CFTC Reauthorization

CFTC Reauthorization
Mark Jickling
Specialist in Financial Economics
Government and Finance Division
Summary
Authorization for the Commodity Futures Trading Commission (CFTC), a “sunset”
agency established in 1974, expired on September 30, 2005. In the past, Congress has
used the reauthorization process to consider amendments to the Commodity Exchange
Act (CEA), which provides the basis for federal regulation of commodity futures
trading. The last reauthorization resulted in the enactment of the Commodity Futures
Modernization Act of 2000 (CFMA), the most significant amendments to the CEA since
the CFTC was created in 1974. Both chambers considered reauthorization bills in the

109^th Congress, but none was enacted.

In the 110^th Congress, CFTC reauthorization provisions were added to the Farm
Bill (H.R. 2419) and enacted over the President’s veto on May 22, 2008, as P.L. 110-
234. This report provides brief summaries of the issues addressed in that law, including
(1) regulation of energy derivatives markets, where some blame excessive price
volatility on a lack of effective regulation, (2) the legality of futures-like contracts based
on foreign currency prices offered to retail investors, and (3) the market in security
futures, or futures contracts based on single stocks, which were authorized by the
CFMA, but trade in much lower volumes than their proponents expected.
This report will be updated as developments warrant.
Futures contracts — like other financial derivatives such as options or swaps — gain
or lose value as the price of some underlying commodity rises or falls. They allow traders
to invest in corn, gold, or T-bills without actually owning the underlying commodities
themselves. Futures can be used to avoid, or “hedge,” price risk. That is, farmers,
utilities, airlines, banks, and many other businesses can use derivatives to protect
themselves against unfavorable changes in commodity prices, interest rates, or other
variables. Most futures trading, however, is done by speculators who profit if their
forecasts of price trends are correct. (The futures exchanges are associations of
professional speculators.) There are two benefits to speculation: liquidity and price
discovery. Speculators provide liquidity because they are willing to assume the risks that
hedgers wish to avoid. Speculation provides an efficient price discovery mechanism
because futures prices adjust immediately to new information and serve as the basis for
many physical (or spot market) transactions in energy, agricultural, and other markets.

The public interest in regulating derivatives markets flows from these two functions:
price discovery and risk transfer. Because futures prices are used as reference points for
many physical transactions, manipulation in the futures markets can affect the prices
actually paid by consumers or received by farmers and other producers. Similarly, the
ability to hedge risks allows the economy to function more efficiently. Former Federal
Reserve Chairman Alan Greenspan frequently described the general benefits of
derivatives markets. For example:
Derivatives have permitted financial risks to be unbundled in ways that have
facilitated both their measurement and their management.... Concentrations of risk
are more readily identified, and when such concentrations exceed the risk appetites
of intermediaries, derivatives can be employed to transfer the underlying risks to other
entities. As a result, not only have individual financial institutions become less
vulnerable to shocks from underlying risk factors, but also the financial system as a¹
whole has become more resilient.
But although derivatives markets may generally support stability and resilience, they
also enable very high-risk speculative strategies, which at times may pose a threat to
financial stability. How much government regulation is needed to see that derivatives
markets remain sound, to keep markets competitive and free from fraud and manipulation,
and to insulate the financial system from shocks arising from sudden large speculative
losses? What kinds of customers are in need of government protection? These are the
basic questions for congressional oversight of the Commodity Exchange Act (CEA).
The Commodity Futures Modernization Act of 2000 (CFMA)
In several respects, the CFMA was a fundamental rethinking of the government’s
role in derivatives markets. Before 2000, the CEA was intended to regulate all forms of
derivative trading; any contract “in the character of” a futures contract was to be traded
only under CFTC regulation. However, this “one-size-fits-all” regulatory scheme did not
correspond to the reality of the marketplace, where a very large over-the-counter (OTC,
that is, off-exchange) derivatives market was flourishing without CFTC oversight. Under
the CFMA, most trading in OTC derivatives was placed beyond the reach of the CEA
(and thus the CFTC). Where trading was off-limits to small investors, market discipline
was deemed to be a sufficient regulatory force.
The exception was for contracts based on agricultural commodities, which were
thought to be susceptible to price manipulation. As a result, the CFMA did not provide
a statutory exemption for OTC agricultural derivatives. The derivatives market in farm
commodities is dominated by exchange-traded futures contracts.
The CFMA provided for the creation of unregulated futures exchanges, where all
trading involved sophisticated or professional investors. (Again, there is an exception for
farm derivatives.) Potentially, therefore, the futures exchanges can reconfigure
themselves into largely unregulated entities, and several such entities have registered with
the CFTC. However, since the enactment of the CFMA, the major futures exchanges

¹ Remarks by Chairman Alan Greenspan at the 2003 Federal Reserve Bank of Chicago
Conference on Bank Structure and Competition, Chicago, Illinois (via satellite), May 8, 2003.

continue to operate in (more or less) the same regulatory environment as before. Both the
exchanges and the OTC markets have experienced strong growth in trading volumes since

2000.

Reauthorization in the 110^th Congress
Given the CFTC’s satisfaction with its role under the CFMA, the growth of trading
volumes, and continued innovation in the markets, few in the Congress saw the need for
another thorough overhaul of the CEA. During hearings before the House and Senate
Agriculture Committees, however, the CFTC and industry participants suggested several
areas where fine-tuning of the CFMA might be desirable. Several of these issues were^th
addressed by the reauthorization legislation enacted by the 110 Congress — title XIII of
the Farm Bill (P.L. 110-234, H.R. 2419), enacted over the President’s veto on May 22,
2008, and authorizing appropriations for the CFTC through FY2012. Major provisions
are summarized below.
Energy Derivatives
Energy markets have seen turmoil in recent years: prices have been high and
unusually volatile, there have been numerous episodes of fraud, and many suspect that
energy prices have been driven artificially high by excessive speculation. During the
California electricity crisis of 2000, severe shortages were combined with soaring prices,
and several energy trading firms (including Enron) were found to have manipulated the
partially deregulated electricity marketing system that California had established. After
the collapse of Enron, numerous energy firms were found to have made fictitious “wash”
trades, for purposes of manipulating prices and/or falsifying their accounting statements.
The CFTC has charged dozens of traders with manipulating the price of natural gas by
providing false information about market prices and supplies. Finally, many suspect that
hedge funds and other financial speculators have driven prices higher than fundamental
economic factors of supply and demand would warrant, and have called for more CFTC
oversight of OTC markets and/or limits on the size of speculative futures positions.
Some observers attribute these problems in the markets to a regulatory gap, arguing
that neither the CFTC nor the Federal Energy Regulatory Commission (FERC) has
sufficient authority or resources to enforce anti-fraud and -manipulation rules. A
particular focus of these arguments is the over-the-counter (OTC) market for energy
derivatives, which under the CFMA is subject to very limited oversight.
In August 2006, the Amaranth hedge fund lost $2 billion in natural gas derivatives,
and liquidated its entire $8 billion portfolio. A June 2007 staff report by the Senate
Permanent Subcommittee on Investigations (“Excessive Speculation in the Natural Gas
Market”) found that the fund’s collapse triggered a steep, unexpected decline in prices,
and that Amaranth’s large positions had caused significant price movements in the
months before it failed. The report concludes that Amaranth was able to evade limits on
the size of speculative positions (a key feature of the futures exchanges’ anti-manipulation
program) by shifting its trading from Nymex to exempt and unregulated markets.
The reauthorization legislation creates a new regulatory regime for certain OTC
energy derivatives markets, subjecting them to a number of exchange-like regulations.

The provisions would apply to “electronic trading facilities” — markets where multiple
buyers and sellers are able to post orders and execute transactions over an electronic
network. If the CFTC determines that these markets, currently exempt from most
regulation, play a significant role in setting energy prices, they will be required to register
with the CFTC and comply with several regulatory core principles aimed at curbing
manipulation and excessive speculation. They will be required to publish and/or report
to the CFTC information relating to prices, trading volume, and size of positions held by
speculators and hedgers.
These new regulatory requirements apply only to electronic markets that have come
to resemble the regulated futures exchanges. Bilateral OTC derivative contracts between
two principals (e.g., between a swap dealer and an institutional investor customer), that
are not executed on a trading facility where multiple bids and offers are displayed, will
continue to be largely exempt from CFTC regulation.
Security Futures
Security futures are futures contracts based on single stocks or narrow-based stock
indexes. Until the CFMA, these contracts were not permitted, largely because of concerns
that they might be used to manipulate stock prices. The CFMA provided for joint
regulation of the new contracts by the Securities and Exchange Commission (SEC) and
the CFTC. Perhaps as a result, the process of writing trading rules was slow: the first
contracts were not traded until 2003.
Trading volumes in security futures trading remain very low relative to the stock
option market. The only currently active market is OneChicago, a joint venture between
the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and the
Chicago Board Options Exchange (CBOE). During 2007, a total of about 8.1 million
security futures contracts were traded. By contrast, 2007 stock option volume on the
CBOE in 2007 was 944.5 million contracts.
Single-stock futures volume may continue to grow but the product has had difficulty
competing with the highly liquid and well-developed stock options market, which offers
contracts that permit most (if not all) the investment strategies that security futures do.
During the reauthorization hearings in March 2005, several witnesses argued that the
dual regulatory regime is cumbersome and hampers trading. CFTC Chairman Brown-
Hruska stated that the CFTC would continue to work with the SEC to reduce duplicative
regulation. Representatives of the Chicago futures exchanges called for an amendment
to the CFMA to allow security futures to trade like any other futures contract. This would
set aside the joint CFTC/SEC oversight arrangement and allow the futures exchanges to
set margin requirements on security futures, as they do on all other futures contracts.² (At
present, margins are set at 20% of the underlying stocks’ value, a figure that was

² In futures contracts, “margin” is the amount of money that a customer must deposit with a
broker in order to maintain a position in the market. Margin serves to protect the broker and the
exchange from the risk of customer default. If margins are set too high, trading becomes too
expensive and volume drops. If they are too low, exchange members and the clearing house are
vulnerable to credit (or default) risk.

determined by the SEC and CFTC to be comparable to margin requirements on stock
options, as the CFMA requires, but which is much higher than most futures margins,
which generally are in the range of 3%-8% of the value of the underlying commodity.)
By reducing margin requirements, the exchanges would lower the cost of trading security
futures and would likely boost trading volumes. However, such a move would be resisted
by the options exchanges, who would argue unfair competition, and by the SEC, which
would be concerned about the possibility of manipulation of stock prices.
Section 13106 of the reauthorization legislation directs the CFTC and SEC to permit
risk-based, or portfolio margining, for security futures by September 30, 2009. This
would have the effect of lowering margins for traders with partially offsetting positions
in stock options and securities futures, and would reduce trading costs somewhat. The
agencies are further directed to permit trading in futures based on certain foreign stock
indexes, also by September 30, 2009.
Retail Foreign Exchange Contracts
The Commodity Exchange Act generally prohibits the selling of off-exchange futures
contracts to small “retail” investors. There has been some dispute over whether this
prohibition applies to contracts based on foreign currency rates. In 1974, Congress
exempted contracts based on foreign exchange and Treasury securities from CFTC
regulation (the so-called Treasury Amendment). The CFTC has long argued that this
exemption applied only to professional markets, and that it had authority to prevent the
sale of futures-like contracts to small investors. The CFMA addressed this question, and
the CFTC believed it had been given clear authority, but a 2004 federal court case³ held
that certain retail foreign exchange contracts were not futures contracts and could be
legally sold. In 2005 hearings, CFTC Chairman Brown-Hruska suggested that additional
legal authority or clarification might be needed to protect small investors from fraud.
Both House and Senate reauthorization bills in the 109^th Congress sought to clarify
the CFTC’s authority over retail agreements and contracts in foreign currency. S. 1566
as reported included provisions designed to address the impact of the Zelener decision,
specifying that the CFTC has jurisdiction over foreign exchange contracts offered to retail
customers that feature margin or leveraged financing, and that are entered into for reasons
other than commercial or personal use of a foreign currency (that is, speculative
contracts).
In testimony before the Senate Banking Committee on September 8, 2005, the
President’s Working Group on Financial Markets (representing the Federal Reserve, the
Treasury, the SEC, and the CFTC) recommended that the retail foreign exchange
language in S. 1566 be amended to ensure that it did not inadvertently impose restrictions
on large foreign exchange contracts traded by banks and other institutional investors. A
floor amendment satisfactory to all regulators was expected to be offered by Chairman
Chambliss of the Agriculture Committee and Chairman Shelby of the Banking
Committee. However, S. 1566 never reached the Senate floor during the 109^th Congress.

³ CFTC v. Zelener, 373 F.3d 861 (7^th Cir. 2004).

The 110^th Congress legislation contains provisions similar to this regulatory
agreement, clarifying the CFTC’s authority over retail contracts and preserving the ability
of banks and other financial institutions to continue their foreign exchange trading
without CFTC regulation.