The Commodity Exchange Act: Legal and Regulatory Issues Remain (Letter
Report, 04/07/97, GAO/GGD-97-50).

GAO reviewed the legal and regulatory issues surrounding the Commodity
Exchange Act (CEA), focusing on: (1) the extent to which the Commodities
Futures Trading Commission (CFTC) has reduced the legal risk surrounding
the enforceability of over-the-counter (OTC) derivatives under the CEA;
and (2) issues related to the appropriate regulation for exchange-traded
futures and OTC derivatives contracts, including their markets and
market participants.

GAO noted that: (1) under the authority provided by the Futures Trading
Practices Act of 1992, CFTC exempted most swaps and other OTC
derivatives contracts from the CEA's exchange-trading requirement and
thus reduced or eliminated the legal risk that they could be
unenforceable; (2) in granting the exemptions, CFTC was not required to,
and did not, determine that OTC derivatives were futures; (3) as a
result, a question has remained about whether OTC derivatives are
futures and can be regulated under the act: (4) the possibility that
swaps are futures continues to be a source of legal risk for so-called
equity swaps that are ineligible for exemption from the act's
requirements; (5) legal risk also remains for certain agricultural
forwards that are becoming increasingly difficult to distinguish from
futures and that may not be eligible for the swaps exemption; (6)
although CFTC reduced or eliminated the legal risk of being
unenforceable for most swaps and other OTC derivatives, a broader policy
question remains about the appropriate regulation for OTC derivatives
and exchange-traded futures, including their markets and market
participants; (7) the first issue concerns regulation for the OTC
foreign-currency market under CEA; (8) the act excludes from its
regulation certain OTC foreign-currency transactions, but the scope of
the exclusion, called the Treasury Amendment, has been the subject of
disagreement among federal regulators and the courts; (9) a recent U.S.
Supreme Court decision resolved that the exclusion covers all
transactions in foreign currency, including foreign-currency options and
futures; (10) as a result, the extent to which the Treasury Amendment
excludes transactions involving unsophisticated market participants may
still be subject to debate; (11) the second issue concerns the potential
for the swaps market to evolve beyond its exemption and raise additional
regulatory concerns; (12) CFTC exempted swaps from virtually all CEA
requirements, but imposed conditions on the exemption that restricted
their design and trading procedures; (13) the swaps market might develop
in ways that are inconsistent with these conditions; (14) the third
issue concerns the rationale for the regulatory differences between the
OTC derivatives and exchange-traded futures markets; and (15) CFTC
recently granted the exchanges an exemption to enable them to better co*

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-97-50
     TITLE:  The Commodity Exchange Act: Legal and Regulatory Issues 
             Remain
      DATE:  04/07/97
   SUBJECT:  Commodity futures
             Derivative securities
             Commodities exchanges
             Securities regulation
             Waivers
             Jurisdictional authority
             Foreign currency
             Swaps
             Forwards
             Antitrust law
IDENTIFIER:  CFTC Exchange Exemption Pilot Program
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


Cover
================================================================ COVER


Report to Congressional Committees

April 1997

THE COMMODITY EXCHANGE ACT - LEGAL
AND REGULATORY ISSUES REMAIN

GAO/GGD-97-50

Commodity Exchange Act Issues Remain

(233442)


Abbreviations
=============================================================== ABBREV

  CEA - Commodity Exchange Act
  CFTC - Commodity Futures Trading Commission
  OTC - over-the-counter
  SEC - Securities and Exchange Commission

Letter
=============================================================== LETTER


B-259983

April 7, 1997

The Honorable Richard G.  Lugar
Chairman
The Honorable Tom Harkin
Ranking Minority Member
Committee on Agriculture, Nutrition
 and Forestry
United States Senate

The Honorable Thomas W.  Ewing
Chairman
The Honorable Gary A.  Condit
Ranking Minority Member
Subcommittee on Risk Management
and Specialty Crops
Committee on Agriculture
House of Representatives

In the past quarter century, technological advances and fundamental
changes in the global financial markets have accelerated the
development and use of financial products generically called
derivatives.\1 Derivatives include futures contracts\2 that
traditionally have been traded on organized exchanges and are
regulated by the Commodity Futures Trading Commission (CFTC) under
the Commodity Exchange Act (CEA).\3

They also include swaps\4 and other over-the-counter (OTC)
derivatives contracts that resemble exchange-traded futures in their
economic function but are privately negotiated between counterparties
outside organized exchanges.  As we and others have reported,\5
derivatives can serve a useful risk-management function, but their
use can pose risks to participants and the markets.  The total
notional/contract amount of derivatives contracts outstanding
worldwide was an estimated $55.7 trillion as of March 31, 1995.\6

Because of their resemblance to exchange-traded futures, swaps and
other OTC derivatives faced the possibility of falling within the
judicially crafted definition of a futures contract.  As a result,
they faced the legal risk of being unenforceable under the CEA due to
its requirement that futures be traded on exchanges to be legal and
thus enforceable.  The Futures Trading Practices Act of 1992 (P.L. 
102-546) provided CFTC with authority to reduce this legal risk,
which the agency subsequently used.  At the same time, developments
in the exchange-traded futures and OTC derivatives markets brought
regulated financial institutions into these markets, leading to a
greater array of derivatives contracts and greater competition among
those providing such contracts.  Consequently, some of the
distinctions among market participants and between exchange-traded
futures and OTC derivatives have become blurred--raising questions
about the appropriate regulatory structure for these contracts,
markets, and market participants.  Because of the Committees'
interest in the CEA and congressional interest in the continued
vitality and integrity of the U.S.  exchange-traded futures and OTC
derivatives markets, we initiated this review to provide Congress a
context for addressing these questions.  Specifically, we focused on
(1) the extent to which CFTC has reduced the legal risk surrounding
the enforceability of OTC derivatives under the CEA and (2) issues
related to the appropriate regulation for exchange-traded futures and
OTC derivatives contracts, including their markets and market
participants. 


--------------------
\1 Derivatives are contracts that have a market value determined by
the value of an underlying asset, reference rate, or index (called
the underlying).  Underlyings include stocks, bonds, agricultural and
other physical commodities, interest rates, foreign-currency rates,
and stock indexes. 

\2 Futures contracts are derivatives that obligate the holder to buy
or sell a specific amount or value of an underlying asset, reference
rate, or index at a specified price on a specified future date. 

\3 7 U.S.C.  1 et seq. 

\4 Swaps are privately negotiated contracts that typically require
counterparties to make periodic payments to each other for a
specified period.  The calculation of these payments is based on an
agreed-upon amount, called the notional amount, that is not typically
exchanged. 

\5 See Financial Derivatives:  Actions Needed to Protect the
Financial System (GAO/GGD-94-133, May 18, 1994) and the update to
this report, Financial Derivatives:  Actions Taken or Proposed Since
May 1994 (GAO/GGD/AIMD-97-8, Nov.  1, 1996). 

\6 This estimate was based on a comprehensive survey done by the Bank
for International Settlements and represents the most current data
available.  The notional amount of derivatives contracts is one way
that derivatives activity is measured.  Because the notional amount
is not exchanged in most OTC derivatives transactions, it is not
typically a measure of the amount at risk. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Under the authority provided by the Futures Trading Practices Act of
1992, CFTC exempted most swaps and other OTC derivatives contracts
from the CEA's exchange-trading requirement and, in doing so, reduced
or eliminated the legal risk that they could be unenforceable.  The
legal risk arose from the possibility that CFTC or a court could find
that swaps and other OTC derivatives fell within the judicially
crafted definition of a futures contract, in part because, like
futures, they served a risk-shifting function.  If determined to be
futures, these contracts would have violated the CEA's requirement
that futures be traded on an organized exchange, making them illegal
and thus unenforceable.  In granting the exemptions, CFTC was not
required to, and did not, determine that OTC derivatives were
futures.  As a result, a question has remained about whether OTC
derivatives are futures and can be regulated under the act.  The
possibility that swaps are futures continues to be a source of legal
risk for a narrow group of swaps--so-called equity swaps--that are
ineligible for exemption from the act's requirements.  Legal risk
also remains for certain agricultural forwards\7 that are becoming
increasingly difficult to distinguish from futures and that may not
be eligible for the swaps exemption. 

Although CFTC reduced or eliminated the legal risk of being
unenforceable for most swaps and other OTC derivatives, a broader
policy question remains about the appropriate regulation for OTC
derivatives and exchange-traded futures, including their markets and
market participants.  We discuss three issues that are related to
this policy question.  The first issue concerns the appropriate
regulation for the OTC foreign-currency market under the CEA.  The
act excludes from its regulation certain OTC foreign-currency
transactions, but the scope of the exclusion--called the Treasury
Amendment--has been the subject of disagreement among federal
regulators and the courts.  A recent U.S.  Supreme Court decision
resolved that the exclusion covers all transactions in foreign
currency, including foreign-currency options and futures.\8 The Court
did not, however, address the meaning of language that saves from the
exclusion sales for future delivery conducted on a board of trade. 
As a result, the extent to which the Treasury Amendment excludes
transactions involving unsophisticated market participants may still
be subject to debate. 

The second issue concerns the potential for the swaps market to
evolve beyond its exemption and raise additional regulatory concerns. 
CFTC exempted swaps from virtually all CEA requirements but imposed
conditions on the exemption that restricted their design and trading
procedures.  Although difficult to predict, the swaps market might
develop in ways that are inconsistent with these conditions.  Should
this occur, CFTC could use its exemptive authority to accommodate
market developments and address any regulatory concerns, but such an
approach could introduce, among other things, jurisdictional
questions involving other federal regulators.  The President's
Working Group on Financial Markets provides one forum for addressing
such questions.\9

The third issue concerns the rationale for the regulatory differences
between the OTC derivatives and exchange-traded futures markets.  The
types of contracts transacted in each market serve similar economic
functions but differ in other ways, including the way they are traded
and regulated.  CFTC recently granted the exchanges an exemption to
enable them to better compete against the less regulated OTC
derivatives market.  However, under the exemption, regulation of the
two markets will continue to differ substantially.  While the
exchange exemption represents one approach to rationalizing the
regulatory differences between the markets, it also illustrates some
of the challenges in doing so. 

In attempting to address the appropriate regulation of the
exchange-traded futures and OTC derivatives markets, three
fundamental questions arise concerning the goals of federal policy. 
These questions are (1) what is the current public interest in these
markets that needs to be protected; (2) what type of regulations are
needed, if any; and (3) what is the most efficient and effective way
to implement and enforce any needed regulations?  Ultimately,
maintaining globally competitive U.S.  derivatives markets will
require balancing the goal of allowing the U.S.  financial services
industry to innovate and grow with the goal of protecting customers
and the market, including its efficiency, fairness, and financial
integrity. 


--------------------
\7 Forwards are privately negotiated contracts in which the buyer and
seller agree upon delivery of a specified quality and quantity of
goods at a specified future date.  A price may be agreed upon in
advance or determined at the time of delivery.  Delivery is typically
expected, although it may not occur. 

\8 CFTC v.  Dunn, 65 U.S.L.W.  4141 (U.S.  Feb.  25, 1997), rev'g 58
F.  3d 50 (2d Cir.  1995). 

\9 The President's Working Group on Financial Markets was created
following the October 1987 stock market crash to address issues
concerning the competitiveness, integrity, and efficiency of the
financial markets.  The Secretary of the Treasury chairs the working
group, and other members include the chairs of CFTC, the Federal
Reserve System, and the Securities and Exchange Commission. 


   BACKGROUND
------------------------------------------------------------ Letter :2


      THE FUTURES MARKET IS
      REGULATED UNDER THE CEA
---------------------------------------------------------- Letter :2.1

Futures contracts first appeared in the United States in the
mid-1800s and were based on grains.  They provided producers
(farmers) and commodity users with a means of reducing the risk of
financial loss arising from adverse fluctuations in commodity prices,
called hedging.  They also provided a more efficient and transparent
means of determining commodity prices based on supply and demand
factors, called price discovery.  Because of concerns about price
manipulation and other trading abuses in the futures market,
including the operation of bucket shops,\10 Congress passed the CEA
in 1936 to amend the Grain Futures Act of 1922.  Like its
predecessor, the CEA required that futures trading in specified
commodities--such as corn, rye, and wheat--be conducted only on
federally designated markets.  To receive such a designation, an
exchange had to meet certain self-regulatory requirements that
included providing for the prevention of manipulation and fraud. 
Congress periodically amended the act to bring futures trading in
additional commodities under the CEA.  For example, Congress amended
the act in 1968 and brought futures trading in livestock, livestock
products, and frozen concentrated orange juice under federal
regulation. 

By the early 1970s, futures trading had expanded to include
nonagricultural commodities, such as precious metals and foreign
currencies.  Although contracts on these commodities were traded on
futures exchanges, they were not covered by the act and, thus, were
not federally regulated.  In 1974, Congress amended the CEA to ensure
that all futures contracts--whatever their underlying
commodity--would be federally regulated.  It accomplished this goal
by expanding the list of commodities covered by the act to include
virtually anything, tangible or intangible.\11 As a result, the class
of instruments that could be defined as futures and subject to the
act's exchange-trading requirement was broadened.  Any contract that
was legally categorized as a futures contract could be traded only on
federally designated exchanges, making the off-exchange trading of
futures illegal. 

The 1974 amendments to the CEA also created CFTC to administer the
CEA.\12 The CEA gives CFTC exclusive jurisdiction over futures and
establishes a comprehensive regulatory structure designed to protect
the futures market and its participants.  Historically, CFTC's
regulatory structure was designed to assure that all futures
contracts were traded on self-regulated exchanges and through
regulated intermediaries, which were subject to capital, examination,
recordkeeping, registration, reporting, and customer protection
requirements.  The CEA's exchange-trading requirement was intended to
foster both market integrity and customer protection by creating a
centralized market that could be protected against excessive
speculation, price manipulation,\13 and other abusive trade
practices.  According to the act, regulation of the futures market
was necessary to protect the public interest, because futures prices
were susceptible to excessive speculation and could be manipulated to
the detriment of producers, consumers, and others.  Moreover, the
act's legislative history noted that the fundamental purposes of the
act were to ensure fair practices and honest dealing in the futures
market and to control those forms of speculative activity that
demoralize the market to the detriment of producers, consumers, and
the markets. 

While providing for their regulatory oversight, the CEA does not
define the term futures contract.  Instead, CFTC and the courts have
identified certain elements as necessary, but not always sufficient,
for defining a futures contract.  These elements are

  -- the obligation of each party to fulfill the contract at a
     specified price set at the contract's initiation,

  -- the use of the contract to shift or assume the risk of price
     changes, and

  -- the ability to satisfy the contract by either delivering the
     underlying commodity or offsetting\14 the original contract with
     another contract. 

CFTC and the courts have also identified additional elements of
exchange-traded futures contracts, including standardized terms,
margin requirements,\15 use of clearinghouses,\16 open and
competitive trading in centralized markets (such as futures
exchanges), and public price dissemination.  These additional
elements facilitate futures trading on exchanges but do not define
what makes a contract a futures contract.  Also, according to CFTC
and the courts, the requirement that a futures contract be
exchange-traded is what makes the contract legal, not what makes it a
futures contract.  Because CFTC and the courts have defined a futures
contract in a way that reflects its risk-shifting function, the CEA
potentially covers a broad range of risk-shifting products that are
not exchange-traded. 

The CEA also provides CFTC with jurisdiction over commodity
options,\17 except options on securities\18 and options on foreign
currencies traded on a national securities exchange.  CFTC's options
jurisdiction is further limited by the recent U.S.  Supreme Court
decision in CFTC v.  Dunn.\19 Commodity options include options to
acquire futures contracts (called options on futures) and options to
acquire the actual commodity, excluding securities.  CFTC has issued
regulations to allow futures exchanges, subject to its approval, to
trade options on futures in any commodity and options on actual
commodities other than domestic agricultural commodities.  Futures
exchanges have been trading options since 1982, and virtually all
options traded on futures exchanges are options on futures.  CFTC has
also issued regulations to allow certain options on commodities other
than domestic agricultural commodities (called trade options) to be
traded off-exchange.  These OTC options are to be offered and sold to
commercial counterparties who enter into transactions for purposes
related solely to their business. 

Since the 1974 amendments to the CEA and the creation of CFTC, the
U.S.  futures market has evolved far beyond its agricultural origins
and is now dominated by futures based on financial products.  In
1975, the largest commodity group was domestic agricultural
commodities, accounting for nearly 80 percent of total trading
volume.  By 1996, the largest group was interest rate contracts,
accounting for 54 percent of total trading volume.  At the same time,
agricultural commodities accounted for about 19 percent of total
trading volume.  According to the exchanges and others, the
participants in the futures market have changed as the market
evolved.  They noted that the participants are now largely
institutions and market professionals, with retail customers
representing a smaller proportion of total market participants than
they did when the act was amended in 1974.  During this period, the
CEA has remained the primary statute specifically created to regulate
the trading of derivative products. 


--------------------
\10 Bucket shops are firms that purport to conduct a legitimate
business by accepting orders for futures contracts, but that do not
actually execute the orders in the futures market.  When the price on
the futures market moves against the bucket shops, they often close
their doors or file for bankruptcy protection, leaving uncollectible
debts. 

\11 The list of specified commodities was expanded to include "all
goods and articles .  .  .  and all services, rights, and interests
in which contracts for future delivery are presently or in the future
dealt in."

\12 Before the 1974 amendments to the CEA, the Department of
Agriculture administered the act and regulated the futures market. 

\13 Manipulation is the distortion of market prices for economic
gain.  The distortion typically involves creating artificial prices
that do not reflect supply and demand conditions, or creating a false
picture of supply and demand conditions to cause a desired price
movement and/or reaction by other market participants. 

\14 Offset for exchange-traded futures is the liquidation of a long
(short) futures position through the sale (purchase) of an equal
number of contracts of the same delivery month. 

\15 Margins are the cash or collateral deposited by customers with
their agents for the purpose of insuring the agents and, ultimately,
clearinghouses against loss on open exchange-traded futures
contracts. 

\16 Clearinghouses are responsible for the daily clearance and
settlement of all trades.  Clearance is the process of capturing the
trade data, comparing buyer and seller versions of the data, and
guaranteeing that the trade will settle once the data are matched. 
Settlement is the process of fulfilling contractual requirements
through cash payment or delivery. 

\17 Commodity options give the purchaser the right, but not the
obligation, to buy or sell a specified quantity of the underlying
commodity or financial asset at a particular price on or before a
certain future date. 

\18 CEA section 2(a)(1)(B), which codified the Shad-Johnson
Jurisdictional Accord, excludes options on securities from CFTC's
jurisdiction.  Options on securities are regulated by the Securities
and Exchange Commission under federal securities laws. 

\19 In CFTC v.  Dunn, CFTC brought an enforcement action against an
investment fund that was allegedly defrauding its investors through
the purchase and sale of currency options, CFTC v.  Dunn, 65 U.S.L.W. 
4141 (U.S.  Feb.  25, 1997), rev'g 58 F.  3d 50 (2d Cir.  1995).  The
impact of this decision is covered in our discussion of the Treasury
Amendment. 


      OTC DERIVATIVES AND
      EXCHANGE-TRADED FUTURES CAN
      BE USED AS SUBSTITUTES FOR
      AND COMPLEMENTS TO EACH
      OTHER
---------------------------------------------------------- Letter :2.2

OTC derivatives and exchange-traded futures have similar
characteristics and economic functions but differ in other ways.  The
market values of both products are determined by the value of an
underlying asset, reference rate, or index.  The economic uses of
both products include hedging financial risk and investing with the
intent of profiting from price changes, called speculating.  OTC
derivatives and exchange-traded futures differ in the way they are
traded and cleared as well as in their degree of standardization. 
OTC derivatives, which include forwards, options, and swaps, are
privately negotiated contracts.  They are entered into between
counterparties, also called principals, outside centralized trading
facilities\20 such as futures exchanges.  Counterparties negotiate
contract terms--such as price, maturity, and quantity--to customize
the contracts to meet their specific economic needs.  Because OTC
derivatives are entered into on a principal-to-principal basis, each
counterparty is exposed to credit risk--the risk of loss resulting
from the other party's failure to meet its financial obligation.  In
contrast, futures traditionally have been traded on organized
exchanges as well as cleared and settled through clearinghouses. 
Clearinghouses manage counterparty credit risk, in part by
substituting themselves as the buyer to every seller and the seller
to every buyer.  They also guarantee daily settlement of price
changes, thereby eliminating the need for the original counterparties
to monitor each other's creditworthiness.\21 Exchange-traded futures
generally have standardized terms--except for price, which the market
determines. 

The exchange-traded futures and OTC derivatives markets have followed
similar evolutionary paths.  Exchange-traded futures developed from
forward grain contracts that were customized and traded on a
principal-to-principal basis.  They evolved into contracts that have
standardized terms, except for price, and are traded on centralized
exchanges.  Similarly, OTC derivatives originated as customized
contracts that involved brokers finding and matching counterparties. 
Today, almost all OTC derivatives are traded through dealers.\22 An
industry association has developed standardized documentation for
certain OTC derivatives, including swaps.  However, each contract,
including its material terms, continues to be privately negotiated
between the two counterparties.  The less complex interest rate and
foreign-exchange swaps, called plain vanilla swaps, have become more
homogeneous in terms of underlying reference rates or indexes and
maturities.  The majority of both swaps and exchange-traded futures
are settled without delivery of the underlying commodity or financial
asset. 

Because OTC derivatives and exchange-traded futures serve similar
economic functions, they can be used as substitutes for one another
and thus may compete in the marketplace.  However, they are not
perfect substitutes because of potential differences in their
contract terms as well as transaction costs, regulations, and other
factors.  OTC derivatives and exchange-traded futures can also
complement each other.  For example, swaps dealers use
exchange-traded futures to hedge the residual risk resulting from
unmatched positions in their swaps portfolios.  Similarly, food
processors, grain elevators, and other commercial firms use
exchange-traded futures to hedge their forward positions. 


--------------------
\20 Centralized trading facilities are physical or electronic
facilities in which all market participants are able to execute
transactions simultaneously and bind both parties by accepting offers
that are made by one participant but open to all market participants. 

\21 Counterparties still face credit risk from the potential failure
of their clearinghouse and/or clearing member (a member of the
clearinghouse).  Also, clearing members face credit risk from their
exposure to customers, and customers face credit risk from their
exposure to other customers whose funds have been segregated in the
same account.  In the United States, exchange rules and CFTC
regulations provide safeguards to minimize credit risk arising from
such sources. 

\22 Dealers are typically banks and other financial institutions that
stand ready to buy or sell OTC derivatives, providing both a bid and
offer price to the market. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

To address our two objectives, we reviewed the CEA and its
legislative history, Federal Register notices, comment letters, and
other material related to CFTC's exemptions for hybrid, OTC energy,
swaps, and exchange-traded futures contracts.  We also interviewed
CFTC officials, including past commissioners, about the agency's use
of its exemptive authority for OTC derivatives and exchange-traded
futures as well as the legal and regulatory issues raised by these
markets.  Furthermore, we interviewed officials of three futures
exchanges (the Chicago Board of Trade, Chicago Mercantile Exchange,
and New York Mercantile Exchange), the Federal Reserve Board, the
Office of the Comptroller of the Currency, and the Securities and
Exchange Commission (SEC) to obtain their views concerning legal and
regulatory issues related to the exempted OTC derivatives.  In
addition, we attended conferences and congressional hearings as well
as reviewed legal cases, journal articles, books, and reports
pertaining to the CEA and the OTC derivatives and exchange-traded
futures markets. 

Although OTC derivatives raise issues that extend beyond the CEA, we
limited our review to the legal and regulatory issues raised within
the context of the act.  Given this focus, our discussion centered on
futures, forwards, and swaps and generally did not cover other
financial products, including securities options, asset-backed
securities, and structured notes, which are regulated under the
federal securities laws. 

We requested comments on a draft of this report from the heads, or
their designees, of CFTC, the Department of the Treasury, the Federal
Reserve Board, the Office of the Comptroller of the Currency, and
SEC.  We also requested comments from three futures exchanges (the
Chicago Board of Trade, Chicago Mercantile Exchange, and New York
Mercantile Exchange), the New York Stock Exchange, and four industry
associations (the Futures Industry Association,\23 International
Swaps and Derivatives Association,\24 Managed Futures Association,\25
and National Futures Association\26 ).  CFTC, the Department of the
Treasury, the Federal Reserve Board, and SEC provided us with written
comments under a joint response as members of the President's Working
Group on Financial Markets.  We also obtained written comments from
two futures exchanges (the Chicago Mercantile Exchange and Chicago
Board of Trade) and the four industry associations.  These comments
are discussed at the end of this report and are reprinted in
appendixes I through VII.  We did not receive written comments from
the Office of the Comptroller of the Currency, New York Mercantile
Exchange, or New York Stock Exchange.  In addition, officials from
CFTC, the Department of the Treasury, the Federal Reserve Board, the
Office of the Comptroller of the Currency, SEC, the International
Swaps and Derivatives Association, and the Chicago Mercantile
Exchange provided us with technical comments that were incorporated
into the report as appropriate.  We did our work in Chicago, New
York, and Washington, D.C., between August 1994 and February 1997 in
accordance with generally accepted government auditing standards. 


--------------------
\23 The Futures Industry Association is the national trade
association of the futures industry. 

\24 The International Swaps and Derivatives Association is a trade
association that represents more than 150 financial institutions
worldwide.  Its members include investment, commercial, and merchant
banks that deal in OTC derivatives contracts. 

\25 The Managed Futures Association is a national trade association
that represents the managed futures industry.  Its members are
primarily commodity pool operators and commodity trading advisors. 
Commodity pool operators are individuals or firms that solicit or
accept funds, securities, or property for the purpose of trading
commodity futures or options.  Commodity trading advisors are
individuals or firms that are in the business of advising others,
either directly or through publications, on the value or advisability
of trading commodity futures or options. 

\26 The National Futures Association is a self-regulatory
organization that is responsible, under CFTC oversight, for
qualifying commodity futures professionals and for regulating the
sales practices, business conduct, and financial condition of its
member firms. 


   CFTC USED ITS EXEMPTIVE
   AUTHORITY TO REDUCE OR
   ELIMINATE THE LEGAL RISK
   SURROUNDING THE ENFORCEABILITY
   OF MOST OTC DERIVATIVES
------------------------------------------------------------ Letter :4

Before 1993, swaps and other OTC derivatives contracts faced the
legal risk of being deemed illegal off-exchange futures and thus
unenforceable under the CEA.  To reduce this risk and promote
innovation and fair competition, Congress granted CFTC exemptive
authority under the Futures Trading Practices Act of 1992.  CFTC used
its authority in 1993 to exempt swaps and other OTC derivatives from
most CEA provisions (including the exchange-trading requirement),
thereby reducing or eliminating their legal risk.  However, a narrow
group of swaps that are ineligible for the exemption continue to face
the risk of being illegal futures.  In addition, certain unregulated
forwards have become increasingly difficult to distinguish from
regulated futures, resulting in legal risk. 


      SWAPS AND OTHER OTC
      DERIVATIVES FACED THE RISK
      OF BEING ILLEGAL AND THUS
      UNENFORCEABLE FUTURES UNDER
      THE CEA
---------------------------------------------------------- Letter :4.1

The CEA excludes forwards and certain other OTC derivatives from its
regulation, but many swaps and other OTC derivatives could not
qualify for these exclusions.  As a result, they faced the risk that
CFTC or a court could find them to be illegal and, thus,
unenforceable futures under the CEA.  To reduce this legal risk, CFTC
issued a policy statement in 1989 to clarify the conditions under
which it would not regulate swaps as futures.  CFTC's policy
statement, however, did not eliminate the risk of a court finding
swaps to be futures.  In 1990, a court found certain OTC derivatives
that resembled unregulated forwards to be futures, which heightened
the legal risk for swaps and other OTC derivatives.  Following the
court decision, CFTC issued a statutory interpretation holding that
the OTC derivatives in question were forwards, not futures. 


         MANY SWAPS COULD NOT
         QUALIFY FOR AN EXCLUSION
         FROM REGULATION UNDER THE
         CEA
-------------------------------------------------------- Letter :4.1.1

Due to their similarities to futures, swaps and other OTC derivatives
faced the legal risk of being deemed futures under the CEA, making
them illegal and, thus, unenforceable.  These contracts were
developed in the 1980s to meet the risk-management, financing, and
other needs of market participants.  Swaps evolved from parallel
loans that involved two parties making loans to each other in equal
amounts but denominated in different currencies.  Over time, swaps
were developed based not only on foreign currencies but also on
interest rates, commodities, and securities.  These contracts, like
forwards, were entered into between two counterparties outside an
exchange and could be viewed as serving a similar economic function
as a series of forwards.  However, swaps differed from forwards in
that they typically did not entail delivery of the specified
underlying commodity, a hallmark of traditional forwards.  As such,
swaps generally were not considered forwards for regulatory purposes. 
Consequently, they did not fall under the CEA's forward exclusion\27
(discussed below), which would have excluded them from regulation
under the act.  Nor did many swaps fall under the CEA's Treasury
Amendment\28 (discussed below), which excludes certain OTC
transactions in foreign currencies and other financial instruments
from regulation under the act. 

Swaps that could not qualify for an exclusion from the CEA under its
forward exclusion or Treasury Amendment faced the possibility of
falling within the judicially crafted definition of a futures
contract, because they, like futures, served a risk-shifting
function.  This possibility resulted in legal risk for such swaps by
bringing into question their enforceability as futures under the act. 
If such swaps were found to be futures, they would be illegal and
unenforceable, because they would have been traded off-exchange in
violation of the CEA's exchange-trading requirement.  Given the legal
uncertainty surrounding the status of swaps as futures, swaps
counterparties faced legal risk from two sources.  First, CFTC could
take enforcement action and find swaps to be illegal, off-exchange
futures contracts.  Second, counterparties on the losing side of
swaps could try to have a court invalidate the contracts as illegal,
off-exchange futures contracts. 


--------------------
\27 The forward exclusion is set forth in CEA section 2(a)(1)(A)(i). 
Originally enacted as part of the Grain Futures Act of 1922, it
excludes forward contracts from CFTC regulation to facilitate the
movement of agricultural commodities through the merchandizing chain. 

\28 The Treasury Amendment is set forth in CEA section
2(a)(1)(A)(ii). 


         TO REDUCE LEGAL RISK FOR
         SWAPS, CFTC ISSUED A
         POLICY STATEMENT
-------------------------------------------------------- Letter :4.1.2

To reduce the legal risk of unenforceability in the swaps market,
CFTC issued a swaps policy statement in 1989 that clarified the
conditions under which it would not regulate certain swaps as
futures.  In part, CFTC predicated its swaps policy statement on the
rationale that swaps lacked certain elements that facilitated futures
trading on exchanges, such as standardized terms and a clearinghouse. 
As such, swaps were not suitable for exchange trading and, in turn,
not appropriately regulated as exchange-traded futures contracts.  In
this regard, CFTC identified conditions (collectively called a safe
harbor) that swaps settled in cash could meet to avoid regulation
under the CEA.  These conditions were that the swaps

  -- have individually tailored terms,

  -- be used in conjunction with the counterparty's line of business,

  -- not be settled using exchange-style offset or a clearinghouse,
     and

  -- not be marketed to the general public. 

CFTC's swaps policy statement did not eliminate all legal risk of
unenforceability.  It removed the legal risk that CFTC would take
enforcement action against certain swaps, but it did not remove the
legal risk that a swaps counterparty might try to have a court
invalidate a swap as an illegal, off-exchange futures contract.  A
court finding that a swap was a futures contract could call into
question the legality of other swaps--potentially threatening the
market's financial integrity and potentially presenting a source of
systemic risk.\29


--------------------
\29 Systemic risk is the risk that a disruption--at a firm, in a
market, or from another source--will cause difficulties at other
firms, in other market segments, or in the financial system as a
whole. 


         A COURT FOUND THAT
         CERTAIN OTC DERIVATIVES
         WERE FUTURES, CAUSING
         CFTC TO ISSUE A STATUTORY
         INTERPRETATION TO REDUCE
         LEGAL RISK
-------------------------------------------------------- Letter :4.1.3

Following the issuance of CFTC's swaps policy statement, a federal
district court found that certain OTC energy contracts were futures. 
This finding heightened the legal risk of unenforceability for swaps
and other OTC derivatives because of the possibility that a court
could also find them to be futures and subject to the CEA's
exchange-trading requirement.  Judicial proceedings began in 1986
when commercial participants in the Brent oil market\30 were sued for
violating, among other laws, the CEA's antimanipulation provisions. 
The participants responded by claiming that the contracts were
forwards and excluded from the CEA because no contractual right
existed to avoid delivery.  In April 1990, a federal district court
rejected the claim and found that the contracts were futures, not
forwards.\31 The court concluded that even though the contracts did
not include a contractual right of offset for avoiding delivery, both
the opportunity to offset the contracts and the common practice of
doing so were sufficient to determine that the contracts were
futures.  Furthermore, the court found that the Brent oil contracts,
like futures, were undertaken mainly to assume or shift price risk
without transferring the underlying commodity.  The contracts had
highly standardized terms, which facilitated their settlement without
delivery and reflected their use for risk-shifting or speculative
purposes. 

On September 25, 1990, CFTC issued a statutory interpretation for
forwards that adopted the view that the Brent oil contracts were
forwards, not futures.  CFTC did not dispute the court's findings
that these contracts were highly standardized and routinely settled
by means other than delivery.  Rather, it found that the contracts
fell under the CEA's forward exclusion because they required the
commercial parties to make or take delivery, even though the parties
did not routinely do so.  CFTC noted that the contracts did not
include any provisions that enabled the parties to settle their
contractual obligations through means other than delivery, and the
settlement of contracts without delivery was done through subsequent,
separately negotiated contracts.  In that regard, CFTC noted that
these contracts served the same commercial function as forwards
covered under the CEA exclusion, notwithstanding the fact that many
of the individual contracts were settled routinely without delivery. 
One CFTC commissioner dissented from the agency's statutory
interpretation, which, he said, misinterpreted the CEA exclusion by
broadening it to include transactions that were, among other things,
generally standardized, used for noncommercial purposes, and offset. 


--------------------
\30 Brent oil contracts are for the future purchase or sale of Brent
crude oil, which is a blend of oils produced in various fields in the
North Sea and delivered through pipelines for loading on cargo ships
at Sullem Voe in Scotland. 

\31 Transnor (Bermuda) Limited v.  BP North America Petroleum, 738 F. 
Supp.  1472 (S.D.N.Y.  1990). 


      CONGRESS GRANTED CFTC
      EXEMPTIVE AUTHORITY TO
      REDUCE THE LEGAL RISK FACING
      SWAPS AND OTHER OTC
      DERIVATIVES
---------------------------------------------------------- Letter :4.2

Following the court's finding that certain OTC energy contracts were
futures and recognizing the broader implications of that decision for
other OTC derivatives, Congress granted CFTC exemptive authority
under the Futures Trading Practices Act of 1992.  The 1992 act
granted CFTC the authority to exempt any contract from almost all CEA
provisions (including the exchange-trading requirement), provided the
exemption was consistent with the public interest\32 and the contract
was entered into solely between appropriate persons, as defined in
the act.  In granting an exemption, CFTC could impose any conditions
on the exemption that it deemed appropriate.  The only provision from
which CFTC could not exempt a contract was section 2(a)(1)(B), which
generally prohibits futures contracts on individual stocks and
narrowly based stock indexes.\33

According to the 1992 act's legislative history, Congress expected
CFTC to use its exemptive authority promptly to reduce legal risk for
swaps, forwards,\34 and hybrids.\35

The legislative history noted that the goal of providing CFTC with
broad exemptive authority was to give CFTC a means of providing
certainty and stability to existing and emerging markets so that
financial innovation and market development could proceed in an
effective and competitive manner.  It also noted that CFTC could
exempt a contract without first determining that the contract was a
futures contract and subject to the act. 


--------------------
\32 According to the legislative history, the public interest was to
include the national public interest noted in the CEA (discussed in
section 3 of the act), prevention of fraud, preservation of the
financial integrity of the markets, and promotion of responsible
economic or financial innovation and fair competition. 

\33 The section provides procedures under which CFTC, subject to
SEC's review, may permit exchanges to trade futures contracts on
stock indexes provided minimum criteria are met.  These criteria
include that the contract is settled other than through delivery of
the underlying securities and the underlying index of securities is
broadly based. 

\34 In elaborating on the forward exemption in the act's legislative
history, Congress encouraged CFTC to determine whether exemptive or
other action should be taken for Brent Oil contractsn. 

\35 Hybrids are financial instruments that possess, in varying
combinations, characteristics of futures, forwards, options,
securities, and/or bank deposits.  Unlike many other derivatives,
hybrids generally serve a capital-raising function. 


      CFTC USED ITS AUTHORITY TO
      EXEMPT MOST SWAPS AND OTHER
      OTC DERIVATIVES FROM MOST
      CEA PROVISIONS
---------------------------------------------------------- Letter :4.3

Using its exemptive authority, CFTC exempted a broad group of swaps
as well as hybrids from virtually all CEA provisions--including the
exchange-trading requirement--in January 1993.  In response to a
request by a group of commercial firms in the energy market, CFTC
granted a similar exemption in April 1993 to specified OTC energy
contracts, which included Brent oil contracts.  These exemptions
eliminated the legal risk that the qualifying contracts could be
deemed illegal, off-exchange futures contracts.  If CFTC or a court
found an exempted contract to be a futures contract, the contract
would still be legal, because it would no longer need to be traded on
a designated market, or exchange.  As a result, uncertainty was
reduced and with it, the potential for any related systemic risk.  At
that time, CFTC noted that the exemptions should enhance U.S.  market
participants' ability to innovate by enabling them to structure OTC
contracts to best meet their economic needs, which should enable
market participants to compete more effectively in international
markets.  In granting its exemptions, CFTC did not determine that the
OTC derivatives covered by the exemptions were or were not futures or
otherwise excluded from the act's jurisdiction.  CFTC noted that it
had not made and was not obligated to make such a determination. 


      A NARROW GROUP OF SWAPS NOT
      ELIGIBLE FOR THE EXEMPTION
      FACE THE RISK OF BEING
      ILLEGAL FUTURES
---------------------------------------------------------- Letter :4.4

CFTC's swaps exemption does not extend to a narrow group of swaps,
so-called equity swaps.\36 Because of the possibility that swaps are
futures, these nonexempted swaps continue to face the legal risk of
being deemed illegal and, thus, unenforceable futures.  CFTC
enforcement actions involving OTC derivatives can increase such legal
risk for these swaps. 


--------------------
\36 In addition, CFTC's exemption does not extend to swaps based on
securities registered with SEC--such as swaps based on registered
corporate debt.  To the extent that such swaps exist, the following
discussion on equity swaps applies to them. 


         CFTC'S SWAPS EXEMPTION
         DOES NOT COVER ALL SWAPS
-------------------------------------------------------- Letter :4.4.1

CFTC's swaps exemption does not extend to equity swaps, whose returns
are based on stocks or stock indexes.  Even if these swaps met all of
the conditions of CFTC's swaps exemption, they would not be exempt
from CEA section 2(a)(1)(B), which codified the Shad-Johnson
Jurisdictional Accord.  Under the 1992 act, CFTC is allowed to exempt
swaps from any CEA provision, except section 2(a)(1)(B), which
divides jurisdiction on exchange-traded securities-related futures
and options contracts between CFTC and SEC and prohibits futures on
individual stocks or narrowly based stock indexes.  Futures on
broadly based stock indexes may be traded only on CFTC-designated
markets, provided CFTC determines that the contracts are not settled
through the delivery of the underlying stocks and are not readily
susceptible to manipulation.  SEC must also agree with CFTC's
determinations.  According to market observers, if equity swaps were
found to be futures contracts, they could be in violation of section
2(a)(1)(B) and thus be illegal and unenforceable. 

As long as the issue of whether swaps are futures is not definitively
addressed by CFTC, the courts, or Congress, the possibility exists
that equity swaps could be found to be futures and, thus, subject to
the CEA.  CFTC has noted, however, that market participants using
equity swaps may continue to rely on its 1989 swaps policy statement. 
As discussed earlier, the policy statement removed the legal risk
that CFTC would take enforcement action against certain swaps, but it
did not remove the risk that a court could invalidate such contracts
by deeming them to be illegal futures.  In addition, the legal
enforceability of equity swaps could be jeopardized indirectly
through a finding that an exempted swap is a futures contract.  For
example, CFTC had proposed amending its swaps exemption to include a
stand-alone, antifraud rule that would apply to exempted swaps.\37
According to other federal regulators and market participants
commenting on the proposal, the rule would have suggested that the
exempted swaps were futures.  This, in turn, would have suggested
that equity swaps were also futures.  Following the comment period,
CFTC did not amend its swaps exemption to include the proposed
change. 

According to the International Swaps and Derivatives Association, a
finding that an exempted swap is a futures contract could increase
legal risk by prompting losing counterparties to equity swaps to rely
on the resulting legal uncertainty to avoid their performance
obligations under such contracts.  It noted that this could result in
substantial losses and a market disruption.  At a June 1996 hearing
held by the Senate Committee on Agriculture, Nutrition and Forestry,
the association testified that the legal risk surrounding equity
swaps has inhibited their evolution and that this uncertainty needs
to be addressed.  The Bank for International Settlements estimated
that the worldwide market for equity swaps and forwards had a total
notional value of $52 billion, as of March 31, 1995, which accounted
for less than 1 percent of the total notional value of the OTC
derivatives market.\38


--------------------
\37 According to CFTC, questions had been raised about the
applicability of the CEA's antifraud provisions to exempted swaps,
and the proposed stand-alone, antifraud rule would have eliminated
such questions. 

\38 The Bank for International Settlement reported the total notional
amount outstanding of equity swaps and forwards together. 


         CFTC ENFORCEMENT ACTIONS
         INVOLVING OTC DERIVATIVES
         HAVE RAISED QUESTIONS
         ABOUT THE ENFORCEABILITY
         OF EQUITY SWAPS
-------------------------------------------------------- Letter :4.4.2

CFTC's enforcement actions involving OTC derivatives have highlighted
the potential for such action to increase legal risk in the equity
swaps market.  In December 1994, CFTC and SEC cooperated in an
enforcement action against BT Securities, a swaps dealer, for
violating antifraud provisions of futures and securities laws in
connection with swaps it sold.\39 CFTC officials told us that swaps
market participants did not want the agency to take any action
against the swaps dealer that would suggest swaps were futures for
fear of increasing legal risk for equity swaps.  In its enforcement
order, CFTC did not identify any of the swaps as futures.  Rather, it
found that BT Securities violated the CEA's antifraud provisions in
its role as a commodity trading advisor by providing the counterparty
with misleading information about the swaps.  According to market
participants and observers, the finding implied that certain of the
swaps sold by BT securities were futures or commodity options, which
raised questions regarding the status of swaps under the CEA. 
Recognizing the potential legal and regulatory implications, CFTC
issued a news release stating that its actions did not affect the
legal enforceability of swaps or signal an intent to regulate them. 

According to some market participants and observers, CFTC's
enforcement order against MG Refining and Marketing--a commercial
firm--resulted in greater legal risk for forwards and equity swaps. 
In 1995, CFTC took enforcement action against MG Refining and
Marketing for selling illegal, off-exchange futures to commercial
counterparties.  The firm sold contracts that purportedly required
the delivery of energy commodities in the future at a price
established by the parties at initiation.  These contracts provided
counterparties with a contractual right to settle the contracts in
cash without delivery of the underlying commodity.  This right could
be invoked if the price of the underlying commodity reached a
preestablished level.  Based largely on this provision, CFTC found
these contracts to be illegal, off-exchange futures.  CFTC's
conclusion was consistent with prior court and CFTC decisions; it
identified the contractual right to offset as a critical feature
distinguishing forwards from futures.  Nonetheless, some market
participants and observers asserted that CFTC's order broadened the
definition of a futures contract, creating legal uncertainty over
whether swaps and other OTC derivatives are futures and resulting in
greater legal risk for forwards and equity swaps. 

In a letter sent to CFTC, two U.S.  congressmen expressed their
concern about the potential for CFTC's enforcement order to bring
into question the status of swaps as futures and to reflect a change
in CFTC's regulatory position on swaps.  In response to the
congressional inquiry, the then CFTC chairman wrote that the case had
nothing to do with swaps.  She noted that, with regard to swaps
generally, CFTC had not taken a position on whether swaps were
futures and continued to adhere to its 1989 swaps policy statement. 
She also noted that in this case CFTC did not deviate from its
historical practice of looking at the totality of the
circumstances--including the nature of the contract and market--in
determining whether a particular transaction involved a futures
contract. 

On February 4, 1997, Senator Lugar, Chairman of the Senate
Agriculture Committee, Senator Harkin, Ranking Minority Member, and
Senator Leahy introduced a bill to amend the CEA.  The bill is
similar to the one that Senators Lugar and Leahy introduced in the
Fall of 1996, following the June 1996 hearing.  As noted in a
discussion document prepared by Senators Lugar and Harkin, the bill
would provide greater legal certainty for equity swaps by codifying
the existing swaps exemption and extending the exemption's scope to
include equity swaps. 


--------------------
\39 BT Securities is registered with SEC as a broker-dealer.  SEC
found that certain of the OTC derivatives that BT Securities sold
were securities within the meaning of the federal securities laws. 


      CERTAIN FORWARDS HAVE
      EVOLVED TO WHERE IT HAS
      BECOME INCREASINGLY
      DIFFICULT TO DISTINGUISH
      THEM FROM FUTURES, RESULTING
      IN LEGAL RISK
---------------------------------------------------------- Letter :4.5

Forwards have been distinguished from futures based on whether the
parties intended to make or take delivery of the underlying commodity
when they entered into the contract.  However, certain unregulated
forwards have evolved to where delivery of the underlying commodity
may not routinely occur, making it increasingly difficult to
distinguish them from regulated futures and resulting in the legal
risk that they could be unenforceable.  The CEA does not provide
clear criteria for distinguishing forwards from futures, but CFTC's
exemptions reduce the need to do so for the purpose of addressing
legal risk. 


         FORWARDS TRADITIONALLY
         DIFFERED FROM FUTURES IN
         THAT THEY ENTAILED
         DELIVERY
-------------------------------------------------------- Letter :4.5.1

As discussed above, since its enactment in 1936, the CEA has excluded
forward contracts from its regulation to facilitate the movement of
commodities through the merchandizing chain.\40 Absent a definition
of a forward contract in the CEA, CFTC and the courts have generally
defined these contracts in reference to futures contracts. 
Traditionally, they distinguished forwards from futures based on
whether the parties intended to make or take delivery of the
underlying commodity when they entered into the contract.  Forwards
served primarily a commercial function and, as such, entailed
delivery of the underlying commodity in normal commercial channels,
but delivery was to occur at a later date.  In contrast, futures were
used primarily to shift or assume price risk without transferring the
underlying commodity; thus, actual delivery was not expected to
occur.  In short, CFTC and the courts defined a forward as a contract
that bound one party to make delivery and the other to take delivery
of the contract's underlying physical commodity.  Since forwards were
commercial transactions that resulted in delivery, CFTC and the
courts looked for evidence of the contracts' use in commerce.  In
particular, they examined whether the parties were commercial
entities that could make or take delivery and whether delivery
routinely occurred. 


--------------------
\40 For example, a producer and grain elevator would enter into a
forward contract under which the grain elevator would agree to buy
the producer's grain before it was harvested.  The sale price was
agreed to when the contract was initiated, and both parties expected
that the grain would be delivered when harvested.  In entering the
forward contract, the producer would shift the price risk incident to
the farming operation to the elevator. 


         CERTAIN FORWARDS FACE THE
         LEGAL RISK OF BEING
         UNENFORCEABLE
-------------------------------------------------------- Letter :4.5.2

Besides the Brent oil market, other forward markets are evolving in
response to the risk-management and commercial needs of their
participants.  For example, changes in U.S.  farm policy, increased
globalization of the agricultural markets, and other factors may have
increased price volatility in the agricultural markets and created a
demand for more innovative risk-management contracts.  According to
agricultural market participants, traditional forwards do not provide
producers with sufficient flexibility because of their delivery
requirement.  In response to participants' needs, the forward market
for agricultural commodities has evolved to include variations of
forwards that may not routinely result in delivery.  Contracts that
routinely allow parties to offset, cancel, or void delivery
obligations rather than transfer the underlying commodity may be
viewed as futures contracts or trade options, depending on their
pricing structure.  CFTC permits the sale of trade options on
nonagricultural commodities, but prohibits the sale of such options
on domestic agricultural commodities.\41 This prohibition was
intended, in part, to protect producers from unscrupulous parties who
might try to take advantage of their lack of knowledge about these
options. 

One variation of a forward experiencing increased use is the
hedge-to-arrive contract.  Although varying in design, these are
privately negotiated contracts in which a producer agrees with an
elevator to deliver grain on a future date at an agreed-upon
price,\42 and the elevator uses exchange-traded futures to hedge the
sale on behalf of the producer.  Some of these contracts have allowed
producers to defer the delivery dates on their contracts beyond the
current crop year, which has exposed producers to significant price
risk because their contracts were no longer tied to the current crop
year.  According to market observers, unusual factors, such as high
grain prices and poor weather conditions, have resulted in financial
problems for some parties that deferred delivery into future crop
years.  In May 1996, CFTC staff issued a policy statement for
hedge-to-arrive contracts to allow counterparties experiencing losses
to settle their contracts without delivery by entering into
subsequent, separately negotiated contracts.  CFTC noted that it
would not find hedge-to-arrive contracts existing as of May 15, 1996,
to be illegal based solely on the cash settlement of such contracts
for the purpose of unwinding them, but may find them to be illegal
based on other factors.\43

CFTC or a court could find some hedge-to-arrive contracts or other
variations on agricultural forwards to be futures or agricultural
trade options.  Either finding would make them illegal and
unenforceable, provided the contracts did not qualify for the swaps
exemption.  For example, in November 1996, CFTC filed three
administrative complaints, two of which alleged, among other things,
that two elevators had offered and sold hedge-to-arrive contracts
that were illegal, off-exchange futures.  In these two complaints,
CFTC noted that the elevators sold the hedge-to-arrive contracts to
some producers who lacked the intent or capacity to make delivery of
the grain.  CFTC also noted some producers did not qualify as
eligible participants under the swaps exemption.  CFTC further noted
that the contracts contained a cancellation provision that permitted
producers to effect an offset of their contracts. 


--------------------
\41 In December 1995, CFTC held a roundtable discussion to address
the possibility of lifting its ban on agricultural trade options to
provide producers with a broader range of marketing and
risk-management tools.  Based on this discussion, CFTC staff expected
to advise the agency's commissioners of those issues that require
further analysis. 

\42 The final price received for the commodity being sold is
determined by a formula that references the current and future price
of a specified exchange-traded futures contract as well as the future
market price of the commodity. 

\43 According to CFTC, the actual delivery of the underlying physical
commodity (as opposed to offset) has been a hallmark of traditional
agricultural forwards, but the failure to deliver on a contract alone
would not necessarily preclude the contract from qualifying for the
forward exclusion. 


         THE CEA DOES NOT PROVIDE
         CLEAR CRITERIA FOR
         DISTINGUISHING FORWARDS
         FROM FUTURES
-------------------------------------------------------- Letter :4.5.3

While the CEA excludes forwards from its regulation because of their
commercial merchandizing purpose, it does not provide clear criteria
for distinguishing forwards from futures.  In particular, the CEA
does not specify what constitutes delivery under the forward
exclusion and, thus, when a forward becomes a futures contract. 
Given the lack of clear criteria, the evolution of certain forwards
to where delivery may not routinely occur has made it increasingly
difficult to distinguish unregulated forwards from regulated futures. 
As illustrated by the Brent oil and hedge-to-arrive contracts, the
difficulty in distinguishing between forwards and futures can result
in legal risk.  Under its 1990 statutory interpretation for forwards
(discussed above), CFTC tried to reduce the legal risk and regulatory
constraints that forwards face because of the delivery requirement,
thereby permitting them to evolve to better meet the economic needs
of end-users.  However, its interpretation does not provide a clear
basis for distinguishing forwards from futures in terms of their
economic purpose.  For example, it does not preclude forwards from
being settled routinely without delivery and, in the process, being
used primarily for risk-shifting or speculative purposes instead of a
commercial merchandizing purpose. 


         CFTC'S EXEMPTIONS REDUCE
         THE NEED TO DISTINGUISH
         FORWARDS FROM FUTURES FOR
         THE PURPOSE OF ADDRESSING
         LEGAL RISK
-------------------------------------------------------- Letter :4.5.4

CFTC's exemptions for OTC energy and swaps contracts reduce the need
to distinguish unregulated forwards from regulated futures for the
purpose of addressing the legal risk of being unenforceable.  CFTC's
OTC energy contract exemption reduces legal risk for certain forwards
that routinely settle without delivery, but it is limited to OTC
derivatives based on specified energy products.  Although the
exemption covers Brent oil contracts that CFTC determined earlier to
be forwards under its 1990 interpretation, CFTC noted that the
exemption does not affect its interpretation.  However, as with its
1989 swaps policy statement, CFTC's forward interpretation does not
eliminate all legal risk.  It removes the legal risk of CFTC taking
enforcement action against a contract that is consistent with its
interpretation, but it does not eliminate the risk of a counterparty
trying to have a court invalidate the contract as an illegal,
off-exchange futures contract. 

CFTC's swaps exemption further reduces the need to distinguish
unregulated forwards from regulated futures to address legal risk. 
Contracts that resemble forwards but do not entail delivery may
qualify for the swaps exemption.  Qualifying contracts would not be
illegal and unenforceable, even if CFTC or a court found them to be
futures, because they would be exempt from the exchange-trading
requirement.  The swaps exemption is limited to "eligible"
participants, which are largely institutional and other sophisticated
market participants.  Consequently, the exemption generally does not
extend to contracts that involve unsophisticated market participants. 


   ISSUES REMAIN RELATED TO THE
   APPROPRIATE REGULATION FOR THE
   OTC DERIVATIVES AND
   EXCHANGE-TRADED FUTURES MARKETS
------------------------------------------------------------ Letter :5

Notwithstanding CFTC's success in reducing or eliminating the legal
risk of unenforceability that most OTC derivatives faced, issues
remain that raise a broader policy question about the appropriate
regulation for OTC derivatives and exchange-traded futures, including
their markets and market participants.  Congress alluded to this
topic in the legislative history of the Futures Trading Practices Act
of 1992 by noting that the growth and proliferation of OTC
derivatives raises questions of how best to regulate the new market,
adding that studies by us and others would be useful when Congress
considers the broader question of regulatory policy.  To that end, we
discuss, but do not attempt to resolve, three issues that are related
to the question of how best to regulate the OTC derivatives and
exchange-traded futures markets.  These issues concern the (1)
appropriate regulation for the OTC foreign-currency market under the
Treasury Amendment, (2) appropriate regulation for the evolving swaps
market,\44 and (3) rationalization of regulatory differences between
the OTC derivatives and exchange-traded futures markets. 


--------------------
\44 Our discussion focuses on the exempted swaps market, but the
broader question of how best to regulate the OTC derivatives market
also applies to the equity swaps and evolving forwards markets that
are discussed above. 


      THE APPROPRIATE REGULATION
      FOR THE OTC FOREIGN-CURRENCY
      MARKET UNDER THE TREASURY
      AMENDMENT IS AN UNRESOLVED
      ISSUE
---------------------------------------------------------- Letter :5.1

The CEA excludes, among other things, certain OTC foreign-currency
transactions from CFTC regulation under its Treasury Amendment. 
However, the scope of the amendment has been difficult to interpret
and the subject of considerable debate and litigation.  CFTC has
interpreted the amendment to exclude from the act's regulation
certain OTC foreign-currency transactions between sophisticated
participants, but not similar transactions involving unsophisticated
participants.  The Treasury Department has disagreed with CFTC's
interpretation.  While the federal courts have differed in their
interpretation of the Treasury Amendment, they have recognized
congressional intent to exclude the interdealer OTC foreign-currency
market from regulation under the CEA. 


         THE TREASURY AMENDMENT
         EXCLUDES CERTAIN OTC
         FOREIGN-CURRENCY
         TRANSACTIONS FROM CFTC
         REGULATION, BUT IT IS
         DIFFICULT TO INTERPRET
-------------------------------------------------------- Letter :5.1.1

The Treasury Amendment excludes from CFTC regulation certain OTC
transactions in, among other things, foreign currencies and
government securities.\45 During the debate over the 1974 amendments
to the CEA, the Treasury Department expressed concern that the
proposed changes--namely the expansion of the commodities covered
under the act coupled with the exchange-trading requirement--would
prohibit banks and other financial institutions from trading among
themselves in foreign currencies and certain financial instruments,
including government securities.  The Treasury Department noted that
futures trading in foreign currencies was done through an informal
network of banks and dealers (called the interbank market),\46 which
serves the needs of international business to hedge risk stemming
from foreign-exchange rate movements.  The Treasury Department
proposed the Treasury Amendment as a means of clarifying that the CEA
did not cover this market, and Congress adopted the proposed
amendment.  According to the act's legislative history, Congress
noted that the interbank market was more properly supervised by the
bank regulators and, therefore, regulation under the CEA was
unnecessary. 

The Treasury Amendment has been difficult to interpret because its
language is ambiguous.  Although the amendment was motivated
primarily by concern that the interbank foreign-currency market
should be excluded from regulation under the act, its language is not
limited to the interbank market.  Rather, it excludes any transaction
in, among other things, foreign currencies, unless the transaction
involves sale for future delivery conducted on a board of trade.\47
Before the recent U.S.  Supreme Court decision in Dunn v.  CFTC,
considerable debate occurred over the meaning of the phrase
"transactions in," which defines the scope of the exclusion. 
Arguments were made that the phrase could be interpreted narrowly to
mean only cash transactions in the subject commodity or broadly to
encompass derivatives transactions such as futures or option
contracts.  In Dunn, the U.S.  Supreme Court endorsed the broader
interpretation.  Furthermore, the CEA defines the term "board of
trade," which is used in the "unless" clause, to "mean any exchange
or association, whether incorporated or unincorporated, of persons
who shall be engaged in the business of buying or selling any
commodity." Consequently, this clause could be interpreted to save
from the exclusion virtually any futures or option contract sold by a
dealer, a construction that would render the amendment meaningless. 
The ambiguity of the statutory language has led to disagreements
among regulators and courts over how the amendment ought to be
interpreted. 


--------------------
\45 The Treasury Amendment states:  "Nothing in this Act shall be
deemed to govern or in any way be applicable to transactions in
foreign currency, security warrants, security rights, resales of
installment loan contracts, repurchase options, government
securities, or mortgages and mortgage purchase commitments, unless
such transactions involve the sale thereof for future delivery
conducted on a board of trade.  (Emphasis added.) The CEA reference
to "transactions involving the sale for future delivery" refers to
futures contracts and has been interpreted by the U.S.  Supreme Court
to also refer to commodity options. 

\46 The interbank market includes not only banks but also other
financial institutions and industrial corporations.  Because the
market is not limited to banks, some market observers, including the
Treasury Department, have noted that the market is more accurately
characterized as an "institutional market."

\47 As noted above, the U.S.  Supreme Court found that both futures
and options involve sale for future delivery within the meaning of
the Treasury Amendment. 


         CFTC AND THE TREASURY
         DEPARTMENT HAVE
         INTERPRETED THE TREASURY
         AMENDMENT DIFFERENTLY
-------------------------------------------------------- Letter :5.1.2

Because of its significant market impact, the activity that the
Treasury Amendment excludes from regulation under the CEA has been
the subject of considerable debate among federal regulators.  Since
at least 1985, CFTC has interpreted the Treasury Amendment to exclude
from the act's regulation certain OTC transactions between banks and
other sophisticated institutions, drawing a distinction between
sophisticated market participants and unsophisticated market
participants who may need to be protected by government
regulation.\48 An OTC foreign-currency transaction, such as a
foreign-exchange swap, sold to a financial institution would be
excluded from the act's regulation; a similar contract sold to the
general public would not be excluded.  CFTC drew this distinction to
preserve its ability to protect the general public from, among other
things, bucket shops engaging in fraudulent futures transactions--one
of its missions under the CEA.  According to CFTC, since 1990, the
agency has brought 19 cases involving the sale of foreign-currency
futures or options contracts to the general public;\49 in those
cases, more than 3,200 customers invested over $250 million, much of
which was lost.  Whether foreign-currency contracts sold to the
general public are excluded by the Treasury Amendment, however, has
remained a source of legal uncertainty.  According to CFTC, if the
amendment were interpreted to cover contracts sold to the general
public, the agency's ability to prohibit the fraudulent activities of
bucket shops dealing in foreign-currency contracts would be
effectively eliminated, creating a regulatory gap. 

The Treasury Department, however, has objected that CFTC's approach
to the Treasury Amendment lacks a foundation in the language of the
statute.  It has advocated the reading of the Treasury Amendment
adopted by the U.S.  Supreme Court in Dunn--that is, the Treasury
Amendment excludes from CFTC jurisdiction any transaction in which
foreign currency is the subject matter, including foreign-currency
options, unless conducted on a board of trade.  Nevertheless, it has
expressed sympathy with CFTC's concerns over fraudulent
foreign-currency contracts marketed to the general public.  The
Treasury Department has suggested that CFTC may be able to interpret
the term "board of trade" in a carefully circumscribed manner that
would allow appropriate enforcement action against fraud without
raising questions about the validity of established market practices. 


--------------------
\48 50 Fed.  Reg.  42983. 

\49 One approach that CFTC uses to shut down bucket shops is to show
that the contracts they sold were illegal, off-exchange futures,
thereby obviating the need to show fraud. 


         FEDERAL COURT
         INTERPRETATIONS OF THE
         TREASURY AMENDMENT HAVE
         DIFFERED
-------------------------------------------------------- Letter :5.1.3

The federal courts have differed in their interpretation of what
activity the Treasury Amendment excludes from regulation under the
CEA.  In spite of these differences, the courts have recognized
congressional intent to exclude the interdealer foreign-currency
market from regulation.  However, past court cases have highlighted
the legal confusion over whether the Treasury Amendment excludes from
the act's regulation transactions in foreign currencies that involve
the general public. 

The Second Circuit Court of Appeals held in Dunn that option
contracts are not covered by the Treasury Amendment and, therefore,
are subject to CFTC jurisdiction.  In doing so, it followed a
precedent that it had established in a case involving the sale of
currency options to private individuals.  In that case, it reasoned
that an option contract does not become a transaction in foreign
currency that is excluded under the Treasury Amendment until the
option holder exercises the contract.\50

In February 1997, the U.S.  Supreme Court reversed the Second
Circuit's decision in Dunn.  The Court interpreted the "transactions
in" language of the Treasury Amendment to exclude from CFTC
regulation all transactions relating to foreign currency, including
foreign-currency options, unless conducted on a board of trade.  The
Court noted that the public policy issues raised by the various
parties affected by the decision were best addressed by Congress. 

The Fourth Circuit Court, in Salomon Forex, Inc.  v.  Tauber,\51 held
that sales of currency futures and options to a very wealthy
individual are transactions in foreign currency that the Treasury
Amendment excludes from regulation.  The buyer of the contracts
brought the action to avoid payment on transactions in which he had
lost money.  The court interpreted the amendment to exclude from the
CEA individually negotiated foreign-currency option and futures
transactions between sophisticated, large-scale currency traders. 
The court observed that the case did not involve mass marketing of
contracts to small investors and stated that its holding did not
imply that such marketing was exempt from the CEA. 

The Ninth Circuit Court, in CFTC v.  Frankwell Bullion Ltd.,\52
affirmed a lower court holding that the Treasury Amendment excludes
the sale of off-exchange foreign-currency futures and options from
the CEA without regard to whom the contracts are sold.  CFTC brought
action to stop the seller of the contracts from allegedly selling
illegal, off-exchange futures contracts to the general public.  The
Ninth Circuit Court's review focused on the meaning of the clause
"unless .  .  .  conducted on a board of trade." The court
interpreted the clause to carve out of the exclusion only contracts
sold on an organized exchange.  The court acknowledged that the plain
meaning of a board of trade as defined by the act would include more
than exchanges.  But the court rejected this interpretation in the
context of the Treasury Amendment because it would cause the "unless"
clause to encompass the entire exclusion and thereby render the
amendment meaningless.  Turning to congressional reports accompanying
the 1974 legislation to explain the purpose of the Treasury
Amendment, the court concluded that Congress intended to exclude from
the CEA all transactions in the listed commodities except those
conducted on an organized exchange.  In December 1996, CFTC filed a
petition with the Ninth Circuit Court requesting a rehearing, which
was denied. 

At the June 1996 hearing held by the Senate Committee on Agriculture,
Nutrition and Forestry, the then acting CFTC chairman testified that
the agency and Treasury Department were working to clarify the
treatment of foreign-currency transactions under the Treasury
Amendment, but that reaching an accord would take time.  At the
hearing, two futures exchanges testified that congressional action
was needed to clarify the Treasury Amendment's scope, particularly in
view of the U.S.  Supreme Court's decision to review the Dunn case. 
They said that a court finding that the amendment excludes all
off-exchange futures and options on foreign currencies could shift
such business away from the exchanges to the less regulated OTC
market and adversely affect their competitiveness. 

As mentioned earlier, Senators Lugar, Harkin, and Leahy introduced a
bill in February 1997 to amend the CEA.  The bill includes a
provision to clarify the scope of the Treasury Amendment.\53
According to a discussion document prepared by Senators Lugar and
Harkin, the bill reflects the view that a federal role is needed in
the market to protect retail investors from abusive or fraudulent
activity in connection with the sale of foreign currency futures and
options by unregulated entities.  The discussion document further
notes that under the bill CFTC has no jurisdiction over retail
transactions that are subject to oversight by other federal
regulators or nonretail transactions. 

On January 21, 1997, Congressman Ewing, Chairman of the House
Subcommittee on Risk Management and Specialty Crops, introduced a
bill to amend the CEA.  The bill is identical to the one that he
introduced in the Fall of 1996.  It proposes, among other things, to
amend the Treasury Amendment to clarify that CFTC has regulatory
authority only over standardized contracts sold to the general public
and conducted on a board of trade.  The bill defines board of trade
in the context of the Treasury Amendment as "any facility whereby
standardized contracts are systematically marketed to retail
investors."


--------------------
\50 See CFTC v.  The American Board of Trade, 803 F.  2d 1242 (2d
Cir.  1986), cited in CFTC v.  Dunn, 58 F.  3d 50 (2d Cir.  1995),
rev'd 65 U.S.L.W.  4141 (U.S.  Feb.  25, 1997). 

\51 Salomon Forex, Inc.  v.  Tauber, 8 F.  3d 966 (4th Cir.  1993),
cert.  denied, 114 S.  Ct.  1540 (1994). 

\52 CFTC v.  Frankwell Bullion Ltd., 99 F.  3d 299 (9th Cir.  1996). 

\53 As discussed, Senators Lugar and Leahy introduced a bill to amend
the CEA in the Fall of 1996.  Rather than addressing the Treasury
Amendment in that bill, the senators asked CFTC and the Treasury
Department to reach an agreement by the end of 1996 on how the
amendment should be interpreted and, if necessary, amended.  While
the agencies were unable to reach an agreement by that time, they
have continued their discussions.  In the meantime, each agency has
provided the senators with differing language to amend the Treasury
Amendment.  The bill that Senators Lugar, Harkin, and Leahy recently
introduced does not fully adopt either agency's proposed language. 


      THE APPROPRIATE REGULATION
      FOR THE EVOLVING SWAPS
      MARKET IS AN UNRESOLVED
      ISSUE
---------------------------------------------------------- Letter :5.2

The potential for the exempted swaps market to evolve beyond the
conditions of the swaps exemption raises the issue of how to
accommodate market developments and address attendant risks and other
regulatory concerns.  CFTC imposed conditions on exempted swaps that
prohibited them from being traded and cleared in the same ways as
exchange-traded futures--on a centralized trading facility and
through a clearinghouse.  Since then, the swaps market has continued
to develop, becoming more liquid\54 and transparent.\55 Among other
alternatives, CFTC could use its exemptive authority to accommodate
any development that is inconsistent with the conditions of the
existing exemption--for example, the development of a
clearinghouse--and address any attendant risks to the market. 
However, such an approach could prompt legal challenges and raise
jurisdictional questions. 


--------------------
\54 Liquidity is the extent to which market participants can buy and
sell contracts without changing the market's price. 

\55 Transparency is the extent to which information about prices,
trading volume, and trades is disseminated to the public. 


         CFTC EXEMPTED CERTAIN
         SWAPS FROM THE CEA
         SUBJECT TO FOUR
         CONDITIONS
-------------------------------------------------------- Letter :5.2.1

CFTC's swaps exemption allows exempted swaps to trade legally outside
regulated exchanges--free from all CEA provisions, except certain
antifraud and antimanipulation provisions,\56 and free from all CFTC
regulations.  In granting the swaps exemption, CFTC did not take a
position on whether exempted swaps were futures contracts and subject
to the CEA's jurisdiction.  CFTC noted that it had not made and was
not obligated to make such a determination. 

CFTC specified four conditions that swaps had to meet to qualify for
an exemption.  First, they had to be entered into solely by eligible
participants, namely institutional and other sophisticated market
participants.  Eligible participants include banks, securities firms,
insurance companies, commercial firms meeting minimum net worth
requirements, and individuals meeting minimum total asset
requirements.  Second, they could not be fungible with standardized,
material economic terms.  Third, the creditworthiness of the
counterparties had to be a material consideration.  With this
condition, exempted swaps could not be cleared, like exchange-traded
futures, through a clearinghouse.\57 Fourth, they could not be
entered into and traded on or through a multilateral execution
facility, such as a futures exchange. 

According to CFTC, these four conditions were intended to reflect the
way that swaps transactions occurred in 1993 when the exemption was
granted and to draw a line at which such transactions would not raise
significant regulatory concerns under the CEA.  CFTC officials told
us that Congress directed the agency to exempt swaps as they were
then transacted to provide them with legal certainty.  In addition,
the four conditions distinguished the exempted swaps from
exchange-traded futures for regulatory--not legal--purposes.  That
is, the exemption excluded from regulation under the CEA swaps that
did not possess certain characteristics common to exchange-traded
futures; it did not establish that exempted swaps were not futures or
otherwise excluded from the act's jurisdiction.  The conditions
generally reflected the elements that facilitate futures trading on
an exchange, including standardized units, a clearinghouse, and open
and competitive trading in a centralized market.  As CFTC and the
courts have noted, these elements developed in conjunction with the
growth of the futures market to facilitate futures trading on
exchanges; however, their presence or absence does not necessarily
determine whether a contract is a futures contract. 

CFTC and others (including federal regulators and market observers)
have acknowledged that a centralized trading facility and/or
clearinghouse could benefit the swaps market and general public.  For
example, such facilities could increase the market's liquidity and
transparency and enhance the market's financial integrity.  In its
1993 exemptive release for swaps, CFTC noted that such facilities did
not yet exist and their existence would present different regulatory
issues than are raised under the current swaps exemption. 
Recognizing the potential benefits of such facilities, CFTC left open
the opportunity for market participants to develop and use such
facilities, provided that such facilities receive CFTC's prior
approval. 

As discussed, Senators Lugar, Harkin, and Leahy recently introduced a
bill to amend the CEA that includes a provision to codify the
existing swaps exemption.  As noted in the discussion document
prepared by Senators Lugar and Harkin, the provision would not affect
CFTC's power to grant additional exemptions or to amend the existing
exemption to make it less restrictive.  However, the provision would
require a statutory change to make the existing swaps exemption more
restrictive.  According to market observers, the provision addresses
the concern of OTC market participants that CFTC could modify the
swaps exemption in a way that could disrupt the market.  At a
February 11, 1997, hearing held by the Senate Committee on
Agriculture, Nutrition and Forestry, CFTC testified against the
provision, noting that it would eliminate the agency's ability to
modify the existing swaps exemption in response to market
developments. 


--------------------
\56 These antifraud and antimanipulation provisions are limited to
specified types of conduct that involve futures, options, or the cash
market. 

\57 According to the swaps exemptive release (58 Fed.  Reg.  5591),
"the exemption does not extend to transactions 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."


         THE SWAPS MARKET HAS
         CONTINUED TO DEVELOP
         UNDER THE EXEMPTION
-------------------------------------------------------- Letter :5.2.2

Under the swaps exemption, the swaps market has become more liquid
and transparent.  Swaps are traded primarily through dealers, some of
whom are linked through electronic communication networks that allow
them to exchange price information and negotiate transactions.\58
Swaps are commonly executed using standardized documentation, but
each contract--including its material terms--continues to be
privately negotiated between two counterparties.  As mentioned above,
plain vanilla interest rate and foreign-exchange swaps have become
more homogeneous, with dealers providing "indicative" (nonbinding)
quotes for such swaps.  Market participants have noted that the
market for plain vanilla interest rate swaps has become very liquid
and transparent, with pricing information readily available from
independent sources.  Increased liquidity and transparency can
facilitate the use of offsetting contracts to terminate open
contracts.\59

Some swaps market participants are increasingly using practices that
are similar, but not identical, to those used in the exchange-traded
futures market to reduce credit and other risks.  These practices may
reduce systemic risk and encourage greater market efficiency.  Some
swaps participants are using bilateral netting, which is the
combining of payment obligations arising from multiple transactions
with one counterparty into one net payment.  In addition, some are
periodically determining the value of their swaps using market
values, called marking-to-market.  This practice facilitates the
movement of collateral, such as cash or U.S.  government securities,
to reduce the financial exposure of counterparties from open
contracts. 

In comparison, exchanges reduce credit risk by collecting margin
(payment required on open contracts that decline in value) on at
least a daily basis and by interposing a clearinghouse as the
guarantor of all contracts.  As discussed above, in each
exchange-traded futures transaction, the clearinghouse is substituted
for the original parties, becoming the buyer to every seller and the
seller to every buyer.  Through this process, the clearinghouse
assumes the credit risk of each transaction and mutualizes it among
all clearing members.  While swaps market participants do not use
clearinghouses, two futures exchanges are developing collateral
depositories to help manage swaps positions and collateral for OTC
market participants.  Unlike a clearinghouse, they would not
guarantee contract performance.  One exchange has reported that it is
developing exchange-traded swaps and plans for its depository to
ultimately guarantee their performance. 


--------------------
\58 Under the swaps exemption, swaps market participants may use
electronic facilities "to communicate simultaneously with other
participants, so long as they do not use such facilities to enter
orders to execute transactions" (58 Fed.  Reg.  5591). 

\59 A swap can be offset by entering into an equal but opposite
transaction with another counterparty.  Entering into an equal but
opposite contract with the same counterparty eliminates the market
and credit risks associated with the contract.  Doing so with a
different counterparty eliminates market risk but not credit and
other risks associated with carrying two contracts.  Alternatively,
the counterparties can negotiate a termination agreement that settles
the contract or agree to assign the contractual obligation to a third
party. 


         CFTC COULD USE ITS
         EXEMPTIVE AUTHORITY TO
         ACCOMMODATE SWAPS MARKET
         DEVELOPMENTS
-------------------------------------------------------- Letter :5.2.3

Although difficult to predict, the swaps market might develop in ways
that are inconsistent with the conditions of the existing swaps
exemption.  Such developments could present risks to the market that
warrant greater federal regulation to protect the public interest. 
An example of such a development would be the creation of a swaps
clearinghouse.  A clearinghouse could provide benefits, such as
reducing credit risk and increasing market access, but it could also
increase systemic risk by concentrating credit risk in a single
entity and thus might require federal oversight. 

CFTC's swaps exemption does not bar a clearinghouse, but it does
require that a proposal for such a facility be submitted to CFTC for
review.  As noted above, CFTC's swaps exemption includes a condition
that requires each counterparty to consider the other's
creditworthiness.  Because of this requirement, swaps market
participants may not be able to use a clearinghouse without
jeopardizing their exempt status and becoming subject to the CEA's
regulatory requirements.  According to CFTC, the development of a
swaps clearinghouse would not necessarily require CFTC to amend the
exemption.  Instead, CFTC could exempt a swaps clearinghouse from the
CEA's provisions (except section 2(a)(1)(B)) on such conditions as it
deemed appropriate.  According to CFTC officials, the extent to which
CFTC would need to impose conditions on a clearinghouse would depend
on the facility's design, applicability of other regulatory regimes,
and other factors. 

Among other alternatives, CFTC could use its exemptive authority to
accommodate a swaps clearinghouse or any other market development
that is inconsistent with the conditions of the existing swaps
exemption.  In accommodating such a swaps market development, CFTC
may need to include conditions in the exemption to ensure that the
risks and other regulatory concerns of the development are
appropriately addressed.  Depending on the risks and concerns, such
conditions may include reporting, recordkeeping, disclosure, or other
regulatory requirements that are similar to the regulations that CFTC
has imposed on the OTC derivatives under its oversight--trade
options, dealer options,\60 and leverage contracts.\61


--------------------
\60 Dealer options are off-exchange commodity options that are
confined to a limited class of offerors who were in the business of
granting options on physical commodities and buying, selling,
producing, or otherwise using that commodity as of May 1, 1978, and
who satisfy the requirements of CFTC regulations.  Dealer options are
a retail product and are not currently being offered. 

\61 Leverage contracts are long-term (10 years or longer) OTC
contracts involving metals and foreign currencies and are not
currently being offered. 


         CFTC'S USE OF ITS
         EXEMPTIVE AUTHORITY TO
         IMPOSE REGULATORY
         CONDITIONS COULD PROMPT
         LEGAL CHALLENGES AND
         RAISE JURISDICTIONAL
         QUESTIONS
-------------------------------------------------------- Letter :5.2.4

Imposing regulatory conditions on swaps participants might be an
effective way for addressing potential risks to the market that could
result from a swaps market development.  However, such an approach
could prompt legal challenges and raise jurisdictional questions. 
First, as long as the issue of whether swaps are futures is not
definitively addressed, the possibility remains that a court could
find swaps to be outside the jurisdiction of the CEA if CFTC tried to
use its exemptive authority to impose affirmative requirements on
swaps.  Second, imposing affirmative requirements on swaps might
suggest that swaps are futures and subject to regulation under the
CEA, even if CFTC did not explicitly make that determination.  Any
suggestion that swaps are futures and subject to regulation under the
CEA could have policy ramifications for the swaps market because of
CFTC's exclusive jurisdiction over futures.  Any such suggestion
could also raise jurisdictional questions involving federal bank
regulators and SEC because of their oversight or regulation of swaps
participants or swaps.  Tasked with considering new developments in
the financial markets, including the increasing importance of the OTC
derivatives market, the President's Working Group on Financial
Markets provides one forum through which CFTC and other federal
regulators could address such issues. 


      THE RATIONALIZATION OF
      REGULATORY DIFFERENCES
      BETWEEN THE OTC DERIVATIVES
      AND EXCHANGE-TRADED FUTURES
      MARKETS IS AN UNRESOLVED
      ISSUE
---------------------------------------------------------- Letter :5.3

The development of the swaps and exchange-traded futures markets has
raised questions about the rationale for their regulatory
differences--recognizing that each market may not raise the same
risks and, thus, warrant the same regulations.  Swaps and
exchange-traded futures are similar in their characteristics and
economic functions, but differ in, among other ways, their trading
environment and regulations.  As discussed above, CFTC exempted swaps
and other OTC contracts from regulation under the CEA.  In 1995, CFTC
also granted the exchanges an exemption from certain regulations to
enable them to compete more effectively against the less regulated
OTC derivatives market.  Notwithstanding the exemption, OTC
derivatives and exchange-traded futures market regulations continue
to differ substantially.  The exchange exemption represents one
approach to rationalizing regulations between the two markets but
also illustrates some of the challenges in doing so. 


         SWAPS AND EXCHANGE-TRADED
         FUTURES HAVE SIMILARITIES
         AND DIFFERENCES,
         INCLUDING THE SCOPE AND
         FOCUS OF THEIR REGULATION
-------------------------------------------------------- Letter :5.3.1

Swaps and exchange-traded futures are similar in their
characteristics and economic functions but differ in other ways,
including the scope and focus of their regulation.  Swaps and
exchange-traded futures have market values that are determined by the
value of an underlying asset, reference rate, or index.  They also
are used for hedging financial risk and investing with the intent of
profiting from price changes by some of the same general types of
market participants, such as financial institutions, commercial
firms, and governmental entities.  Given their similar economic
functions, OTC derivatives and exchange-traded futures can be used as
substitutes for one another, but they are not perfect substitutes
because of differences in their contract terms, transaction costs,
regulations, and other factors.  They also can be used to complement
each other.  Some market participants--primarily banks and other
financial firms acting as dealers--use exchange-traded futures to
hedge the risk related to their OTC derivatives positions.  As a
former CFTC chairman noted, the exchange-traded futures market has
grown closer to the swaps market as it has expanded to remain
competitive.  The exchanges are offering more flexible option
contracts, whose terms can be customized to meet an end-user's
particular risk-management needs.  Moreover, they are working on
other proposals, such as collateral depositories, to address the
needs of participants using swaps and other OTC derivatives. 

Notwithstanding their similar characteristics and economic functions,
differences between swaps and exchange-traded futures may result in
different risks that lead to differences in the types and/or levels
of oversight needed for each market.  Swaps and exchange-traded
futures differ in ways that are reflected in CFTC's swaps exemption. 
As discussed above, unlike exchange-traded futures, swaps are not
traded on a multilateral execution facility, such as an exchange, or
cleared through a multilateral clearing facility, such as a
clearinghouse.  Rather, swaps are entered into between two
counterparties in consideration of each other's creditworthiness. 
Although plain vanilla swaps have become more homogeneous in terms
such as their underlying reference rates or indexes and maturities,
each contract continues to be privately negotiated. 

Unlike exchange-traded futures, swaps and other OTC derivatives are
not regulated under a single, market-oriented structure or subject to
a contract approval process, because they are privately negotiated
contracts.  They are regulated only to the extent that the
institutions using or dealing in them are regulated.  As we noted in
our May 1994 report, banks are major OTC derivatives dealers.  They
are overseen by federal bank regulators and subject to supervision
and regulations--including minimum capital, reporting, and
examination requirements.  These regulations are designed to ensure
the safety and soundness of banks but are not directly concerned with
protecting those doing business with them.\62 Other major dealers
include affiliates of securities and insurance firms that are subject
to limited or no federal oversight.  Since our 1994 report, CFTC,
federal bank regulators, and SEC have taken several steps to improve
their oversight of the major OTC derivatives dealers, including
affiliates of securities firms.  Also, a group of derivatives
dealers, in coordination with SEC and CFTC, has developed a voluntary
oversight framework for the OTC derivatives activities of unregulated
affiliates of securities and futures firms.  We discuss these and
other actions taken by federal regulators and derivatives market
participants in the November 1996 update to our 1994 report on
financial derivatives. 

Traditionally, exchange-traded futures have been regulated as a
market under a comprehensive regulatory structure, which is designed
to protect customers and the market--including its efficiency,
fairness, and financial integrity.  This regulatory structure covers
not only certain market participants but also the products and
markets on which they trade.  Unless exempted, futures must be traded
on designated exchanges and through regulated intermediaries, subject
to minimum capital, reporting, examination, and customer protection
requirements.  The CEA and CFTC specify certain self-regulatory
duties--including providing for the prevention of manipulation,
making reports and records on market activities, and enforcing
exchange rules--that an exchange must perform to become and remain a
designated exchange.  The CEA also requires CFTC to review and
approve products traded on a designated exchange. 


--------------------
\62 We are currently reviewing OTC derivatives sales practices and
will report our findings separately. 


         CFTC'S EXCHANGE EXEMPTION
         IS ONE APPROACH TO
         RATIONALIZING OTC AND
         EXCHANGE-TRADED FUTURES
         MARKET REGULATIONS BUT
         ILLUSTRATES THE
         CHALLENGES IN DOING SO
-------------------------------------------------------- Letter :5.3.2

In 1993, two futures exchanges separately requested that CFTC exempt
from most of the CEA's regulatory requirements certain
exchange-traded futures that are traded solely by institutional and
other sophisticated market participants.  The exchanges indicated
that they needed regulatory relief to compete fairly with the less
regulated OTC market.  In response to the exchange requests, CFTC
provided the exchanges with regulatory relief under an exemption
issued in November 1995.  CFTC, however, did not provide the
exchanges with the broad regulatory relief they requested.  CFTC
based its position, in part, on comments it received on the exchange
requests from various government agencies, members of Congress, and
the public, as well as on the 1992 act's legislative history.  In the
latter, Congress cautioned CFTC to use its exemptive authority
sparingly and not to prompt a wide-scale deregulation of markets
falling under the act. 

The exchange exemption is to be implemented under a 3-year pilot
program.\63 It is intended to enable qualifying exchanges to list new
contracts with greater ease and construct OTC-like trading
procedures, permitting market participants to negotiate prices
privately and execute trades off of the exchange floor.  The exchange
exemption limits access to the exempted futures market to specified
participants, which are generally the same institutional and
sophisticated participants that may use exempted swaps.  In addition,
the exemption is intended to streamline requirements for registering
brokers and disclosing risks when opening new customer accounts. 
However, with the exception of these regulatory changes, all other
CEA provisions and CFTC regulations would continue to apply to the
exempted futures market.  For example, the requirements related to
recordkeeping and audit trails as well as transaction reporting would
continue to apply. 

According to CFTC, the exchange exemption would enable the exchanges
to compete more effectively with the OTC derivatives market, while
maintaining basic customer protection, financial integrity, and other
protections needed for trading in an exchange environment. 
Furthermore, CFTC noted that the pilot program would provide it with
an opportunity to (1) test the operation of the exemption, (2)
determine the effect of exempted transactions on the integrity of the
market as a whole, and (3) determine whether continued trading under
the exemption would be in the public interest.  To date, CFTC has not
received any proposals under the exchange exemption. 

In a joint statement released at the June 1996 Senate Agriculture
hearing (discussed above), 10 futures exchanges noted that the
exchange exemption does not provide a level playing field for
exempted exchange-traded and OTC derivatives contracts.  They noted
that exempted exchange-traded contracts would continue to be subject
to the bulk of CFTC regulations, even though such contracts, like
exempted OTC derivatives, would not be traded by public customers. 
The exchanges also maintained that CFTC's exchange exemption is not
consistent with the 1992 act's legislative history--noting that,
among other things, Congress intended CFTC, in consideration of fair
competition, to use its exemptive authority in a fair and even-handed
manner to products and systems sponsored by exchanges and
nonexchanges. 

As mentioned earlier, Senators Lugar, Harkin, and Leahy as well as
Congressman Ewing recently introduced bills to amend the CEA.  Each
bill includes a provision that would largely exempt from regulation
under the act certain exchange-traded futures that are traded solely
by institutional and sophisticated market participants.  In a joint
statement released at the February 11, 1997, hearing on reforming the
CEA, 10 futures exchanges noted that the Senate bill "moves exchanges
a long way toward achieving a regulatory balance with the OTC
markets." They noted that the exempted market would rely on market
discipline and self-regulation, with the exchanges having a business
incentive to operate a fair, financially sound, and competitive
market.  At the same hearing, CFTC testified that, if enacted, the
bill would likely cause a broad elimination of federal regulation of
the exchange-traded futures market and create significant risks by
doing so. 

CFTC's exchange exemption represents one approach to rationalizing
regulatory differences between the exchange-traded futures and swaps
markets but illustrates some of the challenges in doing so.  The
exchange and swaps exemptions raised similar policy questions that
CFTC approached from opposite viewpoints, in part because of the
existence of a regulatory structure for one but not the other.  For
futures, the basic question was:  "What is the appropriate regulation
for futures traded on exchanges solely by institutional and other
sophisticated market participants?" In this regard, CFTC's approach
to exempting exchange-traded futures focused on determining which CEA
requirements could be eliminated without compromising the public
interest, as defined in the CEA.  Under this approach, the exchanges
were tasked, in part, with demonstrating which existing regulations
were unnecessary.  In comparison, the basic question for swaps was: 
"Are swaps appropriately regulated under the CEA?" In this regard,
CFTC's approach to exempting swaps focused on determining whether CEA
requirements needed to be imposed on the market. 

Another related challenge in rationalizing regulations between the
two markets arose from the similar nature of the participants.\64 As
required under its exemptive authority, CFTC considered the nature of
the market participants in exempting swaps.  It limited the swaps
exemption to participants it deemed sophisticated or financially able
to bear the risks associated with these transactions.  Likewise, it
considered the exclusion of unsophisticated participants from the
exempted exchange-traded futures market as the most important factor
supporting its exchange exemption.  However, CFTC noted that, unlike
a dealer market, a centralized market composed solely of
sophisticated market participants did not obviate the need to ensure
market integrity, price dissemination, and adequate protections
against fraud, manipulation, and other trading abuses.  It further
noted that CFTC regulations serve other vital functions, even where
such markets include only sophisticated participants, in that the
regulations substitute for individualized credit determinations and
increase market access.  The exchanges have disagreed with CFTC's
conclusions.  They have stated that their safeguards--including
clearinghouse guarantees and price transparency--provide greater
protections than available in the OTC market but, at the same time,
prevent them from obtaining regulatory relief comparable to that
which CFTC provided to the OTC market. 


--------------------
\63 The 3-year pilot program will begin when the first contract is
traded under the exchange exemption. 

\64 CFTC has characterized exchange-traded futures market
participants as largely institutional, and a former CFTC commissioner
stated that the majority of users of regulated, exchange-traded
futures meet the eligibility requirements of the swaps exemption. 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

CFTC has used its exemptive authority to reduce or eliminate legal
risk in the OTC derivatives market arising from the combination of
the CEA's judicially crafted futures definition and exchange-trading
requirement.  Through its efforts, CFTC has enhanced the legal
enforceability of most OTC derivatives contracts and, in doing so,
has enabled the OTC derivatives market to continue to grow and
develop.  Nonetheless, several legal and regulatory issues involving
the CEA remain unresolved.  These include the legal uncertainty
facing equity swaps, the CEA's lack of clear criteria for
distinguishing unregulated forwards from regulated futures, the
uncertainty surrounding the scope of the Treasury Amendment, and the
extent to which CFTC should use its exemptive authority to provide
greater regulatory relief to the futures exchanges.  Ongoing
congressional efforts to amend the CEA could provide specific
solutions to these unresolved issues.  Further, such efforts could
provide a forum for addressing the broader policy question of what
the appropriate regulation is for exchange-traded futures and OTC
derivatives contracts, including their markets and market
participants. 

The appropriate regulation for the exchange-traded and OTC
derivatives markets should flow from the need to protect the public
interest in these markets.  The CEA identifies the public interest in
the futures market as the need to protect the market's price
discovery and risk-shifting functions from market abuses, such as
excessive speculation, manipulation, and fraud.  However,
articulating the public interest in this way may no longer provide a
sufficient basis for regulating all aspects of the futures market,
given market developments and regulatory changes.  As discussed, the
exchange-traded futures market is now dominated by financially based
futures and institutional participants.  Because of the greater
liquidity of the underlying cash markets for financial products, the
exchange-traded futures markets for these products may not serve the
same price discovery function as exchange-traded futures based on
agricultural and other physical commodities.  Accordingly, they may
not serve the price discovery function that Congress intended to
protect when crafting the CEA.  In addition, CFTC now has the
authority to allow futures to be traded off-exchange and free from
the comprehensive regulatory structure applicable to exchange-traded
futures.  Because of the way they would be traded and other factors,
off-exchange futures may not raise the same risks or regulatory
concerns that exchange-traded futures raise and for which regulation
under the CEA was deemed necessary to protect the public interest. 
Nonetheless, off-exchange futures may raise other risks, such as
systemic risk, or regulatory concerns that warrant federal
regulation. 

To address the broader policy question of the appropriate regulation
for the exchange-traded futures and OTC derivatives markets, more
fundamental questions concerning the goals of federal regulatory
policy need to be answered.  These questions include: 

  -- What is the current public interest in the exchange-traded
     futures and OTC derivatives markets that needs to be protected? 

  -- What type of regulations are needed, if any, and what is the
     most efficient and effective way to implement and enforce any
     needed regulations?  To what extent are the answers to these
     questions affected by the nature of the market participants;
     trading environment; and products, including their function,
     type of underlying commodity, and degree of standardization? 

These fundamental questions provide a framework for systematically
determining the appropriate regulation for exchange-traded futures
and OTC derivatives, including their markets and market participants. 
Moreover, answers to these questions would also provide a basis for
considering an array of options for amending the CEA.  These options
include (1) expanding the act's jurisdiction to cover specified swaps
and other OTC derivatives but tailoring their regulation to the
circumstances under which they trade and other appropriate factors;
(2) excluding swaps and other specified OTC derivatives from the
act's jurisdiction and providing for their oversight, as appropriate,
by other federal regulators; and (3) tailoring the level of
regulation for exchange-traded futures to the nature of the market
participants and/or other appropriate factors. 

Swaps and other OTC derivatives involve institutions and activities
in which federal bank regulators and SEC have traditionally had a
supervisory or oversight role, while futures trading and futures
market regulation have fallen under the CFTC's exclusive
jurisdiction.  As a result, any policy questions raised by the
ongoing development of the OTC derivatives and exchange-traded
futures markets cross traditional jurisdictional lines and involve
not only CFTC but also federal bank regulators and SEC.  The
cooperative efforts of these agencies, working with the Department of
the Treasury and the financial industry, will be required to address
such questions.  As discussed, the President's Working Group on
Financial Markets provides one forum through which to coordinate
interagency activities and address policy questions that cross
jurisdictional lines. 

As we concluded in our May 1994 OTC derivatives report, the U.S. 
financial regulatory structure has not kept pace with the dramatic
and rapid changes in the domestic and global financial markets.  We
noted that one issue needing to be addressed is how the U.S. 
regulatory system should be restructured to better reflect the
realities of today's rapidly evolving global financial markets.  Our
conclusion was based partly on the finding that the development of
new types of financial derivatives and their use by a variety of once
separate industries, such as banking, futures, insurance, and
securities, have made it more difficult to regulate them effectively
under the current U.S.  regulatory structure.  The potential legal
and regulatory issues raised by the evolving OTC derivatives and
exchange-traded futures markets under the CEA further illustrate such
difficulty and reinforce the need to examine the existing U.S. 
regulatory structure.  Ultimately, maintaining a globally competitive
U.S.  derivatives market will require balancing the goal of allowing
the U.S.  financial services industry to innovate and grow with the
goal of protecting customers and the market, including its
efficiency, fairness, and financial integrity. 


   AGENCY AND INDUSTRY COMMENTS
   AND OUR EVALUATION
------------------------------------------------------------ Letter :7

We requested comments on a draft of this report from the heads, or
their designees, of CFTC, the Department of the Treasury, the Federal
Reserve Board, the Office of the Comptroller of the Currency, and
SEC.  We also requested comments from three futures exchanges (the
Chicago Board of Trade, Chicago Mercantile Exchange, and New York
Mercantile Exchange), the New York Stock Exchange, and four industry
associations (the Futures Industry Association, International Swaps
and Derivatives Association, Managed Futures Association, and
National Futures Association).  CFTC, the Department of the Treasury,
the Federal Reserve Board, and SEC provided us with written comments
under a joint response as members of the President's Working Group on
Financial Markets.  We also obtained written comments from two
futures exchanges (the Chicago Mercantile Exchange and Chicago Board
of Trade) and the four industry associations.  The written comments
and our additional responses are contained in appendixes I through
VII.  We did not receive written comments from the Office of the
Comptroller of the Currency, New York Mercantile Exchange, or New
York Stock Exchange.  In addition, officials from CFTC, the
Department of the Treasury, the Federal Reserve Board, the Office of
the Comptroller of the Currency, SEC, the International Swaps and
Derivatives Association, and the Chicago Mercantile Exchange provided
us with technical comments that were incorporated into the report as
appropriate. 

The President's Working Group on Financial Markets commented that it
agreed with our conclusion that maintaining a globally competitive
U.S.  derivatives market requires properly balancing the need to
allow the U.S.  financial services industry to innovate and grow with
the need to protect the financial integrity of our markets.  The
Working Group noted that it is effectively addressing intermarket
financial coordination issues and that further discussion in that
forum of issues we identify would be useful. 

The Futures Industry Association commented that the draft did not
adequately address the question of whether or to what extent
additional regulation of the OTC derivatives markets is warranted,
and to the extent warranted, whether the CEA is the appropriate
vehicle for such regulation.  Similarly, the International Swaps and
Derivatives Association stated that there has been no demonstration
that participants would benefit from subjecting swaps to any form of
regulation under the CEA.  Our overall objective was to provide
Congress with information on the legal and regulatory issues
involving the CEA, not to determine the appropriate level of
regulation for the OTC derivatives market or the specific vehicle for
any such regulation.  We identified regulatory gaps in this market in
our May 1994 report on OTC derivatives and recently issued a report
that discusses the actions taken by federal regulators and the
industry since that time.  Nonetheless, the issues that we discuss
lead to the broader policy question of what the appropriate
regulation is for the OTC derivatives and exchange-traded futures
markets.  In our conclusions, we provide a framework for addressing
this policy question and, in turn, related questions, such as whether
the CEA is the appropriate vehicle for regulating swaps and other OTC
derivatives. 

In a related comment, the Futures Industry Association noted that our
draft asserts that financial products serving a risk-shifting
function should be subject to similar regulatory treatment, even
though the CEA has recognized through its statutory exclusions that
the regulation of such products may appropriately differ depending on
their nature and underlying market.  Correspondingly, the
International Swaps and Derivatives Association commented that
risk-shifting activities related to foreign exchange and other
transactions were specifically excluded from the CEA pursuant to the
Treasury Amendment, demonstrating that Congress did not intend for
the CEA to govern all financial transactions involving the transfer
of risk.  We do not assert that risk-shifting contracts should be
subject to similar regulation.  Rather, we note that the CEA covers
futures contracts, which have been defined in a way that reflects
their risk-shifting function.  As a result, OTC derivatives serving a
similar risk-shifting function as futures may fall within the
definition of a futures contract and be subject to the CEA.  We agree
that the CEA's statutory exclusions demonstrate that Congress did not
intend for the CEA to govern all risk-shifting contracts.  However,
these exclusions are not broad enough to provide similar treatment
for all OTC derivatives, many of which, including swaps, did not
exist when the exclusions were created.  CFTC has exempted most swaps
and other OTC derivatives from virtually all the CEA's requirements
to provide them with greater legal certainty, but a question remains
about whether swaps are futures and subject to the CEA.  As we
discuss, the possibility that swaps are futures continues to be a
source of legal risk for equity swaps. 

In another related comment, the Chicago Board of Trade, Futures
Industry Association, and Managed Futures Association noted that the
CEA provides CFTC with the authority and flexibility to address
issues raised by the evolving OTC derivatives and futures markets. 
We agree that the CEA, with its exemptive authority provision, does
not prevent CFTC from addressing regulatory concerns raised by the
OTC derivatives market, as needed.  In our report, we state that CFTC
could use its exemptive authority to address regulatory concerns
raised by a swaps market development that is inconsistent with the
conditions of the existing swaps exemption.  However, we note that
this approach could suggest that swaps are futures and introduce
jurisdictional questions.  We also note that the President's Working
Group on Financial Markets provides one forum through which to
address such questions. 

The Chicago Board of Trade commented that, contrary to the impression
created in the draft, jurisdictional ambiguities in the act (the
definition of a futures contract and the Treasury Amendment) are not
solely responsible for the disparate regulatory treatment of exchange
and OTC markets.  Instead, it cites the manner in which CFTC has
chosen to use its authority as leading to this disparity.  According
to the exchange, CFTC did not use its exemptive authority in a way
that is consistent with the 1992 act's legislative history--that is,
it did not use its authority in a fair and even-handed manner to
products and systems sponsored by exchanges and nonexchanges.  In a
related comment, the Futures Industry Association noted that it
agrees with the draft report's implicit assumption that CFTC's
exchange exemption could be broadened.  However, it stated that the
exchanges must provide CFTC with greater specificity as to the nature
of the products, trading mechanisms, and clearing structure that
would be subject to exemptive relief.  We agree with the Chicago
Board of Trade that the act's jurisdictional ambiguities are not
solely responsible for the regulatory differences between the OTC
derivatives and futures markets.  Our report states that CFTC
provided less regulatory relief under its exchange exemption than it
did under its OTC derivatives exemptions.  We also agree with the
Futures Industry Association that greater specificity could aid CFTC
in the use of its exemptive authority to provide additional
regulatory relief to the exchanges.  However, in granting the
exchange exemption, CFTC followed the congressional admonition to use
its exemptive authority sparingly and not to cause a wide-scale
deregulation of markets falling under the act.  Given the different
ways of interpreting the 1992 act's legislative history, we note in
our conclusions that one of the unresolved issues involving the CEA
is the extent to which CFTC should use its exemptive authority to
provide greater regulatory relief to the futures exchanges. 


---------------------------------------------------------- Letter :7.1

We are sending copies of this report to the Chairperson of CFTC, the
Comptroller of the Currency, the Chairman of the Federal Reserve
Board, the Chairman of SEC, the Secretary of the Treasury, and other
interested parties.  We will also make copies available to others
upon request. 

Please contact me at (202) 512-8678 or Cecile O.  Trop, Assistant
Director, at (312) 220-7600 if you or your staff have any questions. 
Major contributors to this report are listed in appendix VIII. 

Jean Gleason Stromberg
Director, Financial Institutions
 and Markets Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE PRESIDENT'S
WORKING GROUP ON FINANCIAL MARKETS
============================================================== Letter 




(See figure in printed edition.)Appendix II
COMMENTS FROM THE CHICAGO BOARD OF
TRADE
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)




(See figure in printed edition.)Appendix III
COMMENTS FROM THE CHICAGO
MERCANTILE EXCHANGE
============================================================== Letter 



(See figure in printed edition.)


The following are GAO's comments on the Chicago Mercantile Exchange's
August 30, 1996, letter. 

GAO COMMENTS

1.  The Chicago Mercantile Exchange commented that our use of the way
that derivatives are traded (off-exchange versus on-exchange) as the
basis for distinguishing OTC derivatives from futures for regulatory
purposes is not an appropriate dichotomy.  Rather, the exchange
commented that the nature of the market participant (professional
versus retail) is a better basis to use in determining the
appropriate level of regulation needed for derivatives markets.  We
revised our report, and the referenced text no longer appears.  In
our conclusions, we provide a framework for determining the
appropriate regulation for the OTC derivatives and exchange-traded
futures markets, focusing on the current public interest in these
markets that needs to be protected.  As part of that framework, we
note that the nature of the market participant, trading environment,
and other factors should be considered in determining the regulations
that are needed to protect the public interest. 




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FUTURES INDUSTRY
ASSOCIATION
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


The following are GAO's comments on the Futures Industry
Association's September 18, 1996, letter. 

GAO COMMENTS

1.  The association commented that the draft focused on the similar
economic function served by OTC derivatives and exchange-traded
futures but did not adequately address the policy implications
arising from the important distinctions that exist between the two
types of products.  We focus on the similar risk-shifting function
served by OTC derivatives and exchange-traded futures because the CEA
covers futures, which have been defined in a way that reflects their
risk-shifting function.  As we discuss in our conclusions, Congress
and federal regulators will need to consider the similarities and
differences between the OTC derivatives and exchange-traded futures
markets in addressing the broader policy question concerning the
appropriate regulation for these markets.  We agree that important
distinctions exist between OTC derivatives and exchange-traded
futures that have policy implications, and we amplified our
discussion of these distinctions. 

2.  The association commented that our draft cited the CEA as
embracing the principle of functional regulation.  We eliminated the
term functional regulation because of the confusion over its meaning,
but our message has not changed.  That is, the CEA covers futures,
which CFTC and the courts have defined in a way that reflects their
risk-shifting function.  As a result, contracts serving a similar
risk-shifting function as futures may fall within the definition of a
futures contract and be subject to the CEA. 

3.  The association commented that our draft report listed the
necessary elements of a futures contract without mentioning that such
elements are not necessarily sufficient to define a futures contract. 
We modified the report accordingly. 

4.  The association commented that section 3 of the CEA specifically
identifies transactions in contracts for future delivery "commonly
conducted on a board of trade" as the type of activity requiring
regulation under the CEA.  It further noted that this statement
reflects a sensitivity to the regulatory significance of distinctions
between exchange trading and private negotiation of contracts that is
equally relevant today.  We agree that the exchange-trading
requirement is central to the CEA's regulatory structure and
recognize that differences exist between OTC derivatives and
exchange-traded futures that may warrant differences in their
regulation.  In that regard, our conclusions provide a framework for
determining the appropriate regulation for the OTC derivatives and
exchange-traded futures markets, focusing on the public interest in
these markets that needs to be protected.  As part of that framework,
we note that the nature of the market participant, trading
environment, and other factors should be considered in determining
the regulations needed to protect the public interest. 

5.  The association noted that the draft report overstated the
current level of convergence between the OTC derivatives and futures
market.  We revised the report to amplify our discussion of the
similarities and differences between the OTC derivatives and futures
markets. 

6.  The association disagreed with the draft report's observation
that participation of dealers in the OTC derivatives markets implies
that such markets are centralized.  We did not intend to imply that
the swaps market is centralized and have revised the draft
accordingly.  We recognize that swaps continue to be privately
negotiated between counterparties and are neither traded on a
centralized facility nor cleared through a clearinghouse.  We note
that swaps have followed a similar evolutionary path as
exchange-traded futures.  However, we recognize that the extent to
which the swaps market, or some part thereof, will continue to evolve
in the same way as the exchange-traded futures market is unknown. 

7.  The association commented that, with respect to the distinction
between futures and forwards, our draft report sometimes fails to
distinguish between the nature of the obligation to make delivery and
what constitutes delivery.  Our discussion of the disagreement
between CFTC and the federal district court on where to draw the line
regarding the delivery requirement for Brent Oil contracts was meant
to illustrate this difference.  We also note in our conclusions that
one of the unresolved issues is the CEA's lack of criteria for
distinguishing unregulated forwards from regulated futures. 

8.  The association commented that the losses associated with
hedge-to-arrive contracts do not appear to arise from the character
of the delivery obligations.  We note that unusual factors, such as
high grain prices and poor weather conditions, have resulted in
financial problems for parties to these contracts.  However, we also
note that the legal risk facing some hedge-to-arrive contracts due to
the possibility that they could be illegal futures or trade options
has complicated matters.  This legal risk may persist, even in the
absence of the factors contributing to financial risk. 

9.  The association commented that the Treasury Amendment's scope was
broader than the restricted view presented in the draft report.  Our
discussion of the Treasury Amendment was not intended to provide an
interpretation of the amendment's scope but rather to describe the
legal confusion created by how others have interpreted its scope.  We
modified the report accordingly. 




(See figure in printed edition.)Appendix V
COMMENTS FROM THE INTERNATIONAL
SWAPS AND DERIVATIVES ASSOCIATION
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


The following are GAO's comments on the International Swaps and
Derivatives Association's September 10, 1996, letter. 

GAO COMMENTS

1.  The association commented that the draft painted a misleading
picture of the similarities between exchange-traded futures and swaps
by focusing on their risk-shifting function and failed to properly
address the important differences between them that justify their
disparate regulatory treatment.  We focus on the similar
risk-shifting function served by OTC derivatives and exchange-traded
futures because the CEA covers futures, which have been defined in a
way that reflects their risk-shifting function.  As we discuss in our
conclusions, Congress and federal regulators will need to consider
the similarities and differences between the OTC derivatives and
exchange-traded futures markets in addressing the broader policy
question concerning the appropriate regulation for these markets.  We
agree that important distinctions exist between OTC derivatives and
exchange-traded futures that have policy implications, and we
amplified our discussion of these distinctions. 

2.  The association commented that, although OTC derivatives and
exchange-traded futures serve a similar risk-shifting function, many
other financial transactions, including those involving securities,
loans, guarantees, and various types of insurance contracts, can
serve such a function.  It further noted that attempting to implement
a regulatory framework that would subject every form of financial or
commercial activity that involves the transfer of risk to regulation
under the CEA would clearly be inappropriate.  We agree that it would
be inappropriate to subject all instruments that can serve a
risk-shifting function to the CEA.  However, as CFTC and others have
recognized, swaps and other OTC derivatives resemble futures not only
in terms of their economic function but also in terms of their
design.  Given the market's continued growth and development,
questions remain about the extent to which additional regulation of
the OTC derivatives market is needed.  In our conclusions, we provide
a framework for determining the appropriate regulation for the OTC
derivatives and exchange-traded futures markets, focusing on the
public interest in these markets that needs to be protected. 

3.  The association commented that the draft report's assertion that
swaps are a centralized market is not true.  We did not intend to
imply that the swaps market is currently centralized and have revised
the draft accordingly.  We recognize that swaps continue to be
privately negotiated between counterparties and are neither traded on
a centralized facility nor cleared through a clearinghouse.  We note
that swaps have followed a similar evolutionary path as
exchange-traded futures.  However, we recognize that the extent to
which the swaps market, or some part thereof, will continue to evolve
in the same way as the exchange-traded futures market is unknown. 

4.  The association commented that the draft report portrayed swaps
as a centralized market by incorrectly asserting that swaps
participants are actively discussing the possibility of establishing
a swaps clearinghouse.  We discuss the potential for a swaps
clearinghouse to illustrate an example of a development that could
trigger a greater federal interest in the market.  It was not
intended to suggest that the swaps market has evolved into a
centralized market, and we revised the draft accordingly. 

5.  The association noted that more corporations use swaps than
exchange-traded futures to meet their risk-management needs,
disproving the draft report's assertion that swaps and
exchange-traded futures share the same general market participants. 
Our point was that swaps and exchange-traded futures are used by many
of the same general types of market participants, not that swaps and
exchange-traded futures are used by all of the same market
participants.  We revised the report to clarify this point.  We still
note that some of the same firms, namely banks and other financial
firms acting as dealers, use both swaps and exchange-traded futures
because of the complementary relationship of the contracts. 

6.  The association commented that few incidents exist where swaps
participants believed that they were treated unfairly by their
counterparties, which demonstrated both the ability of swaps
participants to protect their rights and the fact that such incidents
represent bilateral disputes with no implications for third parties. 
It added that the draft report offers no evidence that additional
regulatory protection is needed or desired by swaps participants.  We
are currently reviewing OTC derivatives sales practices and will
report our findings separately. 

7.  The association commented that the swaps activities of
institutions that are thought to be subject to systemic risk and/or
are supported by public insurance are closely supervised by various
regulatory agencies.  As we discussed in our May 1994 report on OTC
derivatives, regulatory gaps existed in the OTC derivatives market
that could heighten the potential for systemic risk.  We have issued
a report that updates our 1994 report and discusses actions taken by
federal regulators and the industry since that time. 

8.  The association disagreed with the draft report's assertion that
the CEA, as amended in 1974, embraced the principle of functional
regulation.  While we eliminated the term functional regulation
because of the confusion over its meaning, our message has not
changed.  That is, the CEA covers futures, which CFTC and the courts
have defined in a way that reflects their risk-shifting function.  As
a result, contracts serving a similar risk-shifting function as
futures may fall within the definition of a futures contract and be
subject to the CEA. 

9.  The association commented that our draft report asserts
"uncategorically" and without direct evidence that the legislative
history surrounding the Treasury Amendment indicates that it was
intended to apply solely to the interbank market.  Our discussion of
the Treasury Amendment was not intended to provide an interpretation
of the amendment's scope but rather to describe the legal confusion
created by how others have interpreted its scope.  We revised the
report accordingly. 

10.  The association noted that our draft report listed the necessary
elements of a futures contract without mentioning that such elements
are not necessarily sufficient to define a futures contract.  We
modified the report accordingly. 

11.  The association commented that our definition of offset is
broader than has been defined in regulatory and judicial contexts. 
We amended the offset definition to make it consistent with CFTC's
definition and discussed the way that OTC derivatives are terminated
in a later section of the report. 




(See figure in printed edition.)Appendix VI
COMMENTS FROM THE MANAGED FUTURES
ASSOCIATION
============================================================== Letter 



(See figure in printed edition.)


The following are GAO's comments on the Managed Futures Association's
October 15, 1996, letter. 

GAO COMMENTS

1.  The association commented that it does not share some of our
findings regarding the limitation of the Treasury Amendment's
carve-out of the interbank market, definition of a futures contract,
and failure to recognize the continued noncentralized nature of the
swaps market.  We revised the report to clarify that we were not
providing an interpretation of the Treasury Amendment's scope, but
rather were describing the legal confusion created by how others have
interpreted its scope.  We modified the report to clarify that no
definitive list exists of all the elements of a futures contract.  We
also amplified our discussion of the differences between the OTC
derivatives and exchange-traded futures markets. 




(See figure in printed edition.)Appendix VII
COMMENTS FROM THE NATIONAL FUTURES
ASSOCIATION
============================================================== Letter 



(See figure in printed edition.)


The following are GAO's comments on the National Futures
Association's September 10, 1996, letter. 

GAO COMMENTS

1.  The association commented that the draft report minimized the
inherent tension between the equally important goals of limiting
legal certainty while maximizing regulatory flexibility.  We agree
that tradeoffs exist in addressing the legal and regulatory issues
raised by the ongoing development of the OTC derivatives market under
the CEA.  Such tradeoffs raise difficult and often competing policy
concerns that can lead to more fundamental questions concerning the
goals of federal regulatory policy.  In our conclusions, we provide a
framework for determining the appropriate regulation for the OTC
derivatives and exchange-traded futures markets, focusing on the
public interest in the markets that needs to be protected. 

2.  The association noted that the swaps exemption must be
periodically revisited to make sure that the conditions set by CFTC
for the exemption continue to make sense.  It also noted that CFTC
must also reexamine the exemption granted to exchange-traded
products.  We agree that one alternative is to have CFTC revisit the
exemptions, as needed, to address regulatory concerns raised by
market changes and to ensure regulations do not impede market
innovation and competition.  However, we note that using such an
approach for exempted swaps could suggest swaps are futures and
introduce jurisdictional questions.  Moreover, in our conclusions, we
note that a remaining unresolved issue is the extent to which CFTC
should use its exemptive authority to provide greater regulatory
relief to the futures exchanges. 

3.  The association commented that, with respect to the Treasury
Amendment, it is inconceivable that Congress intended for futures
contracts in foreign currencies to be mass marketed to the retail
public without any of the protections afforded under the CEA.  As we
discuss, confusion exists as to the scope of the Treasury Amendment,
and we note in our conclusions that such confusion remains an
unresolved issue under the CEA. 


MAJOR CONTRIBUTORS TO THIS REPORT
======================================================== Appendix VIII

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Thomas J.  McCool, Associate Director
Cecile O.  Trop, Assistant Director

CHICAGO FIELD OFFICE

Richard S.  Tsuhara, Senior Evaluator
Daniel K.  Lee, Evaluator

OFFICE OF GENERAL COUNSEL,
WASHINGTON, D.C. 

Lorna J.  MacLeod, Attorney

SEATTLE FIELD OFFICE

Desiree W.  Whipple, Reports Analyst

*** End of document. ***