[Senate Hearing 109-910]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-910

 
                         THE COMMODITY FUTURES
                     MODERNIZATION ACT OF 2000 AND
                       RECENT MARKET DEVELOPMENTS

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

EXAMINING THE PROPOSED REAUTHORIZATION OF THE COMMODITY FUTURES TRADING 
COMMISSION, FOCUSING ON THE COMMODITY FUTURES MODERNIZATION ACT OF 2000 
                     AND RECENT MARKET DEVELOPMENTS

                               __________

                           SEPTEMBER 8, 2005

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


                                 ______

                    U.S. GOVERNMENT PRINTING OFFICE
35-904                      WASHINGTON : 2007
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092250 Mail: Stop SSOP, Washington, DC 20402ï¿½090001


            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                         Mark Oesterle, Counsel

                          Justin Daly, Counsel

                 Dean V. Shahinian, Democratic Counsel

             Alex Sternhell, Democratic Professional Staff

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                      THURSDAY, SEPTEMBER 8, 2005

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     3
    Senator Allard...............................................     4
    Senator Crapo................................................     4
    Senator Martinez.............................................     6
        Prepared statement.......................................    42
    Senator Bunning..............................................     7
    Senator Hagel................................................     7

                               WITNESSES

Randy K. Quarles, Under Secretary for Domestic Finance, U.S. 
  Department of the Treasury.....................................     8
    Prepared statement...........................................    42
    Response to written question of Senator Shelby...............   118
Robert L.D. Colby, Deputy Director, Division of Market 
  Regulation, U.S. Securities and Exchange Commission............    10
    Prepared statement...........................................    44
Patrick J. McCarty, General Counsel, Commodity Futures Trading 
  Commission.....................................................    11
    Prepared statement...........................................    50
Patrick M. Parkinson, Deputy Director, Division of Research and 
  Statistics, Board of Governors of the Federal Reserve System...    13
    Prepared statement...........................................    69
    Response to written question of Senator Crapo................   119
Charles P. Carey, Chairman of the Board, Chicago Board of Trade..    22
    Prepared statement...........................................    71
    Response to written question of Senator Bennett..............   119
John M. Damgard, President, Futures Industry Association.........    24
    Prepared statement...........................................    74
Terrence A. Duffy, Chairman, Chicago Mercantile Exchange 
  Holdings, Inc..................................................    25
    Prepared statement...........................................    83
Meyer S. Frucher, Chairman and Chief Executive Officer, 
  Philadelphia Stock Exchange On Behalf of The U.S. Options 
  Exchange Coalition: American Stock Exchange, Boston Options 
  Exchange, Chicago Board Options Exchange, International 
  Securities Exchange, Pacific Exchange, Philadelphia Stock 
  Exchange, and the Options Clearing Corporation.................    27
    Prepared statement...........................................   100
Mark Lackritz, President, Securities Industry Association........    29
    Prepared statement...........................................   105
    Response to written question of Senator Bennett..............   120
Robert G. Pickel, Executive Director and Chief Executive Officer, 
  International Swaps and Derivatives Association, Inc...........    31
    Prepared statement...........................................   109
    Response to written question of Senator Bennett..............   121
Daniel J. Roth, President and Chief Executive Officer, National 
  Futures Association............................................    32
    Prepared statement...........................................   114
    Response to written question of Senator Bennett..............   122


                         THE COMMODITY FUTURES
                     MODERNIZATION ACT OF 2000 AND
                       RECENT MARKET DEVELOPMENTS

                              ----------                              


                      THURSDAY, SEPTEMBER 8, 2005

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:05 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order. This 
morning, the Committee will examine the impact of the Commodity 
Futures Modernization Act of 2000 and recent market 
developments. Five years ago, Congress passed the Commodity 
Futures Modernization Act, making significant changes to the 
Commodity Exchange Act and the regulation of derivatives. The 
CFMA was the product of a comprehensive hearing process 
involving the Banking Committee and the Agriculture Committee. 
The Act provided for legal certainty and regulatory clarity for 
over-the-counter derivatives, modernized the regulatory regime 
for futures trading, and established a framework for trading 
security futures products. The CFMA recognized that certain 
financial products have attributes of securities and futures 
and provided for a regulatory regime intended to assure that 
the purposes of the Commodity Exchange Act and the Federal 
securities laws are carried out.
    As the CFTC's 5-year reauthorization approaches, it is time 
to revisit and to evaluate some of the provisions contained in 
the CFMA. Since passage of the CFMA, the futures markets have 
continued to evolve as innovative products, and new market 
participants now define the marketplace. Although futures 
contracts were originally tied to agricultural and other 
physical commodities, the vast majority of trading now involves 
financial instruments such as foreign currencies, stock indexes 
and government securities. Given that certain futures contracts 
based on financial instruments can function as a proxy for that 
financial instrument, this Committee has a significant role to 
play in examining any proposed changes to the regulatory lines 
established in the CFMA.
    During the current reauthorization process, several issues 
have arisen that are indicative of the changing nature of the 
futures markets. Specifically, we will examine security futures 
and consider how portfolio margining could apply to these 
products and securities options. Given the hybrid nature of 
certain futures, it is important to appreciate the joint 
regulatory regime overlaying these products. We will also 
consider proposed definitional changes to the term ``narrow-
based security index'' that are intended to expand the scope of 
future products that can be based on debt and foreign 
securities. These changes are significant because they govern 
regulatory jurisdiction. We are mindful of the investor 
protection concerns regarding investor protection, insider 
trading, and market manipulation underlying the current 
statutory definition. Finally, we will consider several issues 
related to the sale of foreign exchange contracts to retail 
investors. Some have raised concerns regarding the scope of 
foreign exchange products subject to the CFTC's authority, and 
some have also proposed new registration requirements for 
certain counterparties involved in the sale of retail foreign 
exchange products.
    While considering legislative proposals to amend the 
Commodity Exchange Act, it is important to ensure that any 
resulting amendments do not capture financial products 
specifically excluded from the regulatory regime created by the 
CFMA. Expanding the CFTC's jurisdiction to include new products 
and market participants must be carefully examined to guard 
against unintended consequences that could undermine the legal 
certainty, grant competitive advantages or leave investors 
without necessary protections.
    The Committee's examination of the CFTC's reauthorization 
is consistent with the Senate's approach to these complex 
issues in the year 2000. As the Senate considers 
reauthorization of CFTC, I look forward to working with 
Chairman Chambliss and the other Members of the Committee of 
the Agriculture Committee. We all share an interest in ensuring 
a fair, efficient, and competitive marketplace for financial 
products.
    We will have two panels here this morning. First, we will 
hear from the members of the President's Working Group on 
Financial Markets. During consideration of the Modernization 
Act in 2000, 5 years ago, the Working Group's recommendations 
were invaluable and served as a roadmap for reform. I once 
again expect the Working Group's recommendations to inform and 
guide the current 
reauthorization process. Any legislative proposals to redraw 
the regulatory lines should receive a complete examination and 
endorsement by the Working Group.
    Representing the Working Group this morning we have Mr. 
Randal Quarles, Under Secretary for Domestic Finance, U.S. 
Department of the Treasury; Mr. Robert Colby, Deputy Director 
of the Division of Market Regulation, the Securities and 
Exchange Commission; Mr. Patrick McCarty, General Counsel, 
Commodity Futures Trading Commission; and Mr. Pat Parkinson, 
Deputy Director of the Division of Research and Statistics, the 
Federal Reserve.
    On the second panel today, we will hear from a range of 
market participants. The witnesses on the second panel will be 
Mr. Charles Carey, Chairman of the Chicago Board of Trade; Mr. 
John Damgard, President, Futures Industry Association; Mr. 
Terrence Duffy, Chairman, Chicago Mercantile Exchange; Mr. 
Sandy Frucher, Chairman and Chief Executive Officer of the 
Philadelphia Stock Exchange, and Mr. Mark Lackritz, President, 
Securities Industry Association; Mr. Robert Pickel, Executive 
Director and Chief Executive Officer, International Swaps and 
Derivatives Association; and Mr. Daniel Roth, President, 
National Futures Association.
    I thank each of you for appearing here this morning, and we 
look forward to your testimony and your participation.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to commend you for holding this hearing, and for your 
leadership in asserting the Committee's role with respect to 
some of the issues that are raised with respect to this matter.
    Chairman Shelby. Thank you.
    Senator Sarbanes. And I also want to acknowledge the work 
that Senator Crapo's been doing on this issue. We very much 
appreciate it.
    Five years ago this Committee, working closely with the 
Agriculture Committee, in a joint deliberative process--it was 
a very cooperative working effort at that time--produced the 
Commodities Futures Modernization Act of 2000, the CFMA. Some 
of us will recall that process included a joint hearing of the 
two Committees to receive testimony from the agencies which 
comprise the President's Working Group on Financial Markets. 
Those agencies are actually represented again today here at the 
witness table.
    An important part of the CFMA was the authorizing of 
trading of security futures, ending the prohibition that had 
been established by the Shad-Johnson Accord. The CFMA permits 
trading of security futures subject to joint regulation by the 
SEC and the Commodities Futures Trading Commission. The Act 
requires that the SEC and the CFTC, ``jointly prescribe 
regulations to establish margin requirements,'' and that ``the 
margin requirements for a security futures product be 
consistent with the margin requirements for comparable options 
contracts.''
    It is obviously appropriate for this Committee to review 
the impact of the earlier law, especially, in light of 
legislation that the Agriculture Committee marked up in late 
July. Fed Chairman Alan Greenspan wrote on July 20 of this year 
that legislative provisions which were adopted by the 
Agriculture Committee ``include novel terms and approaches,'' 
and that the ``issues are complex and the potential for 
legislation to have unintended consequences is considerable.'' 
He went on to say, ``I believe it would be a mistake to enact 
legislation that has not been thoroughly evaluated by the 
PWG''--the President's Working Group--``and by market 
participants that may be affected.'' I think this is an 
observation to which we need to pay close attention.
    One provision of the bill, S. 1566, the one marked up in 
the Agriculture Committee, would implement a pilot program for 
single stock futures that would remove certain regulatory 
authority from the SEC. The seven U.S. options exchanges stated 
in a letter date July 20 of this year that they oppose this 
because it is ``not consistent with the regulatory and 
competitive parity between security futures and security 
options established in the CFMA.'' That was an issue that we 
really worked very hard on back when we did that earlier 
legislation.
    There are also other issues and provisions of the S. 1566 
which merit our attention and which the witnesses will be 
addressing.
    The Chairman of the Agriculture Committee said in the 
markup that his Committee was passing the bill to move the 
legislative process along and to stimulate discussion, which is 
of course what is happening here today.
    [Laughter.]
    And he also said that he was committed to working over the 
next few months with the Senate Banking Committee. I look 
forward to working closely, as we have on so many issues, with 
Chairman Shelby and Senator Crapo, who has played an important 
role in all of this, as we try to resolve this matter.
    We have a very collaborative working relationship the last 
time around, and I hope that we will be able to achieve that 
this time around as well. I think it is very important in 
ending up with a constructive resolution of some of these 
issues.
    Mr. Chairman, I join with you in welcoming the panels that 
are before us. I have another engagement this morning, and I am 
not quite sure how long I will be able to stay. I do want to 
say with respect to the first panel that both Bob Colby at the 
SEC and Pat Parkinson of the Fed have each served a quarter of 
a century with distinction at their respective agencies, and I 
want to acknowledge that here this morning. And Pat McCarty has 
served for more than 15 years with a number of agencies and on 
House staff before that. And, Mr. Quarles, we welcome you to 
the panel, and you are a new started, so to speak, but we wish 
you the very best as you move ahead in your responsibilities.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, thank you. I am not going to 
make any opening comments.
    Chairman Shelby. Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman, and I 
want to say at the outset I appreciate both you and Senator 
Sarbanes and the efforts that you have made to put this hearing 
together to work on this year.
    Chairman Shelby. Thank you for the work you did.
    Senator Crapo. Thank you very much.
    Mr. Chairman, I strongly believe that we need to 
reauthorize the Commodity Futures Trading Commission, and 
frankly, I think we need to act promptly. But it is more 
important that we do not undo the excellent work that is 
already based largely on the President's Working Group back in 
1999. Many individuals and groups have referred to the 
subsequent legislation, the Commodities Futures Modernization 
Act of 2000, as a landmark in futures regulation. The end 
result, measured in substantial increase in market volume, has 
been show to work well and to work very well.
    The careful balance that was struck in the CFMA established 
a tiered system of regulation depending upon the market 
participant's decision to trade on a registerd futures exchange 
or on a derivatives transaction execution facility, and 
depending on the sophistication of the parties involved. The 
CFMA also created legal certainty for swaps, prohibiting the 
CFTC from regulating them as futures contracts and prohibiting 
the SEC from regulating them as securities. The CFMA rightly 
recognized that swaps are banking products. The issues 
addressed in the CFMA were very complex and required a 
substantial amount of time to negotiate and to draft.
    The Banking Committee played a key role in creating legal 
certainty for swaps in its work, together with the cooperation 
of the Agriculture Committee, as evident in Titles III and IV 
of the CFMA.
    The CFMA was adopted with broad bipartisan support, after 
careful consideration over a period of years by four 
Congressional Committees and with the active support of the 
Secretary of the Treasury, the Chair of the Board of Governors 
of the Federal Reserve, the Chair of the Commodity Futures 
Trading Commission, and the Chair of the Securities and 
Exchange Commission.
    I am very concerned that we not undo the significant 
achievement of the CFMA that was largely based on the 
President's Working Group report entitled ``Over-the-Counter 
Derivatives Market and the Commodities Exchange Act.'' That 
product was an excellent report produced during the Clinton 
Administration.
    That is why on July 19 I sent a letter to the PWG 
requesting its new views on the draft Commodity Futures Trading 
Commission reauthorization bill that was being worked on by the 
Senate Agriculture Committee. Chairman Greenspan replied, as 
Senator Sarbanes has already indicated that, ``the issues are 
complex and the potential for legislation to have unintended 
consequences, including uncertainty about the enforceability of 
legitimate transactions that do not involve fraud, is 
considerable.'' He went on to say, ``Consequently, I believe it 
would be a mistake to enact legislation that has not been 
thoroughly evaluated by the PWG and by market participants that 
may be affected.''
    I am in complete agreement with that statement and would 
like to thank you, Mr. Chairman, for starting this process 
today, and Senator Sarbanes, for your long history of 
involvement and work with this. This is a very technical 
subject matter and we need to get it right.
    It is my understanding that the PWG staff devoted much time 
and effort during the month of August to address these 
concerns. It is my hope that the PWG principals can come 
together in agreement on this important issue and I look 
forward to the witnesses' testimony today. If the PWG 
principals cannot reach agreement, then I will be very hesitant 
to make very significant changes to the CFMA during 
reauthorization. If the PWG principals reach consensus but 
still have reservations, then I think we need to think long and 
hard about how we proceed.
    I am also very concerned that over the last 3 to 4 years 
there have been proposals for additional regulation of energy 
derivatives that is not warranted and would have changed the 
CFMA balance in reaction to certain market events. Fortunately, 
we were able to turn them back here in the Senate, but had they 
succeeded, I am concerned that those efforts would have 
unraveled the delicate and highly negotiated balance, and 
frankly, would have adversely impacted our economy.
    In fact, in several hearings, Chairman Greenspan, 
commenting on some of these proposals and their potential 
impact, indicated that they could have had a serious dampening 
impacts on the ability of our economy to respond in a timely 
and appropriate fashion to significant events. So we are 
dealing with very critical issues here.
    No doubt we must make sure that those who would commit 
fraud in financial transactions are subject to very aggressive 
and effective regulation, and that they are capable of being 
identified, stopped, and punished, and I do not believe that 
there is anybody who would disagree with that.
    But in our zeal to make sure that we accomplish that 
objective, I do not think that we want to create a disincentive 
for financial markets in this country to work, and to work in 
the smoothness and the effectiveness that they have been shown 
to be able to do in the past. We want to have financial tools 
available that will allow our economy to react swiftly and 
well, to allocate risk properly, and basically to keep us on 
the cutting edge of international competition.
    Mr. Chairman, as we have discussed, it is my intention to 
hold a hearing in the Subcommittee on the International Trade 
and Finance on the regulation of futures based on financial 
instruments and other financial products. In recent years, 
trading in futures contracts has expanded rapidly beyond the 
traditional physical and agricultural commodities into a vast 
array of financial instruments, including foreign currencies, 
U.S. and foreign government securities, and U.S. and foreign 
stock indices.
    I appreciate the Chairman's willingness to facilitate and 
support the Subcommittee's interest in this and look forward to 
holding that hearing.
    Again, Mr. Chairman, I appreciate your attention to this 
issue and look forward to working with you as we move forward.
    Chairman Shelby. Thank you.
    Senator Martinez.

                COMMENTS OF SENATOR MEL MARTINEZ

    Senator Martinez. Mr. Chairman, Thank you very much. I want 
to thank you and Senator Sarbanes for this important hearing. I 
have a brief statement.
    Chairman Shelby. We all want to call you ``Mr. Secretary,'' 
but we are getting used to you being up here.
    [Laughter.]
    Senator Martinez. I have changed now. I am pleased to be 
here in this role, and I just want to submit a brief statement 
for the record.
    Chairman Shelby. Without objection, it will be made part of 
the record.
    Senator Martinez. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman. I have a short 
statement. I would like to just thank you for holding this 
hearing today, and Senator Sarbanes also, on the Commodity 
Futures Modernization Act, the CFMA reauthorization.
    In 2000, we enacted the CFMA after a joint Committee 
hearings process involving the Banking Committee and the 
Agriculture Committee. The CFMA enacted the most significant 
amendment to the CEA and derivatives trading in 25 years. The 
CFMA provided for legal certainty and regulatory clarity for 
over-the-counter derivatives and a framework for trading 
security futures products. The provisions in the CFMA generally 
followed the recommendations contained in the report by the 
President's Working Group on Financial Markets. The CFMA worked 
because the two Committees worked together. Unfortunately, that 
is not the case this time.
    I know the Chairman and Ranking Member have made their 
concerns well-known to the Agriculture Committee. I wish the Ag 
Committee would have worked with us to solve these problems. 
But the Ag Committee chose to go ahead and report their bill, 
despite this Committee's concerns. I believe that was a 
mistake. Now, we find ourselves with serious jurisdictional 
problems, problems I believe could have been worked out to both 
Committees' satisfaction.
    I understand the Ag Committee's frustration with the lack 
of action by the SEC on many of the issues they tried to fix in 
S. 1566. Many of us on this Committee have felt similar 
frustrations with the SEC on other issues. It seems like no 
issue becomes a priority to the SEC unless a State official 
starts making headlines. I am confident this will change with 
Chris Cox as the new Chairman.
    I hope this hearing and this process has gotten the SEC's 
attention. I hope these issues that have sat around for 5 
years-plus now, will become priorities. I hope the SEC and the 
CFTC and the rest of the President's Working Group will 
continue to work together, I commend the staff of the group for 
coming up with an agreement to clarify the Zelener decision 
problems and allow the CFTC to protect retail investors. And 
finally, I hope, going forward, that the Ag Committee will work 
with this Committee, as we did in 2000 and pass a good bill 
that protects investors and help markets.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank all of you.
    The panel's written testimony will be made part of the 
hearing record. If you would, sum up your strongest parts and 
your recommendations and observations. We will start with 
Secretary Quarles. Welcome to the Committee.
    Oh, excuse me. Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, I thank you for holding this 
hearing today on such a timely topic. I just want to welcome 
all of the witnesses today and thank them for coming. I am sure 
we will benefit from their knowledge.
    Chairman Shelby. Okay. He wants to go to the panel. Thank 
you. Go ahead, Mr. Secretary.

                 STATEMENT OF RANDY K. QUARLES

              UNDER SECRETARY FOR DOMESTIC FINANCE

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Quarles. Thank you, Chairman Shelby, Ranking Member 
Sarbanes, and other Members of the Committee. I will be very 
brief given that my written remarks will be included in the 
record.
    As you know, the Secretary of the Treasury is the Chair of 
the President's Working Group. The other members of the 
President's Working Group are here with us. In recent weeks, 
the Working Group and members of the senior staff have met to 
discuss the effect of last year's Seventh Circuit Court of 
Appeals decision in CFTC v. Zelener, and the effect of that 
decision on the CFTC's antifraud authority, and in particular, 
the ability to address certain retail foreign exchange 
contracts.
    We have produced a proposal that addresses the issues that 
were raised by the Zelener case, reflecting a consensus of the 
President's Working Group, while being very sensitive to 
preserve the careful compromises of the CFMA of 2000.
    Let me just say at the outset that one of the important 
elements of this consensus is that we do not think that the 
modification that this proposal would produce should extend 
beyond retail foreign exchange to any other commodities. We 
think that major changes to the significant modernizations of 
the CFMA are not warranted. But one change that the CFMA did 
make was to modify the Commodity Exchange Act so that certain 
provisions of the Act, including antifraud provisions, did 
apply to foreign exchange futures and certain options with 
retail customers if the counterparty was not otherwise 
regulated.
    Those changes were intended to provide the CFTC with tools 
to pursue fraud against retail customers by bucket shops 
offering certain foreign exchange contracts. What the Zelener 
case showed was that there were some weaknesses in the CFTC's 
ability to pursue this type of bucket shop fraud, but we think 
that with the work that we have done over the course of August, 
the proposal that we currently have here, that those weaknesses 
can be addressed without upsetting the compromises of the CFMA. 
They can be addressed in a very narrow way.
    The changes that we are proposing would be, as I said, 
limited to cover only certain retail foreign exchange contracts 
that have been the subject of abuse. They would apply the CEA 
or its antifraud provisions to certain retail foreign currency 
futures and certain options and their sales chains when an FCM 
is involved. And they would apply the antifraud provisions to 
certain retail foreign exchange contracts that are not 
securities, that are not contracts that result in actual 
delivery within 2 days or certain contracts in connection with 
a line of business, as well as to their sales chains.
    Our proposal makes futures transactions and certain options 
on foreign currency between a retail participant and a 
counterparty that is not an otherwise regulated entity, such as 
a financial institution, a broker-dealer, or an insurance 
company, subject to the CEA. It would provide the CFTC with 
antifraud jurisdiction over those retail foreign exchange 
contracts and the persons who engage in sales activity in 
connection with those contracts if the counterparty is an FCM. 
And any person who participated in the solicitation or 
recommendation of such a contract within the FCM sales chain 
would register with the CFTC and be a member of a registered 
futures association. The PWG proposal would preserve the 
exclusion for otherwise regulated entities that was crafted by 
the CFMA.
    This proposal would make certain foreign currency contracts 
between a retail participant and counterparty that is not 
otherwise regulated subject to CFTC antifraud jurisdiction if 
the contracts were leveraged, margined, or financed, except 
that they would not apply to, as I said, securities, contracts 
that result in actual delivery within 2 days, or certain 
contracts in connection with a line of business. It would make 
such retail foreign exchange contracts and the persons who 
engage in activity in connection with them subject to the 
antifraud provisions, and any person who participated in the 
solicitation or recommendation of such a contract would have to 
register with the CFTC and be a member of the NFA.
    Let me move on and say just a few words then about the 
issues of portfolio-style margin systems and contracts and 
products based on narrow-based indices. The CFMA granted to the 
Board of Governors of the Federal Reserve System the authority 
to establish margin requirements for security futures products. 
The Board delegated that authority to the SEC and the CFTC 
jointly. The SEC and the CFTC are continuing to work toward 
permitting portfolio-style margin models. At the Treasury 
Department, we support the concept of portfolio-style margining 
systems. They increase the efficiency of capital allocation. 
They encourage risk management activities. We note some 
progress has been made very recently, and we remain hopeful 
that the SEC and the CFTC can work together to facilitate the 
implementation of these margining systems soon.
    The CFMA also created a distinction between broad-based 
security indices, which have been regulated solely by the CFTC, 
and narrow-based security indices, which are regulated by the 
SEC and the CFTC jointly. The definition of ``narrow-based 
security index'' seems to have been formulated using criteria 
that are appropriate for equity securities as opposed to debt 
securities. And so in that context, the Treasury Department can 
support reviewing the appropriateness of certain criteria in 
this definition of ``narrow-based security index'' in the 
context of debt and foreign security index futures given that 
the nature of the underlying securities differs from domestic 
equities, which seems to have been what was the context of the 
development of the definition. And so we are supportive of that 
review.
    In conclusion, I very much appreciate the opportunity to 
appear today to discuss these issues, present the consensus 
proposal of the President's Working Group. The proposal does 
provide the CFTC with the statutory enforcement authority that 
is necessary to combat fraud against retail customers while 
preserving what we think are the very important provisions of 
the CFMA and avoiding unintended consequences of overly broad 
changes.
    I look forward to continuing to work with my colleagues 
from the President's Working Group and with Members of Congress 
on these issues, and I look forward to your questions.
    Chairman Shelby. Thank you, Secretary Quarles.
    Mr. Colby.

                 STATEMENT OF ROBERT L.D. COLBY

         DEPUTY DIRECTOR, DIVISION OF MARKET REGULATION

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Colby. Chairman Shelby, Ranking Member Sarbanes, and 
Members of the Committee, I am pleased to be here today to 
testify on behalf of the Securities and Exchange Commission. I 
will briefly summarize the Commission's views on the Commodity 
Exchange Reauthorization Act of 2005, which are more completely 
set forth in my written testimony.
    There are three changes proposed by S. 1566 that I will 
discuss: First, the changes to the margin requirements for 
securities futures; second, the directive to change the 
definition of ``narrow-based security index''; and, finally, 
the changes to the Commodity Exchange Act designed to address 
the Seventh Circuit decision's in CFTC v. Zelener.
    The Commission supports the expansion portfolio margining 
to all equity products. We believe, however, that it can, and 
should, be accomplished without undermining the current 
requirements regarding comparability between security futures 
margin and options margin. Section 7 of S. 1566 would permit 
security futures margin to be calculated using a portfolio 
margining methodology, but would do so by removing the current 
requirements regarding comparability between security future 
margin and exchange-traded options margin. It would also 
eliminate the SEC's role in establishing margin requirements 
for security futures. The Commission strongly opposes these 
changes to the joint regulatory framework for security futures 
and believes that these changes would provide security futures 
a regulatory advantage over security options, products that are 
economic equivalents. The SEC believes that competition should 
be based on better products, services, and prices, not on 
regulatory differences.
    We acknowledge that implementing portfolio margining has 
not been the Commission's top priority over the past few years 
and that it is time for more concrete action to implement 
portfolio margining. In this regard, Chairman Cox met recently 
with CFTC Chairman Jeffery and committed to make the expansion 
of portfolio margining a Commission priority. Already, on July 
14, 2005, the SEC approved companion proposals by the New York 
Stock Exchange and the Chicago Board Options Exchange that 
permit their members, on a pilot basis, to compute certain 
customers' margin requirements using a portfolio margin 
methodology. These portfolio margin rules are limited, but the 
Commission staff has been actively discussing with the 
securities industry, CBOE, and New York Stock Exchange an 
approach to portfolio margining, including single stock 
futures, narrow-based securities index futures, and other 
equity securities.
    The self-regulatory organizations, too, have reinvigorated 
their efforts to allow for risk-based portfolio margining, and 
we anticipate that the New York Stock Exchange and CBOE will 
propose to expand their portfolio margining pilot drawing from 
recommendations of a committee of representatives of securities 
firms.
    Finally, we believe it would be helpful for legislation to 
make certain changes to the Securities Interview Protection Act 
of 1970, or SIPA. Such amendments could be targeted to provide 
that futures held in a portfolio margin account to offset 
positions in related securities would receive SIPA protection 
in the event of bankruptcy. This type of change to SIPA would 
encourage customers to take full advantage of portfolio 
margining rules.
    The Commission also has serious concerns about the 
amendments in Section 8 of S. 1566. These changes would 
potentially remove products currently considered securities 
from Commission oversight and eliminate key protections 
currently provided by the Federal securities laws to investors 
in futures based on such excluded indices. Also, if these 
indices were excluded from the definition, it would give the 
CFTC exclusive jurisdiction over futures on such indexes, and 
give futures exchanges the exclusive right to trade these 
products. Securities exchanges would be precluded from trading 
such instruments.
    I would also like to note that Section 8 of S. 1566 
introduces a subjective standard that the SEC and CFTC would be 
required to consider in assessing whether an index should be 
considered broad-based. One of the significant achievements of 
the CFMA was to establish clear, objective standards for which 
indexes were narrow and which were broad. We urge Congress not 
to reintroduce uncertainty into this area by establishing 
standards for determining jurisdictional boundaries that are 
subjective and subject to differing interpretations.
    Finally, the Commission shares the concerns of this 
Committee's Chairman and Ranking Member, as well as other 
members of the Working Group, regarding the potential adverse 
consequences of the provisions in S. 1566 designed to address 
the Seventh Circuit decision in CFTC v. Zelener. The Commission 
is concern that the changes proposed to be made to the CEA 
would compromise the legal certainty and regulatory clarity 
achieved by the CFMA.
    In addition, S. 1566 would curtail the foreign currency 
exclusions from the CEA for the securities industry that were 
established by the CFMA. The Commission believes these changes 
would undermine the competitive parity between broker-dealers 
and banks in foreign currency transactions. There is no 
evidence of involvement in the retail foreign currency fraud by 
these currently excluded broker-dealer affiliates that would 
justify elimination of their exclusion. Instead, we think the 
Zelener decision just calls for fine-tuning of the Treasury 
Amendment. We stand with what Under 
Secretary Quarles has said, and we look forward to finalizing 
legislative language.
    Thank you very much. I would be happy to answer any 
questions you may have.
    Chairman Shelby. Thank you.
    Mr. McCarty.

       STATEMENT OF PATRICK J. McCARTY, GENERAL COUNSEL,

              COMMODITY FUTURES TRADING COMMISSION

    Mr. McCarty. Mr. Chairman and Senator Sarbanes, good 
morning. I am pleased to testify today on behalf of the 
Commodity Futures Trading Commission regarding the 
reauthorization of the Commodity Exchange Act.
    The last such exercise by Congress resulted in the 
Commodity Futures Modernization Act of 2000, which truly was 
landmark legislation. This Committee deserves credit for its 
role in the drafting of that law. The CFTC concurs with the 
widely held view that the current reauthorization should 
involve only incremental changes to the Commodity Exchange Act.
    Mr. Chairman, you asked us to comment on several issues, 
and I will begin with portfolio margining for security futures 
products. This is an important issue because we have heard from 
exchanges and market participants that the current margining 
scheme has been an impediment for traders to buy and sell 
SFP's. They are being traded quite successfully in other 
jurisdictions, including in Europe, and in the vast majority of 
foreign SFP markets, margin requirements are risk based.
    I would note that the reauthorization bill reported by the 
Senate Ag Committee calls for a pilot program for risk-based 
portfolio margining of SFP's. That SFP pilot program would be 
similar to the CBOE portfolio margining pilot program that was 
approved by the SEC on July 14. The CBOE pilot program does not 
include SFP's. The CFTC strongly supports the concept of risk-
based and portfolio margining for both security futures 
products and for security options. These types of margining, 
standard in the futures industry, are both efficient and 
effective from a regulatory point of view, and have been very 
successful in protecting customer funds.
    The use of risk-based portfolio margining for financial 
products has received support in the past from the Board of 
Governors of the Federal Reserve System and the Securities and 
Exchange Commission. Details are in my written testimony.
    Mr. Chairman, regarding definitional changes for narrow-
based security indexes, the current statutory tests enacted in 
the CFMA were based on the U.S. equity market, the largest, 
deepest, and most liquid market in the world. They are 
inappropriate for the smaller size in trading volume that 
generally characterizes foreign markets and debt markets. The 
CFMA gave the CFTC and the SEC authority to exclude certain 
foreign indexes and instruments from this narrow-based 
category. However, the agencies have not acted, thus preventing 
these new products from being made available to U.S. customers.
    This is not a matter of altering the existing 
jurisdictional division between the SEC and the CFTC, but 
rather ensuring that foreign security indexes and debt security 
indexes may qualify to be traded in the United States under a 
test that more accurately takes into account the nature and 
size of these markets as the CFMA requires. The CFTC has 
developed specific definitions to achieve this end and they are 
set forth in my written testimony.
    Finally, the issue that has received the most public 
attention involves the Commission's antifraud authority over 
retail foreign currency transactions in light of the recent 
Zelener court decision. 
Retail forex fraud from sales pitches with false assurances of 
guaranteed profits to outright absconding with customer funds 
has posed a significant enforcement challenge to our agency.
    Since the CFMA was enacted, the CFTC has brought 79 
enforcement actions in the retail forex sphere involving more 
than 23,000 victims, and court-ordered restitution and 
penalties of approximately $267 million. I want to stress that 
the CFTC continues to believe the contracts at issue in Zelener 
were futures contracts. To protect customers from fraud, our 
Division of Enforcement will continue to litigate similar cases 
aggressively.
    As you are aware, there are a number of views as to how the 
Zelener decision should be addressed. Recognizing this, the 
President's Working Group on Financial Markets, of which CFTC 
Chairman Reuben Jeffery is a member, set out to develop a 
consensus position to recommend to the Congress. As Under 
Secretary Quarles of the Treasury has testified, the PWG 
members have reached agreement in concept. Final details are 
being worked out.
    With respect to questions posed by the Committee, I can say 
the concept would be a narrow fix that applies only to futures 
and Zelener type contracts in foreign currency that are offered 
to retail customers. In addition, the concept retains the 
current otherwise regulated regime in which retail forex 
transactions by financial institutions, including banks, 
broker/dealers, and insurance companies, are excluded from the 
CFTC's jurisdiction.
    We look forward to providing our authorizing committees and 
this Committee our recommendations when the detailed language 
has been finalized.
    Thank you again, Mr. Chairman, and I am prepared to answers 
your questions.
    Chairman Shelby. Mr. Parkinson.

               STATEMENT OF PATRICK M. PARKINSON

      DEPUTY DIRECTOR, DIVISION OF RESEARCH AND STATISTICS

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Parkinson. Chairman Shelby, Senator Sarbanes, and 
Members of the Committee, thank you for the opportunity to 
testify on the CFMA and on regulatory issues that have arisen 
in the context of the reauthorization of the CFTC.
    The Federal Reserve Board believes the CFMA has 
unquestionably been a successful piece of legislation. The CFMA 
has made our financial system and our economy more flexible and 
resilient by facilitating the transfer and dispersion of risk. 
Consequently, the Board believes that major amendments to the 
regulatory framework established by the CFMA are unnecessary 
and unwise.
    Nonetheless, the Board supports some targeted amendments to 
the CEA to address persistent problems with fraud and retail 
foreign currency transactions and to facilitate the trading of 
security futures products and futures on security indexes.
    In its 1999 report, the PWG concluded that to address 
problems associated with foreign currency bucket shops, the CEA 
should be applied to transactions in foreign currency futures 
if they are entered into between a retail customer and an 
entity that is neither federally regulated nor affiliated with 
a federally regulated entity.
    The CFMA included provisions that were largely consistent 
with the PWG's recommendation.
    The CFMA has allowed the CFTC to take numerous enforcement 
actions against retail foreign currency fraud. However, the 
CFTC has continued to encounter certain difficulties in this 
area. The Board supports targeted amendments to the CEA that 
address the specific difficulties that the CFTC has 
encountered. However, it is critical that those amendments be 
carefully crafted to avoid creating legal or regulatory 
uncertainty for legitimate businesses providing foreign 
exchange services to retail clients. The Board would be opposed 
to extending any new CFTC authority to retail transactions in 
other commodities without further careful consideration and 
demonstrated need. Provisions crafted to avoid creating 
uncertainty for legitimate foreign currency businesses are 
unlikely to provide the same protection to a much wider range 
of businesses.
    The agreement in principle that has been reached by the PWG 
appears to be fully consistent with the Board's views and 
therefore deserving of its support.
    Turning to portfolio margins, the CFMA gave the Board 
authority to prescribe regulations establishing initial and 
maintenance margins for security futures products or to 
delegate that authority jointly to the CFTC and the SEC. The 
Board delegated its authority to the Commissions in a letter 
dated March 6, 2001. The Board has supported the use of 
portfolio margining for some time. For example, in 1998 the 
Board amended its Regulation T to allow securities exchanges to 
develop portfolio margining as an alternative to strategy-based 
margining subject to SEC approval.
    In its 2001 letter delegating its authority over margins 
for security futures jointly to the CFTC and SEC, the Board 
requested that the Commissions report to the Board annually on 
their experience, exercising the delegated authority, and in 
particular to include in those reports an assessment of 
progress toward portfolio margining for security futures 
products.
    Unfortunately, to date, no progress has been made toward 
portfolio margining of security futures products. Because the 
CFMA stipulates that margin requirements for security futures 
products must be consistent with margin requirements on 
comparable security options, progress for security futures 
requires progress on options. Although margin requirements for 
options have for many years been portfolio based at the 
clearing level, customer margins were, until very recently, 
strictly strategy based.
    However, in July the SEC approved rule changes that create 
a 2-year pilot program that would permit portfolio margining of 
options and futures positions in broad-based stock indexes held 
by certain customers with very large accounts. If this pilot 
program were adopted as a margining system available to all 
customers for a broad range of products, significant progress 
toward portfolio margining security futures products would 
become possible.
    The Board believes that it is appropriate for the Congress 
to spur progress toward portfolio margining for security 
futures. For example, the Congress could spur progress for both 
security futures products and options by requiring the 
Commissions to jointly adopt regulations permitting the use of 
risk-based portfolio margining 
requirements for securities futures products within a short 
reasonable time period, and requiring the SEC to approve risk-
based portfolio margin requirements for options within the same 
period.
    Finally, some futures exchanges argue that the definition 
of a narrow-based index in the CFMA was drafted with reference 
to the U.S. equities markets, and that in any event the 
definition unnecessarily restricts the trading of futures on 
indexes of U.S. debt obligations and foreign securities. 
Although the Board has not had a strong interest in this issue, 
it favors taking another look at the appropriateness of 
applying the existing definition to indexes of foreign 
securities.
    First, for many years several futures on foreign equity 
indexes have been trading aborad and have been offered to 
customers in the United States. Although these indexes would be 
considered narrow-based indexes under the existing definition, 
we see no evidence that these indexes have been susceptible to 
manipulation.
    Second, the provision in the 2005 Reauthorization Act can 
be seen as simply reiterating an existing requirement in the 
CFMA that the CFTC and the SEC jointly adopt rules that define 
narrow-based indexes based on foreign securities.
    That concludes my prepared remarks. Thank you.
    Chairman Shelby. I think I have about four questions. Other 
people have more. The futures markets continue to evolve, as we 
all know, as an increasing number of future contracts are based 
on financial instruments. It seems increasingly likely that 
exchanges will soon seek to trade both securities and future 
products.
    As a result of this market convergence, the differences 
between securities and futures becomes less clear. In light of 
these developments here, does the regulatory regime need to be 
modernized to reflect current market realities? Does the 
current regulatory scheme that draws a line between futures 
regulation and regulation for other financial products make 
sense? Secretary Quarles, do you want to comment first?
    Mr. Quarles. That is a thoughtful question. The official 
sector always needs to be very mindful of changes that are 
happening in markets and in the structure of industries that 
affect changes in market----
    Chairman Shelby. Is the market getting ahead of the 
regulatory regime?
    Mr. Quarles. We need to make sure that the regulatory 
framework is reflecting what is actually happening in practice. 
I think that that requires further reflection. I would not be 
prepared today to make specific recommendations in light of 
that, but having recently been sworn into this job, that theme 
is something that I am asking my people at the Treasury 
Department to be focused on, is ensuring that changes in the 
industry over the last 5, 10 years, changes and the effects on 
markets that those changes in the structure of the industry 
might be having, that we are thinking about appropriate policy 
responses. Today, I would not be prepared to recommend any 
particular ones, but that is a theme that we are definitely 
pursuing.
    Chairman Shelby. Mr. Colby, you have any comment?
    Mr. Colby. Chairman Shelby, this is an issue that has been 
of acute interest to the Commission over the years. We deal 
with the ramifications of this very important issue on a daily 
basis. Our new Chairman, however, has not had time to focus on 
this crucial issue, so I would like to defer answering the 
question.
    Chairman Shelby. Mr. McCarty, you have a different view?
    [Laughter.]
    Mr. McCarty. No. I think I will have to defer to get an 
answer from our Chairman.
    But I think your observation is absolutely correct. There 
seems to be a convergence occurring over the last several 
years. The CFMA has worked extremely well, and I would say that 
the regulatory structure has seen the markets and helped them 
develop I think that convergence is a big issue that is coming.
    Chairman Shelby. Mr. Parkinson, do you have a comment?
    Mr. Parkinson. I think the distinctions between securities 
and futures have been blurring, and where they exist they are 
often arbitrary--based on legal distinctions rather than 
economic differences. But having encountered this question 
several times over the years, I do not think one should 
underestimate the difficulty of developing a new regulatory 
structure that improves on the existing one.
    For example, some seem to think that simply merging the 
CFTC and SEC would solve all these problems, but I think that, 
by itself, would not achieve consistent regulation of 
securities and futures. The fact is that the underlying 
statutes the CEA and the 34 Act, provide for quite different 
approaches to regulation. Moreover, if OTC derivatives come 
into the picture here, they are neither futures nor securities, 
and in our view are not appropriately regulated as either. In 
that case, private market discipline rather than Government 
regulation is really the critical mechanism ensuring that 
public policy objectives are met.
    Again, much as I can understand the frustrations with the 
existing regime, I think it is going to be difficult to come up 
with a better one.
    Chairman Shelby. The product is not a security, per se, and 
it is not a futures, per se. Is it a hybrid? Is it something 
that man has invented and is very resourceful?
    Mr. Parkinson. At the insistence of this Committee, the 
CFMA explicitly identifies a class of products called banking 
products that are neither securities nor futures nor regulated 
as either. So that is an example.
    Chairman Shelby. It seems that there is agreement among the 
witnesses that portfolio margining is a positive step for not 
only security futures but also for security options. There 
seems to be consensus on this point. To date, the regulators 
have been unable to produce a rule adopting portfolio 
margining. Given this inaction, should Congress mandate that 
the regulators adopt portfolio margining for security futures 
and security options? If not, then what assurances does 
Congress have that it will be done in a timely manner?
    Mr. Colby.
    Mr. Colby. I recognize first of all that this issue has 
been a long time in coming. I believe that we are on the cusp 
of moving much more quickly to address portolio margining. We 
have a framework now established in the pilot program that was 
set up by the CBOE and New York Stock Exchange. The NYSE and 
the CBOE, I believe, are reenergized in order to move this 
forward.
    We have a consensus in the industry about a way to move 
forward, and so I do not think the issue merits legislation. If 
there were legislation, I think it would remain important that 
the margin requirements be determined by the SRO's who bring 
the expertise of the industry and the ability to work on the 
issues and find a workable and inexpensive way to do it, 
subject to the approval of the CFTC and the Commission.
    Chairman Shelby. Secretary Quarles, you have a different 
view?
    Mr. Quarles. No. I think, as I indicated in my testimony, I 
think we are beginning to see progress.
    Chairman Shelby. What about you, Mr. McCarty, you have a 
different view than the SEC?
    Mr. McCarty. I think that it has been a long time coming, 
and I guess our point of view is we would like to work with the 
SEC to get this done as quickly as possible. I would note 
however that there is nothing like a statutory deadline to get 
one to move.
    Chairman Shelby. Mr. Parkinson.
    Mr. Parkinson. As I indicated in my testimony, the Board 
believes it is appropriate for Congress to spur progress here, 
both in the case of security futures and security options. The 
step that the SEC took recently was a very important one, but 
as you have indicated, it was a long time in coming, and I 
think the concern of 
people in industry is that we not come to the next CFTC 
reauthorization and see that there still has not been 
meaningful progress.
    Chairman Shelby. Some have proposed that Congress should 
direct the regulators to amend the definition of what we call 
narrow-based security indexes to account for debt and foreign 
securities. Do the SEC and the CFTC currently have the 
necessary statutory authority to modify this term or is 
legislation necessary?
    Mr. Colby.
    Mr. Colby. We absolutely have the necessary authority to--
--
    Chairman Shelby. Without question?
    Mr. Colby. Without question. And we have in the past 
excluded some indices from the definition narrow-based 
volatility indexes that are----
    Chairman Shelby. If you have the authority, what are you 
going to do about it?
    Mr. Colby. Yes, that is a fair question. Our plan is to 
work closely with the CFTC to address each of these issues. 
Some of them are new to us. The debt issue has not previously 
been presented to us before this legislation. The foreign 
securities issue is familiar. The debt issue is new.
    Chairman Shelby. Can you afford to let the market get ahead 
of you as a regulator? Both of you. In a sense you cannot, can 
you?
    Mr. Colby. We never want the market to get ahead of us. I 
think we can work with the CFTC to make real progress here.
    Chairman Shelby. Secretary Quarles and Mr. Parkinson, would 
you please comment briefly on changes to the definition of 
narrow-based security index? In other words, can the members of 
the Working Group here resolve this issue, or does Congress 
need to step in? What do you think, Secretary Quarles and Mr. 
Parkinson? The Treasury and the Fed play a role here.
    Mr. Quarles. If you are asking is it appropriate for the 
Working Group to have on its agenda this issue. It is the issue 
that the Working Group can consider. I do think that the SEC 
and the CFTC obviously have the principal expertise here, and 
so I do not know that it is necessary that it become an agenda 
item. Certainly if it was the desire of this Committee that it 
become one----
    Chairman Shelby. If they have the expertise, which I do not 
question, if they have the statutory authority, they need 
acceleration perhaps in doing something?
    Mr. Quarles. The Working Group has been in the past an 
accelerating device.
    [Laughter.]
    Chairman Shelby. Senator Crapo, you spent a lot of time on 
these issues.
    Senator Crapo. Thank you very much, Mr. Chairman. I have 
been checking off my questions as you asked them, but I still 
have a couple of others.
    I want to go into what I understand to be the consensus 
position that the Working Group is prepared to submit with 
regard to the Zelener decision. Let me clarify, it is my 
understanding that we have a consensus position in concept, but 
we do not have specific language; is that correct?
    Mr. Quarles. That is correct, but there has been a very 
substantial element that remains to have final language done, 
so this is not just concept.
    Senator Crapo. And the only area on which we have consensus 
at this point is the matter of dealing with the Zelener 
decision. I mean there are other issues that the Working Group 
is working on, I understand, and I understand there is not 
necessarily a consensus position on other issues. Is that 
correct?
    Mr. Quarles. We have begun with the Zelener issue, so it is 
not as though we have been considering the other issues and 
have reached any impasse. It is that as a working procedure we 
began with the Zelener issue and completed that agreement, and 
the time that that took, took the time until this hearing.
    Senator Crapo. That is a good clarification and I 
appreciate that. I know that each of you in your testimony have 
basically said this already, but I want to nail it down, and 
that is that my understanding is that the consensus that has 
been developed is that the fraud issues dealing with retail 
foreign currency transactions that were raised by the Zelener 
case can be handled with a narrow antifraud fix that does not 
expand the jurisdiction of the Act otherwise, a narrow 
antifraud fix dealing with retail foreign currency transactions 
specifically; is that correct? Everybody is nodding their head 
yes.
    Mr. Quarles. Yes, it is.
    Senator Crapo. So the record can reflect that at least the 
Working Group is in consensus, that a narrow fix is all that is 
necessary and can accomplish the objectives necessary to deal 
with the fraud issues?
    Mr. Quarles. That is correct.
    Senator Crapo. Let me ask a question then about the rest of 
the agenda. It is clear to me that the fraud issues were one 
that we needed to deal with. The Zelener case brought this to 
the forefront and the concern about the potential fraud, 
particularly in retail foreign currency transactions, required 
some action, and there is now consensus in terms of how we 
should approach that, at least from the Working Group. Are 
there other areas such as the Zelener case or the retail fraud 
issues that we just discussed, that Congress needs to talk 
about, or is the Zelener case really the area that we need to 
focus on? Are there other problem areas that require statutory 
solutions right now?
    Mr. Colby. As I mentioned in my testimony, there is a small 
amendment to the Securities Investor Protection Act that we 
think would facilitate cross-margining, which we would be happy 
to transmit to you for your consideration. The aim of it is to 
protect futures that are in a cross-margin account under the 
Securities Investor Protection Act so you do not run the risk 
of insolvency where part of the account will be protected and 
part of it will not.
    Senator Crapo. Any others? Yes, Mr. McCarty.
    Mr. McCarty. Senator Crapo, we had two other provisions in 
our testimony dealing with fraud authority. One is with respect 
to clarifying that we have principal-to-principal fraud 
authority under our Section 4(b) provision. This is a very 
important issue for us, and we can discuss it later on, but it 
is a very important part of the Senate bill.
    The second item is clarification of our civil and 
administrative authority to bring actions under Section 9 of 
our Act. Those two provisions are actually in the Senate bill 
and they are quite important to the Commission.
    Senator Crapo. Any others?
    Mr. Parkinson. As we indicated, we do support the Congress 
taking steps to spur progress on portfolio margining, and I 
think less strongly we would support doing something to move 
forward on the narrow-based index question as well.
    Senator Crapo. But in that context you are talking about 
more deadline setting rather than Congress establishing those 
substantive changes?
    Mr. Parkinson. That is correct. I think Congress would not 
want to take on the question of redrawing the narrow-based 
index definition, for example, which is extremely complex.
    Senator Crapo. Mr. McCarty.
    Mr. McCarty. If I might come back to that issue just 
briefly. One, I think that we clearly have the statutory 
authority, as the Chairman suggested, the SEC and ourselves at 
the CFTC, to work out exceptions from the narrow-based index 
definition. We have some proposed definitions that we have 
supplied in our testimony. There may be a difference of opinion 
between the two staffs as to exactly where Congress--what their 
intentions were and were not about the scope of those 
exceptions that we might make from the narrow-based security 
index definition. That is one thing that we may need to talk to 
you or your staffs about to get a clear focus on exactly how to 
fulfill Congress's intent in terms of what you would like to 
exclude.
    Senator Crapo. Anything else? I am trying to just get the 
waterfront laid out here so we know what we want to look at.
    Just one last question of the panel, Mr. Chairman.
    Chairman Shelby. Go ahead.
    Senator Crapo. And that is, Mr. McCarty, you raised Section 
9 of the Agriculture Committee's bill as a matter that you feel 
did address some important issues that you need to deal with. 
In the context of legal certainty for swaps, one of the issues 
that was addressed by this Committee was the creation of legal 
certainty for swaps in the legislation. Sections 2(g), 2(h), 
and 2(i) in the Act were included specifically to establish 
this legal certainty.
    As I read at least the report language and my understanding 
of the bill's language itself that the Senate Agriculture 
Committee just put out, it would adversely affect these or 
significantly change these sections, in that the report states 
that the CFTC believes that Section 9 dealing with false 
reporting applies to excluded transactions, even though the 
statute currently specifically states that nothing in that 
section applies to these swap transactions.
    So the question I have is: If Section 9 applies to any 
excluded transactions, would this not cover securities and 
mortgage finance as well as OTC swaps, and does this not 
undermine the legal certainty for swaps that was established in 
the original Act?
    Mr. McCarty. Senator, I think what you are referring to 
here is the false reporting cases that we have brought. Our 
Section 9 authority actually has many aspects to it. One is 
where people supply knowingly false reports in an attempt to 
manipulate commodity indexes and prices. We have always taken 
the position that the 2(g) and 2(h) exclusion and exemption 
apply to the contracts themselves. We are not actually saying 
that our Section 9 authority brings those contacts back in. The 
distinction that we make is that those contacts are clearly 
excluded from our jurisdiction except when someone, like an 
energy company, would report falsely or make up transactions 
and report them to index providers, publishers, in an attempt 
to manipulate those commodity prices.
    We just had a very significant victory in the Northern 
District of Oklahoma in the Bradley case. In Bradley, the 
Federal District Court agreed with the CFTC that in fact while 
the 2(g) and 2(h) provisions exclude the contracts transactions 
and their legal certainty is assured, the act of false 
reporting those transactions is a separate act. No one is 
required, who engages in a transaction under 2(g) or 2(h), to 
report those transactions to anyone.
    Chairman Shelby. That is correct.
    Mr. McCarty. What we found in the Bradley case is that 
hundreds of false reports were submitted to the index providers 
in an attempt to benefit positions that the energy traders had.
    Senator Crapo. Have you been successful in asserting 
jurisdiction over that false reporting?
    Mr. McCarty. Yes, sir. August 1 of this year, the U.S. 
Federal District Court for the Northern District of Oklahoma in 
Bradley agreed with our long-held position that false reporting 
is a separate act from the actual exclusion of the transactions 
under 2(g) and 2(h).
    Senator Crapo. Would there need to be any statutory change 
since you have already successfully asserted that?
    Mr. McCarty. Senator, yes, we still do need the change that 
has been agreed to with the industry. That language is in the 
Senate Ag bill. It is needed to clarify the language in Section 
9 which looks as if it applies only to felonies. We want to 
make sure that it clearly applies to our civil and 
administrative actions.
    Senator Crapo. But you are not seeking to extend the reach 
of the Act to anything beyond what you have already done I 
these enforcement actions?
    Mr. McCarty. That is absolutely correct, Senator.
    Senator Crapo. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Crapo.
    I will direct this question to Secretary Quarles and Mr. 
Colby. It seems that the Working Group is developing a proposal 
regarding registration requirements for certain counterparties 
engaged in the sale of retail foreign exchange contracts. How 
would such registration requirements apply to broker/dealers 
and their affiliates? Secretary Quarles?
    Mr. Quarles. They would not apply.
    Chairman Shelby. Do you have the same opinion?
    Mr. Colby. I certainly hope so.
    [Laughter.]
    Chairman Shelby. You hope so.
    Mr. Colby. My understanding is they would not apply, that 
is right.
    Chairman Shelby. I want to thank the first panel here--we 
have another panel--for your appearance this morning. It seems 
to me here that the Working Group has developed a consensus 
position regarding the regulatory ambiguity arising from the 
Zelener case, as Senator Crapo referred to. If I am wrong, you 
tell me.
    While I am encouraged by this positive result, or seemingly 
so, I would request that the Working Group continue to meet, 
hopefully over the coming weeks, regarding portfolio margining 
and definitional changes to the term ``narrow-based security 
indexes.'' As in 2000, consensus from the President's Working 
Group would be extremely constructive to this Committee, to our 
process, and I believe it is critical to advancing any CFTC 
reauthorization legislation through the Senate. I hope that the 
Working Group will report back to this Committee with 
recommendations and proposed legislative language regarding the 
issues that we have discussed here this morning. We know they 
are complex, but you deal with complex issues.
    I would also ask that you consult with the Committee staff 
here, as you have, as to when you might bring forth such 
recommendations.
    We would also look forward to working, as always, with our 
colleague Senator Crapo, who has put so much effort into this, 
as he considers the regulatory scheme for futures based on 
financial instruments and other financial products at an 
upcoming Subcommittee hearing that he mentioned earlier. 
Senator Crapo, as we have acknowledged here--I have and Senator 
Sarbanes--has been a leader on this issue, has spent a lot of 
time on this issue, and I think his upcoming hearing will 
further inform the Senate as we consider the CFTC 
reauthorization. I hope you all will be forthcoming soon.
    Thank you very much.
    Senator Crapo. Mr. Chairman.
    Chairman Shelby. Yes.
    Senator Crapo. Could I ask one more real quick question?
    Chairman Shelby. Go ahead.
    Senator Crapo. I apologize for that. This is for everybody 
on the panel. As you know, in the past, the President's Working 
Group has explained why proposals that we have faced in the 
last couple of years for additional regulation of energy 
derivatives were not warranted, and the panel has unanimously 
urged Congress to be aware of the potential unintended 
consequences of those proposals. Is that still true today? I 
have not heard anybody discuss bringing that issue back up 
today and I just wanted to be clear that there is agreement 
that that does not need to be addressed.
    Mr. Quarles. That is correct.
    Mr. Colby. Our view has not changed.
    Senator Crapo. And one other aspect of that: Would that 
also apply to natural gas derivatives; any reason for us to try 
to start jumping into changing the dynamic for regulating 
derivatives in the energy markets of any kind?
    Mr. Quarles. Not at this time.
    Mr. Colby. We agree.
    Senator Crapo. Thank you. I want the record to show that 
the answer was no from all members of the panel.
    Chairman Shelby. The record will so show.
    Thank you very much.
    Our second panel--I introduced them earlier, but I will do 
it again for the record. Mr. Charles Carey, Chairman of the 
Chicago Board of Trade, Mr. John Damgard, President, Futures 
Industry Association; Mr. Terrence Duffy, Chairman, Chicago 
Mercantile Exchange; Mr. Meyer Frucher, Chairman and Chief 
Executive Officer of the Philadelphia Stock Exchange; Mr. Mark 
Lackritz, President, Securities Industry of America; Mr. Robert 
Pickel, Executive Director and Chief Executive Officer of the 
International Swaps and 
Derivatives Association; and Mr. Daniel Roth, President, 
National Futures Association.
    If the second panel will make their way to the table. As I 
said before, your written testimony is made part of the record, 
the hearing record, without objection, and if I could ask you 
to sum up your pertinent points, your strongest points that you 
want to make, as brief as you can, we would be very 
appreciative.
    Mr. Carey, we will start with you if you are ready, and 
welcome to the Committee, all of you.

                 STATEMENT OF CHARLES P. CAREY

         CHAIRMAN OF THE BOARD, CHICAGO BOARD OF TRADE

    Mr. Carey. Mr. Chairman and Members of the Committee, my 
name is Charlie Carey and I am Chairman of the Chicago Board of 
Trade, the oldest and one of the largest futures exchanges in 
the world. Thank you for allowing me to appear before you 
today. I have also submitted written testimony for the record 
for the consideration of the Committee.
    The CBOT thanks and congratulates the Congress for the 
passage of the Commodity Futures Modernization Act of 2000. The 
CFMA provided for increased competition and legal certainty in 
the derivatives industry, and reduced many unnecessary and 
costly regulatory burdens. Overall, it has been a great 
success.
    Unfortunately, some of the goals and promises of the CFMA 
have not been fully realized. Dual regulation and inefficient 
margining have contributed to an environment that has inhibited 
the development of a robust, single-stock futures industry. 
Regulatory confusion may be keeping other innovations from the 
market. And an unfortunate court decision has been issued, 
which if not addressed, raises the specter of increased fraud. 
The Seventh Circuit Court of Appeals in Chicago rendered an 
opinion in the recent CFTC v. Zelener case, which essentially 
does away with previously settled law setting out 
characteristics of a futures contract. By determining that the 
contracts in question were not futures because they did not 
include a guaranteed right of offset, this decision provides a 
road map for potential wrongdoers to offer fraudulent 
transactions outside the reach of the CFTC.
    Such fraud involving commodities has the potential of 
tarnishing the reputations of exchanges, firms, and individuals 
who engage in legitimate business activities in the futures and 
derivatives industry.
    When Congress passed the CFMA, it recognized that persons 
who did not meet the criteria for becoming eligible contract 
participants still needed the protection of Federal regulation 
by the CFTC if they dealt in commodity futures. Yet still, 
these retail investors are being solicited by telephone, 
Internet, and television pitches to invest in fraudulent deals 
involving foreign currency, heating oil, gold, and other 
commodities. CBOT urges Congress to enact an amendment giving 
the CFTC the authority to shut down fraudulent operators before 
this activity results in the loss of hard-earned savings of the 
investing public.
    We believe that a solution that only addresses foreign 
currency transactions will not solve the problems created by 
this decision but merely shift them to other commodities.
    In addition to clarifying law to protect the public from 
ongoing and future fraud due to the Court's decision in the 
Zelener case, the CBOT hopes that Congress will also continue 
the goal of reducing regulatory barriers to innovation in two 
areas. First, the CBOT asks that Congress consider clarifying 
that the definition of ``narrow-based security indexes'' does 
not include indexes on fixed income securities, corporate 
bonds, and other nonequity securities. The present definition 
creates a series of tests to distinguish narrow-based indexes 
from broad-based indexes. These tests are only workable for 
indexes on U.S. equity securities. Index products based on 
nonequity securities do not implicate the same regulatory 
concerns that led to the creation of the definition and test.
    However, the possibility that the definition could be 
interpreted to cover nonequity products has hampered 
development of such products due to confusion as to what 
regulations may or may not apply. Clarification of this 
definition is an important issue that deserves to be addressed 
at this time.
    Second, the CBOT asks the Congress to address the present 
inefficient and noneconomic margin requirements which continue 
to stymie growth of single-stock futures in this country while 
they flourish overseas. The CBOT hopes Congress will take this 
opportunity to facilitate the margining of stock futures as 
futures contracts, recognizing that the economic function of a 
futures contract is not to acquire ownership of the stock, but 
rather to act as a hedging vehicle.
    The Chicago Board of Trade, along with all other U.S. 
exchanges, vigorously competes in the international 
marketplace. We ask Congress and this Committee to remain 
cognizant of the continued need to reduce unnecessary 
regulatory complexities that inhibit the ability of U.S. 
exchanges to compete effectively with their counterparts around 
the world.
    We also ask the Congress to give the CFTC the tools 
necessary to prevent peripheral scandals that have the 
potential of harming the U.S. derivatives industry.
    Once again, the CBOT thanks the Committee for this 
opportunity and I am happy to answer any questions the 
Committee may have.
    Chairman Shelby. Thank you.
    Mr. Damgard.

                  STATEMENT OF JOHN M. DAMGARD

            PRESIDENT, FUTURES INDUSTRY ASSOCIATION

    Mr. Damgard. Good morning, Mr. Chairman. Thank you, Senator 
Crapo, for inviting me to testify.
    I am John Damgard, President of the Futures Industry 
Association. The FIA's regular members comprise the largest 
futures brokerage firms, called Futures Commission Merchants, 
and its other members come from all segments of the futures 
industry. Thank you very much for the opportunity to present 
our views.
    Both the CFMA and the CFTC have worked well, and we believe 
the CFTC should be reauthorized. Only two areas of the CFMA 
need discussion: Retail FX transactions and security futures. 
For retail FX, the issue is sales fraud. In recent years, the 
CFTC has devoted considerable resources to prosecuting firms 
for defrauding the retail public in FX transactions. Some have 
sought a major change in this area, which would grant the CFTC 
general jurisdiction over nonfutures FX transactions. They 
argue that because the CFTC lost one case, the Zelener case, 
the CFTC needs general jurisdiction over nonfutures retail FX 
or even other commodities.
    FIA believes that would be a serious mistake. Just as the 
SEC was set up to regulate securities, the CFTC was set up to 
regulate futures. Expanding the CFTC's regulatory mission to 
nonfutures would be unwise and unnecessary. A better approach 
would be to address the fraud problem head on. In my testimony 
last March, FIA recommended that Congress grant the CFTC 
special fraud authority to move against unregulated firms that 
purvey retail FX transactions even if not futures. We still 
support that reform.
    FIA also recommends making changes to CFMA's provisions for 
retail FX futures. As detailed in my written statement, FIA 
supports prohibiting shell FCM's from becoming qualifying 
counterparties to retail customers, registering those who 
solicit orders from retail customers, imposing special net 
capital levels on FCM's whose affiliates seek to qualify as 
counterparties, subjecting those qualifying affiliates to CFTC 
recordkeeping and reporting rules, and expanding the CFTC's 
enforcement powers to cover principal to principal fraud.
    These important measures should give the CFTC the tools to 
curb the retail fraud scams that we have seen in recent years.
    In security futures, FIA has one overriding goal. We want 
U.S. investors to have access to a full menu of innovative 
liquid and capital efficient markets for managing their 
security price risk. Allowing portfolio margining for U.S. 
security futures, that is, futures on individual stocks and 
narrow-based security indexes, would serve that goal. It is 
true that the U.S. securities futures markets are not as well-
developed as foreign markets. But portfolio margining will help 
our markets grow through more efficient use of trading capital 
under well-tested systems long in use by the futures industry.
    We strongly urge the CFTC and the SEC to allow portfolio 
margining to be implemented without delay for security futures.
    FIA also would encourage the SEC to move quickly on similar 
systems for the cash and options markets that it regulates. 
Anything that this Committee could do to help bring about 
portfolio margining would be grately appreciated.
    Foreign security futures products is another area where 
congressional attention is warranted. Right now U.S. 
institutional investors are prohibited from trading foreign 
security futures products. CFTC and the SEC could lift this 
ban, but thus far no action has been taken. The result is that 
U.S. investors, including Federal Government employee pension 
funds, earn different and usually lower rates of return than 
their foreign counterparts who do have access to these foreign 
security products. Again, we ask for the Committee's help to 
rectify this disparity.
    This handicap could also be reduced if the CFTC and the SEC 
adopted a targeted criteria for determining when foreign 
security indexes are narrow or broad. If an index is broad-
based and the subject of a futures contract, it may be traded 
by U.S. investors; if narrow-based it may not be. Many diverse 
foreign security indexes, some with over 200 stocks, would not 
qualify under the CFMA's narrow-based index criteria. Yet many 
of these foreign indexes pose no threat of being used as a 
surrogate for trading an individual stock. This Committee could 
encourage the CFTC and the SEC to address this issue so that 
U.S. investors will have access to more products for managing 
their foreign equity price risk.
    Thank you for your time and attention to these issues, and 
we look forward to working with the Committee on this 
legislation.
    Chairman Shelby. Thank you.
    Mr. Duffy.

           STATEMENT OF TERRENCE A. DUFFY, CHAIRMAN,

           CHICAGO MERCANTILE EXCHANGE HOLDINGS, INC.

    Mr. Duffy. Thank you, Chairman Shelby and Senator Crapo. I 
am Terry Duffy. I am the Chairman of Chicago Mercantile 
Exchange Holdings, Incorporated, which owns and operates the 
largest U.S. futures exchange, and by most standards, the 
largest futures exchange in the world.
    This hearing permits the Committee to consider whether the 
Commodity Futures Modernization Act of 2000 has lived up to its 
promise. I want to use this time to explain the CME's 
suggestions for extending the positive impact of CFMA.
    First, I urge this Committee to direct the SEC and the CFTC 
to exercise their statutory authority, to permit U.S. futures 
markets to implement genuine risk-based margining for 
securities futures products and to fully participate in the 
worldwide market for futures trading in broad-based indexes.
    Second, we urge that the Commodity Exchange Act be amended 
to stop the explosion of off-exchange, retail futures fraud, 
and to close the Zelener loophole, which is being exploited to 
avoid CFTC jurisdiction. I am confident that our solutions 
cause no harm, competitive or otherwise, to any customer or to 
the marketplace itself.
    In my Congressional testimony of June 2003, I characterized 
single-stock futures as the CFMA's unfulfilled promise. I am 
sad to say what was true then remains so even today. The 
success of single-stock futures in European markets proves the 
value of the product. In this country, inter-exchange 
competitive concerns, combined with regulatory turf contests, 
largely mitigated the hope for this product long before it was 
launched. The regulatory system that has slowly evolved between 
the SEC and the CFTC has not addressed key issues. Several of 
the regulations that have been produced thus far are overly 
burdensome or inflexible.
    We are not asking to undo the CFMA. We are only asking that 
the CFTC and the SEC be directed to do exactly what was 
contemplated by Congress when the CFMA was enacted. That is to 
jointly issue regulations to permit risk-based portfolio 
margining. This will put U.S. markets on par with financially 
sophisticated markets throughout the world. No one disagrees 
that risk-based margining is the world standard.
    Any opposition to CME's proposal is based on ill-conceived 
notions of competitive parity. This claim is baseless. The 
average daily trading volume on options exchanges is 5 to 6 
million contracts per day. One single-stock futures exchange 
has already failed, and the other trades about 6,000 contracts 
per day. The opponents of relief want Congress to suppress a 
potential competitor because they have been unable to get 
regulatory relief. The CME does not oppose equivalent relief 
for the securities options exchanges.
    The CFMA defined one class of broad-based security indexes 
and left it to the agencies to jointly create an inclusive 
definition. The agencies have not done so. As a result, futures 
exchanges and U.S. Futures Commission Merchants have been 
unable to provide their customers with broad-based indexes on 
U.S. debt obligations, foreign debt obligations, and foreign 
equity securities.
    The CFTC, the futures exchanges, and FIA are in agreement 
in principle that this should be fixed now. Our proposal 
requires the agencies to adopt a broad-based index definition 
that will fill in the statutory void that the agencies left 
unattended for the past 5 years.
    The last point I want to talk about is off-exchange, retail 
futures trading. Off-exchange promotion of futures contracts to 
retail customers is a continuing source of harm to consumers. 
Just over the last 4 years of the CFMA, the CFTC has brought 79 
enforcement actions involving 267 companies and individuals for 
illegal retail foreign exchange trading. The CFTC estimates 
that these cases involve trading with over 20,000 customers, 
and resulted in over $260 million in penalties and restitution 
orders. This is just the tip of the iceberg.
    The massive continuing fraud committed against retail 
customers in the OTC foreign exchange market, and the recent 
unfortunate decision of the Seventh Circuit Court of Appeals in 
CFTC v. Zelener, compel this industry to reexamine the public 
policy of how the CFMA addresses retail foreign exchange 
futures and the threshold definition of what transactions 
should be subject to CFTC jurisdiction. The Zelener case held 
that the CFTC jurisdiction is avoided if the contract does not 
guarantee a right of offset. This was a surprising result since 
futures contracts traded at our exchange do not guarantee a 
right of offset.
    The bucket shops have already figured out that the 
rationale of the Zelener opinion can apply to commodities other 
than FX. Heating oil and unleaded gas appear to be the hot 
targets as a result of the price run-ups in those commodities. 
How soon will it be before the CFTC's jurisdiction and its 
retail consumer protections are reduced to irrelevance?
    Our Zelener fix puts the crooks out of business before they 
take the money and run, and it protects the public against the 
fraudulent oil and orange juice scams that will replace 
currency scams if the legislative response is limited to 
foreign exchange scams. It does not interfere with any 
legitimate business operation. CME believes that the law should 
be returned to its pre-Zelener status. A futures contract has 
always included leveraged, speculative contracts for future 
delivery sold to retail customers. All pertinent registration 
and other customer protection provisions should apply to such 
transactions.
    Congress faces the challenge of adapting the CEA to an 
ever-changing world to assure the efficiency, competitiveness, 
and fairness of U.S. futures markets.
    The CME looks forward to working with the Banking Committee 
to produce legislation that meets that objective. I thank you 
very much for your time.
    Chairman Shelby. Thank you, Mr. Duffy.
    Mr. Frucher.

                 STATEMENT OF MEYER S. FRUCHER

             CHAIRMAN AND CHIEF EXECUTIVE OFFICER,

                  PHILADELPHIA STOCK EXCHANGE

    Mr. Frucher. Thank you very much, Mr. Chairman, Senator 
Crapo. Thank you very much for having this hearing. This is 
very important to the industry.
    I testify today, not just on behalf of the Philadelphia 
Stock Exchange, but also on behalf of the five other U.S. 
securities markets that trade options, namely the American 
Stock Exchange, the Boston Options Exchange, the CBOE, ISE, and 
the Pacific Exchange, as well as on behalf of our 
clearinghouse, the Options Clearing Corporation.
    Securities options, that is, options on individual stocks 
and on broad-based stock indexes, play an important role in the 
U.S. financial system. U.S. options exchanges offer market 
participants a liquid, low-cost opportunity to hedge positions 
held in the cash markets. Market participants have been 
embracing exchange traded security options in record numbers in 
recent years, and daily trading volumes have roughly doubled 
from 2000 to 2005, and are up roughly 20 percent from 2004 to 
2005 alone.
    U.S. options exchanges operate in a highly competitive 
marketplace. Unlike the market for trading stocks, no options 
exchange enjoys a dominant market share, let alone anything 
like the market share the New York Stock Exchange commands in 
its listed stocks. The markets for trading individual equity 
options have, for several years now, been characterized by 
cross-listing of products that are traded on multiple 
exchanges. The markets for trading futures, in contrast, are 
marked by monopoly products traded on single exchanges. 
Competition is a fact of life among the options 
exchanges, and we accept it as a fact of life between the 
options exchanges and exchanges that trade other products.
    Since enactment of the Commodity Futures Modernization Act 
of 2000, the options exchanges have faced competition from a 
new product, security futures, or futures on individual stocks 
and on narrow-based stock indexes. Prior to 2000, Congress had 
prohibited trading in these instruments, in large part due to 
the concerns about the adequacy of regulating them strictly as 
futures.
    The U.S. options exchanges did not object to the 
introduction of security futures. We are used to competition. 
But we did urge Congress to ensure that they are regulated in a 
manner that provides a level playing field for security 
options. So did the President's Working Group. Congress agreed 
that security futures contain elements of both securities and 
futures and provided a role for the SEC and the principles of 
securities regulation in the oversight of these products.
    This was the right policy in 2000 and is the right policy 
today. It has allowed a new product to develop, facilitating a 
market participant's ability to engage in hedging and other 
strategies. At the same time, it has prevented regulatory 
arbitrage. And the way you conducted your hearings in 2000 
eliminated the need for legislative arbitrage, protected 
investors, reduced risk in the financial markets as a whole.
    The U.S. options exchanges urge Congress to maintain the 
parity of treatment for security options and security futures 
that was enacted in the CFMA. Any legislation should preserve 
parity, not just on day one, but going forward as well. It 
should not authorize any one exchange or regulator to end this 
parity in the future.
    The U.S. futures exchanges advocate ending that parity in 
the crucial area of customer margin. They propose allowing the 
futures exchanges total discretion to set margin requirements 
for security futures. This approach is contained in the bill 
reported by the Senate Agriculture Committee. Should this bill 
become law, it would put Congress in the position of picking 
winners and losers in the marketplace, exactly what Congress 
sought to avoid in 2000.
    The U.S. options exchanges have an alternative approach 
that would preserve the consistent treatment endorsed by 
Congress while ensuring appropriate margin levels for both 
products. Under this approach, Congress would direct the SEC 
and CFTC to adopt joint rules permitting the use of portfolio 
margin for securities futures and also to direct the SEC to 
adopt a consistent rule for securities options. I think as a 
consequence of today's hearing, that position was endorsed 
today by the SEC.
    This would allow for more efficient margin treatment than 
the current approach used for the two products, while 
maintaining an adequate protection against risk. We have shared 
this approach with the SEC, the CFTC, and look forward to its 
consideration by the President's Working Group as the process 
of reauthorization moves forward.
    I also would like to commend you, Mr. Chairman, and this 
Committee, for including the President's Working Group in this 
very key and important dialogue on this product, and I think it 
is important that they be part of the process.
    I will conclude by noting that the SEC recently authorized 
portfolio margining for a narrow range of products and a narrow 
category of market participants. Even this relatively modest 
step 
followed 3 years of consideration by the SEC following 
submission of a formal proposal.
    While I appreciate the need for careful review by the SEC 
of exchange rulemaking, that process must not move so slowly as 
to stifle innovation. I have said this to you before in another 
context. The 9-month period specified for rulemaking in our 
proposal is sufficient to ensure the legitimate regulatory 
concerns are addressed, while allowing the exchanges to move 
forward. The SEC testified on the first panel that the agency 
will move forward on this issue, and I believe they will.
    Thank you again, Mr. Chairman. I would be happy to answer 
questions.
    Chairman Shelby. Mr. Lackritz.

                   STATEMENT OF MARK LACKRITZ

           PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

    Mr. Lackritz. Thank you, Mr. Chairman and Senator Crapo. I 
appreciate the opportunity to testify today on S. 1566 and to 
articulate SIA's concerns about a couple provisions in this 
bill. I would also like to thank you, Mr. Chairman, for 
convening this hearing and for taking the interest in these 
particular provisions that are of significant importance to the 
securities industry and to the capital markets.
    We strongly support reauthorization of the CFTC this year, 
but we do not support certain provisions that go beyond the 
CFTC reauthorization and would amend the Commodity Exchange Act 
and the recently enacted modifications to the CEA codified in 
the CFMA in 2000.
    We are deeply concerned with two principal areas in S. 
1566: First, the provisions addressing portfolio margining; 
and, second, the scope of the language addressing the so-called 
Zelener decision and related foreign exchange issues, including 
the provisions to limit the scope of permissible activities of 
broker-dealers.
    We support the agency rulemakings and the SRO rule 
approvals under the CEA and the Securities Exchange Act of 1934 
that would promote the adoption of portfolio margining. Any 
portfolio margining legislation, however, should ensure that 
all financial instruments--and here we are not talking about 
just futures or single stock futures or options, but all 
financial products--should be included in a manner so it does 
not result in margin-based competitive disparities.
    The conventional approach to margin setting is called 
strategy-based, and its primary deficiency is that only certain 
precisely specified positions are treated as offsets. 
Combinations of financial instruments that act as hedges to 
reduce risk are just not recognized unless they appear on the 
list of acceptable offsets. But it is simply impossible for a 
strategy-based system to accurately capture all the different 
possible combinations of financial instruments that might 
change the risk of a given portfolio. That could only be done 
through a model to perform the necessary number crunching. So 
strategy-based margining creates two significant problems: 
First, it penalizes customers for failing to link their margin 
requirements to the true risk of loss in their portfolios; and, 
second, U.S. financial firms can and, unfortunately do lose 
business where customers are able to invest with financial 
services firms, often offshore, that are permitted to calculate 
margin on a portfolio basis.
    An ad hoc committee of the SIA has been working with the 
SRO's and the SEC to expand the use of portfolio margining, 
really across the board, and we hope a proposal we recently 
submitted to the New York Stock Exchange will be approved in 
the near future.
    We, therefore, oppose the provisions that are in S. 1566 
currently. They are addressed solely to portfolio margining for 
security futures. These provisions are way too narrowly drawn, 
creating the potential for inappropriate competitive 
disparities across competing product markets. We would support 
legislation, however, that the SEC and CFTC agree would 
facilitate adoption of SRO rules implementing portfolio 
margining.
    With respect to broker-dealer affiliates, we strongly 
oppose the provisions of S. 1566 that would cut back 
significantly existing provisions of the CFMA that permit SEC-
registered broker-dealers and their material affiliates to 
conduct over-the-counter foreign exchange futures activities 
with counterparties that do not qualify as eligible contract 
participants. It is our understanding that these provisions are 
intended to deal with a practice in which firms establish and 
register shell FCM's for the purpose of permitting under-
capitalized and unregulated affiliates, also known as bucket 
shops, to engage in retail over-the-counter foreign exchange 
futures activities.
    We emphasize that affiliates of SEC-registered broker-
dealers where most U.S. broker-dealer holding company groups 
conduct their over-the-counter foreign exchange activities are 
well-capitalized and regulated. Moreover, there is no history 
of foreign exchange-related abuse occurring in the context of 
SEC-registered broker-dealers, their affiliated entities, or 
the affiliated broker-dealer's personnel. Nor is there any 
reason to believe or suspect that such a problem will arise in 
the future. Requiring reorganization of this business line and 
registration of personnel would be both costly, burdensome, and 
entirely unjustified by the record.
    With respect to retail foreign exchange fraud, Mr. 
Chairman, we understand that retail fraud in connection with 
speculative foreign exchange activities continues to be 
problematic, but we do not agree that there is a compelling 
need for modifications to the CEA to address these problems. We 
believe that the Zelener decision was correctly decided based 
on the facts that were in evidence, and we do not agree with 
claims that the Zelener decision will lead to a chamber of 
horrors or similar decisions in cases involving retail 
transactions in physical commodities that typically require 
costly, complex, and burdensome delivery mechanisms. We 
strongly support efforts to root out fraud against retail 
investors, but we believe the provisions of S. 1566 are overly 
broad and could well result in unintended adverse consequences. 
We are encouraged by the agreement in principle by the 
President's Working Group and look forward to seeing that 
specific language.
    Finally, we would add that CFMA resolved many significant 
issues in an innovative fashion and has enabled the U.S. 
derivatives market to provide important benefits for the U.S. 
economy. The products subject to the CEA, as well as those 
covered by the exclusions from the CEA are complex and 
extremely difficult to define. History has shown repeatedly 
that a lack of clarity under the CEA can produce significant 
adverse consequences. As such, we urge you to proceed 
cautiously in considering provisions that go beyond the CFTC 
reauthorization. We are eager to continue working with you, Mr. 
Chairman, your Committee, and staff to achieve your legislative 
objectives in a constructive manner that preserves the many 
benefits of the CFMA.
    Thank you very much.
    Chairman Shelby. Mr. Pickel.

                 STATEMENT OF ROBERT G. PICKEL

        EXECUTIVE DIRECTOR AND CHIEF EXECUTIVE OFFICER,

        INTERNATIONAL SWAPS AND DERIVATIVES ASSN., INC.

    Mr. Pickel. Mr. Chairman and Senator Crapo, I am the 
Executive Director and Chief Executive Officer of the 
International Swaps and Derivatives Association. I appreciate 
the Committee's invitation to appear today to present ISDA's 
views on proposed legislation to reauthorize the Commodity 
Futures Trading Commission.
    ISDA is an international organization, and its more than 
650 members in 48 countries include the world's leading dealers 
in and many users of OTC derivatives. We welcome this 
Committee's interest in the CFTC reauthorization legislation.
    Throughout this reauthorization process, we have worked 
closely with three other financial services trade associations. 
Two of these--the SIA and the FIA--are on our panel this 
morning. The third--the Bond Market Association--has filed a 
written statement for the record and joins in my statement 
today.
    For the reasons explained in our written statement, our 
experience since 2000 confirms that Congress achieved its 
objectives of providing legal certainty and regulatory clarity 
for OTC derivatives transactions in a manner that has reduced 
systemic risk and encouraged financial innovation. The 
carefully crafted exclusions and exemptions in Section 2 of the 
CFMA are critical to that legal certainty.
    From all indications, the CFMA has been a broad-based 
success for the capital markets generally. ISDA commends the 
CFTC for the effective manner in which it has implemented the 
CFMA, and we will continue to actively support passage of the 
legislation to reauthorize the CFTC.
    As discussed in detail in our written statement, ISDA 
believes there is no compelling need to make substantive 
changes to those portions of the CFMA governing OTC 
derivatives. In considering any amendments, we urge the 
Committee to take a cautious approach. If any such amendments 
are agreed to, they should be narrowly targeted to specific 
policy problems requiring a legislative 
response and carefully crafted to avoid unintended collateral 
consequences that could undermine the legal certainty provided 
for OTC derivatives by the CFMA.
    Let me illustrate our concerns by references to proposals 
to amend the so-called ``Treasury Amendment,'' which is the 
core provision of the CFMA intended to provide legal certainty 
for OTC derivatives based on foreign currency. All of these 
amendments seek to address the decision in Zelener. In that 
case, the U.S. Court of Appeals for the Seventh Circuit held 
that the foreign exchange contracts before it were not futures 
contracts and that the CEA's antifraud rules were, therefore, 
not applicable. The proposed amendments, including that 
approved by the Agriculture Committee, seek to address the 
Zelener issue by giving the CFTC for the first time 
jurisdiction over certain off-exchange contracts that are 
neither futures nor options. In ISDA's view, the Zelener case 
was correctly decided based on the facts before the court. It 
does not preclude the CFTC from successfully bringing similar 
cases in the future, and we heard this morning that the CFTC 
continues to pursue those cases. And it does not provide a road 
map for an end run around the CEA that can be exported to 
physical commodities such as heating oil and grain.
    ISDA does not believe that it has been demonstrated that 
legislation is necessary to address the so-called ``Zelener 
problem.'' Moreover, there is a significant problem that 
amendments will be so broad they will have collateral 
consequences that will undermine the legal certainty provided 
by Congress in 2000. Finally, Congress needs to carefully 
consider extension of the CFTC's jurisdiction to new classes of 
contracts and how that could hamper the Commission's ability to 
carry out its core mission of supervising the Nation's futures 
exchanges.
    We stand ready to work with the relevant committees of 
Congress, including this Committee, and the members of the 
President's Working Group as legislative proposals are 
developed and considered. We believe, however, that there 
should be a significant burden placed on those who seek to 
amend what all agree is a highly effective and successful piece 
of legislation--the CFMA.
    I thank you for this opportunity to present our views, and 
I am prepared to answer any questions you may have.
    Chairman Shelby. Mr. Roth.

                  STATEMENT OF DANIEL J. ROTH

             PRESIDENT AND CHIEF EXECUTIVE OFFICER,

                  NATIONAL FUTURES ASSOCIATION

    Mr. Roth. Thank you, Senator. My name is Dan Roth, and I am 
the President of the National Futures Association. NFA is the 
industry-wide self-regulatory body for the futures industry. 
Our only mission really is customer protection, and I 
appreciate the opportunity to appear here today to talk about 
an issue that is directly related to customer protection, and 
that is the Zelener issue. If possible, I would like to take a 
few minutes and discuss the Zelener issue from a little bit of 
a historical perspective.
    When NFA began operations back in 1982, the futures 
industry, frankly, was plagued with a pretty large-scale sales 
practice problem. There were a lot of boiler rooms. They were 
very big, and they were very brazen in their fraud.
    Since 1982, when we began operations, volume on U.S. 
futures exchanges has grown by well over 1,200 percent. During 
that same period of time, customer complaints have actually 
dropped by over 75 percent, and that dramatic drop was not an 
accident. It was the result of a lot of hard work and a very 
close working relationship between the CFTC and NFA to crack 
down on those boiler rooms.
    Unlike Mr. Pickel, I am concerned that the impact of the 
Zelener decision could be to return us to the bad old days of 
the wild, wild West because I do think it provides something of 
a road map to the fraudsters on how to avoid CFTC jurisdiction. 
And let me see if I can explain that.
    Prior to Zelener, the main case dealing with the definition 
of ``futures contracts'' for retail customers was the Co Petro 
decision, which was decided in 1982, and there the court 
rejected the idea of any bright-line test or definition for 
``futures contract,'' but they said we have to look at the 
underlying purpose of the transaction, and they found that 
where the contract for future delivery is being marketed to 
retail customers as a speculative investment vehicle and those 
retail customers have no expectation of delivery, then that was 
a futures contract subject to the CFTC's jurisdiction.
    In Zelener, you basically had all of those elements 
present, but the court there found that the contracts were not 
futures contracts because, instead of focusing on the 
underlying purpose of the transaction, they focused primarily 
on the written contract between the parties. And because there 
was no guaranteed right of offset, the court found that they 
were not futures.
    Now, I understand that the President's Working Group agrees 
that Congress should do something to address the Zelener issue, 
and that is good. I understand that their proposal will be 
limited in scope to the forex area, and I am sure that their 
reasoning is that the forex is where the problem is so that is 
where the solution should be. And that sounds pretty 
reasonable. But I think that reasoning ignores two important 
factors.
    First is the language of the decision itself because there 
is nothing in the Zelener decision which limits its application 
to forex products. If a fraudster can set up a Zelener-type 
contract for forex and avoid the CFTC's jurisdiction, he can do 
the same thing with a Zelener contract for heating oil.
    Second, I think the narrow an approach ignores the history 
of sales practice problems in the futures industry because the 
fact is that in our 20 years of experience, frankly, what 
boiler rooms love to sell are products that retial customers 
have day-to-day experience with. So that for years, I mean, the 
problems tended to be sugar futures, and then it was orange 
juice, and then it was metals, and then it was unleaded gas, 
and then it was heating oil. But it was always something that 
the customers could relate to based on their day-to-day 
experience, and, frankly, forex does not fit that mold at all. 
Forex became the scam of choice only when it became recognized 
as an unregulated niche. And that really happened in a 1996 
decision called Frankwell Bullion where the court found that 
CFTC had no jurisdiction over retail forex transactions. That 
is when forex became the unregulated niche. That is when the 
fraudsters started selling forex, and that is when our problems 
began to mushroom. Congress tried to address that in the CFMA, 
but I think their efforts were largely negated by the Zelener 
decision.
    I think the problem I have with the so-called ``narrow 
fix'' is that I do not think it is a fix at all. It does not 
really close the unregulated niche. It just shifts it. It seems 
to tell the fraudsters that they cannot sell Zelener contracts 
for forex, but it could suggest that they can sell those types 
of contracts for heating oil, unleaded gas, or any other 
product and do so outside the regulatory jurisdiction of the 
CFTC. That is basically an invitation to the fraudsters, and if 
some people feel that they will not take up that invitation, 
well, I respectfully disagree.
    The better approach, I think, is not to expand the CFTC's 
jurisdiction, which is, frankly, what I think the Senate Ag 
Committee bill did. I do not think the right solution is to do 
anything new. I think the right solution is to do something old 
and tried and true and tested, and that is to codify the Co 
Petro decision, and that is what our proposal, which is 
attached to my testimony, would basically do.
    I see the red light is on, so let me wrap up by just saying 
that I believe that our proposal would not in any way impose a 
rigid definition of futures contract. It would not disturb 
jurisdictional boundaries between agencies. It would not 
implicate any forward contracts or spot contracts. It would not 
interfere with otherwise regulated entities and their ability 
to sell retail forex. It would simply codify the Co Petro 
decision, which stood for over 22 years and which gave the 
Commission ample authority to protect retail customers without 
inhibiting legitimate business activity.
    I know there is a fair number of people that disagree with 
me, Senator, and you heard from a lot of them today. And I kind 
of expect I will be getting fewer Christmas cards this year. 
But the fact is that----
    Chairman Shelby. You will have fewer to open, won't you?
    [Laughter.]
    Mr. Roth. The fact is that codifying the Co Petro decision 
I think is the right response to the Zelener issue, and if 
Congress does, in fact, adopt the narrow approach, I would at 
least hope that there would be a firm commitment that we would 
not have to wait 5 years until the next reauthorization process 
to address this issue, to revisit this issue and to get it 
right, because I would hope that when the problems are 
discussed become more apparent, then we could revisit the 
issue--if, in fact, Congress takes the narrow approach, which I 
hope they will not.
    Thank you, Senator. I would be happy to answer any 
questions.
    Chairman Shelby. Thank you.
    During the first panel of witnesses--most of you were here, 
I believe--they discussed whether the current regulatory regime 
fits the realities of the marketplace where futures and other 
financial products are virtually indistinguishable and are 
traded by affiliates of the same broker-dealers. I would like 
each of you briefly to address whether the current regulatory 
regime should be modernized to reflect market realities. Does 
the jurisdictional line between the SEC and the CFTC still make 
sense? This is central to all of this. Mr. Carey, just briefly.
    Mr. Carey. In light of the----
    Chairman Shelby. Yes or no.
    Mr. Carey. Yes or no? I guess----
    Chairman Shelby. Well, and a few more words.
    [Laughter.]
    Mr. Carey. Well, I think while we are here to express 
frustration on certain parts of CFMA, the fact of the matter is 
I would be hard pressed to argue for a different regulatory 
scheme after the growth that we have witnessed over the last 5 
years since its passage. So I would have a hard time supporting 
a wholesale change to the regulatory framework.
    Chairman Shelby. Mr. Damgard.
    Mr. Damgard. I would agree with Mr. Carey. I think our 
markets globally have probably tripled in the last 3 years, and 
I think from the standpoint of modernization, thanks to this 
Committee and the Ag Committee, we did a lot of that work for 
you 5 years ago.
    I do think there is a difference. I mean, futures markets 
have historically been institutional markets, and the mission 
of the CFTC has been to protect the market. The regulatory 
regime has worked very well. And I think that there is a lot of 
credit to be spread around on the basis of the success of these 
two exchanges and other exchanges around the world.
    The SEC obviously has a different role; its regulatory 
regime is centered on customer protection rather than market 
protection. And those two missions are at least different 
enough so that I think the current regulatory scheme serves at 
least our market pretty well. We have seen other countries that 
have combined their regulators, particularly in Great Britain. 
It is awfully difficult to pass rules that are going to work 
across the board. One shoe really does not fit all.
    Chairman Shelby. Mr. Duffy.
    Mr. Duffy. I actually think that Mr. Damgard and Mr. Carey 
said it all. I definitely agree with their comments. I do not 
believe that these agencies at this time should even be 
remotely considered for being put together. I think that our 
industry has been able to prosper and grow. I think Mr. Roth 
cited some incredible growth numbers over the last several 
year.
    Chairman Shelby. Is the market ahead of the regulatory 
regime?
    Mr. Duffy. Is the market ahead of the regulatory regime?
    Chairman Shelby. Yes.
    Mr. Duffy. No.
    Chairman Shelby. You do not think so?
    Mr. Duffy. No.
    Chairman Shelby. Mr. Frucher.
    Mr. Frucher. What an extraordinarily prescient question. I 
think it goes right to this question of regulatory arbitrage. 
What you see here is the futures industry trying to move into, 
legitimately, in a competitive way, a realm that had 
traditionally been on the securities side of the business.
    Chairman Shelby. Eighty percent, more or less, of the 
futures financial products perhaps?
    Mr. Frucher. That is correct. And I think your point is 
certainly an open question that requires a look-see. We talk 
about the need for modernization here or change in the margin 
requirements because, ``this product,'' which is really a 
securities-related product, is not competitive. But the fact is 
this product has not been successful and it really has not been 
successful in Europe. It has been successful in parts of 
Europe--Spain, for example--and it has been successful in India 
where the securities markets are not particularly efficient. 
And what you have now is a world that is moving away from 
floor-based exchanges into electronic markets. Those electronic 
markets are going to be traded on one screen--equities, 
options, and equity futures. And you are going to trade 
Microscoft three different ways. And if you are going to have 
regulatory arbitrage between these products, I think you are 
opening up a serious Pandora's box. Who knows? These people may 
be trading Pandora's box futures in the future, because I think 
that this question that you have before you today opens up this 
question.
    Chairman Shelby. Mr. Lackritz.
    Mr. Lackritz. Mr. Chairman, I would echo a lot of what Mr. 
Frucher has just said. I think we have a historical anomaly 
here where we have a futures market that began as an 
agricultural futures market evolving into basically a financial 
futures market that is inextricably linked with other financial 
markets. And I think there is no question about the fact that 
the technology is driving the products and the services into 
convergence. So, I think it clearly deserves a very careful 
look.
    I would suggest as well that as you look at other 
jurisdictions around the world, they do organize this 
differently in terms of their regulatory oversight. And some 
have been more successful, some have been less successful. But 
at the same time, this clearly deserves a careful look. It is a 
complicated area, and it is one of those areas that can absorb 
huge amounts of time and energy of the Committee. But at the 
same time, it is very important and I think very appropriate to 
take that look.
    Chairman Shelby. Mr. Pickel.
    Mr. Pickel. I think what we have focused on is the 
underlying risk and how it gets managed. We have developed, 
working with our membership----
    Chairman Shelby. That is central, is it not, the underlying 
risk?
    Mr. Pickel. That is right. We have developed an extensive 
documentation structure, market practices, private discipline 
in the derivatives business, the OTC derivatives business, that 
has served the market extremely well. And so it manages the 
risks that you might manage in the cash markets or on the 
futures exchanges, but it does it through this private 
discipline that has been developed, and we think that is a very 
important feature of that particular product.
    Chairman Shelby. Mr. Roth.
    Mr. Roth. Senator, the only point I would make would be 
that it is an interesting question to consider, but in 
considering it, one should never underestimate the value of 
having a regulatory agency which is devoted to futures, which 
has deep expertise in understanding these markets and can be 
responsive to its regulatory challenges.
    Chairman Shelby. But the regulatory regime has to 
understand the very complicated products as they evolve, 
doesn't it?
    Mr. Roth. That is exactly right, and I think that there is 
a real value to having that expertise reside in one agency that 
focuses on futures products, and it has been a tremendous 
benefit to the futures industry over the past--well, since the 
CFTC was created in 1974.
    Chairman Shelby. The representatives of the President's 
Working Group that you heard recommended basically that 
Congress respond to the Zelener decision by adopting a narrow 
amendment that addresses only retail foreign exchange products. 
What about this? What is the merit of this recommendation? In 
your view.
    Mr. Carey.
    Mr. Carey. Well, Mr. Chairman, I think that they want to 
keep it specific to forex only, but our concerns are that it 
will spread to other commodities, as was stated so well by 
Chairman Terry Duffy of the Mercantile Exchange, and Dan Roth. 
So these are our concerns. What is the merit of a forex fix? We 
think we will be back for other fixes afterwards.
    Chairman Shelby. Mr. Duffy, do you have a different view?
    Mr. Duffy. No, obviously not. We agree with the President's 
Working Group, what they believe should be done, except that 
the fix does need to extend to other commodities because we 
really cannot draw that line like they can for some reason. We 
can see, like Mr. Roth clearly can see, that scamsters are 
certainly going to go to the product de jour.
    Chairman Shelby. Any of you have a different opinion?
    Mr. Damgard.
    Mr. Damgard. I think the issue here is really the resources 
of the agency. If Congress wants to create another consumer 
fraud agency, they really should reflect on what kind of 
resources are necessary. The CFTC has done an excellent job 
over the last 25 or 30 years nurturing the growth of futures 
markets.
    Chairman Shelby. That has primarily been financial futures 
products, hasn't it?
    Mr. Damgard. That has grown a lot, but there are also 
energy markets and agricultural markets. I mean, the mechanism 
itself has proved to work across the board on financial 
instruments just as easily, as Mark pointed out, originally 
agricultural products.
    Chairman Shelby. Mr. Roth.
    Mr. Roth. With respect to the CFTC's resources, I would 
just point out that the day before the Zelener decision, the 
CFTC had precisely the authority that we are trying to restore, 
and their resources were just fine. In fact, the track record 
that I cited in the decline of customer complaints is largely a 
result of their enforcement efforts. So we are not talking 
about an expansion of CFTC responsibility. We are talking about 
restoring its responsibility. It had the resources necessary to 
do the job very well the day before the Zelener decision, and I 
think it would have the same resources and the same ability 
today.
    Chairman Shelby. Mr. Lackritz.
    Mr. Lackritz. Mr. Chairman, with all due respect to my 
colleagues on the panel, I think that the Zelener case does not 
need to give rise to any new legislative fix. I mean, we used 
to have a saying in law school about bad cases making bad law, 
and this particular case I think was decided exactly right 
based on the facts that were presented by the litigants. The 
Solicitor General of the United States decided not to take it 
up further. So from that standpoint, I think the case on its 
facts before the court was rightly decided.
    In addition, the case is now over a year old, and we have 
no evidence whatsoever that there is a broad problem that has 
resulted as a result of this particular case. So, I do not 
think there is any need for it.
    Chairman Shelby. Mr. Pickel.
    Mr. Pickel. We have advocated the President's Working Group 
getting engaged on this and certainly will take a serious look 
at the proposals that they have developed, but I would share 
Mr. Lackritz's view. The court case basically said that they 
did not have other facts presented to them so that their only 
solution was to look at the written contract. I am sure that 
the CFTC in the cases that it is developing now and bringing in 
a similar fashion is developing that factual record so that if 
they truly believe that those are futures contracts, a court in 
another circuit will find them to be futures contracts.
    Also, the Zelener case did not overrule Co Petro as the 
test for what a futures contract is. It just interpreted based 
on the facts before it whether the elements of a futures 
contract applied in that case.
    Mr. Roth. Senator?
    Chairman Shelby. Go ahead.
    Mr. Roth. Just that with respect to Mr. Pickel's comments, 
the Zelener decision did not explicitly overturn the Co Petro 
decision, but it basically tore its guts out. It did so by 
saying that we are not going to look at the underlying purpose 
of the transaction, we are going to look at the written 
agreement and look and determine whether there is a guaranteed 
right of offset. The notion that the CFTC--God bless the CFTC 
if they can litigate their way out of this thing--but I think 
it is putting an awful lot of chips on a bet that is no sure 
thing, because the idea that they will be able to present 
testimony or evidence of oral representations made by a 
salesman concerning a guaranteed right of offset suggests that 
the salesman cannot be more evasive than the written contract. 
And I have dealt with these salesmen long enough to know that 
that is just not true.
    So, I think the idea of litigating our way out of this 
problem is a pretty difficult and tall order.
    Mr. Frucher. Mr. Chairman, I think your first question, 
interestingly enough, has some relevance here. I think the 
question may not be a single legislative fix on the Zelener 
situation but, rather, to look at the gaps between regulators. 
I think that is a bigger issue, and that is the one I think 
that really deserves to be looked at. There are gaps.
    Chairman Shelby. I am going to defer to my Harvard Law 
graduate, Senator Crapo, right now and see what he says about 
all this.
    [Laughter.]
    Senator Crapo. Mr. Chairman, frankly, the discussion that 
you just caused to happen here answered most of the questions 
that I was going to ask. But one question that I do want to get 
into which takes the current discussion another step further 
is, as I listen to this panel, I can see that Mr. Carey, Mr. 
Duffy, and Mr. Roth would like to have a broader solution for 
the Zelener case. And I am assuming that the others would 
support the more narrow solution. Is that correct?
    Mr. Damgard. That is correct.
    Senator Crapo. I think that the question is, as Mr. Roth 
proposes, that we just go back to the Co Petro case. I think we 
probably all felt that that was the standard before the Zelener 
case was decided, and there is a little dispute among the panel 
members here as to whether the Zelener case is really going to 
be a broad case or not and create a big loophole or not. But 
this notion of a broader legislative solution to the Zelener 
case I think raises a question as to whether Congress will, 
intentionally or not, change that jurisdictional balance that 
the CFMA created. I think that is the real issue here that is 
behind the positions that people are taking.
    And so first I wanted to ask, if I am correct about that, 
if you believe that there is a risk here, that if Congress 
starts going down the road of trying to figure out a broader 
solution than the one that the President's Working Group 
apparently is going to put forward, will that create an 
imbalance--or will that change the balance of jurisdiction that 
we now have that seems to be working so well as a result of the 
President's Working Group conclusions and Congress' actions in 
1999 and 2000?
    Mr. Damgard. I think that is the danger, Senator. We think 
the problem is FX only. What we have proposed I think is a 
scalpel approach to the problem of fraud versus the sledge 
hammer approach. Firms have gotten into the business of doing 
legitimate FX business. Customers now have a choice between 
taking their business to an exchange or doing this business 
with a legitimate counterparty. The problem has been in the 
shell FCM's go in and register without any qualifications at 
all and create an affiliate. We are proposing that we require 
$20 million capital to be an FCM and have the affiliate that is 
actually selling the product register with the CFTC. That gets 
at the FX problem.
    Congress did carve out a special role for the CFTC in the 
2000 CFMA for FX based on the Treasury Amendment, and that is 
why we have looked at this and decided that, from the CFTC's 
standpoint, this grants them all the authority that they really 
need.
    Senator Crapo. Mr. Duffy.
    Mr. Duffy. Senator, right now I believe that the CME's and 
the NFA's approaches obviously are very similar, and we do not 
believe that this affects any legitimate business dealings. For 
anybody that has legitimate, bona fide business in any product, 
our solution does not impede them from doing business, and for 
us to go back to things pre-Zelener we think only makes sense.
    To think that we can fix it in FX and leave it alone in 
other products I think is a little bit naive. In light of what 
is going on in this world, I actually believe exactly what Dan 
is saying, that it is insufficient to merely stop fraudsters 
from conning people for FX and ill-gotten gains. It is going to 
be very easy for these scamsters to pick up the phone and tell 
somebody how they can create 80-percent gains in heating oil in 
the next 3 weeks in light of what is going on. I mean, people 
are actually going to believe that type of sales pitch.
    So we are very concerned about this, and we do believe it 
needs to be a broader fix, and we do not believe our fix 
impedes any legitimate business dealings.
    Mr. Roth. Senator, you are exactly right on what the 
problem is here. I am sick of talking about Zelener. I have 
been talking about it with everybody for a real long time, and 
I have not talked to anybody that disagreed with me that was in 
favor of fraud. No one, none of the people that disagree with 
us are on that point. The trick is trying to restore the CFTC's 
jurisdiction in a way that does not disturb any of the 
jurisdictional agreements that were part of the CFMA. And it is 
not easy, and we have worked very hard to try to craft our 
proposal in a way that does precisely that. We are not aware of 
any way in which we would be infringing on another agency's 
jurisdiction, not aware of any way in which we would be 
infringing on legitimate business activities. But for God's 
sake, if there is something in our proposal that does that, let 
us know and we will find the right words in the English 
language to do it. But we should not have to settle for a 
narrow fix that I think it just shifts the unregulated niche 
and does not really address the underlying problem.
    Mr. Lackritz. Senator Crapo, if I can just address that 
question you raise, I think your concern is exactly right in 
terms of the risk of any kind of broad-based solution, or even 
a narrow-based solution here, which is to alter the balance 
that has worked so effectively as a result of the CFMA in 2000. 
I am pushed back to the old adage that physicians take the 
Hippocratic Oath, which is, ``First, do no harm.'' And given 
the fact that this is one decision in one case where the facts 
were not presented very well in the record, to justify adding 
all of this other legislation and new law and new authority is 
a very slim reed to base that one.
    Mr. Pickel. I think the balance that was struck in the CFMA 
is exactly why the President's Working Group is looking at a 
narrow fix and the FIA has proposed a narrow fix, because there 
was a determination in the CFMA that as it relates to retail 
foreign exchange futures, there would be authority for the CFTC 
to take action. So, I think it is appropriate in that context 
if Congress wants to look at the Zelener case and whether it 
undermined that policy decision. But what we are hearing from 
some of the panelists is a broader opening up of that policy 
decision from 2000, and it does run the risk of upsetting some 
of the balance that you allude to.
    Senator Crapo. Anybody else want to jump in?
    Mr. Frucher. There is only me, and I agree with that side.
    [Laughter.]
    Senator Crapo. I figured that.
    All right. I know that our time is basically gone, and I 
appreciate, again, Mr. Chairman, you letting us do this, and I 
look forward to exploring a lot of this further as we conduct 
our hearing in the Subcommittee.
    Chairman Shelby. Thank you, Senator Crapo.
    Senator Crapo. Thank you.
    Chairman Shelby. I want to thank all of you for appearing. 
We have had a spirited discussion. We think these are very 
important issues that we are dealing with and very complicated 
issues.
    Thank you very much.
    [Whereupon, at 12:13 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR MEL MARTINEZ

    I would like to thank Chairman Shelby and Senator Sarbanes for 
holding this hearing and for their efforts to work in cooperation with 
the Senate Agriculture Committee on the Commodities Exchange Act 
Reauthorization legislation.
    Five years ago, when Congress reauthorized the CEA, the Banking and 
Agriculture Committees worked cooperatively with the input of the 
President's Working Group and industry representatives to develop 
changes to the Commodities Exchange Act that revolutionized over-the-
counter derivatives and security futures products. By providing a 
regulatory regime that recognized that certain financial products have 
attributes of securities and futures and giving the SEC and the CFTC 
shared regulatory authority, the Commodity Futures Modernization Act 
created parody among single-stock futures and options. Industry and the 
President's Working Group agreed that the legislation that was passed 5 
years ago has been very successful. However, the markets are very 
sophisticated and can change overnight. There have been numerous market 
developments, specifically changes in the traditional futures market, 
since Congress last reauthorized the CEA that this Committee needs to 
study and have input on before a final CEA reauthorization bill can go 
to the floor of the Senate.
    Our witnesses today are going to speak on several major issues that 
must be addressed and fully vetted by this Committee. These issues 
include portfolio margining, the definition of narrow-based securities, 
the jurisdiction the CFTC has over retail foreign exchange contracts, 
and broker-dealer registration requirements.
    Before the Senate can reauthorize the CEA for the next 5 years, the 
Agriculture and Banking Committees need to work together as they did 5 
years ago to ensure that all of these issues have been fully explored 
and that parody in the markets is maintained.
    Thank you to our witnesses. I look forward to their testimonies.

                               ----------

                 PREPARED STATEMENT OF RANDY K. QUARLES
 Under Secretary for Domestic Finance, U.S. Department of the Treasury
                           September 8, 2005

    Thank you Chairman Shelby, Ranking Member Sarbanes, and other 
Members of the Committee. I appreciate the opportunity to address 
certain issues that have arisen in the context of Congressional 
reauthorization of the Commodity Futures Trading Commission (CFTC). As 
you know, Treasury is a Member of the President's Working Group on 
Financial Markets and the Secretary serves as the PWG's Chairman. The 
other Members of the PWG are the Chairmen of the Federal Reserve Board, 
the Securities and Exchange Commission, and the Commodity Futures 
Trading Commission.
    In recent weeks, the PWG Members and senior staff have met to 
discuss the effect of last year's 7th Circuit Court of Appeals decision 
in CFTC v. Zelener on the CFTC's antifraud authority, in particular the 
CFTC's ability to address retail foreign exchange fraud by otherwise 
unregulated entities. The proposal that we have produced reflects a 
consensus of the President's Working Group that would make narrow 
changes to the CFTC's antifraud authority to provide the CFTC with 
enforcement tools to combat fraud against retail customers involving 
certain foreign exchange contracts, while preserving the complex and 
delicate compromises reached in the Commodity Futures Modernization Act 
of 2000 (CFMA). In this regard, the President's Working Group opposes 
extension of such provisions beyond retail foreign exchange contracts 
to other commodities.
The Importance of the Commodity Futures Modernization Act of 2000
    The CFMA provided important legal certainty to risk management 
efforts. Businesses, financial institutions, and investors throughout 
the economy rely on derivatives products to protect them from market 
volatility and unexpected events. The ability to manage risks makes the 
economy more resilient to financial and economic events and imbalances, 
and its importance cannot be underestimated. Consequently, the 
President's Working Group believes that major changes to the 
significant modernizations made by the CFMA are not warranted.
    The CFMA modified the Commodity Exchange Act (CEA) so that 
provisions of the Act (including antifraud provisions) apply to foreign 
exchange futures and certain options with retail customers if the 
counterparty is not an otherwise-regulated entity such as a financial 
institution, broker-dealer, Futures Commission Merchant (FCM), or 
insurance company. Those changes were intended to provide the CFTC with 
tools to pursue fraud against retail customers by bucket shops offering 
certain foreign exchange contracts. In the 2004 Zelener case, the 
CFTC's jurisdiction over a retail foreign exchange contract was 
challenged, and the 7th Circuit found that the CFTC lacked jurisdiction 
over the specific contract in question. The President's Working Group 
is supportive of narrow and tailored changes to the CEA that would 
address the Zelener issue.
Pursuing Retail Foreign Exchange Fraud
    The changes we are proposing would be limited to cover only certain 
retail foreign exchange contracts that have been the subject of abuse. 
Any such changes must be very carefully formulated to avoid creating 
barriers or undue burdens for legitimate businesses, undermining legal 
certainty, and creating unintended consequences. As a consequence, the 
President's Working Group opposes the extension of such provisions for 
retail foreign exchange contracts to other commodities, absent a 
clearly demonstrated need and thorough public policy debate.
President's Working Group Consensus on Pursuing Retail Foreign
Exchange Fraud
    At the direction of the President's Working Group, senior staff of 
PWG member agencies have been meeting frequently to discuss and draft a 
legislative proposal to address fraud perpetrated against retail 
customers using futures or futures--like foreign exchange contracts. 
The staff group has drafted language that would accomplish that goal in 
two ways: (1) by applying the CEA or its antifraud provisions to 
certain retail foreign currency futures and certain options, and their 
sales chains, when an FCM is involved; and (2) by applying the 
antifraud provisions to certain retail foreign exchange contracts that 
are not securities, contracts that result in actual delivery within 2 
days, or certain contracts in connection with a line of business, as 
well as to their sales chains.
    The PWG proposal makes futures transactions and certain options in 
foreign currency between a retail participant and a counterparty that 
is not an otherwise-regulated entity--such as a financial institution, 
broker-dealer, or insurance company--subject to the CEA. It also would 
provide the CFTC with antifraud jurisdiction over such retail foreign 
exchange contracts, and the persons who engage in activity in 
connection with those contracts, if the counterparty is an FCM. Any 
person who participated in the solicitation or recommendation of any 
such contract within the FCM sales chain would have to register with 
the CFTC and be a member of a registered futures association, in this 
case the National Futures Association (NFA), the futures industry's 
sole self-regulatory organization. The PWG proposal would preserve the 
exclusion for otherwise-regulated entities crafted by the CFMA.
Retail Foreign Exchange Futures-Like Contracts
    The PWG proposal would make certain foreign currency contracts 
between a retail participant and a counterparty that is not an 
otherwise-regulated entity subject to CFTC antifraud jurisdiction if 
the contracts were leveraged, margined, or financed, except that they 
would not apply to securities, contracts that result in actual delivery 
within 2 days, or certain contracts in connection with a line of 
business. It also would make such retail foreign exchange contracts and 
the persons who engage in activity in connection with those contracts 
subject to the antifraud provisions of the CEA. Additionally, any 
person who participated in the solicitation or recommendation of any 
such contract would have to register with the CFTC and be a member of 
the NFA. Again, this proposal would preserve the previous carefully 
crafted CFMA exclusion for otherwise-regulated entities.
Portfolio-Style Margining Systems
    The CFMA granted to the Board of Governors of the Federal Reserve 
System (Board) the authority to establish margin requirements for 
security futures products. The Board delegated that authority to the 
SEC and CFTC jointly. The SEC and CFTC continue to work toward 
permitting portfolio-style margining models. The Treasury Department 
generally supports the concept of portfolio-style margining systems, 
which increase the efficiency of capital allocation and encourage risk 
management activities. We note that some progress has been made very 
recently and we remain hopeful that the SEC and CFTC can work together 
to facilitate the implementation of such margining systems soon.
Securities Futures Products and Narrow-Based Indexes
    The CFMA created a distinction between broad-based security 
indexes, which have been regulated solely by the CFTC, and narrow-based 
security indexes, which are regulated by the SEC and CFTC jointly. The 
definition of ``narrow-based security index'' seems to have been 
formulated using criteria appropriate for equity securities, as opposed 
to debt securities. The Treasury Department generally supports 
reviewing the appropriateness of certain criteria in the definition of 
``narrow-based security index'' in the context of debt and foreign 
security index futures given that the nature of the underlying 
securities differs from domestic equities.

                               ----------

                PREPARED STATEMENT OF ROBERT L.D. COLBY
          Deputy Director of the Division of Market Regulation
                U.S. Securities and Exchange Commission
                           September 8, 2005

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I am pleased to appear today to testify on behalf of the 
Securities and Exchange Commission (Commission) to express the 
Commission's views on the Commodity Exchange Reauthorization Act of 
2005, S. 1566, reported out of the Senate Agriculture Committee on July 
29, 2005. My testimony will focus on those sections of S. 1566 that 
would affect the regulatory framework for security futures products 
established by the Commodity Futures Modernization Act of 2000 (CFMA), 
which is administered jointly by the CFTC and the SEC.
    The Commission shares the concerns of this Committee's Chairman and 
Ranking Member expressed in their letter of July 20 to the Chairman of 
the Senate Committee on Agriculture, Nutrition, and Forestry regarding 
Section 7 of S. 1566. The Commission supports the expansion of 
portfolio margining to all equity products but believes it should be 
accomplished without undermining the current requirements regarding 
comparability between security futures margin and options margin. The 
Commission also has serious concerns about the amendments in Section 8 
of S. 1566. These changes would remove products currently considered 
securities from Commission oversight, thereby compromising both 
investor protection and market integrity and prohibiting securities 
exchanges from trading such instruments.
    Finally, the President's Working Group on Financial Markets 
(Working Group) has reached an agreement in principle on how to address 
the questions raised in the 7th Circuit's decision in CFTC v. Zelener. 
Commission staff has been working diligently with staff of the other 
members of the Working Group and has reached agreement on how to grant 
the CFTC targeted, additional antifraud authority, and an appropriate 
registration requirement for solicitors of retail foreign exchange 
contracts, that they believe would address Zelener without compromising 
legal certainty or competitive parity.
    On this point, the Commission would especially like to thank the 
CFTC and its staff for their significant contribution to this effort. 
We fully support the CFTC in its efforts to combat retail foreign 
currency fraud.

Security Futures
Current Regulatory Framework
    The Commodity Futures Modernization Act of 2000 (CFMA) was a 
significant legislative achievement. Among other things, it lifted the 
ban on the trading of futures on single stocks and narrow-based indexes 
and established a framework for trading security futures products over 
which the CFTC and the SEC share regulatory authority. Its enactment 
was the product of much effort by Congress, the members of the Working 
Group, and participants in the securities and futures industries. The 
SEC has a significant and legitimate interest in any legislative 
changes that affect the consensus achieved in the CFMA.
    The ban on single stock futures was considered as part of the 
Working Group's 1999 report on OTC derivatives and the Commodity 
Exchange Act.\1\ The report identified several important issues to be 
resolved before trading of single stock futures should be permitted, 
including issues about the integrity of the securities market and 
regulatory arbitrage. In December 1999, various Members of Congress 
requested that the Chairmen of the SEC and CFTC formulate a legislative 
plan for lifting the ban on single stock futures. The legislative 
proposal negotiated by the Chairmen of the two agencies to eliminate 
the ban on single stock futures was transmitted to Congress by the 
Working Group in September 2000. Much of this proposal was incorporated 
into the bill that was enacted by Congress as the CFMA.
---------------------------------------------------------------------------
    \1\ Report of the President's Working Group on Financial Markets, 
Over-the-Counter Derivatives Markets and the Commodity Exchange Act 
(Nov. 1999) (OTC Derivatives Report).
---------------------------------------------------------------------------
    Under the joint regulatory framework established by the CFMA, 
security futures may trade on both futures and securities exchanges, as 
well as derivatives transaction execution facilities and alternative 
trading systems. Moreover, broker-dealers and futures commission 
merchants are both permitted to trade these products and offer them to 
their customers. While both agencies have enforcement and examination 
authority, it is clear that the CFTC is the lead regulator for futures 
markets and futures commission merchants and that the SEC is the lead 
regulator for securities broker-dealers and securities markets. 
Consultation between the two agencies generally is required when 
examinations or enforcement actions are undertaken, and examination 
reports of the lead regulator are to be used whenever possible.
    The SEC staff has worked cooperatively with the CFTC in overseeing 
the market for security futures products. For example, our coordinated 
efforts to fulfill the objectives of the CFMA led to the establishment 
of a memorandum of understanding between the SEC and CFTC under which 
the two agencies agreed to share examination and trading-related 
information, coordinate examinations involving security futures 
activities, and notify each other concerning significant regulatory 
issues in the oversight of security futures products.
    The SEC shares regulatory authority over security futures products 
because such products are surrogates for their underlying securities 
and therefore can be used to engage in frontrunning and manipulation in 
the underlying securities markets. For example, an investor who has 
agreed to sell a block of stock at the closing price could buy futures 
on that stock with the expectation of causing the stock's price to tick 
up at the close. In the same fashion, single stock futures and narrow-
based security index futures have the potential to be used for insider 
trading and intermarket trading abuses, such as frontrunning and market 
manipulation. Because 
security futures are a substitute for their underlying securities and, 
therefore, have the potential to impact those underlying securities 
markets, the CFMA applies the securities laws to these products.
    In addition, unlike many OTC derivative products, which are complex 
and relatively inaccessible to retail investors, security futures are 
readily available to retail investors. An intermediary can offer an 
investor either a security futures product or the securities underlying 
that product, or both. The CFMA recognizes that direct access to audit 
trails, coordinated market surveillance, and inspection authority, as 
well as suitability and customer protection regulation, are all 
necessary to the SEC's ability to regulate effectively and protect 
investors. Finally, the CFMA clearly provided that security futures 
could not be used to avoid the registration and disclosure provisions 
of the Securities Act of 1933 (Securities Act).\2\
---------------------------------------------------------------------------
    \2\ See Section 2(a)(3) of the Securities Act, 15 U.S.C. 77b(a)(3).
---------------------------------------------------------------------------
Changes to Regulatory Framework for Security Futures Products in S. 
        1566
    The SEC believes that, if enacted, the changes to the current SEC-
CFTC regulatory framework that are provided for in Sections 7 and 8 of 
the Commodity Exchange Reauthorization Act of 2005 would disrupt the 
jurisdictional balance and regulatory interaction that Congress, the 
members of the Working Group, and participants in the securities and 
futures industries have worked so hard to achieve, undermining both the 
accomplishments of the CFMA and our ability to protect investors and 
maintain market integrity. The SEC's specific concerns are discussed 
below.

Portfolio Margining
    Importance of Comparability of Margin Requirements. The SEC 
supports the implementation of risk-based portfolio margining for all 
equity products. Under such a methodology, customer margin levels are 
determined by assessing the market risk of a ``portfolio'' of financial 
instruments taken as a whole. The advocates of this approach stress 
portfolio margining results in customer margin requirements that more 
realistically reflect the risk to the broker-dealer of financing the 
customer's securities positions better than the current strategy-based 
methodology, which computes margin requirements for each individual 
position or strategy in a portfolio. Of course, this result depends on 
the accuracy of the models used to calculate risk, under normal and 
extreme market circumstances. While Section 7 of S. 1566 would permit 
security futures margin to be calculated using a portfolio margining 
methodology, it would do so by removing the current requirements 
regarding comparability between security futures margin and exchange-
traded options margin, and eliminate the SEC's role in establishing 
margin requirements for security futures.\3\
---------------------------------------------------------------------------
    \3\ Section 7 of S. 1566 would relieve certain markets trading 
security futures from the requirement to comply with the rules jointly 
adopted by the Commission and CFTC under Section 7(c)(2)(B) of the 
Exchange Act or any SRO rules pertaining to the levels of initial and 
maintenance margin that would preclude the implementation of portfolio 
margining.
---------------------------------------------------------------------------
    Because of the balancing that is required to ensure equivalent 
margin treatment among related instruments, the SEC strongly believes 
that it would not be advisable for Congress to effect these changes to 
the joint regulatory framework for security futures through 
legislation. In fact, the SEC fears that these changes might lead to 
regulatory arbitrage between security futures and options. The 
amendments in Section 7 of S. 1566 would, for example, permit futures 
markets to establish portfolio margin requirements that treat 
unfavorably instruments held in a portfolio that were traded on a 
competing market. The SEC firmly believes that margin requirements 
should not be permitted to be used to gain a competitive advantage for 
securities futures over options.
    The SEC believes that competition should be based on better 
products, services, and prices--not on regulatory differences. To avoid 
this possibility, the CFMA established that the margin requirements for 
security futures shall be no lower than margin requirements for 
comparable options contracts and that margin requirements would be set 
jointly by the SEC and CFTC.\4\ These requirements were included to 
ensure that security futures were not provided a regulatory advantage 
over options and that exchanges would not compete on the basis of 
margin requirements. The changes in Section 7 of S. 1566 violate this 
principle and would provide security futures a regulatory advantage 
over securities options--products that are economic equivalents.
---------------------------------------------------------------------------
    \4\ Section 7(c)(2) of the Exchange Act directs the Board of 
Governors of the Federal Reserve System (Federal Reserve Board) to 
prescribe rules establishing initial and maintenance customer margin 
requirements imposed by brokers, dealers, and members of national 
securities exchanges for security futures products. The Federal Reserve 
Board may delegate this rulemaking authority jointly to the Commission 
and the CFTC, which it did on March 6, 2001. The Commission and the 
CFTC adopted customer margin requirements for security futures on July 
31, 2002. See Securities Exchange Act Release No. 46292, 67 FR 53416 
(August 14, 2002) (File No. S7-16-01).
---------------------------------------------------------------------------
    SEC Action. Importantly, if done imprudently, risk-based margining 
involves risks to the firms providing the margin, the investors, and 
the markets as a whole. For this reason, risk-based margining must be 
done carefully by the entity with the greatest familiarity with the 
issues involved. Therefore, other than initial margin requirements for 
stock, margin requirements in the securities markets are proposed, in 
the first instance, by the self-regulatory organizations, or SRO's. The 
SRO's are best able to draw on the expertise of their members in 
developing such proposals. The SEC believes this is a more prudent 
approach to implementing risk-based portfolio margining, but 
acknowledges that this has not been our top priority over the past few 
years. However, on July 14, 2005, the SEC approved companion proposals 
by the NYSE and the CBOE that permit their members, on a pilot basis, 
to compute certain customers' margin requirements using a portfolio 
margin methodology. These portfolio margin rules are limited to 
portfolios of financial instruments based on broad-based security 
indexes such as the S&P 500, Nasdaq 100, and the Russell 2000. 
Moreover, Chairman Cox has met recently with CFTC Chairman Jeffery and 
has committed to making the expansion of portfolio margining a 
priority.
    In taking steps to expand portfolio margining to a broader array of 
financial instruments, including single stock futures, narrow-based 
securities index futures and other equity securities, and a wider range 
of customer accounts, the SEC staff has been actively discussing with 
the securities industry and the NYSE an approach to portfolio margining 
that would both lower margin requirements and protect against systemic 
risk in the event of extreme market movements. The SRO's have 
reinvigorated their efforts to allow for risk-based portfolio 
margining, and we anticipate that the NYSE and CBOE will propose to 
expand their portfolio margining pilot based on recommendations of a 
committee composed of representatives of the securities firms, the NYSE 
and CBOE.\5\ Recently, this committee reached agreement on an approach 
to portfolio margining that allows its full benefits to be realized, 
while retaining the prudential benefits of margin requirements. 
Accordingly, we expect the SRO's to file a proposal that would expand 
portfolio margining to include equity products.
---------------------------------------------------------------------------
    \5\ SEC, Federal Reserve Board, and CFTC staff have also been 
invited to participate as observers in meetings of this committee.
---------------------------------------------------------------------------
    Amendments to SIPA. The SEC believes that Congress can promote 
portfolio margining by targeted legislative changes to the Securities 
Investor Protection Act of 1970 (SIPA), which will encourage customers 
to take full advantage of new portfolio margining rules. The NYSE and 
CBOE portfolio margin rules necessarily have a cross-margin component 
under which futures and futures options can be combined with related 
securities to make up a portfolio, provided the futures positions 
offset securities positions. For example, a portfolio made up of 
securities based on the S&P 500 could include futures and futures 
options based on the S&P 500 as well. Losses on the securities 
positions could be offset by gains on the futures positions to arrive 
at the customer's margin requirement.
    Under the NYSE's and CBOE's rules, the securities and futures 
positions must be carried in a securities account to provide the 
customer with the protections of the securities laws and regulations. 
This raises an issue as to how the futures positions would be treated 
in a liquidation of the broker-dealer under the SIPA.
    SIPA was enacted to protect customers of a failed broker-dealer. In 
general, it operates as a short-cut through the bankruptcy process, 
thereby providing the failed broker-dealer's customers with quicker 
access to their cash and securities. Part of this protection includes 
provisions for the trustee in the SIPA proceeding to make advances to 
customers up to $500,000 per customer to be used to return securities 
or cash that are missing or otherwise not available to be returned. 
Consistent with FDIC protection, only $100,000 of the $500,000 maximum 
can be used to return cash. The advances and the other costs of a SIPA 
liquidation are financed through a fund maintained by the Securities 
Investor Protection Corporation (SIPC). If the trustee does not recover 
the amounts advanced from the estate of the failed broker-dealer, the 
SIPC fund incurs the loss (rather than the customer who received the 
advance).
    The SIPA protections apply to cash and securities held at a broker-
dealer, but not to futures positions. This result is a function of the 
SIPA definition of ``security,'' which specifically excludes futures. 
Moreover, there is no corresponding statutory protection for futures 
customers under which they would receive advances if futures assets are 
missing. Because, as noted above, the NYSE and CBOE rules permit 
futures and futures options to be included in a portfolio where they 
will hedge offsetting positions in related securities, the question is 
raised as to how the futures positions should be treated in a SIPA 
liquidation of the broker-dealer. The SEC believes they should be 
protected under SIPA because their inclusion lowers the risk of the 
portfolio as a whole.
    To assure SIPA protection to all products in these accounts, the 
SEC recommends that Congress amend certain definitions in SIPA. Such 
amendments could be very narrowly tailored to, in effect, provide that 
futures (including options on futures) held in a portfolio margin 
account under a SEC approved portfolio margin rule would receive SIPA 
protection. Thus, the amendments would extend SIPC protection to those 
products that are permitted to be deposited into a portfolio margin 
account that are hedging offsetting securities positions and, 
therefore, lowering the broker-dealer's risk of carrying the financed 
customer positions.

Proposed Amendments Affecting the Definition of ``Narrow-Based Security 
        Index''
    The SEC is concerned that the proposal in Section 8 of S. 1566 to 
amend the definition of narrow-based index would remove the SEC's 
jurisdiction over futures on certain security indexes, which we believe 
would negatively impact investor protection and market integrity. 
Specifically, Section 8 of S. 1566 would direct the SEC and CFTC to 
exclude from the definition of ``narrow-based security index'' indexes 
based on specified types of instruments: (a) indexes based on foreign 
and U.S. debt securities; (b) indexes based on foreign equity 
securities; and (c) other U.S. securities. The blanket exclusion in 
Section 8 would eliminate key protections currently provided by the 
Federal securities laws, such as the registration and disclosure 
provisions of the Securities Act, to investors in futures based on the 
indexes (or the underlying securities) that this provision would 
exclude. Also, by excluding these indexes from the definition and 
giving the CFTC exclusive jurisdiction over futures on such indexes, 
futures exchanges would have the exclusive right to trade these 
products, and securities exchanges would be precluded from trading such 
instruments. The impact of this proposal is described further below.
    Indexes Based on Foreign and U.S. Debt. Prior to the proposal of 
legislation to exclude debt indexes from the definition of ``narrow-
based security index,'' no parties had expressed interest to the SEC in 
trading futures based on debt indexes. That said, we agree that the 
current statutory definition of ``narrow-based security index'' does 
not appropriately distinguish between broad-based and narrow-based 
indexes of debt instruments.\6\ However, we do not believe that 
legislative changes are necessary to address this issue. In Section 3 
of the Exchange Act, the limitations of the definition were 
contemplated by Congress, and joint authority was provided to the SEC 
and the CFTC to make determinations with respect to security indexes 
that do not meet the specific statutory criteria without regard to the 
types of securities that comprise the index.\7\ The SEC and CFTC 
already have the tools necessary to exclude indexes composed of debt 
securities (United States or foreign), and we look forward to working 
with the CFTC to expeditiously address the trading of futures on debt 
indexes through joint action. To legislate such a change would make an 
unwarranted jurisdictional shift while limiting the flexibility of the 
two agencies to respond to interest in developing and trading new 
security futures products relating to debt indexes.
---------------------------------------------------------------------------
    \6\ Specifically, an index is considered narrow-based if its lowest 
weighted component securities, in the aggregate, have average daily 
trading volume below $50 million ($30 million if the index has at least 
15 securities). This requirement was intended to ensure that indexes of 
equity securities that are composed disproportionately of illiquid, and 
therefore more manipulable, securities are covered by the definition of 
``narrow-based security index.'' Individual debt securities do not 
trade with the same regularity as equity securities. Therefore, it 
would be very difficult to create a debt index that does not fall 
within the definition of ``narrow-based security index''--even if that 
index would be widely considered broadly based. Moreover, the frequency 
with which a particular debt securities trades is not a good indicator 
of whether it is susceptible to manipulation.
    \7\ See Section 3(a)(55)(C)(vi) of the Exchange Act, 15 U.S.C. 
78c(a)(55)(C)(vi).
---------------------------------------------------------------------------
    Foreign Security Indexes. Section 8 of S. 1566 would require the 
SEC and the CFTC to exclude from the definition of ``narrow-based 
security index'' indexes on foreign equities consistent with the 
capitalization, trading patterns, and trade reporting conditions in the 
foreign market. The SEC believes that it is important for the 
securities laws to apply to any index future that can be a surrogate 
for the index's component securities. A future on a narrow-based index 
composed of foreign securities can be a surrogate for underlying 
securities in the same way that a narrow-based index composed of 
domestic securities can be. Whether or not an index is a surrogate of 
its component securities depends on the number, concentration, and 
liquidity of the securities composing the index. The capitalization, 
trading patterns, or trade reporting conditions in a particular foreign 
market are not determinative of whether a future on a particular index 
could be a surrogate for the index's component securities.
    Currently, the principal impediment to trading security futures on 
narrow-based indexes composed of foreign securities is the statutory 
requirement that all the securities underlying a security future be 
registered under Section 12 of the Exchange Act.\8\ Because today all 
foreign stock indexes include unregistered securities, this requirement 
precludes U.S. exchanges from trading futures on such indexes if the 
indexes are ``narrow-based.'' By moving the jurisdictional line to deem 
such indexes ``broad-based,'' the requirement that underlying 
securities be registered under Section 12 would be removed. Thus, none 
of the protections of the securities laws would apply, including the 
prohibition on insider trading, raising market integrity, and investor 
protection concerns. Moreover, redefining an index as broad-based would 
grant futures exchanges a monopoly to trade futures on such indexes 
because broad-based index futures may only trade on futures exchanges.
---------------------------------------------------------------------------
    \8\ 15 U.S.C. 78l.
---------------------------------------------------------------------------
    The SEC believes that there is an alternative way to address the 
impediments to trading these products as security futures (that is, the 
Section 12 registration requirement), and SEC staff has shared this 
approach with CFTC staff. Specifically, the SEC and the CFTC have the 
authority to exempt security futures from the requirement that 
underlying securities be registered under Section 12 of the Exchange 
Act. The SEC believes such an exemption would be appropriate under 
certain circumstances, including where such products are only available 
to sophisticated investors. The SEC and its staff would welcome the 
opportunity to work with the CFTC to resolve this issue.
    Other U.S. Securities. Finally, Section 8 of S. 1566 would require 
the SEC and the CFTC to exclude from the definition of ``narrow-based 
security index'' indexes on other U.S. securities. It is unclear what 
this provision contemplates; yet it directs the two agencies to agree 
to change the jurisdictional line established by the CFMA.
    Prior to the enactment of the CFMA, futures exchanges were 
permitted to offer a futures contract on a securities index only if the 
futures contract satisfied certain statutory criteria, including a 
requirement that the underlying securities index measure and reflect 
the entire market or a substantial segment of the market.\9\ In 
addition to lifting the ban on trading of futures contracts if they did 
not satisfy these criteria, the CFMA's definition of ``narrow-based 
security index'' established a clear, objective standard for which 
indexes were narrow and which were broad. The SEC urges Congress not to 
reintroduce uncertainty into this area by establishing standards for 
determining jurisdictional boundaries that are subjective and subject 
to differing interpretations.\10\ The SEC believes the current 
definition of ``narrow-based security index'' reasonably identifies 
those indexes of U.S. securities that are so small, highly 
concentrated, or illiquid that a future on such an index would be a 
surrogate for the underlying securities.
---------------------------------------------------------------------------
    \9\ The jurisdictional agreement, commonly referred to as the 
``Shad-Johnson Accord,'' was passed into law as part of both the 
Securities Acts Amendments of 1982 and the Futures Trading Act of 1982. 
See P.L. No. 97-303; 96 Stat. 1409 (1982) and 97-444; 96 Stat. 2294 
(1982). Under the Shad-Johnson Accord, the CFTC retained exclusive 
jurisdiction over all futures contracts on broad-based security 
indexes. The agreement prohibited the trading of single stock futures 
and futures on narrow-based security indexes.
    \10\ See Board of Trade of City of Chicago v. SEC, 677 F.2d 1137 
(7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982); and Chicago 
Mercantile Exchange v. SEC, 883 F.2d (7th Cir. 1989); Board of Trade of 
the City of Chicago v. SEC, 187 F.3d 713 (7th Cir. 1999).
---------------------------------------------------------------------------
Application of CEA to Foreign Currency Transactions
Legal Certainty for OTC Derivatives Markets
    It is widely recognized that OTC derivative instruments are 
important financial management tools that, in many respects, reflect 
the unique strength and innovation of U.S. capital markets. Indeed, 
U.S. markets and market professionals have been global leaders in 
derivatives technology and development. The enormous size of the OTC 
derivatives market demonstrates its critical role in our capital 
markets. OTC derivative instruments provide significant benefits to 
corporations, financial institutions, and institutional investors by 
allowing them to isolate and manage risks associated with their 
business activities or their financial assets. These instruments, for 
example, can be used by corporations and local governments to lower 
funding costs, or by multinational corporations to reduce exposure to 
fluctuating exchange rates.
    Legal certainty and regulatory clarity are essential to ensure that 
the United States continues to play a leading role with regard to 
innovation and growth in the OTC derivative market. An environment that 
lacks legal certainty could undermine the flexibility and 
competitiveness of the U.S. financial markets. The OTC Derivatives 
Report issued by the Working Group prior to the enactment of the CFMA 
contained several recommendations designed to address legal uncertainty 
regarding the application of the CEA to the execution and clearance of 
OTC derivatives products. In response, Congress sought in the CFMA to 
provide legal certainty and regulatory clarity in the OTC derivatives 
market. The SEC believes it is critical that these achievements be 
retained.

Proposed Amendments to Address Retail Foreign Currency Fraud
    The SEC has worked closely with staff of the other members of the 
Working Group on issues related to the sale of foreign currency 
products to retail customers. The goal has been to give the CFTC clear 
authority to take action against foreign-exchange boiler rooms without 
undermining the so-called Treasury Amendment, which excludes certain 
transactions in foreign currency from CFTC jurisdiction.
    This effort is a response to the Seventh Circuit's decision in CFTC 
v. Zelener,\11\ upholding the dismissal of a CFTC fraud action on the 
grounds that certain leveraged contracts of sale for foreign currency 
marketed to retail customers were spot transactions, not futures 
contracts, and thus not subject to the CEA. As others have noted, the 
decision raised questions about the scope of the CFTC's jurisdiction 
under the Treasury Amendment. S. 1566 would address the Zelener 
decision by significantly expanding the jurisdiction of the CFTC.
---------------------------------------------------------------------------
    \11\ 373 F.3d 861 (7th Cir. 2004).
---------------------------------------------------------------------------
    The SEC believes that any change to the CEA should not be so broad 
as to affect the securities markets or the SEC's ability to effectively 
oversee those markets. In its current form, S. 1566 could do both by 
generating legal uncertainty regarding whether the CFTC would have 
jurisdiction over options on foreign currency that are traded on 
national securities exchanges and certain other securities, such as 
structured notes that reflect currency values. In addition, S. 1566 
would undermine the competitive parity between broker-dealers and banks 
in foreign currency transactions that Congress established in 2000 with 
the CFMA. The securities and banking industries rely on parallel 
exclusions from the CEA that were fashioned by the CFMA for foreign 
currency transactions. However, S. 1566 would substantially curtail 
those exclusions for the securities industry by eliminating the 
exclusion for certain affiliates of broker-dealers. Because we have not 
seen evidence of involvement in retail foreign currency transaction 
fraud by these unregistered affiliates of broker-dealers, we do not 
believe it is appropriate to eliminate the exclusion.
    The Working Group principals created a staff-level working group 
and directed their staff to work together to craft a legislative 
solution that would address the Zelener decision in a more targeted way 
than does S. 1566. The Working Group has reached agreement in principle 
on how to address the issues raised by this decision. The staff have 
met regularly over the past several weeks and is crafting legislative 
language that would grant the CFTC additional antifraud authority over 
a narrow category of leveraged transactions in foreign currency with 
retail customers by unregulated foreign exchange bucket shops, and a 
registration requirement for solicitors of such transactions. Important 
to the Commission is that this agreement would preserve the existing 
exclusion from the CEA for foreign currency transactions by certain 
broker-dealer affiliates, as well as other regulated financial 
institutions.

Conclusion
    The SEC appreciates the opportunity to participate in the dialogue 
that S. 1566 has engendered regarding security futures products and 
derivative products. We look forward to working closely with this 
Committee, the Working Group, market participants, and other 
legislators as these issues continue to be considered.

                               ----------

                PREPARED STATEMENT OF PATRICK J. McCARTY
         General Counsel, Commodity Futures Trading Commission
                           September 8, 2005

    Mr. Chairman, Senator Sarbanes, and Members of the Committee, I 
appreciate the opportunity to appear on behalf of the Commodity Futures 
Trading Commission (CFTC) at this hearing on the reauthorization of the 
Commodity Exchange Act (CEA).
    Congress's most recent exercise in reauthorizing the CEA resulted 
in the Commodity Futures Modernization Act of 2000 (CFMA). It was, most 
assuredly, landmark legislation under which the futures industry has 
flourished. This Committee deserves credit for its role in the CFMA's 
development. The CFTC concurs with the widely held view that this 
reauthorization--unlike the sweeping nature of the CFMA--should involve 
only incremental changes to the CEA.
    The issue in this legislative round that has received the most 
public attention involves the CFTC's antifraud authority with respect 
to retail foreign currency transactions in light of the Zelener 
decision. CFTC v. Zelener, 373 F.3d 861 (7th Cir.), rehearing denied en 
banc, 387 F.3d 624 (7th Cir. 2004) (Zelener). I am pleased to note that 
the staff of the President's Working Group on Financial Markets (PWG) 
has reached an agreement in concept on a legislative recommendation to 
address the post-Zelener situation, though the final details are being 
worked out for approval by the PWG Principals.
    I will cover today the issues the Committee specifically asked us 
to address, as well as two others of importance to the CFTC: (1) risk-
based and portfolio margining for both security futures products 
(SFP's) and for security options; (2) clarification of exclusions from 
the CEA's definition of narrow-based security index; (3) the Zelener/
retail foreign currency fraud consensus proposal endorsed by the PWG; 
(4) amendments to Section 4b of the CEA providing the Commission with 
clear ``principal-to-principal'' antifraud authority over off-exchange 
futures transactions; and (5) amendments to Section 9 of the CEA 
clarifying the Commission's authority to bring administrative and civil 
actions as well as increasing civil and criminal penalties.

Risk-Based Portfolio Margining of Security Futures Products and 
        Security
Options
    Section 7 of the Senate Agriculture Committee bill as reported, S. 
1566, provides for the institution of a pilot program for risk-based 
portfolio margining of SFP's. The CFTC supports risk-based and 
portfolio margining for both SFP's and security options.\1\ Risk-based 
margining and portfolio margining, standard in the futures industry, 
are both efficient and effective from a regulatory point of view, and 
have been remarkably successful in protecting customer funds.
---------------------------------------------------------------------------
    \1\ Risk-based margining, as opposed to strategy-based margining, 
establishes margin levels based upon an analysis of the historical 
performance and expected price volatility of individual products. Risk-
based margin requirements are designed to cover the expected one-day 
price movement with an established level of statistical confidence 
(generally 99 percent). Risk-based portfolio margining establishes 
margin levels by assessing the net market risk of a portfolio of 
positions in an account. Portfolio margining is based upon the premise 
that combinations of positions can have offsetting risk characteristics 
due to historic or expected correlations in their price movements. 
Under a risk-based portfolio margining system, the minimum level of 
margin is determined by (1) analyzing the risk of each component 
position in an account and (2) recognizing any risk offsets in an 
overall portfolio of positions. Portfolio margining, as opposed to 
strategy-based margining, more accurately evaluates the economic risks 
of open positions, thereby minimizing the chance of over-margining or 
under-margining. In addition, portfolio margining acknowledges the 
reality that an offsetting position can be a better risk mitigant than 
deposited collateral.
---------------------------------------------------------------------------
    The use of a more risk-sensitive, portfolio-based approach to 
margining for financial products has received wide support. For 
example, the Federal Reserve Board of Governors expressed support for 
risk-based and portfolio margining in its March 2001 letter to the 
Securities and Exchange Commission (SEC) and CFTC delegating margin 
authority over SFP's. The Board specifically noted its expectation that 
the creation of this new product would promote opportunities for 
portfolio margining for all securities, including security options and 
SFP's.
    The SEC has also taken steps that show support for risk-based and 
portfolio margining. On July 14, 2005, the SEC approved a Chicago Board 
Options Exchange (CBOE) 2-year pilot program for portfolio margining 
and cross margining \2\ with respect to certain products. On the same 
date, the SEC also approved New York Stock Exchange (NYSE) rule changes 
that would enable NYSE members to participate in the CBOE pilot 
program. However, SFP's are not included in the portfolio margining 
provisions of the pilot program, and therefore it would not directly 
facilitate the use of portfolio margining for these products. In 
addition, while broad-based securities index futures and broad-based 
equity options are included in the cross-margining provisions of the 
pilot program, they must be held in a securities account in order to 
receive the benefit of cross-margining; market participants should have 
the choice to have margin held in a futures account if they so desire.
---------------------------------------------------------------------------
    \2\ Cross-margining is a type of risk-based margining that jointly 
margins related products (securities, options, and futures contracts) 
that are traded in different markets and generally cleared by different 
clearing entities.
---------------------------------------------------------------------------
    The CBOE pilot program has similarities to the pilot program for 
SFP's found in Section 7 of the Senate Agriculture Committee bill 
insofar as the CBOE program permits portfolio margining. The CFTC urges 
Congress to enact legislation that will allow firms and their customers 
to benefit from the use of risk-based portfolio margining systems.

Clarification of Narrow-Based Security Indexes
    Section 8 of S. 1566 as reported by the Senate Agriculture 
Committee directs the SEC and the CFTC to undertake a joint rulemaking 
that would exclude certain types of indexes from the definition of 
``narrow-based security index.'' In the CFMA, Congress determined that 
SFP's, which include ``narrow-based security indexes,'' would be 
subject to joint regulation by the SEC and the CFTC. At the same time, 
Congress directed the SEC and the CFTC to issue rules defining both 
broad- and narrow-based security indexes for foreign securities 
markets.\3\ Neither set of rules has yet been promulgated. Further, 
Congress, in the CFMA, provided the SEC and CFTC with the authority to 
exclude certain other types of indexes and instruments from the 
definition of ``narrow-based security index.'' \4\ The agencies have 
not acted to exclude certain types of indexes which we believe Congress 
did not intend to be regulated as SFP's. Legislation to compel a joint 
SEC/CFTC rulemaking in this area would be appropriate to provide legal 
certainty to market participants, and to give effect to the intent of 
Congress when it enacted the CFMA, which we understand was to make 
these products available to U.S. investors.
---------------------------------------------------------------------------
    \3\ See CEA Section 1a(25)(C) and Securities Exchange Act Section 
3a(55)(D)(joint broad-based rulemaking), and CEA Section 2(a)(1)(E)(i) 
and Securities Exchange Act Section 6(k)(1)(joint narrow-based 
rulemaking). CEA Section 2(a)(1)(E)(ii) and Securities Exchange Act 
Section 6k(2) specifically require that, in promulgating rules pursuant 
to Sections 2(a)(1)(E)(i) and 6(k)(1), the agencies shall take into 
account the nature and size of the markets underlying the foreign 
security index.
    \4\ CEA Section 1a(25)(B)(vi).
---------------------------------------------------------------------------
    The Senate Agriculture Committee bill would not cause the SEC to 
lose jurisdiction or alter the prior jurisdictional division between 
the agencies but, rather, would add needed clarification regarding the 
classification of these products. The CFTC has had exclusive 
jurisdiction over futures on broad-based security indexes, and 
options on such futures, for well over 20 years. These markets have 
operated effectively under CFTC oversight. Prior to enactment of the 
CFMA in 2000, approximately 100 futures contracts on broad-based 
security indexes--both domestic and foreign--were approved for trading 
by the CFTC in coordination with the SEC.\5\ In the CFMA, Congress 
preserved the CFTC's exclusive jurisdiction over futures on broad-based 
security indexes. Congress provided joint jurisdiction with the SEC 
only over futures on single stock and narrow-based security indexes--
CEA Sec. 2(a)(1)(D)--not with respect to futures on broad-based 
security indexes.\6\
---------------------------------------------------------------------------
    \5\ See Appendix A.
    \6\ The SEC has explicitly acknowledged the CFTC's exclusive 
jurisdiction over futures on broad-based security indexes on many 
occasions. In 1983, an SEC no-action letter stated, ``The Commodity 
Futures Trading Commission (CFTC) has exclusive jurisdiction over . . . 
futures contracts on broad-based indices of any securities.'' See 
Granite Fund, SEC No-Action Letter, October 31, 1983. The SEC again 
acknowledged the CFTC's exclusive jurisdiction more recently, in 2002, 
in the joint order issued by the SEC and the CFTC excluding certain 
security indexes from the definition of ``narrow-based security index'' 
under the CEA and the Federal securities laws. The CFTC/SEC Joint Order 
on Grandfathered Security Indexes stated, ``[t]o distinguish between 
security futures on narrow-based security indexes, which are jointly 
regulated by the Commissions, and futures contracts on broad-based 
security indexes, which are under the exclusive jurisdiction of the 
CFTC . . . .) (emphasis added). 67 Fed. Reg. 38,941 (June 6, 2002).
---------------------------------------------------------------------------
    It has been 5 years since enactment of the CFMA. The agencies have 
not adopted rules for foreign security indexes and debt security 
indexes because of divergent views over whether the current narrow-
based security index test applies to those markets and indexes. It is 
appropriate at this time to provide more statutory clarity regarding 
what constitutes a broad-based security index. Congress should act to 
provide legal certainty to market participants and to regulators, and 
at the same time allow for innovation and competition in these markets.
    Further, we believe that the four broad-based security index 
definitions that we have developed are reasonable and consistent both 
with past CFTC practice in approving futures on broad-based security 
indexes, and with Congressional intent in enacting the CFMA. In brief, 
these definitions relate to: (1) foreign security indexes; (2) U.S. 
debt security indexes; (3) foreign debt security indexes; and (4) a 
general broad-based security index definition. These four definitions 
are more fully described in Appendix B.
    The current statutory test for ``narrow-based security indexes'' is 
quite detailed and was tailored to fit the U.S. equity market.\7\ In 
addition, the CFMA included a ``nonnarrow-based'' security index 
test.\8\ These current statutory tests for narrow- and nonnarrow-based 
security indexes are appropriate for the U.S. equity market, which is 
the largest, deepest, and most liquid securities market in the world by 
far.
---------------------------------------------------------------------------
    \7\ The statutory test for ``narrow-based security indexes'' 
provides that an index will be considered ``narrow-based'' if: (1) it 
has nine or fewer components; (2) one of the component securities 
comprises more than 30 percent of the index's weighting; (3) the five 
highest weighted component securities in the aggregate comprise more 
than 60 percent of the index's weighting; or (4) the value of average 
daily trading volume of the bottom quartile of the index, by weight, 
falls below $50 million (or below $30 million in the case of indexes 
with 15 or more component securities). CEA Section 1a(25)(A), 
Securities Exchange Act Section 3a(55)(B).
    \8\ The statutory test for a ``nonnarrow-based security index'' 
provides that a security index will be considered ``nonnarrow'' if: (1) 
it has at least nine component securities; (2) no component security 
comprises more than 30 percent of the index's weighting; and (3) each 
component security is registered under Section 12 of the Securities 
Exchange Act, is one of 750 securities with the largest market 
capitalization, and is one of 675 securities with the largest dollar 
value of average daily trading volume. CEA Section 1a(25)(B), 
Securities Exchange Act Section 3a(55)(C).
---------------------------------------------------------------------------
    These tests were not designed to apply to foreign markets, as most 
of these countries do not list even 200 equity securities--let alone 
675 securities as contemplated by the ``nonnarrow-based'' test. In 
addition, foreign equities generally are not registered under Section 
12 of the Securities Exchange Act of 1934, and so it is difficult, if 
not impossible, to meet the current nonnarrow-based security index 
test. With regard to indexes that are currently not being offered in 
the United States (due in large part to the barrier to entry created by 
the current narrow-based security index test), CFTC economists have 
identified numerous well-established foreign indexes that would not 
meet the current test, but which should be considered broad-based under 
a test that more accurately takes into account the nature, size, and 
character of foreign markets (as required by the CFMA).\9\ (See 
Appendix C.) This point is evidenced by the clear language of the CFMA, 
which mandated that in developing joint foreign narrow-based security 
index product rules, the Agencies should consider the size and nature 
of the markets underlying the foreign indexes.\10\
---------------------------------------------------------------------------
    \9\ Application of the current narrow-based security index 
definition almost certainly means that all foreign industry and sector 
indexes will be considered to be narrow-based.
    \10\ CEA Section 2(a)(1)(E)(ii), Securities Exchange Act Section 
6(k)(2).
---------------------------------------------------------------------------
    In addition, application of the current narrow-based security index 
test in foreign markets results in strange anomalies. Several well-
known foreign security indexes that are currently trading as broad-
based indexes pursuant to the ``grandfather'' provision in the CFMA--
the IBEX-35 (Spain); the Hang Seng (Hong Kong); the MSCI Singapore 
Free; and the MSCI Hong Kong--would not meet the current statutory 
test. This results in a situation in which existing indexes may 
continue to trade, but an identical new index that is required to meet 
the current ``narrow-based security index'' test could not qualify to 
trade. These anomalous results, and the clear language of the statute, 
evidence that Congress did not intend to apply the narrow-based 
security index test to foreign markets.
    Similar difficulties occur in attempting to apply the current 
statutory definition to domestic debt securities. Additionally, it is 
very clear that Congress intended U.S. Government debt to be excluded 
from the definition of SFP's. And the language of the CFMA indicates 
that Congress did not intend for foreign government debt or agency debt 
to be traded under the dual SFP regulatory scheme.\11\ The market 
capitalization and quartile tests, and particularly the trading volume 
measures, in the narrow-based security index test are not appropriate 
for these markets. To illustrate this point, after passage of the CFMA, 
the agencies were contacted by the Chicago Board of Trade (CBOT), which 
wanted to increase the number of component securities (from 40 
securities to 200 securities) in its existing municipal debt security 
index. However, the data was not available to evaluate the volume 
requirement of the test, and so the new (200-security) index could not 
pass the statutory test. This would seem to defy common sense. If the 
old (40-security) index contract was considered broad-based, then there 
is something wrong with the current definition if it will not 
accommodate as broad-based the same index with 200 underlying 
securities. The result has been a barrier to entry, such that exchanges 
simply do not attempt to offer futures on broad-based debt security 
index contracts to the marketplace.
---------------------------------------------------------------------------
    \11\ There is a long history of futures being offered on U.S. 
Treasury bonds, notes, and bills at the Chicago Board of Trade (CBOT). 
The same can be said for futures on German Government bund, bobl, and 
schatz, first at the London Stock Exchange, then Eurex, and most 
recently at Eurex US and the CBOT. There is no evidence that Congress, 
in enacting the CFMA, had any intention of requiring futures on these 
government debt instruments to be SFP's subject to joint CFTC/SEC 
jurisdiction, as opposed to being solely subject to the CFTC's 
exclusive jurisdiction. It may be appropriate at this time to consider 
statutory or regulatory revisions to broaden the list of exempted 
securities that may appropriately underlie futures contracts and be 
included as component securities in debt security index contracts.
---------------------------------------------------------------------------
    Accordingly, a separate test is needed for domestic debt 
securities. And because foreign debt markets are significantly 
different from U.S. debt and equity markets, there also needs to be an 
appropriately crafted test developed specifically for foreign debt 
security indexes.
    The Senate Agriculture Committee bill would promote clarity in this 
area by requiring the CFTC and the SEC to jointly promulgate final 
rules within 180 days. It also provides criteria that the CFTC and the 
SEC are to use in excluding indexes on U.S. debt instruments, foreign 
equities, foreign debt instruments, and other U.S. securities from the 
definition of ``narrow-based security index.'' As noted above, the CFTC 
has developed specific definitions to address each area \12\ that would 
tailor the rules for foreign equity markets (which are significantly 
smaller than U.S. equity markets) and debt instruments (which are 
inherently unable to meet the current volume and market capitalization 
tests in the statute) based on the size and nature of those markets, 
and on the potential for insider trading and market manipulation. 
Either these definitions should be codified, or joint regulations 
adopting such definitions should be issued. These definitions would 
address a significant problem, and are consistent with the language in 
the CFMA.
---------------------------------------------------------------------------
    \12\ See Appendix B.
---------------------------------------------------------------------------
The Zelener Decision/Foreign Currency Fraud
    With regard to the adverse impact of the Seventh Circuit Court of 
Appeals decision in the Zelener case on the CFTC's ability to combat 
retail foreign currency (forex) fraud, the CFTC continues to believe 
that the Zelener case was wrongly decided and that the contracts at 
issue in that case were futures contracts. We therefore urge Congress 
to restore legal certainty by clarifying the CFTC's jurisdiction in 
this area.
    Retail forex fraud is a significant concern for the CFTC. In the 
last 4 years, the CFTC has brought 79 enforcement actions involving 
forex fraud against unsuspecting retail customers. In these 79 cases, 
there were 23,000 victims who invested approximately $350 million. 
Courts have awarded approximately $267 million in customer restitution 
and civil penalties in these cases. The Commission has been able to 
recover some funds for distribution to customers, but the total amount 
of funds frozen and/or distributed is less than $15 million.
    There are divergent views over whether Congress should address the 
Zelener decision broadly with respect to all commodities, or narrowly 
with a ``forex-only'' solution. The Commission transmitted legislative 
language limited to forex to the Senate Agriculture Committee on May 
20, 2005, and noted at the time that the legislative package 
``represents a consensus among the Commissioners and the minimum which 
the Commission believes it needs in terms of change to the Commodity 
Exchange Act during reauthorization.''
    As you may know, the staff of the PWG members met at least weekly 
during the month of August with respect to the Zelener issue. As noted 
in the introduction, PWG staff has reached agreement in concept on a 
Zelener solution that it believes will give the CFTC adequate authority 
to address the significant retail forex fraud problem.
    The final details of the language are being worked out for approval 
by the PWG Principals. I would note, though, that the staff believes 
the concept would provide the CFTC with fraud authority over retail 
forex ``futures look-alike'' contracts, and thus specifically address 
the problem raised by the Zelener decision. It would address the 
significant problem that our enforcement staff has faced in the 
investigation and prosecution of fraudulent bucket shops and solicitors 
who prey upon retail customers in the forex arena.
    The proposed language, however, would apply only to certain retail 
foreign currency transactions--futures and ``futures look-alike'' 
contracts as were involved in the Zelener case. Its scope is narrow, as 
it also makes clear that legitimate spot transactions (such as the 
purchase of foreign currency at a currency exchange) are not included 
within the jurisdiction of the CFTC.
    The proposal also would retain the current ``otherwise regulated'' 
scheme established in the CFMA, whereby retail foreign currency 
transactions by financial institutions such as banks, broker-dealers, 
and insurance companies are excluded from the CFTC's jurisdiction. The 
CFMA excluded these ``otherwise regulated'' financial institutions 
based on the premise that their regulators will oversee, examine, and 
bring fraud actions if there are problems. SEC-registered broker-
dealers will not be required to register with the CFTC in order to 
engage in off-exchange forex transactions with retail customers. They 
will still be able to rely upon the ``otherwise regulated'' exclusion 
in the statute, subject to the review and oversight of the SEC.
    Finally, it is important to reiterate that the CFTC continues to 
believe that Zelener was wrongly decided. We believe that the foreign 
currency contracts that were the subject of that controversy were 
futures contracts, and that they were not excluded spot contracts 
because no deliveries of foreign currency were ever made to any 
customers under any of the contracts. We also note that the court in 
Zelener determined that there clearly was fraud involved. The CFTC will 
continue to litigate this issue vigorously to protect customers against 
precisely this type of fraud and abuse.
Principal-to-Principal Antifraud Authority
    Section 2 of S. 1566 amends Section 4b of the CEA to address an 
important issue relating to the CFTC's antifraud authority. Section 4b, 
the CFTC's main antifraud provision, has been amended in this bill to 
clarify that the CFTC has the authority to bring fraud actions in off-
exchange ``principal-to-principal'' futures transactions. These changes 
are necessary to eliminate significant obstacles to the use of the 
CFTC's antifraud authority in today's nonintermediated markets.
    In late November 2000, the Seventh Circuit Court of Appeals ruled 
that the CFTC could use Section 4b only in ``intermediated'' 
transactions--those involving a broker-customer relationship. Commodity 
Trend Service, Inc. v. CFTC, 233 F.3d 981, 991-992 (7th Cir. 
2000)(CTS). In other words, the court ruled that the CFTC cannot use 
its Section 4b antifraud authority in ``principal-to-principal'' 
transactions. Meanwhile, at about the same time, the CFMA amended the 
CEA to permit off-exchange futures and options transactions that are 
done on a principal-to-principal basis, such as energy transactions 
pursuant to CEA Sections 2(h)(1) and 2(h)(3). Congress specifically 
reserved the CFTC's Section 4b antifraud authority in Section 2(h) so 
that the CFTC could prosecute fraud involving transactions conducted 
under that Section of the CEA. Since all Section 2(h) transactions must 
be done on a principal-to-principal basis to qualify for the exemption, 
it is important to clarify that Section 4b antifraud authority applies 
to nonintermediated transactions. Without this clarification, the work 
of Congress in 2000 to protect energy markets from fraud could be 
rendered meaningless.
    Accordingly, the Senate Agriculture Committee's reported bill 
amends subsection 4b(a)(2) by adding the words ``or with'' to address 
off-exchange principal-to-principal transactions. This new language 
would make it clear that the CFTC has the authority to bring antifraud 
actions in off-exchange principal-to-principal futures transactions, 
including exempt commodity transactions in energy under Section 2(h) as 
well as all transactions conducted on derivatives transaction execution 
facilities. This amendment to Section 4b would implement Congressional 
intent to reserve the CFTC's antifraud authority with regard to 
principal-to-principal transactions.
    In addition, the amended Section 4b would clarify that market 
participants in these transactions are not required to disclose 
information that may be material to the market price, rate, or level of 
the commodity in such off-exchange transactions. It also would codify, 
however, existing law that prohibits market participants from using 
``half-truths'' in negotiations and solicitations by requiring 
necessary disclosures to protect against materially misleading 
statements.
    I note that the Section 4b language is supported by the Futures 
Industry Association, the National Futures Association, the Chicago 
Mercantile Exchange, the Chicago Board of Trade, the New York 
Mercantile Exchange, Eurex U.S., and others.

Civil and Administrative Actions under Section 9
    Section 3 of S. 1566 amends CEA Section 9 by adding a new 
subsection 9(f) that would clarify the CFTC's authority to bring civil 
and administrative actions. Under Section 9 of the CEA, it is a felony 
for any person to knowingly make false, misleading, or inaccurate 
reports regarding the price of any commodity--including electricity and 
natural gas. Most of the other provisions of Section 9 similarly 
identify types of misconduct that constitute felonies. The CFTC lacks 
criminal powers, but it has brought civil enforcement proceedings under 
Section 9 throughout its history. In fact, in the last 25 years the 
CFTC has brought over 70 civil injunctive or administrative enforcement 
actions under Section 9.
    In the last 3 years, the CFTC has used Section 9 to achieve 
approximately 30 significant monetary settlements, totaling nearly $300 
million in civil monetary penalties, for ``false reporting'' by energy 
trading firms or their traders in violation of CEA Section 9. In many 
of these cases, the energy trading firms or their traders reported a 
very large number of fictitious transactions, or reported significantly 
altered data about transactions, to publications that compile and 
publish natural gas price indexes. The reporting was done in an attempt 
to manipulate index prices.
    Energy firms and traders have argued that the reporting of 
fictitious transactions and significantly altered data about 
transactions is excluded from the CFTC's jurisdiction by Section 2(g) 
of the CEA. The CFTC has consistently taken the position that, even if 
a transaction is excluded from CFTC jurisdiction under Section 2(g), 
the false reporting of such a transaction is a separate act that 
remains a violation of Section 9 that the CFTC has authority to 
prosecute. On August 1, 2005 the CFTC's position regarding false 
reporting and the scope of the exclusion under Section 2(g) (and the 
related exemption under CEA Section 2(h)) were upheld in CFTC v. 
Bradley, Case No. 05-CV-00062-JHP-FHM (N.D. OK August 1, 2005). This is 
the first reported decision in this area, and an extremely important 
one that affirms the CFTC's authority and ability to prosecute false 
reporting cases under CEA Section 9.
    Even with the Bradley decision, we feel a legislative change to 
Section 9 is still necessary because it would clarify the CFTC's 
authority to bring civil and administrative actions, and would ensure 
that the CFTC can continue to bring false reporting cases in the energy 
arena for acts or omissions that occurred prior to enactment. The 
Senate Agriculture Committee bill expressly provides that these 
amendments restate, without substantive change, existing CFTC civil 
enforcement authority. This clarifying change does not grant any new 
statutory authority, and provisions of Section 9, as restated, continue 
to apply to any action for any alleged violation occurring before, on, 
or after the date of enactment.
    Section 3 of S. 1566 also amends CEA Section 9 to double the civil 
and criminal penalties available for certain criminal violations of the 
CEA such as manipulation, false reporting, and conversion. The maximum 
fines under Section 9 would be increased from $500,000 to $1 million, 
and the maximum prison sentence would be increased from 5 to 10 years. 
In a similar vein, Section 3 of S. 1566 includes conforming amendments 
to the procedural enforcement provisions in Sections 6(c), 6b, and 6c 
of the CEA to effectuate this increase in civil monetary penalties.
    I note that the Section 9(f) statutory language is consensus 
language that has been agreed to by the Futures Industry Association, 
the Chicago Mercantile Exchange, the Chicago Board of Trade, the New 
York Mercantile Exchange, Eurex U.S., and others.

Conclusion
    The CFTC's reauthorization is a unique opportunity to address the 
five areas that I have mentioned: Portfolio margining for security 
futures products and security options; clarification of definitions 
applicable to broad-based foreign security indexes and debt indexes; 
the Zelener/forex fraud provision; the CEA's principal-to-principal 
antifraud authority; and increased penalties and clarification of civil 
and administrative authority. The CFTC is eager to work with the 
Congress to successfully complete reauthorization of the CFTC this 
year. Thank you for the opportunity to testify on these important 
matters.




               PREPARED STATEMENT OF PATRICK M. PARKINSON
          Deputy Director, Division of Research and Statistics
            Board of Governors of the Federal Reserve System
                           September 8, 2005

    Chairman Shelby, Senator Sarbanes, and Members of the Committee, 
thank you for the opportunity to testify on the Commodity Futures 
Modernization Act of 2000 (CFMA) and on regulatory issues that have 
arisen in the context of the reauthorization of the Commodity Futures 
Trading Commission (CFTC). The Chairman's invitation letter requested 
that the testimony and written statement provide an overall evaluation 
of the CFMA and address three specific regulatory issues: (1) 
legislative measures to address fraud in certain retail foreign 
currency transactions; (2) portfolio margining for security futures 
products; and (3) futures on narrow-based securities indexes.

Overall Evaluation of the CFMA
    The Federal Reserve Board believes that the CFMA has unquestionably 
been a successful piece of legislation. Most important, as recommended 
by the President's Working Group on Financial Markets in its 1999 
report, it excluded transactions between institutions and other 
eligible counterparties in over-the-counter financial derivatives and 
foreign currency from regulation under the Commodity Exchange Act 
(CEA).\1\ As the Working Group argued, regulation of such transactions 
under the CEA was unnecessary to achieve the act's principal objectives 
of deterring market manipulation and protecting investors. Such 
transactions are not readily susceptible to manipulation and eligible 
counterparties can and should be expected to protect themselves against 
fraud and counterparty credit losses. Exclusion of these transactions 
resolved long-standing concerns that a court might find that the CEA 
applied to these transactions, thereby making them legally 
unenforceable. At the same time, the CFMA modernized the regulation of 
U.S. futures exchanges, replacing a one-size-fits-all approach to 
regulation with an approach that recognizes that the regulatory regime 
necessary and appropriate to achieve the objectives of the CEA depends 
on the nature of the underlying assets traded and the capabilities of 
market participants. Together, these provisions of the CFMA have made 
our financial system and our economy more flexible and resilient by 
facilitating the transfer and dispersion of risk. Consequently, the 
Board believes that major amendments to the regulatory framework 
established by the CFMA are unnecessary and unwise.
---------------------------------------------------------------------------
    \1\ President's Working Group on Financial Markets (1999), Over-
the-Counter Derivatives Markets and the Commodity Exchange Act 
(Washington, DC: November). www.ustreas.gov/press/releases/reports/
otcact.pdf.
---------------------------------------------------------------------------
    Nonetheless, the Board supports some targeted amendments to the CEA 
to address persistent problems with fraud in retail foreign currency 
transactions and to facilitate the trading of security futures products 
and futures on security indexes.

Fraud in Retail Foreign Currency Transactions
    In its 1999 report, the President's Working Group concluded that, 
to address problems associated with foreign currency ``bucket shops,'' 
the CEA should be applied to transactions in foreign currency futures 
if they are entered into between a retail customer (an individual or 
business that does not meet the definition of an eligible counterparty) 
and an entity that is neither federally regulated nor affiliated with a 
federally regulated entity. The CFMA included provisions that were 
largely consistent with the Working Group's recommendation.
    The CFMA has allowed the CFTC to take numerous enforcement actions 
against retail foreign currency fraud. However, the CFTC has continued 
to encounter certain difficulties in this area. These difficulties have 
stemmed from two sources. First, the CFTC's authority is limited to 
foreign currency futures, and some entities have fraudulently marketed 
contracts that, although similar to futures, have characteristics that 
have led some courts to conclude that they are not futures and that the 
CFTC has no jurisdiction. Second, some perpetrators of fraud have taken 
advantage of the CFMA's exclusion from CFTC jurisdiction of retail 
foreign currency futures offered by futures commission merchants 
(FCM's) and their affiliates. These perpetrators have set up thinly 
capitalized FCM's and used affiliates of those FCM's or unregulated 
unaffiliated entities to fraudulently solicit retail customers.
    The Board believes that fraud undermines the functioning of 
financial markets and that some governmental entity must have the 
authority to protect retail investors in foreign currencies by taking 
enforcement action against entities that are defrauding them. Although 
the States have an important role to play in combating fraud, the 
President's Working Group concluded in 1999 that the CFTC is the 
appropriate Federal regulator and should have clear authority to pursue 
retail fraud by foreign currency bucket shops. Consequently, the Board 
supports targeted amendments to the CEA that address the specific 
difficulties that the CFTC has 
encountered in taking enforcement action in this area. It is critical 
that those amendments be carefully crafted to avoid creating legal or 
regulatory uncertainty for legitimate businesses providing foreign 
exchange services to retail clients. The Board would be opposed to 
extending any new CFTC authority to retail transactions in other 
commodities without further careful consideration and demonstrated 
need. Provisions crafted to avoid creating uncertainty for legitimate 
foreign currency businesses are unlikely to provide the same protection 
to a much wider range of businesses.

Portfolio Margining for Security Futures
    The CFMA gave the Board authority to prescribe regulations 
establishing initial and maintenance margins for security futures 
products or to delegate that authority jointly to the CFTC and the 
Securities and Exchange Commission (SEC). The Board delegated its 
authority to the commissions in a letter dated March 6, 2001. The 
letter indicated that the Board concluded that delegation is 
appropriate because it believes that the most important function of 
margin regulations is prudential--that is, to protect margin lenders 
from credit losses. In the case of security futures, the lenders are 
broker-dealers and FCM's, and the commissions are responsible for all 
other aspects of prudential regulation of those firms.
    Portfolio margining is a method for setting margin requirements 
that evaluates positions as a group or portfolio and takes into account 
the potential for losses on some positions to be offset by gains on 
others. Specifically, the margin requirement for a portfolio is 
typically set equal to an estimate of the largest possible decline in 
the net value of the portfolio that could occur under assumed changes 
in market conditions. Portfolio margining is an alternative to 
``strategy-based'' margining. With strategy-based margining, the 
potential for gains on one position in a portfolio to offset losses on 
another position is taken into account only if the portfolio implements 
one of a designated set of recognized trading strategies. The margin 
requirements for recognized strategies are set out in the rules of 
self-regulatory organizations. Each strategy is viewed in isolation; 
the remainder of the portfolio and other strategies are not taken into 
account.
    The Board has supported the use of portfolio margining for some 
time. For example, in 1998 the Board amended Regulation T to allow 
securities exchanges to develop portfolio margining as an alternative 
to strategy-based margining, subject to SEC approval. In its 2001 
letter delegating its authority over margins for security futures 
products jointly to the CFTC and the SEC, the Board requested that the 
commissions, either jointly or individually, report to the Board 
annually on their experience exercising the delegated authority and to 
include in those reports an assessment of progress toward portfolio 
margining for securities futures products. The Board continues to 
believe that portfolio margining is both more risk-sensitive and more 
efficient than strategy-based margining.
    Unfortunately, to date no progress has been made toward portfolio 
margining of security futures products. Because the CFMA stipulates 
that margin requirements for security futures products must be 
consistent with margin requirements on comparable securities options, 
progress for security futures requires progress on options. Although 
margin requirements for options have for many years been portfolio-
based at the clearing level, customer margins were until very recently 
strictly strategy-based. However, in July the SEC approved rule changes 
that create a 2-year pilot program that would permit portfolio 
margining of options and futures positions in broad-based stock indexes 
held by customers with a minimum account equity of $5 million or more. 
If this pilot program were adopted as a margining system available to 
all customers for a broader range of products, significant progress 
toward portfolio margining of securities futures products would become 
possible.
    The Commodity Exchange Reauthorization Act of 2005, which the 
Senate Agriculture Committee approved in July, proposes to make 
progress on portfolio margining (1) by eliminating the need for margins 
required on security futures to be consistent with those required on 
comparable options and (2) by substituting CFTC oversight of security 
futures margins for joint regulation by the CFTC and the SEC under 
delegation from the Board. This approach would be a marked departure 
from the regulatory regime for security futures that was established by 
the CFMA. The Board believes that it is appropriate for the Congress to 
spur progress toward portfolio margining for security futures but that 
this can be accomplished without changing so fundamentally the 
regulatory regime for security futures margins. For example, the 
Congress could spur more rapid progress toward portfolio margining for 
both security futures products and options by requiring the commissions 
to jointly adopt regulations permitting the use of risk-based portfolio 
margin requirements for security futures products within a short but 
reasonable time period and requiring the SEC to approve risk-based 
portfolio margin requirements for options within the same period.

Futures on Narrow-Based Securities Indexes
    The CFMA distinguished between futures on broad-based security 
indexes, which are subject to the exclusive jurisdiction of the CFTC, 
and futures on narrow-based securities indexes, which are considered 
security futures products and, as such, are subject to joint CFTC and 
SEC jurisdiction. Some futures exchanges argue that the definition of a 
narrow-based index in the CFMA was drafted with reference to the U.S. 
equities markets and that, in any event, the definition unnecessarily 
restricts the trading of futures on indexes of U.S. debt obligations 
and foreign securities.
    The 2005 Reauthorization Act would address those concerns by 
requiring the CFTC and the SEC to jointly promulgate a revised 
definition of a narrow-based securities index that would better reflect 
capitalization, trading patterns, and trade reporting in the underlying 
markets. Such a definition would permit futures on indexes of U.S. debt 
obligations and foreign securities to trade as broad-based indexes if 
the indexes are not readily susceptible to manipulation.
    Although the Board does not have a strong interest in this issue, 
it favors taking another look at the appropriateness of applying the 
existing definition of a narrow-based index to indexes of foreign 
securities. First, for many years several futures on foreign equity 
indexes have been trading abroad and have been offered to customers in 
the United States. Although these indexes would be considered narrow-
based indexes under the existing definition, we see no evidence that 
these indexes have been susceptible to manipulation. Second, the 
provision in the 2005 Reauthorization Act can be seen as simply 
reiterating an existing requirement in the CFMA that the CFTC and the 
SEC jointly adopt rules that define narrow-based indexes based on 
foreign securities.

                               ----------

                 PREPARED STATEMENT OF CHARLES P. CAREY
             Chairman of the Board, Chicago Board of Trade
                           September 8, 2005

    Mr. Chairman and Members of the Committee, thank you for the 
opportunity to submit this written testimony on behalf of the Chicago 
Board of Trade (CBOT) for the record and for the consideration of the 
Committee. The CBOT also thanks and congratulates the Congress for the 
passage in 2000 of the Commodity Futures Modernization Act (CFMA). The 
CFMA provided for increased competition and legal 
certainty in the derivatives industry and reduced many unnecessary 
regulatory burdens that served only to increase costs for the investing 
and hedging participants in U.S. financial markets. Some of the goals 
and promises of the CFMA have not been fully realized, however. Dual 
regulation and inefficient margining have contributed to an environment 
that has inhibited the development of a robust single stock futures 
industry. Regulatory confusion may be keeping other innovations from 
the market. And an unfortunate court decision has been issued which, if 
not overturned, raises the specter of increased fraud.

Fraud by Unregistered Persons Offering Leveraged Futures ``Look-a-
        Like''
Contracts Should be Addressed
    The influential Seventh Circuit Court of Appeals in Chicago has 
rendered an opinion which essentially does away with previously settled 
law setting out determining characteristics of a futures contract. 
Commodity Futures Trading Commission v. Zelener 373 F.3d. 861 (7th Cir. 
2004). This decision provides a road map for unregulated commodity 
transactions that can be used to defraud those least able to defend 
against it.
    The CFMA excluded from the coverage of the Act certain over-the-
counter transactions that involve highly capitalized, sophisticated 
persons--defined in the CFMA as ``eligible contract participants.'' 
These persons were deemed by the Congress to possess, or at least to be 
able to obtain, the acumen or expertise to engage in margined or 
leveraged transactions in commodities without the protection of 
Commission regulation. Congress continued to believe that persons who 
did not meet the criteria for becoming eligible contract participants 
still needed the protection of Federal regulation by the Commodity 
Futures Trading Commission (CFTC) if they dealt in commodity futures.
    When the CFMA was enacted and for 4 years after that, there was 
relative certainty as to what constituted a futures contract. For 22 
years, the decision in CFTC v. Co Petro Marketing Group, Inc., 680 F.2d 
573, 577 (9th Cir.1982) provided the means for the Commission, the 
industry, and the courts to determine whether a financial transaction 
that could be used for leveraged or margined speculation on the prices 
of commodities was a futures contract. Using a ``totality of the 
circumstances'' test, the Commission and the courts could effectively 
deal with persons who offered speculative contracts involving 
commodities without proper registration.
    Registration and the capital requirements found in Commission 
regulations acted to ensure persons who offered futures contracts to 
the public had a large enough financial stake that they would not 
simply close up shop and disappear with their customers' money. 
Commission regulation and capital requirements essentially provided a 
credit and background check on such firms, which individuals and 
smaller entities, that is, persons who are not eligible contract 
participants, lack the resources or ability to carry out for 
themselves.
    When fraudulent dealings in commodities came to the attention of 
the Commission, typically the perpetrator was not a Commission 
registrant. The CFTC could immediately shut the operation down because 
the unregistered person was not permitted to offer or solicit orders 
for futures contracts because of the lack of registration. By moving 
quickly, and without first having to show all the requisites of fraud, 
the CFTC frequently could catch wrongdoers off guard and prevent them 
from hiding or otherwise further dissipating the assets of those who 
had been defrauded.
    These Federal protections for persons who are not eligible contract 
participants, along with the ability of the Commission to bring 
enforcement actions in appropriate cases, are no longer available 
against those who commit fraud using the form contract deemed not to be 
a futures contract in Zelener. Persons who are not eligible contract 
participants, that is, those who Congress believed in 2000 still needed 
the protection of Federal regulatory jurisdiction, are now protected 
only by the threat of after-the-fact legal actions by local prosecutors 
under the laws of the individual States.
    The fundamental weakness of this approach was clearly demonstrated 
in the early part of the 2000's and lead to the enactment of the 
Federal securities laws. In that era, persons who defrauded others in 
connection with the sale of securities were relatively safe from 
prosecution if they took care to cheat only persons located in another 
State. Local prosecutors in the State in which the criminal was located 
may have had little incentive to use their resources if the bulk of the 
victims were in other States, having more immediate and pressing needs 
in other areas; and prosecutors in States where the victims were 
located did not have jurisdiction over the person committing the fraud 
from another State. The Congress, according to Stephen M. Cutler, a 
former Director of Enforcement for the Securities and Exchange 
Commission, addressed this problem by making investor protection one of 
the goals of Federal securities legislation in 1933 and 1934. Congress, 
recognizing ``the ability of scammers to `take advantage of State 
boundaries,' '' saw fit to establish the Securities and Exchange 
Commission as a Federal presence to deal with the interstate nature of 
securities fraud.\1\
---------------------------------------------------------------------------
    \1\ See, Remarks of Stephen M. Cutler, Director, Division of 
Enforcement, Securities and Exchange Commission, at Washington 
University School of Law, February 21, 2003, on SEC website found at 
http://www.sec.gov/news/speech/spch022103smc.htm#footnote_5, citing 
Hearing on the Federal Securities Act, 73rd Congress, First Session, A 
Study of the Economic and Legal Aspects of the Proposed Federal 
Securities Act (submitted for the record by the Department of Commerce) 
pp. 99, 101.
---------------------------------------------------------------------------
    To further quote Mr. Cutler, but in the similar context of 
commodity fraud, ``these concerns have a surprisingly contemporary 
sound to them.'' Current day wrongdoers use telephone, internet, and 
television appeals to showcase their fraudulent ``pitches'' involving 
heating oil, gold, and other commodities. The National Futures 
Association and the Commodity Futures Trading Commission try to monitor 
these websites and infomercials, but the advent of the Zelener opinion 
may leave them impotent in the face of flagrant fraud.
    The Zelener case is not about only foreign exchange products. The 
contract the Zelener Court found to be outside the jurisdiction of the 
CFTC may just as easily be utilized by scammers to induce the 
unsuspecting to invest in other commodities. Unless checked by an 
amendment to the CEA overturning the Zelener opinion, such fraudulent 
operators could cause a scandal similar to those involving options on 
sugar and other commodities in the mid-1970's. Such a scandal could, as 
then, reflect adversely on the legitimate financial services and 
derivatives industry here in the United States.
    The Chicago Board of Trade hopes that Congress will enact an 
amendment giving the CFTC the power to shut these fraudulent operators 
down by showing that they are dealing in futures contracts without the 
required registration, before this activity results in the loss of 
hard-earned savings of citizens. We favor an amendment that would cover 
all margined or leveraged speculative commodities transactions entered 
into with persons who are not eligible contract participants. Merely 
providing enhanced antifraud authority that can be used only after a 
fraud has been foisted on the public is insufficient to effectively 
address the problem.
    Some have questioned whether anything at all should be done, 
raising the possibility that someone's legitimate business may be 
somehow affected. A properly drawn amendment that restricts only those 
who deal with persons who are not eligible contract participants, along 
with the forward exclusion, the Treasury Amendment and the other 
provisions enacted as part of the CFMA, should not adversely impact the 
operations of any legitimate person or firm. Indeed, the industry 
carried out its business for years when the Co Petro standard was in 
place, including the 4 years between the passage of the CFMA and the 
issuance of the Zelener opinion, and a return to the regulatory 
landscape of that period should not further restrict any legitimate 
firm. To the extent, however, that persons may believe that proposed 
language may infringe on their legitimate operations, we would hope 
that they would provide specific examples so that language can be 
crafted to alleviate those concerns while giving the CFTC the necessary 
tools to protect the investing public.

Dual Regulation Poses Barriers to Innovation
    The CFMA provided much-needed regulatory relief to entities 
regulated by the CFTC and granted the Commission flexibility to deal 
with new ideas and technological advances, while at the same time 
retaining concepts of customer protection that are essential to our 
industry. In addition, the CFMA brought legal certainty to many 
products either by removing them from Commission jurisdiction or by 
establishing standards and procedures by which products can be and 
remain exempt from further CFTC regulation. The CFMA also allowed for 
the trading of security futures products for the first time. This 
legislation and its implementation by the Commission have seen many 
successes. While the financial services industry has benefited greatly 
from the reforms of the CFMA, the goal of the Congress of reducing 
regulatory barriers to innovation has not been achieved in at least two 
areas, however.
    First, the CBOT asks that the Congress consider clarifying that the 
definition of narrow-based security indexes does not include indexes on 
fixed income securities, corporate bonds, and other nonequity 
securities. The present definition creates a series of tests to 
distinguish narrow-based indexes from broad-based indexes. 
Unfortunately, these tests are only workable for indexes on U.S. equity 
securities, and index products based on nonequity securities do not 
implicate the same issues. However, the possibility that the definition 
could be interpreted to cover nonequity products has hampered 
development of such products due to confusion as to what regulations 
may or may not apply.
    To illustrate this point, the CBOT, and I am sure a number of other 
exchanges, have considered offering futures based on corporate bond 
indexes. While we do not believe such indexes were intended to be 
captured by the definition of narrow-based security indexes, current 
law is not clear on that point. Many such indexes, if the tests 
designed to distinguish broad- from narrow-based indexes were applied, 
would fall into the narrow-based index category. As such, futures on 
these indexes could then be assumed to be regulated as stock futures 
products, jointly by the CFTC and SEC. Given that corporate bonds are 
not subject to the same regulatory regime as equity securities, the 
underlying reason for applying these tests to equity security indexes 
does not exist for corporate bond indexes. We believe that futures 
contracts on these types of indexes--whether indexes of corporate 
bonds, municipal bonds, or other securities--should be regulated by the 
CFTC just as all other nonequity security futures and broad-based 
security index futures are regulated. Clarification of the definition 
is an important issue that deserves to be addressed at this time.
    Another issue the CBOT hopes Congress will consider is the 
margining regime for stock futures products. The CFMA constituted both 
the Securities and Exchange Commission and the CFTC as regulators of 
stock futures products. This dual regulation of stock futures products 
has been challenging to date and the growth of single stock futures in 
the United States has been anemic, at best. The inability, at least to 
this point, of the SEC and the CFTC to afford rational regulatory 
treatment of margining for these products continues to stymie further 
development of stock futures and other needed products.
    Historically, the power to set margins for futures products was 
reserved to the exchanges. Congress recognized that futures margins 
were performance bonds, posted by both buyers and sellers of 
commodities for future delivery, to ensure the performance of 
obligations under the contract, especially if the price moved adversely 
to one's position. Because futures contracts were not assets, such as 
stocks, and because margins were not a credit function in the 
acquisition of an asset, exchanges typically set margin at levels 
designed to cover the risk of several days' price movement on a 
historical basis. The levels of margin, set as a dollar amount per 
contract rather than as a percentage of the price of the underlying 
product, could quickly be changed in the event of higher volatility in 
prices, in other words, increased risk. With the advent of more 
powerful data processing and sophisticated financial valuation models 
and techniques, this risk-based margining today can be applied more 
precisely to futures positions and even to whole portfolios, measuring 
the risk inherent in individual positions as affected by other 
positions within the same portfolio. Using risk-based margining across 
whole portfolios has provided participants in the financial markets 
with greater flexibility and efficiencies, while at the same time 
affording greater stability to the markets themselves.
    The CBOT hopes Congress will facilitate the margining of stock 
futures as futures contracts, recognizing that the economic function of 
a futures contract is not to acquire ownership of the stock, but rather 
is to act as a hedging vehicle.
    The Chicago Board of Trade, the oldest and one of the largest 
futures exchanges in the world, vigorously competes in the 
international marketplace. We ask the Congress, and this Committee, to 
remain cognizant of the continued need to reduce unnecessary regulatory 
complexities that tend to inhibit the ability of U.S. exchanges to 
compete effectively with their counterparts around the world. We also 
ask the Congress to give the CFTC the tools necessary to prevent 
peripheral scandals that have the potential of tarnishing the U.S. 
derivatives industry.
    Once again, the CBOT thanks the Committee for this opportunity. If 
the Committee or Members have questions, the CBOT will be happy to 
provide answers and additional information.

                               ----------

                 PREPARED STATEMENT OF JOHN M. DAMGARD
                President, Futures Industry Association
                           September 8, 2005

    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
I am John Damgard, President of the Futures Industry Association (FIA). 
On behalf of FIA, I want to thank you for the opportunity to appear 
before you today. FIA is a principal spokesman for the commodity 
futures and options industry. Our regular membership is comprised of 
approximately 40 of the largest futures brokerage firms, known as 
futures commission merchants (FCM's), in the United States. Among its 
associate members are representatives from virtually all other segments 
of the futures industry, both national and international. FIA estimates 
that its member firms serve as brokers for more than 90 percent of all 
customer transactions executed on United States futures exchanges.
    In the last Reauthorization of the Commodity Futures Trading 
Commission (CFTC), this Committee played an important role in forging 
the landmark legislation known as the Commodity Futures Modernization 
Act of 2000 (CFMA). With the goal of promoting ``responsible innovation 
and fair competition among boards of trade, other markets and market 
participants,'' the CFMA amended the Commodity Exchange Act (CEA) to:

 Assure legal certainty for over-the-counter derivatives;
 Remove the 20-year (supposedly temporary) prohibition on 
    futures on individual securities and narrow-based securities index 
    contracts through the joint regulation of these products by the 
    CFTC and the Securities and Exchange Commission (SEC); and
 Provide a more flexible regulatory system for futures and 
    options.

    In any legislation of hundreds of pages, some provisions do not 
work out as expected. The CFMA is no exception. In a handful of areas, 
the provisions of the CFMA could use some improvement. FIA looks 
forward to working with this Committee again on that effort.
    On the overriding issue of the CFTC's Reauthorization, FIA's 
position is unequivocal. FIA believes the CFTC is an excellent agency 
that discharges its statutory obligations efficiently and effectively. 
We look forward to a continuation of this tradition of excellence under 
the CFTC's new Chairman, Reuben Jeffrey. The CFTC deserves to be 
reauthorized.
    FIA believes there are four primary areas that should be addressed 
in order to fulfill the promise of the CFMA: Off-exchange retail 
foreign currency (FX) transactions; security futures; SRO transparency 
and governance; and competition. Retail FX transactions have been the 
main focus of attention in the President's Working Group in recent 
weeks and the CFTC Reauthorization bill reported by the Senate 
Agriculture Committee, S. 1566, contains specific proposals for dealing 
with retail FX transactions. Most of my remarks will therefore focus on 
that issue, followed by a general summary of FIA's positions in the 
other areas.

Retail FX Transactions
    As the Committee will recall, in 1997 the U.S. Supreme Court 
dismissed a CFTC fraud prosecution, ruling that the CEA's Treasury 
Amendment enacted in 1974 provided a ``complete exclusion'' from the 
CEA for any off-exchange FX transactions, including FX futures and 
options transactions with retail customers. Dunn v. CFTC, 519 U.S. 465, 
476 (1997). Three years later, Congress reconsidered the Treasury 
Amendment and made certain modest modifications. The CFMA reaffirmed 
that the CEA does not apply generally to any FX futures or options 
transactions, with three exceptions: (1) futures contracts traded on an 
organized exchange; (2) currency options not traded on a securities 
exchange; and (3) some FX futures that are offered to retail customers, 
what the statute calls ``noneligible contract participants.'' \1\
---------------------------------------------------------------------------
    \1\ Section 1a(12) of the CEA defines ``eligible contract 
participant'' to mean an individual with more than $10 million in total 
assets or $5 million if the individual retains a professional price 
risk manager.
---------------------------------------------------------------------------
    This last category--retail FX transactions--has been the focal 
point of most of the debate in this CFTC Reauthorization. Current law 
grants the CFTC full jurisdiction over retail FX futures unless the 
retail customer's counterparty qualifies in one of six different 
categories: banks, broker-dealers, FCM's, affiliates of broker-dealers 
or FCM's, insurance companies, financial holding companies, or 
investment bank holding companies. Retail FX futures entered into with 
five of these six categories of qualifying entities--including banks, 
broker-dealers, and their affiliates--continue to enjoy a complete 
exclusion from the CEA. The only exception is for retail FX futures 
where a registered FCM or its affiliate is the counterparty; then the 
transactions are subject to the CFTC's powers to enforce the antifraud 
and antimanipulation prohibitions of the CEA.
    In recent years, some unsavory, sharp operators have been 
registering shell companies as FCM's, avoiding any real exchange-traded 
futures business, creating affiliates to enter into retail FX 
transactions with consumers and engaging in or promoting fraudulent 
sales practices in connection with retail FX futures contracts. The 
CFTC has brought many cases to shut down these schemes. Still more 
firms are engaging in this form of sales fraud.
    The CFTC's enforcement efforts in this area have been substantial. 
The CFTC has won many cases and put many firms out of business. 
However, last year the CFTC did lose one of these cases when it failed 
to prove that the firm involved was selling a futures contract. This is 
the Zelener case.\2\
---------------------------------------------------------------------------
    \2\ CFTC v. Zelener, 373 F.2d 861 (7th Cir. 2004).
---------------------------------------------------------------------------
    Zelener and the retail FX fraud problem have raised a series of 
issues that many believe should be addressed in this CFTC 
Reauthorization. Let me summarize those issues and FIA's positions.
Broad Fix (All Commodities) or Narrow Fix (FX only)?
    Some believe that the Zelener decision, even though it arose in the 
context of a single retail FX fraud case, could lead to broader 
enforcement issues for the CFTC in areas beyond FX. They would argue 
that the Zelener decision shrank the legal definition of a futures 
contract and thereby shrank the CFTC's enforcement jurisdiction 
generally, allowing con artists in the agricultural, energy, or 
precious metals area to defraud customers and avoid CFTC policing by 
proving that their offerings were not futures contracts under the 
Zelener precedent.
    FIA disagrees with those who seek a broad fix. Since 1922, the 
CFTC's jurisdiction has been limited wisely to futures and options 
contracts. In fact, Congress as recently as 1982 pruned back CFTC 
jurisdiction to avoid any possibility that it could spill over into 
commodity cash or forward markets that operate throughout our country, 
and are subject to the jurisdiction of other agencies, including law 
enforcement at the Federal, State, and local levels.\3\ Expanding the 
CFTC's jurisdiction to apply to any form of nonfutures contracts would 
have profound and, FIA believes, adverse implications for the CFTC's 
ability to discharge its oversight of futures and options exchange-
trading, especially given the agency's structure and limited resources. 
Congress granted the CFTC exclusive jurisdiction over the futures and 
related options markets in order to make certain the CFTC would 
concentrate its efforts on those vital areas of our economy. Nothing 
should distract the CFTC from its core mission.
---------------------------------------------------------------------------
    \3\ In 1982, Congress amended the definition of a commodity trading 
adviser. Prior to the 1982 Act, a commodity trading advisor was broadly 
defined to include any person who was engaged in the business of 
providing advice ``as to the value of commodities,'' including cash and 
forward market transactions. As amended in 1982 Act, a commodity 
trading adviser is now defined as any person providing advice ``as to 
the value of or advisability of trading in any contract for futures 
delivery made on or subject to the rules of any contract market, any 
commodity option authorized under section 4c, or any leverage contract 
authorized under Section 19 of this Act.'' That is, a person is 
required to be registered as a commodity trading advisor only if that 
person is providing advice with respect to transactions that fall 
within the Commission's exclusive jurisdiction.
---------------------------------------------------------------------------
    Overreacting to Zelener would also be particularly inappropriate 
since the Zelener court just applied the evidence before it to the 
traditional legal guidelines for determining whether a transaction is a 
futures contract, focusing on whether the parties had the right to and 
contemplated offset of the transaction, and therefore mimicked the 
offset properties of exchange-traded futures. The CFTC's inability to 
prove its case to one court is no reason to transform the agency into a 
national police force for consumer fraud committed in any transaction 
with a commodity theme. In this regard, FIA is pleased that the CFTC's 
legislative package and S. 1566 as reported by the Senate Committee on 
Agriculture (even if adopted only as a ``placeholder'') do not support 
the broader ``all commodity'' fix.
    That does not mean FIA supports a ``do nothing'' approach to the 
retail FX issues. Far from it. Certain adjustments to the CFMA's 
provisions would help the CFTC combat the fraud and abuse we have seen 
in retail FX transactions in recent years. The CFTC claims it would be 
easier for it to curb that activity if it did not have to prove that 
the perpetrators of fraud were offering a futures contract. Yet 
granting the CFTC powers over nonfutures transactions has historically 
had troubling implications. Those two differing views frame the next 
issue being debated.

CFTC's Non-Futures FX Jurisdiction: General or Antifraud Only?
    Both the CFTC and the Senate Agricultural Committee have proposed 
granting the CFTC new general jurisdiction over retail FX nonfutures 
transactions. Their proposal would empower the CFTC to develop any 
regulations it sees fit for retail FX transactions that are leveraged, 
margined, or financed and not for commercial use or where the customer 
takes immediate ownership and possession of the currency involved. It 
is not clear why the CFTC needs such sweeping regulatory power over 
these transactions or what kind of regulatory structure the CFTC would 
set up for these transactions. But it would be expected that the CFTC 
would adopt an array of regulations for it to enforce or may even ban 
these products outright.\4\
---------------------------------------------------------------------------
    \4\ FIA is concerned that granting the CFTC general nonfutures 
authority also will lead to considerable legal confusion. One part of 
the CFTC's proposal states, for example, that the CEA antifraud 
provisions apply to retail FX futures offered by certain FCM's and 
their affiliates, but not FCM's that also operate as broker-dealers. 
Another part of the CFTC's proposal would apply those same antifraud 
provisions to any retail FX transaction even if not futures and even if 
offered by FCM's that are also broker-dealers. This inconsistency 
illustrates the difficulty of trying to superimpose nonfutures onto the 
futures regulatory provisions.
---------------------------------------------------------------------------
    Expanding the CFTC's general regulatory jurisdiction to nonfutures 
would not only drain the agency's limited resources, but would lead to 
unwarranted legal uncertainty of the kind the CFMA stamped out in 2000. 
Both the CFTC's proposal and S. 1566 introduce jurisdictional concepts 
that will not promote legal certainty. Statutory trip-wires like 
``financed on a similar basis'' or ``immediate ownership and 
possession'' leave room for reasonable differences of interpretation 
that could lead unsuspecting and legitimate enterprises to run afoul of 
CFTC regulation. Moreover, the emphasis on ownership or possession of 
FX suggests that CFTC jurisdiction might turn on some of the same 
definitional dividing lines that have bedeviled courts and even the 
agency itself for many years in the area of distinguishing futures from 
forward contracts. Compounding the unintended collateral implications 
of these ambiguities is that the CFTC-S. 1566 proposal apparently would 
allow the CFTC to render ``per se'' illegal FX-related financing 
activities of legitimate financial institutions or others.
    For many months, FIA has proposed a different approach. We believe 
the CFTC's enforcement arsenal should be enhanced so that the agency 
could pursue retail FX fraud cases against bucket shops and boiler 
rooms without having to prove that the applicable FX transaction was a 
futures contract. This proposal would be a targeted response to the 
real problem--retail FX sales abuses--without expanding the CFTC's 
general regulatory jurisdiction and mission beyond futures. Removing 
the shield of the ``futures contract defense'' from those who prey on 
unsuspecting FX customers should make the CFTC's already impressive 
enforcement track record in this area, even more impressive. And by 
focusing the CFTC's resources on bringing fraud cases for retail FX, 
rather than adopting regulations, the retail public can expect better 
protection and better sales practices.
    FIA recognizes that allowing the CFTC to pursue nonfutures, off-
exchange fraud cases would be a significant departure from the CEA's 
regulatory scheme. We know that many have criticized us for not simply 
taking the position that sales fraud in connection with transactions 
that are not futures contracts should be of no more concern to the CFTC 
than sales fraud in connection with nonsecurities transactions is to 
the SEC. But, in our view, the CEA recognized that FX was a special 
commodity which Congress had treated with special provisions for many 
years. Moreover, the special nonfutures retail FX antifraud provision 
would not apply to any transactions where the counterparty was one of 
the six types of qualifying entities Congress recognized in 2000.\5\ 
Thus, granting the CFTC special, limited, and targeted nonfutures 
antifraud authority over certain retail FX transactions that operate 
outside existing regulatory systems seemed like an appropriate 
compromise.
---------------------------------------------------------------------------
    \5\ Under our proposal, the CFTC would retain its existing 
authority to pursue antifraud and antimanipulation actions against 
FCM's and their affiliates (unless the FCM is also a broker-dealer or 
other qualifying entity) in connection with retail FX futures were the 
FCM or affiliate is a counterparty.
---------------------------------------------------------------------------
    FIA also believes that certain important enhancements should be 
enacted for the retail FX futures transactions Congress permitted in 
the CFMA. Experience has shown that some of the CFMA's provisions in 
this area need tightening. A discussion of these issues follows.
Should Solicitors of Retail FX Futures be CFTC-Registered?
    The CFMA has been interpreted by the CFTC to preclude the 
registration of many of those who solicit retail FX futures contracts. 
Since the problem with retail FX transactions has been sales fraud, it 
makes sense to ensure that any person who solicits retail customer 
business meet traditional CFTC fitness standards.
    FIA proposes that any person who participates in the solicitation 
or recommendation of any retail FX futures contract where an FCM or its 
affiliate is the counterparty must be both CFTC registered and a member 
of National Futures Association. That would mean that any employee of 
an FCM or its affiliate that solicits retail FX futures business must 
be CFTC-registered. It also means that independent firms that introduce 
retail FX futures customers to FCM's or their affiliates must be CFTC-
registered. The only exceptions from this requirement would be for the 
other qualifying entities (including broker-dealers as well as broker-
dealers that are also FCM's) and those who are already subject to 
Federal regulatory supervision (like investment advisers). In addition, 
any person soliciting a customer to buy a retail FX futures contract 
where the counterparty is not a qualifying entity (including where the 
counterparty is not an FCM or affiliate meeting the conditions set 
forth below) would be engaging in the illegal offer of an off-exchange 
futures contract under the CEA. That person would be subject to the 
full enforcement authority of the CFTC.
    Right now, no member of the public can find out who is eligible to 
solicit retail FX futures business. As a result of this reform, both 
the CFTC and NFA would have a list of those firms and individuals that 
are qualified to sell retail FX futures under CFTC jurisdiction. Either 
the CFTC or NFA, or both, may make this list available to the public 
through their websites or public information efforts. This proposal 
therefore would provide greater transparency to the investing public.
Should Shell FCM's Be Qualifying Entities?
    No. The CFMA has been interpreted by the CFTC to allow firms to 
register as FCM's even if the firm does not intend to engage in the 
business of being an FCM, brokering or clearing exchange-traded futures 
contracts for others. Those firms (or their affiliates) can then become 
the counterparties to retail FX futures contracts and enjoy the 
benefits of an exemption that Congress wrote for FCM's that would be 
engaged in the exchange-traded futures business.
    FIA believes that when Congress granted this exemption for 
registered FCM's, Congress intended those FCM's would be real futures 
brokers, not shells. To achieve that objective, FIA has proposed that 
any FCM qualifying for the exemption to serve as a counterparty for 
retail FX futures must be ``substantially and primarily'' engaged in 
the exchange-traded futures business. The CFTC will have discretion to 
define ``substantially and primarily'' in this context. Through this 
requirement, the shell FCM loophole should be ended. S. 1566 does not 
contain a similar limitation on registered FCM's acting as 
counterparties for retail FX transactions.
    This new ``substantially and primarily'' requirement also should 
contribute materially to reducing many of the sales practice abuses 
experienced in recent years. Substantial FCM's who deal with the retail 
public everyday will not want to see their reputations tarnished by 
sales practice abuses committed in connection with retail FX futures to 
which those FCM's (or their affiliates) are the counterparties.
Should FCM Affiliates Be Allowed to Continue to be Qualifying Entities?
    Yes. The CFMA treats affiliates of broker-dealers and FCM's 
equally. Both are allowed to serve as qualifying entities that may be 
counterparties to retail FX futures under Section 2(c)(2)(B) of the 
CEA. FIA understands that the CFTC may now be proposing to allow 
broker-dealer affiliates to continue to act as counterparties to retail 
FX transactions but would bar FCM affiliates from continuing to do so. 
FIA believes both broker-dealer affiliates and FCM affiliates should 
continue to be able to serve as qualifying entities under Section 
2(c)(2)(B) of the CEA. No basis exists to treat affiliates of broker-
dealers more favorably in this regard than the affiliates of FCM's, 
especially once the shell FCM loophole is plugged as we have 
recommended.
    FIA also believes the FCM affiliate provisions in Section 
2(c)(2)(B) should be improved in two important respects. First, FIA 
recommends that only affiliates of FCM's with at least $20 million in 
net capital (or higher if the CFTC believes it to be appropriate) 
should be eligible to be qualifying entities. This will ensure as a 
practical matter that if an affiliate of an FCM faces financial 
difficulty in performing its counterparty role, its FCM will have the 
capacity to step in and cover those obligations in order to avoid the 
harm to its reputation from a default. Second, FIA recommends that in 
order for any FCM affiliate to qualify under Section 2(c)(2)(B), the 
FCM must undertake to comply with the CFTC regulatory requirements 
(recordkeeping and reporting) for material associated persons or the 
affiliate must be a material associated person (MAP) of the FCM. By 
this requirement, the CFTC will retain an important measure of 
oversight for the FCM affiliate serving as the counterparty to the 
retail FX transaction.\6\
---------------------------------------------------------------------------
    \6\ Current law contains a perverse anomaly that this proposal will 
cure. Under current law, the affiliate of a modestly capitalized FCM 
would qualify as a MAP and be eligible as a qualifying entity. The 
affiliate of a substantially capitalized FCM might not qualify as a MAP 
since its operations would not be material to the overall financial 
picture of the FCM. In FIA's view, if the FCM undertakes in writing to 
the CFTC that its affiliate will comply with all MAP requirements even 
if the affiliate is not technically a MAP, that affiliate should be 
considered to be a qualifying entity so long as the FCM has at least 
$20 million in net capital.
---------------------------------------------------------------------------
    In 2000, the CFMA authorized FCM affiliates to qualify as 
counterparties for retail FX transactions. Based on that authorization, 
some affiliates have engaged in this business without customer 
complaints for years. Congress should not over-react to the sales 
problems others have caused by insisting now that those affiliates must 
cease operations.

Should the CEA Prohibit Principal to Principal Fraud?
    Section 2(c)(2(C) of the CEA makes the general antifraud provision 
in Section 4b applicable to all retail FX futures where an FCM (that is 
not also a broker-dealer) or its affiliate is the counterparty. Section 
4b, however, was enacted in 1936 in the context of FCM's acting as 
brokers for customers on futures exchanges and prohibited defrauding 
any one the FCM was acting ``for or on behalf of'' as an agent. Section 
4b did not, however, cover fraud in connection with transactions where 
the FCM or its affiliate would act as a principal or counterparty to 
the transaction. Since the retail FX futures transactions authorized by 
the CFMA contemplate that FCM's would act as principals to those 
transactions, questions were raised whether the CFTC's antifraud 
jurisdiction actually applied to those retail FX futures.
    Section 2 of S. 1566 contains an amendment to Section 4b of the CEA 
that would extend that antifraud prohibition to principal to principal 
fraud. FIA supports this amendment. It would strengthen the CFTC's 
enforcement efforts in the retail FX futures area by removing another 
possible defense to a CFTC fraud prosecution.
    FIA understands that the President's Working Group has focused its 
deliberations on the retail FX issue and we have accordingly focused 
our testimony on those issues. In summary, FIA sees no need for either 
a broad, all-commodity response to Zelener or to grant the CFTC general 
jurisdiction over retail FX nonfutures. Instead, FIA recommends 
Congress amend the CFMA in the retail FX futures area by (1) 
prohibiting shell FCM's; (2) registering soliciting retail FX futures 
firms and individuals; (3) imposing at least a $20 million net capital 
requirement on FCM's whose affiliates are acting as permissible 
counterparties; (4) requiring any qualifying affiliates to comply with 
CFTC MAP regulation; and (5) expanding the CEA to cover principal to 
principal fraud. In addition, FIA continues to propose that Congress 
grant the CFTC special new enforcement powers to pursue fraud actions 
in connection with narrowly defined retail FX transactions even if not 
futures contracts. These changes will respond to the customer 
protection challenges of recent years without compromising the CFTC's 
overall mission or the CFMA's goal of legal certainty.\7\
---------------------------------------------------------------------------
    \7\ The goal of legal certainty is also threatened by Committee 
Reports that attempt to create legislative history for statutory 
provisions that do not exist. For example, the Report of the Senate 
Committee on Agriculture claims to make certain amendments to Section 
2(c)(2)(C) of the CEA that are mere clarifications of existing law. S. 
Rep. No. 109-19, 109th Cong. 1st Sess. 8 (2005). But those 
``clarifications'' create significant new legal obligations and causes 
of action not contained in the CFMA and not discussed in any Committee 
hearings or deliberations. In addition, the Committee Report attempts 
to graft onto provisions that confirm the CFTC's ability to pursue 
civil enforcement actions for violations of the criminal provisions of 
the CEA limitations in the CFMA's exclusions and exemptions that 
contradict the actual language Congress enacted to achieve the goal of 
legal certainty. Id. at 6. Any expansions or contractions of the CFTC's 
jurisdiction in this important area should come from provisions 
Congress actually enacts.
---------------------------------------------------------------------------
Security Futures Products
    Since the enactment of the CFMA, FIA has worked diligently with the 
CFTC, the SEC and the exchange community to implement both the spirit 
and the letter of the provisions authorizing trading in security 
futures products. Although volume on these markets has not been as 
robust as we would like, we continue to believe that this is an 
important product that will grow over time. Last year, the only U.S. 
market for security futures--OneChicago--increased its annual trading 
volume by 19 percent from 1.6 million contracts in 2003 to 1.9 million 
in 2004.
    In contrast, security futures are more popular in other countries. 
As the following chart shows, at the London based Euronext.Liffe 
exchange, 2004 single stock futures volume was up 114 percent over 2003 
volume, with a total of 13.5 million contracts traded. And at Italy's 
Borsa Italiana, single stock futures volume rose more than 250 percent 
last year as it traded over 1.7 million contracts. At the Stock 
Exchange of India, 2004 single stock futures volume was up 72 percent 
to 44 million contracts. And finally, even at Spain's MEFF exchange, 
where single stock futures volume was basically flat, they were still 
able to trade 12.1 million contracts. As you can see, it is clear that 
at this time the security futures industry in the United States has not 
caught up with our competitors on foreign exchanges.



    FIA supports action in three areas relating to security futures. In 
each area, legislation would not be needed if the CFTC and SEC adopted 
administrative solutions as contemplated by the CFMA. But that has not 
happened. Reluctantly, FIA believes Congress should take some action to 
make certain that the agencies address these three areas.
    First, U.S. futures exchange representatives believe that U.S. 
security futures markets would grow if their portfolio margining 
systems for futures generally were made available to security futures 
trading. The U.S. futures exchanges and clearing firms are deservedly 
proud of their portfolio margining systems. These systems provide 
financial integrity for the futures markets while allowing for more 
efficient use of capital by traders and clearing firms. The CFTC and 
the SEC are empowered to allow portfolio margining systems to apply to 
U.S. security futures markets. Since those markets are struggling now 
to catch up with foreign competition, FIA would urge the agencies to 
allow existing futures clearing portfolio margining systems to be 
applied to security futures products as soon as practicable.
    FIA understands that the options and cash markets in securities 
also would like to have the SEC approve futures-style portfolio 
margining for their market users. FIA supports these efforts as well, 
provided that nothing tips the competitive scales in favor of broker-
dealers at the expense of FCM's. Perhaps the fledgling security futures 
markets can offer a pilot program for this concept while the SEC 
considers adapting that system to the options and cash markets. Or the 
new leadership at the SEC and the CFTC can agree to a reasonable and 
mutually acceptable timetable for implementing portfolio margining. 
This is not a matter of seeking competitive advantage for security 
futures; it is a matter of competitive viability for security futures 
in the United States.
    Second, provisions of the CFMA combined with regulatory 
intransigence are creating a significant competitive disadvantage for 
U.S. investors and U.S. firms. The problem stems from the definition of 
a ``narrow-based'' securities index in the CFMA, its application to 
indexes on securities other than U.S. equity securities, and the 
regulatory consequences for futures trading on any index that falls 
within the ``narrow-based'' definition.
    Prior to the CFMA, in fact since 1981, futures contracts had been 
trading on stock indexes which were generally considered to be broad-
based. Those stock index 
futures were traded subject to the CFTC's exclusive jurisdiction. An 
index was considered to be broad-based if the index could not be used 
as a surrogate for an individual stock or a small group of stocks or to 
manipulate the underlying cash market price. Otherwise, the CFTC and 
the SEC were concerned that insider trading in the stock could take 
place outside the SEC's purview through trading in the stock index 
futures contract.
    In deciding to lift the ban on single stock futures in the CFMA, 
Congress chose to set up a special regulatory regime for those new 
futures products subject to shared CFTC and SEC regulatory authority. 
At the same time, Congress decided that some existing stock indexes, 
and surely those to be developed, could not be considered to be broad-
based, but could become the subject of futures trading under the same 
rules as single stock futures. Congress decided therefore to treat and 
regulate both single stock futures and ``narrow-based'' stock index 
futures as ``security futures products'' subject to CFTC and SEC 
jurisdiction.
    For a stock index, therefore, the issue whether it is ``narrow-
based'' or ``broad-based'' has important regulatory consequences under 
the CFMA. Broad-based indexes (those are that not narrow-based) may be 
traded under the traditional rules for futures trading subject to CFTC 
jurisdiction. Narrow-based indexes may be traded only as security 
futures subject to the special rules set out in the CFMA. And, as 
discussed more fully below, U.S. investors are banned from trading 
foreign security futures products, including foreign futures on narrow-
based indexes.
    In the CFMA, Congress defined through numerical criteria what 
indexes would be considered to be ``narrow-based''--at least 9 
securities, no single security more than 30 percent of the index value, 
no five securities more than 60 percent of the index value, and 
aggregate capitalization amounts for the lowest quartile of the index. 
These criteria were authored jointly by the CFTC and SEC. While those 
criteria were adopted with U.S. equity markets in mind, the CFMA 
literally applies those criteria to any ``security'' market--debt or 
equity, foreign or domestic. For that reason, the CFMA grants the CFTC 
and SEC joint power to adopt criteria for defining ``narrow based'' 
indexes for these other security markets. To date, that has not 
happened.
    Instead, we understand that the SEC has taken the view that the 
CFMA's narrow-based criteria apply to all equity markets, not just 
those in the United States. That position leads to some unintended and 
unfathomable results. For example, one foreign stock index comprised of 
229 stocks traded in Switzerland is considered ``narrow-based'' because 
it would not meet the criterion that no five stocks may comprise 60 
percent of the value of the index. Indexes developed to reflect the 
value of equity markets in many other countries, including Japan, 
Greece, Australia, Portugal, Russia, Belgium, Denmark, and Norway also 
do not meet the rigid CFMA narrow-based index criteria.
    As a result, no U.S. firm may offer, and no U.S. investors may buy 
or sell, foreign futures on these indexes since they are foreign 
security futures products (foreign futures contracts on a narrow-based 
index). This is the case even though in foreign jurisdictions trading 
in these stock index futures is treated like any other futures 
contract.
    FIA understands the agencies' rationale for the CFMA's ``narrow-
based'' criteria as applied to U.S. equity markets. But misapplying 
those criteria to foreign equity markets has disadvantaged U.S. 
investors and U.S. FCM's in a profoundly anticompetitive manner. 
Congress should provide the agencies with direct guidance on this issue 
and make certain that the ``narrow-based'' criteria no longer operate 
as a competitive barrier for U.S. exchanges, firms, and investors.
    Third, as mentioned above, U.S. institutional investors are being 
discriminated against today because they are barred from trading 
futures on individual securities and narrow-based security index 
futures contracts on a non-U.S. exchange. These instruments could be of 
significant value to customers for various purposes, including risk 
management and asset allocation. The best way to understand the issue 
is this. FIA has been told by investment managers of the pension funds 
for U.S. Government employees that the rate of return earned on the 
U.S. employees' funds is often not as high as the rate of return earned 
on the pension funds of foreign government employees. The reason is 
that the investment manager may not use foreign security futures 
products to manage the U.S. employees' funds, but may use those risk 
management tools for foreign government employees.
    In the CFMA, Congress instructed the SEC and the CFTC ``to the 
extent necessary and appropriate in the public interest, to promote 
fair competition, and consistent with promotion of market efficiency, 
innovation, and expansion of investment opportunities'' to ``issue such 
rules regulations or orders as may be appropriate to permit the offer 
and sale of a security futures product traded on or subject to the 
rules of a foreign board of trade to United States persons.'' 
Consistent with this explicit Congressional direction, FIA had been 
assured that necessary rules or orders permitting the offer and sale of 
foreign security futures products to U.S. persons would be adopted 
contemporaneously with the rules authorizing security futures products 
on U.S. exchanges. However, the CFTC and SEC did not promulgate such 
rules.
    The investment objectives of pension plans, investment companies, 
endowments, hedge funds, and other large money managers that FIA 
members serve have been restricted by the agencies' failure to act. 
Those institutional customers are free to engage in transactions in the 
international securities markets with few regulatory limitations. These 
institutions also are authorized to enter into principal-to-principal 
derivatives transactions that replicate foreign security index 
contracts, but may be more difficult, and substantially more expensive, 
to effect than exchange-traded instruments. In these circumstances, no 
U.S. regulatory purpose is served by preventing U.S. institutional 
customers, in particular, from using foreign futures on narrow-based 
indexes or single securities, provided that a U.S. stock exchange is 
not the primary market for the securities underlying such security 
futures products.
    Unfortunately, S. 1566 does not address this issue. We request that 
this Committee work with your counterparts on the Agriculture Committee 
and the new leaders at the CFTC and SEC to determine when action in 
this area may be forthcoming and to codify that timetable in 
legislation. If the agencies believe that they need additional 
statutory authority, they should so advise Congress so that appropriate 
amendments can be enacted this year.

SRO Governance
    Like the SEC and the securities markets, SRO governance has been an 
issue under review at the CFTC for some time. In this regard, FIA 
supports the important role that the exchanges, clearing organizations 
and National Futures Association perform as self-regulatory 
organizations (SRO's). Given their strong market knowledge and close 
proximity to the trading markets, they provide the best vantage point 
for addressing many of the futures markets' oversight functions. 
However, to be fully effective, there must be an increased degree of 
public confidence in the integrity and objectivity of SRO's.
    The Commission, the SRO's, and the derivatives industry generally 
must act to remove the real and perceived conflicts of interest and 
potential for anticompetitive conduct that are inherent in any self-
regulatory structure, particularly when the exchange is operated on a 
for-profit basis and has issued stock to the public. Specific 
modifications to the SRO structure should increase its overall 
efficiency and effectiveness. For example, FIA believes that 
establishing a meaningful number of truly independent directors on SRO 
Boards is one of the most important reforms that could be considered. 
The FIA has filed extensive comments with the CFTC in this area 
containing many recommendations. We would be pleased to provide our 
comments to this Committee at your request.
    A good illustration of our concern is the recently adopted U.S. 
Treasury futures position limits imposed by the Chicago Board of Trade 
(CBOT). The CBOT imposed these limits through a new procedure made 
available under the CFMA. It allows futures exchanges to self-certify 
that their rule changes are in compliance with the CEA and then place 
the rules into effect without obtaining CFTC approval. On many 
noncontroversial rule changes this kind of administrative efficiency 
may make sense. In this case, however, the CBOT's rule changes had an 
impact on trading in futures contracts with open positions and may have 
caused some to enjoy trading gains and some to suffer trading losses. 
Many market participants have raised serious questions about the 
(unstated) purpose of the CBOT's rule change and the ability of the 
CBOT to enforce its rule as written. Weeks after the CBOT's actions had 
been implemented, the CBOT offered only a partial explanation for why 
it took the action it did and how it intended to enforce its rule 
change.
    Whether the CBOT's actions were wise or precipitous is not the main 
issue for FIA. We believe the fairness and transparency of the exchange 
rule change and approval process is the issue. We fear some market 
participants lost confidence in the CBOT by virtue of its decisions 
both to change the rules of the game during the game and to offer no 
reason for doing so. FIA does not believe that any contract market 
should self-certify rules that change the trading terms and conditions 
for contracts that have already been listed and where traders have 
already established open positions. But surely no exchange should take 
such action without telling the public why it took the action and how 
it reached that decision.
    FIA hopes that CFTC Chairman Jeffrey will take a fresh look at this 
area in the coming months and that no legislation will be needed to 
address these issues.

Fair Competition
    Promoting fair competition should be the goal of any sound 
regulatory program. Robust competition facilitates the ability of U.S. 
futures markets to serve the public interest. Competition leads to 
reduced costs, higher volumes, narrower spreads, and greater 
innovation.
    Our strong support for the CFMA was based in substantial part on 
our belief that competition, rather than a prescriptive regulatory 
structure that established excessively high barriers to entry, would be 
the best regulator. We fully anticipated that the CFMA's regulatory 
reforms would encourage new entrants to apply for designation with the 
Commission as contract markets or clearing organizations. These new 
self-regulatory organizations would compete among themselves and with 
the existing exchanges for customer business based on products, quality 
of execution, and cost.
    Unfortunately, since the CFMA was enacted very little direct 
competition among markets has occurred. Virtually all efforts at direct 
competition have been unsuccessful thus far. Even the largest 
derivatives exchange in the world (EUREX) has been unable to penetrate 
the market share of the Chicago Board of Trade in U.S. Treasury Note 
and Bond futures. Shortly after EUREX US indicated it was reassessing 
its operations, the CBOT announced a fee increase for all market 
participants, an apparent by-product of the absence of competition.
    Some believe that unless or until Congress or the CFTC mandate 
multiple contract listings together with cooperative clearing 
arrangements the potential benefits of meaningful direct competition 
will never be realized. (That would mean, for example, that a ``long'' 
contract entered into on Exchange #1 could be offset by a mirror-image 
``short'' contract on Exchange #2 through cooperative or common 
clearing, and vice versa.) As this Committee well knows, it makes sense 
to give customers the ability to choose their market and obtain the 
best price available for an offsetting trade, even if the market with 
the best price is not the market where the original position was 
established.\8\ These are salutary goals we believe everyone should 
support in the interest of serving the customer and enhancing 
competition. Yet, established exchanges are reluctant to surrender 
their market advantages.
---------------------------------------------------------------------------
    \8\ This system also would encourage customers to enter into 
original positions on a challenger exchange when that exchange offers 
the customer the better price. The customer then could offset that same 
position on the dominant exchange.
---------------------------------------------------------------------------
    As noted above, the efforts of the challenger markets to date have 
done little more than chip away at the entrenched markets' dominance. 
We believe that further study by the CFTC of how to stimulate futures 
market competition would be appropriate now. With the benefit of that 
analysis, Congress may wish in the future to consider whether 
legislation in the direct competition area would help to realize fully 
the goals of the CFMA.

Conclusion
    FIA greatly appreciates the opportunity to present its views to the 
Committee. We look forward to answering any questions you may have and 
to working with the Committee on this year's CFTC Reauthorization 
legislation.




                 PREPARED STATEMENT OF MEYER S. FRUCHER
   Chairman and Chief Executive Officer, Philadelphia Stock Exchange
                              On Behalf of
     The U.S. Options Exchange Coalition: American Stock Exchange,
        Boston Options Exchange, Chicago Board Options Exchange,
          International Securities Exchange, Pacific Exchange,
   Philadelphia Stock Exchange, and the Options Clearing Corporation
                           September 8, 2005

    I am Meyer S. Frucher, Chairman and Chief Executive Officer of the 
Philadelphia Stock Exchange (Phlx). I appear today on behalf of the 
Philadelphia Stock Exchange and the five other United States options 
markets: The American Stock Exchange, the Boston Options Exchange, the 
Chicago Board Options Exchange (CBOE), the International Securities 
Exchange, the Pacific Exchange, and our clearinghouse, The Options 
Clearing Corporation. Together, we comprise the U.S. Options Exchange 
Coalition. Our markets trade all the exchange-traded security options 
in the United States, such as options on individual stocks, stock 
indexes, exchange-traded funds, debt securities, and foreign currency. 
These markets provide the major hedging instruments for the U.S. stock 
market. The U.S. Options Exchange Coalition welcomes this opportunity 
to provide its views on reauthorization of the Commodity Futures 
Trading Commission (CFTC).
    We welcome the Committee on Banking, Housing, and Urban Affair's 
participation in CFTC's reauthorization. The Committee has an important 
role to play in the issues under consideration because of its oversight 
of three of the four members of the President's Working Group on 
Financial Markets (President's Working Group)--the Department of the 
Treasury, the Federal Reserve Board, and the Securities and Exchange 
Commission--as well as its jurisdiction over securities and over-the-
counter derivatives. As a part of the reauthorization, the Senate 
Committee on Agriculture, Nutrition, and Forestry recently reported S. 
1566, the Commodity Exchange Reauthorization Act of 2005, to 
reauthorize the CFTC. This bill touched on a number of issues within 
the Banking Committee's jurisdiction. The U.S. Options Exchange 
Coalition is focused on one aspect of the CFTC reauthorization and S. 
1566--the treatment of security futures products (that is, futures on 
individual stocks and narrow-based stock indexes).
    The U.S. Options Exchange Coalition's interest in the CFTC 
reauthorization is to maintain the competitive balance between security 
futures and security options established by Congress in 2000 in the 
Commodity Futures Modernization Act (CFMA). S. 1566's provisions 
dealing with security futures would destroy this balance by removing 
the consistent margin treatment between security options and 
security futures. The U.S. Options Exchange Coalition has a proposal 
that would preserve this balance while hastening the use of risk-based 
portfolio margining for both security futures and security options. We 
urge the Committee to endorse the principle of regulatory parity 
between security futures and security options as it moves forward with 
CFTC reauthorization.
    In the U.S. Options Exchange Coalition's view, security futures and 
security options should be regulated in a consistent manner in order to 
preserve competitive fairness. Congress made consistent regulation the 
cornerstone of the Congressional compromise that led to the CFMA and 
the introduction of security futures trading. Nothing has occurred 
since the enactment of the CFMA that should lead Congress to change 
this policy of regulatory parity between security futures and security 
options. As discussed in detail below, our proposal would maintain this 
important 
objective while providing margin relief for security futures and 
security options. To accomplish this, our proposal would direct the SEC 
and CFTC to adopt rules within 9 months permitting consistent portfolio 
margin treatment for both products. We strongly urge Congress to follow 
our approach.

The CFMA Was Enacted Based Upon Consistent Regulation
    During consideration of the CFMA, Congress reviewed whether and how 
security futures products should be permitted. Prior to the CFMA 
security futures had been prohibited since an SEC-CFTC jurisdictional 
accord in 1982. Futures on broad-based stock indexes were permitted, 
but not futures on individual stocks or on a narrow-based index of 
securities. The prohibition emanated from a lack of consensus on 
whether to regulate these products as securities or futures. In 1999, 
in anticipation of CFTC reauthorization, the President's Working Group 
advised Congress that futures on individual stocks and narrow-based 
indexes should be permitted to trade if they were appropriately 
regulated. Appropriate regulation of the product was based on the fact 
that futures on individual stocks and narrow-based indexes had 
characteristics of both securities and futures.\1\
---------------------------------------------------------------------------
    \1\ See, Over-the-Counter Derivatives Markets and the Commodity 
Exchange Act, Report of the President's Working Group on Financial 
Markets, November 1999. The President's Working Group noted that ``the 
current prohibition on single stock futures can be repealed if issues 
about the integrity of the underlying securities market and regulatory 
arbitrage are resolved.''
---------------------------------------------------------------------------
    When the CFTC came up for reauthorization in 2000, the futures 
industry advocated a removal of the prohibition on futures on single 
stocks and narrow-based indexes and options on such futures 
(collectively called security futures products). While the U.S. Options 
Exchange Coalition did not object to the introduction of security 
futures products, it urged Congress to ensure that these products be 
regulated in manner that provides a level playing field with security 
options. Consistent with the President's Working Group's findings, the 
U.S. Options Exchange Coalition argued that security futures are not 
traditional futures products but are functionally and economically 
equivalent to security options. As a result, appropriate regulation of 
these products must include a role for the SEC and key elements of 
securities regulation. The U.S. Options Exchange Coalition and SEC 
noted that regulation of security futures solely as futures would pose 
risks for the securities markets and investors and would create 
competitive inequities.
    In general, the securities laws are designed to protect investors, 
provide full disclosure of corporate and market information, and 
prevent fraud and manipulation. The commodities laws are designed to 
facilitate commercial and professional hedging and speculation and to 
oversee the price discovery process. Because of the different emphases 
of the two regulatory schemes, many of the basic regulatory protections 
that apply to each are very different. The U.S. Options Exchange 
Coalition, along with the SEC, argued that it would be a mistake to 
simply impose the futures regulatory model onto a class of products 
that are the functional equivalent of products regulated under the U.S. 
securities model.\2\ Instead, the U.S. Options Exchange Coalition urged 
Congress and the SEC and CFTC to determine how to apply relevant 
portions of the securities regulatory structure to security futures 
products when lifting the prohibition on these products. Our views were 
consistent with those of the SEC and the securities industry.
---------------------------------------------------------------------------
    \2\ See, for example, Testimony of William J. Brodsky, Chairman and 
Chief Executive Officer, Chicago Board Options Exchange, on behalf of 
the U.S. Securities Markets Coalition, before the Subcommittee on Risk 
Management, Research and Specialty Crops, U.S. House of 
Representatives, Regarding the President's Working Group Report on OTC 
Derivatives and the Commodity Exchange Act, February 15, 2000.
---------------------------------------------------------------------------
    Congress agreed with the U.S. Options Exchange Coalition's position 
that security futures should be subject to elements of securities 
regulation. As a result, the SEC and CFTC, under the direction of the 
relevant Congressional committees, negotiated for many months on a 
regulatory structure for security futures products. The SEC-CFTC 
negotiations led to an approach that would regulate the products as 
both securities and futures under the oversight of both agencies, but 
with exemptions in certain areas to prevent duplicative regulation. 
Congress enacted this approach in the CFMA.
    A major component of the dual regulation approach was that security 
futures would be regulated in a manner consistent with comparable 
security options in key areas, such as insider trading, margin, tax, 
and transaction fees, in order to provide regulatory parity between 
these two product groups. Consistent regulation prevents regulatory 
arbitrage and promotes competitive fairness for equivalent products. It 
also avoids market anomalies where participants transact in a product 
to avoid the regulations of an equivalent product rather than for 
economic or commercial considerations. Indeed, regulatory consistency 
between security futures and security options was the linchpin of SEC-
CFTC agreement for regulating security futures. Without it, the U.S. 
Options Exchange Coalition, securities markets, SEC, and Congressional 
securities oversight committees would not have supported the 
introduction of security futures products.
    One of the most important areas of regulatory consistency embodied 
in the CFMA involved margin. Margin has an important function in 
derivative contracts. It not only acts as a performance bond but also 
directly controls the amount of leverage in a derivative such as a 
security future or a security option. It thus acts to affect the cost 
of establishing and maintaining a position in the derivative. As 
security futures and security options are economically equivalent 
instruments, different margin levels would have a significant impact on 
the competitive balance between the two products. To ensure a level 
playing field, the CFMA placed provisions in the Commodity Exchange Act 
and Securities Exchange Act of 1934 that required security futures 
margin to be consistent with the margin for comparable securities 
options. After passage of the CFMA, the SEC and CFTC approved security 
futures products trading with 20 percent margin, the same margin 
required for security options.

The Current CFTC Reauthorization Should Maintain Regulatory
Consistency
    Since their introduction, security futures products have had a slow 
start. While transaction volume and open interest in these products has 
grown substantially over the past year, trading interest still remains 
relatively small. Some of the futures exchanges along with the CFTC 
have questioned whether the dual regulatory approach has burdened 
security futures products, and in particular, whether the application 
of 20 percent margin has hampered the growth of the product. As a 
result, the Chicago Mercantile Exchange (CME) offered a proposal for a 
program that would leave margin setting authority for security futures 
products solely with the futures exchanges, subject to residual 
oversight by the Federal Reserve Board (Federal Reserve), and suspend 
SEC and CFTC oversight of margin for these products. The Senate 
Agriculture Committee adopted that approach in reporting S. 1566. The 
U.S. Options Exchange Coalition believes that approach to be seriously 
flawed because it would end the consistent margin treatment of security 
futures and security options. Instead, the U.S. Options Exchange 
Coalition has developed a proposal that would offer margin relief to 
security futures and security options while maintaining consistency of 
treatment across these two product groups.
    As a preliminary matter, the U.S. Options Exchange Coalition notes 
that it supports efforts to attract new business to security futures 
products. While these products compete directly with securities 
options, they also are complementary to them. Security futures offer 
our markets opportunities for hedging and arbitrage, and likewise 
participants in the securities futures markets use security options for 
hedging and arbitrage. There are a number of reasons why security 
futures have not yet been a huge success: Their introduction several 
years ago during a brutal bear market; robust cash equities and options 
markets that diminish the utility of the products;\3\ and the 
reluctance of broker-dealers to actively market the product to their 
customers. It is doubtful that margin treatment is a major reason for 
the lack of success of security futures. After all, with the same 
margin, security options have experienced record volumes over the past 
few years.\4\ It is also important to understand that more new futures 
and options on futures products fail than succeed.\5\
---------------------------------------------------------------------------
    \3\ Security futures products are offered in a number of countries. 
For the most part, this product has not garnered much trading volume. 
In the few countries where securities futures products have encountered 
success, the country either lacks a very liquid underlying market (so 
that the futures market becomes more desirable as a mechanism for 
transactions) or the country imposes tax or other fees on stock trading 
and not on futures trading (so that persons use futures as a means to 
avoid these taxes or fees).
    \4\ Listed security options had an average daily trading volume of 
2,883,841 contracts in 2000, 4,690,635 contracts in 2004, and 5,571,704 
contract for the first 6 months of 2005.
    \5\ For example, since 1995, the CME has filed to trade 293 new 
futures and options on futures contacts. On July 7, 2005, only 32 of 
these products had any trading volume on that date. Of those, only 10 
had trading volume of 1,000 or more contracts.
---------------------------------------------------------------------------
    Nevertheless, we are sympathetic to the desire of the futures 
industry to implement portfolio margining for security futures 
products. In many cases, the current strategy-based margin system for 
security futures and security options results in collecting more margin 
than is necessary to prudently protect against potential losses.\6\ 
This over margining is an inefficient use of capital by both security 
futures and security options customers. However, implementing portfolio 
margining for security futures must be accomplished in a manner that 
upholds the framework of regulatory consistency between security 
futures and security options. We strongly oppose unilateral efforts to 
reduce margin regulation of security futures without granting 
consistent treatment for security options. That is why we oppose the 
security futures margin provisions of S. 1566. By leaving securities 
futures margin solely up to the futures exchanges, the bill would sever 
the consistent treatment with securities options which has existed 
since the introduction of security futures. Security options margin 
would still be subject to SEC oversight, but security futures margin 
would have no SEC (or CFTC) oversight whatsoever.
---------------------------------------------------------------------------
    \6\ Under a strategy-based margin system, each option position must 
be classified as a covered write, spread, straddle or naked long or 
short position, etc. Once separated into the individual strategy 
positions, which can be a cumbersome process, margin is calculated 
separately for each paired off position, or naked position as the case 
may be, without consideration of any other positions that might further 
offset the risk of that position. Each strategy has a standard formula 
for computing the margin requirement that applies to all option 
classes.
---------------------------------------------------------------------------
    The bill, as reported, would undo the carefully drafted compromise 
embodied in the CFMA, is unfair to security options, and is unnecessary 
to achieve the desired results. It is a certainty that if S. 1566 were 
enacted, the futures exchanges would reduce the margin for security 
futures products far below a level that the SEC would approve for 
security options, perhaps as low as 5 percent. This would place 
security options at a large competitive disadvantage to security 
futures, which is the precise situation that Congress in enacting the 
CFMA sought to avoid. Given this disparity in margin levels, customers 
may choose security futures over security options not because of the 
merits of the product but merely because of its lower cost. S. 1566 
unnecessarily puts Congress in the position of granting regulatory 
advantages to one industry over another.
    The U.S. Options Exchange Coalition has developed an alternative 
approach that would lead to risk-appropriate portfolio margining for 
both products in a manner that would preserve the consistent treatment 
endorsed by Congress in the CFMA. We have shared this approach with the 
SEC, CFTC, CME, and Congressional committees. Under the approach, 
Congress would direct the SEC and CFTC to adopt joint rules permitting 
the use of portfolio margining for security futures within 9 months of 
passage of the legislation, and also direct the SEC to adopt a 
consistent rule permitting the use of portfolio margining for 
comparable security options within 9 months of passage of the 
legislation.\7\ Portfolio margin treatment allows instruments' (stocks, 
bonds, options, and futures) margin to be based upon the aggregate 
risks of all such instruments in a person's portfolio. Because a 
portfolio margining system would calculate margin on the greatest loss 
that could occur in a portfolio if the value of component instruments 
moved up or down by a certain amount, it is a more precise and 
efficient margin treatment than the current strategy-based approach 
used for security options and security futures. It is likely that, in 
many cases, a portfolio margin approach would reduce the amount of 
margin needed for security futures and security options for customers 
while still maintaining adequate risk coverage.\8\
---------------------------------------------------------------------------
    \7\ While the Federal Reserve ultimately has authority over 
securities margin, several years ago it delegated its authority over 
listed security options to enable the margin for these products to be 
set by the rules of the options self-regulatory organizations (SRO's) 
subject to approval by the SEC. Our proposal would direct the SEC, as 
long as the delegation from the Federal Reserve continued, to pass a 
rule that permits the SRO's to allow portfolio margining of security 
options.
    \8\ While the Coalition proposal specifically addresses portfolio 
margin for security futures products and security options, the joint 
rulemaking as well as the separate SEC rulemaking would be free to 
include other related instruments such as stocks and broad-based stock 
index futures in a portfolio margin program.
---------------------------------------------------------------------------
    The U.S. Options Exchange Coalition's legislative proposal is 
consistent with the approach to margin Congress laid out in the CFMA in 
2000. Congress gave the Federal Reserve authority over margin for 
security futures and the ability to delegate this authority to the SEC 
and CFTC jointly. In delegating margin authority, the Federal Reserve 
encouraged the agencies to move toward portfolio margining for security 
futures.\9\ Indeed, portfolio margining has been used at the 
clearinghouse level for security options for many years. In addition, 
markets in many foreign countries already employ portfolio margining 
for futures and options, as do most U.S. futures exchanges for products 
other than security futures. It is a time-tested international 
methodology, and it is imperative and urgent that the U.S. securities 
regulatory structure catches up to the rest of the world in using it. 
Unfortunately, progress toward this goal has been slow and incremental. 
Recently the SEC approved a proposal to implement a 2-year pilot 
program to allow portfolio margining for listed broad-based stock index 
options, index warrants, and related futures and exchange traded funds 
(ETF's).\10\ It took the SEC 3 years after submission of a formal 
proposal to grant this approval. While the pilot program would have 
been a good first step several years ago, it is time to move beyond an 
incremental approach toward the type of comprehensive methodology 
employed elsewhere that covers a wide range of products and market 
participants.\11\
---------------------------------------------------------------------------
    \9\ Letter dated March 6, 2001, from Jennifer J. Johnson, 
Secretary, Board of Governors of the Federal Reserve System, to Mr. 
James E. Newsome, Acting Chairman, CFTC, and Ms. Laura S. Unger, Acting 
Chairman, SEC.
    \10\ Securities Exchange Act Release Nos. 51615 (April 26, 2005) 
and 52032 (July 14, 2005).
    \11\ While the broad-based index options pilot was approved as a 
first step, it has overly restrictive provisions as to the accounts 
eligible to use portfolio margin. A comprehensive rule for portfolio 
margin should not restrict its use to accounts with very high equity or 
high net worth institutions. Rather, it should accommodate a wide range 
of entities that want to use portfolio margin, as is the case for 
portfolio margin in many foreign markets and in the futures industry.
---------------------------------------------------------------------------
    Our proposal would accomplish this by mandating that rules 
permitting portfolio margin for security options and security futures 
be adopted by a date certain, while preserving the consistent margin 
treatment between the two product groups. This proposal would produce a 
win-win situation for security futures and security options markets and 
compel the SEC and CFTC to act swiftly toward this important goal. The 
9-month period for rulemaking in the proposal is appropriate, as much 
of the preliminary work has already been accomplished. The futures 
industry and CFTC are very familiar with portfolio margining and the 
securities industry has been working with the SEC over the past few 
years toward obtaining portfolio margining for securities. This should 
be a familiar territory for both agencies. The SEC could build upon and 
expand the broad-based stock index options pilot to adopt rules for all 
security options and work with the CFTC to adopt consistent rules for 
security futures. With new leadership at the SEC and CFTC and clear 
direction by Congress, we believe the two agencies could act quickly to 
adopt comprehensive rules that would benefit investors and the 
markets.\12\
---------------------------------------------------------------------------
    \12\ The Coalition suggests that Congress require a brief status 
report in the 9-month rulemaking period to make sure that the two 
agencies remain on track.
---------------------------------------------------------------------------
    In permitting portfolio margining, it is critical that the SEC and 
CFTC adopt joint rules for security futures and that such rules are 
consistent with the SEC rulemaking for security options. Due to the 
historically disparate approach between the SEC and CFTC toward 
regulation in general and margin regulation in particular, individual 
rulemaking by each agency would produce different results for 
comparable products under their jurisdiction. Only Congress can ensure 
fair and consistent treatment on this fundamental issue by mandating 
joint rulemaking for 
security futures and by directing the SEC to adopt the same rules for 
security options. The SEC and CFTC worked together to adopt rules to 
facilitate the introduction of security futures after passage of the 
CFMA. There is no reason why they could not do the same for portfolio 
margining. The U.S. Options Exchange Coalition and its members stand 
ready to provide whatever assistance is needed to the SEC and CFTC to 
adopt rules for portfolio margining as well as to Congress as it 
deliberates on margin-related issues.
    The U.S. Options Exchange Coalition's legislative proposal also 
contains definitional changes to the Securities Investor Protection Act 
of 1970 (SIPA). SIPA involves the activities of the Securities Investor 
Protection Corporation (SIPC). SIPC protects customers if a broker-
dealer goes out of business up to specified amounts for customer cash 
and securities at the broker-dealer. SIPC covers most types of 
securities, but does not cover certain futures. Changes to SIPA are 
needed to accommodate portfolio margining by security options 
customers. Optimally, portfolio 
margining looks at all related positions in an account to determine the 
risk of the portfolio and the appropriate level of margin. For example, 
to fully realize the benefits of the portfolio margining pilot recently 
approved for options on broad-based stock indexes and ETF's, a customer 
may choose to have these positions in the same account as positions in 
broad-based stock index futures and futures on ETF's. Margining of 
options and futures in one account is called cross-margining. To 
facilitate cross-margining for such a customer, narrow changes to SIPA 
are needed to make sure that the customer is protected in the unlikely 
event of a broker-dealer bankruptcy. These changes would permit the 
cross-margin accounts of qualifying customers to be treated as 
``securities accounts'' under SIPA and provide that such customers can 
have appropriate claims against customer property consisting of certain 
futures in the event of the insolvency of the carrying broker-
dealer.\13\ Without these changes, portfolio margining cannot be fully 
implemented and inefficiency in the margining of securities will 
remain. The U.S. Options Exchange Coalition has discussed these changes 
with the SEC and the CFTC. It is crucial that Congress adopt these 
changes as part of the CFTC reauthorization process.
---------------------------------------------------------------------------
    \13\ For example, the definition of customer property under SIPA 
needs to be amended to include certain commodity futures and commodity 
option contracts.
---------------------------------------------------------------------------
Broad-Based Index Definition
    The CFTC reauthorization touches upon a variety of other issues, 
such as CFTC jurisdiction in foreign currency markets. The U.S. Options 
Exchange Coalition does not have a position on most of these other 
issues. However, the U.S. Options Exchange Coalition does have an 
interest in potential changes to the definition of narrow-based 
security indexes. The CFMA contains definitions of narrow-based 
security indexes in order to differentiate a narrow-based security 
index future from a broad-based security index future. Narrow-based 
security index futures are treated as security futures products and are 
subject to the dual jurisdiction of the SEC and CFTC, while broad-based 
security index futures are subject to the exclusive jurisdiction of the 
CFTC. These important definitions were carefully crafted by the SEC and 
CFTC.
    The CFTC and others in the futures industry want to create new 
definitions for ``narrow-based security'' indexes based on U.S. debt 
instruments, other U.S. securities, foreign equities, or foreign debt 
instruments. These new definitions for narrow-based security index for 
the four product types noted above could result in differences from the 
same definition applicable currently to an index comprised of U.S. 
equities. The U.S. Options Exchange Coalition will defer to the 
judgment of the SEC as to whether such differences would lead to an 
undesirable result in this area. In any event, the definitions of 
narrow-based security index should be crafted by the SEC and CFTC 
jointly. While there should be a good reason for any deviation from the 
definitions adopted by the CFMA, we will defer to the judgment of the 
two agencies if they jointly decide that the changes are warranted.

Conclusion
    The U.S. Options Exchange Coalition believes that CFTC 
reauthorization provides an opportunity to bring the benefits of 
portfolio margining to both security futures and security options in a 
manner that maintains the CFMA's parity of treatment for security 
futures and security options. The U.S. Options Exchange Coalition's 
proposal provides the means for achieving these goals. S. 1566 does not 
do so. We urge the Committee to maintain the parity of CFMA during 
reauthorization.
    Thank you again for the opportunity to testify at this important 
hearing. I would be happy to answer any questions that you have.

                               ----------

                  PREPARED STATEMENT OF MARK LACKRITZ
               President, Securities Industry Association
                           September 8, 2005

    The Securities Industry Association \1\ appreciates the opportunity 
to testify on The Commodity Exchange Reauthorization Act of 2005 (S. 
1566). We commend the Committee for your interest in provisions of S. 
1566 that are of significant importance to the securities industry.
---------------------------------------------------------------------------
    \1\ The Securities Industry Association brings together the shared 
interests of approximately 600 securities firms to accomplish common 
goals. SIA's primary mission is to build and maintain public trust and 
confidence in the securities markets. SIA members (including investment 
banks, broker-dealers, and mutual fund companies) are active in all 
U.S. and foreign markets and in all phases of corporate and public 
finance. According to the Bureau of Labor Statistics, the U.S. 
securities industry employs nearly 800,000 individuals, and its 
personnel manage the accounts of nearly 93-million investors directly 
and indirectly through corporate, thrift, and pension plans. In 2004, 
the industry generated $236.7 billion in domestic revenue and an 
estimated $340 billion in global revenues. (More information about SIA 
is available at: www.sia.com.)
---------------------------------------------------------------------------
Overview
    SIA strongly supports reauthorization of the Commodity Futures 
Trading Commission (CFTC) in 2005, but we oppose the provisions of S. 
1566 that go beyond CFTC reauthorization and would amend the Commodity 
Exchange Act (CEA) and the recently enacted modifications to the CEA 
codified in the Commodity Futures Modernization Act of 2000 (CFMA). The 
CFMA enjoyed strong bipartisan support in this Committee and in 
Congress, and it was well-received in the public and private sectors. 
In addition to codifying important modernizing amendments to the CEA, 
the CFMA brought much needed legal certainty to the U.S. over-the-
counter (OTC) derivatives markets and provided a statutory framework 
that has enhanced the competitiveness of U.S.-listed and OTC 
derivatives markets. Strong U.S. derivatives markets have, in turn, 
brought important benefits to all sectors of the U.S. economy since 
enactment of the CFMA. Importantly, the CFMA also established a dual 
statutory and regulatory framework for the trading of security futures, 
a class of financial instruments that had previously been prohibited in 
the United States.
    SIA is deeply concerned with two principal areas in S. 1566: (1) 
provisions addressing the margining of security futures and the status 
of certain security index futures; and, (2) the scope of language 
addressing the so-called Zelener decision and related foreign exchange 
issues, including the provisions to limit the scope of permissible 
activities of broker-dealers.
    In relation to security futures, SIA supports agency rulemakings 
and SRO rule approvals under the CEA and the Securities Exchange Act of 
1934 (Exchange Act) that would promote U.S. investor access to a 
broader range of security futures index products and that would 
encourage the adoption of portfolio margining. However, SIA believes it 
is essential that any portfolio margining legislation ensure that all 
financial instruments, including stocks, convertible and equity-linked 
debt, options, and security and security index futures, be included in 
a manner that does not establish margin-based competitive disparities. 
SIA opposes the provisions of S. 1566 that are addressed solely to 
portfolio margining for security futures.
    We understand that retail fraud in connection with speculative 
foreign exchange activities continues to be problematic, as it was 
prior to enactment of the CFMA. We do not agree, however, with the 
assertion that there is a compelling need for modifications to the CEA 
to address these problems. SIA strongly supports efforts to root out 
fraud against retail investors, but we believe the provisions of S. 
1566 are overly broad and could well give rise to unintended adverse 
consequences.

Discussion
Portfolio Margining
    The margin requirements for securities and securities derivatives 
limit the amount of economic leverage that can be achieved in 
connection with an investor's position in securities or other financial 
instruments.
    Generally speaking, the margin requirements applicable to broker-
dealers in connection with securities and securities derivatives are 
established under Regulation T of the Board of Governors of the Federal 
Reserve System (FRB) and under rules adopted by exchanges and other 
self-regulatory organizations (SRO's) and approved by the Securities 
and Exchange Commission (SEC). In the case of security futures, CEA and 
Exchange Act provisions also require that security futures margin 
levels not be lower than the lowest margin requirements applicable to 
comparable stock options. This latter restriction was adopted in the 
CFMA to prevent competitive disparities from arising from the 
application of the margin levels typically required for futures 
contracts (which are generally lower than those applicable to stocks 
and stock options).
    Today's investment portfolios are increasingly comprised of a wide 
array of securities and securities derivatives. These positions often 
have offsetting risk exposures. Under a strict application of the 
margin rules--without any recognition of the impact of multiple 
positions on the effective net exposures within a portfolio--the 
aggregate amount of margin that would be required to be maintained 
would be equal to the sum of the margin requirements applicable to each 
individual position.
    As a result, the aggregate margin requirements applicable to these 
portfolios do not reflect the risk-mitigating impact of offsetting 
positions, thereby leading to over-margining, portfolio inefficiencies, 
and a misalignment of margin and risk-management incentives. Investors 
are not incentivized under this approach to engage in risk-mitigating 
strategies. Excessive margin requirements also impair the competitive 
position of U.S. brokerage firms competing with non-U.S. financial 
service firms for the business of foreign customers.
    In order to ameliorate these effects, SRO's have adopted rules that 
recognize certain offsetting positions by reducing the aggregate margin 
requirements applicable to certain specified position combinations. 
While these so-called ``strategy-based'' margin levels provide some 
relief, they do not comprehensively take into account the exposure 
offsets found in common portfolios of multiple instruments. This is 
because they do not take into account all of the types of products and 
product combinations that may comprise a portfolio and give rise to 
offsetting exposures.
    In recognition of the superiority of portfolio margining as an 
efficient but prudential means of determining margin requirements, the 
FRB adopted an amendment to Regulation T in 1998 to provide an 
exemption for any portfolio margining system permitted by an SRO 
pursuant to SEC-approved rules.\2\
---------------------------------------------------------------------------
    \2\ [63 Fed. Reg. 2805 (Jan, 16, 1998).] Following enactment of the 
CFMA, in a letter dated March 6, 2001 addressed to the SEC and CFTC, 
the FRB reiterated its encouragement for the development of ``more 
risk-sensitive portfolio margining approaches for all securities, 
including security options and security futures products.''
---------------------------------------------------------------------------
    An ad hoc committee of SIA has been working with SRO's and the SEC 
for several years to expand the use of portfolio margining, and we have 
made modest, 
incremental progress during that time. Importantly, regulators have 
become increasingly familiar with the tools and techniques associated 
with portfolio margining, and we are hopeful that in the near future 
considerably greater progress will be made. SIA's portfolio margining 
committee recently submitted the outline of a proposal to the New York 
Stock Exchange that, if adopted and approved by the SEC, would be an 
important step in a process ultimately leading to a system of portfolio 
margining that encompasses the full range of securities and securities 
derivatives.
    Indeed, SIA strongly supports the use of portfolio margining and 
believes that it should be available for all statistically correlated 
portfolio positions, all market participants whose positions are 
subject to Federal margin regulation, and all accounts, with the 
following two stipulations.
    First, portfolio-margining arrangements should encompass and 
provide parity of treatment for all statistically correlated portfolio 
positions. Portfolio margining should not be available selectively to 
certain product categories, but not others, in a manner that might 
produce a potentially anticompetitive result. Ideally, firms would be 
permitted to use proprietary models for the purpose of calculating 
portfolio margin requirements.
    Second, any portfolio-margining arrangements should be limited to 
arrangements that do not give rise to uncertainty as to the 
availability of deposited margin to satisfy outstanding obligations in 
the case of insolvency of the carrying firm or its customer.
    Thus, SIA strongly supports regulatory initiatives designed to 
facilitate and promote portfolio margining on a comprehensive basis. 
Similarly, we would support legislation that encourages SEC and CFTC 
initiatives to approve SRO rules or to adopt rules implementing 
portfolio-margining systems consistent with the parameters articulated 
above.
    SIA opposes, however, the portfolio margining provisions currently 
contained in S. 1566. These provisions, among other deficiencies, are 
too narrowly drawn and have the potential to create inappropriate 
competitive disparities across competing product markets. SIA also 
believes, as a general matter, that the nature of the issues presented 
by portfolio margining are better suited to resolution through the 
cooperative interaction of the industry, SRO's and Federal agencies, 
rather than through a prescriptive legislative approach.

Security Futures Index Definitions
    Derivatives on security indices have provided valuable financial 
tools for the 
investment community, including retail, institutional, and professional 
investors. Limitations on investor access to these products arise under 
the dual regulatory framework for security futures products principally 
in two contexts: Foreign securities and narrow-based security indices 
and domestic nonequity indices.\3\ The current regime also limits the 
ability of U.S. brokerage firms to compete with non-U.S. financial 
services firms in offering transaction execution services to foreign 
customers trading in futures on foreign securities and narrow-based 
security indices.
---------------------------------------------------------------------------
    \3\ Under the current dual regulatory regime, the SEC and CFTC have 
not adopted the joint rules that would be necessary to permit in 
options on security futures.
---------------------------------------------------------------------------
    Access to these products requires the cooperative action of the SEC 
and CFTC. SIA strongly supports cooperative action by the two agencies 
to adopt the rulemaking necessary to make security index futures in 
these categories available to U.S. investors. Although SIA does not 
believe legislation to encourage joint rulemaking to permit U.S. 
trading in foreign stock and stock index futures and domestic nonequity 
securities and security indices is necessary, we would support such an 
initiative if the SEC and CFTC believe they need a legislative mandate. 
We oppose the security index definition provisions contained in S. 
1566.

Retail Foreign Exchange Fraud
General
    Critics of the decision of the Seventh Circuit Court of Appeals in 
CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004) argue that the decision 
created or exposed a significant loophole in the CEA that will 
purportedly provide a road map for retail fraud in a broad range of 
commodities.
    SIA disagrees with this view and believes that the Zelener decision 
was a correct application of current law and was correctly decided 
based on the facts in evidence in the case. SIA also does not find 
credible the claim that the Zelener decision will lead to similar 
decisions in cases involving retail transactions in physical 
commodities that typically require costly, complex, and burdensome 
delivery mechanisms.
    Moreover, the absence of CFTC jurisdiction over certain categories 
of retail commodity fraud does not necessarily result in an enforcement 
vacuum. Recent actions by the State of California \4\ and the Federal 
Trade Commission \5\ are indicative of the availability of other 
enforcement mechanisms for the protection of retail consumers.\6\
---------------------------------------------------------------------------
    \4\ U.S. Commodity Futures Trading Commission and State of 
California Charge San Francisco Foreign Currency Firm National 
Investment Consultants, Inc. And Other Companies And Individuals With 
Fraud, CFTC Press Release July 21, 2005. http://www.cftc.gov/opa/enf05/
opa5099-05.htm.
    \5\ Court Order Bars Deceptive Investment Pitches, Federal Trade 
Commission Press Release, May 17, 2005. http://www.ftc.gov/opa/2005/05/
britishcapital.htm.
    \6\ As noted by former Acting CFTC Chair Sharon Brown-Hruska:

    ``I would point out that our overall track record in the forex area 
is favorable. Since the passage of the CFMA, the Commission, on behalf 
of more than 20,000 customers, has filed 70 cases and prosecuted 267 
companies and individuals for illegal activity in forex. As a result of 
those efforts, we have thus far imposed over $240 million in penalties 
and restitution. Of the 70 cases that have been filed thus far, the 
Commission has lost only three.''

    Testimony of Sharon Brown-Hruska, Hearings of the Senate Committee 
on Agriculture, Nutrition, and Forestry, March 8, 2005.
---------------------------------------------------------------------------
    SIA believes that steps to expand CFTC jurisdiction beyond futures 
should be taken with great care. There are two reasons for this. First, 
the CFTC has a significant regulatory mission to discharge with respect 
to the Nation's currently regulated futures markets.
    These responsibilities already challenge the agency's resources. 
Steps that might expand the CFTC's role to that of a national police 
force for consumer fraud involving credit transactions could place 
significant additional burdens on the CFTC's resources and continued 
ability to meet the challenges of an extremely innovative and 
constantly evolving market.
    Second, the very uncertainties that gave rise to the need for the 
CFMA were themselves the result of the potentially expansive scope of 
the CEA and overlapping jurisdiction of the CFTC with that of the SEC, 
bank supervisors, and others. Nearly every prior amendment to the CEA 
involving the scope of CFTC jurisdiction, with the notable exception of 
the CFMA, has caused significant jurisdictional disputes or uncertainty 
with adverse collateral consequences. It is imperative that Congress 
avoids legislative initiatives that will create these problems in new 
areas of economic activity--particularly where no compelling public 
policy case has been presented for enacting legislation that might give 
rise to such risks.
    Nonetheless, SIA welcomes the attention of the President's Working 
Group on Financial Markets to these issues and supports efforts to 
eliminate or remediate fraud where the need to do so is identified. 
Consistent with the principles articulated above, however, it is 
critical that any such initiative be narrowly drawn to address only the 
substantive antifraud concerns.
    In this regard, we oppose the provisions of S. 1566 dealing with 
these issues and we have serious substantive, policy, and technical 
concerns with the language, including concerns regarding the scope of 
transactions that would be covered by the proposed provisions.

Broker-Dealer Affiliates
    Unrelated to the Zelener decision, S. 1566 would cut back 
significantly existing provisions of the CFMA that permit SEC-
registered broker-dealers and their material associated persons (that 
is, their material affiliates), among other entities, to continue to 
conduct OTC foreign exchange futures activities with counterparties 
that do not qualify as eligible contract participants.
    SIA understands that this proposal responds to a practice in which 
firms establish and register `shell' FCM's for the purpose of 
permitting under-capitalized and unregulated affiliates to engage in 
retail OTC foreign exchange futures activities. In the context of SEC-
registered broker-dealers or their material associated persons, 
however, no similar problem has arisen, and there is no basis for 
concluding that any similar problem will arise in the future.
    Most U.S. broker-dealer holding company groups have historically 
conducted their OTC foreign exchange activities in an affiliate of the 
SEC-registered broker-dealer. These entities are not thinly capitalized 
and, as noted above, there is no history of any retail foreign exchange 
related abuse by these entities or by personnel of the affiliated 
broker-dealer. Requiring reorganization of this business line and 
registration of personnel could be costly and burdensome and would be 
entirely unjustified by the record.
    As a result, SIA strongly opposes the provisions of S. 1566 that 
would modify the scope of permissible activities of broker-dealers or 
their material associated persons under the existing provisions of CEA 
Section 2(c)(2)(B).

Unregistered Solicitors
    SIA understands that certain unregulated persons, other than the 
entities enumerated in existing CEA Section 2(c)(2)(B), have commenced 
operations as solicitors of OTC foreign exchange futures transactions 
in which FCM's or FCM affiliates act as counterparty. SIA would not 
oppose legislative amendments that would require such solicitors to be 
registered with the CFTC where they are not an entity (or an employee 
of an entity) enumerated in CEA Section 2(c)(2)(B) or otherwise 
regulated.

Legal Certainty Concerns
    The CEA is a complex statutory scheme, reflecting, as it does, the 
richness and complexity of this nation's financial markets. In enacting 
amendments to the CEA, unintended consequences can readily occur, 
whether in the form of legal uncertainty, inappropriate restrictions on 
legitimate activity or competitive disparities.
    A potentially significant example of this problem is presented in 
the context of the Report of the Senate Committee on Agriculture, 
Nutrition, and Forestry accompanying S. 1566. That Report notes:

        The Committee concurs with the CFTC's consistent position that 
        even if a transaction is excluded from the CFTC jurisdiction 
        under Section 2(g), the false reporting of such a transaction 
        is a separate act and remains a violation of Section 9 so the 
        CFTC has authority to prosecute.\7\
---------------------------------------------------------------------------
    \7\ Report at page 6.

    SIA agrees that the CFTC has jurisdiction under Section 9 for a 
false report covered by that section even though, had the transaction 
falsely described actually occurred as described, it would have been 
eligible for the exclusion in Section 2(g). A transaction reported 
falsely by definition did not occur and therefore cannot satisfy the 
requirements of an exemption applicable to actual transactions. For 
that reason, the CFTC's enforcement position is justified and we agree 
with the conclusion reached in the Report.
    We do not agree with the basis cited in the Report for its 
conclusion. The Report suggests that the exclusion provided under 
Section 2(g) (and, presumably, the other statutory exclusions contained 
in the CEA) do not, for example, cover false ``statements'' because 
they are ``separate'' from the excluded transactions. The Report thus 
appears to distinguish between ``transactions'' that are exempt, on the 
one hand, and ``statements'' relating to transactions, which, according 
to the Report, are ``separate'' from the transactions and are therefore 
not exempt. The drawing of a general distinction between exempt or 
excluded transactions under the CEA and related ``statements'' or 
conduct of transactors is not justified under the CEA and could 
reintroduce significant uncertainty that the CFMA was expressly enacted 
to eliminate.
    Securities-based swaps, for example, are excluded from regulation 
under the CEA (including the CEA's antifraud provisions) pursuant to 
Section 2(g). Congress instead explicitly subjected securities-based 
swaps to antifraud provisions under the securities laws in Title III of 
the CFMA.
    The above-quoted Report language would suggest, however, that 
statements made in connection with securities-based swaps would be 
subject to CEA antifraud provisions. This is plainly inconsistent with 
Congressional intent. Moreover, the logic applied to ``statements'' 
could be equally applied to other conduct that is independent of the 
``transaction'', thus giving rise to broader uncertainty as to the 
extent to which provisions of the CEA regulate statements, 
communications, and other conduct of transactors in connection with the 
broad range of banking, securities, and other financial transactions 
Congress assumed it had expressly excluded from regulation under the 
CEA. Such uncertainty is unacceptable and should be dispelled.

Conclusion
    The CFMA resolved many significant issues and did so in innovative 
ways. This has enabled the U.S. derivatives market to provide important 
benefits for the U.S. economy. As noted above, the complexity of the 
products subject to the CEA, as well as those covered by exclusions 
from the CEA, are complex and extremely difficult to define. History 
has shown that a lack of clarity under the CEA can produce significant 
adverse consequences. As such, we believe it is extremely important 
that Congress proceed cautiously to avoid unintended adverse 
consequences of the type potentially presented by the Report text cited 
above.
    SIA is eager to work with the Committee and its staff to achieve 
your legislative objectives in a constructive manner that preserves the 
many benefits of the CFMA.

                               ----------

                 PREPARED STATEMENT OF ROBERT G. PICKEL
             Executive Director and Chief Executive Officer
         International Swaps and Derivatives Association, Inc.
                           September 8, 2005

    Mr. Chairman, Senator Sarbanes, and Members of the Committee. I am 
Robert G. Pickel, Executive Director and Chief Executive Officer of the 
International Swaps and Derivatives Association, Inc. (ISDA). I 
appreciate the Committee's invitation to appear today to present ISDA's 
views on proposed legislation to reauthorize the Commodity Futures 
Trading Commission (the CFTC), which administers the Commodity Exchange 
Act (the CEA).

Overview
    ISDA is an international organization, and its more than 650 
members in 48 countries include the world's leading dealers in swaps 
and other off-exchange derivatives transactions (OTC derivatives). 
ISDA's membership also includes many of the businesses, financial 
institutions, governmental entities, and other end users that rely on 
OTC derivatives to manage the financial, commodity market, credit, and 
other risks inherent in their core economic activities with a degree of 
efficiency and effectiveness that would not otherwise be possible.
    Congress substantially amended the CEA in the Commodity Futures 
Modernization Act of 2000 (the CFMA). The CFMA was adopted with broad 
bipartisan support after careful consideration over several years by 
four Congressional Committees, including this Committee, and with the 
active support of the President's Working Group on Financial Markets 
(the PWG); namely, the Secretary of the Treasury, the Chair of the 
Board of Governors of the Federal Reserve System, the Chair of the 
Securities and Exchange Commission, and the Chair of the CFTC.
    The CFMA was intended to provide regulatory relief for the futures 
exchanges; ensure legal certainty and regulatory clarity for OTC 
derivatives; and remove the ban on single-stock futures trading. ISDA 
is of course principally interested in those provisions of the CFMA 
that were enacted to provide legal certainty and regulatory clarity for 
OTC derivatives.\1\ For the reasons explained in Part II of this 
statement, ISDA believes that, based on the experience to date under 
the CFMA, Congress did achieve its objective of providing legal 
certainty and regulatory clarity for OTC derivatives in a manner that 
has reduced systemic risk and encouraged financial innovation. 
Moreover, from all indications, the CFMA seems to have been a broad-
based success for the capital markets generally. ISDA commends the CFTC 
for the effective manner in which it has implemented the CFMA in 
accordance with Congressional intent. ISDA has and will continue 
actively to support passage of legislation to reauthorize the CFTC.
---------------------------------------------------------------------------
    \1\ ISDA's primary members are substantial users of the regulated 
futures exchanges. ISDA therefore supported the provisions of the CFMA 
that provided regulatory relief to the exchanges.
---------------------------------------------------------------------------
    As the Committee is aware, there have been numerous proposals to 
utilize the reauthorization process as a vehicle for substantive 
amendments to the CFMA, including amendments relating to OTC 
derivatives. For the reasons discussed Parts II and III of this 
statement, ISDA believes there is no compelling need to make 
substantive changes to those portions of the CFMA governing OTC 
derivatives. While this Committee should of course consider the views 
of those who take a different position and advocate such amendments, we 
urge the Committee to take a cautious approach to reopening the OTC 
derivatives provisions of the CFMA. If any amendments are agreed to, 
they should be specifically targeted to identified problems requiring 
legislation and carefully crafted to avoid unintended collateral 
consequences that could undermine the legal certainty provided for OTC 
derivatives by the CFMA. In this connection, we also urge the Committee 
to ensure that all proposed substantive amendments to the CFMA are 
subject to advance review by the Committees of jurisdiction. Our 
experience in recent years demonstrates that the use of freestanding 
amendments offered to separate legislation without advance review by 
the Committees of jurisdiction is an undesirable method of considering 
changes to the CFMA.

OTC Derivatives Under the CFMA
    As noted, ISDA is principally interested in the provisions of the 
CFMA that provide legal certainty for OTC derivatives. The phrase 
``legal certainty'' means simply that the parties to OTC derivatives 
transactions must be certain that their contracts will be enforceable 
in accordance with their terms. The availability of OTC derivatives 
transactions within a strong legal framework, such as that provided by 
the CFMA, is of vital importance. Any uncertainty with respect to the 
enforceability of OTC derivatives contracts obviously presents a 
significant source of risk to individual parties to those specific 
transactions. Moreover, any legal uncertainty creates risks for the 
financial markets as a whole and precludes the full realization of the 
powerful risk management benefits that OTC derivatives transactions 
provide.
    As this Committee is aware, the CFMA framework for providing legal 
certainty is based on a long-standing consensus among Congress, key 
financial regulators, including the CFTC, and others that OTC 
derivatives transactions generally are not appropriately regulated as 
futures contracts under the CEA.\2\ The OTC derivatives provisions of 
the CFMA were intended by Congress to resolve the legal certainty 
issues with finality and, at the same time, reduce systemic risk and 
encourage financial innovation. ISDA's experience over the past several 
years indicates that these objectives have been achieved.
---------------------------------------------------------------------------
    \2\ In the late 1980's, the use of interest rate and currency swaps 
and other OTC derivatives transactions to manage financial risks grew 
rapidly. At that time, there was a consensus that OTC derivatives were 
not ``futures'' contracts. Nevertheless, because of certain perceived 
similarities between OTC derivatives and exchange traded futures 
contracts, there was residual concern that the CFTC or a court might 
treat OTC derivatives contracts as futures, which would render them 
illegal and unenforceable by reason of the CEA's exchange trading 
requirement.
---------------------------------------------------------------------------
    A survey of corporate usage of derivatives released by ISDA in 
April 2003 indicated that 92 percent of the world's largest businesses 
use OTC derivatives for risk management purposes and that 94 percent of 
the 196 U.S. companies included in the survey do so. Significantly, the 
use of OTC derivatives to hedge interest rate, foreign currency and 
credit default risks increased substantially in the last 4 years, 
evidencing the importance of OTC derivatives as a tool to manage risk 
in periods of economic downturn and uncertainty. As Federal Reserve 
Chairman Alan Greenspan noted before this Committee on March 2, 2002, 
OTC derivatives ``are a major contributor to the flexibility and 
resiliency of our financial system.'' \3\
---------------------------------------------------------------------------
    \3\ Moreover, as discussed more fully below, the reduction in 
systemic risk resulting from the use of OTC derivatives was also 
evident in the energy markets following the collapse of Enron in 2001. 
Indeed, it appears that the legal certainty provisions of the CFMA and 
the related provisions of the Bankruptcy Code (adopted by Congress in 
1990) may have enhanced the ability of market participants to deal 
effectively with events such as the collapse of Enron.
---------------------------------------------------------------------------
    The reductions in systemic risk resulting from enactment of the 
legal certainty provisions of the CFMA have not come at the expense of 
financial innovation. New types of OTC derivatives have gained 
increased market acceptance since enactment of the CFMA. For example, 
the significant growth in credit default swaps to manage credit risk 
has been greatly enhanced by the legal certainty provisions of the 
CFMA. Similarly, businesses ranging from ski resorts to beverage 
producers have begun to use weather derivatives to hedge the risk of 
adverse climate conditions on their businesses. Again, the legal 
certainty provisions of the CFMA have encouraged dealers to develop, 
and businesses to use, an increasing range of new kinds of OTC 
derivatives to manage additional types of risk. Finally, the legal 
certainty provisions of the CFMA removed the regulatory barriers to 
clearing with respect to OTC derivatives and, while collateralized 
transactions remain more prevalent, clearing proposals have been 
advanced recently and the emergence of these proposals attests to the 
positive effects of the CFMA on financial innovation.
    To summarize, ISDA's experience to date under the CFMA indicates 
that Congress did indeed achieve its objective of providing legal 
certainty and regulatory clarity for OTC derivatives in a manner that 
would both reduce systemic risk and encourage financial innovation. 
Equally significant, three events since the passage of the CFMA have in 
many ways ``stress tested'' the OTC derivatives markets and the 
applicable provisions of the CFMA itself. The results have been 
encouraging.
    First, there is no question but that the CFMA structure enabled 
financial institutions and the American business community to deal with 
the economic downturn in the early part of this decade in a more 
effective manner. The well-publicized events leading to Enron's 
bankruptcy filing in December 2001 presented a second test. Enron 
raised serious concerns involving accounting practices, securities law 
disclosures, and corporate governance policies. These issues received 
serious attention from policymakers and led to intensive investigations 
and enforcement actions, including actions based on the CFMA, by the 
CFTC and other regulators. Had Enron complied with accounting and 
disclosure requirements, it could not have built the ``house of cards'' 
that eventually led to its downfall. The market in the end exercised 
the ultimate sanction over Enron and the market for OTC derivatives 
functioned as expected and with no apparent disruption.
    The equally well-publicized transactions of Enron and others in or 
with respect to the California energy market presented a third test 
involving different public policy questions; namely, the design of the 
California electricity market, the lack of adequate reserves, demand 
response relative to growing electricity demand, and possible 
manipulation of the wholesale market. ISDA views any credible 
allegations of ``manipulation'' in financial or other markets as a 
serious matter requiring attention and therefore welcomed the 
investigations by the appropriate Federal agencies and departments, 
including the CFTC, the Federal Energy Regulatory Commission (FERC), 
and the Department of Justice. Both FERC and the CFTC initiated a 
series of enforcement actions employing the tools available under 
existing law, including the CFMA. Based on this experience, there does 
not appear to be any specific evidence that the Commission's 
antimanipulation authority is deficient. Again, the CFMA contributed 
positively to the ability of the markets to respond effectively to a 
difficult situation.

Possible Amendments to the CFMA Affecting OTC Derivatives
    As noted, there have been several proposals to amend the provisions 
of the CFMA governing OTC derivatives. The most far-reaching of these 
proposals involve OTC derivatives based on foreign currency. One such 
amendment was included in S. 1566, which was approved on July 29, 2005, 
by the Senate's Committee on Agriculture, Nutrition, and Forestry in 
legislation (S. 1566) to reauthorize the CFTC. ISDA has concerns with 
the proposed amendments affecting foreign currency transactions, 
including those contained in S. 1566, and welcomed the recent decision 
of the PWG to review the relevant policy issues. In addition, ISDA has 
concerns with respect to proposals that may be advanced as the 
legislative process moves forward to amend the CFMA provisions 
applicable to OTC derivatives based on energy and other ``exempt 
commodities.'' ISDA's comments on these proposed amendments to the CFMA 
are set forth below.
    Foreign Exchange Contracts-Zelener Issues. In the CFMA, Congress 
revised the so-called ``Treasury Amendment'' (the core provision of the 
CEA governing foreign exchange contracts) to provide legal certainty 
with respect to OTC foreign exchange contracts and, in so doing, gave 
the CFTC jurisdiction over certain specific transactions in foreign 
exchange contracts, but only if and to the extent those contracts are 
``futures'' or ``options''. In CFTC v. Zelener,\4\ the U.S. Court of 
Appeals for the Seventh Circuit held that the foreign exchange 
contracts before it were not ``futures contracts'' and that the CEA's 
antifraud rules were therefore not applicable. In ISDA's view, the 
Zelener case was correctly decided based on the evidence before the 
court, does not preclude the CFTC from successfully bringing similar 
cases in the future,\5\ and does not provide a ``road map'' for an 
``end run'' around the CEA that can be ``exported'' to physical 
commodities such as heating oil and grain.
---------------------------------------------------------------------------
    \4\ 373 F.3d 861 (7th Cir. 2004).
    \5\ In remarks prepared for delivery on March 17, 2005 at the 
Futures Industry Association International Derivatives Conference, CFTC 
Commissioner (and then Acting Chair) Sharon Brown-Hruska stated that 
``while developments like Zelener represent a set-back to our 
enforcement authority, I do not believe they preclude us from 
prevailing in these cases, even in the Seventh Circuit. A more focused 
litigation strategy, one that relies upon the extrinsic evidence 
surrounding the formation of the contract should, in our view, allow us 
to prevail in the future . . .''
---------------------------------------------------------------------------
    At the same time, however, ISDA recognizes that any fraudulent or 
manipulative activity involving the capital markets does warrant 
attention. In the case of the foreign currency markets, the involvement 
of the Department of the Treasury and the Federal Reserve (working in 
this case through the PWG) is critical and Congress has so recognized 
since the original adoption of the Treasury Amendment in 1974. Thus, 
while ISDA does not believe that statutory changes are necessary or 
warranted as a result of the Zelener decision, it could support a 
carefully crafted amendment if the PWG concludes that a legislative 
change is appropriate given the totality of the circumstances. ISDA 
will therefore give any such PWG recommendation serious consideration.
    ISDA does believe, however, that in principle any such amendment 
should be quite narrow in scope. Specifically, in ISDA's view, if the 
CFTC's jurisdiction is to be expanded to include agreements, contracts, 
and transactions that are not futures or options, that expanded 
jurisdiction should be expressly limited to authorizing the CFTC to 
pursue fraud claims in transactions in foreign exchange contracts 
between retail participants (that is, participants who are not eligible 
contract participants under the CFMA) and otherwise unregulated 
persons.
    Such a narrow approach has two distinct and important benefits. 
First, it will reduce the risk of unintended collateral consequences 
that could undermine the legal certainty provided by the CFMA for OTC 
derivatives. The risk of such unintended collateral consequences is 
neither speculative nor academic. For example, S. 1566 would amend 
Section 9 of the CEA to clarify the CFTC's jurisdiction with respect to 
false reporting. In its explanation of that amendment, the proposed 
Report of the Committee on Agriculture, Nutrition, and Forestry on S. 
1566 contains the following statement:

        The Committee concurs with the CFTC's consistent position that 
        even if a transaction is excluded from the CFTC jurisdiction 
        under Section 2(g) [of the CEA as added by the CFMA], the false 
        reporting of such a transaction is a separate act and remains a 
        violation of Section 9 so the CFTC has authority to prosecute.

    The effect of this statement, which in ISDA's view does not follow 
from a reading of the statute itself, is that an allegedly false 
statement made by a person to a third party will trigger CFTC 
jurisdiction over that person even if the statement is made about a 
contract with respect to which the CFTC has no jurisdiction, including 
antifraud jurisdiction.
    The position that the CFMA exclusions such as Section 2(g) protect 
only the ``agreements, contracts or transactions'' themselves and not 
the persons who participate in those transactions is inconsistent with 
the understanding of market participants concerning the scope of the 
legal certainty provisions of the CFMA and will likely erode the legal 
certainty protections intended by Congress in 2000. Moreover, such a 
construction is unnecessary to achieve the apparent legislative 
objectives, which ISDA supports, with respect to Section 9.\6\
---------------------------------------------------------------------------
    \6\ In this connection, ISDA notes that the energy legislation 
enacted earlier this year contains provisions intended to improve the 
quality of reporting by all parties to many energy transactions.
---------------------------------------------------------------------------
    The second benefit of a narrow approach to any Zelener-related 
amendment to the CEA is that it will limit the extent to which the CFTC 
is required to divert its limited resources from its core function of 
providing effective oversight of exchange traded futures and options 
contracts. Congress has on prior occasions evidenced a healthy 
skepticism toward proposals that would enlarge the CFTC's consumer 
protection mandate with respect to contracts not otherwise subject to 
its jurisdiction and it should continue to do so.
    Foreign Exchange Contracts-Affiliates and Solicitors. Proposals 
have been made to limit the ability of firms to create a so-called 
``shell'' futures commission merchant (an FCM) that would enable an 
entity related to the shell FCM (a material affiliated person) to 
qualify under the Treasury Amendment (as revised by the CFMA) to engage 
in OTC foreign exchange futures transactions with persons who are not 
eligible contract participants. Under these proposals, an FCM would 
have to be well-capitalized and engaged in the conduct of the regulated 
futures business. In addition, proposals have been made to require 
persons who market transactions covered the Treasury Amendment to 
register with the CFTC unless the person is either an entity otherwise 
eligible under the Treasury Amendment to engage in the transaction or 
an employee of such an entity.
    If appropriately drafted, ISDA could support amendments to address 
the shell FCM and unregistered solicitor issues. ISDA could not, 
however, support amendments to the CEA that would prohibit those who 
are material associated persons with respect to broker-dealers from 
engaging, in accordance with the CFMA, in OTC foreign exchange futures 
transactions with persons who are not eligible contract participants. 
There has been no evidence of any inappropriate conduct in transactions 
involving these entities and they are generally well-capitalized.
    Energy and Other Exempt Commodities. As the Committee is aware, in 
recent years, proposals have been offered in the Senate in connection 
with energy-related legislation to amend the provisions of the CFMA 
providing legal certainty for OTC derivatives based on energy and other 
so-called ``exempt commodities.'' These proposals, which would expand 
regulation of the OTC markets involving exempt commodities, have been 
consistently opposed by the PWG on policy grounds and, in case of 
energy-based derivatives, on the additional basis that enforcement 
actions taken by regulatory agencies and the Department of Justice 
rendered them unnecessary. ISDA shares the views of the PWG and urges 
the Committee to oppose any amendments to the CFMA based on these prior 
proposals.

Conclusion
    OTC derivatives contribute substantially to the flexibility and 
resiliency of our financial system. They allow businesses, financial 
institutions, governmental entities, and other end users to manage the 
financial, commodity, credit, and other risks inherent in their core 
economic activities in an efficient manner. The CFMA provided legal 
certainty and regulatory clarity for OTC derivatives in a manner 
consistent with the long-standing policies of Congress and the CFTC 
that OTC derivatives are not appropriately regulated under the CEA as 
futures contracts. This policy, as codified in the CFMA, materially 
reduces systemic risk and encourages financial innovation.
    On behalf of ISDA and its members, I thank you for this opportunity 
to present our views and am prepared to respond to any questions you 
may have.

                  PREPARE STATEMENT OF DANIEL J. ROTH
                 President and Chief Executive Officer
                      National Futures Association
                           September 8, 2005

    My name is Daniel Roth, and I am President and Chief Executive 
Officer of National Futures Association. Thank you Chairman Shelby and 
Members of the Committee for this opportunity to appear here today to 
present our views on some of the issues facing Congress as it considers 
legislation to reauthorize the Commodity Futures Trading Commission 
(CFTC). NFA recognizes the importance of completing the reauthorization 
process as quickly as possible. At the same time, however, we feel that 
Congress must deal with important issues involving the protection of 
unsophisticated retail customers.
    NFA is the industry-wide self-regulatory organization for the U.S. 
futures industry. Regulation is all we do at NFA--we do not operate a 
marketplace and we are not a lobbying organization. As a regulator, NFA 
is first and foremost a customer protection organization. Our mission 
is to provide the futures industry with the most effective and the most 
efficient regulation possible.
    Our approximately 4,000 members include futures commission 
merchants (FCM's), introducing brokers (IB's), commodity pool operators 
(CPO's), and commodity trading advisers (CTA's). We also regulate 
approximately 54,000 registered account executives who work for our 
members.
    As a regulator, NFA's main responsibilities are many and varied. We 
establish rules and standards to ensure fair dealing with customers; we 
perform audits and examinations of our members to monitor their 
compliance with those rules; we conduct financial surveillance to 
enforce compliance with NFA financial requirements; we provide 
arbitration and mediation of futures-related disputes; we perform trade 
practice and market surveillance activities for a number of exchanges; 
and we conduct extensive educational programs both for the investing 
public and for our members. We also perform a number of regulatory 
functions on behalf of the CFTC, 
including the entire registration process--from screening applicants 
for fitness to taking actions to deny or revoke registrations when 
those fitness standards are not met. We perform these duties with a 
staff of approximately 235 people and a budget of over $35 million, all 
of which is paid by the futures industry. Since NFA began operations in 
1982, volume on U.S. futures markets has increased by over 1,200 
percent--a great testament to the innovation and value of our futures 
markets. What most people do not realize is that during that same time 
period customer complaints in the futures industry are down by almost 
75 percent. This drop in customer complaints was not an accident. It 
was the result of a close partnership between the CFTC, NFA, and the 
rest of the industry to make sure that we are allocating resources 
where they are most needed, that we do not duplicate each other's 
efforts and that precious regulatory resources are not squandered.
    In the last reauthorization process, Congress made bold changes to 
the Commodity Exchange Act (CEA). The Commodity Futures Modernization 
Act (CFMA) rejected a highly prescriptive, outmoded approach to 
regulation in favor of a more flexible approach that focused regulatory 
protections where they were most needed. I am pleased to join the rest 
of the industry in noting the great success of the CFMA and the superb 
work of the CFTC in implementing exactly the kind of flexible 
regulatory approach that the CFMA envisioned. The CFTC and its staff 
have worked to reduce unnecessary and costly regulatory burdens for 
every segment of the industry while preserving the highest level of 
customer protection.
    Though the CFMA has been a great success, it failed in one of its 
objectives that directly impacts customer protection. Before the CFMA, 
boiler rooms had found their unregulated niche in off-exchange forex, 
where widespread retail fraud was occurring. Congress attempted to 
resolve the so-called ``Treasury Amendment'' issue once and for all in 
the CFMA by clarifying that the CFTC does, in fact, have jurisdiction 
to protect retail customers investing in off-exchange foreign currency 
futures. The basic thrust of the CFMA in this area was that foreign 
currency futures with retail customers were covered by the Act unless 
the counterparty was an ``otherwise regulated entity,'' such as a bank, 
a broker-dealer, or an FCM. Unfortunately, as we sit here today, there 
is as much uncertainty over the CFTC's authority to protect retail 
customers as there was 5 years ago. This uncertainty is clearly not 
what Congress intended in passing the CFMA.
    The main problem stems from a decision in the Seventh Circuit Court 
of Appeals in a forex fraud case brought by the CFTC, the so-called 
Zelener case. In Zelener, the District Court found that retail 
customers had, in fact, been defrauded but that the CFTC had no 
jurisdiction because the contracts at issue were not futures. The 
Seventh Circuit affirmed that decision. The ``rolling spot'' contracts 
in Zelener were marketed to retail customers for purposes of 
speculation; they were sold on margin; they were routinely rolled over 
and over and held for long periods of time; and they were regularly 
offset so that delivery rarely, if ever, occurred. In Zelener, though, 
the Seventh Circuit based its decision that these were not futures 
contracts predominantly on the terms of the written contract itself. 
Because the written contract in Zelener did not include a guaranteed 
right of offset, the Seventh Circuit ruled that the contracts at issue 
were not futures.
    Zelener creates the distinct possibility that, through clever 
draftsmanship, completely unregulated firms and individuals can sell 
retail customers contracts that look like futures, act like futures and 
are sold like futures and can do so outside the CFTC's and any other 
Federal regulatory body's jurisdiction. To make matters worse, the 
rationale of the Zelener decision is not limited to foreign currency 
products. It is very likely that unsophisticated retail customers will 
be victimized by high-pressured sales pitches for futures look-alike 
products covering everything from foreign currencies to precious metals 
to heating oil. The CFMA recognized that these retail customers are the 
ones who most need regulatory protection, and that protection should 
not be stripped from them because a clever lawyer finds a loophole in 
the law.
    I recognize that Zelener is just one case, and we should not 
overreact to it. It is true that the Zelener decision would allow the 
CFTC in other cases to present evidence that the FCM made oral 
representations about the customer's right to offset. But the reality 
is that those cases will be almost impossible to bring. First, in most 
cases the sales pitch is not made by the FCM but by an unregistered, 
unregulated solicitor. It is not clear to me that any court would find 
that the nature of the contract between the customer and the FCM was 
transformed into a futures contract because of oral representations 
made by some third party, registered or not. Second, if the written 
contract is vague about a right of offset, I can guarantee that the 
salesman working the phone will be even more evasive. In my opinion, 
trying to work our way out of the Zelener problem through future 
enforcement actions puts an awful lot of chips on a bet that's no sure 
thing.
    We strongly believe that the Zelener decision makes it much harder 
for the CFTC to prove that contracts sold to retail customers to 
speculate in commodity prices are futures, makes it easier for the 
unscrupulous to avoid CFTC regulation and creates a real, live customer 
protection issue. Therefore, it is NFA's view that Congress should 
address this issue.
    The trick is to protect retail customers without upsetting 
jurisdictional boundaries that were agreed to in the CFMA. We agree 
with the CFTC and the industry that Zelener is not an easy problem to 
resolve. But it must be done if we are to protect retail customers from 
unscrupulous firms and individuals and the solution should not be 
limited to forex. Some have suggested that the best approach is to 
address Zelener only with respect to forex products on the grounds that 
forex is where the bulk of the fraud is occurring. I agree that forex 
is the current scam of choice among fraudsters and I know that those 
who favor a narrow fix have the best of intentions, but limiting a 
Zelener fix to forex ignores the history of sales practice fraud and 
will not, in our view, really address the problem.
    In NFA's 20-years of experience we have seen that boiler rooms 
really prefer to sell physical commodities that retail customers deal 
with all the time. Sugar, gold, unleaded gasoline, heating oil--these 
are the products that boiler rooms have historically favored. Foreign 
exchange rates, by contrast, are fairly arcane. Forex fraud mushroomed, 
however, after the 9th Circuit's 1996 Frankwell Bullion decision made 
clear that the CFTC had no jurisdiction over forex futures contracts 
offered to retail customers. Congress attempted to deal with that 
problem in the CFMA, but the Zelener case basically negated that effort 
and made things worse by providing fraudsters with a road map on how to 
avoid CFTC jurisdiction not just for forex futures but for anything 
else. We are concerned that if Congress adopts a forex only fix to 
Zelener it will not close the unregulated niche--it will just move it 
to other commodities.
    NFA and the exchanges have developed a fix to Zelener that goes 
beyond forex and does not have unintended consequences. Our approach 
codifies the approach the 9th Circuit took in CFTC v. Co Petro--which 
was the accepted and workable state of the law until Zelener--without 
changing the jurisdictional exemptions in Section 2(c). In particular, 
our approach would create a statutory presumption that leveraged or 
margined transactions offered to retail customers are futures contracts 
if the retail customer does not have a commercial use for the commodity 
or the ability to make or take delivery. This presumption is flexible 
and could be overcome by showing that the transactions were not 
primarily marketed to retail customers or were not marketed to those 
customers as a way to speculate on price movements in the underlying 
commodity. I have attached a copy of our proposed language.
    Our approach has a number of advantages:

 First, it codifies Co Petro and returns the law to its pre-
    Zelener state. This would give the CFTC jurisdiction over 
    traditional futures contracts without expanding it.
 Second, it does not touch the interbank currency market.
 Third, Section 2(c) would continue to exempt the retail OTC 
    forex activities of banks, broker-dealers, insurance companies, and 
    similar entities from CFTC jurisdiction.
 Fourth, our approach does not change any of the CFMA 
    exemptions for off-exchange transactions entered into by eligible 
    contract participants.
 And last, but certainly not least, it protects retail 
    customers by giving the CFTC the power to shut down unregulated 
    boiler rooms and freeze their funds.

    Our presumption is not meant to address already regulated 
instruments like securities and banking products. It would, however, 
ensure that scammers cannot tailor their written agreements to sell 
leveraged commodity products to retail customers for speculative 
purposes in a completely unregulated environment.
    NFA believes that the solution to Zelener should go beyond forex. 
Others disagree. One thing we all agree on, though, is that if Congress 
does not adopt a broad fix to Zelener now and boiler rooms move to 
other commodities using Zelener-type contracts, Congress must be 
willing to reopen the Commodity Exchange Act before the next 
reauthorization.
    Unfortunately, the Zelener decision is not the only problem we have 
encountered with retail forex. Since passage of the CFMA, a number of 
firms--that do not engage in any other regulated business--have 
nonetheless registered as FCM's to qualify to be an otherwise regulated 
entity and have become NFA Forex Dealer Members for the sole purpose of 
acting as counterparties to retail customers in these transactions. For 
example, just 2 years ago, NFA had 14 active Forex Dealer Members and 
those Members held approximately $170 million in retail customer funds. 
Since then, the retail forex business has continued to grow by leaps 
and bounds. Today, NFA has 31 active Forex Dealer Members holding over 
$700 million in customer funds. That growth has not been problem free.
    Though less than 1 percent of our member firms, forex dealers have 
accounted for 50 percent of our emergency enforcement actions and over 
10 percent of our arbitration docket. I know the CFTC has been very 
aggressive in enforcement cases involving forex, though most of those 
cases have involved unregistered firms.
    Obviously, retail forex has consumed a good deal of resources at 
NFA, but we are committed to doing whatever it takes to get our job 
done. Late last year, we appointed a blue ribbon committee to review 
all of our forex rules. It recommended, and our Board adopted, 
additional rules to strengthen both our financial requirements and 
sales practice rules for forex. We will continue to enforce our rules 
vigorously and bring actions whenever necessary to ensure compliance 
with our rules. Part of the problem, though, is that some firms can 
operate beyond our reach, in a completely unregulated environment, 
because of an unintended glitch in the wording of the CFMA.
    As I mentioned before, the basic thrust of the CFMA was that only 
``otherwise regulated entities'' could offer retail customers off-
exchange foreign currency futures. Unfortunately, the wording of the 
statute only requires the counterparty to be an otherwise regulated 
entity. This creates the possibility that an FCM, for example, might be 
the counterparty but the firm that actually does the telemarketing for 
these products is completely unregistered and unregulated. There are 
literally hundreds of these unregulated firms doing telemarketing of 
off-exchange forex transactions to retail customers and in some 
instances the people making the sales pitches have been barred from the 
futures industry for sales practice fraud. I do not think that is what 
Congress intended at all and NFA would support an amendment to Section 
2(c) of the Act to make clear that not only the counterparties but also 
the persons actually selling these products to retail customers must be 
``otherwise regulated entities.''
    There was one more forex problem I should mention, though we are 
hopeful that it is a problem we can solve through NFA rules without any 
further legislation from Congress. Section 2(c) of the CEA could be 
read to allow unregulated affiliates of FCM's to act as counterparties 
to retail customers if the FCM makes and keeps records of the 
affiliates under the CEA's risk-assessment provisions. Some firms have 
tried to take advantage of this provision of the Act by creating 
``shell'' FCM's. These shell FCM's do not do any futures business and 
they do not do any retail forex business. Their sole reason for 
existence seems to be to create affiliates that do retail forex 
business in a completely unregulated environment.
    I do not think that that is what Congress had in mind. Therefore, 
NFA is currently working on a solution to adopt a larger minimum 
capital requirement for FCM's with retail forex affiliates. We hope 
these efforts will solve the shell FCM problem without the need for 
legislative relief.
    In closing, let me state that NFA believes the industry and the 
public have benefited greatly from the enlightened regulatory approach 
that Congress adopted in the CFMA and from the CFTC's role in 
implementing the Act. We look forward to working with this Committee, 
other Congressional committees, the CFTC, and the industry to address 
the issues outlined above.

        RESPOSNE TO WRITTEN QUESTION OF SENATOR SHELBY 
                     FROM RANDY K. QUARLES

Q.1. In oral testimony before the Committee, the CFTC General 
Counsel identified a recent decision in the case of CFTC v. 
Bradley as supporting the Commission's interpretation of its 
enforcement jurisdiction under the Commodity Exchange Act. Have 
the members of the President's Working Group reviewed this 
decision? Do the members of the President's Working Group agree 
with the decision? Does the decision raise any issues or 
concerns that the Committee should consider or address?

A.1. The decision referred to by the CFTC's General Counsel 
during the September 8 hearing is an August 2005 order by the 
U.S. District Court for the Northern District of Oklahoma 
denying the defendants' motions to dismiss in the case of CFTC 
v. Bradley. In that case, the CFTC alleged that the defendants 
violated Section 9(a)(2) of the Commodity Exchange Act (CEA) by 
knowingly making, or causing to be made, false reports 
regarding the prices and volumes of transactions in natural gas 
to several reporting firms that compiled natural gas price 
indexes. In addition, the CFTC alleged that defendants did so 
in an effort to manipulate the price of natural gas futures and 
options contracts in violation of Sections 6(c) and (d) and 
9(a)(2).
    Natural gas is an ``exempt commodity'' under the CEA, and 
an ``agreement, contract, or transaction'' in an exempt 
commodity may be excluded or exempt from CFTC jurisdiction, 
respectively, by Sections 2(g) and 2(h) of the CEA. The 
defendants in CFTC v. Bradley requested dismissal of the CFTC's 
complaint by arguing that the CFTC has no jurisdiction over 
their activities based on the 2(g) and 2(h) exemptions. The 
Bradley court put the burden on the defendants to prove the 
exemptions applied. It found that the defendants offered no 
authority for the proposition that the 2(g) or 2(h) exemptions 
apply to reporting activities ``related to'' an exempt 
commodity or contract. The court's order denied dismissal of 
the case in part on a finding that the exemptions did not 
apply.
    The President's Working Group on Financial Markets (PWG), 
of which Secretary Snow is chair, has not reviewed or formed an 
opinion about the August 2005 order in CFTC v. Bradley. 
Treasury consistently has taken the position that legal and 
regulatory certainty are essential for the smooth functioning 
of our financial markets. In the view of some observers the 
Bradley court's interpretation of the scope of the CEA 
exemptions has raised questions concerning the legal certainty 
of the exemptions and exclusions that were set out in the 
Commodity Futures Modernization Act of 2000 (CFMA). Other 
observers believe that the decision is in accordance with the 
CFMA's regulatory framework and accordingly does not raise 
questions about legal certainty. In light of the potential 
impact and complexity of these issues, and the differing 
opinions about their implications, I will recommend to 
Secretary Snow that the PWG take up the issues raised in the 
case of CFTC v. Bradley, but I do not believe that the PWG's 
consideration of these issues should delay legislative 
reauthorization of the CFTC.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 
                   FROM PATRICK M. PARKINSON

Q.1. In oral testimony before the Committee, the CFTC General 
Counsel identified a recent decision in the case of CFTC v. 
Bradley as supporting the Commission's interpretation of its 
enforcement jurisdiction under the Commodity Exchange Act. Have 
the members of the President's Working Group reviewed this 
decision? Do the members of the President's Working Group agree 
with the decision? Does the decision raise any issues or 
concerns that the Committee should consider or address?

A.1. The U.S. District Court for the Northern District of 
Oklahoma's August 2005 opinion in CFTC v. Bradley held that the 
fact that natural gas is an ``exempt commodity'' under Sections 
2(g) and 2(h) of the Commodities Exchange Act (CEA) does not 
mean that any conduct or activity ``related to'' such a 
commodity is excluded from CFTC regulation under the CEA. In 
this case, the CFTC alleged that the defendants delivered 
false, misleading, or knowingly inaccurate reports on natural 
gas transactions to reporting firms in violation of Section 
9(a)(2) of the CEA, and that the defendants did so in an 
attempt to manipulate the price of natural gas futures and 
options contracts on the NYMEX in violation of Sections 6(c), 
6(d), and 9(a)(2) of the CEA.
    While acknowledging that natural gas is an ``exempt 
commodity'' under the CEA, the court noted that Sections 2(g) 
and 2(h) of the CEA exempt an ``agreement, contract, or 
transaction'' in an exempt commodity, but ``do not state that 
the CEA does not apply to any conduct or activity related to 
exempt commodities.'' Rather, the court found that ``the 
exemptions are, by their terms, limited to contracts, 
agreements, or transactions.'' The court held that the 
defendants' false disclosures to the reporting firms did not 
fall within the ambit of Sections 2(g) and 2(h) and, 
accordingly, the exemptions were not applicable.
    The PWG has not discussed the CFTC v. Bradley decision. 
Nonetheless, the Board has taken the position over the years 
that financial markets are best served by public policies that 
create an environment of legal and regulatory certainty. The 
CFTC v. Bradley decision employs reasoning that, particularly 
if applied more broadly, could undermine the legal and 
regulatory certainty that many had expected the CFMA to 
achieve.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT 
                     FROM CHARLES P. CAREY

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 
established regulatory parity between security futures and 
security options. This followed a President's Working Group 
report in 1999 recommending that both the SEC and CFTC work 
together to determine the regulatory framework for security 
futures. Do you support the regulatory parity that currently 
exists between security 
futures and security options? Do you think that the SEC should 
be involved in the regulation of security futures? If so, what 
is the SEC's role?

A.1. The CFMA provided roles to both the Commodity Futures 
Trading Commission and the Securities and Exchange Commission 
as regulators of stock futures products, but did not go so far 
as to require security futures be regulated exactly as security 
options. This approach left room for recognition of the fact 
that security futures and security options are different 
products with different purposes and customers, while providing 
the SEC ability to ensure that security futures were not used 
to circumvent securities law prohibitions. The dual regulatory 
scheme of stock futures products has been challenging to date 
and the growth of single stock futures in the United States has 
been anemic, at best, while the products have flourished in 
other jurisdictions. The CBOT believes that these products 
should be given the best chance possible for success, and that 
whatever regulatory structure is in place, it should not 
hamstring the products with illogical treatment. The CBOT 
continues to believe that requiring absolutely identical 
treatment for two such different products and markets could 
function to hamper the growth of the new product unnecessarily.
    One example of the difficult and unnecessarily burdensome 
regulatory system is the inability, at least to this point, of 
the SEC and the CFTC to afford rational regulatory treatment of 
margining for these products. Historically, the power to set 
margins for futures products has rested with exchanges. 
Congress recognized that futures margins were performance 
bonds, posted by both buyers and sellers of commodities for 
future delivery, to ensure the performance of obligations under 
the contract, especially if the price moved adversely to one's 
position. Because futures contracts are not assets, such as 
stocks, and because margins are not a credit function in the 
acquisition of an asset, exchanges typically set margin at 
levels designed to cover the risk of several days' price 
movement on a historical basis. The levels of margin, set as a 
dollar amount per contract rather than as a percentage of the 
price of the underlying product, can quickly be changed in the 
event of higher volatility in prices, in other words, increased 
risk. With the advent of more powerful data processing and 
sophisticated financial valuation models and techniques, this 
risk-based margining today can be applied more precisely to 
futures positions, measuring the risk inherent in individual 
positions as affected by other positions within the same 
portfolio. Using risk-based margining has provided participants 
in the financial markets with greater flexibility and 
efficiencies, while at the same time affording greater 
stability to the markets themselves.
    As I said in my testimony, the CBOT hopes Congress will 
facilitate the margining of stock futures as futures contracts, 
recognizing that the economic function of a futures contract is 
not to 
acquire ownership of the stock, but rather is to act as a 
hedging vehicle. The CBOT also hopes Congress will provide 
needed clarity on the definition of narrow-based security 
indexes to avoid unintended confusion about potential dual 
regulation of futures on indexes of fixed-income securities, 
corporate bonds, and other nonequity securities that is 
hampering development of those products.

  RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM MARC 
                            LACKRITZ

Q.1.a. The Commodity Futures Modernization Act (CFMA) of 2000 
established regulatory parity between security futures and 
security options. This followed a President's Working Group 
report in 1999 recommending that both the SEC and CFTC work 
together to determine the regulatory framework for security 
futures. Do you support the regulatory parity that currently 
exists between security 
futures and security options?

A.1.a. Yes. Competing financial products should operate on a 
regulatory level playing field and be given the opportunity to 
prove their merits in the marketplace.

Q.1.b. Do you think that the SEC should be involved in the 
regulation of security futures?

A.1.b. Given the SEC's mandate and in light of the fact that 
the CFMA defined ``security futures'' as both ``securities'' 
and ``futures,'' it would be very surprising if the SEC were 
not involved in the regulation of the product.

Q.1.c. If so, what is the SEC's role?

A.1.c. Given the statutory definition of ``security futures,'' 
it appears perfectly appropriate for both the CFTC and the SEC 
to be involved in regulating these products, and we urge 
Congress to continue to encourage the two agencies to work 
together to develop a suitable regulatory framework for 
security futures. However, as indicated in my September 8 
testimony, we do not believe that this effort should be 
conflated with the effort at developing a framework for 
portfolio margining. While a very desirable and achievable 
goal, such a framework should be developed for all financial 
products.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT 
                     FROM ROBERT G. PICKEL

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 
established regulatory parity between security futures and 
security options. This followed a President's Working Group 
report in 1999 recommending that both the SEC and CFTC work 
together to determine the regulatory framework for security 
futures. Do you support the regulatory parity that currently 
exists between security 
futures and security options? Do you think that the SEC should 
be involved in the regulation of security futures? If so, what 
is the SEC's role?

A.1. The International Swaps and Derivatives Association 
represents the world's leading dealers in swaps and other off-
exchange derivatives transactions. Our members have benefited 
significantly from the legal certainty that the Commodity 
Futures Modernization Act of 2000 (CFMA) established for OTC 
derivatives. The CFMA also lifted a 20-year ban on security 
futures products. While, ISDA, as derivatives industry 
association, does not address the securities activities of its 
members, ISDA believes generally that regulations that create 
additional opportunities for market participants can be 
productive for the market itself. ISDA similarly subscribes to 
the principle that statutory schemes should not unduly favor 
specific products but should instead foster a level playing 
field that allows competitive forces to operate efficiently. 
Given the nature of these products and the SEC's role in the 
regulation and oversight of the underlying securities, the SEC 
would appear to have a legitimate regulatory interest in the 
development of security futures. Congress should continue to 
encourage the SEC and CFTC to work together to carry out the 
intent of the CFMA.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT 
                      FROM DANIEL J. ROTH

Q.1. The Commodity Futures Modernization Act (CFMA) of 2000 
established regulatory parity between security futures and 
security options. This followed a President's Working Group 
report in 1999 recommending that both the SEC and CFTC work 
together to determine the regulatory framework for security 
futures. Do you support the regulatory parity that currently 
exists between security 
futures and security options? Do you think the SEC should be 
involved in the regulation of security futures? If so, what is 
the SEC's role?

A.1. NFA has no objection to regulatory parity between security 
futures and security options as long as the regulations work 
efficiently for both products. The current margin regulations--
which were originally developed for security options--do not 
work efficiently for security futures. Portfolio margining has 
proven to be a more effective way to measure and reduce 
financial risk in the futures markets. Therefore, if regulatory 
parity is appropriate, the better approach is to allow futures-
style portfolio margining for security options rather than to 
prohibit it for security futures.
    Regulatory schemes that give regulators overlapping 
responsibilities tend to be less flexible and slower-moving 
than single-regulator schemes. Still, we recognize that both 
agencies have a stake in the security futures markets--the CFTC 
because of its expertise and its responsibility for futures on 
all types of underlying products and the SEC because of its 
interest in safeguarding the integrity of the securities 
markets. We have a good working relationship with SEC staff, 
and we are confident that we will continue that relationship 
regardless of the role Congress assigns to the SEC.
