CFTC Releases For Market Deregulation

The staff of the Commodity Futures Trading Commission (the "CFTC") has issued a report which presents a package of recommended changes to the existing regulatory framework for the futures markets under the Commodity Exchange Act, as amended (the "CEA"), 7 U.S.C. § 1 et seq. See Report of the Commodity Futures Trading Commission Staff Task Force, A New Regulatory Framework (February 2000) (hereinafter, the "Staff Report"). While the Staff Report has not been formally adopted or approved by the CFTC itself, the Commissioners (including Chairman Rainer) have had input into it.

The proposed framework recognizes three new categories of markets which would be subject to varying degrees of CFTC oversight, based upon the nature of the instruments traded and the sophistication of the participants. This multi-tiered framework would replace the current "one size fits all" approach to regulation of the futures markets in the United States. It would substitute flexible "core principles" for prescriptive rules, but the CFTC would retain its oversight authority to safeguard market integrity, to deter manipulation, to protect the markets’ financial integrity, and to protect customers. In addition, the Staff Report recommendations are intended to establish greater legal certainty for swap transactions, provide enhanced flexibility for intermediaries such as futures commission merchants ("FCMs") and introducing brokers by making use of core principles and best practices and by distinguishing between institutional and non-institutional customers. It would also give clearing organizations greater flexibility by making use of core principles and deference to other applicable regulatory schemes.

The CFTC staff believes that these recommendations can be implemented pursuant to its existing exemptive authority under Section 4(c) of the CEA and anticipates initiating a public rulemaking proceeding in the near future, including at least one public hearing. While it is generally complementary to the recommendations of the President’s Working Group on Financial Markets¹, the Staff Report recognizes that the framework does not obviate the need for Congressional action on some of the Working Group’s recommendations.

One category would be the "designated contract market," which would continue to be subject to the existing regulatory scheme. There would be three new categories.

The first new category, which is closest to the current status of designated contract markets, is for a "Recognized Futures Exchange" ("RFE"). An exchange would be eligible to become an RFE if it permits access by any type of customer and trades contracts that are based on commodities that have finite deliverable supplies or cash markets with limited liquidity, e.g., such as existing futures contracts on agricultural commodities. Given the participation of retail customers and the potential for manipulation, the level of CFTC oversight would be greater for this category than for the other two new categories under the framework. However, the framework would provide an RFE with greater operational flexibility than the current regulatory scheme applicable to designated contract markets by substituting fifteen Core Principles for the current body of detailed regulations. The Core Principles would establish flexible standards in a variety of areas, including rule enforcement, position monitoring and reporting, position limits, emergency authority, public information, audit trail, transparency, financial standards, customer protection, dispute resolution, governance, recordkeeping, and competition.

The second new category is for a Recognized Derivatives Transaction Facility ("DTF"). A market would be eligible to become a DTF if the contracts traded on it are for underlying commodities that have an inexhaustible supply (e.g., Eurodollars) or have no underlying cash value (e.g., weather derivatives), or if the market restricts participation to qualifying commercial entities, regardless of the contracts traded. As a DTF, a market must comply with seven Core Principles in a number of areas, including enforcement, market oversight, operational information, transparency, fitness, recordkeeping, and competition.

The final new category, with the least regulatory oversight, is the Exempt Multilateral Trade Execution Facility ("MTEF"). This category is limited to markets with transactions only among institutional participants and only involving commodities with inexhaustible deliverable supplies or supplies that are otherwise sufficiently large and deep so that the risk of manipulation is remote. An MTEF would be exempt from regulation under the CEA, except for: (i) antifraud and antimanipulation provisions; and (ii) a requirement that if it serves a price discovery function it must provide pricing information to the public on a daily basis. In addition, there would be a provision to the effect that a violation of the terms of the exemption would not render the transactions effected on the MTEF void. Such a market could not hold itself out as being regulated by the CFTC.

The Staff Report does not recommend any substantive changes in the Part 35 swaps exemption, the CFTC’s 1989 Swap Policy Statement, or the CFTC’s energy contract exemption.² However, the framework would provide additional legal certainty for swap transactions in certain respects, including by (i) stating that Part 35 swap transactions can be cleared; (ii) providing that transactions entered into in reliance on the Part 35 swaps exemption would not be void as a matter of law due to a violation of the exemption’s provisions; and (iii) confirming that electronic trading systems for over-the-counter transactions are exempt from the CEA and CFTC rules.

The framework is designed to provide greater flexibility for intermediaries such as FCMs, introducing brokers and customers of both, by making use of Core Principles and Statements of Best Practices in lieu of detailed prescriptive rules and by distinguishing the requirements that apply to institutional and non-institutional customers. For example, while non-institutional customers would continue to receive and acknowledge the mandatory risk disclosures for futures and options trading that are currently required (with some streamlining), institutional customers would only have to receive risk disclosure appropriate to the customer and the market on which the customer is trading. The Staff Report also recommends simplifying existing registration procedures and modifying existing segregation requirements for commodity customer funds and revamping the net capital requirements applicable to FCMs.

The proposed framework would establish greater flexibility in the provision of clearing services. For example, while it requires that clearing organizations clearing transactions entered into on an RFE or an DTF be authorized by the CFTC, the Staff Report recommends that the CFTC explore mechanisms by which a clearing organization subject to regulation by other federal or foreign regulatory authorities could be authorized to clear transactions on DTFs, based upon deference to other regulatory schemes. The framework also provides that clearing for transactions exempt under Part 35 or for exempt MTEFs could be subject to oversight by another federal or foreign regulatory authority in lieu of the CFTC. Recognized clearing organizations would be required to meet specified Core Principles in a variety of areas, including financial resources, risk management, settlement procedures, treatment of customer funds, default rules and procedures, rule enforcement, system safeguards, reporting, recordkeeping, public information, information sharing, and competition.

The Staff Report’s recommendations, if adopted, should assist the futures exchanges in dealing with competitiveness issues and may also provide benefits to the over-the-counter markets. To be sure, a number of significant issues need to be clarified and resolved, including:

• legal definitions for various new categories being recommended and other terms used in the Staff Report, such as "institutional traders" or "commercial traders";
• the criteria for deciding which markets are susceptible to manipulation and when a market is performing a price discovery function;
• whether and to what extent an "exempt MTEF" that is not engaging in activities subject to regulation under the CEA may voluntarily submit to CFTC oversight; and
• what the details will be of the various Statements of Best Practices.

1 See Report of the President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (November 1999).

2 See 17 C.F.R. Part 35 (1999); CFTC Policy Statement Concerning Swap Transactions, 54 Fed. Reg. 30694 (July 21, 1989); Exemption for Certain Contracts Involving Energy Products, 58 Fed. Reg. 21286 (April 20, 1993).