THE COMMODITY FUTURES MODERNIZATION ACT OF 2000

Mr. LUGAR. Mr. President, I rise today with Senator Gramm, distinguished Chairman of the Senate Banking Committee, and Senator Fitzgerald, distinguished Chairman of the Subcommittee on Research, Nutrition and General Legislation of the Senate Agriculture Committee, to introduce legislation to reauthorize the Commodity Exchange Act (CEA), which lapses on September 30^th of this year. The Commodity Futures Modernization Act of 2000 would reauthorize the Commodity Exchange Act (CEA) for five additional years and would reform the Commodity Exchange Act in three primary ways. First, it would incorporate the unanimous recommendations of the President's Working Group (PWG) on the proper legal and regulatory treatment of over-the-counter (OTC) derivatives. Second, it would codify the regulatory relief proposal of the Commodity Futures Trading Commission (CFTC) to ensure that futures exchanges are appropriately regulated and remain competitive. Lastly, this legislation would reform the Shad-Johnson jurisdictional accord, which banned single stock futures 18 years ago.

Derivative instruments, both exchange-traded and over-the-counter (OTC), have played a significant role in our economy's current expansion due to their innovative nature and their risk-transferring attributes. According to the International Swaps and Derivatives Association, the global derivatives market has a notional value that exceeds $58 trillion and it has grown at a rate exceeding 20 percent since 1990. Identified by Alan Greenspan as the 'most significant event in finance of the past decade,' the development of the derivatives market has substantially added to the productivity and wealth of our nation.

Derivatives enable companies to unbundle and transfer risk to those entities who are willing and able to accept it. By doing so, efficiency is enhanced as firms are able to concentrate on their core business objective. A farmer can purchase a futures contract, one type of derivative, in order to lock in a price for his crop at harvest. Automobile manufacturers, whose profits earned overseas can fluctuate with changes in currency values, can minimize this uncertainty through derivatives, allowing them to focus on the business of building cars. Banks significantly lessen their exposure to interest rate movements by entering into derivatives contracts known as swaps, which enable these institutions to hedge their risk by exchanging variable and fixed rates of interests.

Signed into law in 1974, the Commodity Exchange Act requires that futures contracts be traded on a regulated exchange. As a result, a futures contract that is traded off an exchange is illegal and unenforceable. When Congress enacted the CEA and the Commodity Futures Trading Commission (CFTC) to enforce it, this was not a concern. The meanings of 'futures' and 'exchange' were relatively apparent. Furthermore, the over-the-counter derivatives business was in its infancy. However, in the 26 years since the statute's creation, the OTC swaps and derivatives market, sparked by innovation and technology, has significantly outpaced the exchange-traded futures markets. And along with this expansion, the definitions of a swap and a future began to blur.

In 1998, the CFTC released a concept release on OTC derivatives, which was perceived by many as a precursor to regulating these instruments as futures. Just the threat of reaching this conclusion could have had considerable ramifications, given the size and importance of the OTC market. The legal uncertainty interjected by this dispute jeopardized the entirety of the OTC market and threatened to move significant portions of the business overseas. If we were to lose this market, most likely to London, it would take years to bring it back to U.S. soil. The resulting loss of business and jobs would be immeasurable.

This threat led the Treasury Department, the Federal Reserve, and the SEC to oppose the concept release and request that Congress enact a moratorium on the CFTC's ability to regulate these instruments until after the President's Working Group (PWG) could complete a study on the issue. As a result, Congress passed a six-month moratorium on the CFTC's ability to regulate over-the-counter derivatives. Despite reservations, I supported this moratorium because it brought legal assurance to this skittish market and it allowed the President's Working Group time to develop recommendations on the most appropriate legal treatment of OTC derivatives. In November 1999, the President's Working Group completed its unanimous recommendations on OTC derivatives and presented Congress with these findings.

This legislation adopts much of the recommendations of the PWG report. Our bill contains three mechanisms for ensuring that legal certainty is attained and that certain transactions remain outside the Commodity Exchange Act. The first, the electronic trading facility exclusion, would exclude transactions in financial and energy commodities from the Act if conducted: (1) on a principal to principal basis; (2) between institutions or sophisticated persons with high net worth; and (3) on an electronic trading facility. The second would exclude these transactions if (1) they are conducted between institutions or sophisticated persons with high net worth; and (2) they are not on a trading facility. The third exclusion clarifies the Treasury Amendment language already contained in the CEA. It would exclude all transactions in foreign currency and government securities from the Act unless those transactions are futures contracts and traded on an organized exchange. As recommended by the PWG, the bill would give the CFTC jurisdiction over non-regulated off-exchange retail futures transactions in foreign currency. Another important recommendation of the PWG was to authorize futures clearing facilities to clear OTC derivatives in an effort to lessen systemic risk and this bill incorporates this finding.

As part of this legal certainty section, our legislation also addresses the concern that excluding OTC derivatives from the futures laws will invite the SEC to regulate these products as securities. With Senator Gramm's leadership, this legislation would adopt language that would ensure that these products maintain their current regulatory status and remain healthy and competitive.

The second major section of this legislation addresses regulatory relief. In February of this year, the CFTC issued a regulatory relief proposal that would provide relief to futures exchanges and their customers. Instead of listing specific requirements for complying with the CEA, the proposal would require exchanges to meet internationally agreed-upon core principals. The CFTC proposal creates tiers of regulation for exchanges based on whether the underlying commodities being traded are susceptible to manipulation or whether the users of the exchange are limited to institutional customers.

The legislation incorporates this framework. A board of trade that is designated as a contract market would receive the highest level of regulation due to the fact that these products are susceptible to manipulation or are offered to retail customers. Futures on agricultural commodities would fall into this category. This bill also sets out that in lieu of contract market designation, a board of trade may register as a Derivatives Transaction Execution Facility (DTEF) if the products being offered are not susceptible to manipulation and are traded among institutional customers or retail customers who use large Futures Commission Merchants (FCMs) who are members of a clearing facility. Lastly, a board of trade may choose to be an Exempt Board of Trade (XBOT) and not be subject to the Act (except for the CFTC's anti-manipulation authority) if the products being offered are traded among institutional customers only (absolutely no retail) and the instruments are not susceptible to manipulation. Our bill would allow a board of trade that is a DTEF or an XBOT to opt to trade derivatives that are otherwise excluded from the Act on these facilities and to the extent that these products are traded on these facilities, the CFTC would have exclusive jurisdiction over them. With this provision, the intent is to provide these facilities that trade derivatives with a choice-if regulation is beneficial, the facility may choose to be regulated. If not, the facility may choose to be excluded or exempted from the Act.

The bill's last section addresses the Shad-Johnson jurisdictional accord. In 1982, SEC Chairman John Shad and CFTC Chairman Phil Johnson reached an agreement on dividing jurisdiction between the agencies for those products that had characteristics of both securities and futures. Known as the Shad-Johnson Accord, this agreement prohibited single stock futures and delineated jurisdiction between the SEC and the CFTC on stock index futures and other options.

Meant as a temporary agreement, many have suggested that the Shad-Johnson accord should be repealed. The President's Working Group unanimously agreed that the Accord can be repealed if regulatory disparities are resolved between the regulation of futures and securities. Recently, the General Accounting Office (GAO) released a report that found that there is no legitimate policy reasons for maintaining the ban on single stock futures since they are being traded in foreign markets, in the OTC market, and synthetically in the options markets. Senator Gramm, chairman of the Senate Banking Committee, and I sent a letter in December requesting the CFTC and the SEC to make recommendations on reforming the Shad-Johnson. On March 2, the SEC and CFTC responded that, although progress had been made, the agencies could not resolve these issues before October. Disappointment with this answer led Senator Gramm and I to once again ask SEC Chairman Arthur Levitt and CFTC Chairman Bill Rainer to attempt to resolve the problems surrounding lifting the ban. Unfortunately, the agencies were not able to reach an agreement within our time-frame.

This legislation would repeal the prohibition on single stock futures and narrow-based stock index futures. It would allow these products, termed designated futures on securities, to trade on either a CFTC-regulated contract market or a SEC-regulated national securities exchange or association. The SEC would maintain its insider trading and antifraud enforcement authority over these products traded on a contract market and the CFTC would maintain its anti-manipulation authority, including large trader reporting, over these products traded on a national securities exchange or association. Margin levels on these products would be harmonized with the options markets. The bill would provide the regulators with one year after enactment to resolve any remaining issues.

The goal of this legislation is to ensure that the United States remains a global leader in the derivatives marketplace and that these markets are appropriately and effectively regulated. Due to the shortened legislative calendar in this election year, it will be difficult to pass this bill without momentum and a strong base of support. If Congress fails to enact a bill, we will begin the debate again next year. However, in this technology-driven economy, a one year delay is an eternity. Legal uncertainty for OTC derivatives will remain and our futures markets will continue to lose market share due in part to an outdated regulatory structure. For this reason, it is imperative that Congress enact thoughtful legislation this year when it has a golden opportunity to do so.

I ask unanimous consent that a section by section analysis of this bill be included in the record immediately after my statement.