WASHINGTON (HedgeWorld.com)–Congress has begun its once-every-five-years reauthorization of the Commodity Futures Trading Commission.
The most recent reauthorization was accompanied by sweeping reform legislation, the Commodity Futures Modernization Act of 2000, and on Wednesday, March 9, a subcommittee of the House of Representatives listened to 14 witnesses give their assessment of the successes or failures of that act.
The consensus emerging from the hearing before the Agriculture Committee’s subcommittee on general farm commodities and risk management was that the CFMA has been in general successful, but, witnesses said, the reform could use some reforming.
The subcommittee heard from three panels.
First Panel: The Exchanges
The first panel included Terrence Duffy, chairman of the Chicago Mercantile Exchange, Charles Carey, chairman of the Chicago Board of Trade, James Newsome, president of the New York Mercantile Exchange, Frederick W. Schoenhut, chairman of the New York Board of Trade, and Satish Nandapurkar, the chief executive of Eurex US.
Mr. Duffy said that the CFMA of 2000 “represents successful landmark legislation that materially and beneficially reformed some of the nation’s most important financial markets.”
CME’s own average daily volume in February 2005 was more than 50% above the same figure a year before, a continuance of the trend in existence since the CFMA, he said.
But he did have suggestions to fine-tune the legislation. He said that the CFTC has been compelled to devote substantial resources to protecting the off-exchange customers of retail futures traders from fraud–its 70 enforcement actions in this area over four years have resulted in the imposition of more than US$240 million in penalties and restitution orders. The need for so much enforcement suggests, he contended, that something is wrong that “cries out for reform.”
Separately, he noted that securities futures products (single-stock futures and narrow-based indexes, which could not lawfully be traded on U.S. exchanges before the passage of this legislation) have remained an unfulfilled promise. In order to jump-start this market, he proposed letting futures exchanges trade the product as a pure futures contract and to let securities exchanges trade it as a pure securities product. Let the relevant exchanges deal solely with their respective regulator, the CFTC or the Securities and Exchange Commission, rather than having to deal with them both in a hybrid regulatory environment.
Mr. Carey of the CBOT likewise praised the CFMA as “a clear success,” but said that there continue to exist some “areas of uncertainty, overlap and the risk of regulatory inconsistency that deserve discussion.”
He had more suggestions than Duffy did, for the regulators as well as for the legislators. For the benefit of regulators, he cautioned that new market entrants “may have less experience in crafting rules that comply with all the provisions of the act, and we hope commission staff will exercise care in reviewing such rules,” and that some incentive programs may encourage payment for order flow. Further, as exchanges and their clearing operations become cross-border, he is concerned that the level of protection for U.S. customers may lapse.
Mr. Carey had harsh words about the Seventh Circuit’s recent Zelener decision , which he said “provides a road map for unscrupulous persons to engage in over-the-counter contracts involving agricultural and other commodities, with no government supervision whatsoever, and entirely free of the anti-fraud jurisdiction of the CFTC.” He urged Congress to restore that jurisdiction.
Mr. Carey, too, spoke of stock futures products. “Unfair and unnecessary margin inequities inhibit the growth of stock futures and their utility as hedging vehicles,” he said.
The three other witnesses in the first panel, though, discouraged the legislative tweaking Messrs. Carey and Duffy have in mind. James Newsome, of Nymex, and until recently himself the chair of the CFTC, warned that the CFMA included a “good number of delicate compromises. Consequently, changes in one area affect and thus could necessitate changes in many other aspects of the regulation.”
Mr. Schoenhut, of Nybot, said that “we believe the CFMA is working as intended,” and “does not need amendment.”
Mr. Nandapurkar, of Eurex US, said that the committee “should ensure that U.S. market participants continue to enjoy the benefits of competition. The faith that the Congress placed in the virtues of competition give years ago has been amply demonstrated to have been deserved. Competition will continue to yield greater efficiencies for consumers and the markets as a whole.”
Second Panel: Self-Regulation
The second group of witnesses consisted of John M. Damgard, president of the Futures Industry Association, Daniel J. Roth, chief executive of the National Futures Association, Micah Green, president of the Bond Market Association, John G. Gaine, president of the Managed Futures Association, and Robert G. Pickel, president of the International Swaps and Derivatives Association.
Mr. Damgard is of the fine-tuning camp. He believes that “the industry and the public have benefited greatly from the enlightened regulatory approach that Congress adopted in the CFMA.” But a reauthorization bill should address four issues: fair competition, self-regulatory organization governance, security futures products and over-the-counter forex transactions.
Under the heading of fair competition, Mr. Damgard cited the rivalry between the Intercontinental Exchange and Nymex, a rivalry within which “even the courts are looking to the CFTC to play a special role in resolving competitive disputes.” He indicated that such a role for the CFTC may be too much to expect without further legislative guidance.
On the second point, Mr. Damgard contended that to enhance “the quality SRO rulemaking and engender confidence in the SRO rulemaking process generally, the procedures by which an SRO adopts and enforces these rules should be transparent and should assure that members and other market participants, not just one constituency, have an opportunity to express their views and otherwise participate in the process.”
Third, his quarrel with the securities-futures aspect of the CFMA is that the CFTC and the Securities and Exchange Commission “have failed to take any action to permit U.S. customers to trade futures on individual securities or on narrow-based indices listed for trading on non-U.S. exchanges.”
Finally, on over-the-counter foreign currency transactions, Mr. Damgard said that he understands the temptation to draft legislation to redress the Seventh Circuit’s decision in Zelener but he is wary of a rush job here, which “could inadvertently interfere with legitimate risk management transactions entered into by commercial parties, including, for example, hedge-to-arrive contracts used by many in the agricultural community.”
Mr. Roth, of the NFA, also contended that the CFMA has been a “great success.” But he thinks Zelener proves that the bill failed in one of its main purposes, to codify the CFTC’s authority to protect retail fore customers from fraud. Aside from addressing the definition problem Zelener exemplifies, he said, there are other forex issues Congress should consider–for example, the fact that section 2(c) of the CEA might be read to allow unregulated affiliates of a futures commission merchant to act as counterparties to retail customers if the FCM makes and keeps records of the affiliates under the CEA’s risk assessment provisions. Some firms have tried to take advantage of such a reading by creating “shell” FCMs, solely for the purpose of then creating unregulated affiliates for them.
The other three members of this panel preferred a clean reauthorization. Mr. Green of the Bond Market Association said that the CFMA has been “extremely successful” in that it “clarified the exclusion from the CEA and the jurisdiction of the [CFTC] of OTC derivatives, swaps, and foreign exchange transactions,” bringing much needed legal certainty to those areas. He made the case that the temptation to impose new CFTC authority to regular metals and energy derivatives ought to be resisted. “The CFTC’s swift and successful enforcement action against Enron for manipulation of the natural gas markets has netted [US] $35 million in penalties to date and is a strong argument for leaving the current regulatory approach to OTC derivatives in energy and metals unchanged.”
Mr. Gaine of the MFA said that because of the success of the act his organization is not advocating any changes. But he did ask the subcommittee to use its oversight authority to encourage the two pertinent agencies to work together on eliminating duplicative regulation.
Mr. Pickel of ISDA said that CFMA “seems to have been a broad-based success for the capital markets generally,” and there is no fundamental need to make substantial changes to it.
Third Panel: Grains and Legal Certainties
The final panel consisted of George Hanley, president of the Hanley Group, Chicago, appearing on behalf of the National Grain Trade Council; Tom Coyle, general manager, Chicago and Illinois River Marketing LLC, and chair of the risk management committee of the National Grain and Feed Association; Jeffrey C. Sprecher, chairman of the Intercontinental Exchange Inc., Atlanta; and Martin Doyle, president of OneChicago LLC.
Mr. Hanley probably was the most severe critic of the existing regulatory structure that the subcommittee heard, although he, too, acknowledged that the CFMA was a step forward. Still, “now is the time to draw from our experiences and examine the application process for new exchanges to ensure that there is enough opportunity for discussion and debate.” He also complained of the negative effect that the Financial Accounting Standard 133 is having on agricultural markets.
“Grain and food processors must either misrepresent their financial state to comply with FAS 133 or opt to not participate in the market” for futures and options,” he said. “Many firms without the internal expertise or staff necessary to deal with the onerous rules have simply opted to avoid hedging, thus increasing their risks and limiting business for the hedging community.”
Mr. Coyle, of the NGFA, was the only speaker of any of the day’s panels who had positive words for the Zelener decision. He said that a careful reading of that and other opinions “can lead to a much better understanding of a clear definition of cash forward contracts that are exempt from CFTC oversight,” bringing legal certainty to that domain analogous to the legal certainty that CFMA brought to over-the-counter financial derivatives.
Mr. Sprecher, ICE, thanked the Agriculture Committee for its “far-sighted work in developing and adopting the [CFMA].” He then observed that ICE was founded in 2000 on the basis of a no-action letter from the CFTC staff in advance of the passage of that law, which later that year formalized the terms of that letter in the category of an exempt commercial market.
Mr. Doyle, of OneChicago, presented a chart of single-stock futures volumes in the exchanges of a variety of nations around the world. The world leader is the Stock Exchange of India, where 2004 single stock futures volume was 44 million, up 72% from the year before. Meanwhile, OneChicago’s volume in that product in that year was a mere 1.9 million, and represented a growth of only 19% from the year before. This situation is “distressing to us, as we believe it will be to the members of this subcommittee,” Mr. Doyle said, and he proposed three changes in the law to allow the U.S.-based exchange to catch up with foreign rivals.
First, he said, in 2000 the CFMA linked security futures margins to the margins for stock options, 20% of notional value. He recommended that Congress bring this figure down to 15%.
Second, Congress should relax the customer suitability requirement that the law imposed. “Fear of the unknown application of securities suitability standards has caused many futures firms to be unwilling to recommend or broker security futures trades.”
Finally, he addressed the issue of taxation, although he acknowledged that this issue is outside the jurisdiction of the Agriculture Committee. He suggested a bright-line test to the effect that all members of an exchange trading securities futures should qualify for 60-40 tax treatment for that activity, replacing the “unduly complicated” and “less favorable” treatment the Treasury Department has settled upon.” (see
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