I am pleased to be here today to present the Federal Reserve Board's views on whether it is necessary to modernize the Commodity Exchange Act (CEA). The Board believes that modernization of the Act is essential. The reauthorization of the Commodity Futures Trading Commission (CFTC) offers the best opportunity to make the necessary changes. If this opportunity is lost, the Board is concerned that market participants will abandon hope for regulatory reform in the United States and take critical steps to shift their activity to jurisdictions that provide more appropriate legal and regulatory frameworks. The Need for Modernization of the CEA The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading on exchanges of grain futures by the general public, including retail investors. The public policy objectives were, and are, clear: to deter market manipulation and to protect investors. The objective of the Grain Futures Act of 1922 was to reduce or eliminate "sudden or unreasonable fluctuations" in the prices of grain on futures exchanges. The framers of the act believed that such price fluctuations reflected the susceptibility of grain futures to manipulation. During the latter part of the nineteenth century and the early part of the twentieth century, attempts to corner the markets for wheat and other grains, while rarely successful, often led to temporary, but sharp, increases in prices that engendered large losses to short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to corner a grain market. Furthermore, because grain futures prices were widely disseminated and widely used as the basis for pricing grain transactions off the exchanges, price fluctuations from attempts at manipulation had broad ramifications for the agricultural sector and, given the relative size of the agricultural sector at the time, for the economy as a whole. The Commodity Exchange Act of 1936 introduced provisions to protect retail investors in agricultural futures. Retail participation in these markets had been increasing and was viewed as beneficial, but retail investors may lack the knowledge and sophistication to protect themselves effectively against fraud or to manage counterparty credit exposures effectively. Safeguards against fraud and counterparty losses were intended to foster their participation in these markets. While the objectives of the CEA have not changed since the 1930s, what are now called the derivatives markets have undergone profound changes. On the futures exchanges themselves, financial contracts now account for about 70 percent of the activity, and retail participation in most financial contracts is negligible. Outside the exchanges, enormous markets have developed in which banks, corporations, and other institutions privately negotiate customized derivatives contracts, the vast majority of which are based on interest rates or exchange rates. The Board believes that the application of the CEA to the trading of financial derivatives by professional counterparties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by, manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate, because they are settled in cash, and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply. For other financial derivatives--for example, futures contracts for government securities--manipulation of prices is possible, but it is by no means easy. Large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instruments can add to the supply if circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover. In addition, professional counterparties simply do not require the kind of investor protections that the CEA provides. Such counterparties typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgment. And, if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system. Nor is there any obvious public policy reason to foster direct retail participation in financial derivatives markets. Most professional counterparties in financial derivatives markets view the regulatory protections imposed by the CEA as unnecessary and burdensome. Although to date there is no clear-cut evidence of a significant migration of activity to other jurisdictions, should the next CFTC reauthorization not provide for modernization of the regulation of financial derivatives, this could change--perhaps quickly. Rapid advances in technology are making electronic trading systems increasingly attractive, both as an alternative to open outcry trading on exchanges and as an alternative to the use of telephones and voice brokers in the over-the-counter (OTC) markets. Such electronic trading systems might develop in the United States, but if the United States continues to impose what market participants perceive as unnecessary regulatory burdens, such systems could instead develop abroad. In particular, much of the existing activity in financial derivatives consists of transactions between large global financial institutions, all of which already have substantial operations in London. Regulatory burdens on financial derivatives transactions in the United Kingdom are generally perceived to be significantly lighter than those currently imposed by the CEA, yet participants have considerable confidence in the integrity of the UK markets. If unnecessary regulatory burdens in the United States prompt global institutions to join, or even develop, a London-based electronic trading system for financial derivatives, the United States would suffer a serious and perhaps irreversible blow to its international competitiveness in financial services. Modernizing the CEA: OTC Derivatives In the Board's view, then, significant changes in the CEA are appropriate and the time to make those changes is in the next CFTC reauthorization. In the case of privately negotiated derivatives transactions between institutions, the Board has supported exclusion of such transactions from coverage under the CEA in the past and continues to do so. In these markets, private market discipline appears to achieve the public policy objectives of the CEA quite effectively and efficiently. Counterparties to these transactions have limited their activity to contracts that are very difficult to manipulate. A global survey conducted by central banks and coordinated by the Bank for International Settlements revealed that, as of June 1998, 97 percent of OTC derivatives were interest rate or foreign exchange contracts. The vast majority of these OTC contracts are settled in cash rather than through delivery. Cash settlement typically is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply--for example, LIBOR or the spot dollar-yen exchange rate. To be sure, some types of OTC contracts that have a limited deliverable supply, such as equity swaps and some credit derivatives, are growing in importance. However, unlike agricultural futures, for which failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets. Finally, the prices established in privately negotiated transactions are not used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can be expected to recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant, sources of information on valuations. Hence, any price distortions in particular transactions would not affect other buyers or sellers of the underlying asset. Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from counterparty insolvencies and from fraud. In general, they have managed credit risks effectively through careful evaluation of counterparties, the setting of internal credit limits, and judicious use of netting and collateral agreements. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud. Dealers are established institutions with substantial assets and significant investments in their reputations. When they have engaged in deceptive practices, the professional counterparties that have been victimized have been able to obtain redress under laws applicable to contracts generally. Moreover, the threat of legal damage awards provides dealers with strong incentives to avoid misconduct. A far more powerful incentive, however, is the fear of loss of the dealer's good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities. The effectiveness of these incentives was confirmed in a 1995 survey of end-users of OTC derivatives that was conducted by the General Accounting Office. When asked if they were satisfied with derivatives dealers' sales practices, 85 percent of users of plain vanilla derivatives and 79 percent of users of more complex derivatives indicated satisfaction. The great majority of the remainder responded neutrally rather than indicating that they were dissatisfied. Modernizing the CEA: Centralized Execution or Clearing of Financial Derivatives Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for clearing or executing OTC derivatives transactions. For example, the London Clearing House plans to introduce clearing of interest rate swaps and forward rate agreements in the second half of 1999, and several entities are developing electronic trading systems for interest rate and foreign exchange contracts. Such mechanisms could well reduce risk and increase transparency in derivatives markets. However, their development in the United States is being impeded by the specter that the CEA might be held to apply to transactions executed or settled through such mechanisms. Application of the Act not only is perceived as entailing unnecessary regulatory burdens, but also, because of the exchange trading requirement of the Act, it raises questions about the legal enforceability of the contracts traded or cleared. Provided that participation is limited to professional counterparties acting as principals, the Board believes financial derivatives executed or cleared through such centralized mechanisms should nonetheless be excluded from the CEA. The use of such mechanisms would not make these transactions any more susceptible to manipulation than when the transactions are bilaterally executed and cleared. Nor would their use impair the demonstrated ability of professional counterparties to protect themselves from losses from fraud. Because clearing concentrates and often mutualizes counterparty risks, some type of government oversight of clearing systems may be appropriate. However, it is not obvious that regulation of such clearing facilities under the CEA would always be the best approach. For example, the Board sees no reason why a clearing agency regulated by the Securities and Exchange Commission should not be allowed to clear OTC derivatives transactions, especially if it already clears the instruments underlying the derivatives. Likewise, if a clearing facility were established in the United States for privately negotiated interest rate or exchange rate contracts between dealers, most of which were banks, oversight by one of the federal banking agencies would seem most appropriate. Modernizing the CEA: Harmonizing Regulation of the OTC Markets and Futures Exchanges Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the Act. Moreover, as the economic differences between OTC and exchange-traded contracts are narrowing, it is becoming more apparent that OTC market participants share this conclusion; their decision to trade outside the regulated environment implies they do not see the benefits of the Act as outweighing its costs. Instead, the Federal Reserve believes that the futures exchanges should be allowed to compete in offering such services to professional counterparties, free from the constraints and burdens of the CEA. The conclusion that centralized mechanisms for professional trading of financial derivatives do not require regulation under the Act is valid even if those centralized mechanisms are operated by entities that also operate traditional futures exchanges. If an exchange chooses to clear professional transactions in financial derivatives through the same clearing house that clears its traditional CEA-regulated contracts, then the clearing should be regulated by the CFTC. But exchanges should be allowed to choose to establish a separate clearing system for such transactions that would be overseen by another regulator. In general, with respect to such transactions, the exchanges should have the same options and be subject to the same constraints as competing service providers. Summary To sum up, the Commodity Exchange Act was designed in the 1920s and 1930s to regulate the trading of grain and other agricultural futures by the general public, including retail investors. Since then, what are now called the derivatives markets have undergone profound changes. Both on futures exchanges and in the OTC markets, financial derivatives now account for the great bulk of the activity. Counterparties to financial derivatives transactions are predominantly institutions and other professional counterparties; retail participation in most of these markets is negligible. Financial derivatives are not susceptible to manipulation and professional counterparties do not need the protections that retail investors do. The Board believes that privately negotiated derivatives transactions between professional counterparties should be excluded from the Act. Furthermore, the exclusion should apply to centrally executed or cleared transactions, provided that any clearing system is subject to official oversight. Futures exchanges should be allowed to compete as operators of such trading or clearing systems, free from the burdens and constraints of the Act.

Return to top

1999 Testimony