Another Win for OTC Derivatives
In what represents yet another win for the OTC derivatives market, the
Supreme Court has ruled unanimously that the 1974 Treasury Amendment does
apply to foreign exchange options.
The ruling is the latest encounter in a long-standing war of attrition
between the OTC derivatives market and the CFTC. The squabble stems from
the CFTC's attempts to prosecute William Dunn, whose $180 million foreign
exchange option fund lost $95 million in 1993. Dunn protested that the 1974
amendment specifically exempted FX options from CFTC regulation when it
said that the CEA did not apply to "transactions in foreign currency."
The CFTC argued that FX options did not enjoy the protection of the 1974 legislation because they weren't actually transactions in foreign currency
until the option was exercised. The Supreme Court was not impressed and
pooh-poohed such speciosity, reversing a decision made by the 2nd Circuit
Court in 1995. "We think it plain that foreign currency options are
'transactions in foreign currency' within the plain meaning of the statute.
We are not persuaded by any of the arguments advanced by the CFTC in support
of a narrower reading," wrote Justice John Paul Stevens.
Listed and OTC derivatives groups lined up on opposite sides of the decision. "The Court's decision is likely to be read as codifying the loophole
used by currency scam artists and unregulated exchanges who prey on the
investing public," protests Chicago Mercantile Exchange (CME) chairman
Sandner. On learning of the verdict, a disappointed CFTC claimed that
"bucket shops" like the one Dunn ran would remain unregulated
and could continue to defraud investors of millions of dollars. The International
Swaps and Derivatives Association, meanwhile, was predictably upbeat. "ISDA
likes this decision because the Treasury Amendment is a good model for legal
certainty," comments legal counsel and acting executive director Beth
Davy. "It is a bright line test for what is subject to the CEA and
what is not."
The war, however, is not over yet; the case has been remanded back to
the 2nd Circuit of the Federal District Court and the CFTC intends to contest
the decision. The Supreme Court itself suggested that the arguments should
be presented to Congress, not to the courts. Stand by for the next bruising
Lugar Stirs a Hornet's Nest
Sen. Lugar's derivatives reform legislation may help futures exchanges, but it angers almost everybody else.
Indiana Sen. Richard Lugar's recently proposed bill, the Commodity Exchange Act Amendments of 1997, advances a cause dear to his heart: the deregulation
of exchange-listed futures and a diminution of the powers of the CFTC. Lugar,
a Republican and chairman of the Senate Agriculture, Nutrition and Forestry
Committee, floated a similar proposal last year, then withdrew it for some
The draft bill, which is cosponsored by Senators Tom Harkin (D-Iowa)
and Pat Leahy (D-Vt.), proposes solutions to many regulatory vexations felt
by the listed-futures markets. It forces a speedup of the CFTC approval
machinery on most new listed contracts from the current 90 days to 10. It
requires that CFTC regulatory rules be subjected to a cost-benefit test-as
in setting audit trail standards. It urges that more of the CFTC's chores
be handed off to such industry groups as the National Futures Association.
And to ensure that the listed exchanges didn't get everything and the OTC
market nothing, the bill proposes to put firmly into law the current swaps
exemption from CFTC regulation, and extends its embrace to equity swaps
With these ingredients, Lugar's bill would have been a political shoe-in. After all, who these days is against deregulation? The CFTC, moreover, is
the kind of weak and politically defenseless target that legislators feel
is ripe for wing-clipping in the current Washington climate of downsizing.
Lugar, however, decided to give the CFTC additional powers to fight an
additional battle-the Internet guerrillas who've been stealing the exchanges'
bread with FX futures and options offerings, an affliction that the futures
exchanges testified to loudly last year. In doing so, Lugar may have overreached
himself. To get at the Internet crowd, he proposed expanding the CFTC's
authority by revising what is, from the swap industry's point of view, the
dike that holds back the sea: the 1974 Treasury Amendment to the Commodities
The reaction from the Treasury couldn't have been stronger, and mirrored the position taken by the International Swap Dealers Association (ISDA).
In mid-February hearings on the legislation, Roger Anderson, deputy assistant
secretary of the Treasury for federal finance, said the changes sought by
the CFTC go beyond what is necessary to prosecute those who perpetrate fraud
against small investors on the Internet. "And far from fixing the legal
uncertainty that surrounds derivatives transactions in FX and government
securities," he said, "the uncertainty would be exacerbated."
At the hearing, CFTC chairperson Brooksley Born was not loath to accept
more power, but argued that the increased CFTC authority Lugar was offering
would apply only to those derivatives not monitored by the other existing
federal agencies-a reassurance that failed to soothe ISDA or Treasury. Overall,
however, Born was unhappy. She objected vehemently to the provisions that
limited CFTC authority over listed exchanges. The net effect, she said,
would be to "eliminate federal power to protect against manipulation,
fraud, financial instability and other dangers."
But Lugar made another set of enemies as well. One new freedom the proposed bill bestows on futures exchanges is a right to create unregulated professionals-only
markets in Treasury Amendment products. This professionals-only market theoretically
could allow listed futures exchanges to recapture a significant share of
the business lost to the OTC market. The stock exchanges promptly weighed
in against it. Alger Chapman, chairman of the CBOE, who also testified on
behalf of NYSE, NASDAQ, and the American, Boston, Chicago, Cincinnati, Pacific
and Philadelphia exchanges, warned that the bill would "lead to futures
and other derivatives based on a single equity security being traded on
the commodities exchanges free from virtually all government regulations."
A further blow to Lugar's proposition came from Sen. Phil Gramm (R-Texas), the chairman of the Senate Banking Committee, who threatened to stall the
bill if he wasn't given a guarantee that the CFTC would not use the modified
Treasury Amendment to increase its regulatory influence. Sen. Lauch Faircloth
(R-N.C.), also on the Banking Committee, seconded these objections. Lugar
then promised to accommodate his colleagues and to incorporate the criticisms
with revised language.
The question is now how far Lugar will retreat. He's said he will mark
up the bill and unveil it later this year. His opponents think that is unlikely.
"It will take longer," says an aide to Fairclough. "This
is a very controversial bill. There are so many people on both sides."