Statement Submitted on Behalf of the International Swaps and Derivatives Association, Inc.


February 13, 1997

Before the Senate Agriculture, Nutrition and Forestry Committee

The International Swaps and Derivatives Association, Inc. ("ISDA") appreciates the opportunity to present this written statement to the Senate Agriculture, Nutrition and Forestry Committee (the "Committee") in connection with the Committee's hearings held on February 13, 1997, and ISDA's oral testimony given in connection therewith.

ISDA is an international organization whose membership comprises more than 300 of the world's largest commercial, merchant and investment banks and other corporations and institutions that conduct significant activities in swaps and other privately negotiated derivatives transactions. Many of the issues addressed in the Committee's hearings regarding reform of the Commodity Exchange Act (the "CEA") are of great importance to ISDA and its members.

In addition to ISDA's members, many corporations, financial institutions and government entities in the United States rely on swaps and other privately negotiated derivatives transactions (collectively, "swap transactions") to manage the risks associated with their financial and commercial activities. Such activities give rise to a host of risks, many of which could not be hedged or managed in an efficient manner, if at all, without the use of such transactions. Therefore, the availability of swap transactions at low cost and within a strong legal framework in the United States is of vital interest to all ISDA members and these other institutions. Any legal uncertainty presents a significant source of risk to individual institutions and to the financial markets as a whole, and precludes the full realization of the powerful benefits such transactions provide. One of ISDA's main goals since its inception has been to promote legal certainty for swaps and other privately negotiated derivatives transactions. ISDA has sought to establish (i) clarity about how swap transactions will be treated under U.S. law and laws in other jurisdictions, (ii) certainty that they will be legally enforceable and not subject to avoidance and (iii) certainty that key provisions in swap transactions (including termination and netting provisions) will be enforceable, even in the case of bankruptcy of one of the parties. In this regard, ISDA has developed standardized documentation, which is utilized by the vast majority of swap participants for their transactions.

ISDA has been particularly concerned with the legal uncertainties relating to the status of swap transactions under the CEA, and continues to believe that legislative measures should be taken to resolve these uncertainties. Privately negotiated swaps and related off-exchange bilateral transactions serve important economic and risk management functions and, due to the tailored nature of such transactions, differ substantially from the fungible exchange-traded futures contracts historically governed by the CEA. Nevertheless, and despite significant efforts by Congress, the Commodity Futures Trading Commission (the "CFTC") and industry representatives, the inapplicability of the CEA to these transactions has not been fully and adequately clarified. The recent introduction by Senators Lugar, Harkin and Leahy of the proposed Commodity Exchange Amendments Act of 1997 is a positive step in this regard.

Derivatives, particularly privately negotiated swaps, are often misunderstood by the general public. A swap is a powerful tool which allows the counterparties to adjust the risk characteristics of their assets and liabilities, fine tune their risk exposures and lower their costs of capital. In such a transaction, two counterparties establish a custom-tailored bilateral agreement to exchange cash flows at periodic intervals during the life of the transaction according to a prearranged formula. These cash flows are determined by applying the prearranged formula to the "notional" principal amount of the swap. In most swaps, such as interest rate swaps, this notional amount never changes hands and is merely used as a reference for calculating the future cash flows.

For example, if a corporation has floating-rate debt outstanding and is concerned about its exposure to rising interest rates, it could use an interest rate swap to convert its floating-rate debt into a fixed-rate obligation. Similarly, if a corporation earns non-dollar revenues from a foreign subsidiary and wants to avoid the risk of fluctuating exchange rates, it could use a currency swap to hedge this exposure. Almost any kind of swap can be created. The flexibility and benefits that swap transactions provide have led to dramatic growth in the use of such transactions. Transactions take place around the globe, and U.S. institutions are leaders in the business at home and abroad.

I. Introduction to the Problems

The legal certainty of swap transactions has been undermined on several occasions in the past decade by the structure of the CEA, which (with certain exceptions) bans off-exchange "futures" contracts without defining the term. The statute has not easily accommodated the great innovations in financial products that have taken place since the enactment of the CEA. In 1974, Congress excluded from the CEA certain wholesale privately negotiated transactions that might otherwise have been thought to be futures. However, at that time, swap transactions did not yet exist and therefore were not specifically excluded. The resulting legal uncertainties, which will be explained in more detail below, have inhibited the evolution of swap transactions in the United States and the natural and beneficial growth in their use.

II. History of CEA's Application to Privately Negotiated Derivatives Transactions

In 1922, Congress enacted the original version of what is now the CEA to protect farmers and other producers and merchants of certain agricultural commodities from the perceived abuses of futures contracts. The protective scheme mandated that all trading of futures contracts on certain commodities be conducted on organized (and regulated) futures exchanges (the "exchange trading requirement"). During the period from 1936 to 1974, the list of covered commodities was expanded periodically.

The statute was substantially revised in 1974 by (i) establishing the CFTC to administer the CEA and regulate U.S. commodities exchanges, (ii) expanding the definition of "commodity" to cover (with certain exceptions) "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt with"and (iii) providing a statutory exclusion from the CEA for "transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade" (the "Treasury Amendment"). In the 1980s, the rapid growth in the use of innovative interest rate and currency swaps and related privately negotiated derivatives transactions to manage financial risk brought with it a desire to ensure a clear and unambiguous legal status for these transactions. In 1987, these legal concerns were significantly heightened when it was widely reported that the CFTC had commenced a formal investigation into the commodity swap business of Chase Manhattan Bank. Despite the fact that no enforcement action ever was commenced, these reports alone created significant uncertainty regarding the status of swaps under the CEA. It was feared that swap transactions would be deemed to be illegal and unenforceable off-exchange futures contracts. This uncertainty was exacerbated when the CFTC issued an Advance Notice of Proposed Rulemaking in which it effectively stated that transactions such as swaps which include certain elements of futures contracts may be subject to the CEA. In response to these concerns, large segments of U.S. swap activity moved offshore, and some U.S. firms ceased development of swaps entirely, reducing the ability of U.S. firms to manage risk and inhibiting the growth of these activities at U.S. institutions.

These actions prompted ISDA and other industry participants to seek action by the CFTC to reduce the substantial legal uncertainty which resulted from these developments. To address these concerns, in 1989 the CFTC issued a policy statement (the "Swaps Policy Statement") stating its view "that at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations [emphasis added]". Thus, a nonexclusive "safe harbor" was extended by the CFTC to those swap transactions that met a series of tests intended to distinguish them from their exchange-traded counterparts. However, the Swaps Policy Statement did not explicitly include interest rate option products. The application of the Swaps Policy Statement to interest rate caps, floors and collars was subsequently clarified in a series of no-action letters. However, legal uncertainties relating to the applicability of the CEA to swap transactions remained.

These uncertainties were further heightened in 1990 as the result of a decision by a United States District Court in New York in Transnor v. BP America Petroleum, which determined that contracts for future delivery of Brent blend crude oil constituted futures contracts and were therefore subject to the CEA. Although swap transactions were not at issue in Transnor, it was feared that if another court were to apply to swap transactions Transnor's limited view of the forward contract exclusion and its expansive definition of a futures contract, and at the same time were to ignore the Swaps Policy Statement, such a court might determine that certain swap transactions were futures contracts under the CEA. The importance and potential consequences of legal risks applicable to swap transactions were subsequently brought to light in 1991 when the London Borough of Hammersmith and Fulham, which had repudiated numerous losses from swap contracts, was able to convince the House of Lords (England's highest court) that it was ultra vires to have entered in the contracts in the first instance, thereby voiding the contracts. Concern increased that similar losses could be realized in the U.S. as a result of ambiguities under the CEA.

In 1992, Congress took a major step by passing the Futures Trading Practices Act of 1992 (the "FTPA"), which provided the CFTC with the power to create exemptions from the CEA for futures contracts and transactions with futures-like elements. The Report of the Committee of Conference of the U.S. House of Representatives and the U.S. Senate for the FTPA (the "Conference Report") stated that the intent of this authority was "to give the [CFTC] a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner". In passing the FTPA, Congress specifically directed the CFTC to resolve legal uncertainty concerns by promulgating an exemption for swaps and certain hybrid contracts. In order to avoid any implication that swaps are futures, Congress expressly noted in the Conference Report that the granting of an exemption does not "require any determination beforehand that the agreement, instrument or transaction for which an exemption is sought is subject to the [CEA]".

In response to the FTPA, the CFTC adopted an exemption for "swap agreements" in January 1993 (the "Swaps Exemption"). Reflecting Congress' direction in the FTPA, the CFTC did not make any determination that swap agreements would otherwise be subject to the CEA. The Swaps Exemption exempted certain types of swap transactions, when entered into by "eligible swap participants", from selected provisions of the CEA, including the exchange-trading requirement. Exempted transactions still must meet certain criteria that are intended to distinguish them from exchange-traded agreements. In general, the Swaps Exemption covers a broader range of swap transactions than does the Swaps Policy Statement.

As a result of the Swaps Exemption, even if a swap were found to be a futures contract, and none has, it would only be subject to (i) the market manipulation and anti-fraud provisions of the CEA and (ii) Section 2(a)(1)(B) of the CEA, which was enacted pursuant to the Futures Trading Act of 1982, otherwise known as the Shad-Johnson jurisdictional accord (the "Jurisdictional Accord"), and which (A) divides jurisdiction over exchange-traded equity derivative transactions between the Securities and Exchange Commission (the "SEC") and the CFTC, and (B) establishes that futures contracts on individual securities and certain securities indices are illegal.

Also in January 1993, the CFTC adopted an exemptive framework for certain hybrid instruments (the "Hybrid Exemption"), which provides an exemption for instruments such as equity or debt securities or depository instruments with imbedded futures or commodity option characteristics. If applicable, the exemption extends to all provisions of the CEA except the provisions adopted pursuant to the Jurisdictional Accord. Other relevant exemptions which exist include those granted for (i) certain contracts for the deferred purchase or sale of specified energy products entered into between commercial participants meeting certain criteria and (ii) trade options sold to commercial counterparties who are entering into a transaction for purposes related to their business.

III. Importance of Swap Transactions

The importance of swap transactions to global commerce and finance has been well-documented. Careful tailoring of the nature, timing and amount of a transaction can insulate a swap participant from adverse movements in market prices, reduce its cost of capital or allow it to take a view on market changes. Efficiency gains are created when risks are shifted to those best able to bear them.

These useful transactions, as the Conference Report noted, "may contain some features similar to those of regulated exchange-traded products but are sufficiently different in their purpose, function, design or other characteristics that, as a matter of policy, traditional futures regulation and the limitation of trading to the floor of an exchange may be unnecessary to protect the public interest and may create an inappropriate burden on commerce". Section 3 of the CEA describes the necessity for regulation of "[t]ransactions in commodities . . . [that] are carried on in large volume by the public generally and by persons engaged in the business of buying and selling commodities and the . . . byproducts thereof in interstate commerce". Section 3 notes that such " . . . transactions and prices of commodities on such boards of trade are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed, to the detriment of the producer or the consumer . . . rendering regulation imperative for the protection of [interstate] commerce and the national public interest therein".

Several factors clearly differentiate swap transactions from the transactions regulated under the CEA. First, such transactions are not "carried on in large volume by the public generally". Swap transactions are entered into on a customized, privately negotiated basis by sophisticated parties, including governments and government-sponsored entities, commercial and investment banks, corporations, and, to a very limited extent, individuals. Second, swap transactions are transactions in which each party assumes the credit risk of the other and thus each party requires specific knowledge about the other. Unlike transactions on an exchange where parties may execute transactions anonymously, swap participants require identifiable counterparties. The limits set forth in the Swaps Exemption preclude transactions that are standardized and fungible, i.e., transactions that are capable of being traded in large volumes. In addition, since such transactions are not standardized and fungible, they are simply not capable of being systematically traded on the floor of an exchange.

The exemption of swap transactions from the CEA has achieved the objective of Congress, promoting economic and financial innovation and fair competition. As stated earlier, swap transactions are used today by a large variety of entities to manage financial risks and develop new opportunities to raise capital. The growth of swap activities has been fueled by demand from these entities for new structures and refinements to address their diverse needs and the ability of swap intermediaries to develop transactions which meet those needs efficiently.

IV. Legal Uncertainties

Despite the efforts referred to above and the related subsequent legislative and regulatory pronouncements, there continue to be concerns about the legal uncertainty with respect to the inapplicability of the CEA to swap transactions. The first stems from the very nature of the Swaps Exemption as an administrative pronouncement that can be revoked or modified by the CFTC; rendering swap transactions illegal except when traded on an organized exchange and enabling parties to privately negotiated derivatives transactions to seek to avoid their contractual obligations by asserting that the transactions are illegal off-exchange futures contracts. This could result in substantial losses to swap participants, including the loss of hedges which companies rely on to manage risk. Even the potential for such action could cause disruption to the financial markets.

Second, the various exemptions from the CEA applicable to swaps have stated that swaps are not "appropriately regulated" as futures under the CEA. But, they have not established with the force of statute that swaps are not futures. Therefore, problems could arise inadvertently, as the CFTC exercises its enforcement authority. The July 1995 enforcement proceeding against MG Refining and Marketing, Inc. and MG Futures, Inc. raised such concerns because the CFTC defined in such order "all the essential elements of a futures contract" in a way which was so broad as to encompass practically any privately negotiated cash-settled forward contract, including most swap transactions. The CFTC sought on two separate occasions to reassure key members of Congress and industry participants that its orders in these cases were not intended to, and did not, change the scope of the term "futures contract" under the CEA. The need for the CFTC to take such actions highlights the fact that the current structure of the CEA is inadequate to provide the requisite degree of legal certainty to swap participants. The mere risk that similar events may occur in the future may lead some to conclude that the United States lacks a sufficiently stable legal framework to continue to function as a center for privately negotiated derivatives transactions. In fact, the United States has become such a center as a result of the establishment of legal certainty with respect to other aspects of swap transactions, such as the enforceability of master agreement netting provisions in the case of insolvency of a U.S. counterparty.

The possibility that some or a substantial category of privately negotiated derivatives transactions may be interpreted, even inadvertently, to be futures contracts also raises serious concerns with respect to those transactions falling outside the scope of the Swaps Exemption, particularly equity swaps and other swaps based on the prices of securities. As discussed above, the CEA prohibits the entering into of futures contracts, unless made on or subject to the rules of an approved futures exchange. Therefore, any financial transaction that is a futures contract must either be (i) transacted on an approved board of trade or (ii) exempted from the board of trade requirement by the CFTC. The CFTC has the power to exempt certain types of financial transactions from the requirements of the CEA under the FTPA, and promulgated the Swaps Exemption based on this authority. The FTPA, however, limits the exemptive authority of the CFTC by prohibiting the CFTC from exempting any futures contracts from the provisions of the Jurisdictional Accord.

Pursuant to the Jurisdictional Accord, the CFTC may not designate a board of trade for futures contracts on individual securities and certain securities indices, and since the CFTC can not issue an exemption for such transactions, such transactions are essentially illegal. The Jurisdictional Accord also divided jurisdiction over equity derivatives between the SEC and the CFTC; futures contracts based on a group or index of securities are treated like other futures contracts under the jurisdiction of the CFTC (i.e., they must be traded on an exchange) and jurisdiction over options on individual securities was granted exclusively to the SEC. As a result, the Swaps Exemption does not cover equity derivative transactions that are proscribed by the Jurisdictional Accord, and the conclusion that those transactions will not be regulated as futures must instead rest on the Swaps Policy Statement, which provides comfort that transactions within its limit are not "appropriately regulated" as futures contracts. To the extent, however, that swaps generally are deemed to be futures contracts, even inadvertently, (i) swaps on single securities and certain narrow indices or groups of securities would be rendered illegal under the Jurisdictional Accord and (ii) swaps on broad-based groups or indices would be required to be traded on an approved board of trade, which in each case would render a privately negotiated transaction pertaining to such securities, groups of securities or indices, as the case may be, subject to challenge by the parties to the transaction as unenforceable. Such risks have led many participants to enter into such equity derivatives transactions through off-shore affiliates.

The scope of the Treasury Amendment, which statutorily excludes certain foreign exchange and other transactions from the CEA, has also been the cause of legal uncertainty. The Treasury Amendment creates a statutory exclusion from the CEA for the transactions to which it applies, and therefore, unlike the Swaps Exemption, may not be revoked or modified by the CFTC. Without explicitly limiting its benefits to certain classes of participants, the Treasury Amendment excludes from the scope of the CEA "transactions in foreign currency . . . unless such transactions involve the sale thereof for future delivery conducted on a board of trade". However, due to ambiguity over the meaning of the term "board of trade" and the potential difference between transactions "in" foreign currency and transactions "involving" foreign currency, certain foreign exchange transactions, such as foreign exchange options, continue to give rise to potential legal concerns.

V. Discussion of Proposed Commodity Exchange Amendments Act of 1997

On February 4, 1997, Senators Lugar, Harkin and Leahy introduced a bill (S. 257) which attempts to provide greater legal certainty as to the inapplicability of the CEA to certain transactions, and to reduce in a prudent manner regulatory burdens imposed on the futures exchanges under the CEA. ISDA believes that the bill represents a constructive step forward in addressing each of these important issues. We applaud the Committee's interest in modernizing the CEA and welcome the opportunity to provide the Committee with suggested technical amendments to ensure that the bill achieves its intended purpose.

As described in more detail above, at present significant legal uncertainty remains as to the inapplicability of the CEA to swap transactions. In particular, the administrative nature of the Swaps Exemption and the Hybrid Exemption, and the inapplicability of such exemptions to certain transactions, like swaps based on securities prices, continue to raise concerns. ISDA welcomes the attempt in the bill to address these concerns.

A. Amendments Codifying the Swaps Exemption

Of great interest to ISDA are the provisions in section 5 of the bill which provide for private transaction exemptions based upon the criteria contained in the existing Swaps Exemption and Hybrid Exemption. ISDA supports the provisions and believes they contribute significantly to the reduction of legal uncertainty, particularly with respect to swaps based on securities prices, which are currently excluded from the Swaps Exemption and Hybrid Exemption. The bill extends the same legal certainty to these transactions as is now available for other swaps and hybrid instruments. ISDA supports this further reduction of legal uncertainty.

In addition, we are pleased that the proposed new section 4(e)(1)-(3) of the CEA would apply generally to all privately negotiated derivative transactions qualifying for the exemption, which helps reduce concerns regarding the scope of the original administrative Swap Exemption. Also, we agree that the existence of an exemption should be a neutral event and should not create an inference that an exempted transaction was otherwise subject to the CEA. This helps to eliminate a possible inference that a transaction is a futures or option subject to CFTC jurisdiction if it does not meet the eligibility requirements for the exemption.

B. Treasury Amendment

ISDA also takes great interest in the provisions in section 2 of the bill which are intended to clarify the scope of the Treasury Amendment. CFTC enforcement actions asserting jurisdiction over foreign currency derivative transactions have created significant interpretive issues as to the exclusion of Treasury Amendment instruments from CFTC jurisdiction. This uncertainty will be reduced by language in the bill which clarifies that the Treasury Amendment applies to all off-exchange transactions "in" or "involving" foreign currency, including currency options. ISDA supports this clarification.

ISDA has been and continues to be skeptical whether efforts to narrow the scope of the Treasury Amendment to expand the CFTC's jurisdiction can be accomplished in a manner that promotes legal certainty for all swap transactions without unduly increasing regulatory burdens. ISDA is concerned that, if enacted in its current form, section 2 of the bill may have implications for the applicability of the CEA to other privately negotiated derivatives transactions. In addition, section 2 of the bill, as currently drafted, would make transactions in or involving foreign currency by unsupervised entities with the retail public, if found to be futures, illegal and unenforceable because of the bill's application of the CEA's exchange trading requirement to such transactions.

We are also concerned about some of the specific language used in section 2. For example, the use of the term "shall include" in the definition of "board of trade" applicable to foreign currency transactions leaves open the possibility that the statute could be construed to apply to organizations other than those included in the definition provided in the statute. In addition, the bill does not define "general public" or "unsupervised entities", as such terms are used in section 2, and leaves the drawing of these important jurisdictional boundaries unresolved. By not defining these terms, the language of the bill could contribute to the same kind of legal uncertainty that has been raised in litigation as to the scope of the existing Treasury Amendment.

ISDA takes note of the recent proposal of the Treasury Department to amend the Treasury Amendment to provide adequate protection of retail participants while achieving legal certainty for derivatives in foreign currency and government securities, as well as the other enumerated instruments. ISDA especially applauds the Treasury Department's view that consideration must be given to expanding the list of enumerated instruments to reflect the expansion in the variety of financial transactions since 1974, and the significance of certain products to investors. We would welcome the opportunity to continue to work with the Committee and the Treasury Department on this expansion of the Treasury Amendment to cover all types of privately negotiated derivatives transactions and to ensure that all other changes to the Treasury Amendment, if ultimately enacted, promote legal certainty.

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ISDA appreciates this opportunity to express its views regarding these important issues, and looks forward to continued discussions with interested parties, including members of the Committee and their staffs, industry participants and financial regulatory bodies, including the CFTC, with a view towards crafting constructive solutions that offer greater legal certainty concerning the inapplicability of the CEA to swap transactions. If you should have any questions or comments, please feel free to contact the undersigned, or any members of the ISDA Board of Directors listed in Annex A.