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Topic Areas About Donate. The Commodity Futures Modernization Act of This report describes the historical market developments and the major issues that shaped consideration of that legislation. Derivatives — which are used to avoid risk of price changes in some underlying commodity or financial variable or in search of speculative profits from the same price changes — were on the verge of a major expansion: The Commodity Exchange Act CEA amendments in gave the CFTC exclusive jurisdiction with some exceptions over derivatives regardless of the nature of the underlying commodity or interest.
During the s, however, a new derivatives market grew up, where neither the CFTC nor any other agency exercised comprehensive oversight.
The two types of instruments serve the same economic functions and are often in direct competition. However, the existence of two markets, where the Commodity Exchange Act amendments envisioned a single market regulated by the CFTC, led many to conclude that the CEA was out of date and in need of major revision. The futures exchanges contended that CEA regulation put them at a competitive disadvantage versus the unregulated OTC market.
OTC contracts could possibly have been invalidated by a court finding that they were in fact illegal, off-exchange futures contracts. Both groups viewed the CEA as an impediment to financial innovation and portrayed themselves as vulnerable to foreign competition.
A joint group of U. This was the general approach followed by the Congress in enacting the Commodity Futures Modernization Act of This report analyzes the transformation of derivatives markets and the legislative response and will not be updated. Legislation in the th Congress. Futures Contracts Traded on U. Exchanges, by Underlying Interest: Derivatives Regulation Reconsidered This report analyzes the major issues that were involved in the consideration and passage of the Commodity Futures Modernization Act of H.
The legislation that created the CFTC in contains a sunset provision: Reauthorization legislation has usually been the vehicle for consideration of regulatory issues related to futures and derivatives markets. This report provides background on the major reauthorization issues. The reauthorization process took place as many regulators and market participants were calling for a fundamental reevaluation of the Commodity Exchange Act CEA , the statutory basis for the CFTC.
Basic changes in the CEA and in the regulation of financial derivatives were proposed, and eventually enacted. Markets had changed dramatically since the CFTC was created, and the existing regulatory framework was under challenge from all sides. Some analysts claimed that CFTCtype regulation was unnecessary in most of the markets where it then applied, that it slowed financial innovation, and that it placed the U.
On the other hand, some believed that deregulation or the growth of unregulated derivatives markets may pose serious risks to market participants and to the stability of the global financial system. What is the appropriate framework for the regulation of financial derivatives? Which federal regulator should have jurisdiction over which forms of trading, and how can jurisdictional quarrels among regulators be prevented? To what extent can industry self-regulation be relied upon to maintain fair, stable, and efficient markets?
These broad questions, the background against which Congress in weighed the future of the CFTC, are examined briefly in this report. CRS-2 Background Derivative Markets Derivatives are financial instruments or contracts whose value is linked to the price of some underlying commodity or financial variable. There are several forms of derivatives — the best-known variations are futures contracts, options, and swap agreements — but all have this common central feature: It is expected that the underlying price or rate will fluctuate over the life of the contract, but the price specified in the derivative instrument remains fixed.
If they succeed in forecasting the direction of prices, derivatives traders will be entitled to buy the underlying commodity for less or sell for more than the going market price. For every winner, there is a loser. Here are three examples: The difference between options and futures is that the option buyer is not obliged to make the transaction on unfavorable terms if prices fail to move as expected. In exchange for this right, the seller of the option receives a cash premium.
A financial institution with large amounts of floating-rate debt fears that interest rates are about to rise, which would increase its debt service costs. It enters into an interest rate swap: A trader may take his profits at any time up to the expiration of the contract by entering into an opposite, or offsetting, contract, so that his net obligation to buy and sell the commodity is zero.
Holders of physical commodity futures have the option of settling the contract by making or taking delivery of the commodity itself at expiration, but only about 0.
The rest are settled in cash. CRS-3 outstanding debt,4 and in return will receive a floating-rate payment on the same principal amount. Thus, if interest rates do rise, the swap payments it makes remains constant, while the swap payment it receives rises, allowing it to meet the rising claims of its floatingrate creditors.
The swap converts floating-rate to fixed-rate debt. Thus, the owner of a derivative gains or loses as the underlying price or rate changes, without actually owning the underlying commodity itself. Derivatives allow traders to take a position in markets at a fraction of the cost of buying an equivalent amount of the underlying item.
Leverage also implies the risk of large, sudden losses. Derivatives are often described as bets on future price changes. This is not incorrect, but it is incomplete. Derivatives can be used to speculate, but they can also provide protection against the risk of unfavorable turns in prices or interest rates. Similarly, the financial institution in the third example above uses an interest rate swap not to seek trading profits but to protect itself against a rise in interest rates.
Derivatives are used by businesses, units of government, and financial institutions to manage risk. For example, the holder of a foreign bond faces two separate risks. Using derivatives, the holder may choose to assume either of these risks or to pass them off to someone else. In sum, derivatives users can be divided into two groups, who use the markets for opposite purposes.
Speculators seek to profit by anticipating future price changes, while hedgers, whose business generally involves them in the cash market for the underlying item, avoid price risk by transferring it to others namely, the speculators.
It is never actually exchanged, but serves as a reference point to determine the size of the swap payments. Producers, distributors, and processors of farm commodities devised futures, options, and forward contracts to protect themselves against rising or falling prices.
These markets became the futures exchanges and flourished because of the existence of speculators willing to assume the risks that others wished to avoid. In the s, the Chicago futures exchanges expanded the market dramatically by introducing contracts based on financial instruments: The success of financial futures attracted competition.
In the s, banks and securities firms — those who dealt in the actual stocks, bonds, and currencies underlying financial futures — began to offer swap contracts and options that had the same functions as exchange-traded futures. They could be used to hedge or speculate. Growth in these markets has been explosive, as figure 2 below shows. The over-the-counter and the exchange markets compete for the same business.
Notional value does not convey any useful information about the market value or riskiness of a particular instrument. Moreover, contracts are traded much more frequently on the exchanges, so that comparisons of value outstanding at the end of a period may be misleading as a gauge of total market activity. Available on the Internet at www. In response to the growing economic scope and importance of futures trading, Congress replaced the existing futures regulator an office within the Department of Agriculture with an independent agency, the CFTC, with exclusive jurisdiction with a few important exceptions over all derivatives trading, regardless of the nature of the underlying commodity.
The rationale for this grant of regulatory authority was that derivatives are susceptible to manipulation and excessive speculation, which can cause artificially high or low prices in the underlying cash markets, or, in extreme cases, instability and panic in the financial system. These were professional markets, where small investors were not present, and were for the most part unregulated. Therefore, Treasury saw no reason why these self-regulating markets should be brought under CFTC regulation.
Congress wrote the Treasury Amendment into law, excluding contracts based on U. What no one could have foreseen in was the development of the OTC swap market. Despite the fact that swaps and futures serve exactly the same economic purposes, and are sometimes interchangeable, the CFTC generally exercised no regulatory authority over the OTC market.
How did this market now measured in the tens of trillions of dollars develop outside the regulatory framework of the CEA?
As the market was established in thes, the CFTC made no move to assert its jurisdiction: Banking regulators took a laissez-faire attitude, perhaps viewing swaps as a welcome source of income for depository institutions whose recent results in commercial and international lending had ranged from poor to disastrous.
Securities broker-dealers tended to locate their swaps business in unregulated affiliates, where SEC authority was extremely limited. Still, a legal uncertainty remained. See Federal Register, v. In , the financial swap market satisfied only the first of these conditions. Many swap contracts are standardized and fungible, and are traded short-term like any other financial instrument. Both in the United States and elsewhere, swaps exchanges and clearing houses had been introduced or proposed.
Legal uncertainty in the U. Market participants and regulators supported making the current exemptions from the CEA a matter of statute rather than regulation, thereby settling the long dispute over who does or should have regulatory jurisdiction over swaps.
Congressional efforts to address the issue in the past were made difficult by disagreements among federal regulators. Thus, the creditworthiness of the other party is not a consideration to futures traders. Under the exemption, swap traders must assess and assume the risk of counterparty default themselves.
Hereinafter cited as Working Group Report. CRS-8 traded are not based on nonfinancial commodities whose supply is finite.
That is, participants in that market are sophisticated and have the means to protect their own interests, and, secondly, manipulation of interest or exchange rates via the swaps market has not been observed in 20 years and is highly unlikely to occur in the future.
The choice before Congress in was whether to accept the recommendations of the Working Group. It could choose to exclude swaps from the CEA by expanding the existing exemption to permit swaps clearing houses and exchange-like trading facilities and making the exclusion a matter of statute rather than of regulation. The effect of such action, besides reducing legal uncertainty in the swaps market, would be to allow the OTC market to adopt features clearing houses and multilateral trading systems of the exchange markets — to strengthen selfregulation, in other words.
Some viewed such changes in the marketplace as not only desirable in themselves13 but essential to protect the U. I see a real risk that, if we fail to rationalize our regulation of centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of global investors without imposing so many regulatory constraints.