[Federal Register Volume 63, Number 91 (Tuesday, May 12, 1998)]
[Proposed Rules]
[Pages 26114-26127]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-12539]


=======================================================================
-----------------------------------------------------------------------

COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 34 and 35


Over-the-Counter Derivatives

AGENCY: Commodity Futures Trading Commission.

ACTION: Concept Release.

-----------------------------------------------------------------------

SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or 
``Commission'') has been engaged in a comprehensive regulatory reform 
effort designed to update the agency's oversight of both exchange and 
off-exchange markets. As part of this reform effort, the Commission is 
reexamining its approach to the over-the-counter (``OTC'') derivatives 
market.
    OTC derivatives are contracts executed outside of the regulated 
exchange environment whose value depends on (or derives from) the value 
of an underlying asset, reference rate, or index. They are used by 
market participants to perform a wide variety of important risk 
management functions. The CFTC's last major regulatory actions 
involving OTC derivatives were regulatory exemptions for certain swaps 
and hybrid instruments adopted in January 1993. Since that time, the 
OTC derivatives market has grown dramatically in both volume and 
variety of products offered and has attracted many new end-users of 
varying degrees of sophistication. The market has also changed, with 
new products being developed, with some products becoming more 
standardized, and with systems for central execution or clearing being 
studied or proposed.
    The Commission hopes that the public comments filed in response to 
this release will constitute an important source of relevant data and 
analysis that will assist it in determining whether its current 
regulatory approach continues to be appropriate or requires 
modification. The Commission wishes to maintain adequate safeguards 
without impairing the ability of the OTC derivatives market to continue 
to grow and the ability of U.S. entities to remain competitive in the 
global financial marketplace. The Commission has identified a broad 
range of issues and potential approaches in order to generate detailed 
analysis from commenters. The Commission urges commenters to analyze 
the benefits and burdens of any potential regulatory modifications in 
light of current market realities. The Commission has no preconceived 
result in mind. The Commission is open both to evidence in support of 
easing current restrictions and evidence indicating a need for 
additional safeguards. The Commission also welcomes comment on the 
extent to which certain matters are being or can be adequately 
addressed through self-regulation, either alone or in conjunction with 
some level of government oversight, or through the regulatory efforts 
of other government agencies.
    New regulatory restrictions ultimately adopted, if any, will be 
adopted only after publication for additional public comment and will 
be applied prospectively only. This release in no

[[Page 26115]]

way alters the current status of any instrument or transaction under 
the Commodity Exchange Act. All currently applicable exemptions, 
interpretations, and policy statements issued by the Commission 
regarding OTC derivatives products remain in effect, and market 
participants may continue to rely upon them.

DATES: Comments must be received on or before July 13, 1998.

ADDRESSES: Comments should be mailed to Jean A. Webb, Secretary, 
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st 
Street, NW, Washington, D.C. 20581; transmitted by facsimile to (202) 
418-5521; or transmitted electronically to {[email protected]}. 
Reference should be made to ``Over-the-Counter Derivatives Concept 
Release.''

FOR FURTHER INFORMATION CONTACT: I. Michael Greenberger, Director, 
David M. Battan, Special Counsel, or John C. Lawton, Associate 
Director, Division of Trading and Markets, Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street N.W., Washington, 
D.C. 20581 (202) 418-5430.

SUPPLEMENTARY INFORMATION:
I. Introduction
    A. Description of Over-the-Counter Products and Markets
    B. Purpose of This Release
II. Current Exemptions
    A. Swaps
    1. Policy Statement
    2. Part 35
    B. Hybrid Instruments
    1. Background
    2. Part 34
III. Issues for Comment
    A. Background
    B. Potential Changes to Current Exemptions
    1. Eligible Transactions
    2. Eligible Participants
    3. Clearing
    4. Transaction Execution Facilities
    5. Registration
    6. Capital
    7. Internal Controls
    8. Sales Practices
    9. Recordkeeping
    10. Reporting
    C. Self-Regulation
IV. Summary of Request for Comment

I. Introduction

A. Description of Over-the-Counter Products and Markets

    Over-the-counter (OTC) derivatives are contracts executed outside 
of the regulated exchange environment whose value depends on (or 
derives from) the value of an underlying asset, reference rate or 
index.\1\ The classes of underlying assets from which a derivative 
instrument may derive its value include physical commodities (e.g., 
agricultural products, metals, or petroleum), financial instruments 
(e.g., debt and interest rate instruments or equity securities), 
indexes (e.g., based on interest rates or securities prices), foreign 
currencies, or spreads between the value of such assets.
---------------------------------------------------------------------------

    \1\See Group of Thirty, Derivatives: Practices and Principles 2 
(1993).
---------------------------------------------------------------------------

    Like exchange-traded futures and option contracts, OTC derivatives 
are used to perform a wide variety of important risk management 
functions. End-users employ OTC derivatives to address risks from 
volatility in interest rates, foreign exchange rates, commodity prices, 
and equity prices, among other things. OTC derivative instruments also 
can be used to assume price risk in order to increase investment yields 
or to speculate on price changes. Participants in the OTC derivatives 
market include banks, other financial service providers, commercial 
corporations, insurance companies, pension funds, colleges and 
universities, and governmental entities.
    Use of OTC derivatives has grown at very substantial rates over the 
past few years. According to the most recent market survey by the 
International Swaps and Derivatives Association (``ISDA''), the 
notional value of new transactions reported by ISDA members in interest 
rate swaps, currency swaps, and interest rate options during the first 
half of 1997 increased 46% over the previous six-month period.\2\ The 
notional value of outstanding contracts in these instruments was 
$28.733 trillion, up 12.9% from year-end 1996, 62.2% from year-end 
1995, and 154.2% from year-end 1994.\3\ ISDA's 1996 market survey noted 
that there were 633,316 outstanding contracts in these instruments as 
of year-end 1996, up 47% from year-end 1995, which in turn represented 
a 40.7% increase over year-end 1994.\4\ An October 1997 report by the 
General Accounting Office (``GAO'') suggests that the market value of 
those OTC derivatives represents ``about 3 percent'' of the notional 
amount.\5\ Applying the 3% figure to the most recent ISDA number for 
contracts outstanding for the first half of 1997 indicates that the 
world-end market value of these OTC derivatives transactions is over 
$860 billion.
---------------------------------------------------------------------------

    \2\ International Swaps and Derivatives Association, Summary of 
Recent Market Survey Results, ISDA Market Survey, available at 
(http://www.isda.org).
    \3\ Id.
    \4\ Id.
    \5\ General Accounting Office, GAO/GGD-98-5, OTC Derivatives: 
Additional Oversight Could Reduce Costly Sales Practice Disputes 3 
n.6 (1997) [hereinafter ``1997 GAO Report'']. The notional amount 
represents the amount upon which payments to the parties to a 
derivatives transaction are based and is the most commonly used 
measure of outstanding derivatives transactions. Notional amounts 
generally overstate the amount at risk and the market value of such 
transactions.
---------------------------------------------------------------------------

    While OTC derivatives serve important economic functions, these 
products, like any complex financial instrument, can present 
significant risks if misused or misunderstood by market participants. A 
number of large, well publicized, financial losses over the last few 
years have focused the attention of the financial services industry, 
its regulators, derivatives end-users, and the general public on 
potential problems and abuses in the OTC derivatives market.\6\ Many of 
these losses have come to light since the last major regulatory actions 
by the CFTC involving OTC derivatives, the swaps and hybrid instruments 
exemptions issued in January 1993.\7\
---------------------------------------------------------------------------

    \6\ See, e.g., Jerry A. Markham, Commodities Regulation: Fraud, 
Manipulation & Other Claims, Section 27.05 nn. 2-22.1 (1997) 
(listing 22 examples of significant losses in financial derivatives 
transactions); 1997 GAO Report at 4 (stating that the GAO identified 
360 substantial end-user losses). Some of these transactions 
involved instruments that are not subject to the CEA.
    \7\ Each of these exemptions is discussed in Part II, below.
---------------------------------------------------------------------------

B. Purpose of This Release

    The Commission has been engaged in a comprehensive regulatory 
reform effort designed to update the agency's oversight of both 
exchange and off-exchange markets.\8\ As part of this process, the 
Commission believes that it is appropriate to reexamine its regulatory 
approach to the OTC derivatives market taking into account developments 
since 1993. The purpose

[[Page 26116]]

of this release is to solicit comments on whether the regulatory 
structure applicable to OTC derivatives under the Commission's 
regulations should be modified in any way in light of recent 
developments in the marketplace and to generate information and data to 
assist the Commission in assessing this issue.
---------------------------------------------------------------------------

    \8\ See, e.g., Proposed Rulemaking Permitting Future-Style 
Margining of Commodity Options, 62 FR 66569 (Dec. 19, 1997); Concept 
Release on the Denomination of Customer Funds and the Location of 
Depositories, 62 FR 67841 (Dec. 30, 1997); Account Identification 
for Eligible Bunched Orders, 63 FR 695 (Jan. 7, 1998); Maintenance 
of Minimum Financial Requirements by Futures Commission Merchants 
and Introducing Brokers, 63 FR 2188 (Jan. 14, 1998); Requests for 
Exemptive, No-Action and Interpretative Letters, 63 FR 3285 (Jan. 
22, 1998); Regulation of Noncompetitive Transactions Executed on or 
Subject to the Rules of a Contract Market, 63 FR 3708 (Jan. 26, 
1998); Distribution of Risk Disclosure Statements by Futures 
Commission Merchants and Introducing Brokers, 63 FR 8566 (Feb. 20, 
1998); Amendments to Minimum Financial Requirements for Futures 
Commission Merchants, 63 FR 12713 (March 16, 1998); Two-Part 
Documents for Commodity Pools, 63 FR 15112 (March 30, 1998); and 
Trade Options on the Enumerated Agricultural Commodities, 63 FR 
18821 (April 16, 1998). See also Application of FutureCom, Ltd. as a 
Contract Market in Live Cattle Futures and Options, 62 FR 62566 
(Nov. 24, 1997) (Internet-based trading system); Application of 
Cantor Financial Futures Exchange as a Contract Market in US 
Treasury Bond, Ten-Year Note, Five-Year Note and Two-Year Note 
Futures Contracts, 63 FR 5505 (Feb. 3, 1998) (electronic trading 
system).
---------------------------------------------------------------------------

    The market has continued to grow and to evolve in the past five 
years. As indicated above, volume has increased dramatically. New end-
users of varying levels of sophistication have begun to participate in 
this market. Products have proliferated, with some products becoming 
increasingly standardized. Systems for centralized execution and 
clearing are being proposed.
    The Commission hopes that the public comments filed in response to 
this release will constitute an important source of relevant data and 
analysis that will assist it in determining how best to maintain 
adequate regulatory safeguards without impairing the ability of the OTC 
derivatives market to continue to grow and the ability of U.S. entities 
to remain competitive in the global financial marketplace. The 
Commission has no preconceived result in mind. The Commission wishes to 
draw on the knowledge and expertise of a broad spectrum of interested 
parties including OTC derivatives dealers, end-users of derivatives, 
other regulatory authorities, and academicians. The Commission urges 
commenters to provide detail on current custom and practice in the OTC 
derivatives marketplace in order to assist the Commission in gauging 
the practical effect of current exemptions and potential modifications.
    The Commission is open both to evidence in support or broadening 
its exemptions and to evidence indicating a need for additional 
safeguards. Serious consideration will be given to the views of all 
interested parties before regulatory changes, if any, are proposed. In 
evaluating the comments and ultimately deciding on its course of 
action, the Commission will, of course, also engage in its own research 
and analysis. Any proposed changes will be carefully designed to avoid 
unduly burdensome or duplicative regulation that might adversely affect 
the continued vitality of the market and will be published for public 
comment. Moreover, any changes which impose new regulatory obligations 
or restrictions will be applied prospectively only.
    As this process goes forward, the Commission is mindful of the 
industry's need to retain flexibility in designing new products as well 
as the need for legal certainty concerning the enforceability of 
agreements. Therefore, the Commission wishes to emphasize that, as was 
the case with other recent concept releases, this release identifies a 
broad range of issues in order to stimulate public discussion and to 
elicit informed analysis. This release does not in any way alter the 
current status of any instrument or transaction under the CEA. All 
currently applicable exemptions, interpretations, and policy statements 
issued by the Commission regarding OTC derivatives products remain in 
effect, and market participants may continue to rely upon them.

II. Current Exemptions \9\
---------------------------------------------------------------------------

    \9\ In addition to the exemptions discussed in the text, the CEA 
excludes certain transactions. Forward contracts are excluded in 
section 1a(11) of the CEA, 7 U.S.C. 1A(11). The Treasury Amendment 
of the CEA excludes ``transactions in foreign currency, security 
warrants, security rights, resales of installment loan contracts, 
repurchase options, government securities, or mortgage and mortgage 
purchase commitments, unless such transactions involve the sale 
thereof for future delivery conducted on a board or trade.'' Section 
2(a)(1)(A)(ii), 7 U.S.C. 2(ii). Furthermore, options on securities 
or securities indexes are excluded from the Act. Section 
2(a)(1)(B)(i), 7 U.S.C. 2a(i). The Commission by order has also 
exempted certain transactions in energy products from the provisions 
of the CEA. Exemption for Certain Contracts Involving Energy 
Products, 58 FR 21286 (April 20, 1993). In addition, the Commission 
has exempted certain trade options. 17 C.F.R. 32.4; Trade Options on 
Enumerated Agricultural Commodities, 63 FR 18821 (April 16, 1998). 
The Commission has also exempted certain transactions in which U.S. 
customers establish or offset foreign currency options on the Honk 
Kong Futures Exchange. Petition of the Philadelphia Stock Exchange, 
Inc. for Exemptive Relief To Permit United States Customers To 
Establish or Offset Positions in Certain Foreign Currency Options on 
the Hong Kong Futures Exchange, Ltd. Through Registered Broker-
Dealers, 62 FR 15659 (April 2, 1997).
---------------------------------------------------------------------------

A. Swaps

1. Policy Statement
    The Policy Statement was adopted by the Commission on July 21, 
1989.\10\ It provides a safe harbor from regulation by the Commission 
under the CEA for qualifying agreements. It addresses only swaps 
settled in cash, with foreign currencies considered to be cash.\11\
---------------------------------------------------------------------------

    \10\ 54 FR 30694 (July 21, 1989).
    \11\ Id. at 30696.
---------------------------------------------------------------------------

    To qualify for a safe harbor from regulation under the Policy 
Statement, a swap agreement must have all of the following 
characteristics: (1) individually tailored terms; (2) an absence of 
exchange-style offset; (3) an absence of a clearing organization or 
margin system; (4) undertaken in conjunction with a line of business; 
and (5) not marketed to the general public.
    These conditions limit the applicability of the Policy Statement 
primarily to agreements entered into by institutional and commercial 
entities such as corporations, commercial and investment banks, thrift 
institutions, insurance companies, governments and government-sponsored 
or -chartered entities. The Commission indicated however, that the 
restrictions did not ``preclude dealer transactions in swaps undertaken 
in conjunction with a line of business, including financial 
intermediation services.'' \12\ Moreover, the restrictions reflect the 
Commission's understanding that qualifying transactions will be entered 
into with the expectation of performance by the counterparties, will be 
bilaterally negotiated as to material economic terms based upon 
individualized credit determinations, and will be documented by the 
parties in an agreement (or series of agreements) that is not 
standardized.\13\ The restrictions are not intended to prevent the use 
of master agreements between two counterparties, provided that the 
material terms of the master agreement and the transaction 
specifications are individually tailored by the parties.\14\
---------------------------------------------------------------------------

    \12\ Id. at 30697.
    \13\ Id at 30696-97.
    \14\ See id. at 30696 n. 17.
---------------------------------------------------------------------------

2. Part 35
    The Futures Trading Practices Act of 1992 (``1992 Act'') \15\ added 
subsections (c) and (d) to section 4 of the Act. Section 4(c)(1) \16\ 
authorizes the Commission, by rule, regulation or order, to exempt any 
agreement, contract or transaction, or class thereof from the exchange-
trading requirements of Section 4(a) or any other requirement of the 
Act other than Section 2(a)(1)(B). Section 4(c)(2) \17\ provides that 
the Commission may not grant any exemption unless the Commission 
determines that the transaction will be entered into solely between 
``appropriate persons.'' \18\ that the exchange trading requirements of 
Section 4(a) should not be applied, that the agreement, contract or 
transaction in question will not have a material adverse effect on the 
ability of the Commission or any contract market to discharge its 
regulatory or self-regulatory duties under the Act, and that the 
exemption would be consistent with the public interest and the purposes 
of the Act.
---------------------------------------------------------------------------

    \15\ Pub. L. No. 102-546 (1992), 106 Stat 3590, 3629.
    \16\ 7 U.S.C. 6(c)(1).
    \17\ 7 U.S.C. 6(c)(2).
    \18\ 7 U.S.C. 6(c)(3).
---------------------------------------------------------------------------

    The Commission may grant exemptions ``either unconditionally or on 
stated terms or conditions.'' \19\ Thus,

[[Page 26117]]

Section 4(c) gives the Commission the authority to tailor its 
regulatory program to fit the realities of the marketplace and the 
needs of market participants.
---------------------------------------------------------------------------

    \19\ 7 U.S.C. 6(c)(1). Section 4(d), 7 U.S.C. 6(d), provides 
that
    [t]he granting of an exemption under this section shall not 
affect the authority of the Commission under any other provision of 
the Act to conduct investigations in order to determine compliance 
with the requirements or conditions of such exemption or to take 
enforcement action for any violation of any provision of this Act or 
any rule, regulation or order thereunder caused by failure to comply 
with or satisfy such conditions or requirements.
---------------------------------------------------------------------------

    Part 35 of the Commission's regulations exempts swap agreements 
meeting specified criteria from the provisions of the CEA and the 
Commission's regulations promulgated thereunder except for the 
following: Section 2(a)(1)(B) of the CEA; \20\ the antifraud provisions 
set forth in Sections 4b and 4o of the CEA \21\ and Commission Rule 
32.9; \22\ and the antimanipulation provisions set forth in Sections 
6(c) and 9(a)(2) of the CEA.\23\ The Part 35 swap exemption is 
retroactive and effective as of October 23, 1974, the date of enactment 
of the Commodity Futures Trading Commission at of 1974.\24\ Part 35 was 
promulgated under authority granted to the Commission by Section 4(c) 
of the Act.\25\
---------------------------------------------------------------------------

    \20\ 7 U.S.C. 2a. Section 2(a)(1)(B) of the Act establishes the 
respective jurisdiction of the CFTC and of the SEC over different 
instruments and restricts or prohibits certain types of securities 
futures.
    \21\ 7 U.S.C. 6b and 6o.
    \22\ Regulation 32.9, 17 CFR 32.9, prohibits fraud in connection 
with commodity options transactions.
    \23\ 7 U.S.C. 9 and 13(a)(2).
    \24\ Pub. L. No. 93-463 (1974), 88 Stat. 1389. See Commission 
Regulation 35.1(a) and Exemption for Certain Swap Agreements, 58 FR 
5587 at 5588 (January 22, 1993) (adopting Part 35 Rules).
    \25\ In issuing the swap exemption, the Commission also acted 
pursuant to its authority to regulate options under Section 4c(b) of 
the CEA, 7 U.S.C. 6c(b). See Exemption for Certain Swap Agreements, 
58 FR 5587 at 5589 (Jan. 22, 1993).
---------------------------------------------------------------------------

    To be eligible for exemptive treatment under Part 35, an agreement: 
(1) must be a swap agreement as defined in Regulation 35.1(b)(1); (2) 
must be entered into solely between eligible swap participants; (3) 
must not be a part of a fungible class of agreements that are 
standardized as to their material economic terms; (4) must include as a 
material consideration the creditworthiness of a party with an 
obligation under the agreement; and (5) must not be entered into and 
traded on or through a multilateral transaction execution facility. 
These criteria were designed to assure that the exempted swaps 
agreements met the requirements set forth by Congress in Section 4(c) 
of the CEA and ``to promote domestic and international market 
stability, reduce market and liquidity risks in financial markets, 
including those markets (such as futures exchanges) linked to swap 
markets and eliminate a potential source of systemic risk.'' \26\
---------------------------------------------------------------------------

    \26\ Id. at 5588.
---------------------------------------------------------------------------

    The definition of ``swap agreement'' provided in Regulation 
35.1(b)(1) is as follows:

    Swap agreement means: (i) An agreement (including terms and 
conditions incorporated by reference therein) which is a rate swap 
agreement, basis swap, forward rate agreement, commodity swap, 
interest rate option, forward foreign exchange agreement, rate cap 
agreement, rate floor agreement, rate collar agreement, currency 
swap agreement, cross-currency rate swap agreement, currency option, 
any other similar agreement (including any option to enter into any 
of the foregoing); (ii) Any combination of the foregoing; or (iii) A 
master agreement for any of the foregoing together with all 
supplements thereto.

This definition is the same as the definition of swap agreement set 
forth in Section 4(c)(5)(B) of the CEA.\27\
---------------------------------------------------------------------------

    \27\ See id. at 5589.
---------------------------------------------------------------------------

    Regulation 35.1(b)(2) defines ``eligible swap participant'' as 
follows:

    (i) A bank or trust company (acting on its own behalf or on 
behalf of another eligible swap participant);
    (ii) A savings association or credit union;
    (iii) An insurance company;
    (iv) An investment company subject to regulation under the 
Investment Company Act of 1940 . . . or a foreign person performing 
a similar role or function subject as such to foreign regulation, 
provided that such investment company or foreign person is not 
formed solely for the specific purpose of constituting an eligible 
swap participant;
    (v) A commodity pool formed and operated by a person subject to 
regulation under the Act or a foreign person performing a similar 
role or function subject as such to foreign regulation, provided 
that such commodity pool or foreign person is not formed solely for 
the specific purpose of constituting an eligible swap participant 
and has total assets exceeding $5,000,000;
    (vi) A corporation, partnership, proprietorship, organization, 
trust, or other entity not formed solely for the specific purpose of 
constituting an eligible swap participant (A) which has total assets 
exceeding $10,000,000; or (B) the obligations of which under the 
swap agreement are guaranteed or otherwise supported by a letter of 
credit * * * or other agreement by any such entity referenced in 
this subsection (vi)(A) * * * or * * * in paragraph (i), (ii), 
(iii), (iv), (v), (vi) or (viii) of this section; or (C) which has a 
net worth of $1,000,000 and enters into the swap agreement in 
connection with * * * its business; or which has a net worth of 
$1,000,000 and enters into the swap agreement to manage the risk of 
an asset or liability owned or incurred in the conduct of its 
business or reasonably likely to be owned or incurred in * * * its 
business;
    (vii) An employee benefit plan subject to the Employee 
Retirement Income Security Act of 1974 or a foreign person 
performing a similar role or function subject as such to foreign 
regulation with total assets exceeding $5,000,000, or whose 
investment decisions are made by a bank, trust company, insurance 
company, investment adviser subject to regulation under the 
Investment Advisers Act of 1940 * * * or a commodity trading advisor 
subject to regulation under the Act;
    (viii) Any governmental entity (including the United States, any 
state, or any foreign government) or political subdivision thereof, 
or any multinational or supranational entity or any instrumentality, 
agency, or department of any of the foregoing;
    (ix) A broker-dealer subject to regulation under the Securities 
Exchange Act of 1934 * * * or a foreign person performing a similar 
role or function subject as such to foreign regulation, acting on 
its own behalf or on the behalf of another eligible swap 
participant: Provided, however, that if such broker-dealer is a 
natural person or proprietorship, the broker-dealer must also meet 
the requirements of either subsection (vi) or (xi) of this section;
    (x) A futures commission merchant, floor broker, or floor trader 
subject to regulation under the Act or a foreign person performing a 
similar role or function subject as such to foreign regulation, 
acting on its own behalf or on behalf of another eligible swap 
participant: Provided, however, that if such futures commission 
merchant, floor broker or floor trader is a natural person or 
proprietorship, the futures commission merchant, floor broker or 
floor trader must also meet the requirements of subsection (vi) or 
(xi) of this section; or
    (xi) Any natural person with total assets exceeding at least 
$10,000,000.

    The definition of ``eligible swap participant'' in Regulation 
35.1(b)(2) is based on the list of appropriate persons set forth in 
Section 4(c)(3)(A)-(J) of the CEA. However, the Commission, relying on 
authority provided in Section 4(c)(3)(K) of the CEA, adjusted those 
definitions when it adopted Part 35. These adjustments reflected the 
international character of the swaps market by assuring that both 
foreign and United States entities could quality for treatment as 
eligible swap participants. In addition, the Commission raised the 
threshold for the net worth or total asset test that must be met by 
certain eligible swap participants. It applied this test as an 
indication of a swap participant's financial sophistication and 
background.\28\ The Commission indicated its belief that the definition 
of ``eligible swap participant,'' as adopted, would not adversely 
affect the swap market as it then existed.\29\
---------------------------------------------------------------------------

    \28\ See id. at 5589-90.
    \29\ See id. at 5590.
---------------------------------------------------------------------------

    The remaining conditions that must be satisfied by swap agreements 
in order

[[Page 26118]]

to qualify for the Part 35 exemption are meant, among other goals, to 
assure that the exemption does not permit the establishment of an 
unregulated exchange-like market in swaps.\30\ These conditions require 
that the creditworthiness of any party having an obligation under the 
swap agreement must be a material consideration in entering into the 
agreement and prohibit a swap that is part of a fungible class of 
agreements, standardized as to their material economic terms, or that 
is entered into and traded on or through a multilateral transaction 
execution facility from qualifying for the Part 35 exemption. The 
Commission has made clear that the Part 35 exemption does not extend to 
transactions that are subject to a clearing system where the credit 
risk of individual counterparties to each other is effectively 
eliminated.\31\
---------------------------------------------------------------------------

    \30\ See id. at 5590-91.
    \31\ See id. at 5591.
---------------------------------------------------------------------------

    These conditions do not prevent parties who wish to rely on the 
Part 35 exemption from undertaking bilateral collateral or margining 
arrangements nor from applying bilateral or multiparty netting 
arrangements to their transactions, provided however that, in the case 
of multilateral netting arrangements, the underlying gross obligations 
among the parties are not extinguished until all netted obligations are 
fully performed.\32\ Nor is the Part 35 restriction on multilateral 
transaction execution facilities meant to preclude parties who engage 
in negotiated, bilateral transactions from using computer or other 
electronic facilities to communicate simultaneously with other 
participants, so long as they do not use such facilities to enter 
orders or execute transactions.\33\
---------------------------------------------------------------------------

    \32\ See id.
    \33\ See id.
---------------------------------------------------------------------------

    Similarly, standardization of terms that are not material economic 
terms does not necessarily prevent an agreement from qualifying for an 
exemption under Part 35, provided that the material economic terms of 
the swap agreement remain subject to individual negotiation by the 
parties.\34\ In this respect, the Commission has explained that:

    \34\ See id. at 5590.
---------------------------------------------------------------------------

    [T]he phrase ``material economic terms'' is intended to 
encompass terms that define the rights and obligations of the 
parties under the swap agreement, and that as a result, may affect 
the value of the swap at origination or thereafter. Examples of such 
terms may include notional amount, amortization, maturity, payment 
dates, fixed and floating rates or prices (including method by which 
such rates or prices may be determined), payment computation 
methodologies, and any rights to adjust any of the foregoing.\35\
---------------------------------------------------------------------------

    \35\ Id. at 5590 n. 24.
---------------------------------------------------------------------------

B. Hybrid Instruments

1. Background
    In 1989, the Commission recognized that certain instruments 
combined characteristics of securities or bank deposits with 
characteristics of futures or options and wished to exclude from CEA 
regulation those hybrid instruments whose commodity-dependent value was 
less than their commodity-independent value. The Commission issued a 
Statutory Interpretation Concerning Certain Hybrid Instruments 
(``Interpretation'') \36\ which excluded from regulation under the CEA 
and CFTC regulations debt securities within the meaning of Section 2(1) 
of the Securities Act of 1933 and time deposits within the meaning of 
12 CFR Section 204.2(c)(1) that had the following characteristics: (1) 
indexation to a commodity on no more than a one-to-one basis; (2) a 
limited maximum loss; (3) inclusion of a significant commodity 
component; (4) lack of a severable commodity component; (5) no required 
delivery of a commodity by means of an instrument specified in the 
rules of a designated contract market; and (6) no marketing of the 
instruments as futures contracts or commodity options.\37\
---------------------------------------------------------------------------

    \36\ 54 FR 1139 (January 11, 1989).
    \37\ Id.
---------------------------------------------------------------------------

    Later in 1989, the Commission adopted Part 34, which exempted 
certain hybrid instruments with commodity option components from the 
CEA and from the Commission's regulations.\38\ While Part 34 expanded 
the category of hybrid instruments that were considered to be outside 
of the CEA and the Commission's regulations, the Commission explicitly 
stated that it intended not ``to address the entire universe of hybrid 
instruments in the proposed rules, but rather to establish an exemptive 
framework'' that would apply to certain instruments in which issuers 
had expressed an interest to that point.\39\ In 1990, the Commission 
issued a revised Interpretation designed to conform the 
Interpretation's treatment of hybrids with the treatment of hybrids in 
Part 34.\40\ The revised Interpretation expanded the class of 
securities and depository accounts eligible as hybrid instruments and 
expanded the class of institutions eligible to transact in hybrids.
---------------------------------------------------------------------------

    \38\ 54 FR 30684 (July 21, 1989).
    \39\ Id.
    \40\ 55 FR 13582 (April 11, 1990).
---------------------------------------------------------------------------

    Congress included a provision in the 1992 Act permitting the 
Commission to exempt any transaction from all provisions of the CEA 
except Section 2(a)(1)(B). Using this new authority contained in 
Section 4(c) of the CEA, the CFTC substantially modified the Part 34 
regulations to exempt certain hybrids (including, for the first time, 
hybrid instruments with futures-like components) from most provisions 
of the CEA and from the Commission's regulations.
2. Part 34
    A hybrid instrument is defined in Part 34 of the Commission's 
regulations as an equity security, a debt security, or a depository 
instrument with at least one commodity-dependent component that has a 
payment feature similar to that of a commodity futures contract, a 
commodity option contract or a combination thereof.\41\ Part 34 exempts 
such hybrids, and those transacting in and/or providing advice or other 
services with respect to such hybrids, from all provisions of the CEA 
except Section 2(a)(1)(B) of the CEA, provided that a number of 
conditions are met.\42\ The conditions include: (1) a requirement that 
the issuer must receive full payment of the hybrid's purchase price; 
\43\ (2) a prohibition on requiring additional out-of-pocket payments 
to the issuer during the hybrid's life or at its maturity; \44\ (3) a 
prohibition on marketing the instrument as a futures contract or 
commodity option; \45\ (4) a prohibition on settlement by delivery of 
an instrument specified as a delivery instrument in the rules of a 
designated contract market; \46\ (5) a requirement that the hybrid be 
initially sold or issued subject to federal or state securities or 
banking laws to persons permitted thereunder to purchase the 
instrument; \47\ and (6) a requirement that the sum of the values of 
the commodity-dependent components of a hybrid instrument be less than 
the value of the commodity-independent components.\48\
---------------------------------------------------------------------------

    \41\ 17 CFR 34.2(a) (1997).
    \42\ 17 CFR 34.3(a) (1997).
    \43\ 17 CFR 34.3(a)(3)(i) (1997).
    \44\ Id.
    \45\ 17 CFR 34.3(a)(3)(ii) (1997).
    \46\ 17 CFR 34.3(a)(3)(iii) (1997).
    \47\ 17 CFR 34.3(a)(4) (1997).
    \48\ 17 CFR 34.3(a)(2) (1997).
---------------------------------------------------------------------------

    In imposing the first two conditions of Part 34's exemptions--the 
requirement that the issuer of a hybrid instrument receive full payment 
of the hybrid's purchase price and the ban on out-of-pocket payments 
from a hybrid purchaser or holder to the instrument's issuer--the 
Commission sought to limit the possible losses due to the

[[Page 26119]]

commodity-dependent components of a hybrid instrument, reasoning that 
an instrument permitting the accrual of losses in excess of the face 
value of such instrument is more akin to a position in a commodity 
derivative than to a debt, equity, or depository instrument.\49\ The 
third condition outlined above, a limitation on marketing the 
instrument as a futures contract or a commodity option, was intended to 
prevent purveyors of hybrid instruments from misleading investors as to 
the nature, legal status and form of regulatory supervision to which 
such instruments are subject.\50\ The Commission did not want potential 
buyers to believe that hybrids were subject to the full protections of 
the CEA.
---------------------------------------------------------------------------

    \49\ Regulation of Hybrid Instruments, 58 FR 5580 at 5585 
(January 22, 1993) (promulgating current Part 34 Rules).
    \50\ Regulation of Hybrid Instruments, 54 FR 1128 at 1135 
(January 11, 1989) (proposing original Part 34 Rules).
---------------------------------------------------------------------------

    The fourth condition noted above, a prohibition on settlement by a 
contract market delivery instrument, was designed to guard against 
interference with deliverable supplies for settlement of exchange-
traded futures or options contracts.\51\ In adopting the fifth 
condition, a limitation on persons permitted to purchase an instrument, 
the Commission was seeking both to address customer protection concerns 
and Congress's concern, as embodied in Section 4(c)(2)(B)(i) of the 
CEA,\52\ that only transactions entered into between appropriate 
persons may be exempted from the CEA.\53\
---------------------------------------------------------------------------

    \51\ 58 FR 5580 at 5582.
    \52\ 7 U.S.C. 6(c)(2)(B)(i).
    \53\ 58 FR 5580 at 5585.
---------------------------------------------------------------------------

    This sixth requirement is referred to as the ``predominance test.'' 
\54\ It was designed in response to authorization granted by Congress 
in Section 4(c)(5)(A) of the CEA for the Commission to exempt hybrids, 
which were predominantly securities or depository instruments. The 
predominance test starts from the premise that hybrid instruments can 
be viewed as a combination of simpler instruments, the payments on 
which can be viewed as either commodity-independent or commodity-
dependent. The payments on a hybrid's commodity-independent component 
are not indexed or calculated by reference to the price of an 
underlying commodity, including any index, spread or basket of 
commodities; the payments on a hybrid's commodity-dependent component 
are so indexed or referenced.
---------------------------------------------------------------------------

    \54\ 17 CFR 34.3(a)(2) (1997).
---------------------------------------------------------------------------

    For a hybrid instrument to be exempted by Part 34, the present 
value of the returns associated with the commodity-independent 
component of an instrument (including any return of principal) must be 
greater than the ``commodity-dependent value'' of the instrument. In 
order to calculate the commodity-dependent value of a hybrid, Part 34 
conceptually decomposes a hybrid's commodity-dependent portion into 
options. The absolute values of the premiums of all implicit options 
that are at- or out-of-the-money are summed to arrive at the commodity-
dependent value of the hybrid instrument.\55\ These values are 
calculated as of the time of issuance of the hybrid instrument.\56\
---------------------------------------------------------------------------

    \55\ More specifically, the absolute net value of all put option 
premiums with strike prices less than or equal to the reference 
price would be added to the absolute net value of all call option 
premiums with strike prices greater than or equal to the reference 
price. 58 FR 5580 at 5584. ``Reference price'' is defined in 
Regulation 34.2(g), 17 CFR 34.2(g), ``as the nearest current spot or 
forward price at which a commodity-dependent payment becomes non-
zero, or in the case where two potential reference prices exist, the 
price that results in the greatest commodity-dependent value.''
    \56\ 58 FR 5580 at 5584-85.
---------------------------------------------------------------------------

III. Issues for Comment

A. Background

    As the foregoing discussion indicates, the Commission has 
recognized that differences between exchange-traded markets and the OTC 
derivatives market warrant differences in regulatory treatment. 
Pursuant to the exemptions, activity in the OTC derivatives market has 
generally been limited to decentralized, principal-to-principal 
transactions between large traders. This has significant regulatory 
implications.
    The OTC derivatives market does not appear to perform the same 
price discovery function as centralized exchange markets. Accordingly, 
certain regulatory requirements related to price discovery have not 
been applied to the OTC derivatives market. Thus, for example, the 
Commission has not suggested that it should preapprove contract design 
in the OTC derivatives market as it does for exchanges.
    Similarly, the decentralization of trading in the OTC market and 
the relative sophistication of the participants have meant that issues 
of financial integrity and customer protection differ from exchange 
markets. Thus for example, while the Commission has retained its fraud 
authority for the swap market, it has not required segregation of 
customer funds.
    Developments in the market in the last five years, however, 
indicate the need to review the current exemptions. As mentioned above, 
new end-users have entered the market, new products have been 
developed, some products have become more standardized, and systems for 
centralized execution and clearing have been proposed. The terms and 
conditions of the exemptions may need adjustment to reflect changes in 
the marketplace and to facilitate continued growth and innovation.
    In addition, the explosive growth in the OTC market in recent years 
has been accompanied by an increase in the number and size of losses 
even among large and sophisticated users which purport to be trying to 
hedge price risk in the underlying cash markets. Market losses by end-
users may lead to allegations of fraud or misrepresentation after they 
enter transactions they do not fully understand. Moreover, as the use 
of the market has increased, entities such as pension funds and school 
districts have been affected by derivatives losses in addition to 
corporate shareholders.\57\
---------------------------------------------------------------------------

    \57\ See 1997 GAO Report at 71.
---------------------------------------------------------------------------

    Accordingly, the Commission believes it is appropriate at this time 
to consider whether any modifications to the scope or the terms and 
conditions of the swap and hybrid instrument exemptions are needed to 
enhance the fairness, financial integrity, and efficiency of this 
market. The Commission reiterates that the items listed below are 
intended solely to encourage useful public comment.
    The Commission urges commenters to analyze the benefits and burdens 
of any potential modifications in light of current market realities. In 
some areas, regulatory relief or expanded access to the market may be 
warranted while in others additional safeguards may be appropriate. The 
Commission is especially interested in whether modifications can be 
designed to stimulate growth. This might be accomplished, for example, 
by increasing legal certainty and investor confidence, thereby 
attracting new market participants, or by facilitating netting and 
other transactional efficiencies, thereby reducing costs. As discussed 
below, the Commission also welcomes comment on the extent to which 
certain matters can be adequately addressed through self-regulation. 
Finally, the Commission invites other regulators to express their views 
on the issues raised in this release and, in particular, how best to 
achieve effective coordination among regulators. The Commission 
anticipates that, where other regulators have adequate programs or 
standards in place to address

[[Page 26120]]

particular areas, the Commission would defer to those regulators in 
those areas.

B. Potential Changes to Current Exemptions

    The exemptions provided by Part 34 and Part 35 reflect 
circumstances in the relevant market at the time of their adoption. As 
noted, the Commission believes that it should review these exemptions 
in light of current market conditions. At the most general level, three 
issues are presented with respect to these exemptions: first, what 
criteria should be applied in determining whether a transaction or 
instrument is eligible for exemption from the CEA; second, what should 
be the scope of that exemption; and third, what conditions should be 
imposed, if any, to ensure that the public interest and the policies of 
the CEA are served.
1. Eligible Transactions
    (a) Swaps. Part 35 sets forth certain criteria that an instrument 
must meet in order to qualify for the swap exemption. These criteria 
impose restrictions upon the design and execution of transactions that 
distinguish the exempted swap transactions from exchange-traded 
products.\58\ Given the changes in the swap market since Part 35 was 
adopted, the Commission seeks comments as to whether the criteria set 
forth in Part 35 continue to provide a meaningful, objective basis for 
exempting transactions from provisions of the CEA and CFTC regulations.
---------------------------------------------------------------------------

    \58\ CFTC, OTC Derivatives Markets and Their Regulation 78-79 
(1993) (``CFTC OTC Derivatives Report'') (discussing swaps 
exemption).
---------------------------------------------------------------------------

    In particular, some swap agreements have become highly 
standardized. The Part 35 exemption does not extend to ``fungible 
agreements, standardized as to their material economic terms.'' The 
Commission seeks comment on whether this part of the Part 35 criteria 
provides sufficient guidance for parties involved in swaps. Parties may 
have difficulty in readily assessing whether a particular transaction 
qualifies for treatment under the Part 35 exemption.
    In order to provide greater clarity, the Commission could adopt 
additional or alternative requirements governing exempted swap 
agreements. For example, the Commission could provide additional detail 
concerning the concept of fungibility in this context. The Commission 
could also clearly specify which terms of an agreement would be 
considered to be material economic terms under Part 35.
    Moreover, subject to consideration of the requirements set forth in 
Sections 4(c)(1) and (c)(2) of the CEA, the Commission could consider 
expanding the scope of the swap exemption so that it more clearly 
applies to certain classes of transactions that exhibit some degree of 
standardization. In this regard, while Section 4(c)(5)(B) authorizes 
the Commission to exempt non-fungible swaps, the lack of fungibility is 
not a necessary criterion under Sections 4(c)(1) or (c)(2) for 
exercising exemptive authority.
    Request for comment. The Commission requests comment on whether the 
swaps exemption should be extended to fungible instruments and, if so, 
under what circumstances. The Commission is also seeking more general 
comment as to whether the swaps exemption continues to fulfill its 
stated goals. In this regard, the Commission is interested in 
commenters' views on what changes in the current rules may be needed to 
assure that Part 35 provides legal certainty to the current market and 
fulfills the statutory goals set forth in Section 4(c) of the CEA.
    In particular, the Commission requests comment on the following 
questions.
    1. In what ways has the swap market changed since the Commission 
adopted Part 35. Please address:
    (a) the nature of the products;
    (b) the nature of the participants, both dealers and end-users;
    (c) the location of transactions;
    (d) the business structure of participants (e.g., the use of 
affiliates for transacting OTC derivatives);
    (e) the nature of counterparty relationships;
    (f) the mechanics of execution;
    (g) the methods for securing obligations; and
    (h) the impact of the current regulatory structure on any of the 
foregoing.
    2. What are the mechanisms for disseminating the prices for swap 
transactions?
    3. Does the swap market serve as a vehicle for price discovery in 
underlying cash markets? If so, how? Please describe.
    4. To what extent is the swap market used for hedging? To what 
extent is it used for speculation? Please provide details.
    5. Is there a potential for transactions in the swap market to be 
used to manipulate commodity prices? Please explain.
    6. To what degree is the swap market intermediated, i.e., to what 
extent do entities
    (a) act as brokers bringing end-users together?
    (b) act as dealers making markets in products?
    Please describe the intermediaries in the market and the extent and 
nature of their activities.
    7. To what extent do swap market participants act in more than one 
capacity (e.g., as principal in some transactions and broker in 
others)?
    8. In light of current market conditions, do the existing Part 35 
requirements provide reasonable, objective criteria for determining 
whether particular swaps transactions are exempted under the CEA? 
Should the meaning of terms such as ``fungible,'' ``material economic 
terms,'' or ``material consideration'' be clarified or modified in any 
way? If so, how?
    9. What steps can the Commission take to promote greater legal 
certainty in the swap market?
    10. What types of documentation are relevant in determining whether 
a particular transactions falls within the swaps exemption and/or the 
Policy Statement? Should the Commission set standards in this regard?
    11. If the current restrictions set forth in the Part 35 
requirements negatively affect or potentially limit the OTC market or 
its development in the United States, what changes would alleviate the 
negative effects? Should the exemption in Part 35 be broadened in any 
manner?
    12. What steps, if any, can the Commission take to promote greater 
efficiency in the swap market, such as for example, by facilitating 
netting?
    13. Are any changes in regulation relating to the design or 
execution of exempted swap transactions needed to protect the interests 
of end-users in the swap market? Are there changes in regulation that 
would attract new end-users to the market or lead existing end-users to 
increase their participation?
    14. Should distinctions be made between swaps that are cash-settled 
and swaps that provide for physical delivery? Please explain.
    15. Should transactions in fungible instruments be permitted under 
the swaps exemption?
    16. To what extent should the creditworthiness of a counterparty 
continue to be required to be a material consideration under the swaps 
exemption? Please explain.
    (b) Hybrid instruments. Part 34 was designed to exempt from 
Commission regulation instruments in which the commodity futures or 
option characteristics were subordinate to their characteristics as 
securities and deposits. Some experienced practitioners have stated 
that the definition of a hybrid instrument under Part 34 is extremely 
complex and difficult to understand and to apply. Moreover, the 
Commission staff has

[[Page 26121]]

recently reviewed several hybrid instruments that had very significant 
commodity components yet were apparently eligible for exemption under 
Part 34's technical definition.
    For example, the Commission staff recently reviewed an instrument 
structured as a medium-term debt instrument paying a small quarterly 
coupon rate. At maturity, after subtracting out a ``factor'' reflecting 
certain costs borne by the issuer, the purchaser would receive a 
payment that was based on the performance of an index of futures 
contract prices with no upward limit on the commodity-based return. 
Moreover, the holder could lose its entire investment based on a 
downward movement in the commodity index. Commission staff believed 
that, under Part 34 as currently written, the instrument apparently 
would be exempt from regulation under the CEA. A regulatory definition 
that treats the entire principal as ``commodity independent'' despite 
the fact that all of the principal on this instrument could be lost as 
a direct result of movement in the commodity index warrants additional 
analysis.
    Another conceptual concern with the current definition is the 
manner in which it assigns value to the ``commodity dependent'' 
component. Futures-like elements are analyzed as a combination of 
offsetting at-the-money puts and calls. The sum of the absolute values 
of these option premiums is the assigned value of the futures-like 
component. Some observers have suggested that this test is not an 
appropriate measure of the commodity dependent value. As Part 34 is 
currently structured, whether or not an instrument qualifies for an 
exemption depends critically on the total volatility of the commodity-
dependent portion. This creates three potential problems. First, the 
technical knowledge needed to identify the commodity-dependent 
volatility may be a challenge for some market participants. Second, for 
two instruments that are identical except for their commodity-dependent 
volatility, one might be classified as exempt while the other might 
not. Indeed, if the volatility of the underlying commodity changes 
through time, the classification of identical hybrid instruments issued 
on different dates might be different. Thus, Part 34 may create some 
undesirable ambiguity regarding which instruments qualify for an 
exemption. Third, it appears to be paradoxical that short-term 
instruments are more likely to be classified as exempt than long-term 
instruments even though short-term instruments generally are more akin 
to exchange-traded futures in many respects.
    If the Commission were to modify or to clarify the predominance 
test in a way that resulted in more instruments being found to have a 
predominant commodity-dependent component, the Commission could 
exercise its authority under Section 4(c) to exempt some or all of such 
instruments subject to specified terms and conditions. As is the case 
today, instruments in which the commodity-independent component was 
predominant would not be subject to any such terms and conditions.
    Request for comment. The Commission requests comment on the 
foregoing analysis. It welcomes alternative suggestions for analyzing 
hybrid instruments and for simplifying the definition of exempt hybrid 
instruments.
    17. In what ways has the hybrid instrument market changed since the 
Commission adopted Part 34? Please address:
    (a) the nature of the products;
    (b) the nature of the participants, both dealers and end-users;
    (c) the location of transactions;
    (d) the nature of the counterparty relationships;
    (e) the mechanics of execution;
    (f) the methods for securing obligations; and
    (g) the impact of the current regulatory structure on any of the 
foregoing.
    18. What are the mechanisms for disseminating prices for hybrid 
instrument transactions?
    19. Does the hybrid instrument market serve as a vehicle for price 
discovery in underlying commodities? If so, how? Please describe.
    20. To what extent is the hybrid instrument market used for 
hedging? To what extent is it used for speculation? Please provide 
details.
    21. Is there a potential for transactions in the hybrid instrument 
market to be used to manipulate commodity prices? Please explain.
    22. To what degree is the hybrid instrument market intermediated, 
i.e., to what extent do entities
    (a) act as brokers bringing end-users together?
    (b) act as dealers making markets in products?
    Please describe the intermediaries in the market and the extent and 
nature of their activities and the extent to which transactions in 
these instruments are subject to other regulatory regimes.
    23. To what extent do hybrid instrument market participants act in 
more than one capacity (e.g., as a principal in some transactions and 
broker in others)?
    24. In light of current market conditions, do the existing Part 34 
requirements provide reasonable, objective criteria for determining 
whether a particular hybrid instrument performs the functions of a 
futures or option or those of a security or depository instrument? Are 
the criteria easily understood and applied by participants in the 
market? Do they properly distinguish types of instruments? If not, 
should they be changed? How?
    25. What steps, if any, can the Commission take to promote greater 
legal certainty in the hybrid instrument market? Please explain.
    26. Should Part 34 be amended to reflect more accurately or more 
simply whether commodity-dependent components predominate over 
commodity-independent components?
    27. Are changes in regulation relating to the design or execution 
of transactions in exempted hybrid instruments needed to protect the 
interests of end-users in the hybrid instrument market? Are there 
changes in regulation that would attract new end-users to the market or 
lead existing end-users to increase their participation?
    28. Should the Commission exercise its authority to exempt any 
hybrid instruments with a predominant commodity component subject to 
specified terms and conditions? Please explain.
2. Eligible Participants
    Section 4(c)(2) states that ``the Commission shall not grant any 
exemption under'' authority granted therein ``unless the Commission 
determines that . . . the agreement, contract or transaction will be 
entered into solely between appropriate persons.'' Section 4(c)(3) 
further states that ``the term `appropriate person' shall be limited'' 
to the classes of persons specifically listed therein including 
``[s]uch other persons that the Commission determines to be appropriate 
in light of their financial or other qualifications or the 
applicability of appropriate regulatory protections.''
    (a) Swaps. Part 35 currently contains a requirement that an exempt 
swap agreement be between eligible swap participants, as defined in 
Regulation 35.1(b)(2). The list of eligible swap participants in Part 
35 is based substantially on the list of ``appropriate person'' defined 
in the CEA. The Commission seeks comments as to whether the current 
list of eligible swap participants should be modified in any way. The 
Commission requests comment regarding whether the definition is 
adversely affecting the

[[Page 26122]]

swaps market by excluding persons who should be included or, 
alternatively, by including persons who are not, or should not be, 
active in the current market. The Commission also seeks comment on 
whether additional persons should be added and, if so, whether 
additional protections would be appropriate. In either case, commenters 
are asked to describe such persons and the protections they need, if 
any.
    Any potential change must be analyzed in light of the stated 
Congressional intent that any exempted transaction must be entered into 
solely by appropriate persons as defined in Section 4(c)(3)(A)-(K) of 
the Act. In addition, any changes to the definition of eligible swap 
participant would be considered in light of any other relevant changes 
that may result from Commission follow-up to this concept release.
    (b) Hybrid instruments. As discussed above, if the Commission were 
to modify the predominance test under Part 34, it might also decide to 
exempt certain commodity-like hybrid instruments subject to specified 
terms and conditions. The Commission invites analysis on the potential 
applicability of an appropriate person standard in that context.
    Request for comment. 29. Should the current list of eligible swap 
participants be expanded in any way? Should it be contracted in any 
way? If so, how and why?
    30. Are there currently eligible swap participants who would 
benefit from additional protections? Are there potential swap 
participants who are not currently eligible but would be appropriate 
subject to additional protections? In either case, please describe the 
types of persons and the types of protections.
    31. Should the Commission establish a class of eligible 
participants for the trading of hybrid instruments with a predominant 
commodity-dependent component? If so, please describe.
    32. Is it advisable to use a single definition of sophisticated 
investor whenever that concept arises under the Commission's 
regulations? If so, what definition should apply?
3. Clearing
    Clearing of swaps is not permitted under Part 35. The Commission 
expressly stated that:

    The exemption does not extend to transactions that are subject 
to a clearing system where the credit risk of individual members of 
the system to each other in a transaction to which each is a 
counterparty is effectively eliminated and replaced by a system of 
mutualized risk of loss that binds members generally whether or not 
they are counterparties to the original transaction.\59\
---------------------------------------------------------------------------

    \59\ 54 FR 5587 at 5591.

    Regulation 35.2 provides, however, that ``any person may apply to 
the Commission for exemption from any of the provisions of the Act 
(except 2(a)(1)(B)) for other arrangements or facilities, on such terms 
and conditions as the Commission deems appropriate. * * *'' The 
Commission included this proviso in order to hold open the possibility 
that swap agreements cleared through an organized clearing facility 
could be exempted from requirements of the Act under appropriate terms 
and conditions. The Commission affirmatively stated that the proviso 
``reflects the Commission's determination to encourage innovation in 
developing the most efficient and effective types of systemic risk 
reduction'' and that ``a clearing house system for swap agreements 
could be beneficial to participants and the public generally.'' \60\
---------------------------------------------------------------------------

    \60\ Id. at 5591 n.30.
---------------------------------------------------------------------------

    In the years since Part 35 was issued, interest in developing 
clearing mechanisms for swaps and other OTC derivatives has increased. 
The Commission has had extensive discussions with several organizations 
engaged in designing clearing facilities.\61\ The Commission believes 
that these efforts have reached a stage where it is necessary to 
consider and to formulate a program for appropriate oversight and 
exemption of swaps clearing.
---------------------------------------------------------------------------

    \61\ Not all the proposed arrangements have included the 
mutualization of risks among members of a clearing organization. In 
some cases, a single entity proposed to support the clearing 
arrangements using its own assets.
---------------------------------------------------------------------------

    Clearing organizations can provide many benefits to participants, 
such as the reduction of counterparty credit risk, the reduction of 
transaction and administrative costs, and an increase in liquidity. 
They also can provide benefits to the public at large by increasing 
transparency. These benefits are obtained at the cost of concentrating 
risk in the clearing organization. Accordingly, a greater need may 
exist for oversight of the operations of a clearing organization than 
for any single participant in an uncleared market.
    In the 1993 CFTC OTC Derivatives Report, the Commission stated that 
the regulatory issues presented by a facility for clearing swaps 
``would depend materially upon the facility's design, such as, for 
example, the extent to which the construction of such a facility is 
consistent with the minimum standards for netting systems recommended 
by the Report of the Committee on Interbank Netting Schemes of the 
Central Banks of the Group of Ten Countries (Lamfalussy Report).'' \62\ 
Comment is requested concerning the usefulness of the Lamfalussy 
standards in this context.
---------------------------------------------------------------------------

    \62\ CFTC OTC Derivatives Report at 136-37. The Lamfalussy 
standards are the following:
    1. Netting schemes should have a well-founded legal basis under 
all relevant jurisdictions;
    2. Netting scheme participants should have a clear understanding 
of the impact of the particular scheme on each of the financial 
risks affected by the netting process;
    3. Multilateral netting systems should have clearly-defined 
procedures for the management of credit risks and liquidity risks 
which specify the respective responsibilities of the netting 
provider and the participants. These procedures should also ensure 
that all parties have both the incentives and the capabilities to 
manage and contain each of the risks they bear and that limits are 
placed on the maximum level of credit exposure that can be produced 
by each participant.
    4. Multilateral netting systems should, at a minimum, be capable 
of ensuring the timely completion of daily settlements in the event 
of an inability to settle by the participant with the largest single 
net-debit position;
    5. Multilateral netting systems should have objective and 
publicly-disclosed criteria for admission which permit fair and open 
access; and
    6. All netting schemes should ensure the operational reliability 
of technical systems and the availability of back-up facilities 
capable of completing daily processing requirements.
---------------------------------------------------------------------------

    The Commission has identified the following core elements that 
should be addressed: the functions that an OTC derivatives clearing 
facility would perform; the products it would clear; the standards it 
would impose on participants; and the risk management tools it would 
employ. As discussed below, the Commission invites comments on each of 
these topics.
    (a) Functions. An OTC derivatives clearing facility could perform a 
variety of functions ranging from simple trade comparison and 
recordation to netting of obligations to the guarantee of performance. 
For example, the Commission notes that, in jurisdictions other than the 
U.S., there may not be a clearing guarantee, or the guarantee may 
attach at a time other than the initiation of the trade. The Commission 
requests comment on which of these functions, if any, should be 
permitted and under what circumstances.
    (b) Products cleared. The definition of the term ``swap agreement'' 
in Regulation 35.1(b)(1) is very broad. Financial engineers are 
continually designing new products that fall within that definition but 
have novel characteristics. As a practical matter, the Commission 
believes that any OTC derivatives clearing facility would be most 
likely in the context of ``plain vanilla'' products for which prices 
can be readily established and for which there is some standardization 
as to

[[Page 26123]]

terms. The Commission requests comment on whether the range of products 
that may be cleared through an OTC derivative clearing facility, or 
their terms of settlement, should be limited in any way.
    (c) Admission standards. The class of eligible swap participants 
ias defined in Regulation 35.1(b)(2). There is an inherent tension 
between the desire to promote open and competitive markets by allowing 
access.\63\ and the desire to maintain financial integrity by imposing 
admission standards. The Commission requests comment on what standards, 
if any, it should establish, or permit an OTC derivatives clearing 
facility to establish, for admission as a clearing participant. Comment 
is also requested on whether clearing should be limited to transactions 
undertaken on a principal-to-principal basis or whether agency 
transactions should be included.\64\
---------------------------------------------------------------------------

    \63\ See Section 15 of the Act, 7 U.S.C. 19.
    \64\ Current Part 35 allows only certain eligible swap 
participants to act on the behalf of another eligible swap 
participant. See 17 CFR 35.1(b)(2) (1997).
---------------------------------------------------------------------------

    (d) Risk management tools. An OTC derivatives clearing facility 
could choose from among many potential risk management tools. These 
include capital requirements for participants, reporting requirements, 
position or exposure limits, collateral requirements, segregation 
requirements, mark-to-market or other valuation procedures, risk 
modeling programs, auditing procedures, and information-sharing 
arrangements. The clearing facility could also draw upon its own 
capital, its lines of credit, any guarantee funds financed by clearing 
members, or other arrangements for sharing losses among participants. 
The relevance of these various items would depend, of course, on the 
functions the clearing facility performed and the products its cleared. 
The Commission requests comment on how best to assure that a clearing 
facility uses appropriate risk management tools without preventing 
flexibility in the design of such tools or inhibiting the evolution of 
new risk management technology.
    (e) Other considerations. Permitting OTC products to be cleared may 
make them more like exchange-traded products. The Commission welcomes 
comment on how best to promote fair competition and even-handed 
regulation in the context of the clearance of OTC derivative products.
    In approving Part 35, the Commission noted that it was ``mindful of 
the costs of duplicative regulation \65\ and added the proviso to 
Regulation 35.2 that the Commission would consider ``the applicability 
of other regulatory regimes'' in addressing petitions for further 
exemptive relief relating to swaps facilities. The Commission 
recognizes that existing clearing facilities that are regulated by 
another federal regulatory authority because the clear products subject 
to that regulator's jurisdiction may wish to develop swap clearing 
facilities. The Commission requests comment on how to address this 
situation.
---------------------------------------------------------------------------

    \65\ 58 FR 5587 at 5591 n.30.
---------------------------------------------------------------------------

    Request for comment. 33. Are any swaps currently subject to any 
type of clearing function, either in the U.S. or abroad? If so, please 
provide details.
    34. Would permitting swap clearing facilities promote market growth 
and assist U.S. participants in remaining competitive? If so, please 
describe the appropriate elements of a program for the oversight of 
swap clearing organizations.
    35. Should there be a limit on the clearing functions permitted for 
swaps?
    36. Should there be a limit on the range of products that may be 
cleared through a swap clearing facility?
    37. Should there be standards for admission as a clearing 
participant?
    38. What types of risk management tools should a clearing facility 
employ?
    39. To what degree would cleared swaps be similar to exchange 
traded products? How best can the Commisison promote fair competition 
and even-handed regulation in this context?
    40. How should the Commission address OTC derivative clearing 
facilities that are subject to another regulatory authority by virtue 
of conducting activities subject to that regulator's jurisdiction?
4. Transaction Execution Facilities
    Regulation 35.2(d) provides that a swap agreement may not be 
entered into or traded on or through a multilateral transaction 
execution facility (``MTEF'').\66\ In the release issuing Part 35, the 
Commission described an MTEF as:

    \66\ 17 CFR 35.2(d) (1997).
---------------------------------------------------------------------------

    [A] physical or electronic facility in which all market makers 
and other participants that are members simultaneously have the 
ability to execute transactions and bind both parties by accepting 
offers which are made by one member and open to all members of the 
facility.\67\
---------------------------------------------------------------------------

    \67\58 FR 5587 at 5591.

---------------------------------------------------------------------------
    The Commission specified that the MTEF limitation did not:

    [P]reclude participants from engaging in privately negotiated 
bilateral transactions, even where these participants use computer 
or other electronic facilities, such as ``broker screens,'' to 
communicate simultaneously with other participants so long as they 
do not use such systems to enter orders to execute transactions.\68\

    \68\ Id.
---------------------------------------------------------------------------

    The Commission noted that there were no swap MTEFs in existence at 
that time.\69\ Consistent with the proviso in Regulation 35.2, the 
Commission invited application for appropriate exemptive relief for 
such facilities as they were developed.\70\
---------------------------------------------------------------------------

    \69\ Id.
    \70\ Id.
---------------------------------------------------------------------------

    The Commission is requesting comment on whether the regulatory 
approach to execution facilities should be modified in any way. 
Specifically, the Commission invites comment on whether the description 
of MTEFs set forth above is sufficiently clear, whether it accurately 
delineates the relevant features, and how the Commission should address 
other types of entities that facilitate execution, such as market 
makers or bulletin board services. The Commission recognized when it 
promulgated Part 35 that MTEFs ``could provide important benefits in 
terms of increased liquidity and price transparency.'' \71\ The 
Commission seeks comment on whether it should permit swaps to be traded 
through an MTEF or other similar facilities and, if so, what terms and 
conditions should be applied. It also seeks comment on the degree to 
which such trading would be similar to exchange trading and the degree 
to which similar safeguards are needed. As in the case of clearing 
facilities, the Commission is mindful of the need to promote fair 
competition between and even-handed regulation of exchanges and the 
swap market.
---------------------------------------------------------------------------

    \71\ Id.
---------------------------------------------------------------------------

    Part 36 of the Commission's regulations \72\ was designed to allow 
reduced regulation for exchange trading limited to sophisticated 
traders. It was intended to ``permit * * * exchange-traded products 
greater flexibility in competing with foreign exchange-traded products 
and with both foreign and domestic over-the-counter transactions while 
maintaining basic customer protection, financial integrity and other 
protections associated with trading in an exchange environment.'' \73\ 
No contract market has applied for exemption under Part 36. An analysis 
of the perceived strengths and weaknesses of Part 36 may be a useful 
starting point in determining an appropriate regulatory regime for 
execution facilities. Accordingly, the Commission requests comment on 
whether elements

[[Page 26124]]

of Part 36 should be applicable to execution facilities. Proposals for 
modification of Part 36 are welcome.
---------------------------------------------------------------------------

    \72\ 17 CFR 36.1-36.9 (1997).
    \73\ Section 4(c) Contract Market Transactions, 60 FR 51323 
(Oct. 2, 1995).
---------------------------------------------------------------------------

    Request for comment. 41. Should the definition of MTEF be changed 
in any way to provide more clarity?
    42. Are MTEFs or other types of execution facilities currently 
being used for swap trading, either in the U.S. or abroad? If so, 
please provide details.
    43. What terms and conditions, if any, should be applied to 
execution facilities? Please address potential competitive effects on 
current exchange trading and the degree to which similar requirements 
should be made applicable. Please also address the strengths and 
weaknesses of current Part 36 for this purpose.
5. Registration
    Registration has been called ``the kingpin in [the CEA's] statutory 
machinery, giving the Commission the information about participants in 
commodity trading which it so vitally requires to carry out its other 
statutory functions of monitoring and enforcing the Act.\74\ 
Registration identifies participants in the markets and allows for a 
``screening'' process by requiring applicants to meet fitness 
standards. Registration may also facilitate enforcement of fraud 
prohibitions. In addition, the requirement to register may trigger 
other standards and obligations for registrants under the CEA and 
Commission rules.\75\ Part 34 and Part 35 of the Commission's 
regulations currently exempt parties from the registration requirements 
of the Act with respect to qualifying transactions.
---------------------------------------------------------------------------

    \74\ Commodity Futures Trading Commission v. British American 
Commodity Options Corp., 560 F.2d 135 at 139-40 (2d Cir. 1977) cert. 
denied, 438 U.S. 905 (1978).
    \75\ See, e.g., Sections 8a(2) and 8a(3) of the Act (statutory 
disqualification) and Regulation 1.12 (requirement that registered 
futures commission merchants (``FCMs'') and registered introducing 
brokers (``IBs''), or any person who files an application to be so 
registered, notify the Commission if its capital falls below minimum 
capital requirements); Regulation 1.15 (risk assessment reporting 
for registered FCMs); Regulation 1.17 (minimum capital requirements 
for registered FCMs and registered IBs); Regulation 4.21 
(requirement that commodity pool operators (``CPOs'') who are 
registered or required to be registered deliver a disclosure 
document to clients or potential clients). Other regulations, 
however, may be applicable to parties whether or not they are 
registered or required to be registered. See, e.g., Part 189 (large 
trader reporting requirements).
---------------------------------------------------------------------------

    The Commission seeks comment on whether registration requirements 
for dealers or intermediaries would be useful or necessary for the 
Commission in its oversight of the OTC derivatives market. Registration 
would identify key players in the OTC derivatives markets but would not 
necessarily trigger the full range of regulations applicable to 
registered persons involved in exchange-traded futures and options. 
Instead it could be related to separate and limited OTC derivatives 
market regulations. Alternatively, the Commission seeks comment on 
whether it would be appropriate to adopt a notice filing, requiring 
parties involved in certain activities within the OTC derivatives 
markets to identify themselves to the Commission.
    In addressing this issue, commenters should consider, among other 
things, whether a distinction should be made between swaps and hybrid 
instruments. Comment also would be useful on whether it would be 
sufficient that a person is registered or regulated by another federal 
agency so that the Commission should waive any registration 
requirements for such persons with respect to OTC derivatives 
transactions.
    Differences between the OTC derivative market and exchange-traded 
futures and option markets may affect the need for registration in the 
context of OTC derivatives trading. For example, since swap 
transactions occur among institutional participants who bilaterally 
negotiate an agreement, there may be reduced value added in requiring 
dealers or advisors to undergo fitness checks. Such institutional 
participants would likely have the resources to investigate the fitness 
of potential counterparties and advisors.
    Request for comment. 44. What benefits might arise from requiring 
registration of dealers, intermediaries, advisors, or others involved 
in OTC derivative transactions? Should any requirement be in the form 
of a notice filing or full registration?
    45. What criteria should be used in determining the types of 
transactions and the types of market participants subject to 
registration requirements?
    46. Should regulation by other federal agencies be a factor in 
permitting an exemption from registration or notice filing?
    47. What role should membership in a designated self-regulatory 
organization play?
6. Capital
    Capital requirements have long been considered important for 
assuring a firm's ability to perform its obligations to its customers 
and to its counterparties and for controlling systemic risk. The 
Commission currently imposes no capital requirements on participants in 
the OTC derivatives markets. Given the sophistication of the 
participants, the generally principal-to-principal nature of their 
relationships with one another, the fact that OTC derivatives dealers 
typically do not hold customer's funds in an agency relationship (in 
contrast to futures commission merchants or broker-dealers), and the 
applicability of other regulatory capital standards to many market 
participants, capital requirements may be unnecessary.
    The Commission seeks to explore whether regulatory capital might 
serve a useful function in the context of the OTC derivatives markets. 
For example, regulatory capital might provide an OTC derivatives 
dealer's counterparties with independent assurance of the 
creditworthiness of the dealer or might prevent the dealer from 
assuming excessive leverage. Capital requirements might also serve the 
function of providing early warning of financial difficulties.
    Request for comment. 48. Are any capital requirements for OTC 
derivatives dealers needed? Why? What benefits would they provide to 
the market? What burdens would they impose?
    49. Should any reporting or disclosure requirements be established 
for dealers as an alternative to capital requirements in order to 
permit counterparties to evaluate their creditworthiness adequately? 
Please explain.
    50. Do ratings by nationally recognized statistical rating 
organizations fulfill the function of assuring end-user counterparties 
of the creditworthiness of OTC derivatives dealers?
7. Internal Controls
    The importance of internal controls for financial services firms 
generally and for derivatives dealers in particular is widely 
recognized.\76\ The Commission has long required information concerning 
risk management and internal control systems from FCMs, as well as 
prompt reporting of any material inadequacies in such systems.\77\ 
Close attention to risk management and internal control systems may be 
especially important in an environment where capital standards (whether 
imposed by regulators or internally) are reduced and are based on the 
results of internal value-at-risk models and calculations rather than 
on more standardized ``haircuts.'' While a

[[Page 26125]]

complete discussion of internal control programs is beyond the scope of 
this release, the following elements of such a program are generally 
considered particularly important: effective models for measuring 
market and credit risk exposure; careful procedures for continuously 
validating those models, including rigorous backtesting and stress 
testing; netting arrangements that are enforceable in the relevant 
jurisdictions (and programs to review their enforceability on a regular 
basis); and a risk monitoring unit which reports directly to senior 
management, is independent of the business units being monitored, and 
has the necessary training and resources to accomplish its control 
objectives.
---------------------------------------------------------------------------

    \76\ See, e.g., DPG Framework at 13-22; IOSCO, The Implications 
for Securities Regulators of the Increased use of Value at Risk 
Models by Securities Firms, Section 2 (Jul. 1995); Basle Committee 
on Banking Supervision, Framework for the Evaluation of Internal 
Control Systems at 1 (Jan. 1998); Group of Thirty, Derivatives: 
Practices and Principles at 2 (1993).
    \77\ See, e.g., Regulations 1.14(a)(1)(ii); 1.15(a)(1)(ii); 
1.16(e)(2).
---------------------------------------------------------------------------

    Request for comment. 51. Would OTC derivatives market participants 
benefit from internal control guidelines? If so, what market 
participants should be covered?
    52. What provisions should be included in internal control 
requirements, if any?
    53. How should compliance with any internal control requirements be 
monitored (e.g., regular audits, periodic spot checks, required 
reports)?
    54. Who should be responsible for monitoring compliance with any 
internal control requirements (e.g., regulatory agencies, SROs, 
independent auditors)?
    55. Could and should internal control standards serve as a 
substitute for regulatory capital requirements?
8. Sales Practices
    As noted in the Introduction, a significant number of participants 
in the OTC derivatives markets have experienced large financial losses 
since the Commission's last regulatory initiatives involving OTC 
derivatives. The 1997 GAO Report notes that ``[s]ales practice concerns 
were raised in 209, or 58 percent, of [the] losses [reviewed in the 
Report] and were associated with an estimated $3.2 billion in losses.'' 
\78\ Size and sophistication of a market participant may not provide 
meaningful protection against sales practice concerns, such as fraud.
---------------------------------------------------------------------------

    \78\ 1997 GAO Report at 71.
---------------------------------------------------------------------------

    The parties to OTC derivatives transactions are commonly referred 
to as end-users and dealers.\79\ End-users and OTC derivatives dealers 
may have differing views concerning the respective responsibilities of 
the parties to an OTC derivatives transaction. According to a survey 
undertaken in conjunction with the GAO Report, ``about one-half of all 
end-users of plain vanilla or more complex OTC derivatives believed 
that a fiduciary relationship of some sort existed in some or all 
transactions between them and their dealer.'' \80\ By contrast, ``two 
dealer groups issued guidance asserting that such transactions are 
conducted on a principal-to-principal, or an `arm's-length,' basis 
unless more specific responsibilities are agreed to in writing or 
otherwise provided by law.'' \81\ These differences in view can create 
problems, especially because of the extraordinary complexity of some 
OTC derivatives instruments and the information disparity between a 
derivatives dealer and many end-users. Therefore, comments concerning 
whether there is a need for sales practice rules applicable to OTC 
derivatives dealers would be useful.
---------------------------------------------------------------------------

    \79\ By ``end-users'' the Commission is referring generally to 
participants who use derivatives to manage financial risks and 
opportunities that arise in the course of their businesses. Dealers 
are distinguished from end-users by their willingness to make two-
way markets in OTC derivatives, either for end-users or for other 
dealers. See however, Derivatives Policy Group, Framework for 
Voluntary Oversight (Mar. 1995) (``DPG Framework'') (the Framework 
was developed by a group of six major investment firms). The DPG 
Framework refers to dealers as ``professional intermediaries'' and 
to end-users as ``nonprofessional counterparties.'' This difference 
in articulation is symptomatic of the differing views that sometimes 
exist among the participants in these markets concerning their 
respective roles.
    \80\ 1997 GAO Report at 5.
    \81\ Id. See DPG Framework at 9; and Federal Reserve Bank of New 
York, Principles and Practices for Wholesale Financial Market 
Transactions 1 (Aug. 17, 1995) (the Principles and Practices were 
developed by a group of six financial industry trade associations in 
coordination with the Federal Reserve Bank of New York).
---------------------------------------------------------------------------

    In granting the Part 35 swaps exemption, the Commission retained 
the applicability of its basic antifraud and antimanipulation 
authority.\82\ In addition, some OTC derivatives transactions are 
subject to sales practice standards administered by other financial 
regulatory agencies. For example, both the Office of the Comptroller of 
the Currency and the Federal Reserve Board have issued guidance 
addressing sales practice issues in the context of a bank's overall 
responsibilities for managing the risks of its financial activities, 
including OTC derivatives.\83\
---------------------------------------------------------------------------

    \82\ See 17 CFR 35.2 (1997).
    \83\ See, e.g., OCC, Banking Circular 277: Risk Management of 
Financial Derivatives, BC-277, 1993 WL 640326 (OCC) (Oct. 23, 1993); 
OCC Bulletin, Questions and Answers Re: BCC 277, OCC 94-31, 1994 WL 
194290 (OCC) (May 10, 1994); and Division of Banking Supervision and 
Regulation, Board of Governors of the Federal Reserve System, 
Examining Risk Management and Internal Controls for Trading 
Activities of Banking Organizations, [SR 93-69 (FIS)], (Dec. 20, 
1993). These are not sales practice standards in the usual sense but 
bank risk management standards.
---------------------------------------------------------------------------

    The Commission seeks comments concerning potential sales practice 
standards for principal-to-principal transactions between dealers and 
end-users. The Commission would also welcome information from 
commenters concerning the volume of transactions, if any, in which 
dealers act strictly as agents, rather than principals, in facilitating 
transactions between two end-users and whether any specific sales 
practice rules should apply to such agency transactions. Likewise, the 
Commission would welcome comments on the volume of transactions in 
which dealers trade directly with other dealers for their own 
proprietary accounts and whether any specific sales practice rules 
should apply to those dealer-to-dealer transactions.
    (a) Disclosure. Traditionally, the most fundamental regulatory 
protection in the area of sales practices has been the duty to disclose 
risks and other material information concerning transactions to 
potential customers. Disclosure concerns have often been raised with 
respect to OTC derivatives transactions. For example, the DPG 
Framework, in its section on counterparty relationships, states that 
dealers should consider providing new end-users with ``[g]eneric [r]isk 
[d]isclosure,'' which it characterizes as ``disclosure statements 
generally identifying the principal risks associated with OTC 
derivatives transactions and clarifying the nature of the relationship 
between the [dealer] and its counterparties.'' \84\ This section of the 
DPG Framework goes on to provide additional details on the nature of 
the relationship to be clarified, stating the DPG's view that ``OTC 
derivatives transactions are predominantly arm's-length transactions in 
which each counterparty has a responsibility to review and evaluate the 
terms and conditions, and the potential risks and benefits, of 
prospective transactions * * *.'' \85\ However, the DPG Framework 
provides no further guidance as the nature or content of the generic 
risk disclosure.\86\ Comment is

[[Page 26126]]

solicited on whether risk disclosure should be required and, if so, the 
nature and content of such disclosure.
---------------------------------------------------------------------------

    \84\ DPG Framework at 37. The 1997 GAO Report recommends that 
the CFTC and SEC establish a mechanism for determining that the DPG 
firms are, in fact, following this and other sales practice 
standards in the DPG Framework.
    \85\ Id.
    \86\ The section of the DPG Framework on risk management 
controls lists five basic risks of OTC derivative transactions: 
market risk, credit risk, liquidity risk, legal risk, and 
operational risk. Id. at 14-15. in addition to these firm-specific 
risks, the CFTC OTC Derivatives Report lists a number of potential 
risks arising from OTC derivatives activities generally, including 
the complexity of the derivatives marketplace, the fact that dealer 
activity tends to be concentrated in a relatively small number of 
large entities, the lack of transparency, and systemic risk. See 
CFTC OTC Derivatives Report at 112-122. It may also be appropriate 
to consider whether to require dealers to disclose to prospective 
end-users other material information concerning OTC derivatives 
transactions, such as the relationship of the parties, the material 
terms of the contract, periodic reports of the status of the end-
user's account, information on how the value of the OTC derivatives 
instrument would be affected by changes in the markets for the 
underlying components, and other similar information.
---------------------------------------------------------------------------

    (b) Customer information. Comment is also solicited on whether it 
would be appropriate to require the dealer to obtain certain 
information from the end-user. Such information might include, for 
example:
     net worth information;
     information confirming that the end-user is within the 
class of eligible participants set out in Section 35.1 of the 
Commission's regulations; \87\ or
---------------------------------------------------------------------------

    \87\ 17 CFR 35.1(b)(2) (1997).
---------------------------------------------------------------------------

     information demonstrating that the end-user is authorized 
to enter into the transaction.

    (c) Other possible sales practice rules. Potential sales practice 
rules might also include provisions requiring dealers to supervise 
sales personnel and other employees responsible for handling the 
accounts of end-user customers. One element of such supervision might 
be to ensure that sales personnel are properly trained.
    The Commission also wishes to consider what regime, if any, would 
be appropriate for overseeing the implementation and enforcement of any 
sales practice rules for OTC derivatives, including the costs and 
benefits of alternative oversight mechanisms. In that context, the 
Commission is seeking comments on: (1) the appropriate direct 
regulatory role of the CFTC with respect to potential sales practice 
rules; (2) the appropriate regulatory role of other financial 
regulatory agencies, including the applicability of any sales practice 
rules administered by other agencies and the degree of deference that 
should be accorded to such rules; and (3) the appropriate sales 
practice role of industry self-regulatory bodies, including the degree 
of CFTC oversight necessary to assure that any industry self-regulatory 
standards are properly implemented and enforced.
    Request for comment. 56. Since Part 35 was adopted, has the swap 
market experienced significant problems concerning fraud or sales 
practice abuses? Since Part 34 was adopted, has the hybrid instrument 
market experienced significant problems concerning fraud or sales 
practice abuses? If so, please describe.
    57. Is there a need for any sales practice rules in the OTC 
derivatives market? If so, what should the rules provide, and to whom 
and under what circumstances should they be applicable?
    58. Is there a need for risk disclosures by OTC derivatives dealers 
to end-users? If so, what risks should be disclosed?
    59. Should OTC derivatives dealers be required to supplement any 
required generic risk disclosure statement with additional firm- or 
transaction-specific disclosures? If so, what should such disclosures 
cover?
    60. What kind of disclosures, if any, should dealers make to end-
users clarifying the nature of the relationship between the parties? 
Should there be rules establishing duties of the OTC derivatives dealer 
to its customers, and if so, what should they require?
    61. What kind of disclosures, if any, should dealers make 
concerning the material terms of OTC derivatives contracts, including 
methods for calculating price, value, profit and loss, as well as the 
amount of commissions, fees and other costs involved?
    62. What other kinds of disclosures, if any, might be appropriate 
concerning, for example, potential conflicts of interest, the dealer's 
policies on helping end-users to unwind transactions and matters such 
as the dealer's financial soundness, experience, or track record?
    63. Should dealers be required to make periodic status reports to 
end-users concerning the status of their OTC derivatives positions 
(e.g., value, profits and losses)? If so, what kind of reports should 
be required, and how often should such reports be made?
    64. Should dealers be required to collect information concerning 
their end-user customers? If so, what kind of information? Should 
dealers be required to retain documentation in their files concerning 
such information, and if so, what kind of documentation (e.g., 
confirming that particular information has been collected and reviewed 
by management to assure transactions are in conformity with the end-
user's investment goals and policies)?
    65. What sales practice rules, if any, should apply to transactions 
where a dealer is acting as an agent or broker to facilitate a 
principal-to-principal transaction between two end-users? Similarly, 
what sales practice rules, if any, should apply to dealer-to-dealer 
transactions where both dealers are trading for their own proprietary 
accounts?
    66. Should dealers have to comply with different sales practice 
standards in dealing with end-users having different levels of 
sophistication, based, for example, or portfolio size, investment 
experience, or some other measure? If so, please elaborate.
    67. Should dealers be required to follow any supervision 
requirements in connection with the activities of sales personnel and 
other employees responsible for handling the accounts of end-user 
customers? Should complex or highly leveraged transactions require 
prior approval by senior management of the dealer?
    68. What is the appropriate regime for formulating and overseeing 
the implementation and enforcement of possible sales practices rules, 
including the appropriate roles of the Commission, other financial 
regulators and industry self-regulatory bodies?
9. Recordkeeping
    The Commission has not required any recordkeeping requirements for 
OTC derivatives dealers or other OTC market participants. Having 
retained authority over fraudulent and manipulative behavior in the OTC 
derivative market, the Commission wishes comment on whether some 
recordkeeping requirements would facilitate its exercise of that 
authority. Provisions requiring the retention of written records of 
transactions with counterparties, for example, might be considered. The 
Commission requests comment on whether there should be specific 
recordkeeping requirements for transactions in the OTC derivatives 
markets and, if so, what types of records should be kept and by whom.
    Request for comment. 69. Are recordkeeping requirements for 
participants in the OTC derivatives markets needed? If so, what records 
should be required? Who should be required to keep them?
10. Reporting
    The Commission currently does not impose reporting requirements on 
OTC derivatives market participants.\88\ The

[[Page 26127]]

Commission requests comment on whether specific reporting requirements 
for participants in the OTC derivatives markets are needed and, if so, 
what reports should be made and by whom. If the Commission were to 
establish reporting requirements, it would coordinate with other 
regulatory agencies and, to the extent possible, accept reports 
provided to other regulatory agencies in satisfaction of the 
Commission's requirements. The Commission solicits comment concerning 
how these goals might best be accomplished.
---------------------------------------------------------------------------

    \88\ The DPG has established voluntary reporting requirements. 
See DPG Framework at 23-25. The DPG has committed to regular 
periodic reporting and to respond in good faith to ad hoc requests 
for additional information by the CFTC. Id. at 1. The DPG member 
firms currently provide to the Commission on a quarterly basis a 
report detailing for each member except Credit Suisse First Boston: 
(1) a Credit-Concentration Report listing (on a ``no-names'' basis) 
the top 20 OTC derivatives exposures and, for each exposure, the 
internal credit rating, the industry segment, the current net 
exposure, the next replacement value, the gross replacement values 
(receivable and payable) and the potential additional credit 
exposure (at a ten-day, 99-percent confidence interval); (2) a 
Portfolio Summary listing, by credit rating category and industry 
segment, the current net exposure, net replacement value, and gross 
replacement values; (3) a Geographic Distribution listing, by 
country, the current net exposure, the net replacement value, and 
the gross replacement values; (4) a Net Revenues Report listing, by 
product category and month, the net revenue; and (5) a Consolidated 
Activity Report listing, by product category, the aggregate notional 
amount.
---------------------------------------------------------------------------

    Request for comment. 70. Should the Commission establish reporting 
requirements for participants in the OTC derivatives markets? If so, 
what information should be reported? By whom?

C. Self-Regulation

    Having identified areas in which current exemptions might be 
modified, the Commission is also interested in the views of commenters 
concerning whether, and to what extent, any needed changes concerning 
the oversight of the OTC derivatives market could be accomplished 
through initiatives of industry bodies either voluntarily or through a 
self-regulatory organization empowered to establish rules and subject 
to Commission oversight. The Commission notes that several industry 
organizations already exist with an interest in maintaining and 
improving the integrity of the OTC derivatives marketplace. These 
organizations include, among others, the Derivatives Policy Group, the 
International Swaps and Derivatives Association, the Group of Thirty, 
and the End-Users of Derivatives Association. Industry groups have 
already issued a number of voluntary initiatives aimed at reducing 
risks and promoting stability and integrity in the OTC derivatives 
marketplace.\89\ The Commission is interested in exploring the extent 
to which concerns described in this release might be addressed, and 
adequate oversight of the OTC derivatives marketplace might be 
attained, through industry bodies or through self-regulatory 
organizations.
---------------------------------------------------------------------------

    \89\See, e.g.: Framework for Voluntary Oversight, supra; 
Principles and Practices for Wholesale Financial Market 
Transactions, supra; and Global Derivatives Study Group, Group of 
Thirty, Derivatives: Practices and Principles, supra.
---------------------------------------------------------------------------

    Request for comment. 71. How effective are current self-regulatory 
efforts? What are their strengths and weaknesses?
    72. Are there particular areas among those discussed above where 
self-regulation could obviate the need for government regulation?
    73. Please discuss the costs and benefits of existing voluntary 
versus potential mandatory self-regulatory regimes.
    74. If a self-regulatory regime were adopted, what mechanism would 
best assure effective oversight by the Commission?
    75. How best can the Commission achieve effective coordination with 
other regulators in connection with the oversight of the OTC 
derivatives market?

IV. Summary of Request for Comment

    Commenters are invited to discuss the broad range of concepts and 
approaches described in this release. The Commission specifically 
requests commenters to compare the advantages and disadvantages of the 
possible changes discussed above with those of the existing regulatory 
framework. In addition to responding to the specific questions 
presented, the Commission encourages commenters to submit any other 
relevant information or views.

    Issued in Washington, D.C. this 6th day of May, 1998, by the 
Commodity Futures Trading Commission.

    By the Commission (Chairperson BORN, Commissioners TULL and 
SPEARS; Commissioner HOLUM dissenting).
Jean A. Webb,
Secretary of the Commission.

Dissenting Remarks of Commissioner Barbara Pedersen Holum, Concept 
Release, Over-the-Counter Derivatives

    In Section 4(c)(1) of the Commodity Exchange Act, Congress 
authorized the Commission to exempt certain transactions ``[i]n order 
to promote responsible economic or financial innovation and fair 
competition.'' Indeed, it appears that the dramatic growth in volume 
and the products offered in the OTC derivatives market may be 
attributed in part to the Commission's past exemptive action. In the 
spirit of the Commission's ongoing regulatory review program, it is 
appropriate to examine the continuing applicability of the existing 
exemptions, focusing on the expanding economic significance of the OTC 
market. However, in my judgement,the release goes beyond the scope of 
regulatory review by exploring regulatory areas that may be 
inapplicable to an OTC market. Accordingly, I am dissenting from the 
majority's decision to issue the Concept Release on OTC Derivatives in 
its current form.

    Dated: May 6, 1998.
Barbara Pedersen Holum,
Commissioner.
[FR Doc. 98-12539 Filed 5-11-98; 8:45 am]
BILLING CODE 6351-01-M