Statement of the Foreign Exchange Committee

The Senate Committee on Agriculture, Nutrition and Forestry
United States Senate

February 13, 1997

I. The Foreign Exchange Committee

The Foreign Exchange Committee is pleased to submit this statement regarding the bill entitled "The Commodity Exchange Act Amendments of 1997" (the "Bill") sponsored by Senators Lugar, Harkin and Leahy, which proposes, among other changes, to amend the so-called "Treasury Amendment" of the Commodity Exchange Act (the "Act"). S. 257, 105th Cong., 1st Sess. (1997).

The Foreign Exchange Committee was formed in 1978 under the sponsorship of the Federal Reserve Bank of New York, and includes representatives of major domestic and foreign commercial and investment banks and foreign exchange brokers. The Foreign Exchange Committee represents many of the most significant participants in foreign currency trading in the United States. The objectives of the Foreign Exchange Committee are to (i) provide a forum for discussing technical issues in the foreign exchange and related international markets, (ii) serve as a channel of communication between those markets and the Federal Reserve and, when appropriate, to other official institutions in the United States, (iii) enhance the knowledge and understanding of the foreign exchange and related international markets, (iv) foster improvements in the quality of risk management in those markets and (v) develop recommendations and prepare issue papers on specific market-related topics for circulation to market participants and others.

The Foreign Exchange Committee strongly supports the essence and intent of the Bill's proposed amendments to the Treasury Amendment. Most importantly, the Bill's proposed amendments to the Treasury Amendment clarify that transactions in or involving foreign currency are covered by the Treasury Amendment and that the "unless" clause of the Treasury Amendment excludes only unsupervised retail transactions involving the general public from the scope of the Amendment. For these reasons, the proposed amendments provide important legal certainty regarding the enforceability of billions of dollars of foreign currency transactions involving United States market participants and help create efficiency in the United States foreign currency markets by limiting the duplicative and excessive regulation of U.S. entities engaged in trading foreign currency products.

II. The Foreign Currency Markets and the Importance of the Proposed Amendments

The over-the-counter foreign currency markets are highly evolved, sophisticated and very active. Trading is conducted twenty-four hours a day, from 6:00 a.m. Sydney, Australia time on Monday until 5:00 p.m. New York time on Friday, with exchange rate quotations available worldwide on computer screens and similar electronic devices. Over-the-counter transactions are not conducted on organized exchanges. Instead, most trading is conducted electronically or over the telephone directly with dealers or through brokers. These markets are extremely sensitive to political and financial developments around the world and around the clock.

In addition to commercial and investment banks, the most significant participants in the over-the-counter currency markets are foreign exchange dealers and brokerage companies, corporations, money managers, insurance companies, governments and central banks. Governments and businesses have historically relied upon the over-the-counter currency markets to serve a number of their fiscal and commercial needs. For example, the Federal Reserve Bank of New York, foreign central banks and foreign governments frequently intervene in the over-the-counter markets in an effort to implement their policies with respect to their national currencies.

The importance of the over-the-counter currency markets to the United States economy is considerable. United States businesses and financial institutions depend on active trading in, and the orderly functioning of, the over-the-counter currency markets. These liquid markets provide businesses with access to international markets for goods and services by providing the foreign currency necessary for transactions worldwide. United States firms transacting business abroad require highly liquid over-the-counter currency markets so that they can obtain the best prices for their currency purchases and sales.

The over-the-counter foreign currency markets also assist international businesses faced with the vagaries of global interest rate and currency volatility by providing a means of managing the risk of adverse exchange rate movements. Over-the-counter foreign currency contracts are commonly used to hedge inventories, accounts receivable or payable and contract bids denominated in a particular currency. Such contracts allow participants to shift the risk of adverse exchange rate movements to a counterparty willing to accept that risk, thereby enhancing their ability to engage profitably in international commerce.

The global significance of these over-the-counter markets and the full scope of trading activity in this country are evident from a triennial survey conducted by twenty-six national monetary authorities and coordinated by the Bank for International Settlements in Basle, Switzerland. With respect to foreign currency forwards, this survey reports that the average daily turnover in these twenty-six countries was approximately $100 billion in April 1995, representing approximately a 70% increase over the prior three-year period. BIS "Central Bank Survey of Foreign Exchange Market Activity in April 1995; Preliminary Global Findings" at 2, Table 1 (Oct. 24, 1995); cf. BIS, "Central Bank Survey of Foreign Exchange Market Activity in April 1992" at 19, Table 1-A (March 1993). With respect to foreign currency options, the survey reports that the average daily turnover was $40 billion in April 1995, representing a 29% increase over the prior three-year period. BIS, "Central Bank Survey of Derivatives Market Activity: Release of Preliminary Global Totals" at 4 (Dec. 18, 1995). Approximately one-half ($20 billion) of the daily turnover of over-the-counter currency options is attributable to the United States. Federal Reserve Bank of New York "Central Bank Survey of Derivative Markets Activity Results of the Survey in the United States," at Annex II, Table 5-U.S. (Dec. 18, 1995). The United States and United Kingdom rank top in the world, with 16% and 30%, respectively, of the global daily turnover in foreign exchange. BIS, "Central Bank Survey of Foreign Exchange and Derivatives Market Activity 1995" at Table 2-G.

Members of the Foreign Exchange Committee and other participants in the foreign currency markets have been entering into over-the-counter foreign currency transactions with each other and other counterparties in the United States and around the world for years with the understanding that their activities are not subject to the Act. In fact, London has grown as a global center for foreign currency activities. Many large-scale participants in foreign currency transactions, which historically have centered their business activities in the United States, could respond to the existing uncertainty regarding the scope of the Treasury Amendment by shifting the center of their foreign currency trading to their overseas offices to the detriment of the United States markets. Such a shift could result in a lessening of the liquidity of domestic foreign currency markets, which in turn could have an adverse impact on those United States businesses that engage in foreign trade and thus rely on those markets to assist their dealings in international commerce.

The recent uncertainty regarding the scope of the existing Treasury Amendment places in question the legal enforceability of over-the-counter foreign currency contracts where a U.S. person is a party to the contract, as such contracts would be unenforceable if the Act were found to apply. If it remains uncertain whether such transactions are subject to the Act, U.S. market participants could be placed at a significant disadvantage in global competition, as any finding that such contracts were subject to the Act would impose tremendous regulatory and transactional costs on the over-the-counter foreign exchange markets.

Because of the current uncertainty regarding the scope of the existing Treasury Amendment, it is of the utmost importance to clarify, as is the intent of the Bill, that the Treasury Amendment excludes all unsupervised, non-retail over-the-counter transactions of any kind in, based on, involving or indexed to foreign currency, including options on foreign currency, from the coverage of the Act. For these reasons, passage of the proposed amendments to the Treasury Amendment (with certain technical modifications), and the legal certainty that such amendments provide, are of vital importance to the members of the Foreign Exchange Committee and to the United States economy.

III. The Treasury Amendment

The Act regulates commodity futures and options trading. It requires, among other things, that all commodity futures and options trading take place on exchanges approved and regulated by the Commission (so-called "contract markets"), unless such activities fall within a statutory exclusion (such as the Treasury Amendment) or a regulatory exemption. If a commodity futures or options contract (that does not fall within an exclusion or exemption) is not executed on a contract market, it is unenforceable.

The Treasury Amendment was added to the Act at the request of the Treasury Department in 1974. The Acting General Counsel of the Department of Treasury wrote to the Senate Committee on Agriculture and Forestry to express concern that, as a result of the proposed expansion of the Act's scope, foreign currency transactions and transactions in certain other financial instruments that were generally traded by large, sophisticated institutional participants would become subject to unnecessary regulation. Because the foreign currency market consisted primarily of banks and dealers, the Treasury Department believed that further regulation of this market by the Commission would impose unnecessary costs on the market and U.S. market participants. The Treasury Department stated that "new regulatory limitations and restrictions could have an adverse impact on the usefulness and efficiency of foreign exchange markets for traders and investors." In view of these concerns, the Treasury Department urged that the proposed legislation be amended "to make clear that its provisions would not be applicable to futures trading in foreign currencies or other [specified] financial transactions."

Congress adopted the Treasury Department's proposed statutory exclusion almost verbatim. The Treasury Amendment currently provides in relevant part:

      Nothing in this chapter shall be deemed to govern or in any way be applicable to transactions in       foreign currency [and certain other financial instruments]. . ., unless such transactions involve the       sale thereof for future delivery conducted on a board of trade. 7 U.S.C. § 2 (a)(1)(A)(ii).

The Treasury Department recently reaffirmed its objectives in proposing the original Treasury Amendment in a letter addressed to Chairman Lugar dated February 3, 1997. In a description of its legislative proposal to amend the Treasury Amendment annexed to the February 3 letter, the Treasury Department described and restated its original objectives in suggesting the Treasury Amendment in 1974. In addition, the Treasury Department stated "[a]s a result, the goal of the Treasury Amendment, to preserve the efficiency of these markets by avoiding unnecessary regulation and uncertainty, is even more compelling today."

There has been extensive litigation regarding the scope of the Treasury Amendment, most of which have been Commission enforcement actions brought against bucketshops and boilerrooms engaging in retail marketing to the general public. The Foreign Exchange Committee has participated as amici curiae in a number of these cases to seek clarification of the scope of the Treasury Amendment and to thereby promote legal certainty in the foreign exchange market.

Neither the courts nor the Commission have provided definitive guidance on the precise scope of the Treasury Amendment. As a result of the contradictory holdings of federal courts regarding the scope of the Treasury Amendment, there is confusion as to what the Treasury Amendment excludes from the Act and the jurisdiction of the Commission. This confusion has created a significant amount of legal uncertainty over the enforceability of a substantial volume of foreign exchange forward and option contracts. This confusion also allows enterprising plaintiffs to forum shop in an attempt to invalidate their unprofitable foreign currency transactions. In addition, the existing uncertainty regarding the scope of the Treasury Amendment's exclusion could impose great regulatory and transactional costs on the over-the-counter currency markets and could possibly drive those over-the-counter markets out of the United States. The Bill's proposed amendments to the Treasury Amendment help to alleviate this uncertainty.

IV. The Proposed Amendments to the Treasury Amendment

A. Covered Products

The proposed amendments to the Treasury Amendment state that "[n]othing in this Act shall be deemed to govern or in any way be applicable to transactions in or involving foreign currency . . ., unless such transactions involve the sale thereof to the general public for future delivery conducted on a board of trade". An option on foreign currency is explicitly recognized as a "transaction" for the purposes of the Treasury Amendment.

The proposed amendment clarifies that all transactions in or involving foreign currency are included in the scope of the Treasury Amendment. The proposal's statement that options are transactions also would clarify the ambiguity existing after the Second Circuit's holding that over-the-counter foreign currency options were not excluded from the Act by the Treasury Amendment in CFTC v. Dunn, now on appeal to the Supreme Court. 58 F.3d 50 (2d. Cir. 1995), cert. granted, 116 S.Ct. 1846 (1996). Considering the amount of confusion regarding the existing language of the Treasury Amendment, the Foreign Exchange Committee will submit suggested revisions to the language of the proposed amendment to the Committee to further clarify that transactions of any kind in, based on, involving or indexed to foreign currencies are also included within the scope of the Treasury Amendment. The Foreign Exchange Committee believes that the proposed amendment is a major step in providing legal certainty for foreign currency markets in the United States.

B. "Unless" Clause

The proposed amendment to the Treasury Amendment clarifies that the term "board of trade" contained within the unless clause of the Treasury Amendment only includes "unsupervised entities that are engaged in the systematic marketing of standardized, non-negotiable foreign currency transactions to retail investors." In addition, the Bill amends the Treasury Amendment to state that Treasury Amendment products are exempt from the Act "unless such transactions involve the sale thereof to the general public for future delivery conducted on the board of trade." Together, these proposed amendments limit the jurisdiction of the Commission in transactions in or involving foreign currency to the retail marketing of such transactions to members of the general public by unregulated entities. The proposed amendments confirm that all foreign currency non-retail, and all foreign currency retail transactions where one of the parties is supervised are excluded from the scope of the Act.

The Bill instructs the Commission to define the term "retail investors" for the purpose of the definition of "board of trade." Instead of delegating the responsibility of defining "retail investors" to the Commission, the Foreign Exchange Committee suggests that this Committee adopt the definition of "retail customer" contained in the Treasury Amendment Legislation proposed by the Treasury Department (annexed to the February 3, 1997 letter addressed to Chairman Lugar). The Treasury Department's definition sets out the appropriate level of sophistication for individual participants in foreign currency transactions and provides important objective certainty in the interpretation of the definition of retail customer.

The Foreign Exchange Committee agrees with the objectives of the proposed amendments to the "unless" clause of the Treasury Amendment, although it will suggest some technical amendments to further clarify the scope of the clause. The Foreign Exchange Committee supports the Bill's objective of protecting the general public from the systematic mass-marketing of foreign currency instruments by unsupervised entities. The proposed amendments recognize that the general public should be protected against the fraudulent activities of so-called "bucketshops" and "boilerrooms" by the anti-fraud jurisdiction of the Commission. In addition, the Bill's proposed amendments will help to ensure the enforceability of off-exchange foreign currency transactions, and will therefore be extremely beneficial to foreign currency markets in the United States.

As the Bill is currently drafted, the provisions of the entire Act would apply to any transaction in or involving foreign currency that involves the sale thereof to the general public for future delivery conducted on a board of trade. The Foreign Exchange Committee believes that the Commission's jurisdiction over unsupervised and unregulated off-exchange foreign currency transactions involving the general public should be limited to jurisdiction to police fraud. The Commission would not have the authority to simply challenge and invalidate transactions as illegal off-exchange futures or options contracts.

The primary concern of regulators with the Treasury Amendment has been that the general public will be unprotected against the fraudulent practices of bucketshops and boilerrooms. The Commission's anti-fraud authority over unsupervised and unregulated off-exchange foreign currency transactions involving the general public sufficiently addresses this concern. If the Treasury Amendment continues to provide that the provisions of the entire Act apply to unsupervised and unregulated off-exchange foreign currency transactions, there is a risk that legitimate off-exchange transactions could be found to be unenforceable, illegal futures contracts, even without the existence of fraudulent activity. Such a finding could be potentially damaging to foreign currency markets as a whole.

C. Exchange Activities in Treasury Amendment Products

As described in Section IV.B. above, the Bill proposes to amend the Treasury Amendment to state that Treasury Amendment products are exempt from the Act "unless such transactions involve the sale thereof to the general public for future delivery conducted on a board of trade." In addition to clarifying that all non-retail transactions that involve a supervised party will be excluded from the Act by the Treasury Amendment, the addition of the words "to the general public" also has the express intention of allowing organized exchanges to offer products in or involving foreign currency (except to the general public) without being subject to the Act or the jurisdiction of the Commission. The bill instructs the Commission to define the term "the general public".

We believe it is essential that the term "board of trade" not extend to entities that facilitate bilateral transactions where party creditworthiness is a material consideration. Such transactions, whether executed in a physical or electronic market place or otherwise, clearly should be outside the scope of the Act and Commission jurisdiction. In this regard, we commend to the Committee the framework advanced by the Department of the Treasury in its definition of what is included and not included in the term "organized exchange" ("organized exchange" is equivalent to the Bill's term "board of trade").

There are regulatory and public policy considerations associated with concentrating financial risk and systemic risk when transactions are traded on a board of trade that do not apply to bilateral off-exchange transactions. Accordingly, where Treasury Amendment products are traded on a board of trade, our view is that the board of trade should be supervised or regulated by the Commission or another appropriate government agency. Certainly, where the board of trade does not include the general public, the scope of oversight should be less rigorous than required for a retail exchange market.

V. Conclusion

We appreciate the opportunity to present this statement. We applaud Senators Lugar, Harkin and Leahy for proposing amendments to the Treasury Amendment that help to clarify the scope of the Treasury Amendment and provide greater certainty for the foreign currency markets in the United States while protecting retail investors from systematic marketing by unregulated entities. The proposed amendments to the Treasury Amendment will help to ensure the efficiency of foreign currency markets in the U.S. by avoiding costly and unnecessary regulation, the objective of the Treasury Amendment when it was enacted. We believe the Bill's proposed amendments to the Treasury Amendment, with several technical amendments, will greatly benefit United States participants in the foreign currency markets and will help to retain the United States' substantial share of the over-the-counter foreign currency markets. Should the Committee have any questions for the Foreign Exchange Committee, we will be pleased to respond.