TESTIMONY of a
COALITION Of INVESTMENTAND COMMERCIAL BANKS

regarding S.257

"THE COMMODITYEXCHANGEACTAMENDMENTS OF]997"

before the COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY
UNITED STATES SENATE

FEBRUARY 3,1997

Chairman Lugar, members of the Committee, this testimony is offered on behalf of the following financial institutions:

Morgan Stanley & Co. Incorporated Goldman, Sachs & Co. Merrill Lynch & Co., Inc. Citibank, N.A. Salomon Inc The Chase Manhattan Bank Lehman Brothers Inc. Bankers Trust Credit Suisse First Boston Inc.

This Coalition is grateful for the opportunity to present its views to the Committee on S.257 "The Commodity Exchange Act Amendments of 1997." The Coalition strongly supports S.257. While the Coalition would propose certain changes to the proposed bill, the Coalition nonetheless strongly supports S.257.

The Coalition

The nine firms on whose behalf this testimony is offered are major participants in all of the country's financial markets, including the securities markets, government securities markets, foreign exchange markets, futures markets and derivatives markets. These firms also compete globally with non-U.S. financial institutions for international business in all financial markets.

These nine firms have established an unprecedented coalition for one purpose: to present to this Committee a consensus, market-sensitive view on revisions to the Commodity Exchange Act (LEA). As participants in all financial markets and members of nearly every major trade association affected by this legislation, this group is able to provide a unique perspective that cuts across product lines and reflects the integrated character of the global markets in these products.

The Coalition welcomes and endorses the Committee's reexamination of the CEA. Any statute that regulates activity in arenas that are as fast paced and critical to the economic well-being of this nation as our financial markets must be reexamined from time to time in light of the evolving needs of the markets and market participants.

The Coalition commends Chairman Lugar and Senators Harkin and Leahy both for their leadership and for proposing legislation designed to maintain the efficiency and competitive position of U.S. financial markets and market participants consistent with the preservation of market integrity.

II. Legal Certainty; Overview of Coalition Objectives

The Futures Trading Practices Act of 1992 (FTPA) and subsequent rulemaking by the CFTC contributed significantly to the reduction of legal uncertainty affecting over-the-counter OTC) derivative transactions and hybrid instruments. Very generally, OTC derivative transactions are privately negotiated contractual arrangements under which the parties agree to exchange payments based on the value of a reference asset, rate or index. Hybrid instruments are securities or bank deposits that have principal or interest payments that are indexed to the value of a reference asset, rate or index. (These instruments are thus called "hybrids" because they are part security (or deposit) and part derivative.)

By clarifying that such transactions do not violate the CEA's strict offexchange trading prohibition, the FTPA and CFTC rulemaking significantly reduced the risk of contract repudiation for a broad category of OTC derivative transactions and hybrid instruments.

Despite these measures, however, legal uncertainty continues to affect OTC derivative transactions and hybrid instruments -- particularly those based on stocks and (non-exempt) fixed-income securities. The Coalition thus strongly endorses further amendments to the CEA to foster and preserve legal certainty for transactions in OTC derivatives and hybrid instruments currently conducted by U.S. participants in the U.S. and international financial markets.

The Coalition believes the principal steps to accomplish this objective include:

. Codification of an exemption from the CEA for qualifying OTC derivative transactions based on the objective criteria incorporated in the swap exemption previously promulgated by the Commodity Futures Trading Commission as Part 35 of its regulations (known as the CFTC "Swap Exemption").

Codification of an exemption from the CEA for qualifying hybrid instruments based on the objective criteria incorporated in the hybrid instrument exemption previously promulgated by the CFTC as Part 34 of its regulations (known as the 1CFTC "Hybrid Exemption").

Clarification that OTC derivative transactions and hybrid instruments that qualify for the proposed statutory exemptions referenced immediately above do not violate the provisions of CEA section 2(a)(1)(B) (known as the "Jurisdictional Accord").

Amendments to CEA section 2(a)(1)(A)(ii) (known as the "Treasury Amendment") to clarify and update the scope of transactions that are excluded from the CEA thereunder and to expand the CFTC's authority to prosecute fraud against the public by unregulated "boilerrooms" where federal securities or federal bank regulatory protections are not present.

Conforming amendments to CEA section 12(e) to include transactions satisfying the proposed statutory exemptions within the existing category of exempted transactions that are currently protected against legal uncertainty under state gaming and bucket shop laws.

Generally speaking, these measures would not represent a substantive expansion in the scope of transactions that currently are conducted in the financial marketplace on the basis of the view that they do not violate the CEA. In the case of securities-based OTC derivatives and hybrid instruments, these measures would provide such transactions with the same legal status accorded other OTC derivatives and hybrid instruments under the CEA and would permit such transactions to be effected within the same parameters as are applicable to other OTC derivatives and hybrid instruments, free of the stigma of legal uncertainty that currently attaches to such instruments in the U.S.

III. The Commodity Exchange Act Amendments of 1997

The Commodity Exchange Act Amendments of 1997 represent an important contribution to the promotion of legal certainty. The Coalition believes the proposed legislation would significantly reduce the risk of contract repudiation, would contribute to market efficiency and innovation and would bolster the competitive position of U.S. financial institutions in the international financial marketplace.

The Coalition's comments on those provisions of the proposed legislation that address its objectives are summarized immediately below. The Coalition would welcome the opportunity to work with Committee staff going forward to implement these comments and other technical amendments to the proposed legislation.

A. The Treasury Amendment

The Coalition strongly endorses amendments to the Treasury Amendment designed to clarify the original objective of the Treasury Amendment: to exclude from regulation under the CEA transactions in the OTC financial markets. The Coalition thus endorses modifications to the Treasury Amendment that would clarify and update the provision's scope and establish an antifraud role for the CFTC targeted to the protection of the general public from "boilerroom" fraud in circumstances where supervision or regulation under federal securities or federal banking is not present. The Coalition, however, strongly opposes any modification of the Treasury Amendment that would have the effect of circumscribing, or imposing CEA regulation on, these existing financial markets.

The following summarizes the Coalition's comments on specific aspects of the proposed amendments to the Treasury Amendment.

1. Covered Transactions and Products

a. Covered Transactions

The proposed legislation would modify the Treasury Amendment to confirm that the amendment includes transactions in and involving the enumerated instruments. This modification would clarify that the Treasury Amendment applies to options on foreign currencies, an issue that has been and is currently the subject of litigation. The Coalition supports this modification.

The Coalition believes, however, that even this clarification may be argued to retain an element of uncertainty as to the intended scope of the amendment. This uncertainty could potentially affect a broad category of instruments (such as cash-settled instruments, instruments based on yields rather than prices, and other forms of OTC derivatives on the enumerated instruments that are not options). For the avoidance of doubt, the Coalition therefore urges the Committee to clarify its intent that the amendment applies to any transaction "in, involving or relating to or based on" an enumerated instrument "or the value, yield or rate thereof" There is other-wise a risk that the proposed amendment would have addressed issues in past litigation without having effectively anticipated and forestalled future litigation that could affect a potentially broad category of instruments.

b. Covered Products

The Coalition also strongly urges the Committee to update the scope of the products covered by the Treasury Amendment to reflect the evolution of the OTC financial marketplace since the original enactment of the Treasury Amendment in 1974. The Coalition believes that the Treasury Amendment should apply to all OTC transactions in the financial marketplace and should not be limited to the incomplete list of enumerated instruments the amendment currently incorporates. Such an approach would obviate the need for the balance of the legal uncertainty measures under consideration by the Committee and would provide a parity of legal status for all OTC financial products.

In any event, the Coalition urges the Committee to clarify and broaden the scope of products covered under the Treasury Amendment by incorporating: securities of government agencies and government sponsored entities, foreign government securities, and bank deposits. Although certain of these instruments (for example, bank deposits) would represent additions to the list of enumerated instruments, others are currently regarded as covered by the Treasury Amendment, although the conclusion may be subject to some ambiguity. Each of these products, however, is an integral part of the international fixed income markets. Applying different regulatory parameters under the CEA to certain of these instruments would contribute to market inefficiencies.

2. Scope of CoveredActivity

The proposed legislation -- by defining the term "board of trade" -- would clarify that the Treasury Amendment excludes privately negotiated OTC transactions in the enumerated products. The Coalition strongly endorses this clarification and urges the Committee to consider further refinements to its proposed modifications consistent with those proposed by the Department of the Treasury in its letter dated February 3, 1997 addressed to Chairman Lugar.

The specific elements of the proposed clarification that the Coalition believes merit further consideration by the Committee are discussed immediately below.

The Coalition agrees with the general underlying premises of the proposed modifications to the Treasury Amendment: (1) that there is a category of investor for whom protection is appropriate -- either under the CEA or other supervisory schemes -and (2) that the inefficiency and expense of duplicative regulatory responsibility should be avoided. However, the Coalition believes that the approach adopted in the proposed legislation to accomplish this (as well as the approach proposed by the Commodity Futures Trading Commission in its letter dated December 26, 1996 to Senator Lugar) could be improved. In this regard, the Coalition supports the approach proposed by the Department of the Treasury.

Specifically, the proposed legislation would exclude from the Treasury Amendment (and therefore render per se unlawful under the CEA) a certain category of transactions involving "retail investors." We believe this approach is undesirable because it effects a strict prohibition on potentially innocent activity and would not contribute to liquidity or competition. Nonetheless, the Coalition acknowledges the Committee's desire to protect retail investors. For that reason, the Coalition agrees with the approach proposed by the Department of the Treasury, namely, that a defined category of retail investors be afforded the protections of the antifraud provisions of the CEA and CFTC regulations where federal banking or securities protections are not present.

The Coalition also agrees with the Department of the Treasury that the CFTC proposal to exercise general anti-manipulation authority in the foreign currency markets is inappropriate. The CFTC performs an important antimanipulation role in the context of traditional commodities and futures markets. However, the Coalition does not believe it would be realistic, cost-effective or productive for the CFTC to police manipulation in the international foreign currency markets. The Coalition believes it is unlikely that a foreign government would look to or welcome a role by the CFTC in policing that government's local currency. In the United States, responsibility for the U.S. dollar would more appropriately reside in the Department of the Treasury and the Board of Governors of the Federal Reserve System. The Coalition does, however, endorse a continued role for the CFTC in policing CFTC regulated contract markets in foreign currency against manipulation.

The proposed legislation would also delegate to the CFTC, within certain parameters, the authority to define "retail investor." The Coalition prefers the standard proposed by the Department of the Treasury, both because it would establish a clear objective standard in the statute and because the standard proposed by the Department is appropriate in scope.

The scope of the CFTC's regulatory authority under the Treasury Department's proposal addresses precisely the activity that the CFTC has identified as needing its intervention: predatory activity by unregulated "boilerrooms" to the detriment of unsophisticated individual investors. The CFTC is not looking to "regulate" these socalled boilerrooms under the CEA, it is, in our view justifiably, looking to prosecute them. That objective can be readily accomplished with antifraud authority.

The proposed legislation would permit, by excluding retail participation, the operation of an exchange market in enumerated instruments free of regulation under the CEA. Section 6 of the proposed legislation would also pen-nit an exchange, by excluding retail participation, to operate an exchange market in certain categories of new contracts with only limited CFTC authority to prosecute fraud and manipulation and take emergency action.

The Coalition strongly endorses broad CEA exemptive relief for exchanges in the context of "professional markets" in the covered (as well as other) products -- significantly broader relief than that currently afforded the exchanges under Part 36 of the CFTC regulations. Nonetheless, the Coalition believes that exchange markets in standardized financial products covered by the Treasury Amendment (as well as other products) present different policy considerations than privately negotiated OTC transactions. Accordingly, the Coalition does not believe it is appropriate to address exchange markets -- whether or not restricted to professional traders -- under the Treasury Amendment, or to regard exchange markets and OTC transactions as equivalent.

The Coalition endorses clarification that exchanges are not precluded from sponsoring or operating, directly or through an affiliated entity, a trading or clearing facility for activity excluded under the Treasury Amendment -- where the facility is not itself an exchange or "board of trade."

B. Private Transaction Exemption

The Coalition strongly endorses the provisions of proposed section 5 codifying a statutory exemption for privately negotiated OTC transactions. The proposed exemption represents a significant positive development in the elimination of current and future legal uncertainty for products qualifying for the exemption.

1. General

Theproposed exemption is based substantively on the CFTC's existing Swap Exemption andincorporates the substantive criteria that govern the scope of activity permitted under the exemption. The Coalition supports this approach. These criteria were adopted after extensive debate and have provided an effective basis for the conduct of OTC derivatives activity without having given rise to market problems or regulatory criticism.

The Coalition notes that the proposed exemption would vary from the existing CFTC Swap Exemption, however, by eliminating the requirement that a particular transaction be one of the enumerated "swap agreements" specified in the CFTC Swap Exemption. As a result, the exemption would be applicable, generically, to all OTC derivative transactions qualifying for exemption without regard to whether the particular transaction falls within one of the enumerated list of "swap agreements."

Although as originally promulgated it was widely understood and agreed that the definition of the term "swap" agreement in the CFTC Swap Exemption was not intended to be limiting, the Coalition believes that unnecessary uncertainty has arisen in the past and will likely arise in the future as a result of formal and informal administrative positions taken by the CFTC and its staff. As the Congress has appreciated in the past, such uncertainty (or, worse, unnecessary constraints on the scope of permitted activity whether inadvertent or intentional) is not consistent with the goal of fostering responsible, efficient and competitive U.S. capital markets. The Coalition therefore strongly supports this element of the proposed exemption.

The proposed exemption would also vary the scope of counterparties eligible to participate in exempt transactions by replacing the eligible legal entities enumerated by the CFTC in the Swap Exemption with the list of "appropriate persons' previously codified by the Congress in the FTPA (CEA section 4(c)(3)). The Coalition notes that the statutory list of appropriate persons is somewhat broader (and in some respects narrower) than the CFTC's list of "eligible swap participants." The Coalition does not regard these variances as significant. However, the Coalition urges the Committee to consider a limited expansion in the category of natural persons who would be permitted to enter into exempt OTC derivatives transactions. Currently, that group is limited to those who have total assets in excess of $ 1 0 million, regardless of their net worth or other potentially relevant circumstances.

2. OTC Derivatives linked to Non-exempt Securities

The proposed exemption would also vary from the CFTC Swap Exemption by clarifying that qualifying, individually negotiated OTC transactions linked to non-exempt securities would no longer be at risk of being held to violate the Jurisdictional Accord.

This element of the proposed exemption represents the most significant contribution made by the proposed legislation to legal certainty, and to the global competitive position of U.S. financial firms. By eliminating the constraining impact of the risk of contract repudiation, the proposed provisions will contribute to greater capital efficiency and liquidity in domestic and international stock and fixed income markets. The beneficiaries of this development will embrace the entire spectrum of capital markets participants, including large corporations, small businesses, mutual funds, entrepreneurs, investors, and securities exchanges. Where broader opportunities for risk reduction exist, greater liquidity and lower costs of capital are fostered.

OTC derivative products based on equity and fixed income securities are used by investors for diverse objectives, such as:

to manage equity and other capital market exposures;

to diversify credit exposures to specific entities so as to avoid excessive credit concentration;

to create highly customized investment profiles to accomplish specific portfolio investment objectives;

to gain investment exposures in emerging markets in circumstances where the costs and burdens of establishing the local operational capabilities to trade in and hold securities is prohibitive other than for local firms or dealers willing and able to make a significant financial and operational commitment to the local market.

These products are also used by issuers in connection with operations to manage the equity side of their balance sheet.

Entrepreneurs and others whose personal wealth lies entirely in a small (or large) business also use these products to diversify their economic exposures, at lower cost than alternative strategies, so that they and their families do not have their entire financial well-being at risk. Very frequently, such individuals do not wish to sell their shares or lose the voting rights associated with stock ownership of their companies. OTC derivative products enable such individuals to protect themselves and their families from financial hardship without having to give up control of the companies they have built or currently run.

These products thus provide valuable investment and risk management tools and have done so for a number of years, without adversely affecting the financial markets.

Privately negotiated OTC transactions involving securities have been conducted in the U.S. since the late 1980's. Since 1989, these transactions have been conducted in reliance on a CFTC "Policy Statement" providing that the CFTC would not regulate qualifying transactions as futures contracts under the CEA. For 8 years, U.S. market participants have conducted transactions in reliance on that policy statement and assumed the risk that, despite the CFTC's policy, a court might nonetheless conclude that some category of such transactions are futures contracts under the CEA. Any such determination would cause such transactions to violate the Jurisdictional Accord and therefore the CEA.

The CFTC's swap policy statement contained many subjective criteria that have proved difficult to apply. It is widely agreed that, following the FTPA, the Swap Exemption promulgated by the CFTC improved upon the swap policy statement, by articulating more objective criteria for exemption, without materially expanding the scope of permitted activity. Nonetheless, because the FTPA did not authorize the CFTC to grant exemptions from the Jurisdictional Accord, non-exempt securities-based transactions have continued to be conducted in reliance on the original swap policy statement.

While neither the CFTC nor commentators generally have concluded that transactions satisfying the swap policy statement are futures contracts under the CEA, the absence of greater certainty on this point nonetheless causes certain categories of transactions to be abandoned, to be structured in such a manner that they are conducted through entities outside the United States (with obvious collateral consequences to the United States as a global financial center), or to be restructured in a less efficient manner. The impact of legal uncertainty must not be underestimated. In 1990, for example, a district court in the Southern District of New York stunned the energy industry by holding that a widely used forward contract involving Brent crude oil was an illegal off-exchange futures contract. Until the scope of the ruling was clarified by the CFTC in a subsequent interpretative letter, U.S. participation in that multi-billion dollar market was boycotted by foreign firms who feared possible contract repudiation as a result of the CEA -causing significant economic harm to the affected U.S. energy companies and, to this day, a shift in the center of gravity of this market from the U.S. to Europe.

A judicial decision that securities-based OTC derivatives violated the CEA could lead to widespread repudiation of contractual obligations by counterparties to such transactions whose financial interests would be served by repudiation. Non-U.S. financial institutions and clients would avoid dealing with U.S. counterparties in these products and U.S. firms would make every effort to structure ongoing business with international clients outside of the United States. U.S. companies and investors would lose access to these important products.

As noted above, the CFTC determined in the swap policy statement that individually tailored OTC derivatives are sufficiently different from standardized exchange-traded futures contracts that such OTC derivatives should not be subject to regulation as futures contracts under the CEA. For precisely that reason, it is equally true that they should not be regarded as prohibited by the Jurisdictional Accord. The narrow approach adopted under the proposed legislation is consistent with that reasoning and would not either alter the Jurisdictional Accord or pen-nit the exchange trading of single stock futures contracts which the provision was intended to preclude. The proposed approach further assures that the scope of permitted activity remains consistent with that which has been permitted under the Swap Exemption -- an exemption with which there has been 4 years of experience. The proposed legislation would thus not permit activity the Jurisdictional Accord was intended to preclude and would not provide for open-ended activity of uncertain scope and consequence.

c Hybrid Instrument Exemption

1. General

The Coalition also strongly endorses the proposed exemption for hybrid instruments that are predominantly securities or bank depository instruments. The Coalition notes that the substantive criteria for this exemptive relief would be based upon the criteria contained in the current CFTC Hybrid Exemption. Among other benefits, the proposed statutory codification would eliminate certain ambiguities created by the CEA's exclusive jurisdiction provisions and the hybrid character of the covered instruments.

2. Hybrid Instruments linked to Non-exempt Securities

As in the case of the private transaction exemption, the proposed hybrid instrument exemption would also vary from the CFTC Hybrid Exemption by clarifying that qualifying transactions do not violate the Jurisdictional Accord.

Hybrid instruments linked to securities are used by investors and issuers to accomplish diverse objectives, including the creation of instruments that combine characteristics of debt and equity and to implement specific portfolio investment objectives. These instruments can also be used to diversify credit exposures to specific id excessive credit concentration and to gain investment exposures entities so as to avoid excessive credit concentration and to gain investment exposures in emerging markets in circumstances where the costs and burdens of establishing the local operational capabilities to trade in and hold securities are prohibitive other than for local firms or dealers willing and able to make a significant financial and operational commitment to the local market.

These products thus also provide valuable investment risk management tools and have done so for a number of years, without adversely affecting the financial markets.

Hybrid securities and depository instruments linked to the value of other securities have been offered in the U.S. since the late 1980's. Since 1989, these transactions have been conducted in reliance on an interpretation promulgated by the CFTC defining qualifying hybrid instruments as securities or depository instruments, rather than futures contracts under the CEA. Like OTC derivative instruments, hybrid instruments linked to the value of non-exempt securities are also not afforded comprehensive exemptive relief under the CFTC's regulatory exemption promulgated following the FTPA. As a result, hybrid instruments linked to non-exempt securities are subject to greater constraints under the CEA than hybrid instruments linked to traditional commodities -- an anomalous result.

Like the proposed private transaction exemption, the proposed hybrid instrument exemption is narrowly tailored: it would not permit the activity the Jurisdictional Accord was intended to preclude or provide for open-ended activity of uncertain scope and consequence.

The Coalition thus strongly endorses this aspect of the proposed exemption as another very important step in the elimination of legal uncertainty and the promotion of efficient and innovative U.S. capital markets.

D. AdditionalProvisions

In order to complete the proposed legislation's objective of eliminating legal uncertainty, the Coalition urges the Committee to incorporate conforming amendments to CEA section 12(e).

CEA section 12(e) currently specifies the precise scope of the CEA's preemption of other federal and state laws that might otherwise be applicable to transactions subject to the CEA. Section 12(e) currently includes a limited preemption of state gaming and so-called "bucket shop" laws for transactions that are covered by the terms of an exemption (such as the CFTC Swap Exemption and Hybrid Exemption) granted by the CFTC under its CEA section 4(c) authority. This provision was designed to assure that the legal certainty afforded exempt transactions under the FTPA was not undermined by outmoded state laws that largely predate federal regulation of commodity futures and options transactions and securities transactions.

The Coalition urges that the category of exempt transactions eligible for protection be conformed to include transactions covered by the proposed new statutory exemptions (whether or not the exempt transaction would otherwise be subject to the CEA).

Conclusion

The firms comprising the Coalition applaud Chairman Lugar and Senators Harkin and Leahy for recognizing the need for Congress to take action to eliminate impediments under the CEA to market efficiency and the global competitive position of U.S. financial markets and market participants.

As noted above, these steps are particularly important in the context of OTC derivatives and hybrid instruments based on non-exempt securities. These instruments currently perform critical functions for the U.S. capital markets. They significantly enhance liquidity and expand opportunities for risk reduction. The liquidity of the U.S. capital markets and the variety of opportunities available for risk diversification have been critical to the unparalleled success that the U.S. capital markets have experienced and have preserved these markets as the world's most efficient and cost-effective sources of capital for this country's enterprises. These instruments also provide important vehicles for intermediating investment by U.S. institutional investors and other private sources of capital in emerging markets otherwise supported by public sector sources of investment. Other major financial centers, however, do not impose the kinds of discriminatory constraints on securities-based OTC derivatives and hybrid instruments that are imposed under the CEA and the retention of these constraints imposes significant competitive burdens on the U.S. capital markets and market participants.

Because the proposed statutory exemptions are substantively based on regulatory exemptions promulgated four years ago, experience with the scope of these exemptions has provided a practical basis on which to take comfort that the proposed exemptions would not provide a means to conduct undesirable new activity or activity in violation of the Jurisdictional Accord.

Accordingly, the Coalition strongly supports the proposals and believes they will reduce legal uncertainty and the significant resulting constraints on these beneficial instruments.

The Coalition is prepared to assist the Committee in its deliberations in any way the Committee may find helpful. Thank you again for the opportunity afforded the Coalition to share its views on S.257 with the Committee.