Remarks of Frederick W. Hatfield, Commissioner
Commodity Futures Trading Commission
The New York City Bar Association
Futures and Derivatives Committee
March 9, 2006
Good evening. It is a pleasure to be here tonight along with my fellow Commissioner, Walt Lukken. Walt and I have known each other since his days with Senator Lugar and the Senate Agriculture Committee staff and my days with Senator Breaux, and it was Walt who initially sparked my interest in serving on the Commission, which I joined in December 2004. It has been a real pleasure working with him again and getting to know my other fellow Commissioners, Chairman Jeffery, Sharon Brown-Hruska and Mike Dunn. It has been a busy and interesting time, much of which has been devoted to reauthorization issues. I would like to update you tonight on where things stand on that front, both in Congress and in our discussions with the Securities and Exchange Commission (SEC) on several issues related to security futures products (SFPs). And, although the Commission’s budget appropriations are not tied to reauthorization, I’d like to fill you in on developments in that area as well.
Reauthorization
As those of you who’ve been following our current reauthorization cycle know, it started out with hearings in the House and the Senate last March during which everyone who testified agreed that the Commodity Futures Modernization Act of 2000 (CFMA), which came out of the Commission’s last reauthorization, was a resounding success. It streamlined the process for new exchanges and new products to enter the marketplace, and an unprecedented level of competition and innovation has resulted—both domestically and globally—which has benefited customers and the economy as a whole by increasing choices and lowering costs. It also provided legal certainty for over-the-counter (OTC) markets, and authorized the trading of SFPs under the joint supervision of the CFTC and the SEC.
Most everyone who testified also agreed, however, that clarification by Congress in a few areas was warranted, particularly with respect to the Commission’s ability to shut down illegal bucket shops after the 7th Circuit Court of Appeals issued its decision in CFTC v. Zelener. In Zelener, the court decided that the transactions at issue, which allowed retail customers to speculate on price movements in foreign currency by rolling their positions forward, were spot contracts rather than futures contracts, and thus, the Commission had no authority to prosecute the alleged fraudulent activity that occurred in connection with them. Many of those who thought the case was wrongly decided argued for a broad Congressional response to clarify that all such “rolling spot” transactions offered to the retail public for the purpose of speculating on price movements in a commodity are in fact futures contracts within the Commission’s jurisdiction. Others thought that the court got it right and argued that no Congressional response was needed. A third group argued that, whether the court got it right or wrong, any changes should narrowly focus on transactions where the underlying commodity is foreign currency. The Commission, under the leadership of Commissioner Brown-Hruska who was Acting Chairman at the time, asked that Congress, at a minimum, clarify our jurisdiction over Zelener-type transactions in foreign currency.
Other issues raised during reauthorization included whether persons involved in the solicitation or recommendation of retail off-exchange foreign currency contracts should be required to register with the Commission, whether the Commodity Exchange Act’s (CEA or Act) Section 4b antifraud provisions should extend to off-exchange principal-to-principal futures transactions, whether Congress should clarify our authority to bring civil and administrative actions for the criminal violations enumerated in Section 9 of the Act and increase penalties for civil and criminal violations, and whether the Act should be amended to expand the definition of what constitutes a broad-based foreign security index, permit the trading of broad-based debt security indexes, and—an issue I am especially interested in—permit risk-based portfolio margining for SFPs.
In July, the Senate Agriculture Committee reported out a bill, S. 1566, which incorporated language addressing all of these issues, some of which represented a consensus between the CFTC and various industry groups, and some of which had been suggested by the CFTC. The Senate Banking Committee and the President’s Working Group on Financial Markets (PWG) then got involved, which resulted in consensus language drafted by the PWG addressing the Zelener, foreign currency, index and SFP margining issues. The product of its efforts was transmitted to the House and Senate Agriculture Committees on November 3, 2005, and on December 14, 2005, the House approved H.R.4473, which incorporated the PWG language and included provisions on natural gas.
I imagine that most of you are familiar with the details of the House and Senate bills, so I will not recount the legislative twists and turns for you now. But, I have handed out some bullet points reflecting the highlights of the pending bills for your reference. Both S. 1566 and H.R. 4473 are on the Senate’s legislative calendar. It is my understanding that Senator Mike Crapo (R-ID), who was previously opposed to new requirements in the natural gas market, has since removed his objection to the legislation so that the reauthorization can move forward. We have also learned that Senator Richard Durbin (D-IL), in consultation with Chairman Jeffery, has been working to identify Democratic amendments in order that appropriate floor time can ultimately be scheduled. It is not clear exactly when the Senate will consider this measure, but recent discussions indicate activity could occur by the end of March or the first part of April. Amendments to the underlying bill being discussed include:
• broad Zelener fix (Conrad (D-ND))
• a price-gouging provision; not clear how this might implicate the CEA (Cantwell (D-WA))
• an energy provision (Feinstein (D-CA)).
Please keep in mind that whatever bill passes the Senate will be different than the bill passed by the House. Consequently, a conference committee will be required to resolve the differences between the two bills. This brief exercise hopefully will delay enactment for only a few weeks following Senate passage.
Discussions with the SEC
Although the PWG language regarding the index and margin issues has not become law, the SEC and the CFTC have been working steadily to resolve them. Staff of the two agencies have been meeting regularly, and discussions between Chairman Jeffery and Chairman Cox have taken place.
The index issues are related to the statutory tests that distinguish broad-based security indexes from narrow-based indexes. Futures on broad-based indexes have been permitted since 1982 and are under the exclusive jurisdiction of the CFTC. Futures on single stocks and on indexes that qualify as narrow-based (collectively, SFPs) were authorized in 2000 by the CFMA, subject to the joint jurisdiction of the CFTC and the SEC. Due to the qualifying criteria set forth in the statute, however, few foreign index products have been approved for trading since that time, and futures on debt security indexes have not been permitted at all—primarily because the tests were designed with equity securities in mind.
The agencies have made significant progress on the debt security index issue. A joint proposed rulemaking that would permit futures on broad-based debt security indexes, both domestic and foreign, has been drafted, and is expected to be published in the Federal Register for public comment in the near future. We have not gotten as far along on the foreign security index issues, but discussions continue.
Efforts to resolve the margin issues relating to SFPs continue as well. Under the CFMA, margin requirements for SFPs must be “consistent” with requirements for comparable security options. SFPs have thus been subject to the same fixed-rate strategy-based margining scheme that the SEC applies to security options customer accounts, rather than the risk-based portfolio margining system typical in the futures markets. Although security futures markets have been tremendously successful in Europe, where risk-based margining is employed, volumes in the Unites States remain low. Many believe that this is due, at least in part, to how theses products are margined.
The benefits of risk-based portfolio margining, which sets margin levels based upon the historical performance and expected volatility of individual contracts, and allows offsets for highly correlated positions, are well-known and are supported by the securities, options and futures industries, as well as the Federal Reserve Board. The SEC has approved risk-based portfolio margining for security options at the clearing (not customer) level, thus, it is not an unknown concept in the securities world. I believe that the current strategy-based margin requirements for SFPs have placed these products at a competitive disadvantage that must be eliminated if the security futures markets are to thrive here as they are thriving in Europe. I am encouraged that the PWG has focused its attention on this issue and that resolving it has become a priority at the SEC and the CFTC.
Appropriations
Another top priority every year is, of course, getting funded in an amount that will enable us to perform our critical functions appropriately. As the chart I have handed out shows, over the past twelve years, futures and options trading volume has doubled, while staffing levels at the Commission have remained the same or decreased. Last month the Office of Management and Budget announced that the President’s budget will request $127.4 million for the CFTC for FY 2007, which represents a 31% increase over the FY 2006 appropriation of $97.4 million. Most of the Commission’s budget is devoted to funds for staff, which, when measured for comparability, has fallen on average 15% behind the other federal financial regulators since Congress enacted pay parity provisions in 2002. The requested amount would help the Commission to close this widening pay gap, and enable us to hire 37 additional employees (ten for the Division of Clearing an Intermediate Oversight, sixteen for the Division of Enforcement, two for the Division of Market Oversight, five for the Chairman and other Commissioners, and four for the Office of the Executive Director).
The President’s budget proposes to fund the Commission’s activities through a new transaction fee, which, not surprisingly, is opposed by the industry. The administration points out that the CFTC is the only federal financial regulator that is not funded by fees. Last week, the Futures Industry Association, the National Futures Association, and six exchanges joined in a letter to Congress arguing that the fees would be counterproductive, however, and would put U.S. exchanges at a competitive disadvantage with their foreign and OTC competitors. We will be following this debate as it progresses with interest.
Looking Forward—Opportunities for Cooperation
In closing I’d like to make a few observations on the increasing number of areas in which the interests of the CFTC and the SEC overlap. I don’t mean to suggest that I agree with those who periodically argue that the two agencies should be merged. The markets we oversee serve very different functions and different regulation, in my view, is appropriate. But a number of factors do call out for enhanced cooperation and communication. SFPs are an obvious example, but others include issues regarding hedge funds, exchange traded funds, and recent reports that the NYSE is interested in expanding its product line to options and other derivatives. Toward that end, I have proposed to Chairman Jeffery that the CFTC and the SEC form a Joint Task Force on Cooperative Efforts through which Commissioners from the two agencies would meet periodically to discuss areas of mutual concern.
I thank you for asking me here tonight. I hope that this debrief from “inside the beltway” has been helpful; perhaps illuminating the important work being done in Washington that effects each of you. I look forward to working with you in the years ahead and am happy to entertain any questions you may have.
Highlights of S. 1566
• Amends Section 4b antifraud provisions of the Act to cover principal-to-principal off-exchange transactions (consensus language)
• Amends Section 6 of the Act to raise maximum civil monetary penalties for manipulation and attempted manipulation to $1 million per violation, or triple the monetary gain (consensus language)
• Amends Section 9 of the Act to raise maximum criminal penalties to $1 million per violation and/or ten years’ imprisonment per violation for the offenses listed in Section 9 (e.g., conversion, false reporting, manipulation and attempted manipulation) and to clarify that civil and administrative actions may be brought for violations of Section 9 (consensus language)
• Amends Section 2(c)(2) of the Act to give the Commission jurisdiction over retail foreign currency transactions, and persons engaged in any activity in connection with them (other than those in which the counterparty or person offering to be the counterparty is one of the otherwise regulated entities listed), when the transaction is offered or entered into on a leveraged or margined basis (or similarly financed), for purposes other than commercial or personal use (requires immediate ownership and possession) (Zelener fix proposed by CFTC)
• Amends Section 2(c)(2) of the Act to exclude notice registered BDs and unregistered affiliates of BDs and FCMs from the list of otherwise regulated entities, and to require that persons involved in the solicitation or recommendation process be registered with the SEC or the CFTC when the counterparty is a BD or FCM, respectively (proposed by CFTC)
• Authorizes a two-year pilot program for risk-based portfolio margining of SFPs under the oversight of the CFTC that would be eligible to continue beyond two years depending upon the conclusions of a report on the program to Congress made by the Board of Governors of the Federal Reserve
• Requires the CFTC and the SEC to promulgate joint rules within 180 days to permit additional U.S. listings of futures contracts on broad-based foreign and domestic debt indexes and foreign equities
• Contains no provisions specific to energy
Highlights of H.R. 4473
• Amends Section 4b antifraud provision of the Act to cover principal-to-principal off-exchange transactions (consensus language)
• Amends Section 6 of the Act to raise maximum civil monetary penalties for manipulation and attempted manipulation to $1 million per violation, or triple the monetary gain (consensus language)
• Amends Section 9 of the Act to raise maximum criminal penalties to $1 million per violation and/or ten years’ imprisonment per violation for the offenses listed in Section 9 (e.g., conversion, false reporting, manipulation and attempted manipulation) (consensus language); does not contain provision clarifying the Commission’s civil and administrative authority over violations of Section 9
• Amends Section 2(c)(2) of the Act to give the Commission jurisdiction over retail foreign currency transactions (other than those in which the counterparty or person offering to be the counterparty is one of the otherwise regulated entities listed) when the transaction is offered or entered into on a leveraged or margined basis (or similarly financed), unless the transaction results in actual delivery within two days, or creates an enforceable obligation to deliver between a seller and a buyer that have the ability to make or take delivery in connection with their line of business (Zelener fix proposed by PWG)
• Amends Section 2(c)(2) of the Act to exclude notice registered BDs and from the list of otherwise regulated entities, and to require that persons involved in the solicitation or recommendation process be registered with the CFTC when the counterparty is an FCM; does not contain provision excluding the unregistered affiliates of BDs and FCMs from the list of otherwise regulated entities (proposed by PWG)
• Requires the CFTC and the SEC to take action to permit risk-based portfolio margining for SFPs by September 30, 2006, and to resolve issues regarding debt and foreign securities indexes by June 30, 2006 (proposed by PWG)
• Directs the Commission to investigate any “significant and highly unusual change in the settlement price of any physically delivered natural gas futures contract” traded on-exchange, and contains record keeping and reporting requirements giving the Commission authority to require reporting of OTC natural gas positions if it determines that such reporting would help detect or deter manipulation
The Commission and the Industry We Regulate
Indicators of Industry Growth Complexity
Growth in Volume of Futures & Option Contracts Traded & FTEs
Figure 1: Growth of Volume of Contracts Traded and FTE
Last Updated: April 18, 2007