The Commodity Futures Modernization Act of 2000: Derivatives Regulation Reconsidered

Report for Congress
The Commodity Futures
Modernization Act of 2000:
Derivatives Regulation Reconsidered
Updated January 29, 2003
Mark Jickling
Specialist in Public Finance
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

The Commodity Futures Modernization Act of 2000:
Derivatives Regulation Reconsidered
Summary
In December 2000, Congress passed the Commodity Futures Modernization
Act, the most significant amendments to the Commodity Exchange Act in 25 years.
This report describes the historical market developments and the major issues that
shaped consideration of that legislation.
In 1974, Congress created a new independent agency, the Commodity Futures
Trading Commission (CFTC), to oversee trading in derivative financial instruments.
Derivatives – which are used to avoid risk of price changes in some underlying
commodity or financial variable or in search of speculative profits from the same
price changes – were on the verge of a major expansion: from contracts based on
farm commodities and minerals to “financial futures” based on bonds, currencies,
and interest rates. The Commodity Exchange Act (CEA) amendments in 1974 gave
the CFTC exclusive jurisdiction (with some exceptions) over derivatives regardless
of the nature of the underlying commodity or interest.
During the 1980s, however, a new derivatives market grew up, where neither
the CFTC nor any other agency exercised comprehensive oversight. Derivatives can
now be divided into exchange-traded (CFTC-regulated) instruments and over-the-
counter (OTC) instruments. The two types of instruments serve the same economic
functions and are often in direct competition. However, the existence of two
markets, where the 1974 Commodity Exchange Act amendments envisioned a single
market regulated by the CFTC, led many to conclude that the CEA was out of date
and in need of major revision.
The futures exchanges contended that CEA regulation put them at a competitive
disadvantage versus the unregulated OTC market. OTC market participants claimed
that the CFTC’s exclusive jurisdiction under the CEA created legal risk for them:
OTC contracts could possibly have been invalidated by a court finding that they were
in fact illegal, off-exchange futures contracts. Both groups viewed the CEA as an
impediment to financial innovation and portrayed themselves as vulnerable to foreign
competition.
A joint group of U.S. financial regulators recommended in 1999 that the CEA
be amended to 1) exclude certain OTC derivatives from the CEA and 2) permit the
deregulation of financial futures (except when they are marketed to small investors),
on the grounds that these contracts are less susceptible to manipulation than physical
commodities. This was the general approach followed by the Congress in enacting
the Commodity Futures Modernization Act of 2000.
This report analyzes the transformation of derivatives markets and the
legislative response and will not be updated. The legislation passed by the106^th
Congress, the Commodity Futures Modernization Act of 2000, is described in CRS
Report RS20560, Derivatives Regulation: Legislation in the 106^th Congress.

Contents
Background ......................................................1
Derivative Markets.............................................1
Development of Derivatives Markets..............................3
Pre-2000 Regulation of Derivatives................................5
Regulatory Jurisdiction over Derivatives................................7
Regulation of OTC Contracts....................................7
Deregulation of the Futures Exchanges.............................9
The Issue of Fair Competition................................9
Other Regulatory Issues............................................12
Single-Stock Futures and the Shad-Johnson Accord..................12
Conclusion ......................................................13
List of Figures
Figure 1. Futures Contracts Traded on U.S. Exchanges, by
Underlying Interest: 1999......................................4
Figure 2. Notional Value of OTC Swaps versus Exchange-Traded
Financial Contracts, 1991-99...................................5
Figure 3. Futures Contracts Traded: U.S. versus Foreign
Exchanges, 1991-99..........................................10

The Commodity Futures Modernization Act
of 2000: Derivatives Regulation
Reconsidered
This report analyzes the major issues that were involved in the consideration and
passage of the Commodity Futures Modernization Act of 2000 (H.R. 5660; P.L. 106-
554). The legislation that created the CFTC in 1974¹ contains a sunset provision: the
agency must be reauthorized periodically. The CFTC’s authorization expired on
September 30, 2000. Reauthorization legislation has usually been the vehicle for
consideration of regulatory issues related to futures and derivatives markets. The
reauthorization legislation considered and passed in 2000 are described in CRS^th
Report RS20560, Derivatives Regulation: Legislation in the 106 Congress. This
report provides background on the major reauthorization issues.
The 2000 reauthorization process took place as many regulators and market
participants were calling for a fundamental reevaluation of the Commodity Exchange
Act (CEA), the statutory basis for the CFTC. Basic changes in the CEA and in the
regulation of financial derivatives were proposed, and eventually enacted. Markets
had changed dramatically since the CFTC was created, and the existing regulatory
framework was under challenge from all sides. Some analysts claimed that CFTC-
type regulation was unnecessary in most of the markets where it then applied, that it
slowed financial innovation, and that it placed the U.S. futures and derivatives
industries at a disadvantage relative to their foreign competition (much of which did
not exist in 1974). On the other hand, some believed that deregulation (or the growth
of unregulated derivatives markets) may pose serious risks to market participants and
to the stability of the global financial system.
What is the appropriate framework for the regulation of financial derivatives?
Which federal regulator should have jurisdiction over which forms of trading, and
how can jurisdictional quarrels among regulators be prevented? To what extent can
industry self-regulation be relied upon to maintain fair, stable, and efficient markets?
These broad questions, the background against which Congress in 2000 weighed the
future of the CFTC, are examined briefly in this report.

¹ The Commodity Futures Trading Commission Act of 1974, P.L. 93-463.

Background
Derivative Markets
Derivatives are financial instruments or contracts whose value is linked to the
price of some underlying commodity or financial variable. There are several forms
of derivatives – the best-known variations are futures contracts, options, and swap
agreements – but all have this common central feature: two parties promise to make
a transaction (or series of transactions) in the future at a price that is agreed upon
today. It is expected that the underlying price or rate will fluctuate over the life of the
contract, but the price specified in the derivative instrument remains fixed. If they
succeed in forecasting the direction of prices, derivatives traders will be entitled to
buy the underlying commodity for less (or sell for more) than the going market price.
For every winner, there is a loser. Here are three examples:
^!A trader who expects the February price of corn of $2.20/bushel to
rise over the spring and summer may enter into a “long” futures
contract, committing himself to buy 5,000 bushels at that price. (A
promise to sell is a “short” contract.) If the price rises to $2.30, the
contract gains value: the trader can buy 5,000 bushels at $2.20
(thanks to the futures contract), and sell them at the market price of
$2.30, making a profit of 10 cents per bushel, or $500, which is
credited to the trader’s account.²
^!An option to sell 100 shares of Cisco Systems stock at $120/share³
has an intrinsic value of $1,000 if the current market price is $110
(100 X the $10 price differential). If the market price rises above
$120, the option is “out of the money,” and the holder will not
exercise it. The difference between options and futures is that the
option buyer is not obliged to make the transaction on unfavorable
terms if prices fail to move as expected. In exchange for this right,
the seller of the option receives a cash premium.
^!A financial institution with large amounts of floating-rate debt fears
that interest rates are about to rise, which would increase its debt
service costs. It enters into an interest rate swap: it agrees to pay its
swap dealer a fixed rate of interest on a principal amount equal to its

² Futures contracts are “marked-to-market” daily – losses must be paid up, and gains are
credited to the winners’ accounts. A trader may take his profits at any time up to the
expiration of the contract by entering into an opposite, or offsetting, contract, so that his net
obligation to buy and sell the commodity is zero. Holders of physical commodity futures
have the option of settling the contract by making (or taking) delivery of the commodity
itself at expiration, but only about 0.7% of U.S. futures contracts are settled this way. The
rest are settled in cash.
³ The original version of this report was written in early 2000, when many Internet
companies’ shares traded at over $100. In early 2003, Cisco trades at under $15/share,
making the option described above profitable indeed!

outstanding debt,⁴ and in return will receive a floating-rate payment
on the same principal amount. Thus, if interest rates do rise, the
swap payments it makes remains constant, while the swap payment
it receives rises, allowing it to meet the rising claims of its floating-
rate creditors. The swap converts floating-rate to fixed-rate debt.
Thus, the owner of a derivative gains or loses as the underlying price or rate
changes, without actually owning the underlying commodity itself. Derivatives allow
traders to take a position in markets at a fraction of the cost of buying an equivalent
amount of the underlying item. A 5,000-bushel corn futures contract might require
an initial cash outlay – called a margin payment – of about $500, even though the
total underlying commodity value is $11,000. To buy 100 shares of Cisco (at
$110/share) would also cost $11,000, but the premium (price) of the option described
above might be less than $1,100.⁵ Derivatives speculation is therefore said to be
“leveraged,” because traders take relatively large positions in markets with relatively
little capital outlay. As a result, the effects of changes in the underlying commodity’s
price are magnified: if Cisco Stock rises by 10%, the option holder doubles his
money. Leverage also implies the risk of large, sudden losses.
Derivatives are often described as bets on future price changes. This is not
incorrect, but it is incomplete. Derivatives can be used to speculate, but they can also
provide protection against the risk of unfavorable turns in prices or interest rates. On
the other side of a corn speculator’s contract might be a farmer who feared that prices
in the fall would be even lower. Taking the short side would allow him to sell at
$2.20/bushel, no matter how low the market price went. Similarly, the financial
institution in the third example above uses an interest rate swap not to seek trading
profits but to protect itself against a rise in interest rates.
Derivatives are used by businesses, units of government, and financial
institutions to manage risk. Often, they permit the “unbundling” of risks in ways that
give market participants greater control over the risks they assume. For example, the
holder of a foreign bond faces two separate risks. That is, the value of the bond will
fall if 1) interest rates rise or 2) the currency in which the bond is denominated loses
value relative to the holder’s domestic currency. Using derivatives, the holder may
choose to assume either of these risks or to pass them off to someone else.
In sum, derivatives users can be divided into two groups, who use the markets
for opposite purposes. Speculators seek to profit by anticipating future price
changes, while hedgers, whose business generally involves them in the cash market
for the underlying item, avoid price risk by transferring it to others (namely, the
specu lators).

⁴ The principal in an interest rate swap is “notional,” or imaginary. It is never actually
exchanged, but serves as a reference point to determine the size of the swap payments.
⁵ In addition to its intrinsic value (the difference between the market price and the option’s
exercise, or “strike” price) an option has time value – the probability that its value will
increase before expiration.

Development of Derivatives Markets
Derivatives began as an adjunct to agriculture. Producers, distributors, and
processors of farm commodities devised futures, options, and forward contracts to
protect themselves against rising or falling prices. These markets became the futures
exchanges and flourished because of the existence of speculators willing to assume
the risks that others wished to avoid. In the 1970s, the Chicago futures exchanges
expanded the market dramatically by introducing contracts based on financial
instruments: potential derivatives users now included not just producers and
commercial users of commodities, but any business whose profits were affected by
interest rates or foreign exchange rates. Today, as figure 1 shows, financial futures
and currency futures account for about 2/3 of contracts traded on U.S. exchanges.
The success of financial futures attracted competition. In the 1980s, banks and
securities firms — those who dealt in the actual stocks, bonds, and currencies
underlying financial futures — began to offer swap contracts and options that had the
same functions as exchange-traded futures. They could be used to hedge or
speculate. Growth in these markets has been explosive, as figure 2 below shows.
The new derivatives market, where swaps and similar instruments are traded
“over-the-counter” (OTC) or off-exchange, has grown much faster than the
exchange-traded derivative market since its inception in the 1980s, in terms of the
notional principal amount of contracts in force.⁶ When other OTC instruments, such
as options and forward agreements are included, the total notional value of the OTC
market was $81.4 trillion in June 1999.⁷
Traders often view OTC contracts and exchange-traded futures and options
contracts as close substitutes. The over-the-counter and the exchange markets
compete for the same business. A central issue for the CFTC reauthorization in 2000
was whether regulation under the CEA put the U.S. futures industry at a competitive

⁶ Although notional principal is the only basis for comparing the two markets, it is not a very
satisfactory measure. Notional value does not convey any useful information about the
market value or riskiness of a particular instrument. Moreover, contracts are traded much
more frequently on the exchanges, so that comparisons of value outstanding at the end of
a period may be misleading as a gauge of total market activity.
⁷ Bank for International Settlements. The Global OTC Derivatives Market at end-June

1999. November 1999. 5 p. (Available on the Internet at www.bis.org)

Figure 1. Notional Value of OTC Swaps
versus Exchange-Traded Financial Contracts,
1991-99
disadvantage relative to the OTC markets, and to foreign futures exchanges.
Pre-2000 Regulation of Derivatives
Federal regulation of futures trading dates from the Grain Futures Act of 1922
(P.L. 67-331), which became the Commodity Exchange Act. However, the major
features of the pre-2000 regulatory framework date from 1974, when Congress
perceived that derivatives markets were on the verge of expanding from contracts
based on farm commodities and metals into “financial futures” – contracts based on
government bonds, interest rates, and (later) stock indexes. In response to the
growing economic scope and importance of futures trading, Congress replaced the
existing futures regulator (an office within the Department of Agriculture) with an
independent agency, the CFTC, with exclusive jurisdiction (with a few important
exceptions) over all derivatives trading, regardless of the nature of the underlying
commodity.
The CEA, as amended in 1974, specified that trading of derivatives – any
contracts that were “in the character of” futures contracts – was to take place only on
a registered futures exchange whose rules and practices were under CFTC regulation.
The rationale for this grant of regulatory authority was that derivatives are susceptible
to manipulation and excessive speculation, which can cause artificially high or low
prices in the underlying cash markets, or, in extreme cases, instability and panic in
the financial system. At a time when oil and other commodities were in short supply
and prices were soaring, Congress sought a “strong law” to protect investors and to
insulate the economy from the potentially distorting effects of derivatives trading,
much as the Securities and Exchange Commission (SEC) was created in 1934 in
response to the stock market crash of 1929.

However, the extension of “exclusive“ jurisdiction to the CFTC had to take note
of other agencies’ claims. The major exceptions to the CFTC’s exclusive jurisdiction
were contained in the so-called “Treasury Amendment,” part of the 1974 law. The
Treasury expressed concern that exclusive CFTC jurisdiction would conflict with the
U.S. government securities market and the foreign exchange market, where several
forms of off-exchange contracts very similar to futures and options were in common
use. These were professional markets, where small investors were not present, and
were for the most part unregulated. They were, in the Treasury’s view, performing
in a satisfactory manner without significant government oversight. Therefore,
Treasury saw no reason why these self-regulating markets should be brought under
CFTC regulation. Congress wrote the Treasury Amendment into law, excluding
contracts based on U.S. government securities or foreign exchange from the
provisions of the CEA.
What no one could have foreseen in 1974 was the development of the OTC
swap market. Despite the fact that swaps and futures serve exactly the same
economic purposes, and are sometimes interchangeable, the CFTC generally
exercised no regulatory authority over the OTC market. How did this market (now
measured in the tens of trillions of dollars) develop outside the regulatory framework
of the CEA? As the market was established in the1980s, the CFTC made no move
to assert its jurisdiction: the major swaps dealers were large banks and securities
firms, rather than the futures brokers that were CFTC registrants. Banking regulators
took a laissez-faire attitude, perhaps viewing swaps as a welcome source of income
for depository institutions whose recent results in commercial and international
lending had ranged from poor to disastrous. Securities broker-dealers tended to
locate their swaps business in unregulated affiliates, where SEC authority was
extremely limited.
Still, a legal uncertainty remained. Could the courts rule that swaps were in fact
“in the character of” futures contracts, and thus illegal and unenforceable unless
traded on a CFTC-regulated exchange? In 1989, the CFTC issued an exemption for
swaps, which was revised in 1993 (pursuant to the Futures Trading Practices Act of
1992, P.L. 102-546).⁸ Under the terms of the 1993 exemption, swaps would not be
regulated under the CEA as long as they met four conditions that distinguished them
from exchange-traded futures:
^!swaps may be traded only by “eligible participants,” that is, financial
institutions, corporations, governmental units, and individuals with
assets over $10 million;
^!the terms of swap agreements must be individually negotiated
between the counterparties, rather than standardized contracts like
futures and exchange-traded options;

⁸ In April 1993, the CFTC issued a separate exemption for OTC energy derivatives: these
would not be considered subject to the CEA as long as all parties were actually involved in
the underlying energy businesses, all contracts were subject to negotiation as to their
material terms, contracts were held to expiration rather than traded actively, and all trades
involved only principals. See Federal Register, v. 58, April 20, 1993. p. 21286.

^!the creditworthiness of the counterparty must be a material
consideration in swaps transactions;⁹ and
^! there must be no “multilateral transaction execution facility,” i.e.,
a swaps exchange.
In 2000, the financial swap market satisfied only the first of these conditions.
Many swap contracts are standardized and fungible, and are traded short-term like
any other financial instrument. Both in the United States and elsewhere, swaps
exchanges and clearing houses had been introduced or proposed. Therefore, the legal
uncertainty of possible conflict with the CFTC’s exclusive jurisdiction remained, and
there were concerns that the CEA and the CFTC exemptions were preventing the
swaps market from adopting features of the exchange system (e.g., the clearing
house) that would improve market safety and efficiency, or may have pushed such
developments abroad.
Legal uncertainty in the U.S. OTC market was a major issue in the 2000 CFTC
reauthorization. Market participants and regulators supported making the current
exemptions from the CEA a matter of statute rather than regulation, thereby settling
the long dispute over who does (or should) have regulatory jurisdiction over swaps.
This was done by the Commodity Futures Modernization Act of 2000, as described
in CRS report RS20560, Derivatives Regulation: Legislation in the 106^th Congress.
Regulatory Jurisdiction over Derivatives
Regulation of OTC Contracts
Jurisdiction over OTC derivatives was a central issue in the 2000 CFTC
reauthorization. Congressional efforts to address the issue in the past were made
difficult by disagreements among federal regulators. A 1999 report issued by the
President’s Working Group on Financial Markets, however, showed that the
regulators had reached consensus on this and some related issues.¹⁰ The report
recommended that swaps and other OTC markets should be excluded from the CEA,
provided 1) that no retail investors are active in the markets and 2) that the contracts

⁹ All futures contracts are guaranteed against one party’s default through the exchange’s
clearing house, an association of exchange members, which in effect takes the opposite side
of each trade. Thus, the creditworthiness of the other party is not a consideration to futures
traders. Under the exemption, swap traders must assess and assume the risk of counterparty
default themselves.
¹⁰ President’s Working Group on Financial Markets. Over-the-Counter Derivatives Markets
and the Commodity Exchange Act. November 1999. 35 p. (Hereinafter cited as Working
Group Report.) The Working Group consists of the Secretary of the Treasury and the
chairmen of the Federal Reserve, the SEC, and the CFTC.

traded are not based on nonfinancial commodities whose supply is finite.¹¹ These
recommendations proceeded from the regulators’ conclusion that the two
justifications for CEA-style regulation of derivatives – small investor protection and
the potential for price manipulation – did not apply to the swaps market. That is,
participants in that market are sophisticated and have the means to protect their own
interests, and, secondly, manipulation of interest or exchange rates via the swaps
market has not been observed in 20 years and is highly unlikely to occur in the
future.¹² In short, the regulators argue that the swaps market is like the government
bond market or the foreign exchange market, where the general, longstanding view
is that no public interest is served by more than a minimal regulatory presence.
The choice before Congress in 2000 was whether to accept the
recommendations of the Working Group. It could choose to exclude swaps from the
CEA by expanding the existing exemption (to permit swaps clearing houses and
exchange-like trading facilities) and making the exclusion a matter of statute rather
than of regulation. The effect of such action, besides reducing legal uncertainty in
the swaps market, would be to allow the OTC market to adopt features (clearing
houses and multilateral trading systems) of the exchange markets – to strengthen self-
regulation, in other words. Some viewed such changes in the marketplace as not only
desirable in themselves¹³ but essential to protect the U.S. industry. Federal Reserve
Chairman Alan Greenspan testified on February 10, 2000 that
...I see a real risk that, if we fail to rationalize our regulation of centralized
trading mechanisms for financial instruments, these markets and the related
profits and employment opportunities will be lost to foreign jurisdictions that
maintain the confidence of global investors without imposing so many regulatory¹⁴
constraints.
The Working Group’s implicit conclusion was that unregulated financial
speculation is generally benign. The other view of speculation – embodied in the
pre-2000 CEA – is that it may at times become excessive, and that artificial (and
unwelcome) price volatility and market instability may follow. Accordingly,
Congress could have chosen to apply to the OTC market some of the regulatory
requirements that applied to the exchanges. The Working Group recommends that
swaps clearing houses – which represent a concentration of risk¹⁵ – should be

¹¹ While the Working Group did not recommend that “finite supply” commodities be
excluded from the CEA, because of manipulation concerns, it did endorse the exemption for
energy derivatives that the CFTC had issued in 1993, and urged that the CFTC retain and
use its exemptive authority in those markets that it did regulate.
¹² Ibid., p. 16.
¹³ A swaps exchange could mean greater transparency, as prices became available to all
market participants. The ability to open and close positions quickly could increase liquidity,
reducing the cost of hedging. A clearing house would reduce the cost of monitoring
counterparties’ creditworthiness, again possibly lowering the costs of hedging.
¹⁴ Testimony before the Senate Banking Committee on the report of the President’s Working
Group on Financial Markets. Hearing, 106^th Congress, 2^nd session, February 10, 2000.
¹⁵ A clearing house is a vehicle by which the market collectively assumes the risk of default,
(continued...)

overseen by some federal regulator (or a foreign regulator that sets appropriate
standards), but acknowledges that jurisdictional problems may emerge as differently-
regulated institutions offer clearing services for contracts based on many different
underlying interests.¹⁶
The Working Group report also recommended that currently unregulated OTC
derivatives dealers should be required to disclose certain financial information to
regulators, in order that the regulators may be aware of developing problems in the
OTC dealer affiliate that may threaten the regulated parent firm, whose financial
stability is a matter of public interest.¹⁷ Other aspects of CEA- and exchange-type
regulation that Congress could have imposed on OTC dealers include minimum
capital standards, registration of personnel, reporting of large trades and market
positions, various record keeping requirements, disclosure of transaction price and
volume data, and so on. However, measures of this type would draw the objection
that unilateral U.S. regulation will simply drive the business overseas.
The Commodity Futures Modernization Act of 2000 (CFMA) as enacted
excludes financial OTC derivatives from CFTC regulation, provided that trading
occurs only among “eligible contract participants:” financial institutions, businesses,
government units, professional traders and brokers, institutional investors,
individuals with over $10 million in assets, and so on, but not small businesses or
individual investors. Derivatives based on agricultural commodities, on the other
hand, remain under CFTC jurisdiction and can only be traded on regulated
exchanges. All other commodities – including energy and metals – fall into a third
category of “exempt commodities.” OTC derivatives in exempt commodities may
be traded among eligible contract participants without CFTC regulation, but certain
CEA provisions against fraud and manipulation continue to apply to these markets.
OTC clearing houses and exchanges are subject to various disclosure and
oversight provisions in the CFMA. The 2000 law contains no provisions requiring
disclosure by unregulated derivatives dealers.
Deregulation of the Futures Exchanges
The Issue of Fair Competition.
OTC derivatives and exchange-traded financial futures contracts are direct
competitors in the marketplace. Before the 2000 legislation, the futures exchanges
contended that the unregulated status of the OTC markets constituted an unfair
competitive advantage. The pre-2000 CEA required the exchanges to submit rule

¹⁵ (...continued)
removing the risk that a single swaps dealer could be hurt by a customer default. On the
other hand, a clearing house failure – during a severe market disruption – could cause wider
systemic problems than a single dealer failure.
¹⁶ Working Group Report, p. 19. The report does not make specific recommendations as to
the kind of regulatory oversight that would be desirable.
¹⁷ Ibid., p. 34. This would involve amending the securities laws, as well as the CEA.

changes and new contracts for CFTC approval, to maintain an audit trail for all
transactions, to collect data on the trading activity positions of large traders, to
include outsiders on governing boards and disciplinary committees, and so on.
Futures commission merchants (brokers) must register with the CFTC, must meet
proficiency and ethical standards, must segregate customers’ funds, and must disclose
financial information about themselves and certain of their affiliates. In addition, the
CFTC has broad authority to intervene in exchange affairs when it determines that
the public interest requires it. Such “micro-regulation” does not apply to the OTC
markets.
The exchanges for years called for a “level playing field.” In addition to
competition from the fast-growing OTC markets (see figure 2 above), U.S.
exchanges now face competition from foreign futures exchanges, as figure 3
suggests. As electronic trading systems proliferate, and as the trading day lengthens,
a foreign futures exchange listing identical contracts and offering a cost advantage
could take away significant amounts of the U.S. industry’s business.¹⁸
The 105^th Congress considered, but did not enact, legislation that would have
permitted the exchanges to operate “professional markets,” from which small
Figure 2. Futures Contracts Traded: U.S.
versus Foreign Exchanges, 1991-99
investors would be excluded, and which would as a result be free of most of the
requirements of the CEA.¹⁹ Similar proposals reappear in the Working Group’s
report, which questions the need for direct regulation of financial futures markets if

¹⁸ Such international “poaching” is not hypothetical: Singapore dominates the market for
Japanese stock index futures, and London was the center for contracts based on German
government bonds until the recent emergence of a liquid futures market in Germany.
¹⁹ H.R. 467 and S. 257 (105^th Congress). See CRS Report 97-413 E, The Commodity
Exchange Act: Legislative History Since 1974, for analysis of these proposals.

small investors needing protection from fraud are absent and if the possibility for
manipulation is small. The report calls for Congress to provide explicit authority for
the CFTC to provide regulatory relief for exchange-traded financial futures markets,
if it determines that such relief is in the public interest.²⁰ Again, the line is drawn
between financial futures and contracts based on physical commodities where supply
is limited (making the creation of artificial shortages possible) and where the futures
markets serve a price discovery function, that is, where the futures market price is a
benchmark for cash market transactions.
Chairman William Rainer of the CFTC supported these deregulatory initiatives.
The CFTC had in progress two rulemaking initiatives that would allow the exchanges
to introduce new contracts or to change their rules without prior CFTC approval. To
the exchanges, these were crucial changes that would allow them greater flexibility
in responding to competition. The chairman stated his intention of moving the CFTC
“from being a frontline to an oversight regulator.”²¹ This meant, basically, that the
CFTC would stand back and let the financial derivatives markets evolve in response
to market forces, and step in only if something goes wrong. The Working Group
takes a similar attitude towards the rapidly-changing OTC market: “[S]uch systems
should be allowed to grow, unburdened by a new anticipatory statutory structure that
could prove entirely inappropriate to their eventual evolution.”²²
The CFMA includes provisions that allow the futures exchanges to establish
less-regulated or unregulated markets in nonagricultural contracts from which small
investors would be excluded. As of early 2002, however, a year after passage of the
CFMA, the exchanges had not proposed to create such unregulated markets.
It is worth noting that the major costs of exchange trading – margin
requirements, marking-to-market (which requires losses to be paid up daily), and
clearing fees – are not the results of government regulation but of self-regulation.
They are imposed by the industry itself to assure market integrity – to insure, that is,
that all contracts are fulfilled. A number of current ventures propose to bring some
of these self-regulatory mechanisms to the OTC market, as noted above. However,
it is not clear that exchange-trading of swaps or a swaps clearing house will succeed
in the marketplace. The major swaps dealers – 10 institutions accounted for 45% of
the market at the end of 1998²³ – may resist changes in market structure that could
challenge their dominance.
Regarding competition from foreign futures markets, a strong system of
regulation may be a marketing advantage. Traders will certainly seek out the lowest

²⁰ Working Group Report, p. 21-23.
²¹ Remarks of CFTC Chairman William J. Rainer at the 22^nd Annual Chicago-Kent college
of Law Derivatives and Commodities Law Institute. Chicago, October 28, 1999.
²² Working Group Report, p. 18.
²³ Trend Toward Concentration Accelerated Last year. Swaps Monitor, vol. 12, August 2,
1999. p. 1. The top 20 institutions, of which 9 are American, had 64%, up from 50% in

1995.

transaction costs, but their perceptions of market integrity will also influence their
choice of trading venues.
It is uncertain how the futures trading would change if financial futures were
deregulated. Would major features of exchange system (such as standardized
contracts and uniform margin rules) be abandoned, even as the OTC market
considers adopting them? An advantage of the OTC market is said to be the
flexibility of tailoring the terms of each contract to the customer’s individual needs.
Customization, however, discourages short-term trading, making it difficult to
develop the kind of high-volume liquidity that characterizes the exchange system
(and which the OTC market would like to foster).
Other Regulatory Issues
Single-Stock Futures and the Shad-Johnson Accord
In November 1999, Senators Gramm and Lugar sent a letter to regulators asking
for a study of the feasibility of removing the pre-2000 ban on futures contracts based
on individual stocks. The ban dated from the Shad-Johnson accord of 1982, which²⁴
demarcates SEC and CFTC jurisdiction over stock-based derivatives contracts. The
SEC traditionally opposed such futures contracts on the grounds that the leverage
available in futures contracts (purchase of a futures contract generally requires a cash
outlay of only 3-6 percent of the cash value of the underlying commodity) could lead
to excessive price volatility and manipulation of the underlying stocks’ price, and that
individual stock futures could also serve as a vehicle for illegal insider trading.
Nevertheless, the Working Group report states that the members agree that the
prohibition against single-stock futures “can be repealed if issues about the integrity²⁵
of the underlying securities market...are resolved.” The report does not call for
immediate repeal, however, but urges further study of the issue by the SEC and the
CFTC.
The CFMA authorized trading in single-stock futures, although over the course
of consideration of the legislation, the instruments came to be known as “security
futures.” Security futures will be traded on either stock or futures exchange, and the
SEC and CFTC will share regulatory jurisdiction. The CFMA states that trading may
begin one year after enactment, but as of December 20, 2001, the rules and
regulations were not yet in place.
When trading begins, single stock futures can be expected to boost trading
volume in futures and in the underlying stocks themselves. Millions of shares are
traded daily on the New York Stock Exchange as part of index arbitrage trading

²⁴ Basically, the accord said that futures and options on futures could be traded on futures
exchanges, while options on indexes and individual stocks would be traded on securities
exchanges under SEC jurisdiction. The SEC retained a right of approval over new stock-
based derivatives contracts to be traded on futures exchanges.
²⁵ Working Group Report, p. 32.

strategies – the buying and selling of shares in response to fluctuations in the price
of stock index futures and options.
Conclusion
With their 1999 report, the regulatory agencies in the Working Group put aside
their old jurisdictional quarrels and reached a consensus that speculation in financial
derivatives by sophisticated institutions and individuals is generally a beneficial
activity which government regulation is more likely to hinder than help. The pre-
2000 Commodity Exchange Act, with its detailed guidance for market practices and
its statutory bias against “excessive” speculation, is viewed by the Working Group’s
report (and by much of the derivatives industry) as an appropriate model for
regulation of traditional agricultural commodity futures, where shortages occur and
attempts to corner or squeeze the market have been more or less successful in the
past. But the Working Group report viewed the CEA as an obstacle to progress in
the new world of derivative finance, and as a competitive disadvantage to American
firms competing in an international market.
The 2000 CFMA responds to most of the recommendations in the Working
Group’s report. The final legislation included a codification of the unregulated status
of OTC derivatives markets and gave the CFTC authority to deregulate the financial
futures contracts traded on the exchanges.
Earlier in 1999, the Working Group issued a report on hedge funds –
unregulated investment pools available only to financial institutions and very wealthy
individuals – that recommended the imposition of new disclosure requirements, on
the grounds that the failure of a single large speculator with a highly-leveraged²⁶
position could cause widespread financial disruption. The report noted that the
proprietary trading operations of large banks and securities firms pursue the same
trading strategies as hedge funds, and pose the same risks. As noted above, a few
dozen large banks and brokerages dominate the market for OTC derivatives.^th
Legislation considered but not passed by the 106 Congress would have required the
largest hedge funds to file quarterly reports on the size and riskiness of their market²⁷
positions with the Federal Reserve.
In late 2001, the collapse on Enron Corp., a large unregulated dealer in OTC
energy derivatives, raised questions about whether the CFMA left unfinished
business. Would imposing disclosure requirements on OTC dealers bring more
transparency to the markets? Enron’s rapid fall revealed that even sophistcated
observers – such as Wall Street analysts and bond raters – had no clear picture of the
firm’s true financial condition, or even the precise nature of its business activities.
While the Enron bankruptcy seems to have had little visible effect on physical cash
markets in energy products, in other circumstances the failure of a large derivatives

²⁶ President’s Working Group on Financial Markets. Hedge Funds, Leverage, and the
Lessons of Long-Term Capital Management. April 1999. 43 p. and appendices.
²⁷ See CRS Report RS20394, The Hedge Fund Disclosure Act: Analysis of H.R. 2924.

dealer might have wide repercussions and do damage to firms not directly involved
with the failed dealer.
A reduction of government regulation (or an endorsement of the unregulated
status of certain markets, which the CFMA was) need not increase the potential for
market instability. In fact, the U.S. financial system has proved to be very robust and
resilient in response to a series of financial shocks linked to derivatives – from the
1987 stock market crash to the Long-Term Capital Management hedge fund rescue
in 1998, and now the Enron bankruptcy. However, similar events can be expected
in the future,²⁸ and government agencies will have to act, on the basis of whatever
information they have in hand, to prevent crises from spreading and spilling over into
the real economy. The question in regard to unregulated derivatives dealers is
whether regulators and market participants have sufficient information to detect
financial crises in advance, or respond to them as they occur.

²⁸ As the Working Group’s hedge fund report (see note 25 supra) puts it: “[M]arket history
indicates that even painful lessons recede from memory with time.” (p. viii)