Statement Submitted on Behalf of
J.P. Morgan & Co. Incorporated
by Mark C. Brickell
J.P. Morgan Securities Inc.
To the Committee on Banking and Financial Services
United States House of Representatives
April 11, 2000
J.P. Morgan appreciates the opportunity to submit its views on the proper regulatory treatment of privately-negotiated derivatives transactions often referred to as swaps. As an international financial institution, Morgan is one of the worlds largest swaps dealers. In addition, and often in connection with our swaps activity, we are a large user of exchange-traded derivatives, many of which are generally subject to the provisions of the Commodity Exchange Act ("CEA"). Our position and experience in these activities leads us to welcome recent initiatives of this Committee to establish with certainty that swaps are not subject to the CEA, and to assure the enforceability of the netting provisions of master swap agreements and other financial contracts.
Of particular importance to J.P. Morgan are the persistent and potentially harmful legal uncertainties surrounding the status of swap transactions under the Commodity Exchange Act. We believe legislation should be enacted to clarify that swaps are not subject to the CEA. Swaps and related off-exchange transactions have become an essential part of risk management for American business. Swap transactions are custom tailored to meet the unique needs of the companies, governments, and financial institutions that are our clients. Because each swap is custom-tailored, swaps differ substantially from the standardized exchange-traded futures contracts governed by the CEA. As a result, swap transactions cannot fit within the regulatory framework defined by the CEA. In fact, the CEA is such an inappropriate framework for the regulation of swap activity that, if swaps were regulated under the Act, the exchange trading requirement of the CEA would instantly call into question the enforceability of thousands of swap transactions and undermine billions of dollars of transactions at American banks, brokers, and corporations.
It would be ironic indeed if the federal government, because of its own regulatory clumsiness, were to transform an activity designed to mitigate financial risk into a high-risk activity.
The following testimony will compare the swaps regulatory framework with the CEA regulatory framework in order to show that the CEA framework is inappropriate for privately-negotiated activity. We then review the history of legal uncertainty that has resulted from attempts to apply the CEA to swaps. Finally, we review the renewed uncertainty created by recent CFTC actions, and voice our support for both a near-term limitation on unilateral moves by the CFTC and a longer-term reform of the CEA in order to establish statutorily the necessary legal certainty for privately-negotiated swaps activity. J.P. Morgan would like to acknowledge the previous work done on these subjects by the International Swaps and Derivatives Association, and by Dr. Christopher Culp of CP Risk Management in Chicago. In order to ensure that the record includes their important contributions, certain sections of the following testimony draw extensively on the work of both ISDA and Dr. Culp.
The role of privately-negotiated derivatives
There is virtually universal agreement that swaps and other privately-negotiated derivative contracts have been beneficial to the financial system and the economy. Swaps are custom-tailored bilateral risk-shifting contracts. Corporations, financial institutions, and government entities use swaps to manage their exposure to financial risks that arise in the conduct of their business. Prior to the development of privately-negotiated derivatives, many financial risks simply could not be hedged or managed in an efficient manner. Businesses and governments consequently had little choice but to conduct their activities subject to fluctuations of interest rates, exchange rates, and other financial variables.
In a swap transaction, two counterparties agree to exchange cash flows at periodic intervals during the life of the contract according to a prearranged formula; because swaps are custom-tailored, the terms of the contract are left entirely to negotiation by the two parties. For example, a corporation that has floating-rate debt and is concerned that interest rates might rise could use an interest rate swap to convert its floating-rate debt into a fixed-rate obligation. Or, an American corporation that earns deutschmark revenue from its German operations and wants to avoid the risk of fluctuating exchange rates could use a currency swap to hedge the exposure. Together dealers and clients can create almost any kind of swap.
Swap transactions provide flexibility and benefits that enable our clients to concentrate better on their business operations. Rapid growth in the activity or explosive growth, as some have described it occurs because so many clients find swaps useful. The activity has grown in several dimensions in types of contract, in types of underlying risks to manage, and in the uses to which derivatives are put. And it has grown for many reasons in addition to the demand by clients to manage risks: Technological advances, in hardware and software, have reduced the unit costs of computing; reductions in telecommunications costs have increased the quantity and timeliness of information available to use in managing risks; and as derivatives techniques are applied to a broader range of underlying risk exposures, the learning curve makes each new technique cheaper to develop than the last. Swap activity takes place around the world, and U.S. institutions are leaders in the business both at home and abroad.
Swaps are offered to others as a line of business by many types of companies, including the affiliates of investment banks, insurance companies, and commodity companies. Most swaps, however, are written by banks. In a speech to the Futures Industry Association in 1999, Federal Reserve Board Chairman Alan Greenspan, relying on statistics from the Bank for International Settlements, indicated that U.S. commercial banks are "the leading players in global derivatives markets." Those statistics suggest that, worldwide, a bank is a participant in up to 85% of all swap transactions. There is no doubt that swaps are of central importance to the House Banking Committee.
Given both the benefits and extent of swap activity, any change in how swaps are regulated should not be undertaken without careful and thoughtful consideration. In order to understand the dangers associated with applying the CEA to swap activity, the following two sections describe the different regulatory frameworks surrounding swaps and futures.
The swaps regulatory framework
Swaps regulation at its best is characterized by three main features: a strong legal framework; reliance on market discipline; and regulatory diversity.
Legal framework. A strong and clear legal framework is essential to swaps activity; when regulators in developing countries ask what is the single most important contribution they can make, we point to the legal framework first. Indeed, legal uncertainty was the first weakness identified in the swaps framework, and much effort in the past ten years, both from the industry and from legislators and regulators, has been dedicated to strengthening the legal framework and reducing legal risk.
Where the legal framework is not sound, the problems have been significant and disturbing. The classic example occurred in the United Kingdom in 1991, when the House of Lords in its Hammersmith & Fulham decision said that all swaps entered into by all local authorities were ultra vires; the effect was the same as if an entire class of counterparties defaulted at once. In every country, the legal framework occupies a position of such unique importance that a flaw in that structure can trip up every participant.
Fortunately, there are positive examples of actions that increase legal certainty. For example, legislation was enacted in the United States in 1989 and 1990 to recognize netting of obligations under master swap agreements. Another opportunity to increase legal certainty is now before Congress: H.R.1161, the Financial Contract Netting Improvement Act of 1999, introduced by Chairman Leach and other members of this Committee, would revise two federal banking laws along with the bankruptcy codes to clarify the status of cross-product netting and of credit derivatives and other new contracts. If enacted, the legislation will take U.S. financial markets even further in the direction of legal certainty, and will have a positive effect on the stability of both individual financial institutions and the financial system as a whole. We support enactment of this legislation.
Market discipline. Market discipline refers to a system in which market participants control their risks because it is in their own best interest to do so. It exists when participants know they will be forced to bear the costs of their mistakes because no one will assume these costs for them. It works because those who ignore it fail, while those who take it seriously are able to thrive. And it has the paradoxical effect of increasing the likelihood that individual firms will fail, while reducing the prospect of widespread difficulties in the financial system. Market discipline works largely through attempts by swap dealers to improve both their reputation and credit quality. These competitive advantages differentiate those who succeed from those who fail.
For example, swap credit exposures often are long term, so swap dealers strive to be well-capitalized to reassure their counterparties that they will be able to meet their obligations. Here is clear evidence of the benefits of market discipline: If you compare the capital structure of derivatives dealers with other financial institutions, you will find more AAA-rated swap dealers than AAA-rated banks and securities firms combined. And like reputation, a high rating demands a level of effort that simply could not be forced by regulatory pressure alone.
Regulatory diversity. A final feature of the swaps framework is regulatory diversity. There is no market regulator for swaps like the SEC for securities or the CFTC for futures. Instead, different swap participants have different forms of regulation, and some participants may not be regulated by the government at all.
I believe this regulatory diversity is a source of strength. First, regulatory diversity by its nature places greater reliance on market discipline than would a single, monolithic regulator. Second, regulatory diversity provides additional choices to market participants. Third, regulatory diversity enables each regulator to specialize in a particular part of the market instead of forcing one agency to attempt to cover all; the result, particularly when the emphasis is on institutional rather than functional regulation, is greater focus by agencies on understanding the activities of the institutions they supervise. Finally, and most important, regulatory diversity encourages innovation, and examples show up not just in the swaps business but in the entire financial industry.
For example, it has long been recognized that the dual banking system in the United States has been a spur to innovation; interest bearing NOW accounts are an example of such innovation that started at the state level. Here is another example: The fastest growing form of short-term deposit gathering and credit extension does not take place under the basic banking model, but under the money market mutual fund model created under the SEC framework. And, the fastest growing activity for managing market risk is not the standardized, exchange-traded model mandated by market regulators, but the privately-negotiated swaps model that developed under the banking regulatory framework.
In this light, there is no reason to add the CFTC as a regulator of swap activity. The regulatory environment in which swaps dealers operate is consistent with a safe, sound financial system. In fact, it is a framework that has fostered innovation benefiting the banking system and its clients. Swap participants have voted with their transactions; International Swaps and Derivatives Association survey data indicate swap activity has grown at a compound rate of 41 percent between 1987 and year-end 1998. A regulatory framework which produces these benefits is notable not for its failures, but for its successes.
The CEA regulatory framework
The swaps regulatory framework relies on the market as primary regulator, and turns to government intervention only if it can be shown to be necessary. The futures regulatory framework, in contrast, relies on direct government regulation. The nature of futures regulation stems from the product definition, exclusivity, and exchange-trading requirement provisions of the CEA.
Under the CEA, any instrument legally deemed an option or a futures contract on a commodity is subject to regulation by the CFTC. In 1974, because Congress wanted the CFTC to be able to regulate the innovative futures contracts on financial risks that futures exchanges began to offer in the 1970s, it established the CFTC and broadened the definition of commodity beyond agricultural products to include all services, rights, and interests in which contracts for future delivery are presently or in the future dealt with. For the first time, this permitted federal regulation of the financial futures contracts traded on the exchanges. Second, the CEA as amended contains an exclusivity clause, which requires that the CFTC have exclusive jurisdiction over any option or futures contract on a product deemed a commodity. Third, the exchange trading requirement of the CEA requires instruments deemed commodities and subject to the exclusive jurisdiction of the CEA to be traded on a CFTC-designated board of trade. And finally, a commodity exchange can be designated as the contract market on which new futures contracts may be traded only with the approval of the CFTC.
The broad definition of commodity has led to interpretation problems, which Congress addressed by means of exclusion and exemption authority. First, Congress has statutorily excluded certain transactions from the CEA; an example is the Treasury Amendment, which excludes transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted by a board of trade. Despite the extensive list, there have been numerous disputes over what Congress actually intended these terms to cover, with the result that legal uncertainty persists.
Second, Congress in 1992 gave the CFTC the authority to exempt certain transactions from the CEA. In issuing an exemption, the CFTC need not determine whether the transaction falls under the definitions of the CEA; instead, the exemption may simply state that the transaction should not be regulated under the Act. An example of an exemption, one at the heart of todays hearings, is the Swaps Exemption issued in 1993. Again, although the CFTCs action reduced legal uncertainty for a time, there have been several recent occasions when it appeared that legal uncertainty was coming out of remission. In 1998, the CFTC issued a Concept Release concerning swap transactions that was a source of such concern to other members of the Presidents Working Group and to the Congress that legislation was passed to bar the CFTC from taking action to change the regulatory framework for swaps. Recent CFTC staff proposals alter the terms of the Swap Exemption, or to create new exemptions for certain classes of "derivatives," have raised new concerns about legal uncertainty and the CFTCs interpretation of the limits of its jurisdiction.
The combination of the definition of commodity, the exclusivity clause, and the exchange trading requirement, along with continuing disputes surrounding the coverage of both exclusions and exemptions, suggest that almost any new financial product is potentially subject to regulation by the CFTC. The Commodity Exchange Act, with its origins in the 1920s, has become an obstacle to financial innovation. We believe that Congress should address this problem.
Inapplicability of the CEA to swaps
Problems arise when laws and regulations that were designed for one set of activities are applied to another, essentially different set of activities, unless the laws and regulations contain sufficient flexibility and generality to apply to a wide and diverse array of conditions. Of particular relevance here is the applicability of the futures regulatory framework and the swaps regulatory framework to each other. On the one hand, the swaps regulatory framework relies heavily on market discipline, contains great flexibility, and generally avoids locking in by statute and regulation specific characteristics that might otherwise change over time. On the other hand, the futures regulatory framework was designed for a specific set of institutional characteristics, and is ill-equipped to adapt to essentially different forms of activity. The CEA would be an appropriate regulatory framework for swaps only if swaps activity operated under conditions similar to exchange-traded futures.
To be more specific, the CEA was crafted to apply a legal and regulatory framework to standardized contracts that are traded on exchanges and margined to reduce credit exposure among individual counterparties. Further, the CEA was designed to ensure the integrity of commodities markets. In particular, the CEA seeks to preclude market manipulation, which was of particular concern in the institutional and market settings found in commodities markets at the time the CEA was written, and to facilitate the process of price discovery. Section 3 of the CEA describes the necessity for regulation of [t]ransactions in commodities [that] are carried on in large volume by the public generally and by persons engaged in the business of buying and selling commodities and the byproducts thereof in interstate commerce. Section 3 notes that such transactions and prices of commodities on such boards of trade are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed, to the detriment of the producer or the consumer rendering regulation imperative for the protection of [interstate] commerce and the national public interest therein.
It would be difficult to make a convincing case that swaps activity occurs under conditions that give rise to concerns about market manipulation and price discovery as implied in the CEA. Several factors clearly differentiate swap transactions from the transactions regulated under the CEA.
First, such transactions are not carried on in large volume by the public generally. Swap transactions are entered into on a customized, privately negotiated basis by sophisticated parties, including governments and government-sponsored entities, commercial and investment banks, corporations, and, to a very limited extent, certain individuals.
Second, swap transactions are transactions in which each party assumes the credit risk of the other and thus each party requires specific knowledge about the other. The limits set forth in the Swaps Exemption inhibit transactions that are standardized and fungible, that is, transactions that are capable of being traded in large volumes. In addition, since such transactions are not standardized and fungible, they are simply not capable of being systematically traded on the floor of an exchange.
Third, most swaps activity occurs through cash settlement, not physical delivery. And this cash settlement occurs in highly liquid markets in which swap dealers can readily lay off their risks. Such markets are virtually impossible to manipulate; even central banks, with the ability to create money, almost always find exchange market intervention to be futile when they seek to counteract fundamental trends. It is difficult to see how a cash-settled contract could be used to manipulate or "corner" a market, since the supply of such contracts is not limited by the constraint of physical supplies of the underlying commodity. In fact, the existence of cash-settled contracts makes it possible for more participants to enter a market, thereby increasing the liquidity of the risk being traded, and may actually make it more difficult to manipulate prices.
Finally, the price discovery mechanism is fundamentally different between futures and swaps. For futures, prices determined on exchanges are directly relevant to the pricing of other transactions, so an attempt to manipulate prices could arguably affect the integrity of other transactions. But for swaps the price discovery process involves a bilateral agreement between buyer and seller.
Instead of seeking to expand the CFTCs regulatory reach it might be more productive to inquire as to what extent other types of financial activities would benefit from the application of the principles of the swaps regulatory paradigm. For example, a serious source of legal uncertainty is the treatment of equity swaps under the swaps exemption. Some opposition from the futures industry to clarifying this legal uncertainty is based on the claim that exchanges would remain barred from offering futures on single shares and small baskets of stock while leaving swap dealers free to offer equity swaps. It seems anachronistic that, in one of the most technologically advanced industries of our time, some participants still seek to compete by means of excluding competition. Instead, why not take a lesson from the swaps paradigm and do two things: Affirm that equity swaps are not futures, and rescind the legal prohibition on single-share futures. The futures exchanges would benefit from the ability to offer long-sought products. And in addition to benefiting from the long-sought legal certainty, swap dealers would have a new way to hedge the risks of their own activities. As the growth in Eurodollar and Treasury bond futures shows, swaps activity can be a source of growth for exchange-traded futures.
History of the relation between the Commodity Exchange Act and swap transactions
In 1922, Congress enacted the original version of what is now the CEA to protect farmers and other producers and merchants of certain agricultural commodities from the perceived abuses of futures contracts. The protective scheme mandated that all trading of futures contracts on certain commodities be regulated by the Department of Agriculture and conducted on organized futures exchanges. The law was substantially revised in 1936, after which the list of covered commodities was expanded periodically. The law was again revised in 1974 by (i) establishing the CFTC to administer the CEA and regulate U.S. commodities exchanges; (ii) expanding the definition of commodity; and (iii) adding the Treasury Amendment.
In the 1980s, the rapid growth in the use of innovative interest rate and currency swaps as well as related privately-negotiated derivatives transactions to manage financial risk led to a desire to ensure clear and unambiguous legal status for these transactions. In 1987, legal concerns heightened significantly when the CFTC commenced an investigation into the commodity swap business of Chase Manhattan Bank. Although no enforcement action resulted, the reports of the event created significant uncertainty regarding the status of swap transactions under the CEA: It was feared that swap transactions would be deemed to be illegal and unenforceable off-exchange futures contracts. The uncertainty was exacerbated when the CFTC issued an Advance Notice of Proposed Rulemaking, in which it effectively stated that transactions such as swaps which include certain elements of futures contracts may be subject to the CEA. In response, large segments of U.S. swap activity moved offshore, and some U.S. firms ceased development of swaps entirely, reducing the ability of U.S. firms to manage risk and inhibiting the growth of these activities at U.S. institutions.
The events prompted industry participants to seek action by the CFTC to reduce the substantial legal uncertainty that resulted from these developments. To address these concerns, in 1989 the CFTC issued the Swaps Policy Statement that at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations. Thus the CFTC extended a nonexclusive safe harbor to those swap transactions that met a series of tests intended to distinguish them from their exchange-traded counterparts.
The Swaps Policy Statement did not explicitly include interest rate option products, but a subsequent series of no-action letters clarified the application of the Swaps Policy Statement to interest rate caps, floors and collars. Swap transaction activity expanded substantially after the clarifications, but other legal uncertainties relating to the applicability of the CEA to swap transactions remained.
Legal uncertainty emerged in a different form in 1990 with Transnor v. BP America Petroleum, in which a Federal District Court in New York determined that contracts for future delivery of Brent blend crude oil constituted futures contracts and were therefore subject to the CEA. Swap transactions were not at issue in Transnor, but it was feared that another court might apply Transnor's expansive definition of a futures contract to swap transactions and at the same time ignore the Swaps Policy Statement. Such a court might determine that certain swap transactions were futures contracts under the CEA. The potential for such a decision increased concern that ambiguities under the CEA could bring about consequences in the United States similar to the losses triggered by Hammersmith and Fulham in the United Kingdom.
In 1992, Congress took a major step to provide legal certainty that the CEA was not generally applicable to swap transactions by passing the Futures Trading Practices Act of 1992. The Act provided the CFTC with the power to create exemptions from the CEA for futures contracts and transactions with futures-like elements. The Report of the Committee of Conference of the U.S. House of Representatives and the U.S. Senate for the FTPA stated that the intent of this authority was to give the [CFTC] a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner. In passing the Act, Congress specifically directed the CFTC to resolve legal uncertainty concerns by promulgating an exemption for swaps and certain hybrid contracts. In order to avoid any implication that swaps are futures, Congress expressly noted in the Conference Report that the granting of an exemption does not require any determination beforehand that the agreement, instrument or transaction for which an exemption is sought is subject to the [CEA].
In response to the FTPA, the CFTC adopted the Swaps Exemption in January 1993. Reflecting Congress' direction in the FTPA, the CFTC did not make any determination that swap agreements would otherwise be subject to the CEA. The Swaps Exemption exempted certain types of swap transactions, when entered into by eligible swap participants, from selected provisions of the CEA, including the exchange-trading requirement. Exempted transactions still must meet certain criteria that are intended to distinguish them from exchange-traded agreements. In general, the Swaps Exemption covers a broader range of swap transactions than does the Swaps Policy Statement.
As a result of the Swaps Exemption, even if a swap were found to be a futures contract, and none has, it would only be subject to (i) the market manipulation and anti-fraud provisions of the CEA and (ii) Section 2(a)(1)(B) of the CEA, otherwise known as the Shad-Johnson Jurisdictional Accord (the "Accord"). The Accord divides jurisdiction over exchange-traded derivative transactions on securities between the SEC and the CFTC, and establishes that futures contracts on individual securities and certain narrow securities indices are illegal.
Also in January 1993, the CFTC adopted an exemptive framework for certain hybrid instruments, which provides an exemption for instruments such as equity or debt securities or depository instruments with imbedded futures or commodity option characteristics. If applicable, the exemption extends to all provisions of the CEA except the provisions adopted pursuant to the Accord. Other relevant exemptions which exist include those granted for (i) certain contracts for the deferred purchase or sale of specified energy products entered into between commercial participants meeting certain criteria and (ii) trade options sold to commercial counterparties who are entering into a transaction for purposes related to their business.
Among the risks faced by swap dealers and end-users, the greatest area of concern is the risk posed by legal uncertainty. In that connection, the Group of Thirtys 1993 report Derivatives: Practices and Principles pointed out the importance of legal certainty to systemic stability. Of particular concern has been uncertainty over the years of the potential application of the CEA to swaps. Because the CEA normally requires that contracts covered by the CEA be traded on an exchange, extension of the CEA to swaps would automatically make the transactions illegal and unenforceable unless specifically exempted. In addition, because of the restrictions imposed by the Accord, the CFTC lacks the authority to exempt swaps on individual securities or small baskets of securities.
But the legal uncertainty associated with the CEA in its current form runs deeper. First, despite its positive effect on swaps activity, the Swaps Exemption remains an administrative provision that can be revoked or modified by the CFTC. The CFTCs actions in 1998 are evidence that this is a real concern. If the CFTC, by altering the swaps exemption or creating similar new exemptions imposes direct regulation over swaps transactions, or otherwise signals that they are futures, they may render certain swaps illegal except when traded on an organized exchange. In those circumstances, parties to privately-negotiated derivatives transactions might seek to avoid their contractual obligations by asserting that the transactions are illegal unless they either are traded on an organized exchange or conform to conditions added to the Swaps Exemption by the CFTC. If such attempts are successful, swaps participants could experience substantial losses, including the loss of hedges on which companies rely to manage their risks.
Another source of legal uncertainty is that the CFTC has not said that swaps are not futures; instead it has said that swaps are not appropriately regulated as futures under the CEA. Although the CFTCs words simply carry out the requirements of the exemption process, in which the Commission simply declines to regulate an activity without affirming or denying jurisdiction, the Swaps Exemption does not establish with the force of law that swaps are not futures. The result is that problems of enforceability could arise because, as the CFTC exercises its enforcement authority over one set of transactions, the criteria used to assert jurisdiction might be used by litigants in other cases to establish that swaps are themselves futures; this could happen even if it were not the CFTCs explicitly intended result. An example is the CFTC enforcement order in the Metallgesellschaft case, in which the Commission set out all the essential characteristics of a swaps transaction in a broad and inclusive way. Although the CFTC might have intended (and has assured Congress) that the enforcement order was meant only for the MG activities in question, the new definitions in the order were sufficiently broad as to call into question the legality of transactions the CFTC had not intended to reach. The danger, however, is that parties seeking relief from a money-losing swap transaction might attempt to turn to the CFTC for relief.
In 1998 the most severe source of legal uncertainty was the CFTCs bold assertion in the Concept Release that swaps and other privately-negotiated derivatives are by their very nature subject to the CEA unless explicitly excluded or exempted. This assertion marked a departure from previous CFTC arguments. Until the Concept Release, the CFTC appeared to have worked on the assumption that a contract is subject to their jurisdiction if they determine it to be a futures contract, and is not subject to the Act until then. But under the Concept Release, the CFTC moved to the other side and asserted that all derivatives are automatically subject to its jurisdiction, unless it affirmatively states otherwise. Such a radical departure multiplied the uncertainty inherent in an already difficult situation.
The following sections give specific examples of how the CEA framework has intensified legal uncertainty in two different areas of financial activity.
Legal uncertainties relating to privately-negotiated swap transactions involving securities prices. Legal uncertainty is particularly acute with respect to privately negotiated swaps on securities prices, such as equity swaps. As discussed above, the CEA prohibits the entering into of futures contracts, unless made on or subject to the rules of an approved futures exchange. Any financial transaction that is a futures contract must therefore be either (i) transacted on an approved board of trade or (ii) exempted from the exchange trading requirement by the CFTC under the authority granted by the FTPA; the CFTC issued the Swaps Exemption based on this authority.
But the matter is different for swaps on securities prices: If the CFTC were to determine that swaps on the price of individual equity shares were futures, for example, the Shad-Johnson Jurisdictional Accord would prevent the CFTC from issuing an exemption; the result would be that such equity swaps would automatically be deemed illegal off-exchange futures.
To be more specific, the Accord granted the CFTC jurisdiction over futures and the SEC jurisdiction over securities. Futures contracts based on a group or index of securities are treated like other futures contracts under the jurisdiction of the CFTC (so they must be traded on an exchange), and jurisdiction over options on individual securities was granted exclusively to the SEC. But the Accord does not allow the CFTC to designate a board of trade for futures contracts on individual securities and certain narrowly defined securities indices, which means that such futures are forbidden. And since the futures are forbidden, the CFTC could not issue an exemption from the CEA requirements. But if swaps were to be deemed futures contracts, even inadvertently, (i) swaps on single securities and certain narrow indices or groups of securities would be illegal under the Accord; and (ii) swaps on broad-based groups or indices would be required to be traded on an approved board of trade. In both cases, parties to such swaps might challenge the transactions as unenforceable. Such risks have led many participants to enter into such swap transactions on securities prices through offshore affiliates.
Legal uncertainty relating to certain foreign currency transactions. The Treasury Amendment, which excludes certain foreign exchange transactions from the CEA, is statutory in nature and broader in scope than the Swaps Exemption. Unlike the Swaps Exemption, therefore, the Treasury Amendment may not be revoked or modified by the CFTC and creates a statutory exclusion from the CEA for the transactions to which it applies.
There has nonetheless been a significant amount of litigation regarding the scope of the Treasury Amendment. Without limiting its benefits to certain classes of participants, the Treasury Amendment excludes from the scope of the CEA transactions in foreign currency unless such transactions involve the sale thereof for future delivery conducted on a board of trade. A characteristic example of the inherent ambiguity of the wording shows up, for example, in disputes over the potential difference between transactions in foreign currency and transactions involving foreign currency; fortunately, the U.S. Supreme Court in Dunn v. CFTC settled the matter by ruling that the Treasury Amendment excludes options on foreign currency from the Commodity Exchange Act. Yet, the meaning of the term board of trade continues to give rise to potential legal concerns.
The 1998 Concept Release and related CFTC Actions
The imperfect but workable structure established by Congress in 1992 and the CFTC in 1993 was shaken by a series of CFTC actions in 1998. Through comments, public statements and official actions, the CFTC undermined the carefully crafted legal certainty that these transactions enjoyed. Taken together, these actions and statements indicated a troubling shift in CFTC policy that was contrary to the express intent of Congress when it enacted the FTPA. We were faced with a situation that could have been avoided if the CEA was modernized to reflect the unique nature of privately negotiated transactions.
Broker-Dealer Lite Comment Letter. The first indication of a significant shift in CFTC policy was the comment letter it filed on the SEC's proposal to establish a special category of limited purpose securities dealers specializing in privately negotiated derivatives. The most explicit formulation of this change in policy was an assertion in the CFTC's comment letter, supported in neither law nor fact, that many swaps constitute futures. The tone throughout the letter was that jurisdiction over swaps was being wrested from the CFTC by the SEC, even though neither Congress nor the CFTC has ever determined that swaps are subject to CFTC jurisdiction or that swaps are futures. In its comment letter, the CFTC first hinted that it intended to issue a concept release in which it would review developments since its 1993 exemptions for swaps and hybrids.
Agricultural Trade Options. The next sign that the CFTC has been staking out new policy ground came when the Commission considered the loosening of its previous prohibition on off-exchange agricultural trade options. Following the same path on which embarked on swap transactions, it issued a concept release seeking comment on how it should proceed. When it adopted an interim final rule on agricultural trade options, the CFTC gave little with one hand and took much with the other. While off-exchange agricultural trade options are no longer prohibited, they can only be entered into pursuant to a cumbersome and costly regulatory regime. What is worse from the standpoint of legal certainty, the CFTC reduced the scope of the Swaps Exemption, reduced the availability of hedges for agricultural commodities, and increased regulatory burdens by asserting that the provisions of the Swaps Exemption are no longer available for commodity swaps involving agricultural commodities. The CFTCs moves contradict the explicit provisions of the Swaps Exemption and the accepted market practice of those who rely on swaps to manage their exposure to agricultural commodity price fluctuations. The CFTC thus unilaterally prohibited a significant portion of the commodity swap business. Dealers in and users of these hedges of agricultural price risk curtailed their activity in this area in response to the interim final rule.
Concept Release on Swap Transactions. The CFTC's shift in policy culminated in the issuance of its extensive concept release on swap transactions. The Concept Release was cast as merely an information gathering effort, yet the concept release in fact laid out a broad regulatory scheme, in effect, unilaterally declared the CFTC to be the functional regulator of swaps and hybrids to the exclusion of other agencies and against the express will of Congress.
Treasury Secretary Rubin, Federal Reserve Board Chairman Greenspan and SEC Chairman Levitt at the time the concept release was issued and in a susequent letter transmitting proposed legislation to Congress, expressed grave concern about the Concept Release. The CFTC's actions, if left unchecked, would have had serious ramifications for the availability and cost-effectiveness of these risk management transactions for American corporations, financial institutions and government-sponsored enterprises that need to manage the risks inherent in their daily business operations.
On one level the concept release was just a series of questions, ranging from the general to the specific, from the simple to the complex. Yet, long before a reader of the release read any of these questions, it became clear that the CFTC was asserting its view that swap transactions are subject to CFTC regulation. Early in the release the CFTC stated: The purpose of this release is to solicit comments on whether the regulatory structure applicable to OTC derivatives under the Commission's regulations should be modified in any way . (emphasis added). To those who had followed the issues so closely in recent years, such statements caused serious concern about a fundamental shift in CFTC policy. Swap participants feared a repeat of the experiences described earlier in this statement, in which business was curtailed or moved offshore in the face of assertions of CFTC jurisdiction.
The jurisdictional assertions in the concept release were contrary to well-established CFTC policy and inconsistent with the position that Congress took in the FTPA. The dangerous consequences of these assertions were undoubtedly among the reasons that Secretary Rubin, Chairman Greenspan and SEC Chairman Levitt responded immediately to the concept release and expressed their grave concern about the CFTC's actions in issuing the concept release. The CFTC had undertaken a regulatory review of swap transactions without any mandate in the CEA or from Congress to undertake that review.
In the end, thanks in large part to the leadership of Chairman Leach and other members of Congress including House Agriculture Committee it was Congress that addressed the CFTC Concept Release of 1998. It enacted legislation, at the request of the Treasury, the Federal Reserve Board and the SEC, to limit the CFTCs rulemaking authority with respect to swaps and hybrid instruments until March 30, 1999. The legislation put the CFTC on "hold" and sent a clear signal of Congressional intent that the regulatory framework for swaps should not be changed until Congress had a chance to consider the issues. Subsequently, the CFTC withdrew the Concept Release.
J.P. Morgan welcomes the activities of this Committee and other committees of the Congress, including the committees of jurisdiction over the CFTC, to address these important concerns. We are particularly grateful to you, Mr. Chairman, for your leadership this year. You have raised important questions about the most recent CFTC Staff Proposal, and we hope that you will continue to monitor its progress closely. We also applaud the introduction of H.R. 4203 by the leadership of this committee, and we look forward to working with you to modernize the CEA and clarify once and for all that the CEA is inapplicable to swap transactions.
My testimony today principally is concerned with OTC derivatives and legal certainty, and I have commented on the importance of cross-product netting in reducing credit risk for swap participants. I also would like to offer several observations on the Hedge Fund Disclosure Act (H.R.2924).
It is my understanding that the purpose of the Act is to enhance the ability of financial firms to assess the risks to which they are exposed when they enter into transactions with hedge funds, which may be highly leveraged. The Act would accomplish this by, among other things, mandating periodic disclosure of financial information by entities that are referred to as "unregulated hedge funds." We are doubtful about the need for such legally mandated disclosures and concerned that the Act may impose regulatory requirements, and their attendant cost, on entities for which they are not appropriate. Moreover, the Act could have the unintended effect of discouraging foreign entities from doing business with American financial firms.
We do not believe that new laws requiring disclosure of financial information are needed by parties to private business transactions in the circumstances contemplated by this bill. The financial institutions that enter into transactions with hedge funds have all of the negotiating power they need in order to obtain information to assess a counterpartys financial condition. If they are not satisfied with the information provided, they can decline to enter into any particular transaction.
This is a matter of particular concern because of the scope of the Act. Although it apparently is intended to apply to large hedge funds, it appears to be much broader than that. For example, the Acts disclosure requirements also could apply to private equity funds or other joint investment vehicles that are not significantly leveraged and are not commonly thought of as hedge funds. It might even pick up defined contribution pension plans (such as 401(k) and profit sharing plans). Although the Act provides various exclusions, including one for pooled investment vehicles that are subject to examination by, or the reporting requirements of, Federal banking agencies, many such investment vehicles would not be excluded. For example, investment funds advised by banks would not necessarily be excluded. While the bank might be examined or subject to reporting requirements, an equity fund it advised wouldnt be. The burden of new periodic financial reports certainly should not be imposed on entities such as these unless it clearly is needed.
We also are concerned that the Act could discourage foreign funds from doing business with American banks or other financial firms. The Acts disclosure requirements would be imposed on hedge funds, and other investment vehicles, organized anywhere in the world, so long as they borrow from, accept investments by, or are a counterparty to any person organized under U.S. law. In order to avoid the Acts requirements, a foreign fund would have to avoid doing business with U.S. entities. It is not clear that the benefits that might be derived from the Act would justify creating a disincentive to doing business with American firms.