United States General Accounting Office

GAO Report to Congressional Committees

April 1997 THE COMMODITY

EXCHANGE ACT

Legal and Regulatory

Issues Remain

GAO/GGD-97-50

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-259983 

April 7, 1997

The Honorable Richard G. Lugar

Chairman

The Honorable Tom Harkin

Ranking Minority Member

Committee on Agriculture, Nutrition

 and Forestry

United States Senate

The Honorable Thomas W. Ewing

Chairman

The Honorable Gary A. Condit

Ranking Minority Member

Subcommittee on Risk Management

 and Specialty Crops

Committee on Agriculture

House of Representatives

In the past quarter century, technological advances and fundamental

changes in the global financial markets have accelerated the development

and use of financial products generically called derivatives.1

 Derivatives

include futures contracts2

 that traditionally have been traded on organized

exchanges and are regulated by the Commodity Futures Trading

Commission (CFTC) under the Commodity Exchange Act (CEA).3

 They also

include swaps4

 and other over-the-counter (OTC) derivatives contracts that

resemble exchange-traded futures in their economic function but are

privately negotiated between counterparties outside organized exchanges.

As we and others have reported,5

 derivatives can serve a useful

risk-management function, but their use can pose risks to participants and

the markets. The total notional/contract amount of derivatives contracts

1

Derivatives are contracts that have a market value determined by the value of an underlying asset,

reference rate, or index (called the underlying). Underlyings include stocks, bonds, agricultural and

other physical commodities, interest rates, foreign-currency rates, and stock indexes.

2

Futures contracts are derivatives that obligate the holder to buy or sell a specific amount or value of

an underlying asset, reference rate, or index at a specified price on a specified future date.

3

7 U.S.C. 1 et seq.

4

Swaps are privately negotiated contracts that typically require counterparties to make periodic

payments to each other for a specified period. The calculation of these payments is based on an

agreed-upon amount, called the notional amount, that is not typically exchanged.

5

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

1994) and the update to this report, Financial Derivatives: Actions Taken or Proposed Since May 1994

(GAO/GGD/AIMD-97-8, Nov. 1, 1996).

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outstanding worldwide was an estimated $55.7 trillion as of March 31,

1995.6

Because of their resemblance to exchange-traded futures, swaps and other

OTC derivatives faced the possibility of falling within the judicially crafted

definition of a futures contract. As a result, they faced the legal risk of

being unenforceable under the CEA due to its requirement that futures be

traded on exchanges to be legal and thus enforceable. The Futures Trading

Practices Act of 1992 (P.L. 102-546) provided CFTC with authority to reduce

this legal risk, which the agency subsequently used. At the same time,

developments in the exchange-traded futures and OTC derivatives markets

brought regulated financial institutions into these markets, leading to a

greater array of derivatives contracts and greater competition among

those providing such contracts. Consequently, some of the distinctions

among market participants and between exchange-traded futures and OTC

derivatives have become blurred—raising questions about the appropriate

regulatory structure for these contracts, markets, and market participants.

Because of the Committees’ interest in the CEA and congressional interest

in the continued vitality and integrity of the U.S. exchange-traded futures

and OTC derivatives markets, we initiated this review to provide Congress a

context for addressing these questions. Specifically, we focused on (1) the

extent to which CFTC has reduced the legal risk surrounding the

enforceability of OTC derivatives under the CEA and (2) issues related to the

appropriate regulation for exchange-traded futures and OTC derivatives

contracts, including their markets and market participants.

Results in Brief Under the authority provided by the Futures Trading Practices Act of 1992,

CFTC exempted most swaps and other OTC derivatives contracts from the

CEA’s exchange-trading requirement and, in doing so, reduced or

eliminated the legal risk that they could be unenforceable. The legal risk

arose from the possibility that CFTC or a court could find that swaps and

other OTC derivatives fell within the judicially crafted definition of a

futures contract, in part because, like futures, they served a risk-shifting

function. If determined to be futures, these contracts would have violated

the CEA’s requirement that futures be traded on an organized exchange,

making them illegal and thus unenforceable. In granting the exemptions,

CFTC was not required to, and did not, determine that OTC derivatives were

futures. As a result, a question has remained about whether OTC derivatives

6

This estimate was based on a comprehensive survey done by the Bank for International Settlements

and represents the most current data available. The notional amount of derivatives contracts is one

way that derivatives activity is measured. Because the notional amount is not exchanged in most OTC

derivatives transactions, it is not typically a measure of the amount at risk.

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are futures and can be regulated under the act. The possibility that swaps

are futures continues to be a source of legal risk for a narrow group of

swaps—so-called equity swaps—that are ineligible for exemption from the

act’s requirements. Legal risk also remains for certain agricultural

forwards7

 that are becoming increasingly difficult to distinguish from

futures and that may not be eligible for the swaps exemption.

Although CFTC reduced or eliminated the legal risk of being unenforceable

for most swaps and other OTC derivatives, a broader policy question

remains about the appropriate regulation for OTC derivatives and

exchange-traded futures, including their markets and market participants.

We discuss three issues that are related to this policy question. The first

issue concerns the appropriate regulation for the OTC foreign-currency

market under the CEA. The act excludes from its regulation certain OTC

foreign-currency transactions, but the scope of the exclusion—called the

Treasury Amendment—has been the subject of disagreement among

federal regulators and the courts. A recent U.S. Supreme Court decision

resolved that the exclusion covers all transactions in foreign currency,

including foreign-currency options and futures.8

 The Court did not,

however, address the meaning of language that saves from the exclusion

sales for future delivery conducted on a board of trade. As a result, the

extent to which the Treasury Amendment excludes transactions involving

unsophisticated market participants may still be subject to debate.

The second issue concerns the potential for the swaps market to evolve

beyond its exemption and raise additional regulatory concerns. CFTC

exempted swaps from virtually all CEA requirements but imposed

conditions on the exemption that restricted their design and trading

procedures. Although difficult to predict, the swaps market might develop

in ways that are inconsistent with these conditions. Should this occur,

CFTC could use its exemptive authority to accommodate market

developments and address any regulatory concerns, but such an approach

could introduce, among other things, jurisdictional questions involving

7

Forwards are privately negotiated contracts in which the buyer and seller agree upon delivery of a

specified quality and quantity of goods at a specified future date. A price may be agreed upon in

advance or determined at the time of delivery. Delivery is typically expected, although it may not

occur.

8

CFTC v. Dunn, 65 U.S.L.W. 4141 (U.S. Feb. 25, 1997), rev’g 58 F. 3d 50 (2d Cir. 1995).

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other federal regulators. The President’s Working Group on Financial

Markets provides one forum for addressing such questions.9

The third issue concerns the rationale for the regulatory differences

between the OTC derivatives and exchange-traded futures markets. The

types of contracts transacted in each market serve similar economic

functions but differ in other ways, including the way they are traded and

regulated. CFTC recently granted the exchanges an exemption to enable

them to better compete against the less regulated OTC derivatives market.

However, under the exemption, regulation of the two markets will

continue to differ substantially. While the exchange exemption represents

one approach to rationalizing the regulatory differences between the

markets, it also illustrates some of the challenges in doing so.

In attempting to address the appropriate regulation of the exchange-traded

futures and OTC derivatives markets, three fundamental questions arise

concerning the goals of federal policy. These questions are (1) what is the

current public interest in these markets that needs to be protected;

(2) what type of regulations are needed, if any; and (3) what is the most

efficient and effective way to implement and enforce any needed

regulations? Ultimately, maintaining globally competitive U.S. derivatives

markets will require balancing the goal of allowing the U.S. financial

services industry to innovate and grow with the goal of protecting

customers and the market, including its efficiency, fairness, and financial

integrity.

Background

The Futures Market Is

Regulated Under the CEA

Futures contracts first appeared in the United States in the mid-1800s and

were based on grains. They provided producers (farmers) and commodity

users with a means of reducing the risk of financial loss arising from

adverse fluctuations in commodity prices, called hedging. They also

provided a more efficient and transparent means of determining

commodity prices based on supply and demand factors, called price

discovery. Because of concerns about price manipulation and other

trading abuses in the futures market, including the operation of bucket

9

The President’s Working Group on Financial Markets was created following the October 1987 stock

market crash to address issues concerning the competitiveness, integrity, and efficiency of the

financial markets. The Secretary of the Treasury chairs the working group, and other members include

the chairs of CFTC, the Federal Reserve System, and the Securities and Exchange Commission.

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shops,10 Congress passed the CEA in 1936 to amend the Grain Futures Act

of 1922. Like its predecessor, the CEA required that futures trading in

specified commodities—such as corn, rye, and wheat—be conducted only

on federally designated markets. To receive such a designation, an

exchange had to meet certain self-regulatory requirements that included

providing for the prevention of manipulation and fraud. Congress

periodically amended the act to bring futures trading in additional

commodities under the CEA. For example, Congress amended the act in

1968 and brought futures trading in livestock, livestock products, and

frozen concentrated orange juice under federal regulation.

By the early 1970s, futures trading had expanded to include

nonagricultural commodities, such as precious metals and foreign

currencies. Although contracts on these commodities were traded on

futures exchanges, they were not covered by the act and, thus, were not

federally regulated. In 1974, Congress amended the CEA to ensure that all

futures contracts—whatever their underlying commodity—would be

federally regulated. It accomplished this goal by expanding the list of

commodities covered by the act to include virtually anything, tangible or

intangible.11 As a result, the class of instruments that could be defined as

futures and subject to the act’s exchange-trading requirement was

broadened. Any contract that was legally categorized as a futures contract

could be traded only on federally designated exchanges, making the

off-exchange trading of futures illegal.

The 1974 amendments to the CEA also created CFTC to administer the CEA.

12

The CEA gives CFTC exclusive jurisdiction over futures and establishes a

comprehensive regulatory structure designed to protect the futures market

and its participants. Historically, CFTC’s regulatory structure was designed

to assure that all futures contracts were traded on self-regulated

exchanges and through regulated intermediaries, which were subject to

capital, examination, recordkeeping, registration, reporting, and customer

protection requirements. The CEA’s exchange-trading requirement was

intended to foster both market integrity and customer protection by

creating a centralized market that could be protected against excessive

10Bucket shops are firms that purport to conduct a legitimate business by accepting orders for futures

contracts, but that do not actually execute the orders in the futures market. When the price on the

futures market moves against the bucket shops, they often close their doors or file for bankruptcy

protection, leaving uncollectible debts.

11The list of specified commodities was expanded to include “all goods and articles . . . and all services,

rights, and interests in which contracts for future delivery are presently or in the future dealt in.”

12Before the 1974 amendments to the CEA, the Department of Agriculture administered the act and

regulated the futures market.

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speculation, price manipulation,13 and other abusive trade practices.

According to the act, regulation of the futures market was necessary to

protect the public interest, because futures prices were susceptible to

excessive speculation and could be manipulated to the detriment of

producers, consumers, and others. Moreover, the act’s legislative history

noted that the fundamental purposes of the act were to ensure fair

practices and honest dealing in the futures market and to control those

forms of speculative activity that demoralize the market to the detriment

of producers, consumers, and the markets.

While providing for their regulatory oversight, the CEA does not define the

term futures contract. Instead, CFTC and the courts have identified certain

elements as necessary, but not always sufficient, for defining a futures

contract. These elements are

• the obligation of each party to fulfill the contract at a specified price set at

the contract’s initiation,

• the use of the contract to shift or assume the risk of price changes, and

• the ability to satisfy the contract by either delivering the underlying

commodity or offsetting14 the original contract with another contract.

CFTC and the courts have also identified additional elements of

exchange-traded futures contracts, including standardized terms, margin

requirements,15 use of clearinghouses,16 open and competitive trading in

centralized markets (such as futures exchanges), and public price

dissemination. These additional elements facilitate futures trading on

exchanges but do not define what makes a contract a futures contract.

Also, according to CFTC and the courts, the requirement that a futures

contract be exchange-traded is what makes the contract legal, not what

makes it a futures contract. Because CFTC and the courts have defined a

futures contract in a way that reflects its risk-shifting function, the CEA

13Manipulation is the distortion of market prices for economic gain. The distortion typically involves

creating artificial prices that do not reflect supply and demand conditions, or creating a false picture of

supply and demand conditions to cause a desired price movement and/or reaction by other market

participants.

14Offset for exchange-traded futures is the liquidation of a long (short) futures position through the

sale (purchase) of an equal number of contracts of the same delivery month.

15Margins are the cash or collateral deposited by customers with their agents for the purpose of

insuring the agents and, ultimately, clearinghouses against loss on open exchange-traded futures

contracts.

16Clearinghouses are responsible for the daily clearance and settlement of all trades. Clearance is the

process of capturing the trade data, comparing buyer and seller versions of the data, and guaranteeing

that the trade will settle once the data are matched. Settlement is the process of fulfilling contractual

requirements through cash payment or delivery.

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potentially covers a broad range of risk-shifting products that are not

exchange-traded.

The CEA also provides CFTC with jurisdiction over commodity options,17

except options on securities18 and options on foreign currencies traded on

a national securities exchange. CFTC’s options jurisdiction is further limited

by the recent U.S. Supreme Court decision in CFTC v. Dunn.

19 Commodity

options include options to acquire futures contracts (called options on

futures) and options to acquire the actual commodity, excluding

securities. CFTC has issued regulations to allow futures exchanges, subject

to its approval, to trade options on futures in any commodity and options

on actual commodities other than domestic agricultural commodities.

Futures exchanges have been trading options since 1982, and virtually all

options traded on futures exchanges are options on futures. CFTC has also

issued regulations to allow certain options on commodities other than

domestic agricultural commodities (called trade options) to be traded

off-exchange. These OTC options are to be offered and sold to commercial

counterparties who enter into transactions for purposes related solely to

their business.

Since the 1974 amendments to the CEA and the creation of CFTC, the U.S.

futures market has evolved far beyond its agricultural origins and is now

dominated by futures based on financial products. In 1975, the largest

commodity group was domestic agricultural commodities, accounting for

nearly 80 percent of total trading volume. By 1996, the largest group was

interest rate contracts, accounting for 54 percent of total trading volume.

At the same time, agricultural commodities accounted for about

19 percent of total trading volume. According to the exchanges and others,

the participants in the futures market have changed as the market evolved.

They noted that the participants are now largely institutions and market

professionals, with retail customers representing a smaller proportion of

total market participants than they did when the act was amended in 1974.

17Commodity options give the purchaser the right, but not the obligation, to buy or sell a specified

quantity of the underlying commodity or financial asset at a particular price on or before a certain

future date.

18CEA section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional Accord, excludes options on

securities from CFTC’s jurisdiction. Options on securities are regulated by the Securities and

Exchange Commission under federal securities laws.

19In CFTC v. Dunn, CFTC brought an enforcement action against an investment fund that was allegedly

defrauding its investors through the purchase and sale of currency options, CFTC v. Dunn, 65 U.S.L.W.

4141 (U.S. Feb. 25, 1997), rev’g 58 F. 3d 50 (2d Cir. 1995). The impact of this decision is covered in our

discussion of the Treasury Amendment.

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During this period, the CEA has remained the primary statute specifically

created to regulate the trading of derivative products.

OTC Derivatives and

Exchange-Traded Futures

Can Be Used as Substitutes

for and Complements to

Each Other

OTC derivatives and exchange-traded futures have similar characteristics

and economic functions but differ in other ways. The market values of

both products are determined by the value of an underlying asset,

reference rate, or index. The economic uses of both products include

hedging financial risk and investing with the intent of profiting from price

changes, called speculating. OTC derivatives and exchange-traded futures

differ in the way they are traded and cleared as well as in their degree of

standardization. OTC derivatives, which include forwards, options, and

swaps, are privately negotiated contracts. They are entered into between

counterparties, also called principals, outside centralized trading facilities20

such as futures exchanges. Counterparties negotiate contract terms—such

as price, maturity, and quantity—to customize the contracts to meet their

specific economic needs. Because OTC derivatives are entered into on a

principal-to-principal basis, each counterparty is exposed to credit

risk—the risk of loss resulting from the other party’s failure to meet its

financial obligation. In contrast, futures traditionally have been traded on

organized exchanges as well as cleared and settled through

clearinghouses. Clearinghouses manage counterparty credit risk, in part

by substituting themselves as the buyer to every seller and the seller to

every buyer. They also guarantee daily settlement of price changes,

thereby eliminating the need for the original counterparties to monitor

each other’s creditworthiness.21 Exchange-traded futures generally have

standardized terms—except for price, which the market determines.

The exchange-traded futures and OTC derivatives markets have followed

similar evolutionary paths. Exchange-traded futures developed from

forward grain contracts that were customized and traded on a

principal-to-principal basis. They evolved into contracts that have

standardized terms, except for price, and are traded on centralized

exchanges. Similarly, OTC derivatives originated as customized contracts

that involved brokers finding and matching counterparties. Today, almost

20Centralized trading facilities are physical or electronic facilities in which all market participants are

able to execute transactions simultaneously and bind both parties by accepting offers that are made by

one participant but open to all market participants.

21Counterparties still face credit risk from the potential failure of their clearinghouse and/or clearing

member (a member of the clearinghouse). Also, clearing members face credit risk from their exposure

to customers, and customers face credit risk from their exposure to other customers whose funds

have been segregated in the same account. In the United States, exchange rules and CFTC regulations

provide safeguards to minimize credit risk arising from such sources.

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all OTC derivatives are traded through dealers.22 An industry association

has developed standardized documentation for certain OTC derivatives,

including swaps. However, each contract, including its material terms,

continues to be privately negotiated between the two counterparties. The

less complex interest rate and foreign-exchange swaps, called plain vanilla

swaps, have become more homogeneous in terms of underlying reference

rates or indexes and maturities. The majority of both swaps and

exchange-traded futures are settled without delivery of the underlying

commodity or financial asset.

Because OTC derivatives and exchange-traded futures serve similar

economic functions, they can be used as substitutes for one another and

thus may compete in the marketplace. However, they are not perfect

substitutes because of potential differences in their contract terms as well

as transaction costs, regulations, and other factors. OTC derivatives and

exchange-traded futures can also complement each other. For example,

swaps dealers use exchange-traded futures to hedge the residual risk

resulting from unmatched positions in their swaps portfolios. Similarly,

food processors, grain elevators, and other commercial firms use

exchange-traded futures to hedge their forward positions.

Scope and

Methodology

To address our two objectives, we reviewed the CEA and its legislative

history, Federal Register notices, comment letters, and other material

related to CFTC’s exemptions for hybrid, OTC energy, swaps, and

exchange-traded futures contracts. We also interviewed CFTC officials,

including past commissioners, about the agency’s use of its exemptive

authority for OTC derivatives and exchange-traded futures as well as the

legal and regulatory issues raised by these markets. Furthermore, we

interviewed officials of three futures exchanges (the Chicago Board of

Trade, Chicago Mercantile Exchange, and New York Mercantile

Exchange), the Federal Reserve Board, the Office of the Comptroller of

the Currency, and the Securities and Exchange Commission (SEC) to

obtain their views concerning legal and regulatory issues related to the

exempted OTC derivatives. In addition, we attended conferences and

congressional hearings as well as reviewed legal cases, journal articles,

books, and reports pertaining to the CEA and the OTC derivatives and

exchange-traded futures markets.

22Dealers are typically banks and other financial institutions that stand ready to buy or sell OTC

derivatives, providing both a bid and offer price to the market.

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Although OTC derivatives raise issues that extend beyond the CEA, we

limited our review to the legal and regulatory issues raised within the

context of the act. Given this focus, our discussion centered on futures,

forwards, and swaps and generally did not cover other financial products,

including securities options, asset-backed securities, and structured notes,

which are regulated under the federal securities laws.

We requested comments on a draft of this report from the heads, or their

designees, of CFTC, the Department of the Treasury, the Federal Reserve

Board, the Office of the Comptroller of the Currency, and SEC. We also

requested comments from three futures exchanges (the Chicago Board of

Trade, Chicago Mercantile Exchange, and New York Mercantile

Exchange), the New York Stock Exchange, and four industry associations

(the Futures Industry Association,23 International Swaps and Derivatives

Association,24 Managed Futures Association,25 and National Futures

Association26). CFTC, the Department of the Treasury, the Federal Reserve

Board, and SEC provided us with written comments under a joint response

as members of the President’s Working Group on Financial Markets. We

also obtained written comments from two futures exchanges (the Chicago

Mercantile Exchange and Chicago Board of Trade) and the four industry

associations. These comments are discussed at the end of this report and

are reprinted in appendixes I through VII. We did not receive written

comments from the Office of the Comptroller of the Currency, New York

Mercantile Exchange, or New York Stock Exchange. In addition, officials

from CFTC, the Department of the Treasury, the Federal Reserve Board, the

Office of the Comptroller of the Currency, SEC, the International Swaps

and Derivatives Association, and the Chicago Mercantile Exchange

provided us with technical comments that were incorporated into the

report as appropriate. We did our work in Chicago, New York, and

Washington, D.C., between August 1994 and February 1997 in accordance

with generally accepted government auditing standards.

23The Futures Industry Association is the national trade association of the futures industry.

24The International Swaps and Derivatives Association is a trade association that represents more than

150 financial institutions worldwide. Its members include investment, commercial, and merchant

banks that deal in OTC derivatives contracts.

25The Managed Futures Association is a national trade association that represents the managed futures

industry. Its members are primarily commodity pool operators and commodity trading advisors.

Commodity pool operators are individuals or firms that solicit or accept funds, securities, or property

for the purpose of trading commodity futures or options. Commodity trading advisors are individuals

or firms that are in the business of advising others, either directly or through publications, on the value

or advisability of trading commodity futures or options.

26The National Futures Association is a self-regulatory organization that is responsible, under CFTC

oversight, for qualifying commodity futures professionals and for regulating the sales practices,

business conduct, and financial condition of its member firms.

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CFTC Used Its

Exemptive Authority

to Reduce or

Eliminate the Legal

Risk Surrounding the

Enforceability of Most

OTC Derivatives

Before 1993, swaps and other OTC derivatives contracts faced the legal risk

of being deemed illegal off-exchange futures and thus unenforceable under

the CEA. To reduce this risk and promote innovation and fair competition,

Congress granted CFTC exemptive authority under the Futures Trading

Practices Act of 1992. CFTC used its authority in 1993 to exempt swaps and

other OTC derivatives from most CEA provisions (including the

exchange-trading requirement), thereby reducing or eliminating their legal

risk. However, a narrow group of swaps that are ineligible for the

exemption continue to face the risk of being illegal futures. In addition,

certain unregulated forwards have become increasingly difficult to

distinguish from regulated futures, resulting in legal risk.

Swaps and Other OTC

Derivatives Faced the Risk

of Being Illegal and Thus

Unenforceable Futures

Under the CEA

The CEA excludes forwards and certain other OTC derivatives from its

regulation, but many swaps and other OTC derivatives could not qualify for

these exclusions. As a result, they faced the risk that CFTC or a court could

find them to be illegal and, thus, unenforceable futures under the CEA. To

reduce this legal risk, CFTC issued a policy statement in 1989 to clarify the

conditions under which it would not regulate swaps as futures. CFTC’s

policy statement, however, did not eliminate the risk of a court finding

swaps to be futures. In 1990, a court found certain OTC derivatives that

resembled unregulated forwards to be futures, which heightened the legal

risk for swaps and other OTC derivatives. Following the court decision,

CFTC issued a statutory interpretation holding that the OTC derivatives in

question were forwards, not futures.

Many Swaps Could Not Qualify

for an Exclusion From

Regulation Under the CEA

Due to their similarities to futures, swaps and other OTC derivatives faced

the legal risk of being deemed futures under the CEA, making them illegal

and, thus, unenforceable. These contracts were developed in the 1980s to

meet the risk-management, financing, and other needs of market

participants. Swaps evolved from parallel loans that involved two parties

making loans to each other in equal amounts but denominated in different

currencies. Over time, swaps were developed based not only on foreign

currencies but also on interest rates, commodities, and securities. These

contracts, like forwards, were entered into between two counterparties

outside an exchange and could be viewed as serving a similar economic

function as a series of forwards. However, swaps differed from forwards

in that they typically did not entail delivery of the specified underlying

commodity, a hallmark of traditional forwards. As such, swaps generally

were not considered forwards for regulatory purposes. Consequently, they

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did not fall under the CEA’s forward exclusion27 (discussed below), which

would have excluded them from regulation under the act. Nor did many

swaps fall under the CEA’s Treasury Amendment28 (discussed below),

which excludes certain OTC transactions in foreign currencies and other

financial instruments from regulation under the act.

Swaps that could not qualify for an exclusion from the CEA under its

forward exclusion or Treasury Amendment faced the possibility of falling

within the judicially crafted definition of a futures contract, because they,

like futures, served a risk-shifting function. This possibility resulted in

legal risk for such swaps by bringing into question their enforceability as

futures under the act. If such swaps were found to be futures, they would

be illegal and unenforceable, because they would have been traded

off-exchange in violation of the CEA’s exchange-trading requirement. Given

the legal uncertainty surrounding the status of swaps as futures, swaps

counterparties faced legal risk from two sources. First, CFTC could take

enforcement action and find swaps to be illegal, off-exchange futures

contracts. Second, counterparties on the losing side of swaps could try to

have a court invalidate the contracts as illegal, off-exchange futures

contracts.

To Reduce Legal Risk for

Swaps, CFTC Issued a Policy

Statement

To reduce the legal risk of unenforceability in the swaps market, CFTC

issued a swaps policy statement in 1989 that clarified the conditions under

which it would not regulate certain swaps as futures. In part, CFTC

predicated its swaps policy statement on the rationale that swaps lacked

certain elements that facilitated futures trading on exchanges, such as

standardized terms and a clearinghouse. As such, swaps were not suitable

for exchange trading and, in turn, not appropriately regulated as

exchange-traded futures contracts. In this regard, CFTC identified

conditions (collectively called a safe harbor) that swaps settled in cash

could meet to avoid regulation under the CEA. These conditions were that

the swaps

• have individually tailored terms,

• be used in conjunction with the counterparty’s line of business,

• not be settled using exchange-style offset or a clearinghouse, and

• not be marketed to the general public.

27The forward exclusion is set forth in CEA section 2(a)(1)(A)(i). Originally enacted as part of the

Grain Futures Act of 1922, it excludes forward contracts from CFTC regulation to facilitate the

movement of agricultural commodities through the merchandizing chain.

28The Treasury Amendment is set forth in CEA section 2(a)(1)(A)(ii).

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CFTC’s swaps policy statement did not eliminate all legal risk of

unenforceability. It removed the legal risk that CFTC would take

enforcement action against certain swaps, but it did not remove the legal

risk that a swaps counterparty might try to have a court invalidate a swap

as an illegal, off-exchange futures contract. A court finding that a swap

was a futures contract could call into question the legality of other

swaps—potentially threatening the market’s financial integrity and

potentially presenting a source of systemic risk.29

A Court Found That Certain

OTC Derivatives Were Futures,

Causing CFTC to Issue a

Statutory Interpretation to

Reduce Legal Risk

Following the issuance of CFTC’s swaps policy statement, a federal district

court found that certain OTC energy contracts were futures. This finding

heightened the legal risk of unenforceability for swaps and other OTC

derivatives because of the possibility that a court could also find them to

be futures and subject to the CEA’s exchange-trading requirement. Judicial

proceedings began in 1986 when commercial participants in the Brent oil

market30 were sued for violating, among other laws, the CEA’s

antimanipulation provisions. The participants responded by claiming that

the contracts were forwards and excluded from the CEA because no

contractual right existed to avoid delivery. In April 1990, a federal district

court rejected the claim and found that the contracts were futures, not

forwards.31 The court concluded that even though the contracts did not

include a contractual right of offset for avoiding delivery, both the

opportunity to offset the contracts and the common practice of doing so

were sufficient to determine that the contracts were futures. Furthermore,

the court found that the Brent oil contracts, like futures, were undertaken

mainly to assume or shift price risk without transferring the underlying

commodity. The contracts had highly standardized terms, which facilitated

their settlement without delivery and reflected their use for risk-shifting or

speculative purposes.

On September 25, 1990, CFTC issued a statutory interpretation for forwards

that adopted the view that the Brent oil contracts were forwards, not

futures. CFTC did not dispute the court’s findings that these contracts were

highly standardized and routinely settled by means other than delivery.

Rather, it found that the contracts fell under the CEA’s forward exclusion

29Systemic risk is the risk that a disruption—at a firm, in a market, or from another source—will cause

difficulties at other firms, in other market segments, or in the financial system as a whole.

30Brent oil contracts are for the future purchase or sale of Brent crude oil, which is a blend of oils

produced in various fields in the North Sea and delivered through pipelines for loading on cargo ships

at Sullem Voe in Scotland.

31Transnor (Bermuda) Limited v. BP North America Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990).

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because they required the commercial parties to make or take delivery,

even though the parties did not routinely do so. CFTC noted that the

contracts did not include any provisions that enabled the parties to settle

their contractual obligations through means other than delivery, and the

settlement of contracts without delivery was done through subsequent,

separately negotiated contracts. In that regard, CFTC noted that these

contracts served the same commercial function as forwards covered under

the CEA exclusion, notwithstanding the fact that many of the individual

contracts were settled routinely without delivery. One CFTC commissioner

dissented from the agency’s statutory interpretation, which, he said,

misinterpreted the CEA exclusion by broadening it to include transactions

that were, among other things, generally standardized, used for

noncommercial purposes, and offset.

Congress Granted CFTC

Exemptive Authority to

Reduce the Legal Risk

Facing Swaps and Other

OTC Derivatives

Following the court’s finding that certain OTC energy contracts were

futures and recognizing the broader implications of that decision for other

OTC derivatives, Congress granted CFTC exemptive authority under the

Futures Trading Practices Act of 1992. The 1992 act granted CFTC the

authority to exempt any contract from almost all CEA provisions (including

the exchange-trading requirement), provided the exemption was

consistent with the public interest32 and the contract was entered into

solely between appropriate persons, as defined in the act. In granting an

exemption, CFTC could impose any conditions on the exemption that it

deemed appropriate. The only provision from which CFTC could not

exempt a contract was section 2(a)(1)(B), which generally prohibits

futures contracts on individual stocks and narrowly based stock indexes.33

According to the 1992 act’s legislative history, Congress expected CFTC to

use its exemptive authority promptly to reduce legal risk for swaps,

32According to the legislative history, the public interest was to include the national public interest

noted in the CEA (discussed in section 3 of the act), prevention of fraud, preservation of the financial

integrity of the markets, and promotion of responsible economic or financial innovation and fair

competition.

33The section provides procedures under which CFTC, subject to SEC’s review, may permit exchanges

to trade futures contracts on stock indexes provided minimum criteria are met. These criteria include

that the contract is settled other than through delivery of the underlying securities and the underlying

index of securities is broadly based.

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forwards,34 and hybrids.35 The legislative history noted that the goal of

providing CFTC with broad exemptive authority was to give CFTC a means of

providing certainty and stability to existing and emerging markets so that

financial innovation and market development could proceed in an

effective and competitive manner. It also noted that CFTC could exempt a

contract without first determining that the contract was a futures contract

and subject to the act.

CFTC Used Its Authority to

Exempt Most Swaps and

Other OTC Derivatives

From Most CEA Provisions

Using its exemptive authority, CFTC exempted a broad group of swaps as

well as hybrids from virtually all CEA provisions—including the

exchange-trading requirement—in January 1993. In response to a request

by a group of commercial firms in the energy market, CFTC granted a

similar exemption in April 1993 to specified OTC energy contracts, which

included Brent oil contracts. These exemptions eliminated the legal risk

that the qualifying contracts could be deemed illegal, off-exchange futures

contracts. If CFTC or a court found an exempted contract to be a futures

contract, the contract would still be legal, because it would no longer need

to be traded on a designated market, or exchange. As a result, uncertainty

was reduced and with it, the potential for any related systemic risk. At that

time, CFTC noted that the exemptions should enhance U.S. market

participants’ ability to innovate by enabling them to structure OTC

contracts to best meet their economic needs, which should enable market

participants to compete more effectively in international markets. In

granting its exemptions, CFTC did not determine that the OTC derivatives

covered by the exemptions were or were not futures or otherwise

excluded from the act’s jurisdiction. CFTC noted that it had not made and

was not obligated to make such a determination.

A Narrow Group of Swaps

Not Eligible for the

Exemption Face the Risk

of Being Illegal Futures

CFTC’s swaps exemption does not extend to a narrow group of swaps,

so-called equity swaps.36 Because of the possibility that swaps are futures,

these nonexempted swaps continue to face the legal risk of being deemed

illegal and, thus, unenforceable futures. CFTC enforcement actions

involving OTC derivatives can increase such legal risk for these swaps.

34In elaborating on the forward exemption in the act’s legislative history, Congress encouraged CFTC

to determine whether exemptive or other action should be taken for Brent Oil contractsn.

35Hybrids are financial instruments that possess, in varying combinations, characteristics of futures,

forwards, options, securities, and/or bank deposits. Unlike many other derivatives, hybrids generally

serve a capital-raising function.

36In addition, CFTC’s exemption does not extend to swaps based on securities registered with

SEC—such as swaps based on registered corporate debt. To the extent that such swaps exist, the

following discussion on equity swaps applies to them.

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CFTC’s Swaps Exemption Does

Not Cover All Swaps

CFTC’s swaps exemption does not extend to equity swaps, whose returns

are based on stocks or stock indexes. Even if these swaps met all of the

conditions of CFTC’s swaps exemption, they would not be exempt from CEA

section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional

Accord. Under the 1992 act, CFTC is allowed to exempt swaps from any CEA

provision, except section 2(a)(1)(B), which divides jurisdiction on

exchange-traded securities-related futures and options contracts between

CFTC and SEC and prohibits futures on individual stocks or narrowly based

stock indexes. Futures on broadly based stock indexes may be traded only

on CFTC-designated markets, provided CFTC determines that the contracts

are not settled through the delivery of the underlying stocks and are not

readily susceptible to manipulation. SEC must also agree with CFTC’s

determinations. According to market observers, if equity swaps were

found to be futures contracts, they could be in violation of section

2(a)(1)(B) and thus be illegal and unenforceable.

As long as the issue of whether swaps are futures is not definitively

addressed by CFTC, the courts, or Congress, the possibility exists that

equity swaps could be found to be futures and, thus, subject to the CEA.

CFTC has noted, however, that market participants using equity swaps may

continue to rely on its 1989 swaps policy statement. As discussed earlier,

the policy statement removed the legal risk that CFTC would take

enforcement action against certain swaps, but it did not remove the risk

that a court could invalidate such contracts by deeming them to be illegal

futures. In addition, the legal enforceability of equity swaps could be

jeopardized indirectly through a finding that an exempted swap is a

futures contract. For example, CFTC had proposed amending its swaps

exemption to include a stand-alone, antifraud rule that would apply to

exempted swaps.37 According to other federal regulators and market

participants commenting on the proposal, the rule would have suggested

that the exempted swaps were futures. This, in turn, would have suggested

that equity swaps were also futures. Following the comment period, CFTC

did not amend its swaps exemption to include the proposed change.

According to the International Swaps and Derivatives Association, a

finding that an exempted swap is a futures contract could increase legal

risk by prompting losing counterparties to equity swaps to rely on the

resulting legal uncertainty to avoid their performance obligations under

such contracts. It noted that this could result in substantial losses and a

market disruption. At a June 1996 hearing held by the Senate Committee

37According to CFTC, questions had been raised about the applicability of the CEA’s antifraud

provisions to exempted swaps, and the proposed stand-alone, antifraud rule would have eliminated

such questions.

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on Agriculture, Nutrition and Forestry, the association testified that the

legal risk surrounding equity swaps has inhibited their evolution and that

this uncertainty needs to be addressed. The Bank for International

Settlements estimated that the worldwide market for equity swaps and

forwards had a total notional value of $52 billion, as of March 31, 1995,

which accounted for less than 1 percent of the total notional value of the

OTC derivatives market.38

CFTC Enforcement Actions

Involving OTC Derivatives Have

Raised Questions About the

Enforceability of Equity Swaps

CFTC’s enforcement actions involving OTC derivatives have highlighted the

potential for such action to increase legal risk in the equity swaps market.

In December 1994, CFTC and SEC cooperated in an enforcement action

against BT Securities, a swaps dealer, for violating antifraud provisions of

futures and securities laws in connection with swaps it sold.39 CFTC

officials told us that swaps market participants did not want the agency to

take any action against the swaps dealer that would suggest swaps were

futures for fear of increasing legal risk for equity swaps. In its enforcement

order, CFTC did not identify any of the swaps as futures. Rather, it found

that BT Securities violated the CEA’s antifraud provisions in its role as a

commodity trading advisor by providing the counterparty with misleading

information about the swaps. According to market participants and

observers, the finding implied that certain of the swaps sold by BT

securities were futures or commodity options, which raised questions

regarding the status of swaps under the CEA. Recognizing the potential

legal and regulatory implications, CFTC issued a news release stating that

its actions did not affect the legal enforceability of swaps or signal an

intent to regulate them.

According to some market participants and observers, CFTC’s enforcement

order against MG Refining and Marketing—a commercial firm—resulted in

greater legal risk for forwards and equity swaps. In 1995, CFTC took

enforcement action against MG Refining and Marketing for selling illegal,

off-exchange futures to commercial counterparties. The firm sold

contracts that purportedly required the delivery of energy commodities in

the future at a price established by the parties at initiation. These

contracts provided counterparties with a contractual right to settle the

contracts in cash without delivery of the underlying commodity. This right

could be invoked if the price of the underlying commodity reached a

preestablished level. Based largely on this provision, CFTC found these

38The Bank for International Settlement reported the total notional amount outstanding of equity

swaps and forwards together.

39BT Securities is registered with SEC as a broker-dealer. SEC found that certain of the OTC

derivatives that BT Securities sold were securities within the meaning of the federal securities laws.

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contracts to be illegal, off-exchange futures. CFTC’s conclusion was

consistent with prior court and CFTC decisions; it identified the contractual

right to offset as a critical feature distinguishing forwards from futures.

Nonetheless, some market participants and observers asserted that CFTC’s

order broadened the definition of a futures contract, creating legal

uncertainty over whether swaps and other OTC derivatives are futures and

resulting in greater legal risk for forwards and equity swaps.

In a letter sent to CFTC, two U.S. congressmen expressed their concern

about the potential for CFTC’s enforcement order to bring into question the

status of swaps as futures and to reflect a change in CFTC’s regulatory

position on swaps. In response to the congressional inquiry, the then CFTC

chairman wrote that the case had nothing to do with swaps. She noted

that, with regard to swaps generally, CFTC had not taken a position on

whether swaps were futures and continued to adhere to its 1989 swaps

policy statement. She also noted that in this case CFTC did not deviate from

its historical practice of looking at the totality of the

circumstances—including the nature of the contract and market—in

determining whether a particular transaction involved a futures contract.

On February 4, 1997, Senator Lugar, Chairman of the Senate Agriculture

Committee, Senator Harkin, Ranking Minority Member, and Senator Leahy

introduced a bill to amend the CEA. The bill is similar to the one that

Senators Lugar and Leahy introduced in the Fall of 1996, following the

June 1996 hearing. As noted in a discussion document prepared by

Senators Lugar and Harkin, the bill would provide greater legal certainty

for equity swaps by codifying the existing swaps exemption and extending

the exemption’s scope to include equity swaps.

Certain Forwards Have

Evolved to Where It Has

Become Increasingly

Difficult to Distinguish

Them From Futures,

Resulting in Legal Risk

Forwards have been distinguished from futures based on whether the

parties intended to make or take delivery of the underlying commodity

when they entered into the contract. However, certain unregulated

forwards have evolved to where delivery of the underlying commodity

may not routinely occur, making it increasingly difficult to distinguish

them from regulated futures and resulting in the legal risk that they could

be unenforceable. The CEA does not provide clear criteria for

distinguishing forwards from futures, but CFTC’s exemptions reduce the

need to do so for the purpose of addressing legal risk.

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Forwards Traditionally Differed

From Futures in That They

Entailed Delivery

As discussed above, since its enactment in 1936, the CEA has excluded

forward contracts from its regulation to facilitate the movement of

commodities through the merchandizing chain.40 Absent a definition of a

forward contract in the CEA, CFTC and the courts have generally defined

these contracts in reference to futures contracts. Traditionally, they

distinguished forwards from futures based on whether the parties

intended to make or take delivery of the underlying commodity when they

entered into the contract. Forwards served primarily a commercial

function and, as such, entailed delivery of the underlying commodity in

normal commercial channels, but delivery was to occur at a later date. In

contrast, futures were used primarily to shift or assume price risk without

transferring the underlying commodity; thus, actual delivery was not

expected to occur. In short, CFTC and the courts defined a forward as a

contract that bound one party to make delivery and the other to take

delivery of the contract’s underlying physical commodity. Since forwards

were commercial transactions that resulted in delivery, CFTC and the

courts looked for evidence of the contracts’ use in commerce. In

particular, they examined whether the parties were commercial entities

that could make or take delivery and whether delivery routinely occurred.

Certain Forwards Face the

Legal Risk of Being

Unenforceable

Besides the Brent oil market, other forward markets are evolving in

response to the risk-management and commercial needs of their

participants. For example, changes in U.S. farm policy, increased

globalization of the agricultural markets, and other factors may have

increased price volatility in the agricultural markets and created a demand

for more innovative risk-management contracts. According to agricultural

market participants, traditional forwards do not provide producers with

sufficient flexibility because of their delivery requirement. In response to

participants’ needs, the forward market for agricultural commodities has

evolved to include variations of forwards that may not routinely result in

delivery. Contracts that routinely allow parties to offset, cancel, or void

delivery obligations rather than transfer the underlying commodity may be

viewed as futures contracts or trade options, depending on their pricing

structure. CFTC permits the sale of trade options on nonagricultural

commodities, but prohibits the sale of such options on domestic

40For example, a producer and grain elevator would enter into a forward contract under which the

grain elevator would agree to buy the producer’s grain before it was harvested. The sale price was

agreed to when the contract was initiated, and both parties expected that the grain would be delivered

when harvested. In entering the forward contract, the producer would shift the price risk incident to

the farming operation to the elevator.

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agricultural commodities.41 This prohibition was intended, in part, to

protect producers from unscrupulous parties who might try to take

advantage of their lack of knowledge about these options.

One variation of a forward experiencing increased use is the

hedge-to-arrive contract. Although varying in design, these are privately

negotiated contracts in which a producer agrees with an elevator to

deliver grain on a future date at an agreed-upon price,42 and the elevator

uses exchange-traded futures to hedge the sale on behalf of the producer.

Some of these contracts have allowed producers to defer the delivery

dates on their contracts beyond the current crop year, which has exposed

producers to significant price risk because their contracts were no longer

tied to the current crop year. According to market observers, unusual

factors, such as high grain prices and poor weather conditions, have

resulted in financial problems for some parties that deferred delivery into

future crop years. In May 1996, CFTC staff issued a policy statement for

hedge-to-arrive contracts to allow counterparties experiencing losses to

settle their contracts without delivery by entering into subsequent,

separately negotiated contracts. CFTC noted that it would not find

hedge-to-arrive contracts existing as of May 15, 1996, to be illegal based

solely on the cash settlement of such contracts for the purpose of

unwinding them, but may find them to be illegal based on other factors.43

CFTC or a court could find some hedge-to-arrive contracts or other

variations on agricultural forwards to be futures or agricultural trade

options. Either finding would make them illegal and unenforceable,

provided the contracts did not qualify for the swaps exemption. For

example, in November 1996, CFTC filed three administrative complaints,

two of which alleged, among other things, that two elevators had offered

and sold hedge-to-arrive contracts that were illegal, off-exchange futures.

In these two complaints, CFTC noted that the elevators sold the

hedge-to-arrive contracts to some producers who lacked the intent or

capacity to make delivery of the grain. CFTC also noted some producers did

not qualify as eligible participants under the swaps exemption. CFTC

41In December 1995, CFTC held a roundtable discussion to address the possibility of lifting its ban on

agricultural trade options to provide producers with a broader range of marketing and

risk-management tools. Based on this discussion, CFTC staff expected to advise the agency’s

commissioners of those issues that require further analysis.

42The final price received for the commodity being sold is determined by a formula that references the

current and future price of a specified exchange-traded futures contract as well as the future market

price of the commodity.

43According to CFTC, the actual delivery of the underlying physical commodity (as opposed to offset)

has been a hallmark of traditional agricultural forwards, but the failure to deliver on a contract alone

would not necessarily preclude the contract from qualifying for the forward exclusion.

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further noted that the contracts contained a cancellation provision that

permitted producers to effect an offset of their contracts.

The CEA Does Not Provide

Clear Criteria for Distinguishing

Forwards From Futures

While the CEA excludes forwards from its regulation because of their

commercial merchandizing purpose, it does not provide clear criteria for

distinguishing forwards from futures. In particular, the CEA does not

specify what constitutes delivery under the forward exclusion and, thus,

when a forward becomes a futures contract. Given the lack of clear

criteria, the evolution of certain forwards to where delivery may not

routinely occur has made it increasingly difficult to distinguish

unregulated forwards from regulated futures. As illustrated by the Brent

oil and hedge-to-arrive contracts, the difficulty in distinguishing between

forwards and futures can result in legal risk. Under its 1990 statutory

interpretation for forwards (discussed above), CFTC tried to reduce the

legal risk and regulatory constraints that forwards face because of the

delivery requirement, thereby permitting them to evolve to better meet the

economic needs of end-users. However, its interpretation does not provide

a clear basis for distinguishing forwards from futures in terms of their

economic purpose. For example, it does not preclude forwards from being

settled routinely without delivery and, in the process, being used primarily

for risk-shifting or speculative purposes instead of a commercial

merchandizing purpose.

CFTC’s Exemptions Reduce the

Need to Distinguish Forwards

From Futures for the Purpose

of Addressing Legal Risk

CFTC’s exemptions for OTC energy and swaps contracts reduce the need to

distinguish unregulated forwards from regulated futures for the purpose of

addressing the legal risk of being unenforceable. CFTC’s OTC energy

contract exemption reduces legal risk for certain forwards that routinely

settle without delivery, but it is limited to OTC derivatives based on

specified energy products. Although the exemption covers Brent oil

contracts that CFTC determined earlier to be forwards under its 1990

interpretation, CFTC noted that the exemption does not affect its

interpretation. However, as with its 1989 swaps policy statement, CFTC’s

forward interpretation does not eliminate all legal risk. It removes the legal

risk of CFTC taking enforcement action against a contract that is consistent

with its interpretation, but it does not eliminate the risk of a counterparty

trying to have a court invalidate the contract as an illegal, off-exchange

futures contract.

CFTC’s swaps exemption further reduces the need to distinguish

unregulated forwards from regulated futures to address legal risk.

Contracts that resemble forwards but do not entail delivery may qualify for

the swaps exemption. Qualifying contracts would not be illegal and

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unenforceable, even if CFTC or a court found them to be futures, because

they would be exempt from the exchange-trading requirement. The swaps

exemption is limited to “eligible” participants, which are largely

institutional and other sophisticated market participants. Consequently,

the exemption generally does not extend to contracts that involve

unsophisticated market participants.

Issues Remain

Related to the

Appropriate

Regulation for the

OTC Derivatives and

Exchange-Traded

Futures Markets

Notwithstanding CFTC’s success in reducing or eliminating the legal risk of

unenforceability that most OTC derivatives faced, issues remain that raise a

broader policy question about the appropriate regulation for OTC

derivatives and exchange-traded futures, including their markets and

market participants. Congress alluded to this topic in the legislative

history of the Futures Trading Practices Act of 1992 by noting that the

growth and proliferation of OTC derivatives raises questions of how best to

regulate the new market, adding that studies by us and others would be

useful when Congress considers the broader question of regulatory policy.

To that end, we discuss, but do not attempt to resolve, three issues that

are related to the question of how best to regulate the OTC derivatives and

exchange-traded futures markets. These issues concern the

(1) appropriate regulation for the OTC foreign-currency market under the

Treasury Amendment, (2) appropriate regulation for the evolving swaps

market,44 and (3) rationalization of regulatory differences between the OTC

derivatives and exchange-traded futures markets.

The Appropriate

Regulation for the OTC

Foreign-Currency Market

Under the Treasury

Amendment Is an

Unresolved Issue

The CEA excludes, among other things, certain OTC foreign-currency

transactions from CFTC regulation under its Treasury Amendment.

However, the scope of the amendment has been difficult to interpret and

the subject of considerable debate and litigation. CFTC has interpreted the

amendment to exclude from the act’s regulation certain OTC

foreign-currency transactions between sophisticated participants, but not

similar transactions involving unsophisticated participants. The Treasury

Department has disagreed with CFTC’s interpretation. While the federal

courts have differed in their interpretation of the Treasury Amendment,

they have recognized congressional intent to exclude the interdealer OTC

foreign-currency market from regulation under the CEA.

44Our discussion focuses on the exempted swaps market, but the broader question of how best to

regulate the OTC derivatives market also applies to the equity swaps and evolving forwards markets

that are discussed above.

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The Treasury Amendment

Excludes Certain OTC

Foreign-Currency Transactions

From CFTC Regulation, but It

Is Difficult to Interpret

The Treasury Amendment excludes from CFTC regulation certain OTC

transactions in, among other things, foreign currencies and government

securities.45 During the debate over the 1974 amendments to the CEA, the

Treasury Department expressed concern that the proposed

changes—namely the expansion of the commodities covered under the act

coupled with the exchange-trading requirement—would prohibit banks

and other financial institutions from trading among themselves in foreign

currencies and certain financial instruments, including government

securities. The Treasury Department noted that futures trading in foreign

currencies was done through an informal network of banks and dealers

(called the interbank market),46 which serves the needs of international

business to hedge risk stemming from foreign-exchange rate movements.

The Treasury Department proposed the Treasury Amendment as a means

of clarifying that the CEA did not cover this market, and Congress adopted

the proposed amendment. According to the act’s legislative history,

Congress noted that the interbank market was more properly supervised

by the bank regulators and, therefore, regulation under the CEA was

unnecessary.

The Treasury Amendment has been difficult to interpret because its

language is ambiguous. Although the amendment was motivated primarily

by concern that the interbank foreign-currency market should be excluded

from regulation under the act, its language is not limited to the interbank

market. Rather, it excludes any transaction in, among other things, foreign

currencies, unless the transaction involves sale for future delivery

conducted on a board of trade.47 Before the recent U.S. Supreme Court

decision in Dunn v. CFTC, considerable debate occurred over the meaning

of the phrase “transactions in,” which defines the scope of the exclusion.

Arguments were made that the phrase could be interpreted narrowly to

mean only cash transactions in the subject commodity or broadly to

encompass derivatives transactions such as futures or option contracts. In

45The Treasury Amendment states: “Nothing in this Act shall be deemed to govern or in any way be

applicable to transactions in foreign currency, security warrants, security rights, resales of installment

loan contracts, repurchase options, government securities, or mortgages and mortgage purchase

commitments, unless such transactions involve the sale thereof for future delivery conducted on a

board of trade. (Emphasis added.) The CEA reference to “transactions involving the sale for future

delivery” refers to futures contracts and has been interpreted by the U.S. Supreme Court to also refer

to commodity options.

46The interbank market includes not only banks but also other financial institutions and industrial

corporations. Because the market is not limited to banks, some market observers, including the

Treasury Department, have noted that the market is more accurately characterized as an “institutional

market.”

47As noted above, the U.S. Supreme Court found that both futures and options involve sale for future

delivery within the meaning of the Treasury Amendment.

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Dunn, the U.S. Supreme Court endorsed the broader interpretation.

Furthermore, the CEA defines the term “board of trade,” which is used in

the “unless” clause, to “mean any exchange or association, whether

incorporated or unincorporated, of persons who shall be engaged in the

business of buying or selling any commodity.” Consequently, this clause

could be interpreted to save from the exclusion virtually any futures or

option contract sold by a dealer, a construction that would render the

amendment meaningless. The ambiguity of the statutory language has led

to disagreements among regulators and courts over how the amendment

ought to be interpreted.

CFTC and the Treasury

Department Have Interpreted

the Treasury Amendment

Differently

Because of its significant market impact, the activity that the Treasury

Amendment excludes from regulation under the CEA has been the subject

of considerable debate among federal regulators. Since at least 1985, CFTC

has interpreted the Treasury Amendment to exclude from the act’s

regulation certain OTC transactions between banks and other sophisticated

institutions, drawing a distinction between sophisticated market

participants and unsophisticated market participants who may need to be

protected by government regulation.48 An OTC foreign-currency

transaction, such as a foreign-exchange swap, sold to a financial

institution would be excluded from the act’s regulation; a similar contract

sold to the general public would not be excluded. CFTC drew this

distinction to preserve its ability to protect the general public from, among

other things, bucket shops engaging in fraudulent futures

transactions—one of its missions under the CEA. According to CFTC, since

1990, the agency has brought 19 cases involving the sale of

foreign-currency futures or options contracts to the general public;49 in

those cases, more than 3,200 customers invested over $250 million, much

of which was lost. Whether foreign-currency contracts sold to the general

public are excluded by the Treasury Amendment, however, has remained a

source of legal uncertainty. According to CFTC, if the amendment were

interpreted to cover contracts sold to the general public, the agency’s

ability to prohibit the fraudulent activities of bucket shops dealing in

foreign-currency contracts would be effectively eliminated, creating a

regulatory gap.

The Treasury Department, however, has objected that CFTC’s approach to

the Treasury Amendment lacks a foundation in the language of the statute.

It has advocated the reading of the Treasury Amendment adopted by the

4850 Fed. Reg. 42983.

49One approach that CFTC uses to shut down bucket shops is to show that the contracts they sold

were illegal, off-exchange futures, thereby obviating the need to show fraud.

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U.S. Supreme Court in Dunn—that is, the Treasury Amendment excludes

from CFTC jurisdiction any transaction in which foreign currency is the

subject matter, including foreign-currency options, unless conducted on a

board of trade. Nevertheless, it has expressed sympathy with CFTC’s

concerns over fraudulent foreign-currency contracts marketed to the

general public. The Treasury Department has suggested that CFTC may be

able to interpret the term “board of trade” in a carefully circumscribed

manner that would allow appropriate enforcement action against fraud

without raising questions about the validity of established market

practices.

Federal Court Interpretations

of the Treasury Amendment

Have Differed

The federal courts have differed in their interpretation of what activity the

Treasury Amendment excludes from regulation under the CEA. In spite of

these differences, the courts have recognized congressional intent to

exclude the interdealer foreign-currency market from regulation.

However, past court cases have highlighted the legal confusion over

whether the Treasury Amendment excludes from the act’s regulation

transactions in foreign currencies that involve the general public.

The Second Circuit Court of Appeals held in Dunn that option contracts

are not covered by the Treasury Amendment and, therefore, are subject to

CFTC jurisdiction. In doing so, it followed a precedent that it had

established in a case involving the sale of currency options to private

individuals. In that case, it reasoned that an option contract does not

become a transaction in foreign currency that is excluded under the

Treasury Amendment until the option holder exercises the contract.50

In February 1997, the U.S. Supreme Court reversed the Second Circuit’s

decision in Dunn. The Court interpreted the “transactions in” language of

the Treasury Amendment to exclude from CFTC regulation all transactions

relating to foreign currency, including foreign-currency options, unless

conducted on a board of trade. The Court noted that the public policy

issues raised by the various parties affected by the decision were best

addressed by Congress.

The Fourth Circuit Court, in Salomon Forex, Inc. v. Tauber,

51 held that

sales of currency futures and options to a very wealthy individual are

transactions in foreign currency that the Treasury Amendment excludes

from regulation. The buyer of the contracts brought the action to avoid

50See CFTC v. The American Board of Trade, 803 F. 2d 1242 (2d Cir. 1986), cited in CFTC v. Dunn, 58 F.

3d 50 (2d Cir. 1995), rev’d 65 U.S.L.W. 4141 (U.S. Feb. 25, 1997).

51Salomon Forex, Inc. v. Tauber, 8 F. 3d 966 (4th Cir. 1993), cert. denied, 114 S. Ct. 1540 (1994).

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payment on transactions in which he had lost money. The court

interpreted the amendment to exclude from the CEA individually

negotiated foreign-currency option and futures transactions between

sophisticated, large-scale currency traders. The court observed that the

case did not involve mass marketing of contracts to small investors and

stated that its holding did not imply that such marketing was exempt from

the CEA.

The Ninth Circuit Court, in CFTC v. Frankwell Bullion Ltd.,

52 affirmed a

lower court holding that the Treasury Amendment excludes the sale of

off-exchange foreign-currency futures and options from the CEA without

regard to whom the contracts are sold. CFTC brought action to stop the

seller of the contracts from allegedly selling illegal, off-exchange futures

contracts to the general public. The Ninth Circuit Court’s review focused

on the meaning of the clause “unless . . . conducted on a board of trade.”

The court interpreted the clause to carve out of the exclusion only

contracts sold on an organized exchange. The court acknowledged that

the plain meaning of a board of trade as defined by the act would include

more than exchanges. But the court rejected this interpretation in the

context of the Treasury Amendment because it would cause the “unless”

clause to encompass the entire exclusion and thereby render the

amendment meaningless. Turning to congressional reports accompanying

the 1974 legislation to explain the purpose of the Treasury Amendment,

the court concluded that Congress intended to exclude from the CEA all

transactions in the listed commodities except those conducted on an

organized exchange. In December 1996, CFTC filed a petition with the Ninth

Circuit Court requesting a rehearing, which was denied.

At the June 1996 hearing held by the Senate Committee on Agriculture,

Nutrition and Forestry, the then acting CFTC chairman testified that the

agency and Treasury Department were working to clarify the treatment of

foreign-currency transactions under the Treasury Amendment, but that

reaching an accord would take time. At the hearing, two futures exchanges

testified that congressional action was needed to clarify the Treasury

Amendment’s scope, particularly in view of the U.S. Supreme Court’s

decision to review the Dunn case. They said that a court finding that the

amendment excludes all off-exchange futures and options on foreign

currencies could shift such business away from the exchanges to the less

regulated OTC market and adversely affect their competitiveness.

52CFTC v. Frankwell Bullion Ltd., 99 F. 3d 299 (9th Cir. 1996).

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As mentioned earlier, Senators Lugar, Harkin, and Leahy introduced a bill

in February 1997 to amend the CEA. The bill includes a provision to clarify

the scope of the Treasury Amendment.53 According to a discussion

document prepared by Senators Lugar and Harkin, the bill reflects the

view that a federal role is needed in the market to protect retail investors

from abusive or fraudulent activity in connection with the sale of foreign

currency futures and options by unregulated entities. The discussion

document further notes that under the bill CFTC has no jurisdiction over

retail transactions that are subject to oversight by other federal regulators

or nonretail transactions.

On January 21, 1997, Congressman Ewing, Chairman of the House

Subcommittee on Risk Management and Specialty Crops, introduced a bill

to amend the CEA. The bill is identical to the one that he introduced in the

Fall of 1996. It proposes, among other things, to amend the Treasury

Amendment to clarify that CFTC has regulatory authority only over

standardized contracts sold to the general public and conducted on a

board of trade. The bill defines board of trade in the context of the

Treasury Amendment as “any facility whereby standardized contracts are

systematically marketed to retail investors.”

The Appropriate

Regulation for the Evolving

Swaps Market Is an

Unresolved Issue

The potential for the exempted swaps market to evolve beyond the

conditions of the swaps exemption raises the issue of how to

accommodate market developments and address attendant risks and other

regulatory concerns. CFTC imposed conditions on exempted swaps that

prohibited them from being traded and cleared in the same ways as

exchange-traded futures—on a centralized trading facility and through a

clearinghouse. Since then, the swaps market has continued to develop,

becoming more liquid54 and transparent.55 Among other alternatives, CFTC

could use its exemptive authority to accommodate any development that

is inconsistent with the conditions of the existing exemption—for

example, the development of a clearinghouse—and address any attendant

53As discussed, Senators Lugar and Leahy introduced a bill to amend the CEA in the Fall of 1996.

Rather than addressing the Treasury Amendment in that bill, the senators asked CFTC and the

Treasury Department to reach an agreement by the end of 1996 on how the amendment should be

interpreted and, if necessary, amended. While the agencies were unable to reach an agreement by that

time, they have continued their discussions. In the meantime, each agency has provided the senators

with differing language to amend the Treasury Amendment. The bill that Senators Lugar, Harkin, and

Leahy recently introduced does not fully adopt either agency’s proposed language.

54Liquidity is the extent to which market participants can buy and sell contracts without changing the

market’s price.

55Transparency is the extent to which information about prices, trading volume, and trades is

disseminated to the public.

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risks to the market. However, such an approach could prompt legal

challenges and raise jurisdictional questions.

CFTC Exempted Certain Swaps

From the CEA Subject to Four

Conditions

CFTC’s swaps exemption allows exempted swaps to trade legally outside

regulated exchanges—free from all CEA provisions, except certain

antifraud and antimanipulation provisions,56 and free from all CFTC

regulations. In granting the swaps exemption, CFTC did not take a position

on whether exempted swaps were futures contracts and subject to the

CEA’s jurisdiction. CFTC noted that it had not made and was not obligated to

make such a determination.

CFTC specified four conditions that swaps had to meet to qualify for an

exemption. First, they had to be entered into solely by eligible

participants, namely institutional and other sophisticated market

participants. Eligible participants include banks, securities firms,

insurance companies, commercial firms meeting minimum net worth

requirements, and individuals meeting minimum total asset requirements.

Second, they could not be fungible with standardized, material economic

terms. Third, the creditworthiness of the counterparties had to be a

material consideration. With this condition, exempted swaps could not be

cleared, like exchange-traded futures, through a clearinghouse.57 Fourth,

they could not be entered into and traded on or through a multilateral

execution facility, such as a futures exchange.

According to CFTC, these four conditions were intended to reflect the way

that swaps transactions occurred in 1993 when the exemption was granted

and to draw a line at which such transactions would not raise significant

regulatory concerns under the CEA. CFTC officials told us that Congress

directed the agency to exempt swaps as they were then transacted to

provide them with legal certainty. In addition, the four conditions

distinguished the exempted swaps from exchange-traded futures for

regulatory—not legal—purposes. That is, the exemption excluded from

regulation under the CEA swaps that did not possess certain characteristics

common to exchange-traded futures; it did not establish that exempted

swaps were not futures or otherwise excluded from the act’s jurisdiction.

The conditions generally reflected the elements that facilitate futures

56These antifraud and antimanipulation provisions are limited to specified types of conduct that

involve futures, options, or the cash market.

57According to the swaps exemptive release (58 Fed. Reg. 5591), “the exemption does not extend to

transactions subject to a clearing system where the credit risk of individual members of the system to

each other in a transaction to which each is a counterparty is effectively eliminated and replaced by a

system of mutualized risk of loss that binds members generally whether or not they are counterparties

to the original transaction.”

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trading on an exchange, including standardized units, a clearinghouse, and

open and competitive trading in a centralized market. As CFTC and the

courts have noted, these elements developed in conjunction with the

growth of the futures market to facilitate futures trading on exchanges;

however, their presence or absence does not necessarily determine

whether a contract is a futures contract.

CFTC and others (including federal regulators and market observers) have

acknowledged that a centralized trading facility and/or clearinghouse

could benefit the swaps market and general public. For example, such

facilities could increase the market’s liquidity and transparency and

enhance the market’s financial integrity. In its 1993 exemptive release for

swaps, CFTC noted that such facilities did not yet exist and their existence

would present different regulatory issues than are raised under the current

swaps exemption. Recognizing the potential benefits of such facilities,

CFTC left open the opportunity for market participants to develop and use

such facilities, provided that such facilities receive CFTC’s prior approval.

As discussed, Senators Lugar, Harkin, and Leahy recently introduced a bill

to amend the CEA that includes a provision to codify the existing swaps

exemption. As noted in the discussion document prepared by Senators

Lugar and Harkin, the provision would not affect CFTC’s power to grant

additional exemptions or to amend the existing exemption to make it less

restrictive. However, the provision would require a statutory change to

make the existing swaps exemption more restrictive. According to market

observers, the provision addresses the concern of OTC market participants

that CFTC could modify the swaps exemption in a way that could disrupt

the market. At a February 11, 1997, hearing held by the Senate Committee

on Agriculture, Nutrition and Forestry, CFTC testified against the provision,

noting that it would eliminate the agency’s ability to modify the existing

swaps exemption in response to market developments.

The Swaps Market Has

Continued to Develop Under

the Exemption

Under the swaps exemption, the swaps market has become more liquid

and transparent. Swaps are traded primarily through dealers, some of

whom are linked through electronic communication networks that allow

them to exchange price information and negotiate transactions.58 Swaps

are commonly executed using standardized documentation, but each

contract—including its material terms—continues to be privately

negotiated between two counterparties. As mentioned above, plain vanilla

interest rate and foreign-exchange swaps have become more

58Under the swaps exemption, swaps market participants may use electronic facilities “to

communicate simultaneously with other participants, so long as they do not use such facilities to enter

orders to execute transactions” (58 Fed. Reg. 5591).

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homogeneous, with dealers providing “indicative” (nonbinding) quotes for

such swaps. Market participants have noted that the market for plain

vanilla interest rate swaps has become very liquid and transparent, with

pricing information readily available from independent sources. Increased

liquidity and transparency can facilitate the use of offsetting contracts to

terminate open contracts.59

Some swaps market participants are increasingly using practices that are

similar, but not identical, to those used in the exchange-traded futures

market to reduce credit and other risks. These practices may reduce

systemic risk and encourage greater market efficiency. Some swaps

participants are using bilateral netting, which is the combining of payment

obligations arising from multiple transactions with one counterparty into

one net payment. In addition, some are periodically determining the value

of their swaps using market values, called marking-to-market. This

practice facilitates the movement of collateral, such as cash or U.S.

government securities, to reduce the financial exposure of counterparties

from open contracts.

In comparison, exchanges reduce credit risk by collecting margin

(payment required on open contracts that decline in value) on at least a

daily basis and by interposing a clearinghouse as the guarantor of all

contracts. As discussed above, in each exchange-traded futures

transaction, the clearinghouse is substituted for the original parties,

becoming the buyer to every seller and the seller to every buyer. Through

this process, the clearinghouse assumes the credit risk of each transaction

and mutualizes it among all clearing members. While swaps market

participants do not use clearinghouses, two futures exchanges are

developing collateral depositories to help manage swaps positions and

collateral for OTC market participants. Unlike a clearinghouse, they would

not guarantee contract performance. One exchange has reported that it is

developing exchange-traded swaps and plans for its depository to

ultimately guarantee their performance.

CFTC Could Use Its Exemptive

Authority to Accommodate

Swaps Market Developments

Although difficult to predict, the swaps market might develop in ways that

are inconsistent with the conditions of the existing swaps exemption. Such

developments could present risks to the market that warrant greater

federal regulation to protect the public interest. An example of such a

59A swap can be offset by entering into an equal but opposite transaction with another counterparty.

Entering into an equal but opposite contract with the same counterparty eliminates the market and

credit risks associated with the contract. Doing so with a different counterparty eliminates market risk

but not credit and other risks associated with carrying two contracts. Alternatively, the counterparties

can negotiate a termination agreement that settles the contract or agree to assign the contractual

obligation to a third party.

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development would be the creation of a swaps clearinghouse. A

clearinghouse could provide benefits, such as reducing credit risk and

increasing market access, but it could also increase systemic risk by

concentrating credit risk in a single entity and thus might require federal

oversight.

CFTC’s swaps exemption does not bar a clearinghouse, but it does require

that a proposal for such a facility be submitted to CFTC for review. As noted

above, CFTC’s swaps exemption includes a condition that requires each

counterparty to consider the other’s creditworthiness. Because of this

requirement, swaps market participants may not be able to use a

clearinghouse without jeopardizing their exempt status and becoming

subject to the CEA’s regulatory requirements. According to CFTC, the

development of a swaps clearinghouse would not necessarily require CFTC

to amend the exemption. Instead, CFTC could exempt a swaps

clearinghouse from the CEA’s provisions (except section 2(a)(1)(B)) on

such conditions as it deemed appropriate. According to CFTC officials, the

extent to which CFTC would need to impose conditions on a clearinghouse

would depend on the facility’s design, applicability of other regulatory

regimes, and other factors.

Among other alternatives, CFTC could use its exemptive authority to

accommodate a swaps clearinghouse or any other market development

that is inconsistent with the conditions of the existing swaps exemption. In

accommodating such a swaps market development, CFTC may need to

include conditions in the exemption to ensure that the risks and other

regulatory concerns of the development are appropriately addressed.

Depending on the risks and concerns, such conditions may include

reporting, recordkeeping, disclosure, or other regulatory requirements that

are similar to the regulations that CFTC has imposed on the OTC derivatives

under its oversight—trade options, dealer options,60 and leverage

contracts.61

60Dealer options are off-exchange commodity options that are confined to a limited class of offerors

who were in the business of granting options on physical commodities and buying, selling, producing,

or otherwise using that commodity as of May 1, 1978, and who satisfy the requirements of CFTC

regulations. Dealer options are a retail product and are not currently being offered.

61Leverage contracts are long-term (10 years or longer) OTC contracts involving metals and foreign

currencies and are not currently being offered.

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CFTC’s Use of Its Exemptive

Authority to Impose Regulatory

Conditions Could Prompt Legal

Challenges and Raise

Jurisdictional Questions

Imposing regulatory conditions on swaps participants might be an

effective way for addressing potential risks to the market that could result

from a swaps market development. However, such an approach could

prompt legal challenges and raise jurisdictional questions. First, as long as

the issue of whether swaps are futures is not definitively addressed, the

possibility remains that a court could find swaps to be outside the

jurisdiction of the CEA if CFTC tried to use its exemptive authority to impose

affirmative requirements on swaps. Second, imposing affirmative

requirements on swaps might suggest that swaps are futures and subject

to regulation under the CEA, even if CFTC did not explicitly make that

determination. Any suggestion that swaps are futures and subject to

regulation under the CEA could have policy ramifications for the swaps

market because of CFTC’s exclusive jurisdiction over futures. Any such

suggestion could also raise jurisdictional questions involving federal bank

regulators and SEC because of their oversight or regulation of swaps

participants or swaps. Tasked with considering new developments in the

financial markets, including the increasing importance of the OTC

derivatives market, the President’s Working Group on Financial Markets

provides one forum through which CFTC and other federal regulators could

address such issues.

The Rationalization of

Regulatory Differences

Between the OTC

Derivatives and

Exchange-Traded Futures

Markets Is an Unresolved

Issue

The development of the swaps and exchange-traded futures markets has

raised questions about the rationale for their regulatory

differences—recognizing that each market may not raise the same risks

and, thus, warrant the same regulations. Swaps and exchange-traded

futures are similar in their characteristics and economic functions, but

differ in, among other ways, their trading environment and regulations. As

discussed above, CFTC exempted swaps and other OTC contracts from

regulation under the CEA. In 1995, CFTC also granted the exchanges an

exemption from certain regulations to enable them to compete more

effectively against the less regulated OTC derivatives market.

Notwithstanding the exemption, OTC derivatives and exchange-traded

futures market regulations continue to differ substantially. The exchange

exemption represents one approach to rationalizing regulations between

the two markets but also illustrates some of the challenges in doing so.

Swaps and Exchange-Traded

Futures Have Similarities and

Differences, Including the

Scope and Focus of Their

Regulation

Swaps and exchange-traded futures are similar in their characteristics and

economic functions but differ in other ways, including the scope and focus

of their regulation. Swaps and exchange-traded futures have market values

that are determined by the value of an underlying asset, reference rate, or

index. They also are used for hedging financial risk and investing with the

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intent of profiting from price changes by some of the same general types

of market participants, such as financial institutions, commercial firms,

and governmental entities. Given their similar economic functions, OTC

derivatives and exchange-traded futures can be used as substitutes for one

another, but they are not perfect substitutes because of differences in their

contract terms, transaction costs, regulations, and other factors. They also

can be used to complement each other. Some market

participants—primarily banks and other financial firms acting as

dealers—use exchange-traded futures to hedge the risk related to their OTC

derivatives positions. As a former CFTC chairman noted, the

exchange-traded futures market has grown closer to the swaps market as

it has expanded to remain competitive. The exchanges are offering more

flexible option contracts, whose terms can be customized to meet an

end-user’s particular risk-management needs. Moreover, they are working

on other proposals, such as collateral depositories, to address the needs of

participants using swaps and other OTC derivatives.

Notwithstanding their similar characteristics and economic functions,

differences between swaps and exchange-traded futures may result in

different risks that lead to differences in the types and/or levels of

oversight needed for each market. Swaps and exchange-traded futures

differ in ways that are reflected in CFTC’s swaps exemption. As discussed

above, unlike exchange-traded futures, swaps are not traded on a

multilateral execution facility, such as an exchange, or cleared through a

multilateral clearing facility, such as a clearinghouse. Rather, swaps are

entered into between two counterparties in consideration of each other’s

creditworthiness. Although plain vanilla swaps have become more

homogeneous in terms such as their underlying reference rates or indexes

and maturities, each contract continues to be privately negotiated.

Unlike exchange-traded futures, swaps and other OTC derivatives are not

regulated under a single, market-oriented structure or subject to a contract

approval process, because they are privately negotiated contracts. They

are regulated only to the extent that the institutions using or dealing in

them are regulated. As we noted in our May 1994 report, banks are major

OTC derivatives dealers. They are overseen by federal bank regulators and

subject to supervision and regulations—including minimum capital,

reporting, and examination requirements. These regulations are designed

to ensure the safety and soundness of banks but are not directly

concerned with protecting those doing business with them.62 Other major

dealers include affiliates of securities and insurance firms that are subject

62We are currently reviewing OTC derivatives sales practices and will report our findings separately.

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to limited or no federal oversight. Since our 1994 report, CFTC, federal bank

regulators, and SEC have taken several steps to improve their oversight of

the major OTC derivatives dealers, including affiliates of securities firms.

Also, a group of derivatives dealers, in coordination with SEC and CFTC, has

developed a voluntary oversight framework for the OTC derivatives

activities of unregulated affiliates of securities and futures firms. We

discuss these and other actions taken by federal regulators and derivatives

market participants in the November 1996 update to our 1994 report on

financial derivatives.

Traditionally, exchange-traded futures have been regulated as a market

under a comprehensive regulatory structure, which is designed to protect

customers and the market—including its efficiency, fairness, and financial

integrity. This regulatory structure covers not only certain market

participants but also the products and markets on which they trade.

Unless exempted, futures must be traded on designated exchanges and

through regulated intermediaries, subject to minimum capital, reporting,

examination, and customer protection requirements. The CEA and CFTC

specify certain self-regulatory duties—including providing for the

prevention of manipulation, making reports and records on market

activities, and enforcing exchange rules—that an exchange must perform

to become and remain a designated exchange. The CEA also requires CFTC

to review and approve products traded on a designated exchange.

CFTC’s Exchange Exemption Is

One Approach to Rationalizing

OTC and Exchange-Traded

Futures Market Regulations but

Illustrates the Challenges in

Doing So

In 1993, two futures exchanges separately requested that CFTC exempt

from most of the CEA’s regulatory requirements certain exchange-traded

futures that are traded solely by institutional and other sophisticated

market participants. The exchanges indicated that they needed regulatory

relief to compete fairly with the less regulated OTC market. In response to

the exchange requests, CFTC provided the exchanges with regulatory relief

under an exemption issued in November 1995. CFTC, however, did not

provide the exchanges with the broad regulatory relief they requested.

CFTC based its position, in part, on comments it received on the exchange

requests from various government agencies, members of Congress, and

the public, as well as on the 1992 act’s legislative history. In the latter,

Congress cautioned CFTC to use its exemptive authority sparingly and not

to prompt a wide-scale deregulation of markets falling under the act.

The exchange exemption is to be implemented under a 3-year pilot

program.63 It is intended to enable qualifying exchanges to list new

contracts with greater ease and construct OTC-like trading procedures,

63The 3-year pilot program will begin when the first contract is traded under the exchange exemption.

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permitting market participants to negotiate prices privately and execute

trades off of the exchange floor. The exchange exemption limits access to

the exempted futures market to specified participants, which are generally

the same institutional and sophisticated participants that may use

exempted swaps. In addition, the exemption is intended to streamline

requirements for registering brokers and disclosing risks when opening

new customer accounts. However, with the exception of these regulatory

changes, all other CEA provisions and CFTC regulations would continue to

apply to the exempted futures market. For example, the requirements

related to recordkeeping and audit trails as well as transaction reporting

would continue to apply.

According to CFTC, the exchange exemption would enable the exchanges

to compete more effectively with the OTC derivatives market, while

maintaining basic customer protection, financial integrity, and other

protections needed for trading in an exchange environment. Furthermore,

CFTC noted that the pilot program would provide it with an opportunity to

(1) test the operation of the exemption, (2) determine the effect of

exempted transactions on the integrity of the market as a whole, and

(3) determine whether continued trading under the exemption would be in

the public interest. To date, CFTC has not received any proposals under the

exchange exemption.

In a joint statement released at the June 1996 Senate Agriculture hearing

(discussed above), 10 futures exchanges noted that the exchange

exemption does not provide a level playing field for exempted

exchange-traded and OTC derivatives contracts. They noted that exempted

exchange-traded contracts would continue to be subject to the bulk of

CFTC regulations, even though such contracts, like exempted OTC

derivatives, would not be traded by public customers. The exchanges also

maintained that CFTC’s exchange exemption is not consistent with the 1992

act’s legislative history—noting that, among other things, Congress

intended CFTC, in consideration of fair competition, to use its exemptive

authority in a fair and even-handed manner to products and systems

sponsored by exchanges and nonexchanges.

As mentioned earlier, Senators Lugar, Harkin, and Leahy as well as

Congressman Ewing recently introduced bills to amend the CEA. Each bill

includes a provision that would largely exempt from regulation under the

act certain exchange-traded futures that are traded solely by institutional

and sophisticated market participants. In a joint statement released at the

February 11, 1997, hearing on reforming the CEA, 10 futures exchanges

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noted that the Senate bill “moves exchanges a long way toward achieving

a regulatory balance with the OTC markets.” They noted that the exempted

market would rely on market discipline and self-regulation, with the

exchanges having a business incentive to operate a fair, financially sound,

and competitive market. At the same hearing, CFTC testified that, if

enacted, the bill would likely cause a broad elimination of federal

regulation of the exchange-traded futures market and create significant

risks by doing so.

CFTC’s exchange exemption represents one approach to rationalizing

regulatory differences between the exchange-traded futures and swaps

markets but illustrates some of the challenges in doing so. The exchange

and swaps exemptions raised similar policy questions that CFTC

approached from opposite viewpoints, in part because of the existence of

a regulatory structure for one but not the other. For futures, the basic

question was: “What is the appropriate regulation for futures traded on

exchanges solely by institutional and other sophisticated market

participants?” In this regard, CFTC’s approach to exempting

exchange-traded futures focused on determining which CEA requirements

could be eliminated without compromising the public interest, as defined

in the CEA. Under this approach, the exchanges were tasked, in part, with

demonstrating which existing regulations were unnecessary. In

comparison, the basic question for swaps was: “Are swaps appropriately

regulated under the CEA?” In this regard, CFTC’s approach to exempting

swaps focused on determining whether CEA requirements needed to be

imposed on the market.

Another related challenge in rationalizing regulations between the two

markets arose from the similar nature of the participants.64 As required

under its exemptive authority, CFTC considered the nature of the market

participants in exempting swaps. It limited the swaps exemption to

participants it deemed sophisticated or financially able to bear the risks

associated with these transactions. Likewise, it considered the exclusion

of unsophisticated participants from the exempted exchange-traded

futures market as the most important factor supporting its exchange

exemption. However, CFTC noted that, unlike a dealer market, a centralized

market composed solely of sophisticated market participants did not

obviate the need to ensure market integrity, price dissemination, and

adequate protections against fraud, manipulation, and other trading

abuses. It further noted that CFTC regulations serve other vital functions,

64CFTC has characterized exchange-traded futures market participants as largely institutional, and a

former CFTC commissioner stated that the majority of users of regulated, exchange-traded futures

meet the eligibility requirements of the swaps exemption.

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even where such markets include only sophisticated participants, in that

the regulations substitute for individualized credit determinations and

increase market access. The exchanges have disagreed with CFTC’s

conclusions. They have stated that their safeguards—including

clearinghouse guarantees and price transparency—provide greater

protections than available in the OTC market but, at the same time, prevent

them from obtaining regulatory relief comparable to that which CFTC

provided to the OTC market.

Conclusions CFTC has used its exemptive authority to reduce or eliminate legal risk in

the OTC derivatives market arising from the combination of the CEA’s

judicially crafted futures definition and exchange-trading requirement.

Through its efforts, CFTC has enhanced the legal enforceability of most OTC

derivatives contracts and, in doing so, has enabled the OTC derivatives

market to continue to grow and develop. Nonetheless, several legal and

regulatory issues involving the CEA remain unresolved. These include the

legal uncertainty facing equity swaps, the CEA’s lack of clear criteria for

distinguishing unregulated forwards from regulated futures, the

uncertainty surrounding the scope of the Treasury Amendment, and the

extent to which CFTC should use its exemptive authority to provide greater

regulatory relief to the futures exchanges. Ongoing congressional efforts

to amend the CEA could provide specific solutions to these unresolved

issues. Further, such efforts could provide a forum for addressing the

broader policy question of what the appropriate regulation is for

exchange-traded futures and OTC derivatives contracts, including their

markets and market participants.

The appropriate regulation for the exchange-traded and OTC derivatives

markets should flow from the need to protect the public interest in these

markets. The CEA identifies the public interest in the futures market as the

need to protect the market’s price discovery and risk-shifting functions

from market abuses, such as excessive speculation, manipulation, and

fraud. However, articulating the public interest in this way may no longer

provide a sufficient basis for regulating all aspects of the futures market,

given market developments and regulatory changes. As discussed, the

exchange-traded futures market is now dominated by financially based

futures and institutional participants. Because of the greater liquidity of

the underlying cash markets for financial products, the exchange-traded

futures markets for these products may not serve the same price discovery

function as exchange-traded futures based on agricultural and other

physical commodities. Accordingly, they may not serve the price discovery

Page 37 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
B-259983 

function that Congress intended to protect when crafting the CEA. In

addition, CFTC now has the authority to allow futures to be traded

off-exchange and free from the comprehensive regulatory structure

applicable to exchange-traded futures. Because of the way they would be

traded and other factors, off-exchange futures may not raise the same

risks or regulatory concerns that exchange-traded futures raise and for

which regulation under the CEA was deemed necessary to protect the

public interest. Nonetheless, off-exchange futures may raise other risks,

such as systemic risk, or regulatory concerns that warrant federal

regulation.

To address the broader policy question of the appropriate regulation for

the exchange-traded futures and OTC derivatives markets, more

fundamental questions concerning the goals of federal regulatory policy

need to be answered. These questions include:

• What is the current public interest in the exchange-traded futures and OTC

derivatives markets that needs to be protected?

• What type of regulations are needed, if any, and what is the most efficient

and effective way to implement and enforce any needed regulations? To

what extent are the answers to these questions affected by the nature of

the market participants; trading environment; and products, including

their function, type of underlying commodity, and degree of

standardization?

These fundamental questions provide a framework for systematically

determining the appropriate regulation for exchange-traded futures and

OTC derivatives, including their markets and market participants.

Moreover, answers to these questions would also provide a basis for

considering an array of options for amending the CEA. These options

include (1) expanding the act’s jurisdiction to cover specified swaps and

other OTC derivatives but tailoring their regulation to the circumstances

under which they trade and other appropriate factors; (2) excluding swaps

and other specified OTC derivatives from the act’s jurisdiction and

providing for their oversight, as appropriate, by other federal regulators;

and (3) tailoring the level of regulation for exchange-traded futures to the

nature of the market participants and/or other appropriate factors.

Swaps and other OTC derivatives involve institutions and activities in

which federal bank regulators and SEC have traditionally had a supervisory

or oversight role, while futures trading and futures market regulation have

fallen under the CFTC’s exclusive jurisdiction. As a result, any policy

Page 38 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
B-259983 

questions raised by the ongoing development of the OTC derivatives and

exchange-traded futures markets cross traditional jurisdictional lines and

involve not only CFTC but also federal bank regulators and SEC. The

cooperative efforts of these agencies, working with the Department of the

Treasury and the financial industry, will be required to address such

questions. As discussed, the President’s Working Group on Financial

Markets provides one forum through which to coordinate interagency

activities and address policy questions that cross jurisdictional lines.

As we concluded in our May 1994 OTC derivatives report, the U.S. financial

regulatory structure has not kept pace with the dramatic and rapid

changes in the domestic and global financial markets. We noted that one

issue needing to be addressed is how the U.S. regulatory system should be

restructured to better reflect the realities of today’s rapidly evolving global

financial markets. Our conclusion was based partly on the finding that the

development of new types of financial derivatives and their use by a

variety of once separate industries, such as banking, futures, insurance,

and securities, have made it more difficult to regulate them effectively

under the current U.S. regulatory structure. The potential legal and

regulatory issues raised by the evolving OTC derivatives and

exchange-traded futures markets under the CEA further illustrate such

difficulty and reinforce the need to examine the existing U.S. regulatory

structure. Ultimately, maintaining a globally competitive U.S. derivatives

market will require balancing the goal of allowing the U.S. financial

services industry to innovate and grow with the goal of protecting

customers and the market, including its efficiency, fairness, and financial

integrity.

Agency and Industry

Comments and Our

Evaluation

We requested comments on a draft of this report from the heads, or their

designees, of CFTC, the Department of the Treasury, the Federal Reserve

Board, the Office of the Comptroller of the Currency, and SEC. We also

requested comments from three futures exchanges (the Chicago Board of

Trade, Chicago Mercantile Exchange, and New York Mercantile

Exchange), the New York Stock Exchange, and four industry associations

(the Futures Industry Association, International Swaps and Derivatives

Association, Managed Futures Association, and National Futures

Association). CFTC, the Department of the Treasury, the Federal Reserve

Board, and SEC provided us with written comments under a joint response

as members of the President’s Working Group on Financial Markets. We

also obtained written comments from two futures exchanges (the Chicago

Mercantile Exchange and Chicago Board of Trade) and the four industry

Page 39 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
B-259983 

associations. The written comments and our additional responses are

contained in appendixes I through VII. We did not receive written

comments from the Office of the Comptroller of the Currency, New York

Mercantile Exchange, or New York Stock Exchange. In addition, officials

from CFTC, the Department of the Treasury, the Federal Reserve Board, the

Office of the Comptroller of the Currency, SEC, the International Swaps

and Derivatives Association, and the Chicago Mercantile Exchange

provided us with technical comments that were incorporated into the

report as appropriate.

The President’s Working Group on Financial Markets commented that it

agreed with our conclusion that maintaining a globally competitive U.S.

derivatives market requires properly balancing the need to allow the U.S.

financial services industry to innovate and grow with the need to protect

the financial integrity of our markets. The Working Group noted that it is

effectively addressing intermarket financial coordination issues and that

further discussion in that forum of issues we identify would be useful.

The Futures Industry Association commented that the draft did not

adequately address the question of whether or to what extent additional

regulation of the OTC derivatives markets is warranted, and to the extent

warranted, whether the CEA is the appropriate vehicle for such regulation.

Similarly, the International Swaps and Derivatives Association stated that

there has been no demonstration that participants would benefit from

subjecting swaps to any form of regulation under the CEA. Our overall

objective was to provide Congress with information on the legal and

regulatory issues involving the CEA, not to determine the appropriate level

of regulation for the OTC derivatives market or the specific vehicle for any

such regulation. We identified regulatory gaps in this market in our

May 1994 report on OTC derivatives and recently issued a report that

discusses the actions taken by federal regulators and the industry since

that time. Nonetheless, the issues that we discuss lead to the broader

policy question of what the appropriate regulation is for the OTC

derivatives and exchange-traded futures markets. In our conclusions, we

provide a framework for addressing this policy question and, in turn,

related questions, such as whether the CEA is the appropriate vehicle for

regulating swaps and other OTC derivatives.

In a related comment, the Futures Industry Association noted that our

draft asserts that financial products serving a risk-shifting function should

be subject to similar regulatory treatment, even though the CEA has

recognized through its statutory exclusions that the regulation of such

Page 40 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
B-259983 

products may appropriately differ depending on their nature and

underlying market. Correspondingly, the International Swaps and

Derivatives Association commented that risk-shifting activities related to

foreign exchange and other transactions were specifically excluded from

the CEA pursuant to the Treasury Amendment, demonstrating that

Congress did not intend for the CEA to govern all financial transactions

involving the transfer of risk. We do not assert that risk-shifting contracts

should be subject to similar regulation. Rather, we note that the CEA covers

futures contracts, which have been defined in a way that reflects their

risk-shifting function. As a result, OTC derivatives serving a similar

risk-shifting function as futures may fall within the definition of a futures

contract and be subject to the CEA. We agree that the CEA’s statutory

exclusions demonstrate that Congress did not intend for the CEA to govern

all risk-shifting contracts. However, these exclusions are not broad enough

to provide similar treatment for all OTC derivatives, many of which,

including swaps, did not exist when the exclusions were created. CFTC has

exempted most swaps and other OTC derivatives from virtually all the CEA’s

requirements to provide them with greater legal certainty, but a question

remains about whether swaps are futures and subject to the CEA. As we

discuss, the possibility that swaps are futures continues to be a source of

legal risk for equity swaps.

In another related comment, the Chicago Board of Trade, Futures Industry

Association, and Managed Futures Association noted that the CEA provides

CFTC with the authority and flexibility to address issues raised by the

evolving OTC derivatives and futures markets. We agree that the CEA, with

its exemptive authority provision, does not prevent CFTC from addressing

regulatory concerns raised by the OTC derivatives market, as needed. In

our report, we state that CFTC could use its exemptive authority to address

regulatory concerns raised by a swaps market development that is

inconsistent with the conditions of the existing swaps exemption.

However, we note that this approach could suggest that swaps are futures

and introduce jurisdictional questions. We also note that the President’s

Working Group on Financial Markets provides one forum through which

to address such questions.

The Chicago Board of Trade commented that, contrary to the impression

created in the draft, jurisdictional ambiguities in the act (the definition of a

futures contract and the Treasury Amendment) are not solely responsible

for the disparate regulatory treatment of exchange and OTC markets.

Instead, it cites the manner in which CFTC has chosen to use its authority

as leading to this disparity. According to the exchange, CFTC did not use its

Page 41 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
B-259983 

exemptive authority in a way that is consistent with the 1992 act’s

legislative history—that is, it did not use its authority in a fair and

even-handed manner to products and systems sponsored by exchanges

and nonexchanges. In a related comment, the Futures Industry

Association noted that it agrees with the draft report’s implicit assumption

that CFTC’s exchange exemption could be broadened. However, it stated

that the exchanges must provide CFTC with greater specificity as to the

nature of the products, trading mechanisms, and clearing structure that

would be subject to exemptive relief. We agree with the Chicago Board of

Trade that the act’s jurisdictional ambiguities are not solely responsible for

the regulatory differences between the OTC derivatives and futures

markets. Our report states that CFTC provided less regulatory relief under

its exchange exemption than it did under its OTC derivatives exemptions.

We also agree with the Futures Industry Association that greater

specificity could aid CFTC in the use of its exemptive authority to provide

additional regulatory relief to the exchanges. However, in granting the

exchange exemption, CFTC followed the congressional admonition to use

its exemptive authority sparingly and not to cause a wide-scale

deregulation of markets falling under the act. Given the different ways of

interpreting the 1992 act’s legislative history, we note in our conclusions

that one of the unresolved issues involving the CEA is the extent to which

CFTC should use its exemptive authority to provide greater regulatory relief

to the futures exchanges.

We are sending copies of this report to the Chairperson of CFTC, the

Comptroller of the Currency, the Chairman of the Federal Reserve Board,

the Chairman of SEC, the Secretary of the Treasury, and other interested

parties. We will also make copies available to others upon request.

Please contact me at (202) 512-8678 or Cecile O. Trop, Assistant Director,

at (312) 220-7600 if you or your staff have any questions. Major

contributors to this report are listed in appendix VIII.

Jean Gleason Stromberg

Director, Financial Institutions

 and Markets Issues

Page 42 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Page 43 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Contents

Letter 1

Appendix I 

Comments From the

President’s Working

Group on Financial

Markets

46

Appendix II 

Comments From the

Chicago Board of

Trade

47

Appendix III 

Comments From the

Chicago Mercantile

Exchange

53

Appendix IV 

Comments From the

Futures Industry

Association

56

Appendix V 

Comments From the

International Swaps

and Derivatives

Association

64

Page 44 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Contents

Appendix VI 

Comments From the

Managed Futures

Association

75

Appendix VII 

Comments From the

National Futures

Association

78

Appendix VIII 

Major Contributors to

This Report

81

Abbreviations

CEA Commodity Exchange Act

CFTC Commodity Futures Trading Commission

OTC over-the-counter

SEC Securities and Exchange Commission

Page 45 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix I 

Comments From the President’s Working

Group on Financial Markets

See p. 40.

Page 46 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

See pp. 41-42.

See pp. 41-42.

Page 47 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

See p. 35.

Page 48 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

See p. 41.

See p. 34.

See pp. 36-37.

See p. 36.

See pp. 36-37.

Page 49 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

See p. 37.

See p. 36.

See pp. 37-38.

Page 50 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

See p. 41.

See p. 36.

See p. 32.

See p. 8.

See p. 42.

Page 51 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix II 

Comments From the Chicago Board of

Trade

Page 52 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix III 

Comments From the Chicago Mercantile

Exchange

See comment 1.

Now on p. 36.

See comment 1.

Page 53 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix III 

Comments From the Chicago Mercantile

Exchange

Now on p. 39.

See p. 38.

See comment 1.

Page 54 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix III 

Comments From the Chicago Mercantile

Exchange

The following are GAO’s comments on the Chicago Mercantile Exchange’s

August 30, 1996, letter.

GAO Comments 1. The Chicago Mercantile Exchange commented that our use of the way

that derivatives are traded (off-exchange versus on-exchange) as the basis

for distinguishing OTC derivatives from futures for regulatory purposes is

not an appropriate dichotomy. Rather, the exchange commented that the

nature of the market participant (professional versus retail) is a better

basis to use in determining the appropriate level of regulation needed for

derivatives markets. We revised our report, and the referenced text no

longer appears. In our conclusions, we provide a framework for

determining the appropriate regulation for the OTC derivatives and

exchange-traded futures markets, focusing on the current public interest

in these markets that needs to be protected. As part of that framework, we

note that the nature of the market participant, trading environment, and

other factors should be considered in determining the regulations that are

needed to protect the public interest.

Page 55 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

See p. 7.

See p. 7.

Page 56 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

See comment 1.

See pp. 41-42.

See comment 2.

See pp. 40-41.

Page 57 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

See p. 38.

See comment 3.

See comment 4.

See comment 5.

Page 58 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

See comment 6.

See comment 7.

See comment 8.

See comment 7.

See comment 9.

Page 59 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

See p. 40.

See p. 41.

Page 60 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

The following are GAO’s comments on the Futures Industry Association’s

September 18, 1996, letter.

GAO Comments 1. The association commented that the draft focused on the similar

economic function served by OTC derivatives and exchange-traded futures

but did not adequately address the policy implications arising from the

important distinctions that exist between the two types of products. We

focus on the similar risk-shifting function served by OTC derivatives and

exchange-traded futures because the CEA covers futures, which have been

defined in a way that reflects their risk-shifting function. As we discuss in

our conclusions, Congress and federal regulators will need to consider the

similarities and differences between the OTC derivatives and

exchange-traded futures markets in addressing the broader policy

question concerning the appropriate regulation for these markets. We

agree that important distinctions exist between OTC derivatives and

exchange-traded futures that have policy implications, and we amplified

our discussion of these distinctions.

2. The association commented that our draft cited the CEA as embracing

the principle of functional regulation. We eliminated the term functional

regulation because of the confusion over its meaning, but our message has

not changed. That is, the CEA covers futures, which CFTC and the courts

have defined in a way that reflects their risk-shifting function. As a result,

contracts serving a similar risk-shifting function as futures may fall within

the definition of a futures contract and be subject to the CEA.

3. The association commented that our draft report listed the necessary

elements of a futures contract without mentioning that such elements are

not necessarily sufficient to define a futures contract. We modified the

report accordingly.

4. The association commented that section 3 of the CEA specifically

identifies transactions in contracts for future delivery “commonly

conducted on a board of trade” as the type of activity requiring regulation

under the CEA. It further noted that this statement reflects a sensitivity to

the regulatory significance of distinctions between exchange trading and

private negotiation of contracts that is equally relevant today. We agree

that the exchange-trading requirement is central to the CEA’s regulatory

structure and recognize that differences exist between OTC derivatives and

exchange-traded futures that may warrant differences in their regulation.

In that regard, our conclusions provide a framework for determining the

Page 61 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

appropriate regulation for the OTC derivatives and exchange-traded futures

markets, focusing on the public interest in these markets that needs to be

protected. As part of that framework, we note that the nature of the

market participant, trading environment, and other factors should be

considered in determining the regulations needed to protect the public

interest.

5. The association noted that the draft report overstated the current level

of convergence between the OTC derivatives and futures market. We

revised the report to amplify our discussion of the similarities and

differences between the OTC derivatives and futures markets.

6. The association disagreed with the draft report’s observation that

participation of dealers in the OTC derivatives markets implies that such

markets are centralized. We did not intend to imply that the swaps market

is centralized and have revised the draft accordingly. We recognize that

swaps continue to be privately negotiated between counterparties and are

neither traded on a centralized facility nor cleared through a

clearinghouse. We note that swaps have followed a similar evolutionary

path as exchange-traded futures. However, we recognize that the extent to

which the swaps market, or some part thereof, will continue to evolve in

the same way as the exchange-traded futures market is unknown.

7. The association commented that, with respect to the distinction

between futures and forwards, our draft report sometimes fails to

distinguish between the nature of the obligation to make delivery and what

constitutes delivery. Our discussion of the disagreement between CFTC and

the federal district court on where to draw the line regarding the delivery

requirement for Brent Oil contracts was meant to illustrate this difference.

We also note in our conclusions that one of the unresolved issues is the

CEA’s lack of criteria for distinguishing unregulated forwards from

regulated futures.

8. The association commented that the losses associated with

hedge-to-arrive contracts do not appear to arise from the character of the

delivery obligations. We note that unusual factors, such as high grain

prices and poor weather conditions, have resulted in financial problems

for parties to these contracts. However, we also note that the legal risk

facing some hedge-to-arrive contracts due to the possibility that they could

be illegal futures or trade options has complicated matters. This legal risk

may persist, even in the absence of the factors contributing to financial

risk.

Page 62 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix IV 

Comments From the Futures Industry

Association

9. The association commented that the Treasury Amendment’s scope was

broader than the restricted view presented in the draft report. Our

discussion of the Treasury Amendment was not intended to provide an

interpretation of the amendment’s scope but rather to describe the legal

confusion created by how others have interpreted its scope. We modified

the report accordingly.

Page 63 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

Page 64 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 1.

Page 65 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 2.

See pp. 40-41.

See comment 3.

Page 66 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 3.

See comment 4.

See p. 33.

Page 67 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 5.

See p. 40.

See p. 6.

Page 68 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 6.

See comment 7.

See comment 8.

See comment 9.

Page 69 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

See comment 10.

See comment 11.

See comment 7.

Page 70 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

Page 71 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

The following are GAO’s comments on the International Swaps and

Derivatives Association’s September 10, 1996, letter.

GAO Comments 1. The association commented that the draft painted a misleading picture

of the similarities between exchange-traded futures and swaps by focusing

on their risk-shifting function and failed to properly address the important

differences between them that justify their disparate regulatory treatment.

We focus on the similar risk-shifting function served by OTC derivatives

and exchange-traded futures because the CEA covers futures, which have

been defined in a way that reflects their risk-shifting function. As we

discuss in our conclusions, Congress and federal regulators will need to

consider the similarities and differences between the OTC derivatives and

exchange-traded futures markets in addressing the broader policy

question concerning the appropriate regulation for these markets. We

agree that important distinctions exist between OTC derivatives and

exchange-traded futures that have policy implications, and we amplified

our discussion of these distinctions.

2. The association commented that, although OTC derivatives and

exchange-traded futures serve a similar risk-shifting function, many other

financial transactions, including those involving securities, loans,

guarantees, and various types of insurance contracts, can serve such a

function. It further noted that attempting to implement a regulatory

framework that would subject every form of financial or commercial

activity that involves the transfer of risk to regulation under the CEA would

clearly be inappropriate. We agree that it would be inappropriate to

subject all instruments that can serve a risk-shifting function to the CEA.

However, as CFTC and others have recognized, swaps and other OTC

derivatives resemble futures not only in terms of their economic function

but also in terms of their design. Given the market’s continued growth and

development, questions remain about the extent to which additional

regulation of the OTC derivatives market is needed. In our conclusions, we

provide a framework for determining the appropriate regulation for the

OTC derivatives and exchange-traded futures markets, focusing on the

public interest in these markets that needs to be protected.

3. The association commented that the draft report’s assertion that swaps

are a centralized market is not true. We did not intend to imply that the

swaps market is currently centralized and have revised the draft

accordingly. We recognize that swaps continue to be privately negotiated

between counterparties and are neither traded on a centralized facility nor

Page 72 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

cleared through a clearinghouse. We note that swaps have followed a

similar evolutionary path as exchange-traded futures. However, we

recognize that the extent to which the swaps market, or some part thereof,

will continue to evolve in the same way as the exchange-traded futures

market is unknown.

4. The association commented that the draft report portrayed swaps as a

centralized market by incorrectly asserting that swaps participants are

actively discussing the possibility of establishing a swaps clearinghouse.

We discuss the potential for a swaps clearinghouse to illustrate an

example of a development that could trigger a greater federal interest in

the market. It was not intended to suggest that the swaps market has

evolved into a centralized market, and we revised the draft accordingly.

5. The association noted that more corporations use swaps than

exchange-traded futures to meet their risk-management needs, disproving

the draft report’s assertion that swaps and exchange-traded futures share

the same general market participants. Our point was that swaps and

exchange-traded futures are used by many of the same general types of

market participants, not that swaps and exchange-traded futures are used

by all of the same market participants. We revised the report to clarify this

point. We still note that some of the same firms, namely banks and other

financial firms acting as dealers, use both swaps and exchange-traded

futures because of the complementary relationship of the contracts.

6. The association commented that few incidents exist where swaps

participants believed that they were treated unfairly by their

counterparties, which demonstrated both the ability of swaps participants

to protect their rights and the fact that such incidents represent bilateral

disputes with no implications for third parties. It added that the draft

report offers no evidence that additional regulatory protection is needed

or desired by swaps participants. We are currently reviewing OTC

derivatives sales practices and will report our findings separately.

7. The association commented that the swaps activities of institutions that

are thought to be subject to systemic risk and/or are supported by public

insurance are closely supervised by various regulatory agencies. As we

discussed in our May 1994 report on OTC derivatives, regulatory gaps

existed in the OTC derivatives market that could heighten the potential for

systemic risk. We have issued a report that updates our 1994 report and

discusses actions taken by federal regulators and the industry since that

time.

Page 73 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix V 

Comments From the International Swaps

and Derivatives Association

8. The association disagreed with the draft report’s assertion that the CEA,

as amended in 1974, embraced the principle of functional regulation. While

we eliminated the term functional regulation because of the confusion

over its meaning, our message has not changed. That is, the CEA covers

futures, which CFTC and the courts have defined in a way that reflects their

risk-shifting function. As a result, contracts serving a similar risk-shifting

function as futures may fall within the definition of a futures contract and

be subject to the CEA.

9. The association commented that our draft report asserts

“uncategorically” and without direct evidence that the legislative history

surrounding the Treasury Amendment indicates that it was intended to

apply solely to the interbank market. Our discussion of the Treasury

Amendment was not intended to provide an interpretation of the

amendment’s scope but rather to describe the legal confusion created by

how others have interpreted its scope. We revised the report accordingly.

10. The association noted that our draft report listed the necessary

elements of a futures contract without mentioning that such elements are

not necessarily sufficient to define a futures contract. We modified the

report accordingly.

11. The association commented that our definition of offset is broader than

has been defined in regulatory and judicial contexts. We amended the

offset definition to make it consistent with CFTC’s definition and discussed

the way that OTC derivatives are terminated in a later section of the report.

Page 74 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VI 

Comments From the Managed Futures

Association

See comment 1.

See p. 41.

Page 75 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VI 

Comments From the Managed Futures

Association

See p. 41.

See p. 41.

Page 76 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VI 

Comments From the Managed Futures

Association

The following are GAO’s comments on the Managed Futures Association’s

October 15, 1996, letter.

GAO Comments 1. The association commented that it does not share some of our findings

regarding the limitation of the Treasury Amendment’s carve-out of the

interbank market, definition of a futures contract, and failure to recognize

the continued noncentralized nature of the swaps market. We revised the

report to clarify that we were not providing an interpretation of the

Treasury Amendment’s scope, but rather were describing the legal

confusion created by how others have interpreted its scope. We modified

the report to clarify that no definitive list exists of all the elements of a

futures contract. We also amplified our discussion of the differences

between the OTC derivatives and exchange-traded futures markets.

Page 77 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VII 

Comments From the National Futures

Association

See comment 1.

See comment 1.

Page 78 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VII 

Comments From the National Futures

Association

See comment 2.

See comment 1.

See comment 3.

Page 79 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VII 

Comments From the National Futures

Association

The following are GAO’s comments on the National Futures Association’s

September 10, 1996, letter.

GAO Comments 1. The association commented that the draft report minimized the inherent

tension between the equally important goals of limiting legal certainty

while maximizing regulatory flexibility. We agree that tradeoffs exist in

addressing the legal and regulatory issues raised by the ongoing

development of the OTC derivatives market under the CEA. Such tradeoffs

raise difficult and often competing policy concerns that can lead to more

fundamental questions concerning the goals of federal regulatory policy.

In our conclusions, we provide a framework for determining the

appropriate regulation for the OTC derivatives and exchange-traded futures

markets, focusing on the public interest in the markets that needs to be

protected.

2. The association noted that the swaps exemption must be periodically

revisited to make sure that the conditions set by CFTC for the exemption

continue to make sense. It also noted that CFTC must also reexamine the

exemption granted to exchange-traded products. We agree that one

alternative is to have CFTC revisit the exemptions, as needed, to address

regulatory concerns raised by market changes and to ensure regulations

do not impede market innovation and competition. However, we note that

using such an approach for exempted swaps could suggest swaps are

futures and introduce jurisdictional questions. Moreover, in our

conclusions, we note that a remaining unresolved issue is the extent to

which CFTC should use its exemptive authority to provide greater

regulatory relief to the futures exchanges.

3. The association commented that, with respect to the Treasury

Amendment, it is inconceivable that Congress intended for futures

contracts in foreign currencies to be mass marketed to the retail public

without any of the protections afforded under the CEA. As we discuss,

confusion exists as to the scope of the Treasury Amendment, and we note

in our conclusions that such confusion remains an unresolved issue under

the CEA.

Page 80 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
Appendix VIII 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Thomas J. McCool, Associate Director

Cecile O. Trop, Assistant Director

Chicago Field Office Richard S. Tsuhara, Senior Evaluator

Daniel K. Lee, Evaluator

Office of General

Counsel, Washington,

D.C.

Lorna J. MacLeod, Attorney

Seattle Field Office Desiree W. Whipple, Reports Analyst

(233442) Page 81 GAO/GGD-97-50 Commodity Exchange Act Issues Remain
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