Congress enacted amendments to the Commodity Exchange Act (CEA) last May as one title of the comprehensive Farm Bill. However, the version of the Farm Bill sent to the president was incomplete. In lieu of addressing the missing title (on food and international trade programs), it proved to be more expeditious for Congress to re-enact the complete Farm Bill, present it to the president a second time for veto, and then vote to override the president’s veto. That process has concluded. The new Farm Bill explicitly repeals the earlier bill, which took effect on May 22, 2008, but has retained May 22 as the effective date for all titles, including the CEA amendments.
These are the first amendments to the CEA since the Commodity Futures Modernization Act (CFMA) was adopted in 2000, which materially restructured the CEA’s regulatory framework for the futures markets. The recent amendments, called the CFTC Reauthorization Act of 2008 (CRA), represent in some respects a retreat from the CFMA’s deregulatory approach. In particular, they give the Commodity Futures Trading Commission (CFTC), for the first time, express rulemaking authority to regulate certain segments of the off-exchange retail forex markets and increase the regulation of exempt commercial markets such as the Intercontinental Exchange that list contracts in energy and other exempt commodities. The CRA also imposes deadlines on the CFTC and the U.S. Securities and Exchange Commission (SEC) to take certain actions with respect to their joint oversight of security futures products. These changes are discussed below, along with other notable changes.
Regulation of Retail Forex Activities
The Treasury Amendment, CEA §2(c), provides an exclusion from the CEA for over-the-counter (OTC) transactions in certain listed financial instruments, including foreign currencies. Following the 1997 U.S. Supreme Court decision in the Dunn case, the Treasury Amendment has been understood to exclude from the CEA’s scope transactions in futures and options on the financial instruments listed in the Treasury Amendment.1
In 2000, the Treasury Amendment was revised to narrow the scope of the exclusion as it applied to foreign currency transactions; since 2000, when one party to the transaction is not an “eligible contract participant” (referred to in this Legal News Alert as a retail customer), the transaction qualifies for exclusion only if the customer’s counterparty is a financial institution, registered broker-dealer, regulated insurance company, or regulated subsidiary or affiliate of an insurance company, financial holding company, investment bank holding company, futures commission merchant (FCM), or affiliate of an FCM. With the exception of FCMs and their affiliates, each of the categories covers firms that are subject to regulation under U.S. law by banking, insurance, or securities market regulators (or comparable foreign law in the case of an insurance company). FCMs are regulated by the CFTC, but their affiliates are not, at least not directly, unless they also are registered in some capacity with the CFTC.
The CRA revises CEA §2(c) to establish a framework for the CFTC to regulate OTC retail forex activities of FCMs, affiliates of FCMs and firms acting in a newly created category of permissible counterparty called “retail foreign exchange dealer” (collectively referred to in this Legal News Alert as CFTC-Regulated Forex Dealers). In large part, the changes are a reaction to the decision of the Seventh Circuit Federal Court of Appeals in CFTC v. Zelener, 373 F.3d 861 (2004), in which the court ruled that rolling spot contracts at issue in that case were not futures and thus did not support the CFTC’s assertion of enforcement jurisdiction.2
The CRA grants the CFTC the authority to adopt and enforce rules governing most forex trading by CFTC-Regulated Forex Dealers as principal with retail customers. This authority extends to trading of OTC foreign currency futures, options, and options on futures (referred to in this Legal News Alert as forex futures and options) between a CFTC-Regulated Forex Dealer and a retail customer. Significantly, it also extends to OTC foreign currency transactions between a CFTC-Regulated Forex Dealer and a retail customer that are offered or entered into on a leveraged, margined, financed, or similar basis (referred to in this Legal News Alert as leveraged forex), without regard to whether such transactions are futures. However, if a transaction is a contract of sale that results in actual delivery of the foreign currency within two days or creates an enforceable obligation to deliver the currency between parties capable of making and accepting delivery in connection with their respective lines of business, it is not a leveraged forex transaction within the scope of the CFTC’s new authority.
The financial press has referred to the provisions regarding leveraged forex as the “Zelener fix,” because they empower the CFTC to pursue anti-fraud actions involving rolling spot transactions or other leveraged forex transactions without the need to prove that they are futures. Congress took this approach in lieu of declaring such transactions to be futures.
The CRA imposes substantial regulatory costs on CFTC-Regulated Forex Dealers. Specifically:
Solicitors, Trading Advisors, and Pooled Investment Vehicles
Significantly, the CRA adds provisions to the Treasury Amendment that authorize the CFTC to regulate with limited exception firms that (i) solicit retail customers to trade forex futures and options or leveraged forex with a CFTC-Regulated Forex Dealer; (ii) have or exercise trading discretion for retail customers in connection with trading forex futures and options or leveraged forex with a CFTC-Regulated Forex Dealer; or (iii) operate or solicit investments in a pooled investment vehicle where the pooled investment vehicle is not an eligible contract participant and trades forex futures and options or leveraged forex with a CFTC-Regulated Forex Dealer.
The CFTC is given the authority to determine the capacity in which firms engaged in the activities described above should register. The CFTC also may adopt rules regulating the forex activities of such firms. The amendments do not impose a minimum capital requirement on such firms.
Regulation of Significant Price Discovery Contracts of Exempt Commercial Markets
The 2000 CFMA amendments added to the CEA, for the first time, express exclusions and exemptions from CFTC-exchange registration for certain types of centralized derivatives markets, called “trading facilities” in the statute. At the same time, the amendments adopted a “lighter touch” regulatory approach for CFTC-registered exchanges by replacing detail-oriented requirements with general core principles and registration standards.
The CRA modifies the terms of the exemption available to a trading facility operating as an exempt commercial market under CEA §§2(h)(3)-(5). An exempt commercial market is an electronic trading facility that lists contracts on exempt commodities and limits its market participants to a subset of eligible contract participants called “exempt commercial entities.” (Some other conditions also apply.) The CEA defines “exempt commodity” to include commodities other than (i) agricultural commodities or (ii) financial instruments, measures, or events with associated economic or financial consequences, as covered by the CEA definition of an “excluded commodity.” Examples of exempt commodities include natural gas, electricity, and metals. (The Intercontinental Exchange operates as an exempt commercial market for various energy-related contracts.)
The CRA revises CEA §2(h) to apply core principles to an exempt commercial market in connection with any “significant price discovery contract” that it lists. The CFTC is given the discretion to determine whether a contract is a significant price discovery contract, taking into account various factors such as liquidity, or price linkages such as use of prices of exchange-traded futures or other significant price discovery contracts to value the contract.
Under the new core principles, an exempt commercial market, among other requirements, may only list a significant price discovery contract that is not readily susceptible to manipulation; must monitor trading in significant price discovery contracts; must adopt position limits or position accountability standards for significant price discovery contracts; must make certain market data public on a daily basis for significant price discovery contracts; and must monitor and enforce compliance with its rules applicable to significant price discovery contracts. These requirements push exempt commercial markets closer to the model of a regulated futures exchange, with defined self-regulatory responsibilities, but the amendments stop short of requiring an exempt commercial market to register with the CFTC in some capacity as a futures exchange.
The CRA also imposes large trader reporting requirements with respect to significant price discovery contracts listed on an exempt commercial market.
Security Futures Products
The CFMA amended the CEA and federal securities laws in 2000 to permit, for the first time in the United States, transactions in single stock futures, narrow-based stock index futures, and options on such futures, called “security futures products.” Security futures products are classified as both futures and securities, and may be listed for trading on a futures exchange or securities exchange.
The CFTC and SEC have yet to adopt rules in certain areas where their inaction is seen to impede the growth of the security futures markets in the United States, which has been slow in comparison to the growth of comparable markets in Europe. To push the agencies to act in two key areas, the CRA directs the CFTC and SEC to exercise their existing authority to adopt requirements for portfolio margining for security futures products by September 30, 2009, and to resolve issues relating to trading of futures on narrow-based foreign stock indexes by June 30, 2009.
The CRA includes other changes to the CEA:
1 Dunn & Delta Consultants, Inc. v. CFTC, 519 U.S. 465 (1997). As a threshold matter, an instrument must be a futures contract, commodity option, or option on a futures contract to fall within the CEA’s subject matter jurisdiction. The Treasury Amendment was added to the CEA in 1974 to address the concerns of the U.S. Department of Treasury that the CEA could be read to apply to inter-bank markets under a broadly expanded definition of “commodity” that also was added to the statute at that time. In Dunn, the Supreme Court ruled that the Treasury Amendment excluded from the CEA’s scope OTC transactions in options on government securities (one of the financial instruments listed in the Treasury Amendment), resolving long-standing debate on whether the Treasury Amendment should be read to exclude instruments that would otherwise be subject to the CEA.
Kathryn M. Trkla
Scott E. Early