- TESTIMONY OF
LAURENCE E. MOLLNER, CHAIRMAN
FUTURES INDUSTRY ASSOCIATION
ON S.257
BEFORE THE SENATE COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY
FEBRUARY 13, 1997
Mr. Chairman and members of the Committee, my name is Laurence E. Mollner.
I am Executive Vice President at Dean Witter Reynolds, Inc. and Director
of Dean Witter's futures activities world-wide. I am here today in my capacity
as Chairman of the Futures Industry Association.
FIA is the national trade association of the commodity futures and options
trading industry. Our regular membership is comprised of approximately
70 of the largest futures brokerage firms, futures commission merchants
or "FCMs". Our firms handle approximately 80 percent of the public
customer transactions on U.S. futures exchanges. In a very real sense,
therefore, we are the customers of the exchanges and our testimony reflects
the views of a broad base of market participants.
We want to congratulate Senators Lugar, Harkin and Leahy and the Committee
for your willingness to take on many of the critical issues facing the
derivatives industry today. S. 257 is far reaching and we wholeheartedly
support its direction. Our comments today are intended to help move the
process forward.
Last June, FIA testified before the Committee on the issue of the Treasury
Amendment and other issues in the CEA. We said we favored the quick and
speedy resolution of outstanding issues by the Treasury and the CFTC. Senator
Lugar then asked the two agencies to reach a resolution on a proposal to
clarify the Treasury Amendment by the end of the year so that their joint
view could be considered in the bill when it was introduced in the 105th
Congress.
Prior to that deadline, FIA met with both Treasury and CFTC to counsel
them and to urge them to reach a joint position. Conscious of all these
endeavors, the FIA board began to consider what we believe is the principal
issue addressed by various Treasury Amendment and professional market initiatives.
Rather than address the specifics in these positions, our Board agreed
to consider the larger questions how and where can we provide adequate
protection to the public participants in the futures market and yet allow
for free market activities to take place with the least amount of regulatory
oversight and burden?
This consideration is ongoing and we have invited the exchanges to join
in our discussion.
We understand that S.257 is designed to accomplish two principal goals.
The first goal is to bring legal certainty to particular over-the-counter
transactions that now may be subject to legal challenge. FIA strongly supports
this goal. In particular, section 2 of the bill amends the Treasury Amendment
to confirm that the CFTC has no jurisdiction over the offer and sale of
foreign currency and other products listed in the Treasury Amendment, unless
the transactions in such products involve the sale thereof to the "general
public," for future delivery conducted on a board of trade. In addition,
section 5 of the bill codifies the hybrid instruments and swaps exemptions
found in Parts 34 and 35 of the Commission's regulations and confirms that
the swaps exemption extends to swap transactions on securities. Enactment
of this section is essential.
A second goal of the bill is to reduce the regulatory burdens on US futures
exchanges. In this connection, section 2 of the bill would also afford
exchanges the opportunity to develop markets in foreign currency and other
Treasury Amendment products free from CFTC regulation, provided such markets
are limited to professional investors. For example, if the Chicago Board
of Trade were to preclude the general public from entering into transactions
in futures or options on futures in government securities in the existing
markets for these products, the CFTC would have no jurisdiction over such
markets. (The CFTC is authorized to define the term general public, "taking
into account, to the extent practicable, section 4(c)(3) of the Act.")
In addition, section 6 of the bill authorizes the creation of "professional
markets," whose participants are limited to "appropriate persons"
as defined in section 4(c)(3) of the Act and individuals with total assets
exceeding $10 million. With the exception of agricultural commodities and
stock indices, there would be no restriction on the products permitted
to be traded on a professional market. In addition, with the exception
of the anti-fraud and anti-manipulation provisions of the Act, transactions
effected on a professional market would be exempt from all of the provisions
of the Act. Finally, the bill provides that a professional market is "a
market that is traded on a board of trade that is otherwise designated
as a contract market."
FIA has long recognized that participation on US futures markets is comprised
primarily of professional market participants. In this connection, FIA
has endorsed initiatives that recognize the needs of such market participants
and enhance the efficiency of the exchange markets. These have included
various measures intended to alleviate regulatory obstacles that FIA believes
are not necessary for the protection of professional market participants.
Moreover, FIA has supported the exchanges' objectives of promoting product
innovation and enhancing their ability to respond expeditiously to the
needs of professional market participants and the competitive demands of
the international marketplace.
Although we have had only one week to review parts of S.257, we would like
to share with the Committee our initial views with respect to the provisions
of section 2 and section 6 of S.257, and ask the Committee to take these
views and any further thoughts we may have into account in formulating
a final draft. These provisions of the bill establish different standards
by which centralized markets, whose participants are restricted to professional
market participants may be conducted free from or with little federal oversight.
These differences are based solely on the on the nature of the product
underlying the derivative instrument.
As noted above, section 2 of the Senate bill, amending the Treasury Amendment,
excludes from the provisions of the Act and the regulatory oversight of
the CFTC futures and options on futures transactions in government securities
and transactions in foreign currencies, as long as the general public may
not participate. Section 6 of the bill takes a different approach with
respect to those products other than those listed in the Treasury Amendment,
exempting such transactions provided they take place in a market "that
is otherwise designated as a contract market." Although the differences
between these two provisions of the bill, between an exclusion from the
Act and an exemption from the Act, may appear inconsequential, we believe
they are significant and must be addressed by the Committee.
Section 6
Because our concerns rest primarily with section 6, we will discuss the
provisions of that section first. FIA believes that, in contrast to the
exclusion set forth in section 2 of the bill, the professional market exemption
proposed in section 6 of S.257 raises numerous legal and structural questions,
the answers to which are not evident in the bill. In particular:
The bill may create legal uncertainty by implying a certain level of CFTC
oversight with respect to the operation of the professional market and
the transactions effected on that market. This legal uncertainty will only
confuse retail investors and professional market participants alike, to
the detriment of all markets.
By requiring that a professional market be otherwise designated as a contract
market, it may be assumed that the CFTC has found that the rules of the
centralized market comply with those provisions of the Act that impose
requirements that boards of trade must meet in order to be designated as
a contract market. These include requirements with respect to the maintenance
of books and records, the implementation of specific audit trail standards,
exchange governance standards, and conflicts of interest standards. Even
if this were initially true, the CFTC would have no authority under section
6 to compel an exchange to enforce its rules relating to the operation
and governance of the professional market or to review later changes in
these rules.
In addition, it is not clear whether this centralized market would enjoy
the protections from the antitrust laws provided under the Act, or whether
the limitations on private rights of action found in section 22(b) of the
Act would be applicable.
Moreover, the applicability of the exemption from the state gaming and
bucket shop laws provided in section 12(e) of the Act, with respect to
transactions effected pursuant to the professional market exemption, is
uncertain.
Further, because the professional market transactions could be viewed as
occurring "on or subject to the rules of a contract market,"
participants entering this market must assume that certain customer protections
in the Act would continue to apply when, at least as we understand the
purpose of section 6, that is not the case. Segregation of customer funds,
audit trail requirements, trading standards, access to arbitration and
other customer protection fit into this category. (Professional market
participants, of course, may contract among themselves to form certain
rules of the marketplace. However, enforcement of these rules would not
be subject to federal oversight.)
Finally, because the commodity broker liquidation provisions in the Bankruptcy
Code and the CFTC's regulations thereunder are predicated on the assumption
that all exchange-traded futures and options transactions are subject to
the Act, in particular the segregation provisions of the Act, it is not
clear that professional market transactions will be "commodity contracts"
under the Code. Therefore, the consequences in the event of the failure
of a carrying firm or a clearinghouse are uncertain.
Most troubling to FIA, the provision of section 6 requiring that a professional
market to be otherwise designated as a contract market, will act as a barrier
to entry, preventing other entities from offering a centralized market
for professional market participants. In order to promote competition in
the development of efficient professional markets, it is essential that
this requirement be eliminated. Moreover, it must be clear that exchanges
may not use their membership rules to prevent transactions from being executed
away from the exchange.
These are important issues that FIA believes the Committee must first resolve,
if it determines to adopt the statutory exemption set forth in section
6.
Section 2
As noted earlier, section 2 of the bill does more than create an exclusion
from the Act for a centralized market in Treasury Amendment products. Its
principal purpose is to bring legal certainty to this area by confirming
that the CFTC has no jurisdiction over the offer and sale of futures and
options on these products unless they involve transactions offered on a
board of trade to the general public. FIA has not had the opportunity to
consider fully each of the terms of section 2 and the alternative recently
proposed by the Department of the Treasury. Nonetheless, we agree with
the concept embodied in each of these proposals that, except with respect
to transactions involving public participants, a pervasive regulatory scheme
is not required. In this connection, we agree with the proposal set forth.
Moreover, we believe that many of the issues we have identified with respect
to section 6 do not arise in the context of a statutory exclusion as provided
for in section 2 of the bill. There would be no anticipation of CFTC oversight.
If the Committee believes that a statutory exclusion is the correct approach
in dealing with a centralized market in Treasury Amendment products, FIA
sees no reason why the exclusion from CFTC jurisdiction with respect to
professional market participants should be limited to these particular
products. The different standards established in section 2 and section
6 cannot be justified merely on an analysis of the type of product traded.
For example, customers will not be able to understand why Treasury instruments
and Eurodollars are treated differently. This is particularly true since
a critical provision of section 6, requiring that a professional market
be "otherwise designated as a contract market," acts more as
a barrier to entry than a protection for customers in those markets.
FIA suggests that the Committee consider consolidating these two provisions
of the bill. One way to accomplish this goal is to move towards a professional
centralized markets with no CFTC oversight. Such an approach would effectively
expand the provisions of section 2 of the bill to extend its benefits as
they relate to centralized markets to transactions in all commodities and
other products if the Committee determines to include agricultural commodities
and stock indices. We have attempted to describe the attributes of such
markets for your consideration. If the Committee were to determine to retain
section 6, the Committee would still want to consider the issues raised
in this proposal. Clearly, the Committee would need to weigh this approach
against others which might be put forward. We would be happy to work with
the Committee in this regard.
Possible Structure for a Centralized Professional Trading Market
The CFTC would continue to have exclusive jurisdiction with respect to
all transactions executed on designated contract markets. All futures and
options on futures transactions entered into directly by retail investors,
i.e., non-professional market participants, would be required to be executed
on designated contract markets. Professional market participants would
also be free to continue to enter into trades on designated contract markets.
Professional market participants would include "appropriate persons"
as defined in section 4(c)(3) of the Act and CFTC rule 35.1(b). Natural
persons would be required to meet a net worth or similar test that would
provide assurance of financial sophistication.
Except with respect to foreign currency and other Treasury Amendment transactions
entered into by retail investors with regulated persons, over-the-counter
transactions entered into by retail investors would continue to be subject
to CFTC jurisdiction. (Regulated persons would include CFTC registrants,
registered broker-dealers and government securities broker-dealers, investment
companies, and entities subject to regulation or supervision by an appropriate
federal banking agency.)
The CFTC would have no jurisdiction with respect to transactions entered
into by or on behalf of professional market participants, unless executed
on a designated contract market.
An exchange or other legal entity would be permitted to establish a centralized
market for professional market participants that would not be subject to
the jurisdiction of the Act or the CFTC in any way. In contrast to the
professional market exemption in section 6 of the Senate bill, the anti-fraud
and anti-manipulation provisions of the Act would not apply.
Moreover, this centralized market would not enjoy the limited protections
from the antitrust laws provided under the Act, nor would the limitations
on private rights of action found in section 22(b) of the Act be applicable.
In order to avoid confusion among market participants, if a designated
contract market establishes a centralized market for professional market
participants, this market would be required to be conducted in a legal
entity separate from the CFTC designated contract market. (This would not
prevent trading in the centralized market from taking place on the same
exchange floor.)
An exchange or any other entity that establishes a centralized market for
professional market participants would be free to develop its own rules
relating to transactions on that market, i.e., recordkeeping, capital adequacy,
treatment of customer funds. However, an exchange may not prohibit its
members from effecting transactions with or on behalf of professional market
participants away from the centralized market.
Transactions executed in the centralized market could be cleared through
a clearinghouse affiliated with a designated contract market, provided
customer segregated funds held in connection with designated contract market
transactions were not placed at risk. (The effect of a single clearinghouse
on the commodity broker liquidation provisions in the Bankruptcy Code will
have to be considered.)
Section 12(e) of the Act will be amended to confirm that state gaming and
bucket shop laws will not be applicable to transactions effected pursuant
to the professional market participants exemption.
Comments on Other Sections of S.257
The FIA is pleased to support section 3 which clarifies that futures contracts
may be used to hedge non-price risk; section 4 relating to the use of US
warehouses for delivery on foreign futures contracts; section 8 repealing
the requirement that exchanges accept warehouse receipts issued under the
US Warehouse Act; section 10 clarifying the audit trail standards; section
12 relating to the CFTC's enforcement activities; and section 14, which
sets out certain technical and conforming amendments to the Act.
FIA has encouraged the delegation of additional CFTC functions to the NFA;
we believe NFA has performed its previously delegated functions well and,
with CFTC oversight, could, for example, take on such areas of responsibility
as reviewing commodity trading advisor and commodity pool operator disclosure
documents. We therefore support section 13.
Section 11 would require the CFTC, prior to adopting any rule, to consider
the cost and the benefits of the proposed action in light of protection
of market participants, the efficiency, competitiveness, and financial
integrity of futures markets, price discovery, sound risk management practices
and other appropriate factors as determined by the CFTC.
FIA believes that the CFTC already performs some cost benefit analysis
as part of its rulemaking procedures and therefore we question whether
a separate statutory requirement is necessary. In any event, we would be
concerned about any language that may impose a requirement of a strict
quantitative analysis and believe efforts in the area should be limited
to a qualitative analysis only. We need to be careful of legislation is
this area so that we do not require non productive effort or impose standards
leading to legal uncertainty in the rulemaking process.
Sections 5 and 9 would set new standards for reviewing exchange contract
designations and exchange rules. We have previously encouraged adoption
of procedures to expedite significantly the CFTC's review of both sets
of rules. Recently, the CFTC published for public comment changes in both
procedures, including much abbreviated time schedules. The FIA filed comments
in support of both proposals. We have not yet determined if we would prefer
the provisions of the bill to the CFTC proposal.
FIA believes the review of exchange rules is still an important process.
For example, rules involving financial integrity of the market or novel
trading procedures, providing for non competitive trading or different
classes of market participants, establishing linkages between exchanges,
and relating to the application of new technologies to the markets, go
to the heart of how the futures business is undertaken in the US. As long
as the CFTC is responsible for overseeing these markets, they should have
sufficient time to review exchange rules. On the other hand, the Commission
should be required to make a timely decision with respect to these rules.
FIA looks forward to working with members of the Committee in any way that
might be helpful. Thank you for giving us an opportunity to share our views
on S.257.