Senate Agriculture Committee: The Exchange Act S257

TESTIMONY OF ROBERT G. EASTON ON BEHALF OF THE MANAGED FUTURES ASSOCIATION BEFORE THE COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

UNITED STATES SENATE

Mr. Chairman and members of the Committee: My name is Robert G. Easton and I am the Chairman and Chief Executive Officer of Corporation Limited located in Princeton, N.J. I also am Chairman of the Government Relations Committee of the Managed Futures Association ("MFA"). I appreciate the opportunity to testify on behalf of MFA at this hearing on S. 257.

MFA, a nonprofit national trade association with over 600 members, represents the managed futures industry. The objectives of the MFA are to enhance the image and understanding of the industry, to further constructive dialogue with regulators in pursuit of regulatory reform, and to improve communication with, and training of, the Association's members through effective conferences and communications programs. MFA is governed by an elected board of directors and has offices in Washington, D.C. and California. MFA membership is composed primarily of commodity pool operators and commodity trading advisors who are responsible for the discretionary management of the vast majority of the more than $25 billion estimated as currently invested in managed futures products, including commodity pools and managed futures accounts.

Commodities Corporation Limited is an MFA member and is registered as both a commodity pool operator and a commodity trading advisor, managing client capital and its parent company's proprietary capital since 1969. Currently, our company has over $1.3 billion under management. Our members are participants in both the OTC markets and the designated contract markets. As managers of funds provided by their clients, MFA's members act as purchasers of futures industry services and thus are the indirect beneficiaries of market protection rules under the Commodity Exchange Act (the "Act"). Thus, those sections of the Act and those activities of the Commodity Futures Trading Commission ("CFTC") that regulate the functioning of, or participation in, the markets have an important impact on commodity pool operators and commodity trading advisors as representatives of their clients.

The business operations of MFA members are subject to regulation under the Act by the CFTC and, pursuant to delegation of certain regulatory functions under the Act, by the industry's self regulatory organization, the National Futures Association ("NFA"). The Act regulates the business activities of commodity pool operators and commodity trading advisors through registration, disclosure, record keeping and reporting requirements and regulates the activities of the commodity brokers and commodity exchanges through which their trades are executed and cleared. The NFA regulates the sales, promotional, registration and operational activities of these entities. Each of the exchanges also regulates trading activities on their markets. In addition, the offer and sale of interests in commodity funds are subject to both the Securities Act of 1933, requiring registration of interests sold publicly and mandating disclosure requirements, and the Securities Exchange Act of 1934, as well as each of the 50 states' securities laws. In , both the activities of our members and the products they offer are more stringently regulated than any other product in the world. There has been no greater advocate of elimination of unnecessary, burdensome or duplicative regulation of our markets than the MFA.

MFA has long recognized the constraint on investment freedom, costs and inefficiencies of certain provisions of the Act to institutional, professionally managed or sophisticated market participants that provide no corresponding benefit. Consequently, MFA was among the first to support a two-tier regulatory approach which would eliminate many of the regulations which were designed to benefit the retail public from application to sophisticated or professional participants. MFA actively has endorsed and promoted initiatives that would alleviate regulatory obstacles where appropriate. We expressed this view last June in our testimony before this Committee when reform of the Act was first considered. We are, and have been, strong supporters of measures that will promote product innovation, facilitate the use of exchange products by large money managers, decrease costs and increase competitiveness and efficiencies in the international marketplace.

We commend the Committee for taking a fresh approach and undertaking sweeping changes to the Act. Last June, we asked for deregulation to further enact a two-tier regulatory approach and sought Congressional encouragement of the CFTC to more expansively utilize its exemptive authority. With this bill, the Committee has proposed significant deregulation of the futures and options markets, shifting much of the regulatory responsibility to self regulation, particularly to exchanges. We appreciate your responsiveness and consideration. As firm believers in self regulation, we have encouraged delegation of regulatory responsibilities where appropriate. However, as was evident in our testimony then and our testimony today, we also are supportive of the CFTC. We believe the CFTC has had, and should continue to have, a role in ensuring market integrity of centralized markets, and feel that role is equally important to centralized markets, whether dominated by professional or retail participants.

The bill addresses a broad range of issues and envisions several different market models. It is important to distinguish the differences in those models and the purpose behind the regulations that might be applicable to each.

The OTC foreign currency forward and option markets have been an important source of investment opportunities and diversification to our members and their clients. These OTC markets are separate and distinct from commodity exchanges designated by the CFTC for foreign exchange trading. These markets are comprised of individually negotiated, bilateral agreements, in contrast to the contracts that are traded on designated exchanges in which the only variables are the price and timing of the trade. The OTC markets are extremely liquid, highly efficient and provide diverse trading opportunities, in part because the ability to customize transactions and trade in size makes them more flexible and able to accommodate the needs of market participants. There is no centralized market or centralized clearing. Transactions are effected on a principal-to-principal basis rather than agency transactions, which has resulted in substantial mechanisms for evaluations of creditworthiness between participants.

This model differs significantly from the professional markets which the exchanges seek to establish. We can agree that markets restricted to professional participation do not need most of the regulatory protections under the Act. However, if these markets are centralized, providing a centralized clearing function, we believe some level of regulatory oversight would be appropriate. Were these markets in fact to offer open and competitive trading, transparent pricing, margining, mark-to-market, effective self-regulatory standards and financial integrity and clearing on which participants rely, regulatory oversight by the CFTC, whose regulation is in part responsible for the establishment of those standards, may be appropriate. At a minimum, we concur with your conclusions that the CFTC must maintain anti-fraud and anti-manipulation jurisdiction and preserve emergency action powers. However, in defining the CFTC's oversight role, Congress also must maintain sufficient tools for the CFTC to perform these roles effectively.

CLARIFICATION OF THE TREASURY AMENDMENT.

A primary goal of this legislation is to clarify the application of the Treasury Amendment. While the Treasury Amendment has been the source of recent litigation and controversy over the breadth of the provision, it has overall served an important purpose. The Treasury Amendment has justify undisturbed a marketplace of sophisticated professionals to engage in transactions between each other. MFA members, and other sophisticated participants, have been trading foreign exchange on the over-the-counter currency markets between each other and sophisticated investors in the United States and around the world for years with the understanding that their activities were excluded from regulation by the CFTC under the Act. These participants depend on active trading in, and the orderly functioning of, these markets which are essential in managing global interest rate and currency volatility. These markets provide a flexible means of hedging against the risk of adverse exchange rate movements or to particular inventories or accounts receivable denominated in particular currencies. Participants in these markets need counterparties willing to accept the risk they are seeking to shift. Managed funds are one of the counterparties willing and able to bring liquidity to these markets and, in return, are able to diversify their investment opportunities. Preservation of their right to trade in these markets is essential. Any revisions to the Amendment should be unambiguous and should not disturb the ability of MFA members, including retail investors who participate through the professional management of their assets by their commodity trading advisor and commodity pool operators, to continue to engage in these transactions. We look forward to continue to work with the Committee and its staff to ensure this result.

The bill introduces new undefined terms such as "unsupervised entity", "general public" and "retail public" in the Treasury Amendment which, if justify undefined, will not decrease the legal uncertainty surrounding the amendment. In addition, section 2 of the bill will afford exchanges equal opportunity to develop markets in these exempted products provided "retail investors" are not participants in the markets. While we have some concerns as discussed above regarding the nature of markets that may be structured if section 2 is adopted, there is no need for section 6 of the bill if section 2 is adopted. Section 2 of the bill will provide exchanges the opportunity to compete for products in the enumerated instruments where the market is restricted to professional participants. Section 6 merely provides a different, more restrictive professional market model, although it would perhaps extend the opportunity to develop professional markets to products other than those enumerated in section 2. In this regard, if Congress determines that the Treasury Amendment exclusion is the superior model for development of professional markets, we believe this relief should not be limited to the currently enumerated Treasury instruments. Rather, this superior model should be available for agricultural and other markets.

Lastly, we believe the CFTC should have residual jurisdiction with respect to sales of futures and options to retail customers by entities subject to federal regulatory oversight where the federal regulators do not have some regulatory framework for these activities. The CFTC's historic interpretation of the Treasury Amendment has served to chill the sale of its enumerated instruments to the general public. However, if the proposed revisions to the Treasury Amendment are implemented, entities whose primary business is regulated by federal regulators may be free to commence sales of these instruments to the general public with effectively no regulation or supervision. Regulation of one type of activities of an entity will not ensure a regulatory framework broad enough to appropriately regulate an entirely different set of activities. We are unaware of any interested party to these proceedings supporting wholly unregulated sales to the general public and believe there is broad concurrence that the CFTC's regulatory framework has been effective in customer protection and in ensuring market integrity. We do not believe Congress intended to create a regulatory loophole that would permit other entities to make sales to the retail public absent any regulatory framework for the protection of investors and market integrity. We urge you not to unintentionally create this situation.

EXEMPTION AUTHORITY AND SWAP EXEMPTION.

The CFTC has acted, pursuant to its Section 4(c) authority, to clarify that certain transactions among certain participants are exempt from regulation. While we believe the Part 35 exemption is not sufficiently broad to cover all transactions (such as those that might be excluded from CFTC jurisdiction by the Treasury Amendment) engaged in by many managed futures professionals, we believe that the Futures Trading Practices Act of 1992 has given the CFTC sufficient authority to address these issues and are confident the CFTC will work with us to resolve these outstanding issues in the near future. We seek your encouragement of this process. To the extent the proposed revisions to Part 35 and Part 34 provide necessary greater legal certainty to these transactions, we are supportive of that effort as long as these codifications do not impede, or dissuade, the CFTC's exercise of its exemptive authority.

OTHER ISSUES.

The bill recommends a number of important revisions to the Commodity Exchange Act. While we are enthusiastic and supportive of the Committee's work, certain of the proposals may too narrowly define the role of the CFTC, to the detriment of the markets and market participants. We would encourage continued discourse and thoughtfulness in trying to ascertain the appropriate balance.

The bill also proposes revisions that seek to expedite the approval of exchange rule submissions to the CFTC. We feel strongly that exchanges from time to time propose certain rules that significantly impact the end user, the ability of managed funds to access and trade on exchange markets, or other matters of substantial concern to us. Currently, the only means we have of being made aware of these proposed rule changes and of making our views known to the exchanges is by notification from the CFTC and publication in the Federal Register for comment on rules the CFTC determines appropriate. Historically, some of these proposed rules would have had an extremely detrimental effect on MFA members and affected their ability to trade on behalf of their clients had the rules gone into effect first and later been evaluated for their effect. While we are supportive of expediting the time frame in which such determinations are made, we support the continued ability of the CFTC to publish for comment those rules it believes to be of significant importance.

In addition, with respect to audit trail, while we believe generally it is best to establish performance standards to permit registrants with the necessary discretion to utilize the latest technology and best means for compliance, as end users, we believe an audit trail is extremely important and essential to market integrity and confidence in the marketplace. We encourage the exchanges to utilize any new flexibility to improve and seek automation of their audit trail procedures. Lastly, we would encourage the Committee to pursue CFTC delegation of appropriate functions to the NFA, most particularly, the review and handling of disclosure documents.

We appreciate the opportunity to provide testimony to you for this extremely important legislation. We believe the bill has, and will, provoke excellent discussion, and we look forward to working closely with you and Committee staff as you revise its provisions. We would be happy to provide further clarification on any issues for which this Committee needs additional information.