Washington Outlook Mixed for Futures

CHICAGO (HedgeWorld.com)--Refco's problems aside, this has been a pretty good year for the futures industry. Volumes are up, as are profits and bonuses on Wall Street.

Yet despite that success, or perhaps in part because of it, one gets the feeling there is a hint of unease in the glances the industry keeps casting toward Washington. The Commodity Exchange Act is up for reauthorization, and a number of potential issues remain, including more clearly defining the regulatory reaches of the Commodity Futures Trading Commission and the Securities and Exchange Commission.

Also energy markets--in particular, oil--have come under scrutiny by members of Congress. On Tuesday [Nov. 8], executives from five oil companies answered questions from senators and representatives about the record profits the companies earned during a period that saw gasoline prices soar above US$3 per gallon for a time after two hurricanes hit the Gulf Coast.

In response to high gas prices, some members of Congress have discussed tightening position and price limits in oil markets, specifically at the New York Mercantile Exchange; increasing the criminal and civil penalties for market manipulation; giving the CFTC enhanced authority to review price spikes; and requiring more record-keeping by over-the-counter market participants and making those records subject to periodic CFTC review.

Moderating a panel framed as the Washington outlook at this week's Futures Industry Association Expo in Chicago, FIA President John Damgard said there were a number of "misguided amendments" pending on Capitol Hill, particularly with respect to the energy industry.

Not everyone on panel was happy, either, with the progress thus far on the Commodity Exchange Reauthorization Act. Terrence Duffy, chairman of the Chicago Mercantile Exchange, said he thought the recommendations of the President's Working Group "fell far short of our hopes for reauthorization."

Specifically, Mr. Duffy said the CME wants to see provisions allowing for more risk-based portfolio margining, which he said is being done elsewhere in the world but has been stymied in the U.S. except for a couple of pilot programs at the New York Stock Exchange and the Chicago Board Options Exchange, and that there should be as part of the reauthorization certainty surrounding what constitutes narrow-based securities indexes, which have been regulated by the SEC, and broad-based securities indexes, which have fallen under the purview of the CFTC.

The reauthorization, known as S-1566, contains a provision that critics say introduces subjectivity into the process for coming up with a standard definition for broad-based indexes so as to resolve the question of who would regulate futures on debt instruments. The reauthorization act effectively proposes leaving it to the SEC and CFTC to work it out. This is considered a step back from the 2000 Commodity Futures Modernization Act, which clearly outlined which indexes were to be considered broad-based (tracking entire markets) and which were to be considered narrow-based (tracking more thinly traded securities), and allowed the trading of futures on single stocks and narrow-based indexes, although it did not specifically address debt futures.

Mr. Duffy called it "ludicrous" that, nearly six years after the CFMA, a firm definition for narrow- and broad-based indexes was still up in the air. The reauthorization act directs the SEC and CFTC to work out a definition for narrow-based indexes that excludes indexes based on U.S. debt instruments, foreign equities, foreign debt and other U.S. securities. In the past, the idea has been to include in the narrow-based index category indexes of securities that are relatively illiquid, and thus more susceptible to market manipulation.

But some have argued that doing so in this case would eliminate certain investor protections contained in the Securities Act of 1933 by shifting regulatory oversight for these products to the CFTC. The change would also give futures exchanges the exclusive rights to trade these products, when the CFMA gave joint regulatory authority to the CFTC and SEC, allowing the CFTC oversight of the products that traded on exchanges it oversees and the SEC oversight of products trading on exchanges it oversees.

Walt Lukken, a commissioner with the CFTC, pointed out that even though there are disagreements about parts of the Commodity Exchange Reauthorization Act, it's not a groundbreaking piece of legislation like the CFMA was. "The 2000 CFMA made major strides," Mr. Lukken said. "This time around we're talking about revisions."

Still, it's possible disagreement about those revisions that could hold up passage of the act until after the first of the year, a scenario that Charles Carey, chairman of the Chicago Board of Trade, said he would prefer not to see. "It would be better to get it done this year than not and then work with the various agencies to hold their feet to the fire in terms of getting these things [the risk-based portfolio margining and the narrow- versus broad-based index definition] done," he said.

Another aspect of the reauthorization, a provision that would expand the CFTC's authority, had some panel members worried it goes too far, and others concerned it doesn't go far enough. In response to a recent court decision, the reauthorization act would add a section extending the CFTC's oversight to foreign exchange products. The U.S. Seventh Circuit Court of Appeals dismissed a CFTC fraud action against a foreign exchange dealer, saying the contracts were spot transactions, not futures contracts, and thus not subject to the CFTC's oversight. The case, CFTC v. Zelener raised questions about the CFTC's jurisdiction.

Language in the reauthorization act attempts to clear up the confusion by giving the CFTC responsibility for regulating all foreign currency transactions, agreements or contracts. Patricia White, assistant director at the Federal Reserve Board, said some are concerned that's too much authority. "Clearly there is a desire to deter fraud, but you also don't want to put undue regulatory burdens on legitimate businesses," she said.

However Mr. Duffy said he would prefer to see the kind of fix made in response to Zelener also applied to other parts of the industry. "It's a reputational issue," he said. "We feel protected by the fix of Zelener, but we think it's an issue that can be spread to other areas in the futures industry."

S-1566 was introduced in the Senate in July and has been the subject of extensive discussion on Capitol Hill. A vote has not been scheduled.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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