The Commodity Exchange Act: Issues Related to the Commodity Futures
Trading Commission's Reauthorization (Letter Report, 05/05/99,
GAO/GGD-99-74).

Pursuant to a congressional request, GAO provided information on issues
related to the Commodity Futures Trading Commission's (CFTC)
reauthorization, focusing on issues related to derivatives that are
traded on-exchange as well as those that are privately negotiated
off-exchange, or over-the-counter (OTC).

GAO noted that: (1) agreement exists on the basic objectives of
financial market regulation--to protect financial system integrity,
market integrity and efficiency, and customers; (2) however, the most
appropriate means of meeting these objectives has been subject to debate
by Congress, federal regulators, and market participants as the markets
have grown, new products have been introduced, and competition has
increased; (3) as reflected in appendices I through VIII of this report,
the debate has encompassed questions about the appropriate U.S.
regulatory structure for exchange and OTC derivative contracts, markets,
and market participants; (4) the appendices address the following eight
topics: (a) CFTC exemptive authority for OTC derivatives; (b) regulatory
reform efforts for exchange-traded derivatives; (c) the Shad-Johnson
Jurisdictional Accord; (d) the Treasury Amendment; (e) the forward
exclusion; (f) agricultural trade options; (g) electronic trading
systems; and (h) international regulatory coordination; (5) generally,
each appendix discusses the issues related to the topic; captures the
views of interested parties, including those expressed at the roundtable
discussion; and closes with public policy questions related to the
topic; (6) in the context of CFTC's reauthorization, at least two
significant questions surface from a discussion of these topics: (a)
what types of derivative transactions and market participants should be
covered by or excluded from CFTC regulation under the Commodity Exchange
Act (CEA); and (b) how should the various types of transactions and
market participants covered by CEA be regulated; (7) reaching agreement
among interested parties--OTC and exchange-traded market participants,
federal financial regulators, and Congress--on actions needed to address
these questions has proven difficult; and (8) recognizing that in an
increasingly global and competitive marketplace the cost of not reaching
agreement could be high, congressional and industry leaders have begun
discussions that could lead to a consensus.

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

 REPORTNUM:  GGD-99-74
     TITLE:  The Commodity Exchange Act: Issues Related to the
	     Commodity Futures Trading Commission's Reauthorization
      DATE:  05/05/99
   SUBJECT:  Authorization
	     Stock exchanges
	     Securities regulation
	     Derivative securities
	     Futures
	     Forwards

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THE COMMODITY EXCHANGE ACT: Issues Related to the Commodity
Futures Trading Commission's Reauthorization (GAO/GGD-99-74) THE
COMMODITY EXCHANGE ACT

Issues Related to the Commodity Futures Trading Commission's
Reauthorization

United States General Accounting Office

GAO Report to Congressional Committees

May 1999 

GAO/GGD-99-74

May 1999   GAO/GGD-99-74

United States General Accounting Office Washington, D. C. 20548

General Government Division

B-281936

Page 1 GAO/GGD-99-74 CFTC Reauthorization

GAO May 5, 1999 The Honorable Richard G. Lugar Chairman Committee
on Agriculture, Nutrition

and Forestry United States Senate

The Honorable Larry Combest Chairman Committee on Agriculture
House of Representatives

The Honorable Thomas W. Ewing Chairman Subcommittee on Risk
Management,

Research, and Specialty Crops Committee on Agriculture House of
Representatives

As part of your deliberations on the Commodity Futures Trading
Commission's (CFTC) upcoming reauthorization, you have expressed
an interest in exploring issues related to derivatives 1 that are
traded onexchange as well as those that are privately negotiated
off- exchange, or over- the- counter (OTC). This effort builds on
your previous proposals to revise the Commodity Exchange Act (CEA)
to help ensure that the U. S. derivatives markets are
appropriately regulated and remain competitive. In your December
18, 1998, letter, you requested that we provide information on
several topics that your committees plan to cover during the
reauthorization process. We briefed your offices on these topics
in preparation for the CFTC reauthorization roundtable discussion
that you sponsored in February 1999. This report presents
information on the requested topics in appendixes I through VIII.
Additionally, a summary of the CEA's legislative history is
provided in appendix IX, and a glossary and list of GAO- related
products are provided at the end of the report.

Agreement exists on the basic objectives of financial market
regulation to protect financial system integrity, market integrity
and efficiency, and

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. Results in Brief

B-281936 Page 2 GAO/GGD-99-74 CFTC Reauthorization

customers. However, the most appropriate means of meeting these
objectives has been subject to debate by Congress, federal
regulators, and market participants as the markets have grown, new
products have been introduced, and competition has increased. As
reflected in appendixes I through VIII of this report, the debate
has encompassed questions about the appropriate U. S. regulatory
structure for exchange and OTC derivative contracts, markets, and
market participants. The appendixes address the following eight
topics:

 CFTC exemptive authority for OTC derivatives,

 regulatory reform efforts for exchange- traded derivatives,

 the Shad- Johnson Jurisdictional Accord,

 the Treasury Amendment,

 the forward exclusion,

 agricultural trade options,

 electronic trading systems, and

 international regulatory coordination. Generally, each appendix
discusses the issues related to the topic; captures the views of
interested parties, including those expressed at the roundtable
discussion; 2 and closes with public policy questions related to
the topic.

In the context of CFTC's reauthorization, at least two significant
questions surface from a discussion of these topics: (1) what
types of derivative transactions and market participants should be
covered by or excluded from CFTC regulation under the CEA and (2)
how should the various types of transactions and market
participants covered by the CEA be regulated? Reaching agreement
among interested parties OTC and exchange- traded market
participants, federal financial regulators, and Congress on
actions needed to address these questions has proven difficult.
Recognizing that in an increasingly global and competitive
marketplace the cost of not reaching agreement could be high,
congressional and industry leaders have begun discussions that
could lead to a consensus.

Derivatives provide users a means of shifting the risk of price
changes in the underlying to those more willing or able to assume
this risk. Derivatives include exchange- traded and OTC contracts.
Exchange- traded derivatives generally have fixed terms except for
price, which the market determines. OTC derivatives generally have
negotiable terms, including terms such as price, quality and
quantity of the underlying, and method of

2 See appendix X for a list of roundtable participants. Background

B-281936 Page 3 GAO/GGD-99-74 CFTC Reauthorization

payment. Derivatives include forwards, 3 futures, 4 options, 5 and
swaps 6 contracts. Traditionally, futures have been exchange-
traded, while forwards and swaps have been negotiated OTC. Options
are traded on exchanges as well as negotiated OTC.

The increased demand for risk- shifting products, along with
technological advances, has fueled the development of innovative
exchange- traded and OTC derivative products as well as the growth
of these markets. Driven by the introduction of financial futures,
such as interest rate and currency contracts, the U. S. exchange-
traded futures market has experienced substantial growth. Between
1986 and 1998, annual trading volume on U. S. futures exchanges
increased by about 227 percent, from 216.1 million to 707.4
million contracts. Following the U. S. lead, foreign futures
exchanges have introduced new products and increased their share
of the worldwide exchange- trading volume from 21 to 58 percent
over this period. Additionally, the development of swaps and other
OTC derivatives has led to the rapid growth and globalization of
the OTC derivatives market. As of June 1998, the total notional
amount 7 of the OTC derivatives market worldwide was estimated at
$69. 9 trillion, up from $47.5 trillion as of March 1995. 8

CFTC, an independent agency created by Congress in 1974,
administers the CEA. The act gives CFTC exclusive jurisdiction
over all futures and certain option contracts. It also establishes
a regulatory structure that was historically designed to ensure
that all futures were traded on self

3 Forward contracts, according to CFTC, are privately negotiated,
cash transactions in which commercial buyers and sellers agree
upon the delivery of a specified quantity and quality 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.

4 Futures contracts are agreements 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 date.
These contracts may be satisfied by delivery or offset.

5 Option contracts (American style) give the purchaser the right,
but not the obligation, to buy (call option) or sell (put option)
a specified quantity of a commodity or financial asset at a
specified price (the exercise or strike price) on or before a
specified future date.

6 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 that is not typically exchanged.

7 The notional amount is the amount upon which payments between
parties to certain types of derivatives contracts are based.
Because this amount is not typically exchanged, the total notional
amount shown is not an aggregate measure of the amount at risk.

8 Due to differences in the methodology used, the estimates of
notional amounts are not directly comparable.

B-281936 Page 4 GAO/GGD-99-74 CFTC Reauthorization

regulated exchanges and through regulated intermediaries. In
addition to providing a means for shifting price risk, the
exchange- traded futures market has traditionally been a mechanism
for discovering price.

To provide information on the various topics concerning the
exchangetraded and OTC derivatives markets, we reviewed the CEA
and its legislative history, Federal Register notices, and comment
letters on CFTC concept releases and rule proposals. In addition,
we reviewed congressional hearings, legal cases, journal articles,
and reports on the CEA and the exchange- traded and OTC
derivatives markets. We interviewed CFTC officials about the
various topics covered in our report. We also attended the
February 1999 CFTC reauthorization roundtable discussion, recent
congressional hearings on the exchange- traded and OTC derivatives
markets, and a futures industry conference.

We requested comments on a draft of this report from the
Chairperson, CFTC, and Chairman, SEC, or their designees. In
separate meetings held on April 16, 1999, the Director of the
Office of Legislative and Intergovernmental Affairs, CFTC, and the
Chief Counsel of the Division of Market Regulation, SEC, provided
us with oral comments. These comments are discussed below.
Additionally, we discussed the contents of a draft of this report
with officials of the Department of the Treasury and Federal
Reserve Board; self- regulatory organizations (SRO), 9 including
two futures exchanges and a securities exchange; and four industry
trade associations. They provided technical clarification that we
incorporated into the report where appropriate. We did our work in
Chicago, IL, and Washington, D. C., between January and April 1999
in accordance with generally accepted government auditing
standards.

CFTC and SEC generally agreed with the accuracy of the information
presented in this report and provided technical clarification that
we incorporated into the report where appropriate.

We are sending a copy of this report to Senator Tom Harkin,
Ranking Minority Member, Senate Committee on Agriculture,
Nutrition and Forestry; Representative Charles Stenholm, Ranking
Minority Member, House Committee on Agriculture; Representative
Gary A. Condit, Ranking Minority Member, Subcommittee on Risk
Management, Research, and Specialty Crops, House Committee on
Agriculture; the Honorable

9 SROs are private membership organizations given the power and
responsibility under federal law and regulations to adopt and
enforce rules of member conduct. They include all of the U. S.
commodities and securities exchanges, the National Futures
Association, the National Association of Securities Dealers, and
the Municipal Securities Rulemaking Board. Scope and

Methodology Agency Comments

B-281936 Page 5 GAO/GGD-99-74 CFTC Reauthorization

Brooksley Born, Chairperson, CFTC; the Honorable Arthur Levitt,
Chairman, SEC; and other interested parties. We will also make
copies available to others upon request.

Major contributors are listed in appendix XI of this report.
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.

Thomas J. McCool Director, Financial Institutions

and Markets Issues

Page 6 GAO/GGD-99-74 CFTC Reauthorization

Contents 1 Letter 10 Rationale for CFTC Exemptive Authority 10
Limitations of CFTC Exemptions 11 Efforts to Address OTC Market
Issues 12 The Long- Term Capital Management Recapitalization Has

Raised Regulatory Concerns 14

CFTC Left Open the Opportunity for the Development of an OTC
Clearinghouse

15 Public Policy Questions Raised By CFTC Exemptive

Authority For OTC Derivatives 16 Appendix I

CFTC Exemptive Authority for OTC Derivatives

18 U. S. Futures Market Regulation 18 Derivatives Market Growth
and Competition 19

Exemptive Authority 20 CFTC and Congressional Efforts to Provide
Regulatory

Relief 20

Proposals for Revising Market Oversight 22 Costs and Benefits of
Futures Market Regulation Are

Difficult to Measure 24

Public Policy Questions Raised by Regulatory Reform Efforts for
Exchange- Traded Derivatives

26 Appendix II

Regulatory Reform Efforts for ExchangeCFTC Traded Derivatives

27 Rationale for the Accord 27 Evidence of Continued Uncertainty
28 Addressing the Prohibition on Stock- Based Futures 29 Public
Policy Questions Raised by the Accord 31 Appendix III

The Shad- Johnson Jurisdictional Accord

32 Rationale for the Treasury Amendment 32 Problems Interpreting
the Treasury Amendment 32 Proposals to Clarify the Scope of the
Treasury

Amendment 36

Public Policy Questions Raised by the Treasury Amendment

37 Appendix IV

The Treasury Amendment

Contents Page 7 GAO/GGD-99-74 CFTC Reauthorization

38 Historical Definition of a Forward Contract 38 Problems
Differentiating Forwards From Futures 38 Public Policy Questions
Raised by the Forward Exclusion 40 Appendix V

The Forward Exclusion

41 History of the Ban on Commodity Options 41 Narrowing of the
Commodity Option Trading Ban 41 CFTC Pilot Program on Agricultural
Trade Options 42 Status of the Pilot Program 43 Public Policy
Question Raised by Agricultural Trade

Options 43 Appendix VI

Agricultural Trade Options

44 CFTC Role in Facilitating the Development of Electronic

Systems 44

Expansion of Electronic Trading Systems 45 Foreign Futures
Exchanges' Placement of Terminals in

the United States 46

Novel Electronic Futures Trading Systems 47 Industry Views on
Electronic Trading 48 Public Policy Questions Raised by Electronic
Futures

Trading Systems 49 Appendix VII

Electronic Trading Systems

51 Use of CFTC Expanded Authority and Limits to Its

Authority 51

CFTC's Additional Focus on International Concerns 51 Industry
Observations 52 Public Policy Questions Related to International

Regulatory Coordination 52 Appendix VIII

International Regulatory Coordination

53 Grain Futures Act of 1922 (42 Stat. 998) 53 Commodity Exchange
Act of 1936 (49 Stat. 1491) 53 Amendments to the CEA Between 1936
and 1968 54 1968 Amendments to the CEA (Pub. L. No. 90- 258) 54
Commodity Futures Trading Commission Act of 1974

(Pub. L. No. 93- 463) 55

Futures Trading Act of 1978 (Pub. L. No. 95- 405) 56 Appendix IX

Legislative History of the Commodity Exchange Act

Futures Trading Act of 1982 (Pub. L. No. 97- 444) 57

Contents Page 8 GAO/GGD-99-74 CFTC Reauthorization

Futures Trading Act of 1986 (Pub. L. No. 99- 641) 58 Futures
Trading Practices Act of 1992 (Pub. L. No. 102546) 58

CFTC Reauthorization Act of 1995 (Pub. L. No. 104- 9) 59 Omnibus
Appropriations Act of 1998 (Pub. No. 105- 277) 59

60 Moderators 60 Panelists 60 Appendix X

Participants at CFTC Reauthorization Roundtable Discussion Held in
Washington, D. C., on February 25 and 26, 1999

61 Appendix XI Major Contributors to This Report

62 Glossary 72 Related GAO Products

Contents Page 9 GAO/GGD-99-74 CFTC Reauthorization Abbreviations

CFTC Commodity Futures Exchange Commission FSA Financial Services
Authority BIS Bank for International Settlements CBT Chicago Board
of Trade CEA Commodity Exchange Act CFFE Cantor Financial Futures
Exchange CME Chicago Mercantile Exchange DTB Deutsche Terminborse
FCM futures commission merchant HTA hedge- to- arrive LTCM Long-
Term Capital Management NFA National Futures Association NYMEX New
York Mercantile Exchange OTC over- the- counter SEC Securities and
Exchange Commission SRO self- regulatory organization

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 10 GAO/GGD-99-74 CFTC Reauthorization

Because of their similarities to exchange- traded futures, swaps
and other over- the- counter (OTC) derivatives have faced the
possibility of falling within the judicially crafted definition of
a futures contract. 1 This possibility posed a legal risk for many
OTC derivatives because of the Commodity Exchange Act (CEA)
requirement that futures be traded on an exchange to be legal and,
thus, enforceable. In 1989, to reduce the legal risk facing swaps,
the Commodity Futures Trading Commission (CFTC) issued a swaps
policy statement to clarify the conditions under which it would
not regulate certain swaps as futures. In part, CFTC predicated
its policy statement on the rationale that swaps lacked certain
elements that facilitated futures trading on exchanges, such as
standardized terms and a clearinghouse. CFTC's policy statement
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. (See the glossary at
the end of the report for definitions.)

Under the Futures Trading Practices Act of 1992, Congress gave
CFTC broad authority to exempt any contract from all but one of
the CEA provisions, provided the exemption was consistent with the
public interest and the contract was entered into solely between
eligible participants, as defined in the act. According to the
1992 act's legislative history, Congress expected CFTC to use its
exemptive authority promptly to reduce legal risk for swaps,
forwards, and hybrids. It further noted that CFTC could exempt a
contract without first determining that it was a futures contract.
Finally, the legislative history stated that the goal of providing
CFTC with broad exemptive authority was to give CFTC a means of
providing certainty and stability to the markets. Under its
exemptive authority, CFTC could impose any conditions on an
exemption that it deemed appropriate and could exempt contracts
from any provisions of the CEA, except section 2( a)( 1)( B)
(discussed below).

In January 1993, CFTC exempted a broad group of swaps from
virtually all CEA provisions, including the exchange- trading
requirement. Under this exemption, CFTC retained the CEA's
antimanipulation and antifraud provisions for swaps but only to
the extent they were futures. It also imposed four conditions that
swaps had to meet to qualify for an exemption. First, they had to
be entered into solely by eligible participants, including banks;
securities firms; insurance companies; commercial firms meeting
minimum financial requirements (e. g., net worth exceeding $1
million); and individuals with total assets exceeding $10 million.
Second,

1 The CEA does not define the term futures contract. Rationale for
CFTC

Exemptive Authority

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 11 GAO/GGD-99-74 CFTC Reauthorization

they could not be standardized as to their material economic
terms. Third, the creditworthiness of the counterparties had to be
a material consideration. Under this condition, exempted swaps
could not be cleared through clearinghouses that are similar to
those used to clear exchangetraded futures. However, CFTC noted
that it would consider the terms and conditions of an exemption
for a swaps clearinghouse in the context of a specific proposal.
Fourth, exempted swaps 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 when the
exemption was granted and to describe when such transactions would
not raise significant regulatory concerns under the CEA.

In January 1993, CFTC also exempted hybrids from virtually all CEA
provisions, including the exchange- trading requirement; it
granted a similar exemption to specified OTC energy contracts in
April 1993. CFTC's hybrid exemption was designed to exempt
instruments that were predominantly bank deposits or securities
and included a condition to ensure that they would be covered
under banking or securities regulations. CFTC's energy exemption
responded to congressional encouragement that CFTC determine
whether exemptive or other action should be taken for certain OTC
energy contracts. In response to a request by a group of
commercial firms in the energy market, CFTC granted an exemption
to specified OTC energy contracts, which included Brent oil
contracts. CFTC retained the CEA's antimanipulation provisions,
but not the act's antifraud provisions under this exemption.

CFTC's swaps, hybrid, and energy exemptions eliminated the legal
risk that qualifying contracts could be deemed illegal, off-
exchange futures. If CFTC or a court found an exempted contract to
be a futures contract, the contract would still be legal because
the CEA exchange- trading requirement would not apply. In granting
the exemptions, CFTC was not required to, nor did it, determine
that the OTC derivatives covered by the exemptions were futures.
According to an industry association, no swaps have been found to
be futures contracts. However, a question has remained about the
extent to which CFTC can subject OTC derivatives to additional
regulation under the CEA, such as by amending the conditions of
the exemptions.

CFTC's swaps exemption did not provide the same legal certainty to
securities- based swaps, contracts whose returns are based on
prices of securities and securities indexes, as it did for
interest rate, currency, and other swaps. Even if a securities-
based swap met all the conditions of the Limitations of CFTC

Exemptions

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 12 GAO/GGD-99-74 CFTC Reauthorization

swaps exemption, it would not be exempt from CEA section 2( a)(
1)( B), which codified the Shad- Johnson Jurisdictional Accord.
(See app. III on the accord.) According to market observers, if
securities- based swaps were found to be futures contracts, they
could be in violation of CEA section 2( a)( 1)( B) and, thus, be
illegal and unenforceable. In issuing its swaps exemption, CFTC
noted that counterparties to securities- based swaps could
continue to rely on its 1989 swaps policy statement, which sets
forth the conditions under which CFTC would not regulate certain
swaps as futures. According to an industry association,
counterparties to securities- based swaps have continued to rely
on this policy statement to address their legal concerns under CEA
section 2( a)( 1)( B).

In 1997, a Senate bill (S. 257) was introduced that included
provisions intended to provide greater legal certainty for
securities- based swaps by codifying the existing swaps exemption
and extending its scope to include securities- based swaps. As
noted in an accompanying discussion document, the provision would
not have affected CFTC's power to grant additional exemptions or
to amend the existing exemption to make it less restrictive.
However, the provision would have required a statutory change to
make the existing swaps exemption more restrictive. According to
market observers, the provision would have addressed the concern
of OTC market participants that CFTC could modify the swaps
exemption in a way that could disrupt the market. In related
hearings, 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. In a February 1997
letter to Chairman Lugar, SEC expressed concern about the
provision and stated that legal certainty for securities- based
swaps could be better achieved by excluding from the CEA these
products and all hybrid securities that are not predominantly
futures.

In May 1998, CFTC issued a concept release on OTC derivatives that
sought public comment on whether the swaps and hybrid exemptions
continued to be appropriate in light of market changes. In the
concept release, CFTC asked, among other questions, whether
additional oversight of the OTC markets was required, including
whether current fraud and manipulation prohibitions were
sufficient. CFTC indicated that it was receptive to broadening its
exemptions or imposing additional safeguards, if warranted.
Additionally, CFTC noted that the release did not alter the
current status of any instrument or product under the CEA and that
all of Efforts to Address

OTC Market Issues Congress Proposed Legislation to Reduce Legal
Uncertainty

CFTC Issued a Concept Release on OTC Derivatives

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 13 GAO/GGD-99-74 CFTC Reauthorization

its currently applicable exemptions, interpretations, and policy
statements remained in effect.

The Treasury Department, Federal Reserve, and Securities and
Exchange Commission (SEC), as well as some market participants,
have expressed concern that CFTC's concept release raises legal
and regulatory uncertainty in the OTC derivatives markets. First,
concern exists that the release creates legal uncertainty by
suggesting that exempted swaps may be futures, thereby calling
into question the legality of securities- based swaps and other
OTC derivatives potentially subject to CEA section 2( a)( 1)( B).
Second, concern exists that the release creates regulatory
uncertainty by raising the possibility that CFTC might amend the
conditions of its exemptions to subject exempted OTC derivatives
to additional regulation under the CEA.

Opponents of the concept release have stated that it is
unnecessary to extend the CEA to OTC derivatives. They assert that
the OTC derivatives markets generally do not serve a price
discovery function and are not readily susceptible to
manipulation. They further assert that counterparties to OTC
derivatives are capable of protecting themselves from losses
arising from counterparty defaults and fraud using remedies
outside the CEA, such as those provided under state statutory or
common law. They also maintain that the regulatory uncertainty
resulting from the release threatens the competitiveness of the U.
S. financial markets. In addressing these concerns, Congress
directed CFTC, via the Omnibus Appropriations Act (P. L. 105-
277), not to issue or propose new regulations affecting swaps and
hybrids before March 31, 1999. As of April 20, 1999, CFTC had not
proposed or issued any new regulations affecting swaps or hybrids.

At a February 1999 roundtable discussion on CFTC reauthorization
issues, the participants discussed the desirability of resolving
legal uncertainty in the OTC derivatives market. Five of the
participants characterized it as the most important issue that
Congress needs to address during CFTC's upcoming reauthorization.
According to one of these participants, following the issuance of
CFTC's concept release, his firm was inundated with calls from
clients and counterparties, asking about the legal enforceability
of their OTC derivatives. Another roundtable participant commented
that SEC is also a source of legal uncertainty. He said that SEC
has indicated that some swaps are options and within the agency's
jurisdiction. He added that SEC will need to be involved in the
discussion to fully resolve the legal status of OTC derivatives.
Industry Views on the Need

to Address Legal Uncertainty

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 14 GAO/GGD-99-74 CFTC Reauthorization

In a joint statement submitted to the Senate and House Agriculture
Committees on March 19, 1999, the U. S. Securities Market
Coalition 2 stated that clarifying that equity swaps, types of
securities- based swaps, do not fall under the CEA would reduce
unnecessary legal risk for U. S. financial markets. The Coalition
further stated that, if Congress decides to provide greater legal
certainty for equity swaps, it should make it clear that SEC has
the authority to exercise appropriate regulatory oversight over
them. The Coalition opposed granting CFTC exemptive authority for
equity swaps because the Coalition believes that doing so could
affect SEC's ability to react to issues in this market. Finally,
the Coalition stated that Congress should work with SEC to resolve
the legal uncertainty issue.

In a June 1998 letter, the Treasury Department, Federal Reserve,
and SEC told Congress that CFTC's concept release raised important
questions. However, they indicated that these questions were most
appropriately addressed by the President's Working Group on
Financial Markets because they raised jurisdictional issues among
the federal regulators. Accordingly, in September 1998, Senator
Lugar and Representative Smith requested that the Working Group
study the OTC derivatives market and develop legislative
recommendations by the spring of 1999. According to the Federal
Reserve, the Working Group's study will address the following
policy objectives: (1) deterring market manipulation, (2)
deterring fraud and protecting certain counterparties to
transactions, (3) promoting the financial integrity of markets by
limiting potential losses from counterparty defaults, (4)
providing legal certainty with respect to the enforceability of
contracts, (5) avoiding significant competitive disparities across
financial markets and institutions, (6) appropriately limiting
systemic risk, and (7) harmonizing regulations internationally.

In September 1998, the Federal Reserve Bank of New York organized
a meeting that led to a private sector recapitalization of Long-
Term Capital Management (LTCM), a hedge fund that traded in OTC
and exchangetraded derivatives. Although the Federal Reserve Bank
had no regulatory authority over LTCM, officials were concerned
that the firm's financial problems, if not immediately addressed,
could adversely affect the markets and market participants not
directly involved with LTCM.

Although LTCM was not subject to federal banking or securities
regulations, it was subject to CFTC regulation as a commodity pool

2 The U. S. Securities Market Coalition includes the American
Stock Exchange, Boston Stock Exchange, Chicago Board Options
Exchange, Chicago Stock Exchange, Cincinnati Stock Exchange,
NASDAQ Stock Market, National Securities Clearing Corporation, New
York Stock Exchange, Pacific Exchange, Philadelphia Stock
Exchange, and The Options Clearing Corporation. The President's
Working

Group Is Studying the OTC Derivatives Markets

The Long- Term Capital Management Recapitalization Has Raised
Regulatory Concerns

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 15 GAO/GGD-99-74 CFTC Reauthorization

operator because it had U. S. investors and traded on futures
exchanges. As a commodity pool operator, LTCM was subject to
registration, recordkeeping, and limited reporting requirements as
well as the antifraud provisions of the CEA. In March 1998, CFTC
staff received LTCM's 1997 audited annual financial statements and
found them to be in compliance with its reporting requirements.
According to CFTC, nothing in these statements indicated a reason
for concern about the firm's financial condition; thus, it did not
share them with other regulators. CFTC's ability to share any
concerns that it may have had was governed by section 8( e) of the
CEA, which permits CFTC to share information with other federal
agencies only upon their request. According to CFTC, this
requirement would not have impeded its ability to share LTCM's
financial statements because CFTC could have solicited a request
from an agency, if needed.

In response to the LTCM recapitalization, the Secretary of the
Treasury asked the President's Working Group in September 1998 to
study the potential implications of hedge funds and their
relationship with creditors. In March 1999, Treasury testified
that the Working Group was evaluating the costs and benefits of
potential policy options, including relying on market discipline
enhanced by greater regulatory scrutiny of and guidance for
regulated suppliers of credit; resorting to more direct forms of
regulation, such as expanded use of margin requirements; and
imposing direct regulation on some currently unregulated market
participants. According to the Federal Reserve, the central policy
issue raised by LTCM is how financial leverage which LTCM achieved
through a number of means, including the use of OTC derivatives
can be constrained most effectively in a market- based economy. It
added that the Working Group's hedge fund study is separate from
its OTC derivatives study because the issues are distinct
regulation of OTC derivatives raises a wider range of issues, many
of which are unrelated to LTCM. According to CFTC, the near
failure of LTCM demonstrates the unknown risks that OTC
derivatives may pose to the U. S. economy and to financial
stability around the world including the risk arising from lack of
transparency thereby highlighting the need to address the
questions raised in its concept release.

Recognizing the potential benefits of a clearinghouse including
reducing counterparty credit risk and increasing market liquidity
and transparency CFTC's swap exemption left open the opportunity
for the development and use of a swaps clearinghouse, subject to
CFTC's prior approval. In its concept release, CFTC noted that a
clearinghouse's benefits are obtained at the cost of concentrating
risk in the clearinghouse; thus, federal oversight of the
clearinghouse might be necessary. According to CFTC, the extent to
which it would need to impose conditions on a CFTC Left Open the

Opportunity for the Development of an OTC Clearinghouse

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 16 GAO/GGD-99-74 CFTC Reauthorization

clearinghouse would depend on, among other things, the design of
the facility and the applicability of other regulatory regimes.

In June 1998, the London Clearing House petitioned CFTC for an
exemption from most of the provisions of the CEA for its swaps
clearinghouse, called SwapClear. The London Clearing House sought
exemptive relief to alleviate the legal and regulatory uncertainty
that U. S. entities using SwapClear would face under the CEA. That
is, because CFTC's swap exemption does not extend to swaps cleared
through a clearinghouse, the status of otherwise exempted swaps
could be jeopardized if cleared through SwapClear. In March 1999,
CFTC approved the London Clearing House's petition, exempting from
most CEA provisions and CFTC regulations certain swaps cleared
through SwapClear. CFTC exempted SwapClear, in part, because the
clearinghouse and its participants will be subject to a
comprehensive regulatory regime in the United Kingdom, including
oversight by the Financial Services Authority (FSA). The exemption
will not take effect until CFTC and FSA have executed an addendum
to their information- sharing agreement (see app. VIII on
international regulatory coordination), and FSA has notified CFTC
that it has approved SwapClear.

At the roundtable discussion on CFTC reauthorization issues, one
participant advocated that Congress mandate the creation of a
national clearinghouse for OTC derivatives. He asserted that such
a clearinghouse would reduce systemic risk and increase market
efficiency through the use of multilateral netting and other
mechanisms. Other roundtable participants said that an OTC
derivatives clearinghouse is not needed. Still others said that
the competitive advantage associated with the higher credit
ratings of most major OTC derivative market participants reduces
their incentive to support a clearinghouse that would enable
entities with lower credit ratings to compete against them.

Financial Integrity/ Systemic Risk and Market Integrity/
Efficiency: 1. What financial integrity/ systemic risk or market
integrity/ efficiency

issues do the OTC derivatives market raise, if any, and what role
should CFTC and/ or other federal financial regulators play in
addressing them?

2. To what extent, if any, does the lack of legal certainty for
securitiesbased swaps pose systemic risk or introduce competitive
concerns for the U. S. markets? Public Policy

Questions Raised By CFTC Exemptive Authority For OTC Derivatives

Appendix I CFTC Exemptive Authority for OTC Derivatives

Page 17 GAO/GGD-99-74 CFTC Reauthorization

3. What lessons does the LTCM recapitalization provide about the
need to enhance federal regulations, private market mechanisms,
and/ or domestic and international coordination and cooperation to
protect market stability?

4. Under what conditions would it be appropriate to subject an OTC
derivatives clearinghouse to U. S. regulation, and what role
should CFTC and/ or other federal financial regulators play in
providing any such regulation?

Customer Protection: 5. What customer protection issues do the OTC
derivatives market raise,

if any, and what role should CFTC and/ or other federal financial
regulators play in addressing them?

Appendix II Regulatory Reform Efforts for ExchangeTraded
Derivatives

Page 18 GAO/GGD-99-74 CFTC Reauthorization

The traditional function of the exchange markets has been to
provide a mechanism for discovering price and a means for users to
shift the risk of price changes in the underlying to those more
willing or able to assume this risk. Federal regulation of the U.
S. futures market stems from a need to ensure the market's
economic utility by encouraging its competitiveness and
efficiency; ensuring its integrity; and protecting market
participants against manipulation, abusive trade practices, and
fraud. The market's regulatory structure consists of federal
oversight provided by CFTC and industry oversight provided by
self- regulatory organizations (SRO) the futures exchanges and the
National Futures Association (NFA). (See the glossary at the end
of the report for definitions.)

Reliance on the futures SROs is based on a belief that they should
be able to act more quickly and effectively than the federal
government. Futures SROs are responsible for establishing and
enforcing rules governing member conduct and trading; providing
for the prevention of market manipulation, including monitoring
trading activity; setting qualifications for futures industry
professionals; and examining members for financial strength and
other regulatory purposes. Their operations are funded by the
futures industry through transaction fees and other charges.

In regulating the futures market, CFTC independently monitors,
among other things, exchange trading activity, large trader
positions, and certain market participants' financial condition.
CFTC also investigates potential violations of the CEA and CFTC
regulations and prosecutes alleged violators. Additionally, CFTC
oversees the SROs to ensure that each has an effective self-
regulatory program. In this regard, CFTC designates and supervises
exchanges as contract markets and NFA as a registered futures
association, audits SROs for compliance with their regulatory
responsibilities, and reviews and approves SRO rules and products
that are traded on designated exchanges. CFTC is funded through
congressional appropriations but also collects fees from the
industry to recover the costs of certain services and activities.

Traditionally, futures have been exchange- traded; as such, they
have been regulated under a structure designed to protect
customers and the market. The regulatory structure covers not only
certain market participants but also the products and markets on
which they trade. Unless exempted or excluded from the CEA,
futures must be traded on designated exchanges and through
regulated intermediaries that are subject to minimum capital,
reporting, examination, and customer protection requirements. U.
S. Futures Market

Regulation

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 19 GAO/GGD-99-74 CFTC Reauthorization

In the past two decades, technological advances and fundamental
changes in the global financial markets have accelerated the
development and use of exchange- traded and OTC derivatives. Such
advances and changes have led to tremendous growth in not only the
U. S. futures market but also the foreign futures and OTC
derivatives markets. Between 1986 and 1998, annual trading volume
on U. S. futures exchanges increased from 216.1 to 707.4 million
contracts, or about 227 percent; annual trading volume on foreign
futures exchanges in the same products increased from 55.9 to
966.4 million contracts, or about 1,629 percent. As a result,
foreign exchanges' share of worldwide trading volume increased
from 21 percent in 1986 to 58 percent in 1998. Around this period,
the OTC derivatives market also experienced tremendous growth, in
part from the development of swaps and other innovative products.
As of June 1998, the Bank for International Settlements (BIS)
estimated that the total notional amount of the OTC derivatives
market worldwide was $69.9 trillion, up from an estimated $47.5
trillion as of March 1995. 1 Swaps accounted for about 50 percent
of the 1998 total.

While the U. S. futures market has experienced substantial growth,
it has also evolved far beyond its agricultural origins. In 1975,
agricultural commodities accounted for nearly 80 percent of the
total U. S. exchange trading volume. In 1998, financial
instruments and currencies accounted for nearly 70 percent of the
total U. S. exchange trading volume, with agricultural commodities
accounting for about 15 percent of the trading volume and other
commodities, such as energy and metals, accounting for the
remaining volume. According to futures exchanges and others, the
participants in the exchange- traded futures market have changed
as the market evolved. They have noted that the participants are
largely institutions and market professionals, with retail
customers representing about 5 percent of the total market
participants. However, some of these sources have said that
advances in electronic trading could bring new retail customers
into this market.

The growth of the foreign futures markets has provided competition
for the U. S. markets, although the extent of competition varies
by type of product, transaction costs, and other factors. U. S.
and foreign exchanges compete directly with each other when they
trade futures based on the same or similar underlying commodities.
For example, the Coffee, Sugar, and Cocoa Exchange competes
directly with foreign exchanges that trade

1 Due to differences in the methodology used, the estimates of
notional amounts are not directly comparable. Derivatives Market

Growth and Competition

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 20 GAO/GGD-99-74 CFTC Reauthorization

coffee, sugar, and cocoa futures. According to market observers,
the continued expansion of electronic trading systems has
increased competition between U. S. and foreign exchanges. (See
app. VII on electronic trading systems.)

In addition, the U. S. exchange- traded futures and OTC
derivatives markets compete with and complement each other.
Although exchange- traded and OTC derivatives serve similar
economic functions and can, thus, compete with each other, they
differ by, among other things, their contract terms, liquidity,
transparency, transaction costs, and regulation. In addition, the
markets complement each other to the extent that OTC derivatives
activity generates hedging demand in the futures markets. For
example, swaps dealers use exchange- traded futures to hedge the
residual risk resulting from unmatched positions in their swaps
portfolios.

The Futures Trading Practices Act of 1992 gave CFTC authority to
exempt both exchange- traded and OTC derivative contracts from all
but one provision of the CEA, including the exchange- trading
requirement. (See app. I on CFTC exemptive authority for OTC
derivatives and app. III on the Shad- Johnson Jurisdictional
Accord.) The act stipulated, among other things, that exemptions
must be consistent with the public interest. According to the
act's legislative history, the public interest was to include
protecting the futures market's price discovery and risk- shifting
functions from market abuses, such as excessive speculation and
manipulation; preventing fraud; preserving the financial integrity
of the markets; and promoting innovation and fair competition. The
legislative history directed CFTC to be fair and even- handed in
providing regulatory relief for both exchanges and nonexchanges.
However, it also cautioned CFTC to use its exemptive authority
sparingly and not to prompt a wide- scale deregulation of markets
falling under the CEA.

Although the competitiveness of the U. S. futures market is
affected by a number of factors, U. S. futures exchanges have
asserted that regulations imposed by CFTC have stunted their
growth and impeded their ability to compete fairly with the less
regulated foreign futures and OTC derivatives markets. According
to the exchanges, regulatory costs not the quality of their
services and products have handicapped their industry and crippled
their growth and innovation. As discussed below, in 1993, two
exchanges separately requested that CFTC exempt from most CEA
provisions exchange- traded futures traded solely by institutional
and other sophisticated market participants. In addition,
exchanges and other market participants have expressed concerns
that certain aspects of the regulatory structure make U. S.
exchanges less competitive than their CFTC Exemptive

Authority CFTC and Congressional Efforts to Provide Regulatory
Relief

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 21 GAO/GGD-99-74 CFTC Reauthorization

foreign and OTC market counterparts. These concerns relate to
audit trail requirements, restrictions on certain trade execution
procedures, risk disclosure requirements, approval of new
contracts, speculative position limits, and capital requirements.

In response to the exchange requests, CFTC issued an exemption in
November 1995, which is to be implemented under a 3- year pilot
program that begins when the first contract trades under the
exemption. The exemption does not provide the exchanges with
regulatory relief that is as broad as they requested, and it
applies only to proposals to trade new contracts. The exemption
would allow for the creation of a two- tier market differentiated
by the sophistication of market participants. CFTC considered the
exclusion of nonsophisticated market participants as the most
important factor supporting its exemption. Nonetheless, it noted
that a centralized market limited to sophisticated market
participants did not obviate the need to ensure market integrity
and adequate protections against fraud and other trading abuses.
To date, no exchange has applied for an exemption because,
according to the exchanges, the rules provide insufficient
regulatory relief. The exchanges have indicated that they expected
to receive the same level of relief that CFTC provided under the
swaps exemption, because the 1992 act's legislative history
directed CFTC to be fair and even- handed in using its exemptive
authority.

According to CFTC, the agency has taken other actions that are
responsive to the competitive challenges faced by the U. S.
futures industry and its customers, while at the same time
preserving important customer protections and market safeguards
that make U. S. markets attractive. CFTC describes its regulatory
reform efforts as intending to update, modernize, and streamline
regulations to improve market integrity and protect market
participants. These efforts include approving new procedures for
expediting approval of contract market designations and exchange
rules, piloting a program to permit trading of agricultural trade
options (see app. VI on the agricultural trade option pilot
program), improving the fairness and efficiency of the
administrative process, and permitting the use of electronic
technology to reduce paperwork. Market participants and others
have supported these efforts but do not believe that they go far
enough.

The 1997 Senate (S. 257) and House (H. R. 467) bills to amend the
CEA included numerous provisions that were intended to provide
regulatory relief to the U. S. exchanges. First, both bills would
have provided futures exchanges with professional market
exemptions that would largely exempt from regulation under the act
certain exchange- traded futures that

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 22 GAO/GGD-99-74 CFTC Reauthorization

were limited to institutional and sophisticated market
participants. Second, both bills would have allowed exchanges
previously designated by CFTC as contract markets to trade new
contracts without CFTC approval. Third, both bills would have
expedited CFTC approval of exchange rules. Fourth, the House bill
would have required CFTC to issue an objective standard or
methodology for testing exchange audit trails, and both bills
stated that no particular technology was needed to meet the audit
trail requirements. Finally, both bills would have required CFTC
to consider the costs and benefits of its proposed actions before
adopting rules, regulations, and orders. The House bill, however,
would have prohibited CFTC from taking regulatory action if the
benefits did not exceed costs.

The exchanges were supportive of the regulatory relief that the
bills would have provided. According to the exchanges, they were
particularly supportive of the bills' professional market
exemptions, because they would have moved the exchanges a long way
toward achieving a regulatory balance with the OTC derivatives
market. The exchanges noted that the exempted market would have
relied on market discipline and selfregulation, with the exchanges
having a business incentive to operate a fair, financially sound,
and competitive market.

In contrast, CFTC and SEC expressed concerns about the bills
because of the increased risks to the market and its participants
that could have resulted from them. CFTC stated that it opposed
the professional market exemptions, because they would eliminate
federal power to protect against manipulation, fraud, financial
instability and other dangers. SEC expressed concern about the
House bill's professional market exemption, because it would have
eliminated the applicability of the Shad- Johnson Jurisdictional
Accord to these markets. (See app. III on the accord.)

Participants at the CFTC reauthorization roundtable discussion
recommended various ways that federal oversight could be revised
for the benefit of the markets. These recommendations were similar
in that they focused on (1) providing regulatory parity between
the exchange and OTC markets and (2) differentiating regulation on
the basis of the sophistication of market participants. In
addition, a former CFTC chairperson has supported considerable
deregulation of exchange- traded financial futures.

One recommendation made during the roundtable discussion was to
base the level of regulation regardless of what agency provided it
on the sophistication of the market participant, not on the market
in which the transaction occurred. Under this approach,
unsophisticated market participants would be subject to greater
regulatory protections than Proposals for Revising

Market Oversight

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 23 GAO/GGD-99-74 CFTC Reauthorization

sophisticated market participants; however, regulation within each
group would be consistent, regardless of whether trading occurred
on or off of an exchange.

A second recommendation was for CFTC to assume a supervisory role
similar to that of the U. S. banking regulators or the U. K.
single financial services regulator, FSA. U. S. banking regulators
focus on safety and soundness issues rather than regulations.
Under this approach, CFTC would rely more on the SROs to regulate
the markets. The U. K. 's FSA, created in 1997, plans to adopt a
flexible, risk- based approach to regulation that distinguishes
between the varying levels of consumer expertise. It is to use
cost- benefit analysis to ensure that the burdens imposed are
proportionate to their intended benefits. Also, FSA is to
recognize the desirability of maintaining the U. K. 's competitive
position in an international market.

A third recommendation was for regulation to be based on the
activity rather than on the institution or product. Activities
would be categorized according to the three basic goals of market
regulation protecting financial system integrity, market
integrity, and customers. Under this proposal, the sophistication
of the market participant would dictate the regulatory approach.
Sophisticated market participants would be subject to the U. S.
supervisory approach for banks, and unsophisticated market
participants would be subject to more traditional market
regulation.

A fourth recommendation was to replace the existing financial
market regulatory structure with a set of meaningful and
verifiable best practices whose guiding principle would be
transparency. These best practices would be applicable to all
significant market participants worldwide, including institutional
end- users, such as hedge funds, and would be designed to reduce
risks to participants and the financial system. They would address
internal controls, including risk management and credit
assessments; sales practices; documentation; information
availability; senior management accountability; and audit and
compliance. Rather than acting as a regulator, the federal
government would monitor systemic risk. Although existing
financial laws and regulations would be abandoned, best practices
would remain subject to antifraud and contract law. The
participant who made this recommendation was critical of the U. S.
regulatory system, in which different rules exist to address the
same risks in products that are indistinguishable. That is, to the
extent that the products are indistinguishable and the risks are
the same, he said that the rules addressing the risks should be
the same.

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 24 GAO/GGD-99-74 CFTC Reauthorization

Additionally, a former CFTC chairperson testified in December 1998
that differences between physical and financial futures justify
different regulatory approaches. First, she asserted that
financial futures, unlike futures on physical commodities,
generally do not serve a price discovery function. Second, she
noted that although exchanges facilitate the actual delivery of
physical commodities, this function is less necessary for cash
settled financial futures and requires less federal oversight.
Third, she said that financial futures are much less susceptible
to manipulation or supply distortions. Fourth, she noted that
participants in the financial futures market are often supervised
by bank or securities regulators. In a 1999 journal article, she
reiterated these views and noted that given the rapid improvement
in trading technology, the globalization of markets, and
increasingly open avenues of international trade, care must be
taken to ensure that a domestic regulatory structure does not
chase business offshore. Similarly, the Chairman of the Federal
Reserve Board observed that the OTC derivatives market functions
effectively without the benefits of CEA regulation, providing a
strong argument for less regulation of exchange- traded financial
derivatives.

Federal regulations applicable to U. S. futures exchanges and
other regulated market participants are identifiable and impose
costs. However, our previous work has shown that difficulties
exist in measuring the incremental costs of regulation. One
measurement difficulty is distinguishing actual compliance costs
from those costs that would have been incurred as a normal
business expense in the absence of federal regulation. Futures
exchanges have noted that certain regulations provide benefits and
would be retained in exchange rules regardless of whether they
were required by CFTC. The exchanges, however, have not specified
which regulations would be maintained in the absence of CFTC
requirements, making it difficult to measure actual compliance
costs. Similar measurement difficulties exist for other regulated
market participants. For example, in the absence of CFTC
regulation, futures commission merchants (FCM) could still be
subject to regulations imposed on them by exchanges and, if
registered as broker- dealers, by SEC. Additionally, measuring
indirect costs, such as lost productivity or income resulting from
regulations, is more difficult than measuring direct costs.

Even if the incremental costs of regulation could be accurately
measured, such information would be of limited usefulness without
corresponding information on the benefits of regulation. Measuring
the benefits of regulation can be more difficult than measuring
costs particularly for regulatory agencies like CFTC whose
regulations are intended to prevent or deter violations, such as
manipulation and fraud. Moreover, although Costs and Benefits of

Futures Market Regulation Are Difficult to Measure

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 25 GAO/GGD-99-74 CFTC Reauthorization

costs are typically measured in dollars, benefits cannot always be
measured quantitatively. For example, futures industry
representatives and other market participants have indicated that
federal regulation enhances market integrity and customer
protection and promotes the perception that the market and the
financial intermediaries through which users gain access are fair.

CFTC has noted that it considers the costs and benefits that may
result from the rules that it adopts relying, in part, on public
comments. The futures exchanges have supported the use of cost-
benefit analysis, noting that excessive regulation jeopardizes
their competitiveness relative to foreign futures and OTC
derivatives markets. Other market participants and observers have
stressed the importance of ensuring that regulatory costs do not
exceed benefits, citing CFTC's contract approval requirement and
federal audit trail standards, both required by statute, as
examples of regulations whose costs appear to outweigh benefits.

At the CFTC reauthorization roundtable discussion, one participant
commented that it is extremely difficult to analyze the costs and
benefits of futures regulation. He said that costs are measured in
dollars and benefits are measured qualitatively, making the
comparison between them subjective. Another participant agreed
that measuring regulatory costs and benefits is difficult, but he
also said that attempts should be made to do so. He indicated that
cost- benefit analysis should be used to task CFTC with proving
that regulatory benefits exceed costs. Also, as discussed above,
one participant recommended that CFTC assume a supervisory role
similar to that of the U. S. banking regulators or the U. K.
single regulator. The latter plans to use cost- benefit analysis
in deciding whether to issue new regulations.

Finally, roundtable participants warned that overly burdensome
regulations could be avoided by moving transactions to other
markets. For example, OTC derivatives could be used instead of
exchange- traded futures to avoid triggering CFTC's registration
or large trader reporting requirements. Also, market participants
that seek access to markets closed to U. S. citizens could
transact through offshore foreign entities. One roundtable
participant indicated that entities seeking such access were
typically large, sophisticated institutions that did not need the
protections offered by the CEA.

Appendix II Regulatory Reform Efforts for Exchange- Traded
Derivatives

Page 26 GAO/GGD-99-74 CFTC Reauthorization

Financial Integrity/ Systemic Risk: 1. How do the financial
integrity/ systemic risk issues posed by the

exchange- traded derivatives markets differ from those of the OTC
derivatives markets, and what are the regulatory implications?

Market Integrity/ Efficiency: 2. How are the risks posed by
financial futures and options different from

those of physical commodities (e. g., as they relate to price
discovery and market manipulation); and what are the regulatory
implications?

3. What are the implications of a regulated and unregulated
exchange market operating side- by- side for the same or different
contracts?

4. What are the major risks, if any, that threaten the integrity
and efficiency of a futures market limited to sophisticated market
participants, and what are the regulatory implications of any such
risks?

5. To what extent can the costs and benefits of futures market
regulations be measured in an objective, consistent, and reliable
manner that allows for a meaningful comparison between them?

6. How should the terms futures contract and board- of- trade be
defined, if at all, in the CEA?

7. What is the appropriate role for CFTC in approving new
contracts proposed for trading by a futures exchange?

Customer Protection: 8. How do the customer protection issues
posed by the exchange- traded

derivatives markets differ from those of the OTC derivatives
markets, and what are the regulatory implications?

9. How do the customer protection issues differ between tiers in a
market differentiated by the sophistication of market
participants, and what are the regulatory implications?

10. Absent CFTC regulations, what protections exist or should
exist for OTC market participants? Public Policy

Questions Raised by Regulatory Reform Efforts for ExchangeTraded
Derivatives

Appendix III The Shad- Johnson Jurisdictional Accord

Page 27 GAO/GGD-99-74 CFTC Reauthorization

The Shad- Johnson Jurisdictional Accord is an agreement reached
between the Chairmen of SEC and CFTC in 1981 to resolve a dispute
concerning jurisdiction over securities- based derivatives. The
dispute was precipitated by CFTC's 1975 approval of a Chicago
Board of Trade (CBT) futures contract on Government National
Mortgage Association pass- through mortgage- backed certificates.
SEC challenged CFTC's decision, asserting that the contracts for
future delivery of these certificates were securities falling
within its regulatory jurisdiction. SEC later approved an option
on the certificates for trading on a securities exchange. CBT
subsequently prevailed in a court challenge of SEC's approval,
arguing that the option was subject to CFTC's exclusive
jurisdiction. In 1981, the SEC and CFTC Chairmen entered into an
agreement to clarify each agency's jurisdiction. This agreement
was codified in the Securities Acts Amendments of 1982 and in the
Futures Trading Practices Act of 1982 that amended the CEA by,
among other things, adding section 2( a)( 1)( B). (See the
glossary at the end of the report for definitions.)

Under the accord, CFTC retained exclusive jurisdiction over all
futures contracts, including futures on securities- based indexes
and options on futures and physical commodities. CFTC was also
given jurisdiction over options on foreign currencies not traded
on a national securities exchange (subject to the limitations
imposed by the Treasury Amendment). (See app. IV on the Treasury
Amendment.) Futures and options on futures on securities indexes
were allowed only for contracts settled in cash, not readily
susceptible to manipulation, and derived from a substantial
segment of a publicly traded group or index of equity or debt
securities, called broad- based indexes. Such contracts were also
subject to initial SEC review for compliance with these
requirements. If SEC determined that a proposal did not meet these
requirements, CFTC could not approve the contract for trading. 1
Under the accord, SEC retained jurisdiction over securities,
including options on securities, options on certificates of
deposit, options on securities indexes, and options on foreign
currency traded on a national securities exchange.

Futures contracts on individual securities, other than exempted
securities (such as U. S. Treasuries), were prohibited by the
accord. The CFTC chairman who negotiated the accord stated at the
CFTC reauthorization roundtable that the accord was intended to
ban certain stock- based futures until issues of concern to SEC
could be addressed. According to the legislative history, SEC was
concerned that the regulatory scheme

1 Under the accord, SEC authority applied only to contracts
proposed on or after December 9, 1982. The accord provided that
CFTC was to consult with SEC on proposals made before that date.
Rationale for the

Accord

Appendix III The Shad- Johnson Jurisdictional Accord

Page 28 GAO/GGD-99-74 CFTC Reauthorization

governing futures trading did not mirror securities regulation in
important areas such as insider trading prohibitions, customer
protections, floor trading rules, and margin requirements. The
former CFTC chairman said that at the time the accord was
negotiated, CFTC had been willing to address these concerns but
the two agencies could not reach agreement on jurisdiction over
the prohibited products.

Questions have remained about how to regulate products covered by
the accord. In 1987, after the stock market crash, SEC and the New
York Stock Exchange cited trading in stock index futures for
exacerbating stock volatility during the crash and threatening the
future stability of the stock market. As a result, SEC requested
that Congress shift oversight responsibility for stock index
futures from CFTC to SEC. No action was taken on this request;
however, Congress granted oversight authority for setting margins
on stock index futures to the Federal Reserve under the Futures
Trading Practices Act of 1992.

In 1989, several stock exchanges introduced contracts, called
index participations, to provide investors with a relatively low-
cost way to obtain an index- equivalent portfolio. The courts
subsequently ruled, in response to a suit by Chicago futures
exchanges, that the index participations were futures contracts
and thus could be offered only on CFTC- regulated futures
exchanges. As a result, these contracts ceased trading. The
American Stock Exchange subsequently developed a securities
product that offered investors a benefit similar to these
contracts by providing them an interest in the holdings of a
trust.

The Futures Trading Practices Act of 1992 gave CFTC broad
authority to exempt swaps and other OTC derivatives from all CEA
provisions except section 2( a)( 1)( B), which codified the
accord. Because of their similarities to exchange- traded futures,
certain OTC derivatives faced the possibility of falling within
the judicially crafted definition of a futures contract. This
possibility posed a legal risk for such contracts because of the
CEA requirement that futures be traded on an exchange to be legal
and, thus, enforceable. CFTC's 1993 swaps exemption eliminated
this legal risk for qualifying contracts. However, the exemption
did not eliminate the legal risk for securities- based swaps,
contracts whose returns are based on the prices of securities or
securities indexes, because these contracts might be prohibited by
or subject to CEA section 2( a)( 1)( B).

According to market observers, if securities- based swaps were
found to be futures contracts, they could be in violation of
section 2( a)( 1)( B) and, thus, be illegal and unenforceable.
First, swaps on individual securities Evidence of Continued

Uncertainty

Appendix III The Shad- Johnson Jurisdictional Accord

Page 29 GAO/GGD-99-74 CFTC Reauthorization

that were deemed futures would violate section 2( a)( 1)( B),
which prohibits futures on individual securities. Second, swaps on
securities indexes that were deemed futures would violate the CEA
requirement that futures trade on an exchange. However, swaps
counterparties can still rely on CFTC's swaps policy statement,
which sets forth the conditions under which CFTC would not
regulate certain swaps as futures, to address their legal concerns
under section 2( a)( 1)( B). Provisions of a 1997 Senate bill to
amend the CEA (S. 257) were intended to provide greater legal
certainty for all swaps by codifying the existing swaps exemption
and, for securitiesbased swaps, by extending the scope of the
exemption to include section 2( a)( 1)( B). (See app. I on CFTC's
exemptive authority for OTC derivatives.)

In July 1998, SEC exercised its authority under section 2( a)( 1)(
B) and objected to a CBT application to trade futures based on the
Dow Jones utility and transportation indexes. According to SEC's
written decision, this was the first time SEC had objected to a
proposed stock- index futures contract since 1984. Under the
securities laws, SEC had approved options on these same indexes
for trading on the Chicago Board Options Exchange in 1997. SEC
determined that the CBT- proposed contracts on the Dow Jones
utility and transportation indexes did not satisfy the substantial
segment requirement of the accord. In July 1998, CBT challenged
SEC's determination in federal court. In November 1998, CFTC filed
a brief in support of CBT, asserting that SEC had not accurately
interpreted the provisions of the accord. In January 1999, the New
York Stock Exchange and Chicago Board Options Exchange filed a
brief in support of SEC, asserting SEC's determination was
necessary to protect against injury to the securities markets. The
case is pending.

Finally, although the accord generally divided jurisdiction
between CFTC and SEC, the accord allowed options on foreign
currency to be traded on exchanges under either jurisdiction.
Currently, foreign currency options exist on both futures and
securities exchanges, but the futures exchange options are
dormant.

The 1997 House bill (H. R. 467) to amend the CEA would have
established unregulated professional markets exempt from CEA
section 2( a)( 1)( B). One result would have been to legalize
exchange- trading of futures on individual stocks or on narrowly
based stock indexes. In testifying on the House bill, SEC
expressed concern that by stripping it of its oversight authority
under the accord, the bill would eliminate an important tool for
overseeing the markets for equities and equity derivatives. SEC
was also concerned that because the futures and securities markets
were linked, Addressing the

Prohibition on StockBased Futures

Appendix III The Shad- Johnson Jurisdictional Accord

Page 30 GAO/GGD-99-74 CFTC Reauthorization

undetected fraud and manipulation in futures markets caused by a
lack of audit trails, books and records, and trade reporting
requirements would inevitably spill over into the securities
markets.

At the CFTC reauthorization roundtable discussion, several
participants questioned the rationale for banning futures on
individual stocks. They stated that concerns about the risks
associated with allowing exchangetrading of these contracts ignore
the fact that equivalent products are already being traded in the
United States. Currently, market participants can create the
equivalents to futures on individual stocks, called synthetic
instruments, by taking positions in the options and stock markets.
Also, swaps based on stocks are traded in the OTC market. Although
not discussed at the roundtable, futures based on stocks are
traded on some foreign futures exchanges. For example, exchanges
in Australia and Hong Kong trade futures on individual domestic
stocks and have considered trading futures on major U. S. stocks.

A roundtable participant who worked at SEC when the accord was
negotiated identified several issues that he believed should be
addressed before futures on individual stocks and narrowly based
stock indexes are allowed to trade on exchanges and before a
regulator for these products is determined. These issues are
similar to those that were of concern to SEC when the accord was
negotiated and relate to insider trading, customer protection,
market manipulation, and leverage limits. Additionally, one
participant said that rules limiting the sale of borrowed stocks
when the stock is declining in price, called short- sale rules,
would also need to be examined. The current CFTC chairperson
stated at a March 1999 futures conference that if Congress
excluded equity swaps from the CEA it should also consider
permitting futures on equities to be traded on futures exchanges,
subject to an appropriate regulatory framework.

In a joint statement submitted to the Senate and House Agriculture
Committees on March 19, 1999, the U. S. Securities Market
Coalition expressed its opposition to lifting the ban. Citing the
issues that were of concern when the accord was negotiated, the
statement concluded that lifting the ban could disrupt the
securities markets and undermine investor confidence in these
markets. An SEC official also expressed these views to us,
emphasizing the agency's concern that if the ban were lifted, the
futures markets could become the pricing mechanism for securities.
The official said the agency was concerned that if price discovery
for securities occurred on the futures markets, the goals of the
federal securities law could be undermined, regulatory disparities
could be exploited to the

Appendix III The Shad- Johnson Jurisdictional Accord

Page 31 GAO/GGD-99-74 CFTC Reauthorization

detriment of securities investors, and liquidity in the securities
markets could be dissipated.

Financial Integrity/ Systemic Risk and Market Integrity/
Efficiency: 1. To what extent do futures on individual stocks and
narrowly based

stock indexes raise financial integrity/ systemic risk or market
integrity risks that are different from those raised by options on
such stocks and stock indexes?

2. What are the implications, if any, to the efficiency and
integrity of the U. S. securities markets of separating the
regulation of stock and stock index futures from the regulation of
the underlying stocks?

3. What are the implications should foreign exchanges trade
futures on individual U. S. stocks and narrowly based U. S. stock
indexes? Public Policy

Questions Raised by the Accord

Appendix IV The Treasury Amendment

Page 32 GAO/GGD-99-74 CFTC Reauthorization

Before 1974, the CEA provided for CFTC's predecessor to regulate
futures trading in those commodities specifically listed in the
act. Futures trading in other commodities was not subject to the
act, including its exchangetrading requirement. In 1974, Congress
proposed amending the CEA to expand the list of commodities
covered by the act to include not only physical commodities but
also intangibles, such as interest and foreign exchange rates. The
proposed amendments would have significantly broadened the
transactions that would be subject to regulation under the act.
Under the CEA, any contracts that were defined as futures but
traded off- exchange, or OTC, would be illegal. (See the glossary
at the end of the report for definitions.)

The Department of the Treasury expressed concern that the proposed
expansion of the CEA's commodity definition, when coupled with the
act's exchange- trading and other provisions, would prohibit banks
and other financial institutions from trading among themselves in
foreign currencies and certain financial instruments, including
government securities. According to Treasury, virtually all U. S.
futures trading in foreign currencies was conducted off- exchange
through an informal network of banks and dealers (called the
interbank market), which served the needs of international
business to hedge risk stemming from foreign exchange rate
movements. Treasury asserted that unlike some participants in the
exchange- traded markets who might need the protection provided by
government regulation, foreign exchange market participants were
sophisticated and informed institutions not requiring such
protection. In response to Treasury's concern, Congress adopted
the Treasury Amendment to exclude from CFTC regulation certain
transactions in, among other things, foreign currency and
government securities, unless conducted on a board of trade. As
part of the legislative history accompanying the 1974 amendments
to the CEA, which included the Treasury Amendment, Congress noted
that the interbank market was more properly supervised by bank
regulators and, thus, regulation by CFTC 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 and
government securities, unless the transaction involves a sale for
future delivery conducted on a board of trade. Before the February
1997 U. S. Supreme Court decision in Dunn v. CFTC, considerable
debate occurred over the meaning of the phrase transactions in,
which partly Rationale for the

Treasury Amendment Problems Interpreting the Treasury Amendment

Appendix IV The Treasury Amendment

Page 33 GAO/GGD-99-74 CFTC Reauthorization

defines the scope of the exclusion. In Dunn, the U. S. Supreme
Court interpreted the phrase transactions in to include futures
and options contracts, but it did not address the meaning of the
term board of trade as used in the unless clause. The CEA defines
the term board of trade 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. 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.

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. An OTC foreign currency transaction 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. Consistent with this philosophy, CFTC brought 33
cases involving the illegal sale of foreign currency futures or
option contracts to the general public since its inception through
1998. These cases involved more than 3,800 customers who invested
over $260 million. 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. According to some market
observers, other federal agencies, such as the Federal Trade
Commission, and state agencies can also protect retail customers
from investment fraud.

In contrast to CFTC, Treasury has advocated the reading of the
Treasury Amendment adopted by the U. S. Supreme Court in Dunn that
is, the 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. It has
objected to CFTC's approach to the Treasury Amendment, noting that
it lacks a foundation in the language of the statute. According to
Treasury, CFTC enforcement actions CFTC and the Treasury

Department Have Interpreted the Treasury Amendment Differently

Appendix IV The Treasury Amendment

Page 34 GAO/GGD-99-74 CFTC Reauthorization

involving OTC foreign currency derivative transactions have raised
significant issues about the scope of the amendment. Although CFTC
actions have been aimed at protecting unsophisticated market
participants from fraud, Treasury noted that such actions have
created uncertainty over which OTC transactions the amendment
excludes from CEA coverage and, in turn, have generated legal
uncertainty in the financial markets. Nevertheless, it has
expressed sympathy with CFTC's concerns over fraudulent foreign
currency contracts marketed to the general public. Treasury has
agreed 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.

The Foreign Exchange Committee which represents major U. S. and
foreign banks and brokers and other market participants have
expressed concerns similar to those of Treasury. Market
participants have noted that uncertainty regarding the amendment's
scope raises questions about the legal enforceability of OTC
foreign currency contracts involving U. S. parties. They believe
that such uncertainty needs to be addressed, given the foreign
currency market's size and significance to the U. S. economy.
According to CFTC staff, the agency has been taking enforcement
actions involving OTC foreign currency derivatives since at least
1985, and available evidence does not indicate that these actions
have resulted in legal uncertainty.

Market participants have noted that larger scale participants in
OTC foreign currency transactions could respond to legal
uncertainty by shifting trading to their overseas offices. These
market participants have argued that if a sufficiently large shift
in trading were to occur, liquidity in the U. S. foreign currency
markets would be reduced to the detriment of U. S. businesses
engaged in foreign trade. According to a BIS survey, the average
daily turnover in the traditional foreign exchange market was
about $1.49 trillion as of April 1998. The U. S. share of this
market was 18 percent, ranking it second behind the United
Kingdom, whose share was 32 percent.

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 inter- dealer foreign currency
market from regulation. However, past court cases have highlighted
the difficulty in interpreting the meaning of a board of trade as
used in the Treasury Amendment and the legal confusion over
whether the amendment excludes from the act's Federal Court

Interpretations of the Treasury Amendment Have Differed

Appendix IV The Treasury Amendment

Page 35 GAO/GGD-99-74 CFTC Reauthorization

regulation transactions in foreign currencies that involve the
general public. 1

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.

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 Supreme Court, however, did not address the definition
of a board of trade.

The Fourth Circuit Court, in Salomon Forex, Inc. v. Tauber, held
that offexchange sales of currency futures and options to a
wealthy individual were 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.,
affirmed a lower court holding that the Treasury Amendment
excludes the sale of offexchange foreign currency futures and
options from the CEA without regard to whom the contracts are
sold. CFTC brought an 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.

1 While we refer in the text to decisions by federal circuit
courts of appeal, two decisions by the federal district court in
New York (CFTC v. Standard Forex, Inc. (1993) and CFTC v. Rosner
(1998)) interpreted board of trade in the context of the Treasury
Amendment to include sales to the general public of futures based
on foreign currency by firms not otherwise subject to government
regulation. The Standard Forex interpretation was expressly
rejected by the Ninth Circuit in the Frankwell Bullion decision
(1996) discussed in the text.

Appendix IV The Treasury Amendment

Page 36 GAO/GGD-99-74 CFTC Reauthorization

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.

The 1997 Senate bill (S. 257) to amend the CEA included a
provision to clarify the scope of the Treasury Amendment.
According to an accompanying discussion document, the bill
reflected 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 document further noted that the bill
intended that CFTC would have no jurisdiction over nonretail
transactions conducted off- exchange or retail transactions that
were subject to oversight by other federal regulators. CFTC stated
that it opposed the provision because it would have (1) extended
the amendment's exemption to certain exchange- traded futures and
(2) eliminated CEA protections afforded to retail investors in OTC
transactions. Treasury did not take a position on the provision.
However, the agency supported providing CFTC with authority to
prosecute unregulated firms defrauding retail customers but
without burdening successful, efficient markets. The Foreign
Exchange Committee supported the provision's intent of providing
legal certainty to OTC transactions but suggested modifying it to
limit CFTC's jurisdiction to policing fraud. The futures exchanges
supported the provision because it would have clarified that CFTC
has jurisdiction over unregulated entities offering foreign
currency futures to retail investors but not over markets that
exclude the general public.

The 1997 House bill (H. R. 467) to amend the CEA proposed, 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
would have defined board of trade in the context of the Treasury
Amendment as any facility whereby standardized contracts are
systematically marketed to retail investors. CFTC opposed the
provision, in part, because it would have Proposals to Clarify

the Scope of the Treasury Amendment

Appendix IV The Treasury Amendment

Page 37 GAO/GGD-99-74 CFTC Reauthorization

permitted exchanges to trade certain futures free from CFTC
regulation. Treasury did not take a position on the provision but
supported providing CFTC with authority over unregulated entities
that defraud retail investors. The Foreign Exchange Committee
supported the provision but suggested modifying it to limit CFTC's
jurisdiction to unregulated entities and to preserve federal
oversight of the futures exchanges.

Participants in the CFTC reauthorization roundtable discussion
noted the importance of the Treasury Amendment in providing legal
certainty to OTC foreign currency and other covered transactions.
At the same time, however, some recognized the need to protect
unsophisticated retail investors from unregulated firms
fraudulently marketing OTC foreign currency derivatives. Although
one participant advocated abolishing the Treasury Amendment, his
goal was to provide equal regulatory treatment to exchange- traded
and OTC derivatives. He objected to market participants being
excluded from regulation under the CEA when transacting in OTC
instruments covered by the amendment, but being regulated when
trading similar instruments on an exchange. He supported
regulation based on the sophistication of the market participant.
(See app. II on regulatory reform efforts for exchange- traded
derivatives.)

Market Integrity/ Efficiency: 1. To what extent does the legal
uncertainty faced by market participants

under the Treasury Amendment adversely affect the efficiency of
the market?

Customer Protection: 2. How should the Treasury Amendment be
changed, if at all, to clarify

whether unsophisticated market participants are covered by the CEA
when transacting in foreign currency or other enumerated
instruments?

3. To what extent should unregulated entities be allowed to engage
in OTC transactions with unsophisticated market participants?
Public Policy

Questions Raised by the Treasury Amendment

Appendix V The Forward Exclusion

Page 38 GAO/GGD-99-74 CFTC Reauthorization

Congress excluded forward contracts from the CEA to facilitate the
movement of commodities through the merchandizing chain. Absent a
statutory definition of a forward, CFTC and the courts have
defined forwards in reference to futures. Consistent with the CEA
reference to forwards as involving the sale of cash commodities
for deferred delivery, forwards have been distinguished from
futures on the basis of whether the contract served primarily as a
vehicle for deferred delivery or risk shifting. Because forwards
primarily serve a merchandizing purpose, they are expected to
entail delivery, but delivery is expected to occur at a later
date. In contrast, futures primarily serve a risk- transferring
function, and actual delivery is not generally expected to occur.
(See the glossary at the end of the report for definitions.)

Although the CEA excludes forwards from its regulation because of
their merchandizing purpose, the act does not specify what
constitutes delivery under the exclusion and, thus, does not
clearly differentiate forwards from futures. The evolution of
certain contracts in which delivery may not routinely occur has
made it increasingly difficult to distinguish unregulated forwards
from regulated futures and, as discussed below, can result in
legal risk regarding the enforceability of such contracts.

A 1986 lawsuit focused on whether Brent oil contracts OTC
contracts for the future purchase or sale of Brent oil were
forwards or futures. A firm had sued its counterparties to Brent
oil contracts for violating the CEA's antimanipulation provisions.
The counterparties responded that the contracts were forwards and
thus excluded from the CEA because no contractual right existed to
avoid delivery. In 1990, a federal district court rejected the
claim and found that the contracts were futures. The court
concluded that even though the contracts did not include a
contractual right of offset to avoid delivery, the opportunity to
offset contracts and the common practice of doing so were
sufficient to determine that the contracts were futures. Because
the court's decision created the possibility that Brent oil
contracts could be illegal, off- exchange futures, market
participants urged CFTC to issue an interpretation to clarify the
status of these contracts under the CEA. According to market
observers, as a result of the court decision, many participants in
the Brent oil market permanently stopped entering these contracts
in the United States.

In a subsequent 1990 statutory interpretation on forwards, CFTC
adopted the view that Brent oil contracts were forwards, because
they required the commercial parties to make or take delivery,
even though they did not routinely do so. CFTC stated that the
contracts did not include any provisions that enabled the parties
to settle their contractual obligations Historical Definition of

a Forward Contract Problems Differentiating Forwards From Futures

Appendix V The Forward Exclusion

Page 39 GAO/GGD-99-74 CFTC Reauthorization

through means other than delivery, and the settlement of contracts
without delivery was done through subsequent, separately
negotiated contracts. In 1993, to provide the market with greater
legal certainty, CFTC used its newly granted authority to exempt
Brent oil and other OTC energy contracts from virtually all CEA
provisions. (See app. I on CFTC exemptive authority for OTC
derivatives.) However, this exemption did not address the legal
risk faced by OTC derivatives that resembled both forwards and
futures but were not based on energy- related commodities, such as
agricultural commodities.

Although CFTC's statutory interpretation on forwards was intended
to reduce the legal risk surrounding Brent oil contracts and allow
that market to evolve, it did not provide a clear basis for
distinguishing forwards from futures on the basis of their
economic purpose. That is, it did not preclude forwards from being
settled routinely without delivery and, in the process, being used
primarily for risk- shifting or speculative purposes instead of
merchandizing purposes. In dissenting from the agency's
interpretation on forwards, a CFTC commissioner stated that it
broadened the CEA's forward exclusion to include transactions that
were standardized, used for noncommercial purposes, and offset.

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
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 pre- established level. Based largely on this provision, a CFTC
settlement order found these contracts to be illegal, offexchange
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 action broadened the definition of a futures contract and
resulted in greater legal risk for forwards and securities- based
swaps.

In 1996, CFTC filed a complaint against a grain elevator, alleging
that certain of its hedge- to- arrive (HTA) contracts were
illegal, off- exchange futures. In 1997, before CFTC's case was
heard, a federal district court held in a separate civil case
involving the same grain elevator and its producers that the
elevator's HTA contracts were forwards and excluded from the CEA.
The court found that the contracts were grain marketing

Appendix V The Forward Exclusion

Page 40 GAO/GGD-99-74 CFTC Reauthorization

instruments, noting that the parties were in the business of
growing and merchandizing grain and had the ability to make or
take delivery. Given the court's decision, the grain elevator
requested that the court dismiss CFTC's case, but the request was
denied. The federal district court also refused to block CFTC's
case. In 1998, a CFTC administrative law judge found that the
grain elevator's HTA contracts at issue in the case were futures
and not forwards. The administrative law judge found that the
contractual terms of the elevator's HTA contracts readily allowed
producers to unilaterally and unequivocally avoid delivery for any
reason.

In January 1999, CFTC filed administrative complaints against two
other grain elevators alleging, among other things that their HTA
contracts were illegal, off- exchange futures. Although the facts
and circumstances differed between the two cases, CFTC found in
one case and charged in the other that the contracts were futures,
in part, because they could be terminated without delivery.
Dissenting against both complaints, a CFTC commissioner maintained
that the elevators' HTA contracts were forwards, noting that the
contracts were limited to commercial parties and included a
contractual obligation to deliver.

Market Integrity/ Efficiency: 1. What types of OTC transactions
should be covered by the CEA's

forward exclusion? 2. To what extent should the forward exclusion
turn on the nature of the

counterparty to a forward contract? Public Policy

Questions Raised by the Forward Exclusion

Appendix VI Agricultural Trade Options

Page 41 GAO/GGD-99-74 CFTC Reauthorization

Under the CEA of 1936, Congress banned exchange- traded and OTC
options on regulated commodities because of their suspected role
in disrupting the market. Regulated commodities were those
commodities specifically listed in the CEA and initially included
corn, wheat, oats, barley, rye, flax, and sorghum. As Congress
periodically amended the CEA, it added other agricultural
commodities to the list, effectively extending the scope of the
act's options ban. In aggregate, the regulated agricultural
commodities became known as the enumerated commodities; all others
became known as the nonenumerated commodities. (See the glossary
at the end of the report for definitions.)

In 1974, Congress amended the CEA to create CFTC and bring all
nonenumerated commodities under federal regulation. Rather than
adding new commodities to the act's list, Congress amended the
commodity definition with a catchall phrase to include virtually
anything, thereby bringing futures and options trading on all
commodities under the CEA. This broadening of the act's scope was
meant, in part, to address abusive practices and fraud in the
marketing of options on nonenumerated commodities. Under the act's
authority, CFTC promulgated a regulatory framework for trading
these previously unregulated commodities.

In 1978, responding to continued fraud and abuse, CFTC suspended
OTC options trading on the nonenumerated commodities, except for
trade options off- exchange commodity options offered or sold to
commercial users of the underlying commodity solely for purposes
related to their business. Later in 1978, Congress codified CFTC's
ban but provided CFTC with the authority to lift the prohibition
on trading options on nonenumerated commodities after notifying
Congress. The 1936 statutory ban and CFTC rule prohibiting options
on the enumerated commodities remained in effect.

Since 1978, CFTC and congressional actions have narrowed the scope
of the ban on commodity options to allow for exchange- trading of
options. Under a 1981 pilot program, CFTC allowed exchanges to
trade options on futures contracts on the nonenumerated
commodities. On the basis of the experience of the pilot program,
the Futures Trading Act of 1982 lifted the 1936 statutory ban on
options on the enumerated commodities. Under a 1983 pilot program,
CFTC allowed exchange- trading of options on futures contracts on
the enumerated commodities but did not allow exchangetrading of
options on the underlying physical commodities. CFTC permitted
this limited exchange- trading of options because such trading
would be subject to the comprehensive regulation of an exchange.
History of the Ban on

Commodity Options Narrowing of the Commodity Option Trading Ban

Appendix VI Agricultural Trade Options

Page 42 GAO/GGD-99-74 CFTC Reauthorization

On numerous occasions since 1984, CFTC has sought public comment
or facilitated public discussion on lifting the prohibition on
trade options on the enumerated commodities. Until recent changes
in U. S. agricultural programs, however, industry opposition
impeded a lifting of the ban. Through a 1985 interpretative letter
on forwards, CFTC lessened the debate by permitting producers to
obtain certain of the benefits associated with the use of
agricultural trade options by using bona fide forward contracts
containing option- like features. (See app. V on the forward
exclusion.)

On the basis of the results of the pilot programs and a shifting
of industry views, CFTC began to consider lifting the ban on trade
options on the enumerated commodities. In a 1997 study, CFTC
concluded that the elimination of certain U. S. agricultural
programs (e. g., elimination of crop deficiency payments) and
changes in international markets (resulting in part from changes
in trade agreements) increased uncertainty and price volatility in
the agricultural markets, warranting new forms of risk- shifting
instruments. Accordingly, in April 1998, after two rounds of
public comment, CFTC published rules for a 3- year pilot program
for trade options on the enumerated commodities. To allow for
competition by the exchanges, CFTC also removed the prohibition on
exchange- trading of options on the commodities enumerated in the
act.

The pilot program is limited to agricultural trade options on the
enumerated commodities and requires that the options result in
delivery of the commodity. Such options may not be resold,
repurchased, or otherwise cancelled, except through the exercise
or natural expiration of the contract. Also, the pilot program
permits only those entities that handle the commodity in normal
cash market channels to solicit, offer to buy or sell, or buy or
sell such options. Vendors of such options, usually grain
elevators, are required to register as agricultural trade option
merchants with NFA, report transactions to CFTC, provide customers
with disclosure statements, keep books and records, and safeguard
customers' premiums. Certain employees of these merchants are also
required to register and meet training requirements. The rules
also include an exemption for commercials with not less than $10
million in net worth. According to CFTC, the program rules were
designed to protect program participants and to account for recent
experience with agricultural marketing schemes; for example, HTA
contracts. CFTC reported that although the pilot program is a 3-
year test, it would consider changes to these rules, as experience
warrants, before the conclusion of the test. CFTC Pilot Program

on Agricultural Trade Options

Appendix VI Agricultural Trade Options

Page 43 GAO/GGD-99-74 CFTC Reauthorization

According to CFTC, as of April 20, 1999, no firm had applied to
NFA to become an agricultural trade option merchant. Some
producers and industry representatives have told CFTC that the
rules of the pilot program are too onerous. In particular, they
said that the delivery requirement reduced the potential benefit
of the options, and the paperwork requirements were too
burdensome. Industry representatives compared the proposed
regulations to other trade options that are exempt from
regulation. They proposed, among other changes, lowering the net
worth exemption to $1 million, consistent with the swap exemption.
According to CFTC, the lack of interest in the program may be due
to producers (1) not wanting to lock into prevailing low commodity
prices and (2) focusing on production rather than marketing
strategies at the time the program was introduced. Additionally,
CFTC identified a general lack of knowledge about the program.
CFTC officials told us that the agency has issued three
educational brochures that will also be available on the Internet.
A participant at the CFTC reauthorization roundtable discussion
commented that CFTC regulations were an overly conservative
reaction to the HTA controversy. Another suggested that CFTC grant
trade options an exemption from the CEA similar to that provided
to swaps. (See app. I on CFTC exemptive authority for OTC
derivatives.)

Market Integrity/ Efficiency:

 How can the rules of the agricultural trade options program be
changed to better address industry concerns and encourage
participation, while also providing sufficient market and customer
protections? Status of the Pilot

Program Public Policy Question Raised by Agricultural Trade
Options

Appendix VII Electronic Trading Systems

Page 44 GAO/GGD-99-74 CFTC Reauthorization

The Futures Trading Practices Act of 1992 mandated that CFTC (1)
facilitate the development and operation of electronic trading as
an adjunct to open outcry systems and (2) assess the benefits of
U. S. electronic trading systems. Under open outcry systems,
futures are traded by floor participants who verbally or through
hand signals make bids and offers to each other at centralized
exchange locations. In contrast, under electronic trading systems,
bids and offers are entered into a host computer through computer
terminals and then electronically matched and executed. (See the
glossary at the end of the report for definitions.)

CFTC addressed the 1992 act's mandates in a November 1994 report.
First, CFTC reported that the agency facilitated the development
and operation of electronic trading by reviewing and approving the
Chicago Mercantile Exchange (CME) and New York Mercantile Exchange
(NYMEX) electronic trading systems. The CME system, called Globex,
and the New York system, called NYMEX ACCESS, began operating in
1992 and 1993, respectively. (The CBT electronic system, called
Project A, was approved by CFTC and began operating in 1994 but
was not sufficiently advanced to be addressed in CFTC's report.)
CFTC also reported that it entered into information- sharing
arrangements with foreign regulators to assist CBT and NYMEX in
placing in foreign countries computer terminals that would provide
access to their electronic trading systems. CFTC further reported
working through the International Organization of Securities
Commissions to develop international principles for regulatory
review of electronic trading systems that were published in 1990.
According to CFTC, it has adopted these general principles, uses
them as part of its process for reviewing electronic trading
systems, and is working with foreign regulators to assess the need
to update them.

Second, CFTC reported the results of its assessment of the CME and
NYMEX electronic trading systems. CFTC found that these systems
(1) enhanced market access by extending exchange trading hours and
providing direct market access, (2) improved the agency's audit
ability by providing precise and unalterable audit trails, and (3)
appeared to reduce the opportunity for trading abuse by
electronically executing trades and providing precise audit
trails. CFTC concluded that it needed to clarify exchange
responsibilities for supervising such systems and would consider
establishing standards and procedures for technical reviews of
electronic trading systems. According to CFTC officials, the
agency has not explicitly established such standards or procedures
but has implicitly defined them in its review and approval of the
Cantor Financial Futures Exchange (CFFE) (discussed below). CFTC
Role in

Facilitating the Development of Electronic Systems

Appendix VII Electronic Trading Systems

Page 45 GAO/GGD-99-74 CFTC Reauthorization

Although CBT, CME, and NYMEX principally rely on open outcry
systems to trade futures, they have continued their efforts to
expand the use of electronic trading systems. These efforts
include introducing new contracts for electronic trading,
extending the trading hours of their electronic systems so that
certain contracts can be simultaneously traded on the exchange
floor and electronically, and increasing the number of computer
terminals in domestic and foreign locations. Today, all three
electronic systems operate internationally: CBT has terminals in
France, Japan, and the United Kingdom; CME has terminals in
Bermuda, France, Hong Kong, Japan, and the United Kingdom; and
NYMEX has terminals in Australia, Hong Kong, and the United
Kingdom. In response to the exchanges' expansion efforts,
electronic trading volume at each exchange has grown rapidly. For
example, CBT, CME, and NYMEX electronic trading volume in 1998
exceeded the prior year's electronic trading volume by 108, 123,
and 51 percent, respectively. Nonetheless, the electronic trading
volume at each exchange accounted for less than 5 percent of each
exchange's total trading volume in 1998.

Major foreign futures exchanges have expanded their electronic
trading systems in the same ways as have U. S. exchanges. However,
they are taking an additional step and moving away from open
outcry to electronic trading systems as a means of enhancing their
competitiveness. Although no single data source on electronic
futures trading volume exists, it has been estimated that such
volume accounts for about 20 to 30 percent of the total trading
volume worldwide, with most of the volume occurring on foreign
exchanges. In 1998, in response to growing competition, the
Deutsche Terminborse (DTB) and Swiss Options and Financial Futures
Exchange merged to create Eurex, a fully electronic exchange. On
the basis of 1998 trading volume, Eurex was the world's fourth
largest futures exchange; on the basis of first quarter 1999
trading volume, it had become the world's largest futures
exchange. Other foreign exchanges, such as the London Financial
Futures and Options Exchange and Sydney Futures Exchange, are also
moving toward replacing their open outcry systems with electronic
trading systems to reduce trading costs and enhance their
competitiveness. The Marche a Terme International de France
completed this transition in 1998.

Finally, U. S. and foreign exchanges are increasingly seeking
electronic linkages to boost volume and cut costs. For example,
CME and the Marche a Terme International de France have an
agreement that permits each exchange to trade the contracts of the
other under certain circumstances. These exchanges and the
Singapore International Monetary Exchange announced on February 8,
1999, that they are taking the additional step of Expansion of

Electronic Trading Systems

Appendix VII Electronic Trading Systems

Page 46 GAO/GGD-99-74 CFTC Reauthorization

creating a common electronic trading system that will allow them
to trade each other's products in the North American, European,
and Asian time zones. The system is expected to be operational by
the third quarter of 1999. Also, NYMEX has arrangements with the
Sydney Futures Exchange and Hong Kong Futures Exchange that permit
the members of these foreign exchanges to trade NYMEX products.

According to CFTC, technological advances raise a variety of
issues concerning the degree to which a foreign futures exchange's
trading activities in the United States are subject to CFTC
regulation. These issues arise because electronic trading systems
make it possible for U. S. market participants to use computer
terminals located in the United States to execute trades on
foreign exchanges. Also, electronic order routing systems enable
customers to submit orders electronically to FCMs and to have such
orders routed to foreign exchanges for execution with little or no
human intervention.

Before placing electronic trading terminals in another country, an
exchange must generally obtain some form of approval from that
country's regulator. In 1989, CFTC staff issued a no- action
letter on the trading of foreign futures contracts through CME's
Globex electronic trading system. The letter stated that CFTC
staff would not recommend enforcement action against a foreign
board of trade that listed products on Globex based solely on its
failure to become designated as a domestic contract market. In
1996, DTB, which later merged with another foreign exchange to
form Eurex, was the first foreign exchange to seek and receive a
noaction letter from CFTC allowing placement of DTB trading
terminals in the U. S. offices of its member firms for executing
trades on its market. 1 CFTC staff concluded that the public
interest would not be adversely affected because (1) no customer
trading would be allowed unless the DTB member was also registered
with CFTC as a FCM and (2) CFTC would have access to books and
records either on the DTB member's premises or via information-
sharing agreements with DTB's regulator. CFTC's position was also
based on the premise that DTB was a bona fide foreign futures
exchange whose main business activities occur in Germany.

Since 1996, CFTC has received additional no- action requests as
well as inquiries regarding CFTC's position on placing foreign
trading terminals in the United States. In general, these
inquiries sought CFTC's position on

1 The CFTC no- action letter applies only to the placement of
terminals at firms that were either DTB members or had memberships
pending at the time of the letter. Foreign Futures

Exchanges' Placement of Terminals in the United States

Appendix VII Electronic Trading Systems

Page 47 GAO/GGD-99-74 CFTC Reauthorization

whether locating terminals in the United States might subject a
foreign exchange to regulation as a domestic contract market.
Rather than issue separate no- action letters, CFTC decided to
address the subject through its rulemaking process. CFTC issued a
concept release in July 1998 to gather information for use in
proposing a rule on placing foreign exchanges' computer terminals
in the United States.

In March 1999, CFTC issued a proposed rule that would establish a
procedure under which foreign exchanges could petition CFTC to
permit electronic access from within the United States without
being designated as a domestic contract market. The rule would
allow U. S. customers to use order routing systems, including
Internet- based systems, to enter orders and would establish
minimum safety standards for operating these systems. Although all
of the four CFTC commissioners voted to release the proposed rule
for comment, three of the four have expressed concerns that it is
overly complex, imposes unnecessary burdens, could negatively
affect the competitiveness of U. S. exchanges, and/ or may be
illegal. Some participants at a recent industry conference also
expressed frustration with the complexity of the rule, the effect
of this complexity on the time that will ultimately be required
for approval of the rule, and the impact on the competitiveness of
foreign exchanges that are currently unable to access U. S.
customers in the absence of a rule.

A CFTC representative told us that the agency considered the
numerous comments it received on its concept release in
formulating its proposed rule and was interested in working with
the industry to quickly address remaining concerns. On April 20,
1999, CFTC sponsored a roundtable discussion of the proposed rules
that was attended by representatives of U. S. and foreign
exchanges, U. S. and foreign brokers, foreign regulators, and
technology experts. The comment period on the proposed rule was to
expire on April 30, 1999.

In September 1998, CFFE was approved by CFTC and began
electronically trading U. S. Treasury futures contracts. CFFE is
jointly operated by the New York Cotton Exchange, a CFTC-
designated exchange, and Cantor Fitzgerald, an interdealer- broker
in the U. S. Treasury securities market. The New York Cotton
Exchange is responsible for all of CFFE's selfregulatory
responsibilities, and Cantor Fitzgerald provides the electronic
trading system that CFFE uses to match and execute trades. Certain
market participants, including FCMs and their approved customers,
have direct keyboard access to the electronic trading system.
Others must submit their orders to terminal operators, who are
agents of the exchange but employees of Cantor Fitzgerald.
Although CFFE is subject to generally Novel Electronic

Futures Trading Systems

*** End of document. ***