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Testimony of Patrick M. Parkinson
Associate Director, Division of Research and Statistics
H.R. 4541, the Commodity Futures Modernization Act of 2000
Before the Subcommittee on Risk Management, Research and Specialty Crops of the Committee on Agriculture, U.S. House of Representatives
June 14, 2000

I am pleased to be here to present the Federal Reserve Board's views on legislation to modernize the Commodity Exchange Act (CEA). The Board continues to believe that such legislation is essential. To be sure, the Commodity Futures Trading Commission (CFTC) has recently proposed issuing regulatory exemptions that would reduce legal uncertainty about the enforceability of over-the-counter (OTC) derivatives transactions and would conform the regulation of futures exchanges to the realities of today's marketplace. These administrative actions by no means obviate the need for legislation, however. The greatest legal uncertainty affecting OTC derivatives is in the area of securities-based transactions, to which the CFTC's exemptive authority does not extend. Furthermore, as events during the past few years have clearly demonstrated, regulatory exemptions carry the risk of amendment by future commissions. If our derivatives markets are to remain innovative and competitive internationally, they need the legal and regulatory certainty that only legislation can provide.

The Board commends this committee for introducing comprehensive legislation (H.R. 4541) that addresses these critical issues. In my remarks today I shall focus on the three principal areas that the legislation covers: (1) OTC derivatives; (2) regulatory relief for U.S. futures exchanges; and (3) repeal of the Shad-Johnson restrictions on the trading of single-stock futures.

OTC Derivatives
In its November 1999 report, Over-the-Counter Derivatives and the Commodity Exchange Act, the President's Working Group on Financial Markets (PWG) concluded that OTC derivatives transactions should be subject to the CEA only if necessary to achieve the public policy objectives of the act--deterring market manipulation and protecting investors against fraud and other unfair practices. In the case of financial derivatives transactions involving professional counterparties, the PWG concluded that regulation was unnecessary for these purposes because financial derivatives generally are not readily susceptible to manipulation and because professional counterparties can protect themselves against fraud and unfair practices. Consequently, the PWG recommended that financial OTC derivatives transactions between professional counterparties be excluded from coverage of the CEA. Furthermore, it recommended that these transactions between professional counterparties be excluded even if they are executed through electronic trading systems. Finally, the PWG recommended that transactions that were otherwise excluded from the CEA should not fall within the ambit of the act simply because they are cleared. The PWG concluded that clearing should be subject to government oversight but that such oversight need not be provided by the CFTC. Instead, for many types of derivatives, oversight could be provided by the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve, or a foreign financial regulator that the appropriate U.S. regulator determines to have satisfied its standards.

The provisions of H.R. 4541 that address OTC derivatives are generally consistent with the PWG's conclusions and recommendations. However, the Board is troubled by a provision that might leave uncertainty about whether some electronic trading systems for financial contracts between professional counterparties were subject to the CEA. Specifically, restricting exclusions for transactions conducted on electronic trading facilities to "bona fide" principal-to-principal transactions is unnecessary and undesirable. This restriction could be construed to preclude a counterparty from entering into "back-to-back" principal-to-principal transactions, that is, from using an excluded electronic trading system to hedge transactions executed outside the trading system. We can identify no public policy reason for precluding such back-to-back transactions. Doing so would discourage the use of electronic trading systems and thereby inhibit realization of the improvements in market efficiency and transparency that such systems promise to deliver.

In addition, H.R. 4541 does not require government oversight of clearing organizations for OTC derivatives, contrary to the recommendation of the PWG. The Board continues to believe that such oversight is appropriate and that alternatives to CFTC oversight should be provided. In this regard, the Board recommends incorporating into legislation the provisions of H.R. 1161 (the bill that House Banking Committee Chairman James A. Leach introduced in April), which would enhance the Federal Reserve's authority to oversee clearing organizations that choose to be regulated as uninsured state member banks and would clarify the treatment of bank clearing organizations (including those overseen by the OCC) in bankruptcy.

Regulatory Relief for U.S. Futures Exchanges
The PWG did not make specific recommendations about the regulation of traditional exchange-traded futures markets that use open outcry trading or that allow trading by retail investors. Nevertheless, it called for the CFTC to review the existing regulatory structures, particularly those applicable to financial futures, to ensure that they remain appropriate in light of the objectives of the CEA. In February, the CFTC published a report by a staff task force that provided a comprehensive review of its regulatory framework and proposed sweeping changes to the existing regulatory structure. We understand that the regulatory relief provisions of H.R. 4145 are intended to codify these proposals.

Using the same approach as the PWG, the CFTC has evaluated the regulation of futures exchanges in light of the public policy objectives of deterring market manipulation and protecting investors. When contracts are not readily susceptible to manipulation and access to the exchange is limited to sophisticated counterparties, the CFTC has proposed alternative regulatory structures that would eliminate unnecessary regulatory burden and allow domestic exchanges to compete more effectively with exchanges abroad and with the OTC markets. More generally, the CFTC proposes to transform itself from a frontline regulator, promulgating relatively rigid rules for exchanges, to an oversight agency, assessing exchanges' compliance with more flexible core principles of regulation.

The Board supports the general approach to regulation that was outlined in the CFTC's proposals. For some time the Board has been arguing that the regulatory framework for futures trading, which was designed for the trading of grain futures by the general public, is not appropriate for the trading of financial futures by large institutions. The CFTC's proposals recognize that the current "one-size-fits-all" approach to regulation of futures exchanges is inappropriate, and they generally incorporate sound judgments regarding the degree of regulation needed to achieve the CEA's purposes.

Furthermore, the Board generally supports codification of the CFTC's proposals so as to provide the exchanges with greater certainty regarding future regulation. However, the Treasury Department is concerned that the exempt board of trade provisions might have unintended consequences that could reduce the effectiveness of the existing regulatory framework for the trading of government securities. It may be prudent, therefore, to limit the codification of the exempt board of trade provisions, at least so that markets currently regulated under the Government Securities Act of 1986 are not affected. This would allow the CFTC to address any unintended consequences for the regulation of government securities by changing the terms of its exemptions.

Single-Stock Futures
The PWG concluded that the current prohibition on single-stock futures (part of the Shad-Johnson Accord) can be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. The Board believes that these issues can and should be resolved through negotiations between the CFTC and the SEC. The Congress should continue to urge the two agencies to settle their remaining differences so that investors have the opportunity to trade single-stock futures, both on futures exchanges and on securities exchanges.

If it would facilitate repeal of the prohibition, the Board is willing to accept regulatory authority over levels of margin on single-stock futures, as provided in H.R. 4541, so long as the Board can delegate that authority to the CFTC, the SEC, or an Intermarket Margin Board consisting of representatives of the three agencies. The Board understands that the purpose of such authority would be to preserve the financial integrity of the contract market and thereby prevent systemic risk and to ensure that levels of margins on single-stock futures and options are consistent. The Board would note that, for purposes of preserving financial integrity and preventing systemic risk, margin levels on futures and options should be considered consistent, even if they are not identical, if they provide similar levels of protection against defaults by counterparties, taking into account any differences in (1) the price volatility of the contracts, (2) the frequency with which margin calls are made, or (3) the period of time within which margin calls must be met.

In conclusion, the Board continues to believe that legislation modernizing the Commodity Exchange Act is essential. The Board appreciates this committee's efforts to foster the consensus necessary to enact legislation. Although some difficult issues remain unresolved, H.R. 4541 represents significant progress toward that goal.

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2000 Testimony