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The chairman's invitation letter requested that the testimony and written statement commodities options and futures trading act of 2000 an overall evaluation of the CFMA and address three specific regulatory issues: Most important, as recommended by the President's Working Group on Financial Markets in its report, it excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act CEA.

Such transactions are not readily susceptible to manipulation and eligible counterparties can and should be expected to protect themselves against fraud and counterparty credit losses.

Exclusion of these transactions resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable. Together, these provisions of the CFMA have made our financial system and our economy more flexible and resilient by facilitating the transfer and dispersion of risk. Consequently, the Board believes that major amendments to the regulatory framework established by the CFMA are unnecessary and unwise.

Nonetheless, the Board supports some targeted amendments to the CEA to address persistent problems with fraud in retail foreign commodities options and futures trading act of 2000 transactions and to facilitate the trading of security futures products and futures on security indexes.

Fraud in Retail Foreign Currency Transactions In its report, the President's Working Group concluded that, to address problems associated with foreign currency "bucket shops," the CEA should be applied to transactions in foreign currency futures if they are entered into between a retail customer an individual or business that does not meet the definition of an eligible counterparty and an entity that is neither federally regulated nor affiliated with a federally regulated entity.

Commodities options and futures trading act of 2000, the CFTC has continued to encounter certain difficulties in this area. These difficulties have stemmed from two sources. Commodities options and futures trading act of 2000, the CFTC's authority is limited to foreign currency futures, and some entities have fraudulently marketed contracts that, although similar to futures, have characteristics that have led some courts to conclude that they are not futures and that the CFTC has no jurisdiction.

Second, some perpetrators of fraud have taken advantage of the CFMA's exclusion from CFTC jurisdiction of retail foreign currency futures offered by futures commission merchants FCMs and their affiliates. These perpetrators have set up thinly capitalized FCMs and used affiliates of those FCMs or unregulated unaffiliated entities to fraudulently solicit retail customers. The Board believes that fraud undermines the functioning of financial markets and that some governmental entity must have the authority to protect retail investors in foreign currencies by taking enforcement action against commodities options and futures trading act of 2000 that are defrauding them.

Although the states have an important role to play in combating fraud, commodities options and futures trading act of 2000 President's Working Group concluded in that the CFTC is the appropriate federal regulator and should have clear authority to pursue retail fraud by foreign currency bucket shops. Consequently, the Board supports targeted amendments to the CEA that address the specific difficulties that the CFTC has encountered in taking enforcement action in this area.

It is critical that those amendments be carefully crafted to avoid creating legal or regulatory uncertainty for legitimate businesses providing foreign exchange services to retail clients. The Board would be opposed to extending any new CFTC authority to retail transactions in other commodities without further careful consideration and demonstrated need. Provisions crafted to avoid creating uncertainty for legitimate foreign currency businesses are unlikely to provide the same protection to a much wider range of businesses.

Commodities options and futures trading act of 2000 Board delegated its authority to the commissions in a letter dated March 6, The letter indicated that the Board concluded that delegation is appropriate because it believes that the most important function of margin regulations is prudential--that is, to protect margin lenders from credit losses.

In the case of security futures, the lenders are broker-dealers and FCMs, and the commissions are responsible for all other aspects of prudential regulation of those firms. Portfolio margining is a method for setting margin requirements that evaluates positions as a group or portfolio and takes into account the potential for losses on some positions to be commodities options and futures trading act of 2000 by gains on others.

Specifically, the margin requirement for a portfolio is typically set equal to an estimate of the largest possible decline in the net value of the portfolio that could occur under assumed changes in market conditions. Portfolio margining is an alternative to "strategy-based" margining. With strategy-based margining, the potential for gains on one position in a portfolio to offset losses on another position is taken into account only if the portfolio implements one of a designated set of recognized trading strategies.

The margin requirements for recognized strategies are set out in the rules of self-regulatory organizations. Each strategy is viewed in isolation; the remainder of the portfolio and other strategies are not taken into account. The Board has supported the use of portfolio margining for some time. For example, in the Board amended Regulation T to allow securities exchanges to develop portfolio margining as an alternative to strategy-based margining, subject to SEC approval.

In its letter delegating its authority over margins for security futures products jointly to the CFTC and the SEC, the Board requested that the commissions, either jointly or individually, report to the Board annually on their experience exercising the delegated authority and to include in those reports an assessment of progress toward portfolio margining for securities futures products.

The Board continues to believe that portfolio margining is both more risk-sensitive and more efficient than strategy-based margining. Unfortunately, to date no progress has been made toward portfolio margining of security futures products. Because the CFMA stipulates that margin requirements for security futures products must be consistent with margin requirements on comparable securities options, progress for security futures requires progress on options.

Although margin requirements for options have for many years been portfolio-based at the clearing level, customer margins were until very recently strictly strategy-based. If this pilot program were adopted as a margining system available to all customers for a broader range of products, significant progress toward portfolio margining of securities futures products would become possible. The Commodity Exchange Reauthorization Act ofwhich the Senate Agriculture Committee approved in July, proposes to make progress on portfolio margining 1 by eliminating the need for margins required on security futures to be consistent with those required on comparable options and 2 by substituting CFTC oversight of security futures margins for joint regulation by the CFTC and the SEC under delegation from the Board.

This approach would be a marked departure from the regulatory regime for security futures that was established by the CFMA. The Board believes that it is appropriate for the Congress to spur progress toward portfolio margining for security futures but that this can be accomplished without changing so fundamentally the regulatory regime for security futures margins.

For example, the Congress could spur more-rapid progress toward portfolio margining for both security futures products and options by requiring the commissions to jointly adopt regulations permitting the use of risk-based portfolio margin requirements for security futures products within a short but reasonable time period and requiring the SEC to approve risk-based portfolio margin requirements for options within the same period. Some futures exchanges argue that the definition of a narrow-based index in the CFMA was drafted with reference to the U.

The Reauthorization Act would address those commodities options and futures trading act of 2000 by requiring the CFTC and the SEC to jointly promulgate a revised definition of a narrow-based securities index that would better reflect capitalization, trading patterns, and trade reporting in the underlying markets.

Such a definition would permit futures on indexes of U. Although the Board does not have a strong interest in this issue, it favors taking another look at the appropriateness of applying the existing definition of a narrow-based index to indexes of foreign securities. First, for many years several futures on foreign equity indexes have been trading abroad and have been offered to customers in the United States. Although these indexes would be considered narrow-based indexes under the existing definition, we see no evidence that these indexes have been susceptible to manipulation.

September 8,

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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.