On December 21, 2000, President Clinton signed into law the Commodity Futures Modernization Act of 2000 (CFMA), implementing the most far reaching amendments to the Commodity Exchange Act (CEA) since the creation of the Commodity Futures Trading Commission (CFTC) in 1975. Congress enacted the CFMA to, among other things, streamline and eliminate unnecessary regulation, promote innovation and competition, enhance legal certainty concerning the enforceability of commodity transactions and transform the role of the CFTC in overseeing the futures and over-the-counter (OTC) derivatives markets from front-line regulator to high-level supervisory agency. Significantly, the legislation also grants the CFTC limited jurisdiction over securities-based futures products.
The CFMA scales back the jurisdictional reach of the CEA based, in part, on the category of commodity traded: excluded, exempt or agricultural. The CFMA also establishes separate, but interrelated, market- and transaction-based exemptions and exclusions (Relief) from the CEA. The exemptions and the exclusions depend, in part, on the parties involved in the transactions.
Certain Relief is limited to transactions conducted other than on "trading facilities," while other Relief is available for transactions conducted either on or off of such facilities. The CFMA generally accords greater Relief to electronic markets than to their non-electronic counterparts. For the first time, the CEA explicitly provides that contracts that do not comply with the provisions of an exemption or exclusion from the CEA are nevertheless enforceable.
The CFMA also changes the regulatory regime with respect to clearing. Clearing of futures and options for certain categories of transactions no longer implicates CFTC registration requirements. In addition, clearing of swap transactions is now open to clearing organizations regulated by the Securities and Exchange Commission (SEC), bank regulators, foreign regulators or the CFTC.
II. NEW EXCLUSIONS AND EXEMPTIONS FROM THE COMMODITY EXCHANGE ACT
A. Transaction-Based Relief
1. The Treasury Amendment
The CFMA clarifies the scope of the so-called "Treasury Amendment," by amending the CEA to provide that transactions in certain specified commodities (including foreign currency and government securities) are excluded from the CEA unless conducted on an organized exchange. The CFMA also grants the CFTC express jurisdiction over foreign currency futures and option contracts (other than currency options traded on national securities exchanges) offered by unregulated persons to retail investors.
2. Excluded Derivative Transactions
Agreements, contracts or transactions (Transactions) in "excluded commodities" are excluded from almost all provisions of the CEA if either: (1) the Transactions are entered into solely between "eligible contract participants" (ECPs) and are not conducted on a "trading facility" (TF); or (2) the Transactions are entered into on a principal-to-principal basis on an "electronic trading facility" (ETF) between ECPs trading for their own accounts or, in the case of specified investment managers, for client accounts. Excluded derivative Transactions are subject only to the clearing provisions of the CEA, unless they are traded on a derivatives transaction execution facility (DTEF) or an exempt board of trade (EBOT) (both discussed below), in which case the Transactions are subject to those provisions of the CEA applicable to DTEFs and EBOTs, subject to certain exceptions.
a. Excluded Commodities
In general, "excluded commodities" are commodities that are not susceptible to manipulation. Excluded commodities include rates, currencies, securities, macroeconomic indexes, economic or commercial measures that are broad-based or based on commodities lacking cash markets, economic or commercial measures based on an underlying commodity not within the control of a party to the relevant contract and an occurrence not within the control of such a party.
b. Eligible Contract Participants
The ECP class is based on the definition of "eligible swap participant" contained in Part 35 of the CFTC’s rules. The CFMA lowered the threshold for individuals to include in the ECP definition, in addition to individuals with more than $10,000,000 in total assets (the requirement for natural person eligible swap participants), individuals with more than
$5,000,000 in total assets who enter into Transactions for risk management purposes.
c. Trading Facility
A "trading facility" (TF) is defined as a physical or electronic facility or system permitting multiple participants to execute Transactions by accepting bids or offers made by other participants and open to multiple participants in the facility or system. "Trading facility" expressly does not include, among other facilities: (1) a facility solely because it permits participants to negotiate and enter into bilateral transactions by exchanging communications between the parties and not by the interaction of multiple bids/offers within a predetermined, nondiscretionary automated trade matching and execution algorithm; or (2) those on which bids and offers, and acceptances of bids and offers effected on the facility, are not binding. The term "trading facility" also does not include any facility on which only a single firm may participate as a market-maker and other participants cannot accepts bids/offers from participants other than the market-maker.
d. Electronic Trading Facility
An "electronic trading facility" (ETF) is a TF that operates by means of an electronic or telecommunications network and maintains an automated audit trail of bids and offers and order matching or transaction execution.
3. Transactions in Exempt Commodities
The CFMA created two separate exclusions for transactions in "exempt commodities": one for Transactions not conducted on TFs and one for Transactions conducted on ETFs. Transactions in "exempt commodities" that are entered into between ECPs and not on a TF are now excluded from all provisions of the CEA other than the clearing and antifraud and anti-manipulation provisions.
Transactions in exempt commodities that are entered into on a principal-to-principal basis solely between "eligible commercial entities" (ECEs) and executed or traded on an ETF are also excluded from all provisions of the CEA other than the clearing and antifraud and anti-manipulation provisions. The CFMA also permits Transactions in exempt commodities to occur on an EBOT and/or a DTEF, subject, for the most part, to those CEA provisions applicable to EBOTs and DTEFs. If the CFTC determines that the ETF performs a significant price discovery function for cash market transactions in a commodity, the CFTC may require the ETF to publicly disseminate price, volume and other trading information. ETFs relying on the foregoing Transactions in Exempt Commodities exclusion must provide the CFTC with certain information prior to commencing trading in exempt commodities. ETFs are also subject to ongoing reporting and recordkeeping requirements.
a. Exempt Commodities
"Exempt commodities" are all commodities other than excluded commodities or agricultural commodities. They include physical commodities such as power and metals.
b. Eligible Commercial Entities
ECEs are defined as persons within specified ECP categories who, with respect to a Transaction in a commodity: (1) in connection with their business, (a) can directly or by contract make or take delivery of the commodity in which they contract, (b) incur commodity-related risks other than price risk, or (c) are dealers who regularly provide risk management, hedging or market-making services to the foregoing persons in connection with cash or derivatives market transactions in the relevant commodity; or (2) are ECPs, other than natural persons or government entities, who regularly enter into Transactions to buy or sell the commodity and who have (a) $1,000,000,000 in total assets (for collective investment vehicles that admit persons other than certain enumerated classes of "sophisticated" investors), or (b) $100,000,000 in total assets (for all other persons). The monetary thresholds can be satisfied by a single entity or by aggregating the entity’s assets with those of other collective investment vehicles or persons under common control or management.
4. Excluded Swap Transactions
Individually negotiated Transactions in excluded and exempt commodities that are entered into between ECPs and not traded on a TF are subject only to the clearing provisions of the CEA. The CFMA also permits such Transactions to occur on an EBOT and/or a DTEF, subject generally to those CEA provisions applicable to EBOTs and DTEFs.
Notably, the CFMA requires the Federal Reserve Board, Treasury, CFTC and SEC (Agencies) to conduct a study of issues implicated by offering swaps to non-ECPs (Retail Swaps). The study must address potential uses of Retail Swaps, the extent to which financial institutions would be willing to offer Retail Swaps, the appropriate regulatory structure and any other issues deemed relevant by the Agencies. The Agencies must present the study and their recommendations for legislative action to Congress prior to December 21, 2001.
B. Relief for Commodities Markets
1. Excluded ETFs
Nothing in the CEA applies to ETFs that limit the contracts they trade to excluded derivative Transactions, excluded swap Transactions or Transactions in exempt commodities between ECEs (Excluded ETF Transactions). In the event that an ETF fails to limit transactions to Excluded ETF Transactions, the Transactions themselves are still legal and enforceable.
2. Derivatives Transaction Execution Facilities
Markets meeting the conditions for registration as a DTEF can operate under less regulation than traditional futures exchanges. To be a DTEF, a market must limit contracts to: (1) commodities with a nearly inexhaustible deliverable supply or a deliverable supply large enough that the contract is highly unlikely to be susceptible to manipulation; (2) those with no underlying cash markets; (3) security futures products (in this case, the DTEF must also be a registered national securities exchange); (4) contracts that the CFTC has determined (based on market characteristics, surveillance history, and other factors) are highly unlikely to be susceptible to manipulation; or (5) those based on non-agricultural commodities (if the market is a DTEF on this basis, it must also limit trading access to ECEs trading for their own account).
DTEFs must also limit traders to ECPs or one or more of the following categories: (1) registered futures commission merchants that are members of a derivatives clearing organization (DCO) and have net capital of $20,000,000; (2) broker-dealers; (3) depository institutions; and (4) farm credit system banks.
To register as a DTEF, a facility must: (1) have adequate means to deter trading (and other) abuses; (2) establish and enforce trading procedures; and (3) establish and enforce rules regarding the financial integrity of transactions and intermediaries and the safety of customer funds. To remain registered, the DTEF must adhere to nine core principles, including fitness standards for directors, members with trading privileges and certain others, standards for monitoring the market and avoiding and resolving conflicts of interest in the DTEF’s governance processes, and disclosure and recordkeeping requirements.
3. Exempt Boards of Trade
Markets meeting the conditions for registration as an EBOT can operate under less regulation than a traditional futures exchange designated as a contract market in a commodity. To be an EBOT, a market must limit contracts to those based on commodities with: (1) a nearly inexhaustible deliverable supply; (2) a deliverable supply large enough that they are highly unlikely to be subject to manipulation; or (3) no underlying cash market. Trading must be limited to ECPs. Security- and security index-based futures and option contracts cannot be traded on EBOTs.
4. Contract Markets
The CFMA prescribes that futures contracts which are based on enumerated agricultural commodities and that were listed on a futures exchange as of December 21, 2000, may be traded only on a CFTC-designated "contract market." Facilities already designated as a contract market in a commodity as of December 21, 2000 retain that designation under the CFMA. The CFMA provides that the CFTC can issue rules permitting the trading of futures and futures options contracts (with the exception of agricultural commodity contracts) on DTEFs.
A market applying for designation as a contract market must meet specified criteria (Designation Criteria), including having the capacity to prevent market manipulation, provide public access to its rules, regulations and contract specifications and establishing and enforcing rules: (1) promoting fair and equitable trading; (2) governing other operations of the market; (3) ensuring the financial integrity of transactions on the board of trade (including requiring clearing and settlement through a DCO); (4) implementing disciplinary procedures; and (5) enabling the market to obtain any information necessary to perform these Designation Criteria.
In order to maintain its designation, a contract market must adhere to no less than 18 core principles, including: (1) enforcing compliance with its rules; (2) listing only contracts not readily susceptible to manipulation; (3) monitoring trading to prevent abuses; (4) retaining the right to exercise emergency authority; (5) making its trading execution mechanisms, listed contract terms and trading information public; (6) providing for the financial integrity of Transactions and intermediaries and the protection of customer funds; (7) protecting participants from abusive practices by intermediaries; (8) establishing proper fitness standards for, among other persons, directors and those with trading privileges; and (9) maintaining records of all contract market-related activities for five years. A contract market may comply with any of the core principles though delegation of any relevant function to a registered futures association or another registered entity, but remains responsible for carrying out each function.
C. Product-Based Relief: Hybrid Instruments
A hybrid instrument is defined by the CFMA as a security or banking product with a payment indexed to a commodity value or rate or providing for delivery of a commodity. Hybrid instruments that are predominantly securities or banking products are completely excluded from all CEA requirements. Unlike the former CFTC predominance test, the new predominance test should be straightforward to apply. A hybrid instrument will be considered predominantly a securities or banking product, as applicable, if: (1) the issuer of the hybrid instrument receives full payment substantially contemporaneously with the delivery of the hybrid; (2) the purchaser of the hybrid is not required to make any additional payments to the issuer during the life of the hybrid or at maturity; (3) the issuer is not subject by the terms of the instrument to mark-to-market margin requirements; and (4) the hybrid is not marketed as a futures contract or option on a futures contract subject to the CEA.
Transactions in futures, options on futures or options on commodities, if cleared, must be cleared by a DCO registered with the CFTC as such, unless the transactions are excluded or exempted from the CEA or in a security futures product cleared by a clearing agency registered under the ‘34 Act. Generally, OTC derivatives Transactions may be cleared only by a bank, clearing agency registered with the SEC, or registered DCO. However, entities supervised by a foreign financial regulator that a U.S. bank regulator, the SEC or the CFTC (depending on which underlying commodity is involved) has determined satisfies appropriate standards can also clear OTC derivatives Transactions. The CFMA also provides that an entity that would not otherwise be a TF cannot be considered a TF solely as a result of the entity’s submission to a DCO of transactions executed on the TF.
A DCO is defined as an entity that, with respect to a Transaction: (1) enables each party to the Transaction to substitute the entity’s credit for the credit of the parties, by novation or otherwise; (2) arranges or provides multilateral settlement or netting of obligations resulting from Transactions executed by participants in the entity; or (3) otherwise provides services that mutualize or transfer among the entity’s participants the credit risk arising from Transactions by participants in the entity.
An entity is not a DCO solely because it arranges or provides for: (1) settlement, netting or novation of obligations on a bilateral basis and without a central counterparty; (2) settlement or netting of cash payments through an interbank payment system; or (3) settlement, netting or novation of spot market commodity transaction obligations.
A DCO must be registered with the CFTC to clear futures, options on futures and options on commodities unless the futures or option transactions to be cleared fall within specified exclusions or exemptions from the CEA. To become and remain registered as a DCO, an entity must demonstrate compliance with specified core principles designed to ensure the financial integrity of the DCO, including standards for financial resources, participant and product eligibility, risk management and treatment of funds, settlement procedures and system safeguards.
III. SECURITY FUTURES
Although futures contracts on broad stock indices and individual exempted securities under Section 3(a) of the Securities Act of 1933 ("’33 Act") or Section 3(a)(12) of the ‘34 Act (Exempted Securities) have long been permitted, futures and option contracts written on narrow-based groups of securities or on single, non-Exempted Securities (collectively, Security Futures) had not been permitted before enactment of the CFMA. Prior to the CFMA, futures contracts (which had been subject to the exclusive jurisdiction of the CFTC) were regulated as such, regardless of the underlying commodity, even when that commodity was a securities index or Exempted Security. Security Futures, however, are now defined by the CFMA as securities and subject to regulation by both the SEC and CFTC. By contrast, futures contracts on broad-based securities indices, which had been subject to SEC approval, are now regulated solely by the CFTC.
Any market listing, and intermediaries trading, Security Futures must be registered with both the SEC and the CFTC. To expedite registration, the CFMA establishes an abbreviated notice registration procedure for such markets and intermediaries. The National Futures Association now has the authority to regulate broker-dealers in Security Futures. Clearing organizations must establish procedures for the clearing of Security Futures products by one of two deadlines set forth in the CFMA.
The drafters of the CFMA included several measures to ensure that Securities Futures do not have a Congressionally-imposed competitive advantage over securities options. Perhaps most important, initial and maintenance margin requirements for Security Futures cannot be less than the lowest level of margin required for comparable securities options traded on a national securities exchange. Security Futures will initially be subject to the same transaction fee as securities options. The transaction fee is currently set to begin at $0.02 per "round turn" (one purchase and one sale of a futures contract); it will become $0.0075 beginning October 1, 2006. Dealers and market-makers will receive 60-40 capital gains treatment for tax purposes, consistent with security options. All other market participants will be taxed on the profits and losses accruing from Security Futures transactions as if such transactions were in the underlying securities.
Security Futures products cannot be offered until one year after the enactment of the CFMA or on the date on which the National Futures Association is registered as a limited purpose national securities association. Certain principal-to-principal and limited other transactions in Security Futures between eligible contract participants can be effected as early as eight months after enactment of the CFMA. Options on Security Futures cannot be offered until three years after the CFMA’s enactment.
IV. EXCLUSION OF SWAPS FROM SEC JURISDICTION
Title III of the CFMA excludes both security-based and non-security-based swap agreements from the SEC’s jurisdiction. The term "security-based swap agreement" means a swap agreement (as defined in new section 206A of the Gramm-Leach-Bliley Act) of which a material term is
based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein. A "non-security-based swap agreement" is defined as a swap agreement that is not a security-based swap agreement.
The SEC retains limited antifraud, anti-manipulation and anti-insider trading authority over security-based swap agreements.
V. REGULATORY RESPONSIBILITY FOR BANK PRODUCTS
The CFMA excludes certain banking products and "covered swap agreements" from the jurisdiction of the CFTC. The exclusion covers: (1) products commonly offered by any bank on or before December 5, 2000 and not prohibited or regulated by the CFTC as a futures contract or commodity option; (2) products not offered on or before December 5, 2000 that have no payment indexed to the value of any commodity or that are otherwise excluded from the CEA; (3) hybrid instruments that are predominantly banking products under the new predominance test established by the CFMA; and (4) covered swap agreements offered, entered into, or provided by a bank. A covered swap agreement means a swap agreement (as defined in new section 206A of the Gramm-Leach-Bliley Act) based on a commodity other than an agricultural commodity enumerated in Section 1a(4) of the CEA, that is either entered into:
(1) only between ECPs other than on a TF; or (2)(i) based on an excluded commodity, (ii) on an ETF; and (iii) on a principal-to-principal basis between ECPs trading for their own accounts or, in the case of specified investment managers, for client accounts. The CFTC must now "consult with and seek the concurrence of" the Federal Reserve Board before commencing a rule making or making a determination under a rule concerning hybrid instruments issued under the CFMA.
The CFMA provides that no hybrid instrument or covered swap agreement is void, voidable or unenforceable, and no party to either is entitled to rescind or recover a payment with respect to such instrument or agreement, based solely on the failure of the hybrid instrument or covered swap agreement to comply with the terms or conditions of any CFTC exemption or exclusion.