated by the 

CFTC and granted the Commission flexibility to deal with new ideas and technological advances, while at the same time retaining concepts of customer protection 

that are essential to our industry. In addition, the CFMA brought legal certainty 

to many products either by removing them from Commission jurisdiction or by establishing standards and procedures by which products can be and remain exempt 

from further CFTC regulation. The CFMA also allowed for the trading of security 

futures products for the first time. This legislation and its implementation by the 

Commission have seen many successes. While the financial services industry has 

benefited greatly from the reforms of the CFMA, the goal of the Congress of reducing regulatory barriers to innovation has not been achieved in at least two areas, 

however. 

First, the CBOT asks that the Congress consider clarifying that the definition of 

narrow-based security indexes does not include indexes on fixed income securities, 

corporate bonds, and other nonequity securities. The present definition creates a series of tests to distinguish narrow-based indexes from broad-based indexes. Unfortunately, these tests are only workable for indexes on U.S. equity securities, and index 

products based on nonequity securities do not implicate the same issues. However, 

the possibility that the definition could be interpreted to cover nonequity products 

has hampered development of such products due to confusion as to what regulations 

may or may not apply. 

To illustrate this point, the CBOT, and I am sure a number of other exchanges, 

have considered offering futures based on corporate bond indexes. While we do not 

believe such indexes were intended to be captured by the definition of narrow-based 

security indexes, current law is not clear on that point. Many such indexes, if the 

tests designed to distinguish broad- from narrow-based indexes were applied, would 

fall into the narrow-based index category. As such, futures on these indexes could 

then be assumed to be regulated as stock futures products, jointly by the CFTC and 

SEC. Given that corporate bonds are not subject to the same regulatory regime as 

equity securities, the underlying reason for applying these tests to equity security 

indexes does not exist for corporate bond indexes. We believe that futures contracts 

on these types of indexes—whether indexes of corporate bonds, municipal bonds, or 

other securities—should be regulated by the CFTC just as all other nonequity security futures and broad-based security index futures are regulated. Clarification of 

the definition is an important issue that deserves to be addressed at this time. 

Another issue the CBOT hopes Congress will consider is the margining regime for 

stock futures products. The CFMA constituted both the Securities and Exchange 

Commission and the CFTC as regulators of stock futures products. This dual regulation of stock futures products has been challenging to date and the growth of single 

stock futures in the United States has been anemic, at best. The inability, at least 

to this point, of the SEC and the CFTC to afford rational regulatory treatment of 

margining for these products continues to stymie further development of stock futures and other needed products. 

Historically, the power to set margins for futures products was reserved to the 

exchanges. Congress recognized that futures margins were performance bonds, postVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00077 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
74

ed by both buyers and sellers of commodities for future delivery, to ensure the performance of obligations under the contract, especially if the price moved adversely 

to one’s position. Because futures contracts were not assets, such as stocks, and because margins were not a credit function in the acquisition of an asset, exchanges 

typically set margin at levels designed to cover the risk of several days’ price movement on a historical basis. The levels of margin, set as a dollar amount per contract 

rather than as a percentage of the price of the underlying product, could quickly 

be changed in the event of higher volatility in prices, in other words, increased risk. 

With the advent of more powerful data processing and sophisticated financial valuation models and techniques, this risk-based margining today can be applied more 

precisely to futures positions and even to whole portfolios, measuring the risk inherent in individual positions as affected by other positions within the same portfolio. 

Using risk-based margining across whole portfolios has provided participants in the 

financial markets with greater flexibility and efficiencies, while at the same time 

affording greater stability to the markets themselves. 

The CBOT hopes Congress will facilitate the margining of stock futures as futures 

contracts, recognizing that the economic function of a futures contract is not to acquire ownership of the stock, but rather is to act as a hedging vehicle. 

The Chicago Board of Trade, the oldest and one of the largest futures exchanges 

in the world, vigorously competes in the international marketplace. We ask the Congress, and this Committee, to remain cognizant of the continued need to reduce unnecessary regulatory complexities that tend to inhibit the ability of U.S. exchanges 

to compete effectively with their counterparts around the world. We also ask the 

Congress to give the CFTC the tools necessary to prevent peripheral scandals that 

have the potential of tarnishing the U.S. derivatives industry. 

Once again, the CBOT thanks the Committee for this opportunity. If the Committee or Members have questions, the CBOT will be happy to provide answers and 

additional information. 

—————

PREPARED STATEMENT OF JOHN M. DAMGARD

PRESIDENT, FUTURES INDUSTRY ASSOCIATION

SEPTEMBER 8, 2005

Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, I am 

John Damgard, President of the Futures Industry Association (FIA). On behalf of 

FIA, I want to thank you for the opportunity to appear before you today. FIA is a 

principal spokesman for the commodity futures and options industry. Our regular 

membership is comprised of approximately 40 of the largest futures brokerage firms, 

known as futures commission merchants (FCM’s), in the United States. Among its 

associate members are representatives from virtually all other segments of the futures industry, both national and international. FIA estimates that its member 

firms serve as brokers for more than 90 percent of all customer transactions executed on United States futures exchanges. 

In the last Reauthorization of the Commodity Futures Trading Commission 

(CFTC), this Committee played an important role in forging the landmark legislation known as the Commodity Futures Modernization Act of 2000 (CFMA). With the 

goal of promoting ‘‘responsible innovation and fair competition among boards of 

trade, other markets and market participants,’’ the CFMA amended the Commodity 

Exchange Act (CEA) to:

• Assure legal certainty for over-the-counter derivatives; 

• Remove the 20-year (supposedly temporary) prohibition on futures on individual 

securities and narrow-based securities index contracts through the joint regulation of these products by the CFTC and the Securities and Exchange Commission 

(SEC); and 

• Provide a more flexible regulatory system for futures and options.

In any legislation of hundreds of pages, some provisions do not work out as expected. The CFMA is no exception. In a handful of areas, the provisions of the 

CFMA could use some improvement. FIA looks forward to working with this Committee again on that effort. 

On the overriding issue of the CFTC’s Reauthorization, FIA’s position is unequivocal. FIA believes the CFTC is an excellent agency that discharges its statutory obligations efficiently and effectively. We look forward to a continuation of this tradition 

of excellence under the CFTC’s new Chairman, Reuben Jeffrey. The CFTC deserves 

to be reauthorized. 

75

1Section 1a(12) of the CEA defines ‘‘eligible contract participant’’ to mean an individual with more than $10 million in total assets or $5 million if the individual retains a professional price 

risk manager. 2 CFTC v. Zelener, 373 F.2d 861 (7th Cir. 2004). 3 In 1982, Congress amended the definition of a commodity trading adviser. Prior to the 1982 

Act, a commodity trading advisor was broadly defined to include any person who was engaged 

in the business of providing advice ‘‘as to the value of commodities,’’ including cash and forward 

market transactions. As amended in 1982 Act, a commodity trading adviser is now defined as 

Continued

FIA believes there are four primary areas that should be addressed in order to 

fulfill the promise of the CFMA: Off-exchange retail foreign currency (FX) transactions; security futures; SRO transparency and governance; and competition. Retail 

FX transactions have been the main focus of attention in the President’s Working 

Group in recent weeks and the CFTC Reauthorization bill reported by the Senate 

Agriculture Committee, S. 1566, contains specific proposals for dealing with retail 

FX transactions. Most of my remarks will therefore focus on that issue, followed by 

a general summary of FIA’s positions in the other areas. 

Retail FX Transactions 

As the Committee will recall, in 1997 the U.S. Supreme Court dismissed a CFTC 

fraud prosecution, ruling that the CEA’s Treasury Amendment enacted in 1974 provided a ‘‘complete exclusion’’ from the CEA for any off-exchange FX transactions, including FX futures and options transactions with retail customers. Dunn v. CFTC,

519 U.S. 465, 476 (1997). Three years later, Congress reconsidered the Treasury 

Amendment and made certain modest modifications. The CFMA reaffirmed that the 

CEA does not apply generally to any FX futures or options transactions, with three 

exceptions: (1) futures contracts traded on an organized exchange; (2) currency options not traded on a securities exchange; and (3) some FX futures that are offered 

to retail customers, what the statute calls ‘‘noneligible contract participants.’’ 1

This last category—retail FX transactions—has been the focal point of most of the 

debate in this CFTC Reauthorization. Current law grants the CFTC full jurisdiction 

over retail FX futures unless the retail customer’s counterparty qualifies in one of 

six different categories: banks, broker-dealers, FCM’s, affiliates of broker-dealers or 

FCM’s, insurance companies, financial holding companies, or investment bank holding companies. Retail FX futures entered into with five of these six categories of 

qualifying entities—including banks, broker-dealers, and their affiliates—continue 

to enjoy a complete exclusion from the CEA. The only exception is for retail FX futures where a registered FCM or its affiliate is the counterparty; then the transactions are subject to the CFTC’s powers to enforce the antifraud and 

antimanipulation prohibitions of the CEA. 

In recent years, some unsavory, sharp operators have been registering shell companies as FCM’s, avoiding any real exchange-traded futures business, creating affiliates to enter into retail FX transactions with consumers and engaging in or promoting fraudulent sales practices in connection with retail FX futures contracts. The 

CFTC has brought many cases to shut down these schemes. Still more firms are 

engaging in this form of sales fraud. 

The CFTC’s enforcement efforts in this area have been substantial. The CFTC has 

won many cases and put many firms out of business. However, last year the CFTC 

did lose one of these cases when it failed to prove that the firm involved was selling 

a futures contract. This is the Zelener case.2

Zelener and the retail FX fraud problem have raised a series of issues that many 

believe should be addressed in this CFTC Reauthorization. Let me summarize those 

issues and FIA’s positions. 

Broad Fix (All Commodities) or Narrow Fix (FX only)? 

Some believe that the Zelener decision, even though it arose in the context of a 

single retail FX fraud case, could lead to broader enforcement issues for the CFTC 

in areas beyond FX. They would argue that the Zelener decision shrank the legal 

definition of a futures contract and thereby shrank the CFTC’s enforcement jurisdiction generally, allowing con artists in the agricultural, energy, or precious metals 

area to defraud customers and avoid CFTC policing by proving that their offerings 

were not futures contracts under the Zelener precedent. 

FIA disagrees with those who seek a broad fix. Since 1922, the CFTC’s jurisdiction has been limited wisely to futures and options contracts. In fact, Congress as 

recently as 1982 pruned back CFTC jurisdiction to avoid any possibility that it could 

spill over into commodity cash or forward markets that operate throughout our 

country, and are subject to the jurisdiction of other agencies, including law enforcement at the Federal, State, and local levels.3 Expanding the CFTC’s jurisdiction to 

76

any person providing advice ‘‘as to the value of or advisability of trading in any contract for 

futures delivery made on or subject to the rules of any contract market, any commodity option 

authorized under section 4c, or any leverage contract authorized under Section 19 of this Act.’’ 

That is, a person is required to be registered as a commodity trading advisor only if that person 

is providing advice with respect to transactions that fall within the Commission’s exclusive jurisdiction. 4FIA is concerned that granting the CFTC general nonfutures authority also will lead to considerable legal confusion. One part of the CFTC’s proposal states, for example, that the CEA 

antifraud provisions apply to retail FX futures offered by certain FCM’s and their affiliates, but 

not FCM’s that also operate as broker-dealers. Another part of the CFTC’s proposal would apply 

those same antifraud provisions to any retail FX transaction even if not futures and even if offered by FCM’s that are also broker-dealers. This inconsistency illustrates the difficulty of trying 

to superimpose nonfutures onto the futures regulatory provisions. 

apply to any form of nonfutures contracts would have profound and, FIA believes, 

adverse implications for the CFTC’s ability to discharge its oversight of futures and 

options exchange-trading, especially given the agency’s structure and limited resources. Congress granted the CFTC exclusive jurisdiction over the futures and

related options markets in order to make certain the CFTC would concentrate its 

efforts on those vital areas of our economy. Nothing should distract the CFTC from 

its core mission. 

Overreacting to Zelener would also be particularly inappropriate since the Zelener

court just applied the evidence before it to the traditional legal guidelines for determining whether a transaction is a futures contract, focusing on whether the parties 

had the right to and contemplated offset of the transaction, and therefore mimicked 

the offset properties of exchange-traded futures. The CFTC’s inability to prove its 

case to one court is no reason to transform the agency into a national police force 

for consumer fraud committed in any transaction with a commodity theme. In this 

regard, FIA is pleased that the CFTC’s legislative package and S. 1566 as reported 

by the Senate Committee on Agriculture (even if adopted only as a ‘‘placeholder’’) 

do not support the broader ‘‘all commodity’’ fix. 

That does not mean FIA supports a ‘‘do nothing’’ approach to the retail FX issues. 

Far from it. Certain adjustments to the CFMA’s provisions would help the CFTC 

combat the fraud and abuse we have seen in retail FX transactions in recent years. 

The CFTC claims it would be easier for it to curb that activity if it did not have 

to prove that the perpetrators of fraud were offering a futures contract. Yet granting 

the CFTC powers over nonfutures transactions has historically had troubling implications. Those two differing views frame the next issue being debated. 

CFTC’s Non-Futures FX Jurisdiction: General or Antifraud Only? 

Both the CFTC and the Senate Agricultural Committee have proposed granting 

the CFTC new general jurisdiction over retail FX nonfutures transactions. Their 

proposal would empower the CFTC to develop any regulations it sees fit for retail 

FX transactions that are leveraged, margined, or financed and not for commercial 

use or where the customer takes immediate ownership and possession of the currency involved. It is not clear why the CFTC needs such sweeping regulatory power 

over these transactions or what kind of regulatory structure the CFTC would set 

up for these transactions. But it would be expected that the CFTC would adopt an 

array of regulations for it to enforce or may even ban these products outright.4

Expanding the CFTC’s general regulatory jurisdiction to nonfutures would not 

only drain the agency’s limited resources, but would lead to unwarranted legal uncertainty of the kind the CFMA stamped out in 2000. Both the CFTC’s proposal and 

S. 1566 introduce jurisdictional concepts that will not promote legal certainty. Statutory trip-wires like ‘‘financed on a similar basis’’ or ‘‘immediate ownership and possession’’ leave room for reasonable differences of interpretation that could lead 

unsuspecting and legitimate enterprises to run afoul of CFTC regulation. Moreover, 

the emphasis on ownership or possession of FX suggests that CFTC jurisdiction 

might turn on some of the same definitional dividing lines that have bedeviled 

courts and even the agency itself for many years in the area of distinguishing futures from forward contracts. Compounding the unintended collateral implications 

of these ambiguities is that the CFTC-S. 1566 proposal apparently would allow the 

CFTC to render ‘‘per se’’ illegal FX-related financing activities of legitimate financial 

institutions or others. 

For many months, FIA has proposed a different approach. We believe the CFTC’s 

enforcement arsenal should be enhanced so that the agency could pursue retail FX 

fraud cases against bucket shops and boiler rooms without having to prove that the 

applicable FX transaction was a futures contract. This proposal would be a targeted 

response to the real problem—retail FX sales abuses—without expanding the 

CFTC’s general regulatory jurisdiction and mission beyond futures. Removing the 

77

5 Under our proposal, the CFTC would retain its existing authority to pursue antifraud and 

antimanipulation actions against FCM’s and their affiliates (unless the FCM is also a brokerdealer or other qualifying entity) in connection with retail FX futures were the FCM or affiliate 

is a counterparty. 

shield of the ‘‘futures contract defense’’ from those who prey on unsuspecting FX 

customers should make the CFTC’s already impressive enforcement track record in 

this area, even more impressive. And by focusing the CFTC’s resources on bringing 

fraud cases for retail FX, rather than adopting regulations, the retail public can expect better protection and better sales practices. 

FIA recognizes that allowing the CFTC to pursue nonfutures, off-exchange fraud 

cases would be a significant departure from the CEA’s regulatory scheme. We know 

that many have criticized us for not simply taking the position that sales fraud in 

connection with transactions that are not futures contracts should be of no more 

concern to the CFTC than sales fraud in connection with nonsecurities transactions 

is to the SEC. But, in our view, the CEA recognized that FX was a special commodity which Congress had treated with special provisions for many years. Moreover, the special nonfutures retail FX antifraud provision would not apply to any 

transactions where the counterparty was one of the six types of qualifying entities 

Congress recognized in 2000.5 Thus, granting the CFTC special, limited, and targeted nonfutures antifraud authority over certain retail FX transactions that operate outside existing regulatory systems seemed like an appropriate compromise. 

FIA also believes that certain important enhancements should be enacted for the 

retail FX futures transactions Congress permitted in the CFMA. Experience has 

shown that some of the CFMA’s provisions in this area need tightening. A discussion of these issues follows. 

Should Solicitors of Retail FX Futures be CFTC-Registered? 

The CFMA has been interpreted by the CFTC to preclude the registration of 

many of those who solicit retail FX futures contracts. Since the problem with retail 

FX transactions has been sales fraud, it makes sense to ensure that any person who 

solicits retail customer business meet traditional CFTC fitness standards. 

FIA proposes that any person who participates in the solicitation or recommendation of any retail FX futures contract where an FCM or its affiliate is the 

counterparty must be both CFTC registered and a member of National Futures Association. That would mean that any employee of an FCM or its affiliate that solicits 

retail FX futures business must be CFTC-registered. It also means that independent 

firms that introduce retail FX futures customers to FCM’s or their affiliates must 

be CFTC-registered. The only exceptions from this requirement would be for the 

other qualifying entities (including broker-dealers as well as broker-dealers that are 

also FCM’s) and those who are already subject to Federal regulatory supervision 

(like investment advisers). In addition, any person soliciting a customer to buy a retail FX futures contract where the counterparty is not a qualifying entity (including 

where the counterparty is not an FCM or affiliate meeting the conditions set forth 

below) would be engaging in the illegal offer of an off-exchange futures contract 

under the CEA. That person would be subject to the full enforcement authority of 

the CFTC. 

Right now, no member of the public can find out who is eligible to solicit retail 

FX futures business. As a result of this reform, both the CFTC and NFA would have 

a list of those firms and individuals that are qualified to sell retail FX futures under 

CFTC jurisdiction. Either the CFTC or NFA, or both, may make this list available 

to the public through their websites or public information efforts. This proposal 

therefore would provide greater transparency to the investing public. 

Should Shell FCM’s Be Qualifying Entities? 

No. The CFMA has been interpreted by the CFTC to allow firms to register as 

FCM’s even if the firm does not intend to engage in the business of being an FCM, 

brokering or clearing exchange-traded futures contracts for others. Those firms (or 

their affiliates) can then become the counterparties to retail FX futures contracts 

and enjoy the benefits of an exemption that Congress wrote for FCM’s that would 

be engaged in the exchange-traded futures business. 

FIA believes that when Congress granted this exemption for registered FCM’s, 

Congress intended those FCM’s would be real futures brokers, not shells. To achieve 

that objective, FIA has proposed that any FCM qualifying for the exemption to serve 

as a counterparty for retail FX futures must be ‘‘substantially and primarily’’ engaged in the exchange-traded futures business. The CFTC will have discretion to 

define ‘‘substantially and primarily’’ in this context. Through this requirement, the 

78

6 Current law contains a perverse anomaly that this proposal will cure. Under current law, 

the affiliate of a modestly capitalized FCM would qualify as a MAP and be eligible as a qualifying entity. The affiliate of a substantially capitalized FCM might not qualify as a MAP since 

its operations would not be material to the overall financial picture of the FCM. In FIA’s view, 

if the FCM undertakes in writing to the CFTC that its affiliate will comply with all MAP requirements even if the affiliate is not technically a MAP, that affiliate should be considered to 

be a qualifying entity so long as the FCM has at least $20 million in net capital. 

shell FCM loophole should be ended. S. 1566 does not contain a similar limitation 

on registered FCM’s acting as counterparties for retail FX transactions. 

This new ‘‘substantially and primarily’’ requirement also should contribute materially to reducing many of the sales practice abuses experienced in recent years. 

Substantial FCM’s who deal with the retail public everyday will not want to see 

their reputations tarnished by sales practice abuses committed in connection with 

retail FX futures to which those FCM’s (or their affiliates) are the counterparties. 

Should FCM Affiliates Be Allowed to Continue to be Qualifying Entities? 

Yes. The CFMA treats affiliates of broker-dealers and FCM’s equally. Both are allowed to serve as qualifying entities that may be counterparties to retail FX futures 

under Section 2(c)(2)(B) of the CEA. FIA understands that the CFTC may now be 

proposing to allow broker-dealer affiliates to continue to act as counterparties to retail FX transactions but would bar FCM affiliates from continuing to do so. FIA believes both broker-dealer affiliates and FCM affiliates should continue to be able to 

serve as qualifying entities under Section 2(c)(2)(B) of the CEA. No basis exists to 

treat affiliates of broker-dealers more favorably in this regard than the affiliates of 

FCM’s, especially once the shell FCM loophole is plugged as we have recommended. 

FIA also believes the FCM affiliate provisions in Section 2(c)(2)(B) should be improved in two important respects. First, FIA recommends that only affiliates of 

FCM’s with at least $20 million in net capital (or higher if the CFTC believes it 

to be appropriate) should be eligible to be qualifying entities. This will ensure as 

a practical matter that if an affiliate of an FCM faces financial difficulty in performing its counterparty role, its FCM will have the capacity to step in and cover 

those obligations in order to avoid the harm to its reputation from a default. Second, 

FIA recommends that in order for any FCM affiliate to qualify under Section 

2(c)(2)(B), the FCM must undertake to comply with the CFTC regulatory requirements (recordkeeping and reporting) for material associated persons or the affiliate 

must be a material associated person (MAP) of the FCM. By this requirement, the 

CFTC will retain an important measure of oversight for the FCM affiliate serving 

as the counterparty to the retail FX transaction.6

In 2000, the CFMA authorized FCM affiliates to qualify as counterparties for retail FX transactions. Based on that authorization, some affiliates have engaged in 

this business without customer complaints for years. Congress should not over-react 

to the sales problems others have caused by insisting now that those affiliates must 

cease operations. 

Should the CEA Prohibit Principal to Principal Fraud? 

Section 2(c)(2(C) of the CEA makes the general antifraud provision in Section 4b 

applicable to all retail FX futures where an FCM (that is not also a broker-dealer) 

or its affiliate is the counterparty. Section 4b, however, was enacted in 1936 in the 

context of FCM’s acting as brokers for customers on futures exchanges and prohibited defrauding any one the FCM was acting ‘‘for or on behalf of’’ as an agent. Section 4b did not, however, cover fraud in connection with transactions where the 

FCM or its affiliate would act as a principal or counterparty to the transaction. 

Since the retail FX futures transactions authorized by the CFMA contemplate that 

FCM’s would act as principals to those transactions, questions were raised whether 

the CFTC’s antifraud jurisdiction actually applied to those retail FX futures. 

Section 2 of S. 1566 contains an amendment to Section 4b of the CEA that would 

extend that antifraud prohibition to principal to principal fraud. FIA supports this 

amendment. It would strengthen the CFTC’s enforcement efforts in the retail FX 

futures area by removing another possible defense to a CFTC fraud prosecution. 

FIA understands that the President’s Working Group has focused its deliberations 

on the retail FX issue and we have accordingly focused our testimony on those 

issues. In summary, FIA sees no need for either a broad, all-commodity response 

to Zelener or to grant the CFTC general jurisdiction over retail FX nonfutures. Instead, FIA recommends Congress amend the CFMA in the retail FX futures area 

by (1) prohibiting shell FCM’s; (2) registering soliciting retail FX futures firms and 

individuals; (3) imposing at least a $20 million net capital requirement on FCM’s 

whose affiliates are acting as permissible counterparties; (4) requiring any qualifying affiliates to comply with CFTC MAP regulation; and (5) expanding the CEA 

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7The goal of legal certainty is also threatened by Committee Reports that attempt to create 

legislative history for statutory provisions that do not exist. For example, the Report of the Senate Committee on Agriculture claims to make certain amendments to Section 2(c)(2)(C) of the 

CEA that are mere clarifications of existing law. S. Rep. No. 109–19, 109th Cong. 1st Sess. 8 

(2005). But those ‘‘clarifications’’ create significant new legal obligations and causes of action not 

contained in the CFMA and not discussed in any Committee hearings or deliberations. In addition, the Committee Report attempts to graft onto provisions that confirm the CFTC’s ability 

to pursue civil enforcement actions for violations of the criminal provisions of the CEA limitations in the CFMA’s exclusions and exemptions that contradict the actual language Congress 

enacted to achieve the goal of legal certainty. Id. at 6. Any expansions or contractions of the 

CFTC’s jurisdiction in this important area should come from provisions Congress actually enacts. 

to cover principal to principal fraud. In addition, FIA continues to propose that Congress grant the CFTC special new enforcement powers to pursue fraud actions in 

connection with narrowly defined retail FX transactions even if not futures contracts. These changes will respond to the customer protection challenges of recent 

years without compromising the CFTC’s overall mission or the CFMA’s goal of legal 

certainty.7

Security Futures Products 

Since the enactment of the CFMA, FIA has worked diligently with the CFTC, the 

SEC and the exchange community to implement both the spirit and the letter of 

the provisions authorizing trading in security futures products. Although volume on 

these markets has not been as robust as we would like, we continue to believe that 

this is an important product that will grow over time. Last year, the only U.S. market for security futures—OneChicago—increased its annual trading volume by 19 

percent from 1.6 million contracts in 2003 to 1.9 million in 2004. 

In contrast, security futures are more popular in other countries. As the following 

chart shows, at the London based Euronext.Liffe exchange, 2004 single stock futures 

volume was up 114 percent over 2003 volume, with a total of 13.5 million contracts 

traded. And at Italy’s Borsa Italiana, single stock futures volume rose more than 

250 percent last year as it traded over 1.7 million contracts. At the Stock Exchange 

of India, 2004 single stock futures volume was up 72 percent to 44 million contracts. 

And finally, even at Spain’s MEFF exchange, where single stock futures volume was 

basically flat, they were still able to trade 12.1 million contracts. As you can see, 

it is clear that at this time the security futures industry in the United States has 

not caught up with our competitors on foreign exchanges.

FIA supports action in three areas relating to security futures. In each area, legislation would not be needed if the CFTC and SEC adopted administrative solutions 

as contemplated by the CFMA. But that has not happened. Reluctantly, FIA believes Congress should take some action to make certain that the agencies address 

these three areas. 

First, U.S. futures exchange representatives believe that U.S. security futures 

markets would grow if their portfolio margining systems for futures generally were 

made available to security futures trading. The U.S. futures exchanges and clearing 

firms are deservedly proud of their portfolio margining systems. These systems provide financial integrity for the futures markets while allowing for more efficient use 

of capital by traders and clearing firms. The CFTC and the SEC are empowered to 

allow portfolio margining systems to apply to U.S. security futures markets. Since 

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urge the agencies to allow existing futures clearing portfolio margining systems to 

be applied to security futures products as soon as practicable. 

FIA understands that the options and cash markets in securities also would like 

to have the SEC approve futures-style portfolio margining for their market users. 

FIA supports these efforts as well, provided that nothing tips the competitive scales 

in favor of broker-dealers at the expense of FCM’s. Perhaps the fledgling security 

futures markets can offer a pilot program for this concept while the SEC considers 

adapting that system to the options and cash markets. Or the new leadership at 

the SEC and the CFTC can agree to a reasonable and mutually acceptable timetable 

for implementing portfolio margining. This is not a matter of seeking competitive 

advantage for security futures; it is a matter of competitive viability for security futures in the United States. 

Second, provisions of the CFMA combined with regulatory intransigence are creating a significant competitive disadvantage for U.S. investors and U.S. firms. The 

problem stems from the definition of a ‘‘narrow-based’’ securities index in the 

CFMA, its application to indexes on securities other than U.S. equity securities, and 

the regulatory consequences for futures trading on any index that falls within the 

‘‘narrow-based’’ definition. 

Prior to the CFMA, in fact since 1981, futures contracts had been trading on stock 

indexes which were generally considered to be broad-based. Those stock index

futures were traded subject to the CFTC’s exclusive jurisdiction. An index was considered to be broad-based if the index could not be used as a surrogate for an individual stock or a small group of stocks or to manipulate the underlying cash market 

price. Otherwise, the CFTC and the SEC were concerned that insider trading in the 

stock could take place outside the SEC’s purview through trading in the stock index 

futures contract. 

In deciding to lift the ban on single stock futures in the CFMA, Congress chose 

to set up a special regulatory regime for those new futures products subject to 

shared CFTC and SEC regulatory authority. At the same time, Congress decided 

that some existing stock indexes, and surely those to be developed, could not be considered to be broad-based, but could become the subject of futures trading under the 

same rules as single stock futures. Congress decided therefore to treat and regulate 

both single stock futures and ‘‘narrow-based’’ stock index futures as ‘‘security futures products’’ subject to CFTC and SEC jurisdiction. 

For a stock index, therefore, the issue whether it is ‘‘narrow-based’’ or ‘‘broadbased’’ has important regulatory consequences under the CFMA. Broad-based indexes (those are that not narrow-based) may be traded under the traditional rules 

for futures trading subject to CFTC jurisdiction. Narrow-based indexes may be traded only as security futures subject to the special rules set out in the CFMA. And, 

as discussed more fully below, U.S. investors are banned from trading foreign security futures products, including foreign futures on narrow-based indexes. 

In the CFMA, Congress defined through numerical criteria what indexes would 

be considered to be ‘‘narrow-based’’—at least 9 securities, no single security more 

than 30 percent of the index value, no five securities more than 60 percent of the 

index value, and aggregate capitalization amounts for the lowest quartile of the 

index. These criteria were authored jointly by the CFTC and SEC. While those criteria were adopted with U.S. equity markets in mind, the CFMA literally applies 

those criteria to any ‘‘security’’ market—debt or equity, foreign or domestic. For that 

reason, the CFMA grants the CFTC and SEC joint power to adopt criteria for defining ‘‘narrow based’’ indexes for these other security markets. To date, that has not 

happened. 

Instead, we understand that the SEC has taken the view that the CFMA’s narrow-based criteria apply to all equity markets, not just those in the United States. 

That position leads to some unintended and unfathomable results. For example, one 

foreign stock index comprised of 229 stocks traded in Switzerland is considered 

‘‘narrow-based’’ because it would not meet the criterion that no five stocks may comprise 60 percent of the value of the index. Indexes developed to reflect the value 

of equity markets in many other countries, including Japan, Greece, Australia, Portugal, Russia, Belgium, Denmark, and Norway also do not meet the rigid CFMA 

narrow-based index criteria. 

As a result, no U.S. firm may offer, and no U.S. investors may buy or sell, foreign 

futures on these indexes since they are foreign security futures products (foreign futures contracts on a narrow-based index). This is the case even though in foreign 

jurisdictions trading in these stock index futures is treated like any other futures 

contract. 

FIA understands the agencies’ rationale for the CFMA’s ‘‘narrow-based’’ criteria 

as applied to U.S. equity markets. But misapplying those criteria to foreign equity 

markets has disadvantaged U.S. investors and U.S. FCM’s in a profoundly antiVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00084 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
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competitive manner. Congress should provide the agencies with direct guidance on 

this issue and make certain that the ‘‘narrow-based’’ criteria no longer operate as 

a competitive barrier for U.S. exchanges, firms, and investors. 

Third, as mentioned above, U.S. institutional investors are being discriminated 

against today because they are barred from trading futures on individual securities 

and narrow-based security index futures contracts on a non-U.S. exchange. These 

instruments could be of significant value to customers for various purposes, including risk management and asset allocation. The best way to understand the issue 

is this. FIA has been told by investment managers of the pension funds for U.S. 

Government employees that the rate of return earned on the U.S. employees’ funds 

is often not as high as the rate of return earned on the pension funds of foreign 

government employees. The reason is that the investment manager may not use foreign security futures products to manage the U.S. employees’ funds, but may use 

those risk management tools for foreign government employees. 

In the CFMA, Congress instructed the SEC and the CFTC ‘‘to the extent necessary and appropriate in the public interest, to promote fair competition, and consistent with promotion of market efficiency, innovation, and expansion of investment 

opportunities’’ to ‘‘issue such rules regulations or orders as may be appropriate to 

permit the offer and sale of a security futures product traded on or subject to the 

rules of a foreign board of trade to United States persons.’’ Consistent with this explicit Congressional direction, FIA had been assured that necessary rules or orders 

permitting the offer and sale of foreign security futures products to U.S. persons 

would be adopted contemporaneously with the rules authorizing security futures 

products on U.S. exchanges. However, the CFTC and SEC did not promulgate such 

rules. 

The investment objectives of pension plans, investment companies, endowments, 

hedge funds, and other large money managers that FIA members serve have been 

restricted by the agencies’ failure to act. Those institutional customers are free to 

engage in transactions in the international securities markets with few regulatory 

limitations. These institutions also are authorized to enter into principal-to-principal 

derivatives transactions that replicate foreign security index contracts, but may be 

more difficult, and substantially more expensive, to effect than exchange-traded instruments. In these circumstances, no U.S. regulatory purpose is served by preventing U.S. institutional customers, in particular, from using foreign futures on 

narrow-based indexes or single securities, provided that a U.S. stock exchange is not 

the primary market for the securities underlying such security futures products. 

Unfortunately, S. 1566 does not address this issue. We request that this Committee work with your counterparts on the Agriculture Committee and the new 

leaders at the CFTC and SEC to determine when action in this area may be forthcoming and to codify that timetable in legislation. If the agencies believe that they 

need additional statutory authority, they should so advise Congress so that appropriate amendments can be enacted this year. 

SRO Governance 

Like the SEC and the securities markets, SRO governance has been an issue 

under review at the CFTC for some time. In this regard, FIA supports the important role that the exchanges, clearing organizations and National Futures Association perform as self-regulatory organizations (SRO’s). Given their strong market 

knowledge and close proximity to the trading markets, they provide the best vantage point for addressing many of the futures markets’ oversight functions. However, to be fully effective, there must be an increased degree of public confidence 

in the integrity and objectivity of SRO’s. 

The Commission, the SRO’s, and the derivatives industry generally must act to 

remove the real and perceived conflicts of interest and potential for anticompetitive 

conduct that are inherent in any self-regulatory structure, particularly when the exchange is operated on a for-profit basis and has issued stock to the public. Specific 

modifications to the SRO structure should increase its overall efficiency and effectiveness. For example, FIA believes that establishing a meaningful number of truly 

independent directors on SRO Boards is one of the most important reforms that 

could be considered. The FIA has filed extensive comments with the CFTC in this 

area containing many recommendations. We would be pleased to provide our comments to this Committee at your request. 

A good illustration of our concern is the recently adopted U.S. Treasury futures 

position limits imposed by the Chicago Board of Trade (CBOT). The CBOT imposed 

these limits through a new procedure made available under the CFMA. It allows 

futures exchanges to self-certify that their rule changes are in compliance with the 

CEA and then place the rules into effect without obtaining CFTC approval. On 

many noncontroversial rule changes this kind of administrative efficiency may make 

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8This system also would encourage customers to enter into original positions on a challenger 

exchange when that exchange offers the customer the better price. The customer then could offset that same position on the dominant exchange. 

sense. In this case, however, the CBOT’s rule changes had an impact on trading in 

futures contracts with open positions and may have caused some to enjoy trading 

gains and some to suffer trading losses. Many market participants have raised serious questions about the (unstated) purpose of the CBOT’s rule change and the ability of the CBOT to enforce its rule as written. Weeks after the CBOT’s actions had 

been implemented, the CBOT offered only a partial explanation for why it took the 

action it did and how it intended to enforce its rule change. 

Whether the CBOT’s actions were wise or precipitous is not the main issue for 

FIA. We believe the fairness and transparency of the exchange rule change and approval process is the issue. We fear some market participants lost confidence in the 

CBOT by virtue of its decisions both to change the rules of the game during the 

game and to offer no reason for doing so. FIA does not believe that any contract 

market should self-certify rules that change the trading terms and conditions for 

contracts that have already been listed and where traders have already established 

open positions. But surely no exchange should take such action without telling the 

public why it took the action and how it reached that decision. 

FIA hopes that CFTC Chairman Jeffrey will take a fresh look at this area in the 

coming months and that no legislation will be needed to address these issues. 

Fair Competition 

Promoting fair competition should be the goal of any sound regulatory program. 

Robust competition facilitates the ability of U.S. futures markets to serve the public 

interest. Competition leads to reduced costs, higher volumes, narrower spreads, and 

greater innovation. 

Our strong support for the CFMA was based in substantial part on our belief that 

competition, rather than a prescriptive regulatory structure that established excessively high barriers to entry, would be the best regulator. We fully anticipated that 

the CFMA’s regulatory reforms would encourage new entrants to apply for designation with the Commission as contract markets or clearing organizations. These new 

self-regulatory organizations would compete among themselves and with the existing exchanges for customer business based on products, quality of execution, and 

cost. 

Unfortunately, since the CFMA was enacted very little direct competition among 

markets has occurred. Virtually all efforts at direct competition have been unsuccessful thus far. Even the largest derivatives exchange in the world (EUREX) has 

been unable to penetrate the market share of the Chicago Board of Trade in U.S. 

Treasury Note and Bond futures. Shortly after EUREX US indicated it was reassessing its operations, the CBOT announced a fee increase for all market participants, an apparent by-product of the absence of competition. 

Some believe that unless or until Congress or the CFTC mandate multiple contract listings together with cooperative clearing arrangements the potential benefits 

of meaningful direct competition will never be realized. (That would mean, for example, that a ‘‘long’’ contract entered into on Exchange #1 could be offset by a mirrorimage ‘‘short’’ contract on Exchange #2 through cooperative or common clearing, and 

vice versa.) As this Committee well knows, it makes sense to give customers the 

ability to choose their market and obtain the best price available for an offsetting 

trade, even if the market with the best price is not the market where the original 

position was established.8 These are salutary goals we believe everyone should support in the interest of serving the customer and enhancing competition. Yet, established exchanges are reluctant to surrender their market advantages. 

As noted above, the efforts of the challenger markets to date have done little more 

than chip away at the entrenched markets’ dominance. We believe that further 

study by the CFTC of how to stimulate futures market competition would be appropriate now. With the benefit of that analysis, Congress may wish in the future to 

consider whether legislation in the direct competition area would help to realize 

fully the goals of the CFMA. 

Conclusion 

FIA greatly appreciates the opportunity to present its views to the Committee. We 

look forward to answering any questions you may have and to working with the 

Committee on this year’s CFTC Reauthorization legislation.

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PREPARED STATEMENT OF MEYER S. FRUCHER

CHAIRMAN AND CHIEF EXECUTIVE OFFICER, PHILADELPHIA STOCK EXCHANGE

ON BEHALF OF

THE U.S. OPTIONS EXCHANGE COALITION: AMERICAN STOCK EXCHANGE,

BOSTON OPTIONS EXCHANGE, CHICAGO BOARD OPTIONS EXCHANGE,

INTERNATIONAL SECURITIES EXCHANGE, PACIFIC EXCHANGE,

PHILADELPHIA STOCK EXCHANGE, AND THE OPTIONS CLEARING CORPORATION

SEPTEMBER 8, 2005

I am Meyer S. Frucher, Chairman and Chief Executive Officer of the Philadelphia 

Stock Exchange (Phlx). I appear today on behalf of the Philadelphia Stock Exchange 

and the five other United States options markets: The American Stock Exchange, 

the Boston Options Exchange, the Chicago Board Options Exchange (CBOE), the 

International Securities Exchange, the Pacific Exchange, and our clearinghouse, The 

Options Clearing Corporation. Together, we comprise the U.S. Options Exchange 

Coalition. Our markets trade all the exchange-traded security options in the United 

States, such as options on individual stocks, stock indexes, exchange-traded funds, 

debt securities, and foreign currency. These markets provide the major hedging instruments for the U.S. stock market. The U.S. Options Exchange Coalition welcomes 

this opportunity to provide its views on reauthorization of the Commodity Futures 

Trading Commission (CFTC). 

We welcome the Committee on Banking, Housing, and Urban Affair’s participation in CFTC’s reauthorization. The Committee has an important role to play in the 

issues under consideration because of its oversight of three of the four members of 

the President’s Working Group on Financial Markets (President’s Working Group)—

the Department of the Treasury, the Federal Reserve Board, and the Securities and 

Exchange Commission—as well as its jurisdiction over securities and over-thecounter derivatives. As a part of the reauthorization, the Senate Committee on Agriculture, Nutrition, and Forestry recently reported S. 1566, the Commodity Exchange 

Reauthorization Act of 2005, to reauthorize the CFTC. This bill touched on a number of issues within the Banking Committee’s jurisdiction. The U.S. Options Exchange Coalition is focused on one aspect of the CFTC reauthorization and S. 1566—

the treatment of security futures products (that is, futures on individual stocks and 

narrow-based stock indexes). 

The U.S. Options Exchange Coalition’s interest in the CFTC reauthorization is to 

maintain the competitive balance between security futures and security options established by Congress in 2000 in the Commodity Futures Modernization Act 

(CFMA). S. 1566’s provisions dealing with security futures would destroy this balance by removing the consistent margin treatment between security options and

security futures. The U.S. Options Exchange Coalition has a proposal that would 

preserve this balance while hastening the use of risk-based portfolio margining for 

both security futures and security options. We urge the Committee to endorse the 

principle of regulatory parity between security futures and security options as it 

moves forward with CFTC reauthorization. 

In the U.S. Options Exchange Coalition’s view, security futures and security options should be regulated in a consistent manner in order to preserve competitive 

fairness. Congress made consistent regulation the cornerstone of the Congressional 

compromise that led to the CFMA and the introduction of security futures trading. 

Nothing has occurred since the enactment of the CFMA that should lead Congress 

to change this policy of regulatory parity between security futures and security options. As discussed in detail below, our proposal would maintain this important

objective while providing margin relief for security futures and security options. To 

accomplish this, our proposal would direct the SEC and CFTC to adopt rules within 

9 months permitting consistent portfolio margin treatment for both products. We 

strongly urge Congress to follow our approach. 

The CFMA Was Enacted Based Upon Consistent Regulation 

During consideration of the CFMA, Congress reviewed whether and how security 

futures products should be permitted. Prior to the CFMA security futures had been 

prohibited since an SEC–CFTC jurisdictional accord in 1982. Futures on broadbased stock indexes were permitted, but not futures on individual stocks or on a 

narrow-based index of securities. The prohibition emanated from a lack of consensus 

on whether to regulate these products as securities or futures. In 1999, in anticipation of CFTC reauthorization, the President’s Working Group advised Congress that 

futures on individual stocks and narrow-based indexes should be permitted to trade 

if they were appropriately regulated. Appropriate regulation of the product was 

101

1See, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, Report of the 

President’s Working Group on Financial Markets, November 1999. The President’s Working 

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

the integrity of the underlying securities market and regulatory arbitrage are resolved.’’ 2See, for example, Testimony of William J. Brodsky, Chairman and Chief Executive Officer, 

Chicago Board Options Exchange, on behalf of the U.S. Securities Markets Coalition, before the 

Subcommittee on Risk Management, Research and Specialty Crops, U.S. House of Representatives, Regarding the President’s Working Group Report on OTC Derivatives and the Commodity 

Exchange Act, February 15, 2000. 

based on the fact that futures on individual stocks and narrow-based indexes had 

characteristics of both securities and futures.1

When the CFTC came up for reauthorization in 2000, the futures industry advocated a removal of the prohibition on futures on single stocks and narrow-based indexes and options on such futures (collectively called security futures products). 

While the U.S. Options Exchange Coalition did not object to the introduction of security futures products, it urged Congress to ensure that these products be regulated in manner that provides a level playing field with security options. Consistent 

with the President’s Working Group’s findings, the U.S. Options Exchange Coalition 

argued that security futures are not traditional futures products but are functionally 

and economically equivalent to security options. As a result, appropriate regulation 

of these products must include a role for the SEC and key elements of securities 

regulation. The U.S. Options Exchange Coalition and SEC noted that regulation of 

security futures solely as futures would pose risks for the securities markets and 

investors and would create competitive inequities. 

In general, the securities laws are designed to protect investors, provide full disclosure of corporate and market information, and prevent fraud and manipulation. 

The commodities laws are designed to facilitate commercial and professional hedging and speculation and to oversee the price discovery process. Because of the different emphases of the two regulatory schemes, many of the basic regulatory protections that apply to each are very different. The U.S. Options Exchange Coalition, 

along with the SEC, argued that it would be a mistake to simply impose the futures 

regulatory model onto a class of products that are the functional equivalent of products regulated under the U.S. securities model.2 Instead, the U.S. Options Exchange 

Coalition urged Congress and the SEC and CFTC to determine how to apply relevant portions of the securities regulatory structure to security futures products 

when lifting the prohibition on these products. Our views were consistent with those 

of the SEC and the securities industry. 

Congress agreed with the U.S. Options Exchange Coalition’s position that security 

futures should be subject to elements of securities regulation. As a result, the SEC 

and CFTC, under the direction of the relevant Congressional committees, negotiated 

for many months on a regulatory structure for security futures products. The SEC–

CFTC negotiations led to an approach that would regulate the products as both securities and futures under the oversight of both agencies, but with exemptions in 

certain areas to prevent duplicative regulation. Congress enacted this approach in 

the CFMA. 

A major component of the dual regulation approach was that security futures 

would be regulated in a manner consistent with comparable security options in key 

areas, such as insider trading, margin, tax, and transaction fees, in order to provide 

regulatory parity between these two product groups. Consistent regulation prevents 

regulatory arbitrage and promotes competitive fairness for equivalent products. It 

also avoids market anomalies where participants transact in a product to avoid the 

regulations of an equivalent product rather than for economic or commercial considerations. Indeed, regulatory consistency between security futures and security options was the linchpin of SEC–CFTC agreement for regulating security futures. 

Without it, the U.S. Options Exchange Coalition, securities markets, SEC, and Congressional securities oversight committees would not have supported the introduction of security futures products. 

One of the most important areas of regulatory consistency embodied in the CFMA 

involved margin. Margin has an important function in derivative contracts. It not 

only acts as a performance bond but also directly controls the amount of leverage 

in a derivative such as a security future or a security option. It thus acts to affect 

the cost of establishing and maintaining a position in the derivative. As security futures and security options are economically equivalent instruments, different margin levels would have a significant impact on the competitive balance between the 

two products. To ensure a level playing field, the CFMA placed provisions in the 

Commodity Exchange Act and Securities Exchange Act of 1934 that required security futures margin to be consistent with the margin for comparable securities options. After passage of the CFMA, the SEC and CFTC approved security futures 

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3Security futures products are offered in a number of countries. For the most part, this product has not garnered much trading volume. In the few countries where securities futures products have encountered success, the country either lacks a very liquid underlying market (so that 

the futures market becomes more desirable as a mechanism for transactions) or the country imposes tax or other fees on stock trading and not on futures trading (so that persons use futures 

as a means to avoid these taxes or fees). 4Listed security options had an average daily trading volume of 2,883,841 contracts in 2000, 

4,690,635 contracts in 2004, and 5,571,704 contract for the first 6 months of 2005. 5For example, since 1995, the CME has filed to trade 293 new futures and options on futures 

contacts. On July 7, 2005, only 32 of these products had any trading volume on that date. Of 

those, only 10 had trading volume of 1,000 or more contracts. 6 Under a strategy-based margin system, each option position must be classified as a covered 

write, spread, straddle or naked long or short position, etc. Once separated into the individual 

strategy positions, which can be a cumbersome process, margin is calculated separately for each 

paired off position, or naked position as the case may be, without consideration of any other 

positions that might further offset the risk of that position. Each strategy has a standard formula for computing the margin requirement that applies to all option classes. 

products trading with 20 percent margin, the same margin required for security options. 

The Current CFTC Reauthorization Should Maintain Regulatory

Consistency 

Since their introduction, security futures products have had a slow start. While 

transaction volume and open interest in these products has grown substantially over 

the past year, trading interest still remains relatively small. Some of the futures 

exchanges along with the CFTC have questioned whether the dual regulatory approach has burdened security futures products, and in particular, whether the application of 20 percent margin has hampered the growth of the product. As a result, 

the Chicago Mercantile Exchange (CME) offered a proposal for a program that 

would leave margin setting authority for security futures products solely with the 

futures exchanges, subject to residual oversight by the Federal Reserve Board (Federal Reserve), and suspend SEC and CFTC oversight of margin for these products. 

The Senate Agriculture Committee adopted that approach in reporting S. 1566. The 

U.S. Options Exchange Coalition believes that approach to be seriously flawed because it would end the consistent margin treatment of security futures and security 

options. Instead, the U.S. Options Exchange Coalition has developed a proposal that 

would offer margin relief to security futures and security options while maintaining 

consistency of treatment across these two product groups. 

As a preliminary matter, the U.S. Options Exchange Coalition notes that it supports efforts to attract new business to security futures products. While these products compete directly with securities options, they also are complementary to them. 

Security futures offer our markets opportunities for hedging and arbitrage, and likewise participants in the securities futures markets use security options for hedging 

and arbitrage. There are a number of reasons why security futures have not yet 

been a huge success: Their introduction several years ago during a brutal bear market; robust cash equities and options markets that diminish the utility of the products;3 and the reluctance of broker-dealers to actively market the product to their 

customers. It is doubtful that margin treatment is a major reason for the lack of 

success of security futures. After all, with the same margin, security options have 

experienced record volumes over the past few years.4 It is also important to understand that more new futures and options on futures products fail than succeed.5

Nevertheless, we are sympathetic to the desire of the futures industry to implement portfolio margining for security futures products. In many cases, the current 

strategy-based margin system for security futures and security options results in 

collecting more margin than is necessary to prudently protect against potential 

losses.6 This over margining is an inefficient use of capital by both security futures 

and security options customers. However, implementing portfolio margining for security futures must be accomplished in a manner that upholds the framework of 

regulatory consistency between security futures and security options. We strongly 

oppose unilateral efforts to reduce margin regulation of security futures without 

granting consistent treatment for security options. That is why we oppose the security futures margin provisions of S. 1566. By leaving securities futures margin solely 

up to the futures exchanges, the bill would sever the consistent treatment with securities options which has existed since the introduction of security futures. Security 

options margin would still be subject to SEC oversight, but security futures margin 

would have no SEC (or CFTC) oversight whatsoever. 

The bill, as reported, would undo the carefully drafted compromise embodied in 

the CFMA, is unfair to security options, and is unnecessary to achieve the desired 

results. It is a certainty that if S. 1566 were enacted, the futures exchanges would 

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7While the Federal Reserve ultimately has authority over securities margin, several years ago 

it delegated its authority over listed security options to enable the margin for these products 

to be set by the rules of the options self-regulatory organizations (SRO’s) subject to approval 

by the SEC. Our proposal would direct the SEC, as long as the delegation from the Federal Reserve continued, to pass a rule that permits the SRO’s to allow portfolio margining of security 

options. 8While the Coalition proposal specifically addresses portfolio margin for security futures products and security options, the joint rulemaking as well as the separate SEC rulemaking would 

be free to include other related instruments such as stocks and broad-based stock index futures 

in a portfolio margin program. 9Letter dated March 6, 2001, from Jennifer J. Johnson, Secretary, Board of Governors of the 

Federal Reserve System, to Mr. James E. Newsome, Acting Chairman, CFTC, and Ms. Laura 

S. Unger, Acting Chairman, SEC. 10Securities Exchange Act Release Nos. 51615 (April 26, 2005) and 52032 (July 14, 2005). 11While the broad-based index options pilot was approved as a first step, it has overly restrictive provisions as to the accounts eligible to use portfolio margin. A comprehensive rule for portfolio margin should not restrict its use to accounts with very high equity or high net worth institutions. Rather, it should accommodate a wide range of entities that want to use portfolio margin, as is the case for portfolio margin in many foreign markets and in the futures industry. 

reduce the margin for security futures products far below a level that the SEC 

would approve for security options, perhaps as low as 5 percent. This would place 

security options at a large competitive disadvantage to security futures, which is the 

precise situation that Congress in enacting the CFMA sought to avoid. Given this 

disparity in margin levels, customers may choose security futures over security options not because of the merits of the product but merely because of its lower cost. 

S. 1566 unnecessarily puts Congress in the position of granting regulatory advantages to one industry over another. 

The U.S. Options Exchange Coalition has developed an alternative approach that 

would lead to risk-appropriate portfolio margining for both products in a manner 

that would preserve the consistent treatment endorsed by Congress in the CFMA. 

We have shared this approach with the SEC, CFTC, CME, and Congressional committees. Under the approach, Congress would direct the SEC and CFTC to adopt 

joint rules permitting the use of portfolio margining for security futures within 9 

months of passage of the legislation, and also direct the SEC to adopt a consistent 

rule permitting the use of portfolio margining for comparable security options within 

9 months of passage of the legislation.7 Portfolio margin treatment allows instruments’ (stocks, bonds, options, and futures) margin to be based upon the aggregate 

risks of all such instruments in a person’s portfolio. Because a portfolio margining 

system would calculate margin on the greatest loss that could occur in a portfolio 

if the value of component instruments moved up or down by a certain amount, it 

is a more precise and efficient margin treatment than the current strategy-based approach used for security options and security futures. It is likely that, in many 

cases, a portfolio margin approach would reduce the amount of margin needed for 

security futures and security options for customers while still maintaining adequate 

risk coverage.8

The U.S. Options Exchange Coalition’s legislative proposal is consistent with the 

approach to margin Congress laid out in the CFMA in 2000. Congress gave the Federal Reserve authority over margin for security futures and the ability to delegate 

this authority to the SEC and CFTC jointly. In delegating margin authority, the 

Federal Reserve encouraged the agencies to move toward portfolio margining for security futures.9 Indeed, portfolio margining has been used at the clearinghouse level 

for security options for many years. In addition, markets in many foreign countries 

already employ portfolio margining for futures and options, as do most U.S. futures 

exchanges for products other than security futures. It is a time-tested international 

methodology, and it is imperative and urgent that the U.S. securities regulatory 

structure catches up to the rest of the world in using it. Unfortunately, progress toward this goal has been slow and incremental. Recently the SEC approved a proposal to implement a 2-year pilot program to allow portfolio margining for listed 

broad-based stock index options, index warrants, and related futures and exchange 

traded funds (ETF’s).10 It took the SEC 3 years after submission of a formal proposal to grant this approval. While the pilot program would have been a good first 

step several years ago, it is time to move beyond an incremental approach toward 

the type of comprehensive methodology employed elsewhere that covers a wide 

range of products and market participants.11

Our proposal would accomplish this by mandating that rules permitting portfolio 

margin for security options and security futures be adopted by a date certain, while 

preserving the consistent margin treatment between the two product groups. This 

proposal would produce a win-win situation for security futures and security options 

markets and compel the SEC and CFTC to act swiftly toward this important goal. 

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12The Coalition suggests that Congress require a brief status report in the 9-month rulemaking period to make sure that the two agencies remain on track. 13For example, the definition of customer property under SIPA needs to be amended to include certain commodity futures and commodity option contracts. 

The 9-month period for rulemaking in the proposal is appropriate, as much of the 

preliminary work has already been accomplished. The futures industry and CFTC 

are very familiar with portfolio margining and the securities industry has been 

working with the SEC over the past few years toward obtaining portfolio margining 

for securities. This should be a familiar territory for both agencies. The SEC could 

build upon and expand the broad-based stock index options pilot to adopt rules for 

all security options and work with the CFTC to adopt consistent rules for security 

futures. With new leadership at the SEC and CFTC and clear direction by Congress, 

we believe the two agencies could act quickly to adopt comprehensive rules that 

would benefit investors and the markets.12

In permitting portfolio margining, it is critical that the SEC and CFTC adopt joint 

rules for security futures and that such rules are consistent with the SEC rulemaking for security options. Due to the historically disparate approach between the 

SEC and CFTC toward regulation in general and margin regulation in particular, 

individual rulemaking by each agency would produce different results for comparable products under their jurisdiction. Only Congress can ensure fair and consistent treatment on this fundamental issue by mandating joint rulemaking for

security futures and by directing the SEC to adopt the same rules for security options. The SEC and CFTC worked together to adopt rules to facilitate the introduction of security futures after passage of the CFMA. There is no reason why they 

could not do the same for portfolio margining. The U.S. Options Exchange Coalition 

and its members stand ready to provide whatever assistance is needed to the SEC 

and CFTC to adopt rules for portfolio margining as well as to Congress as it deliberates on margin-related issues. 

The U.S. Options Exchange Coalition’s legislative proposal also contains definitional changes to the Securities Investor Protection Act of 1970 (SIPA). SIPA involves the activities of the Securities Investor Protection Corporation (SIPC). SIPC 

protects customers if a broker-dealer goes out of business up to specified amounts 

for customer cash and securities at the broker-dealer. SIPC covers most types of securities, but does not cover certain futures. Changes to SIPA are needed to accommodate portfolio margining by security options customers. Optimally, portfolio

margining looks at all related positions in an account to determine the risk of the 

portfolio and the appropriate level of margin. For example, to fully realize the benefits of the portfolio margining pilot recently approved for options on broad-based 

stock indexes and ETF’s, a customer may choose to have these positions in the same 

account as positions in broad-based stock index futures and futures on ETF’s. Margining of options and futures in one account is called cross-margining. To facilitate 

cross-margining for such a customer, narrow changes to SIPA are needed to make 

sure that the customer is protected in the unlikely event of a broker-dealer bankruptcy. These changes would permit the cross-margin accounts of qualifying customers to be treated as ‘‘securities accounts’’ under SIPA and provide that such customers can have appropriate claims against customer property consisting of certain 

futures in the event of the insolvency of the carrying broker-dealer.13 Without these 

changes, portfolio margining cannot be fully implemented and inefficiency in the 

margining of securities will remain. The U.S. Options Exchange Coalition has discussed these changes with the SEC and the CFTC. It is crucial that Congress adopt 

these changes as part of the CFTC reauthorization process. 

Broad-Based Index Definition 

The CFTC reauthorization touches upon a variety of other issues, such as CFTC 

jurisdiction in foreign currency markets. The U.S. Options Exchange Coalition does 

not have a position on most of these other issues. However, the U.S. Options Exchange Coalition does have an interest in potential changes to the definition of narrow-based security indexes. The CFMA contains definitions of narrow-based security 

indexes in order to differentiate a narrow-based security index future from a broadbased security index future. Narrow-based security index futures are treated as security futures products and are subject to the dual jurisdiction of the SEC and 

CFTC, while broad-based security index futures are subject to the exclusive jurisdiction of the CFTC. These important definitions were carefully crafted by the SEC and 

CFTC. 

The CFTC and others in the futures industry want to create new definitions for 

‘‘narrow-based security’’ indexes based on U.S. debt instruments, other U.S. securities, foreign equities, or foreign debt instruments. These new definitions for narrowVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00108 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
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1The Securities Industry Association brings together the shared interests of approximately 

600 securities firms to accomplish common goals. SIA’s primary mission is to build and maintain 

public trust and confidence in the securities markets. SIA members (including investment 

banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets 

and in all phases of corporate and public finance. According to the Bureau of Labor Statistics, 

the U.S. securities industry employs nearly 800,000 individuals, and its personnel manage the 

accounts of nearly 93-million investors directly and indirectly through corporate, thrift, and pension plans. In 2004, the industry generated $236.7 billion in domestic revenue and an estimated 

$340 billion in global revenues. (More information about SIA is available at: www.sia.com.) 

based security index for the four product types noted above could result in differences from the same definition applicable currently to an index comprised of U.S. 

equities. The U.S. Options Exchange Coalition will defer to the judgment of the SEC 

as to whether such differences would lead to an undesirable result in this area. In 

any event, the definitions of narrow-based security index should be crafted by the 

SEC and CFTC jointly. While there should be a good reason for any deviation from 

the definitions adopted by the CFMA, we will defer to the judgment of the two agencies if they jointly decide that the changes are warranted. 

Conclusion 

The U.S. Options Exchange Coalition believes that CFTC reauthorization provides 

an opportunity to bring the benefits of portfolio margining to both security futures 

and security options in a manner that maintains the CFMA’s parity of treatment 

for security futures and security options. The U.S. Options Exchange Coalition’s proposal provides the means for achieving these goals. S. 1566 does not do so. We urge 

the Committee to maintain the parity of CFMA during reauthorization. 

Thank you again for the opportunity to testify at this important hearing. I would 

be happy to answer any questions that you have. 

—————

PREPARED STATEMENT OF MARK LACKRITZ

PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

SEPTEMBER 8, 2005

The Securities Industry Association 1 appreciates the opportunity to testify on The 

Commodity Exchange Reauthorization Act of 2005 (S. 1566). We commend the Committee for your interest in provisions of S. 1566 that are of significant importance 

to the securities industry. 

Overview 

SIA strongly supports reauthorization of the Commodity Futures Trading Commission (CFTC) in 2005, but we oppose the provisions of S. 1566 that go beyond 

CFTC reauthorization and would amend the Commodity Exchange Act (CEA) and 

the recently enacted modifications to the CEA codified in the Commodity Futures 

Modernization Act of 2000 (CFMA). The CFMA enjoyed strong bipartisan support 

in this Committee and in Congress, and it was well-received in the public and private sectors. In addition to codifying important modernizing amendments to the 

CEA, the CFMA brought much needed legal certainty to the U.S. over-the-counter 

(OTC) derivatives markets and provided a statutory framework that has enhanced 

the competitiveness of U.S.-listed and OTC derivatives markets. Strong U.S. derivatives markets have, in turn, brought important benefits to all sectors of the U.S. 

economy since enactment of the CFMA. Importantly, the CFMA also established a 

dual statutory and regulatory framework for the trading of security futures, a class 

of financial instruments that had previously been prohibited in the United States. 

SIA is deeply concerned with two principal areas in S. 1566: (1) provisions addressing the margining of security futures and the status of certain security index 

futures; and, (2) the scope of language addressing the so-called Zelener decision and 

related foreign exchange issues, including the provisions to limit the scope of permissible activities of broker-dealers. 

In relation to security futures, SIA supports agency rulemakings and SRO rule 

approvals under the CEA and the Securities Exchange Act of 1934 (Exchange Act) 

that would promote U.S. investor access to a broader range of security futures index 

products and that would encourage the adoption of portfolio margining. However, 

SIA believes it is essential that any portfolio margining legislation ensure that all

financial instruments, including stocks, convertible and equity-linked debt, options, 

and security and security index futures, be included in a manner that does not esVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00109 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
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2 [63 Fed. Reg. 2805 (Jan, 16, 1998).] Following enactment of the CFMA, in a letter dated 

March 6, 2001 addressed to the SEC and CFTC, the FRB reiterated its encouragement for the 

development of ‘‘more risk-sensitive portfolio margining approaches for all securities, including 

security options and security futures products.’’

tablish margin-based competitive disparities. SIA opposes the provisions of S. 1566 

that are addressed solely to portfolio margining for security futures. 

We understand that retail fraud in connection with speculative foreign exchange 

activities continues to be problematic, as it was prior to enactment of the CFMA. 

We do not agree, however, with the assertion that there is a compelling need for 

modifications to the CEA to address these problems. SIA strongly supports efforts 

to root out fraud against retail investors, but we believe the provisions of S. 1566 

are overly broad and could well give rise to unintended adverse consequences. 

Discussion 

Portfolio Margining 

The margin requirements for securities and securities derivatives limit the 

amount of economic leverage that can be achieved in connection with an investor’s 

position in securities or other financial instruments. 

Generally speaking, the margin requirements applicable to broker-dealers in connection with securities and securities derivatives are established under Regulation 

T of the Board of Governors of the Federal Reserve System (FRB) and under rules 

adopted by exchanges and other self-regulatory organizations (SRO’s) and approved 

by the Securities and Exchange Commission (SEC). In the case of security futures, 

CEA and Exchange Act provisions also require that security futures margin levels 

not be lower than the lowest margin requirements applicable to comparable stock 

options. This latter restriction was adopted in the CFMA to prevent competitive disparities from arising from the application of the margin levels typically required for 

futures contracts (which are generally lower than those applicable to stocks and 

stock options). 

Today’s investment portfolios are increasingly comprised of a wide array of securities and securities derivatives. These positions often have offsetting risk exposures. 

Under a strict application of the margin rules—without any recognition of the impact of multiple positions on the effective net exposures within a portfolio—the aggregate amount of margin that would be required to be maintained would be equal 

to the sum of the margin requirements applicable to each individual position. 

As a result, the aggregate margin requirements applicable to these portfolios do 

not reflect the risk-mitigating impact of offsetting positions, thereby leading to overmargining, portfolio inefficiencies, and a misalignment of margin and risk-management incentives. Investors are not incentivized under this approach to engage in 

risk-mitigating strategies. Excessive margin requirements also impair the competitive position of U.S. brokerage firms competing with non-U.S. financial service firms 

for the business of foreign customers. 

In order to ameliorate these effects, SRO’s have adopted rules that recognize certain offsetting positions by reducing the aggregate margin requirements applicable 

to certain specified position combinations. While these so-called ‘‘strategy-based’’ 

margin levels provide some relief, they do not comprehensively take into account the 

exposure offsets found in common portfolios of multiple instruments. This is because 

they do not take into account all of the types of products and product combinations 

that may comprise a portfolio and give rise to offsetting exposures. 

In recognition of the superiority of portfolio margining as an efficient but prudential means of determining margin requirements, the FRB adopted an amendment 

to Regulation T in 1998 to provide an exemption for any portfolio margining system 

permitted by an SRO pursuant to SEC-approved rules.2

An ad hoc committee of SIA has been working with SRO’s and the SEC for several years to expand the use of portfolio margining, and we have made modest,

incremental progress during that time. Importantly, regulators have become increasingly familiar with the tools and techniques associated with portfolio margining, and we are hopeful that in the near future considerably greater progress will 

be made. SIA’s portfolio margining committee recently submitted the outline of a 

proposal to the New York Stock Exchange that, if adopted and approved by the 

SEC, would be an important step in a process ultimately leading to a system of portfolio margining that encompasses the full range of securities and securities derivatives. 

Indeed, SIA strongly supports the use of portfolio margining and believes that it 

should be available for all statistically correlated portfolio positions, all market participants whose positions are subject to Federal margin regulation, and all accounts, 

with the following two stipulations. 

107

3 Under the current dual regulatory regime, the SEC and CFTC have not adopted the joint 

rules that would be necessary to permit in options on security futures. 4 U.S. Commodity Futures Trading Commission and State of California Charge San Francisco 

Foreign Currency Firm National Investment Consultants, Inc. And Other Companies And Individuals With Fraud, CFTC Press Release July 21, 2005. http://www.cftc.gov/opa/enf05/

opa5099–05.htm. 5 Court Order Bars Deceptive Investment Pitches, Federal Trade Commission Press Release, 

May 17, 2005. http://www.ftc.gov/opa/2005/05/britishcapital.htm. 6 As noted by former Acting CFTC Chair Sharon Brown-Hruska:

Continued

First, portfolio-margining arrangements should encompass and provide parity of 

treatment for all statistically correlated portfolio positions. Portfolio margining 

should not be available selectively to certain product categories, but not others, in 

a manner that might produce a potentially anticompetitive result. Ideally, firms 

would be permitted to use proprietary models for the purpose of calculating portfolio 

margin requirements. 

Second, any portfolio-margining arrangements should be limited to arrangements 

that do not give rise to uncertainty as to the availability of deposited margin to satisfy outstanding obligations in the case of insolvency of the carrying firm or its customer. 

Thus, SIA strongly supports regulatory initiatives designed to facilitate and promote portfolio margining on a comprehensive basis. Similarly, we would support legislation that encourages SEC and CFTC initiatives to approve SRO rules or to adopt 

rules implementing portfolio-margining systems consistent with the parameters articulated above. 

SIA opposes, however, the portfolio margining provisions currently contained in 

S. 1566. These provisions, among other deficiencies, are too narrowly drawn and 

have the potential to create inappropriate competitive disparities across competing 

product markets. SIA also believes, as a general matter, that the nature of the 

issues presented by portfolio margining are better suited to resolution through the 

cooperative interaction of the industry, SRO’s and Federal agencies, rather than 

through a prescriptive legislative approach. 

Security Futures Index Definitions 

Derivatives on security indices have provided valuable financial tools for the

investment community, including retail, institutional, and professional investors. 

Limitations on investor access to these products arise under the dual regulatory 

framework for security futures products principally in two contexts: Foreign securities and narrow-based security indices and domestic nonequity indices.3 The current 

regime also limits the ability of U.S. brokerage firms to compete with non-U.S. financial services firms in offering transaction execution services to foreign customers 

trading in futures on foreign securities and narrow-based security indices. 

Access to these products requires the cooperative action of the SEC and CFTC. 

SIA strongly supports cooperative action by the two agencies to adopt the rulemaking necessary to make security index futures in these categories available to 

U.S. investors. Although SIA does not believe legislation to encourage joint rulemaking to permit U.S. trading in foreign stock and stock index futures and domestic 

nonequity securities and security indices is necessary, we would support such an initiative if the SEC and CFTC believe they need a legislative mandate. We oppose 

the security index definition provisions contained in S. 1566. 

Retail Foreign Exchange Fraud 

General 

Critics of the decision of the Seventh Circuit Court of Appeals in CFTC v. Zelener,

373 F.3d 861 (7th Cir. 2004) argue that the decision created or exposed a significant 

loophole in the CEA that will purportedly provide a road map for retail fraud in 

a broad range of commodities. 

SIA disagrees with this view and believes that the Zelener decision was a correct 

application of current law and was correctly decided based on the facts in evidence 

in the case. SIA also does not find credible the claim that the Zelener decision will 

lead to similar decisions in cases involving retail transactions in physical commodities that typically require costly, complex, and burdensome delivery mechanisms. 

Moreover, the absence of CFTC jurisdiction over certain categories of retail commodity fraud does not necessarily result in an enforcement vacuum. Recent actions 

by the State of California 4 and the Federal Trade Commission 5 are indicative of 

the availability of other enforcement mechanisms for the protection of retail consumers.6

108

‘‘I would point out that our overall track record in the forex area is favorable. Since the passage of the CFMA, the Commission, on behalf of more than 20,000 customers, has filed 70 cases 

and prosecuted 267 companies and individuals for illegal activity in forex. As a result of those 

efforts, we have thus far imposed over $240 million in penalties and restitution. Of the 70 cases 

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

Testimony of Sharon Brown-Hruska, Hearings of the Senate Committee on Agriculture, Nutrition, and Forestry, March 8, 2005. 

SIA believes that steps to expand CFTC jurisdiction beyond futures should be 

taken with great care. There are two reasons for this. First, the CFTC has a significant regulatory mission to discharge with respect to the Nation’s currently regulated 

futures markets. 

These responsibilities already challenge the agency’s resources. Steps that might 

expand the CFTC’s role to that of a national police force for consumer fraud involving credit transactions could place significant additional burdens on the CFTC’s resources and continued ability to meet the challenges of an extremely innovative and 

constantly evolving market. 

Second, the very uncertainties that gave rise to the need for the CFMA were 

themselves the result of the potentially expansive scope of the CEA and overlapping 

jurisdiction of the CFTC with that of the SEC, bank supervisors, and others. Nearly 

every prior amendment to the CEA involving the scope of CFTC jurisdiction, with 

the notable exception of the CFMA, has caused significant jurisdictional disputes or 

uncertainty with adverse collateral consequences. It is imperative that Congress 

avoids legislative initiatives that will create these problems in new areas of economic activity—particularly where no compelling public policy case has been presented for enacting legislation that might give rise to such risks. 

Nonetheless, SIA welcomes the attention of the President’s Working Group on Financial Markets to these issues and supports efforts to eliminate or remediate fraud 

where the need to do so is identified. Consistent with the principles articulated 

above, however, it is critical that any such initiative be narrowly drawn to address 

only the substantive antifraud concerns. 

In this regard, we oppose the provisions of S. 1566 dealing with these issues and 

we have serious substantive, policy, and technical concerns with the language, including concerns regarding the scope of transactions that would be covered by the 

proposed provisions. 

Broker-Dealer Affiliates 

Unrelated to the Zelener decision, S. 1566 would cut back significantly existing 

provisions of the CFMA that permit SEC-registered broker-dealers and their material associated persons (that is, their material affiliates), among other entities, to 

continue to conduct OTC foreign exchange futures activities with counterparties 

that do not qualify as eligible contract participants. 

SIA understands that this proposal responds to a practice in which firms establish 

and register ‘shell’ FCM’s for the purpose of permitting under-capitalized and unregulated affiliates to engage in retail OTC foreign exchange futures activities. In 

the context of SEC-registered broker-dealers or their material associated persons, 

however, no similar problem has arisen, and there is no basis for concluding that 

any similar problem will arise in the future. 

Most U.S. broker-dealer holding company groups have historically conducted their 

OTC foreign exchange activities in an affiliate of the SEC-registered broker-dealer. 

These entities are not thinly capitalized and, as noted above, there is no history of 

any retail foreign exchange related abuse by these entities or by personnel of the 

affiliated broker-dealer. Requiring reorganization of this business line and registration of personnel could be costly and burdensome and would be entirely unjustified 

by the record. 

As a result, SIA strongly opposes the provisions of S. 1566 that would modify the 

scope of permissible activities of broker-dealers or their material associated persons 

under the existing provisions of CEA Section 2(c)(2)(B). 

Unregistered Solicitors 

SIA understands that certain unregulated persons, other than the entities enumerated in existing CEA Section 2(c)(2)(B), have commenced operations as solicitors 

of OTC foreign exchange futures transactions in which FCM’s or FCM affiliates act 

as counterparty. SIA would not oppose legislative amendments that would require 

such solicitors to be registered with the CFTC where they are not an entity (or an 

employee of an entity) enumerated in CEA Section 2(c)(2)(B) or otherwise regulated. 

109

7 Report at page 6.

Legal Certainty Concerns 

The CEA is a complex statutory scheme, reflecting, as it does, the richness and 

complexity of this nation’s financial markets. In enacting amendments to the CEA, 

unintended consequences can readily occur, whether in the form of legal uncertainty, inappropriate restrictions on legitimate activity or competitive disparities. 

A potentially significant example of this problem is presented in the context of 

the Report of the Senate Committee on Agriculture, Nutrition, and Forestry accompanying S. 1566. That Report notes:

The Committee concurs with the CFTC’s consistent position that even if a 

transaction is excluded from the CFTC jurisdiction under Section 2(g), the false 

reporting of such a transaction is a separate act and remains a violation of Section 9 so the CFTC has authority to prosecute.7

SIA agrees that the CFTC has jurisdiction under Section 9 for a false report covered by that section even though, had the transaction falsely described actually occurred as described, it would have been eligible for the exclusion in Section 2(g). A 

transaction reported falsely by definition did not occur and therefore cannot satisfy 

the requirements of an exemption applicable to actual transactions. For that reason, 

the CFTC’s enforcement position is justified and we agree with the conclusion 

reached in the Report. 

We do not agree with the basis cited in the Report for its conclusion. The Report 

suggests that the exclusion provided under Section 2(g) (and, presumably, the other 

statutory exclusions contained in the CEA) do not, for example, cover false ‘‘statements’’ because they are ‘‘separate’’ from the excluded transactions. The Report thus 

appears to distinguish between ‘‘transactions’’ that are exempt, on the one hand, 

and ‘‘statements’’ relating to transactions, which, according to the Report, are ‘‘separate’’ from the transactions and are therefore not exempt. The drawing of a general 

distinction between exempt or excluded transactions under the CEA and related 

‘‘statements’’ or conduct of transactors is not justified under the CEA and could reintroduce significant uncertainty that the CFMA was expressly enacted to eliminate. 

Securities-based swaps, for example, are excluded from regulation under the CEA 

(including the CEA’s antifraud provisions) pursuant to Section 2(g). Congress instead explicitly subjected securities-based swaps to antifraud provisions under the 

securities laws in Title III of the CFMA. 

The above-quoted Report language would suggest, however, that statements made 

in connection with securities-based swaps would be subject to CEA antifraud provisions. This is plainly inconsistent with Congressional intent. Moreover, the logic applied to ‘‘statements’’ could be equally applied to other conduct that is independent 

of the ‘‘transaction’’, thus giving rise to broader uncertainty as to the extent to 

which provisions of the CEA regulate statements, communications, and other conduct of transactors in connection with the broad range of banking, securities, and 

other financial transactions Congress assumed it had expressly excluded from regulation under the CEA. Such uncertainty is unacceptable and should be dispelled. 

Conclusion 

The CFMA resolved many significant issues and did so in innovative ways. This 

has enabled the U.S. derivatives market to provide important benefits for the U.S. 

economy. As noted above, the complexity of the products subject to the CEA, as well 

as those covered by exclusions from the CEA, are complex and extremely difficult 

to define. History has shown that a lack of clarity under the CEA can produce significant adverse consequences. As such, we believe it is extremely important that 

Congress proceed cautiously to avoid unintended adverse consequences of the type 

potentially presented by the Report text cited above. 

SIA is eager to work with the Committee and its staff to achieve your legislative 

objectives in a constructive manner that preserves the many benefits of the CFMA. 

—————

PREPARED STATEMENT OF ROBERT G. PICKEL

EXECUTIVE DIRECTOR AND CHIEF EXECUTIVE OFFICER

INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.

SEPTEMBER 8, 2005

Mr. Chairman, Senator Sarbanes, and Members of the Committee. I am Robert 

G. Pickel, Executive Director and Chief Executive Officer of the International Swaps 

110

1 ISDA’s primary members are substantial users of the regulated futures exchanges. ISDA 

therefore supported the provisions of the CFMA that provided regulatory relief to the exchanges. 

and Derivatives Association, Inc. (ISDA). I appreciate the Committee’s invitation to 

appear today to present ISDA’s views on proposed legislation to reauthorize the 

Commodity Futures Trading Commission (the CFTC), which administers the Commodity Exchange Act (the CEA). 

Overview 

ISDA is an international organization, and its more than 650 members in 48 

countries include the world’s leading dealers in swaps and other off-exchange derivatives transactions (OTC derivatives). ISDA’s membership also includes many of 

the businesses, financial institutions, governmental entities, and other end users 

that rely on OTC derivatives to manage the financial, commodity market, credit, 

and other risks inherent in their core economic activities with a degree of efficiency 

and effectiveness that would not otherwise be possible. 

Congress substantially amended the CEA in the Commodity Futures Modernization Act of 2000 (the CFMA). The CFMA was adopted with broad bipartisan support 

after careful consideration over several years by four Congressional Committees, including this Committee, and with the active support of the President’s Working 

Group on Financial Markets (the PWG); namely, the Secretary of the Treasury, the 

Chair of the Board of Governors of the Federal Reserve System, the Chair of the 

Securities and Exchange Commission, and the Chair of the CFTC. 

The CFMA was intended to provide regulatory relief for the futures exchanges; 

ensure legal certainty and regulatory clarity for OTC derivatives; and remove the 

ban on single-stock futures trading. ISDA is of course principally interested in those 

provisions of the CFMA that were enacted to provide legal certainty and regulatory 

clarity for OTC derivatives.1 For the reasons explained in Part II of this statement, 

ISDA believes that, based on the experience to date under the CFMA, Congress did 

achieve its objective of providing legal certainty and regulatory clarity for OTC derivatives in a manner that has reduced systemic risk and encouraged financial innovation. Moreover, from all indications, the CFMA seems to have been a broad-based 

success for the capital markets generally. ISDA commends the CFTC for the effective manner in which it has implemented the CFMA in accordance with Congressional intent. ISDA has and will continue actively to support passage of legislation 

to reauthorize the CFTC. 

As the Committee is aware, there have been numerous proposals to utilize the reauthorization process as a vehicle for substantive amendments to the CFMA, including amendments relating to OTC derivatives. For the reasons discussed Parts II and 

III of this statement, ISDA believes there is no compelling need to make substantive 

changes to those portions of the CFMA governing OTC derivatives. While this Committee should of course consider the views of those who take a different position and 

advocate such amendments, we urge the Committee to take a cautious approach to 

reopening the OTC derivatives provisions of the CFMA. If any amendments are 

agreed to, they should be specifically targeted to identified problems requiring legislation and carefully crafted to avoid unintended collateral consequences that could 

undermine the legal certainty provided for OTC derivatives by the CFMA. In this 

connection, we also urge the Committee to ensure that all proposed substantive 

amendments to the CFMA are subject to advance review by the Committees of jurisdiction. Our experience in recent years demonstrates that the use of freestanding 

amendments offered to separate legislation without advance review by the Committees of jurisdiction is an undesirable method of considering changes to the CFMA. 

OTC Derivatives Under the CFMA 

As noted, ISDA is principally interested in the provisions of the CFMA that provide legal certainty for OTC derivatives. The phrase ‘‘legal certainty’’ means simply 

that the parties to OTC derivatives transactions must be certain that their contracts 

will be enforceable in accordance with their terms. The availability of OTC derivatives transactions within a strong legal framework, such as that provided by the 

CFMA, is of vital importance. Any uncertainty with respect to the enforceability of 

OTC derivatives contracts obviously presents a significant source of risk to individual parties to those specific transactions. Moreover, any legal uncertainty creates 

risks for the financial markets as a whole and precludes the full realization of the 

powerful risk management benefits that OTC derivatives transactions provide. 

As this Committee is aware, the CFMA framework for providing legal certainty 

is based on a long-standing consensus among Congress, key financial regulators, including the CFTC, and others that OTC derivatives transactions generally are not 

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2 In the late 1980’s, the use of interest rate and currency swaps and other OTC derivatives 

transactions to manage financial risks grew rapidly. At that time, there was a consensus that 

OTC derivatives were not ‘‘futures’’ contracts. Nevertheless, because of certain perceived similarities between OTC derivatives and exchange traded futures contracts, there was residual concern that the CFTC or a court might treat OTC derivatives contracts as futures, which would 

render them illegal and unenforceable by reason of the CEA’s exchange trading requirement. 3Moreover, as discussed more fully below, the reduction in systemic risk resulting from the 

use of OTC derivatives was also evident in the energy markets following the collapse of Enron 

in 2001. Indeed, it appears that the legal certainty provisions of the CFMA and the related provisions of the Bankruptcy Code (adopted by Congress in 1990) may have enhanced the ability 

of market participants to deal effectively with events such as the collapse of Enron. 

appropriately regulated as futures contracts under the CEA.2 The OTC derivatives 

provisions of the CFMA were intended by Congress to resolve the legal certainty 

issues with finality and, at the same time, reduce systemic risk and encourage financial innovation. ISDA’s experience over the past several years indicates that 

these objectives have been achieved. 

A survey of corporate usage of derivatives released by ISDA in April 2003 indicated that 92 percent of the world’s largest businesses use OTC derivatives for risk 

management purposes and that 94 percent of the 196 U.S. companies included in 

the survey do so. Significantly, the use of OTC derivatives to hedge interest rate, 

foreign currency and credit default risks increased substantially in the last 4 years, 

evidencing the importance of OTC derivatives as a tool to manage risk in periods 

of economic downturn and uncertainty. As Federal Reserve Chairman Alan Greenspan noted before this Committee on March 2, 2002, OTC derivatives ‘‘are a major 

contributor to the flexibility and resiliency of our financial system.’’ 3

The reductions in systemic risk resulting from enactment of the legal certainty 

provisions of the CFMA have not come at the expense of financial innovation. New 

types of OTC derivatives have gained increased market acceptance since enactment 

of the CFMA. For example, the significant growth in credit default swaps to manage 

credit risk has been greatly enhanced by the legal certainty provisions of the CFMA. 

Similarly, businesses ranging from ski resorts to beverage producers have begun to 

use weather derivatives to hedge the risk of adverse climate conditions on their 

businesses. Again, the legal certainty provisions of the CFMA have encouraged dealers to develop, and businesses to use, an increasing range of new kinds of OTC derivatives to manage additional types of risk. Finally, the legal certainty provisions 

of the CFMA removed the regulatory barriers to clearing with respect to OTC derivatives and, while collateralized transactions remain more prevalent, clearing proposals have been advanced recently and the emergence of these proposals attests 

to the positive effects of the CFMA on financial innovation. 

To summarize, ISDA’s experience to date under the CFMA indicates that Congress did indeed achieve its objective of providing legal certainty and regulatory 

clarity for OTC derivatives in a manner that would both reduce systemic risk and 

encourage financial innovation. Equally significant, three events since the passage 

of the CFMA have in many ways ‘‘stress tested’’ the OTC derivatives markets and 

the applicable provisions of the CFMA itself. The results have been encouraging. 

First, there is no question but that the CFMA structure enabled financial institutions and the American business community to deal with the economic downturn 

in the early part of this decade in a more effective manner. The well-publicized 

events leading to Enron’s bankruptcy filing in December 2001 presented a second 

test. Enron raised serious concerns involving accounting practices, securities law 

disclosures, and corporate governance policies. These issues received serious attention from policymakers and led to intensive investigations and enforcement actions, 

including actions based on the CFMA, by the CFTC and other regulators. Had 

Enron complied with accounting and disclosure requirements, it could not have built 

the ‘‘house of cards’’ that eventually led to its downfall. The market in the end exercised the ultimate sanction over Enron and the market for OTC derivatives functioned as expected and with no apparent disruption. 

The equally well-publicized transactions of Enron and others in or with respect 

to the California energy market presented a third test involving different public policy questions; namely, the design of the California electricity market, the lack of 

adequate reserves, demand response relative to growing electricity demand, and 

possible manipulation of the wholesale market. ISDA views any credible allegations 

of ‘‘manipulation’’ in financial or other markets as a serious matter requiring attention and therefore welcomed the investigations by the appropriate Federal agencies 

and departments, including the CFTC, the Federal Energy Regulatory Commission 

(FERC), and the Department of Justice. Both FERC and the CFTC initiated a series 

of enforcement actions employing the tools available under existing law, including 

the CFMA. Based on this experience, there does not appear to be any specific eviVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00115 Fmt 6621 Sfmt 6621 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
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4 373 F.3d 861 (7th Cir. 2004). 

5 In remarks prepared for delivery on March 17, 2005 at the Futures Industry Association 

International Derivatives Conference, CFTC Commissioner (and then Acting Chair) Sharon 

Brown-Hruska stated that ‘‘while developments like Zelener represent a set-back to our enforcement authority, I do not believe they preclude us from prevailing in these cases, even in the 

Seventh Circuit. A more focused litigation strategy, one that relies upon the extrinsic evidence 

surrounding the formation of the contract should, in our view, allow us to prevail in the future 

. . .’’

dence that the Commission’s antimanipulation authority is deficient. Again, the 

CFMA contributed positively to the ability of the markets to respond effectively to 

a difficult situation. 

Possible Amendments to the CFMA Affecting OTC Derivatives 

As noted, there have been several proposals to amend the provisions of the CFMA 

governing OTC derivatives. The most far-reaching of these proposals involve OTC 

derivatives based on foreign currency. One such amendment was included in 

S. 1566, which was approved on July 29, 2005, by the Senate’s Committee on Agriculture, Nutrition, and Forestry in legislation (S. 1566) to reauthorize the CFTC. 

ISDA has concerns with the proposed amendments affecting foreign currency transactions, including those contained in S. 1566, and welcomed the recent decision of 

the PWG to review the relevant policy issues. In addition, ISDA has concerns with 

respect to proposals that may be advanced as the legislative process moves forward 

to amend the CFMA provisions applicable to OTC derivatives based on energy and 

other ‘‘exempt commodities.’’ ISDA’s comments on these proposed amendments to 

the CFMA are set forth below. 

Foreign Exchange Contracts-Zelener Issues. In the CFMA, Congress revised the socalled ‘‘Treasury Amendment’’ (the core provision of the CEA governing foreign exchange contracts) to provide legal certainty with respect to OTC foreign exchange 

contracts and, in so doing, gave the CFTC jurisdiction over certain specific transactions in foreign exchange contracts, but only if and to the extent those contracts 

are ‘‘futures’’ or ‘‘options’’. In CFTC v. Zelener,4 the U.S. Court of Appeals for the 

Seventh Circuit held that the foreign exchange contracts before it were not ‘‘futures 

contracts’’ and that the CEA’s antifraud rules were therefore not applicable. In 

ISDA’s view, the Zelener case was correctly decided based on the evidence before 

the court, does not preclude the CFTC from successfully bringing similar cases in 

the future,5 and does not provide a ‘‘road map’’ for an ‘‘end run’’ around the CEA 

that can be ‘‘exported’’ to physical commodities such as heating oil and grain. 

At the same time, however, ISDA recognizes that any fraudulent or manipulative 

activity involving the capital markets does warrant attention. In the case of the foreign currency markets, the involvement of the Department of the Treasury and the 

Federal Reserve (working in this case through the PWG) is critical and Congress 

has so recognized since the original adoption of the Treasury Amendment in 1974. 

Thus, while ISDA does not believe that statutory changes are necessary or

warranted as a result of the Zelener decision, it could support a carefully crafted 

amendment if the PWG concludes that a legislative change is appropriate given the 

totality of the circumstances. ISDA will therefore give any such PWG recommendation serious consideration. 

ISDA does believe, however, that in principle any such amendment should be 

quite narrow in scope. Specifically, in ISDA’s view, if the CFTC’s jurisdiction is to 

be expanded to include agreements, contracts, and transactions that are not futures 

or options, that expanded jurisdiction should be expressly limited to authorizing the 

CFTC to pursue fraud claims in transactions in foreign exchange contracts between 

retail participants (that is, participants who are not eligible contract participants 

under the CFMA) and otherwise unregulated persons. 

Such a narrow approach has two distinct and important benefits. First, it will reduce the risk of unintended collateral consequences that could undermine the legal 

certainty provided by the CFMA for OTC derivatives. The risk of such unintended 

collateral consequences is neither speculative nor academic. For example, S. 1566 

would amend Section 9 of the CEA to clarify the CFTC’s jurisdiction with respect 

to false reporting. In its explanation of that amendment, the proposed Report of the 

Committee on Agriculture, Nutrition, and Forestry on S. 1566 contains the following 

statement:

The Committee concurs with the CFTC’s consistent position that even if a 

transaction is excluded from the CFTC jurisdiction under Section 2(g) [of the 

CEA as added by the CFMA], the false reporting of such a transaction is a separate act and remains a violation of Section 9 so the CFTC has authority to prosecute.

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6 In this connection, ISDA notes that the energy legislation enacted earlier this year contains 

provisions intended to improve the quality of reporting by all parties to many energy transactions. 

The effect of this statement, which in ISDA’s view does not follow from a reading 

of the statute itself, is that an allegedly false statement made by a person to a third 

party will trigger CFTC jurisdiction over that person even if the statement is made 

about a contract with respect to which the CFTC has no jurisdiction, including antifraud jurisdiction. 

The position that the CFMA exclusions such as Section 2(g) protect only the 

‘‘agreements, contracts or transactions’’ themselves and not the persons who participate in those transactions is inconsistent with the understanding of market participants concerning the scope of the legal certainty provisions of the CFMA and will 

likely erode the legal certainty protections intended by Congress in 2000. Moreover, 

such a construction is unnecessary to achieve the apparent legislative objectives, 

which ISDA supports, with respect to Section 9.6

The second benefit of a narrow approach to any Zelener-related amendment to the 

CEA is that it will limit the extent to which the CFTC is required to divert its limited resources from its core function of providing effective oversight of exchange 

traded futures and options contracts. Congress has on prior occasions evidenced a 

healthy skepticism toward proposals that would enlarge the CFTC’s consumer protection mandate with respect to contracts not otherwise subject to its jurisdiction 

and it should continue to do so. 

Foreign Exchange Contracts-Affiliates and Solicitors. Proposals have been made to 

limit the ability of firms to create a so-called ‘‘shell’’ futures commission merchant 

(an FCM) that would enable an entity related to the shell FCM (a material affiliated 

person) to qualify under the Treasury Amendment (as revised by the CFMA) to engage in OTC foreign exchange futures transactions with persons who are not eligible 

contract participants. Under these proposals, an FCM would have to be well-capitalized and engaged in the conduct of the regulated futures business. In addition, proposals have been made to require persons who market transactions covered the 

Treasury Amendment to register with the CFTC unless the person is either an entity otherwise eligible under the Treasury Amendment to engage in the transaction 

or an employee of such an entity. 

If appropriately drafted, ISDA could support amendments to address the shell 

FCM and unregistered solicitor issues. ISDA could not, however, support amendments to the CEA that would prohibit those who are material associated persons 

with respect to broker-dealers from engaging, in accordance with the CFMA, in OTC 

foreign exchange futures transactions with persons who are not eligible contract 

participants. There has been no evidence of any inappropriate conduct in transactions involving these entities and they are generally well-capitalized. 

Energy and Other Exempt Commodities. As the Committee is aware, in recent 

years, proposals have been offered in the Senate in connection with energy-related 

legislation to amend the provisions of the CFMA providing legal certainty for OTC 

derivatives based on energy and other so-called ‘‘exempt commodities.’’ These proposals, which would expand regulation of the OTC markets involving exempt commodities, have been consistently opposed by the PWG on policy grounds and, in case 

of energy-based derivatives, on the additional basis that enforcement actions taken 

by regulatory agencies and the Department of Justice rendered them unnecessary. 

ISDA shares the views of the PWG and urges the Committee to oppose any amendments to the CFMA based on these prior proposals. 

Conclusion 

OTC derivatives contribute substantially to the flexibility and resiliency of our financial system. They allow businesses, financial institutions, governmental entities, 

and other end users to manage the financial, commodity, credit, and other risks inherent in their core economic activities in an efficient manner. The CFMA provided 

legal certainty and regulatory clarity for OTC derivatives in a manner consistent 

with the long-standing policies of Congress and the CFTC that OTC derivatives are 

not appropriately regulated under the CEA as futures contracts. This policy, as codified in the CFMA, materially reduces systemic risk and encourages financial innovation. 

On behalf of ISDA and its members, I thank you for this opportunity to present 

our views and am prepared to respond to any questions you may have. 

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PREPARE STATEMENT OF DANIEL J. ROTH

PRESIDENT AND CHIEF EXECUTIVE OFFICER

NATIONAL FUTURES ASSOCIATION

SEPTEMBER 8, 2005

My name is Daniel Roth, and I am President and Chief Executive Officer of National Futures Association. Thank you Chairman Shelby and Members of the Committee for this opportunity to appear here today to present our views on some of 

the issues facing Congress as it considers legislation to reauthorize the Commodity 

Futures Trading Commission (CFTC). NFA recognizes the importance of completing 

the reauthorization process as quickly as possible. At the same time, however, we 

feel that Congress must deal with important issues involving the protection of unsophisticated retail customers. 

NFA is the industry-wide self-regulatory organization for the U.S. futures industry. Regulation is all we do at NFA—we do not operate a marketplace and we are 

not a lobbying organization. As a regulator, NFA is first and foremost a customer 

protection organization. Our mission is to provide the futures industry with the 

most effective and the most efficient regulation possible. 

Our approximately 4,000 members include futures commission merchants 

(FCM’s), introducing brokers (IB’s), commodity pool operators (CPO’s), and commodity trading advisers (CTA’s). We also regulate approximately 54,000 registered 

account executives who work for our members. 

As a regulator, NFA’s main responsibilities are many and varied. We establish 

rules and standards to ensure fair dealing with customers; we perform audits and 

examinations of our members to monitor their compliance with those rules; we conduct financial surveillance to enforce compliance with NFA financial requirements; 

we provide arbitration and mediation of futures-related disputes; we perform trade 

practice and market surveillance activities for a number of exchanges; and we conduct extensive educational programs both for the investing public and for our members. We also perform a number of regulatory functions on behalf of the CFTC,

including the entire registration process—from screening applicants for fitness to 

taking actions to deny or revoke registrations when those fitness standards are not 

met. We perform these duties with a staff of approximately 235 people and a budget 

of over $35 million, all of which is paid by the futures industry. Since NFA began 

operations in 1982, volume on U.S. futures markets has increased by over 1,200 percent—a great testament to the innovation and value of our futures markets. What 

most people do not realize is that during that same time period customer complaints 

in the futures industry are down by almost 75 percent. This drop in customer complaints was not an accident. It was the result of a close partnership between the 

CFTC, NFA, and the rest of the industry to make sure that we are allocating resources where they are most needed, that we do not duplicate each other’s efforts 

and that precious regulatory resources are not squandered. 

In the last reauthorization process, Congress made bold changes to the Commodity Exchange Act (CEA). The Commodity Futures Modernization Act (CFMA) 

rejected a highly prescriptive, outmoded approach to regulation in favor of a more 

flexible approach that focused regulatory protections where they were most needed. 

I am pleased to join the rest of the industry in noting the great success of the CFMA 

and the superb work of the CFTC in implementing exactly the kind of flexible regulatory approach that the CFMA envisioned. The CFTC and its staff have worked 

to reduce unnecessary and costly regulatory burdens for every segment of the industry while preserving the highest level of customer protection. 

Though the CFMA has been a great success, it failed in one of its objectives that 

directly impacts customer protection. Before the CFMA, boiler rooms had found 

their unregulated niche in off-exchange forex, where widespread retail fraud was occurring. Congress attempted to resolve the so-called ‘‘Treasury Amendment’’ issue 

once and for all in the CFMA by clarifying that the CFTC does, in fact, have jurisdiction to protect retail customers investing in off-exchange foreign currency futures. 

The basic thrust of the CFMA in this area was that foreign currency futures with 

retail customers were covered by the Act unless the counterparty was an ‘‘otherwise 

regulated entity,’’ such as a bank, a broker-dealer, or an FCM. Unfortunately, as 

we sit here today, there is as much uncertainty over the CFTC’s authority to protect 

retail customers as there was 5 years ago. This uncertainty is clearly not what Congress intended in passing the CFMA. 

The main problem stems from a decision in the Seventh Circuit Court of Appeals 

in a forex fraud case brought by the CFTC, the so-called Zelener case. In Zelener,

the District Court found that retail customers had, in fact, been defrauded but that 

the CFTC had no jurisdiction because the contracts at issue were not futures. The 

115

Seventh Circuit affirmed that decision. The ‘‘rolling spot’’ contracts in Zelener were 

marketed to retail customers for purposes of speculation; they were sold on margin; 

they were routinely rolled over and over and held for long periods of time; and they 

were regularly offset so that delivery rarely, if ever, occurred. In Zelener, though, 

the Seventh Circuit based its decision that these were not futures contracts predominantly on the terms of the written contract itself. Because the written contract 

in Zelener did not include a guaranteed right of offset, the Seventh Circuit ruled 

that the contracts at issue were not futures. 

Zelener creates the distinct possibility that, through clever draftsmanship, completely unregulated firms and individuals can sell retail customers contracts that 

look like futures, act like futures and are sold like futures and can do so outside 

the CFTC’s and any other Federal regulatory body’s jurisdiction. To make matters 

worse, the rationale of the Zelener decision is not limited to foreign currency products. It is very likely that unsophisticated retail customers will be victimized by 

high-pressured sales pitches for futures look-alike products covering everything from 

foreign currencies to precious metals to heating oil. The CFMA recognized that 

these retail customers are the ones who most need regulatory protection, and that 

protection should not be stripped from them because a clever lawyer finds a loophole 

in the law. 

I recognize that Zelener is just one case, and we should not overreact to it. It is 

true that the Zelener decision would allow the CFTC in other cases to present evidence that the FCM made oral representations about the customer’s right to offset. 

But the reality is that those cases will be almost impossible to bring. First, in most 

cases the sales pitch is not made by the FCM but by an unregistered, unregulated 

solicitor. It is not clear to me that any court would find that the nature of the contract between the customer and the FCM was transformed into a futures contract 

because of oral representations made by some third party, registered or not. Second, 

if the written contract is vague about a right of offset, I can guarantee that the 

salesman working the phone will be even more evasive. In my opinion, trying to 

work our way out of the Zelener problem through future enforcement actions puts 

an awful lot of chips on a bet that’s no sure thing. 

We strongly believe that the Zelener decision makes it much harder for the CFTC 

to prove that contracts sold to retail customers to speculate in commodity prices are 

futures, makes it easier for the unscrupulous to avoid CFTC regulation and creates 

a real, live customer protection issue. Therefore, it is NFA’s view that Congress 

should address this issue. 

The trick is to protect retail customers without upsetting jurisdictional boundaries 

that were agreed to in the CFMA. We agree with the CFTC and the industry that 

Zelener is not an easy problem to resolve. But it must be done if we are to protect 

retail customers from unscrupulous firms and individuals and the solution should 

not be limited to forex. Some have suggested that the best approach is to address 

Zelener only with respect to forex products on the grounds that forex is where the 

bulk of the fraud is occurring. I agree that forex is the current scam of choice among 

fraudsters and I know that those who favor a narrow fix have the best of intentions, 

but limiting a Zelener fix to forex ignores the history of sales practice fraud and will 

not, in our view, really address the problem. 

In NFA’s 20-years of experience we have seen that boiler rooms really prefer to 

sell physical commodities that retail customers deal with all the time. Sugar, gold, 

unleaded gasoline, heating oil—these are the products that boiler rooms have historically favored. Foreign exchange rates, by contrast, are fairly arcane. Forex fraud 

mushroomed, however, after the 9th Circuit’s 1996 Frankwell Bullion decision made 

clear that the CFTC had no jurisdiction over forex futures contracts offered to retail 

customers. Congress attempted to deal with that problem in the CFMA, but the 

Zelener case basically negated that effort and made things worse by providing 

fraudsters with a road map on how to avoid CFTC jurisdiction not just for forex futures but for anything else. We are concerned that if Congress adopts a forex only 

fix to Zelener it will not close the unregulated niche—it will just move it to other 

commodities. 

NFA and the exchanges have developed a fix to Zelener that goes beyond forex 

and does not have unintended consequences. Our approach codifies the approach the 

9th Circuit took in CFTC v. Co Petro—which was the accepted and workable state 

of the law until Zelener—without changing the jurisdictional exemptions in Section 

2(c). In particular, our approach would create a statutory presumption that leveraged or margined transactions offered to retail customers are futures contracts if 

the retail customer does not have a commercial use for the commodity or the ability 

to make or take delivery. This presumption is flexible and could be overcome by 

showing that the transactions were not primarily marketed to retail customers or 

116

were not marketed to those customers as a way to speculate on price movements 

in the underlying commodity. I have attached a copy of our proposed language. 

Our approach has a number of advantages:

• First, it codifies Co Petro and returns the law to its pre-Zelener state. This would 

give the CFTC jurisdiction over traditional futures contracts without expanding 

it. 

• Second, it does not touch the interbank currency market. 

• Third, Section 2(c) would continue to exempt the retail OTC forex activities of 

banks, broker-dealers, insurance companies, and similar entities from CFTC jurisdiction. 

• Fourth, our approach does not change any of the CFMA exemptions for off-exchange transactions entered into by eligible contract participants. 

• And last, but certainly not least, it protects retail customers by giving the CFTC 

the power to shut down unregulated boiler rooms and freeze their funds.

Our presumption is not meant to address already regulated instruments like securities and banking products. It would, however, ensure that scammers cannot tailor 

their written agreements to sell leveraged commodity products to retail customers 

for speculative purposes in a completely unregulated environment. 

NFA believes that the solution to Zelener should go beyond forex. Others disagree. 

One thing we all agree on, though, is that if Congress does not adopt a broad fix 

to Zelener now and boiler rooms move to other commodities using Zelener-type contracts, Congress must be willing to reopen the Commodity Exchange Act before the 

next reauthorization. 

Unfortunately, the Zelener decision is not the only problem we have encountered 

with retail forex. Since passage of the CFMA, a number of firms—that do not engage in any other regulated business—have nonetheless registered as FCM’s to 

qualify to be an otherwise regulated entity and have become NFA Forex Dealer 

Members for the sole purpose of acting as counterparties to retail customers in these 

transactions. For example, just 2 years ago, NFA had 14 active Forex Dealer Members and those Members held approximately $170 million in retail customer funds. 

Since then, the retail forex business has continued to grow by leaps and bounds. 

Today, NFA has 31 active Forex Dealer Members holding over $700 million in customer funds. That growth has not been problem free. 

Though less than 1 percent of our member firms, forex dealers have accounted 

for 50 percent of our emergency enforcement actions and over 10 percent of our arbitration docket. I know the CFTC has been very aggressive in enforcement cases involving forex, though most of those cases have involved unregistered firms. 

Obviously, retail forex has consumed a good deal of resources at NFA, but we are 

committed to doing whatever it takes to get our job done. Late last year, we appointed a blue ribbon committee to review all of our forex rules. It recommended, 

and our Board adopted, additional rules to strengthen both our financial requirements and sales practice rules for forex. We will continue to enforce our rules vigorously and bring actions whenever necessary to ensure compliance with our rules. 

Part of the problem, though, is that some firms can operate beyond our reach, in 

a completely unregulated environment, because of an unintended glitch in the wording of the CFMA. 

As I mentioned before, the basic thrust of the CFMA was that only ‘‘otherwise 

regulated entities’’ could offer retail customers off-exchange foreign currency futures. Unfortunately, the wording of the statute only requires the counterparty to 

be an otherwise regulated entity. This creates the possibility that an FCM, for example, might be the counterparty but the firm that actually does the telemarketing 

for these products is completely unregistered and unregulated. There are literally 

hundreds of these unregulated firms doing telemarketing of off-exchange forex 

transactions to retail customers and in some instances the people making the sales 

pitches have been barred from the futures industry for sales practice fraud. I do not 

think that is what Congress intended at all and NFA would support an amendment 

to Section 2(c) of the Act to make clear that not only the counterparties but also 

the persons actually selling these products to retail customers must be ‘‘otherwise 

regulated entities.’’

There was one more forex problem I should mention, though we are hopeful that 

it is a problem we can solve through NFA rules without any further legislation from 

Congress. Section 2(c) of the CEA could be read to allow unregulated affiliates of 

FCM’s to act as counterparties to retail customers if the FCM makes and keeps 

records of the affiliates under the CEA’s risk-assessment provisions. Some firms 

have tried to take advantage of this provision of the Act by creating ‘‘shell’’ FCM’s. 

These shell FCM’s do not do any futures business and they do not do any retail 

117

forex business. Their sole reason for existence seems to be to create affiliates that 

do retail forex business in a completely unregulated environment. 

I do not think that that is what Congress had in mind. Therefore, NFA is currently working on a solution to adopt a larger minimum capital requirement for 

FCM’s with retail forex affiliates. We hope these efforts will solve the shell FCM 

problem without the need for legislative relief. 

In closing, let me state that NFA believes the industry and the public have benefited greatly from the enlightened regulatory approach that Congress adopted in the 

CFMA and from the CFTC’s role in implementing the Act. We look forward to working with this Committee, other Congressional committees, the CFTC, and the industry to address the issues outlined above. 

118

RESPOSNE TO WRITTEN QUESTION OF SENATOR SHELBY

FROM RANDY K. QUARLES 

Q.1. In oral testimony before the Committee, the CFTC General 

Counsel identified a recent decision in the case of CFTC v. Bradley

as supporting the Commission’s interpretation of its enforcement 

jurisdiction under the Commodity Exchange Act. Have the members of the President’s Working Group reviewed this decision? Do 

the members of the President’s Working Group agree with the decision? Does the decision raise any issues or concerns that the Committee should consider or address?

A.1. The decision referred to by the CFTC’s General Counsel during the September 8 hearing is an August 2005 order by the U.S. 

District Court for the Northern District of Oklahoma denying the 

defendants’ motions to dismiss in the case of CFTC v. Bradley. In 

that case, the CFTC alleged that the defendants violated Section 

9(a)(2) of the Commodity Exchange Act (CEA) by knowingly making, or causing to be made, false reports regarding the prices and 

volumes of transactions in natural gas to several reporting firms 

that compiled natural gas price indexes. In addition, the CFTC alleged that defendants did so in an effort to manipulate the price 

of natural gas futures and options contracts in violation of Sections 

6(c) and (d) and 9(a)(2). 

Natural gas is an ‘‘exempt commodity’’ under the CEA, and an 

‘‘agreement, contract, or transaction’’ in an exempt commodity may 

be excluded or exempt from CFTC jurisdiction, respectively, by Sections 2(g) and 2(h) of the CEA. The defendants in CFTC v. Bradley

requested dismissal of the CFTC’s complaint by arguing that the 

CFTC has no jurisdiction over their activities based on the 2(g) and 

2(h) exemptions. The Bradley court put the burden on the defendants to prove the exemptions applied. It found that the defendants 

offered no authority for the proposition that the 2(g) or 2(h) exemptions apply to reporting activities ‘‘related to’’ an exempt commodity 

or contract. The court’s order denied dismissal of the case in part 

on a finding that the exemptions did not apply. 

The President’s Working Group on Financial Markets (PWG), of 

which Secretary Snow is chair, has not reviewed or formed an opinion about the August 2005 order in CFTC v. Bradley. Treasury consistently has taken the position that legal and regulatory certainty 

are essential for the smooth functioning of our financial markets. 

In the view of some observers the Bradley court’s interpretation of 

the scope of the CEA exemptions has raised questions concerning 

the legal certainty of the exemptions and exclusions that were set 

out in the Commodity Futures Modernization Act of 2000 (CFMA). 

Other observers believe that the decision is in accordance with the 

CFMA’s regulatory framework and accordingly does not raise questions about legal certainty. In light of the potential impact and 

complexity of these issues, and the differing opinions about their 

implications, I will recommend to Secretary Snow that the PWG 

take up the issues raised in the case of CFTC v. Bradley, but I do 

not believe that the PWG’s consideration of these issues should 

delay legislative reauthorization of the CFTC. 

119

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO

FROM PATRICK M. PARKINSON 

Q.1. In oral testimony before the Committee, the CFTC General 

Counsel identified a recent decision in the case of CFTC v. Bradley

as supporting the Commission’s interpretation of its enforcement 

jurisdiction under the Commodity Exchange Act. Have the members of the President’s Working Group reviewed this decision? Do 

the members of the President’s Working Group agree with the decision? Does the decision raise any issues or concerns that the Committee should consider or address?

A.1. The U.S. District Court for the Northern District of Oklahoma’s August 2005 opinion in CFTC v. Bradley held that the fact 

that natural gas is an ‘‘exempt commodity’’ under Sections 2(g) and 

2(h) of the Commodities Exchange Act (CEA) does not mean that 

any conduct or activity ‘‘related to’’ such a commodity is excluded 

from CFTC regulation under the CEA. In this case, the CFTC alleged that the defendants delivered false, misleading, or knowingly 

inaccurate reports on natural gas transactions to reporting firms in 

violation of Section 9(a)(2) of the CEA, and that the defendants did 

so in an attempt to manipulate the price of natural gas futures and 

options contracts on the NYMEX in violation of Sections 6(c), 6(d), 

and 9(a)(2) of the CEA. 

While acknowledging that natural gas is an ‘‘exempt commodity’’ 

under the CEA, the court noted that Sections 2(g) and 2(h) of the 

CEA exempt an ‘‘agreement, contract, or transaction’’ in an exempt 

commodity, but ‘‘do not state that the CEA does not apply to any 

conduct or activity related to exempt commodities.’’ Rather, the 

court found that ‘‘the exemptions are, by their terms, limited to 

contracts, agreements, or transactions.’’ The court held that the defendants’ false disclosures to the reporting firms did not fall within 

the ambit of Sections 2(g) and 2(h) and, accordingly, the exemptions were not applicable. 

The PWG has not discussed the CFTC v. Bradley decision. Nonetheless, the Board has taken the position over the years that financial markets are best served by public policies that create an environment of legal and regulatory certainty. The CFTC v. Bradley decision employs reasoning that, particularly if applied more broadly, 

could undermine the legal and regulatory certainty that many had 

expected the CFMA to achieve. 

RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT

FROM CHARLES P. CAREY 

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 

established regulatory parity between security futures and security 

options. This followed a President’s Working Group report in 1999 

recommending that both the SEC and CFTC work together to determine the regulatory framework for security futures. Do you support the regulatory parity that currently exists between security

futures and security options? Do you think that the SEC should be 

involved in the regulation of security futures? If so, what is the 

SEC’s role?

A.1. The CFMA provided roles to both the Commodity Futures 

Trading Commission and the Securities and Exchange Commission 

120

as regulators of stock futures products, but did not go so far as to 

require security futures be regulated exactly as security options. 

This approach left room for recognition of the fact that security futures and security options are different products with different purposes and customers, while providing the SEC ability to ensure 

that security futures were not used to circumvent securities law 

prohibitions. The dual regulatory scheme of stock futures products 

has been challenging to date and the growth of single stock futures 

in the United States has been anemic, at best, while the products 

have flourished in other jurisdictions. The CBOT believes that 

these products should be given the best chance possible for success, 

and that whatever regulatory structure is in place, it should not 

hamstring the products with illogical treatment. The CBOT continues to believe that requiring absolutely identical treatment for 

two such different products and markets could function to hamper 

the growth of the new product unnecessarily. 

One example of the difficult and unnecessarily burdensome regulatory system is the inability, at least to this point, of the SEC and 

the CFTC to afford rational regulatory treatment of margining for 

these products. Historically, the power to set margins for futures 

products has rested with exchanges. Congress recognized that futures margins were performance bonds, posted by both buyers and 

sellers of commodities for future delivery, to ensure the performance of obligations under the contract, especially if the price moved 

adversely to one’s position. Because futures contracts are not assets, such as stocks, and because margins are not a credit function 

in the acquisition of an asset, exchanges typically set margin at 

levels designed to cover the risk of several days’ price movement 

on a historical basis. The levels of margin, set as a dollar amount 

per contract rather than as a percentage of the price of the underlying product, can quickly be changed in the event of higher volatility in prices, in other words, increased risk. With the advent of 

more powerful data processing and sophisticated financial valuation models and techniques, this risk-based margining today can 

be applied more precisely to futures positions, measuring the risk 

inherent in individual positions as affected by other positions within the same portfolio. Using risk-based margining has provided 

participants in the financial markets with greater flexibility and efficiencies, while at the same time affording greater stability to the 

markets themselves. 

As I said in my testimony, the CBOT hopes Congress will facilitate the margining of stock futures as futures contracts, recognizing that the economic function of a futures contract is not to

acquire ownership of the stock, but rather is to act as a hedging 

vehicle. The CBOT also hopes Congress will provide needed clarity 

on the definition of narrow-based security indexes to avoid unintended confusion about potential dual regulation of futures on indexes of fixed-income securities, corporate bonds, and other nonequity securities that is hampering development of those products. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT 

FROM MARC LACKRITZ 

Q.1.a. The Commodity Futures Modernization Act (CFMA) of 2000 

established regulatory parity between security futures and security 

121

options. This followed a President’s Working Group report in 1999 

recommending that both the SEC and CFTC work together to determine the regulatory framework for security futures. Do you support the regulatory parity that currently exists between security

futures and security options?

A.1.a. Yes. Competing financial products should operate on a regulatory level playing field and be given the opportunity to prove 

their merits in the marketplace.

Q.1.b. Do you think that the SEC should be involved in the regulation of security futures?

A.1.b. Given the SEC’s mandate and in light of the fact that the 

CFMA defined ‘‘security futures’’ as both ‘‘securities’’ and ‘‘futures,’’ 

it would be very surprising if the SEC were not involved in the regulation of the product.

Q.1.c. If so, what is the SEC’s role?

A.1.c. Given the statutory definition of ‘‘security futures,’’ it appears perfectly appropriate for both the CFTC and the SEC to be 

involved in regulating these products, and we urge Congress to continue to encourage the two agencies to work together to develop a 

suitable regulatory framework for security futures. However, as indicated in my September 8 testimony, we do not believe that this 

effort should be conflated with the effort at developing a framework 

for portfolio margining. While a very desirable and achievable goal, 

such a framework should be developed for all financial products. 

RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT

FROM ROBERT G. PICKEL 

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 

established regulatory parity between security futures and security 

options. This followed a President’s Working Group report in 1999 

recommending that both the SEC and CFTC work together to determine the regulatory framework for security futures. Do you support the regulatory parity that currently exists between security

futures and security options? Do you think that the SEC should be 

involved in the regulation of security futures? If so, what is the 

SEC’s role?

A.1. The International Swaps and Derivatives Association represents the world’s leading dealers in swaps and other off-exchange 

derivatives transactions. Our members have benefited significantly 

from the legal certainty that the Commodity Futures Modernization Act of 2000 (CFMA) established for OTC derivatives. The 

CFMA also lifted a 20-year ban on security futures products. 

While, ISDA, as derivatives industry association, does not address 

the securities activities of its members, ISDA believes generally 

that regulations that create additional opportunities for market 

participants can be productive for the market itself. ISDA similarly 

subscribes to the principle that statutory schemes should not unduly favor specific products but should instead foster a level playing field that allows competitive forces to operate efficiently. Given 

the nature of these products and the SEC’s role in the regulation 

and oversight of the underlying securities, the SEC would appear 

to have a legitimate regulatory interest in the development of secuVerDate 0ct 09 2002 18:15 Jul 06, 2007 Jkt 000000 PO 00000 Frm 00125 Fmt 6602 Sfmt 6602 S:\DOCS\35904.TXT SBANK4 PsN: KEVIN
122

rity futures. Congress should continue to encourage the SEC and 

CFTC to work together to carry out the intent of the CFMA. 

RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT

FROM DANIEL J. ROTH 

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 

established regulatory parity between security futures and security 

options. This followed a President’s Working Group report in 1999 

recommending that both the SEC and CFTC work together to determine the regulatory framework for security futures. Do you support the regulatory parity that currently exists between security

futures and security options? Do you think the SEC should be involved in the regulation of security futures? If so, what is the SEC’s 

role?

A.1. NFA has no objection to regulatory parity between security futures and security options as long as the regulations work efficiently for both products. The current margin regulations—which 

were originally developed for security options—do not work efficiently for security futures. Portfolio margining has proven to be a 

more effective way to measure and reduce financial risk in the futures markets. Therefore, if regulatory parity is appropriate, the 

better approach is to allow futures-style portfolio margining for security options rather than to prohibit it for security futures. 

Regulatory schemes that give regulators overlapping responsibilities tend to be less flexible and slower-moving than single-regulator schemes. Still, we recognize that both agencies have a stake 

in the security futures markets—the CFTC because of its expertise 

and its responsibility for futures on all types of underlying products 

and the SEC because of its interest in safeguarding the integrity 

of the securities markets. We have a good working relationship 

with SEC staff, and we are confident that we will continue that relationship regardless of the role Congress assigns to the SEC.