Order Code RS22028
Updated July 7, 2005
CRS Report for Congress
Received through the CRS Web
CFTC Reauthorization in 2005
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
Authorization for the Commodity Futures Trading Commission (CFTC), a “sunset”
agency established in 1974, expires on September 30, 2005. In the past, Congress has
used the reauthorization process to consider amendments to the Commodity Exchange
Act (CEA), which provides the basis for federal regulation of commodity futures
trading. The last reauthorization resulted in the enactment of the Commodity Futures
Modernization Act of 2000 (CFMA), the most significant amendments to the CEA since
the CFTC was created. Both House and Senate Agriculture Committees held
reauthorization hearings in March 2005. This report provides brief summaries of issues
that Congress may address through the 2005 reauthorization legislation, including (1)
the market in security futures, or futures contracts based on single stocks, which were
authorized by the CFMA, but trade in much lower volumes than their proponents had
hoped, (2) regulation of energy derivatives markets, where some see excessive price
volatility, (3) futures-like contracts based on foreign currency prices offered to retail
investors, and (4) the globalization of futures trading and international regulatory
harmonization.
This report will be updated as developments warrant.
Futures contracts — like other financial derivatives such as options or swaps — gain
or lose value as the price of some underlying commodity rises or falls. They can be used
to avoid, or “hedge,” price risk. That is, farmers, utilities, airlines, banks, and many other
businesses can use derivatives to protect themselves against unfavorable changes in
commodity prices, interest rates, or other variables. Most futures trading, however, is
done by speculators who profit if their forecasts of price trends are correct. (The futures
exchanges are associations of professional speculators.) There are two public benefits to
speculation: speculators provide liquidity that enables hedgers to take positions quickly
and at low cost and to unwind those positions at any time. Speculative trading also
provides a very effective price discovery mechanism: futures prices adjust immediately
to new information and serve as the basis for many physical (or spot market) transactions
in oil, agricultural, and other markets.
Congressional Research Service ˜ The Library of Congress

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The public interest in regulating futures markets flows from these two functions.
Since futures prices are used as reference points for many physical transactions,
manipulation in the futures markets can affect the prices actually paid by consumers or
received by farmers and other producers. Similarly, the ability to hedge risks allows the
economy to function more efficiently. Federal Reserve Chairman Alan Greenspan
frequently describes the general benefits of derivatives markets. For example:
Derivatives have permitted financial risks to be unbundled in ways that have
facilitated both their measurement and their management.... Concentrations of risk
are more readily identified, and when such concentrations exceed the risk appetites
of intermediaries, derivatives can be employed to transfer the underlying risks to other
entities. As a result, not only have individual financial institutions become less
vulnerable to shocks from underlying risk factors, but also the financial system as a
whole has become more resilient.1
How much government regulation is needed to see that the derivatives markets
remain sound, to keep markets competitive and free from fraud and manipulation, and to
insulate the financial system from shocks arising from sudden large speculative losses?
These are the basic questions for congressional oversight of the Commodity Exchange
Act (CEA).
The Commodity Futures Modernization Act of 2000 (CFMA)
In several respects, the CFMA was a fundamental rethinking of the government’s
role in derivatives markets. Before 2000, the CEA was intended to regulate all forms of
derivative trading; any contract “in the character of” a futures contract was to be traded
only under CFTC regulation. However, this “one-size-fits-all” regulatory scheme did not
correspond to the reality of the marketplace, where a very large over-the-counter (OTC,
that is, off-exchange) derivatives market was flourishing without CFTC oversight. Under
the CFMA, most trading in OTC derivatives was placed beyond the reach of the CEA
(and thus the CFTC). Where markets were off-limits to small investors, market discipline
was deemed to be a sufficient regulatory force.
The exception was for contracts based on agricultural commodities, which were
thought to be susceptible to price manipulation. Agricultural derivatives, as a result, can
be traded only on CFTC-regulated futures exchanges.
The CFMA provided for the creation of unregulated futures exchanges, where all
trading involved sophisticated or professional investors. (Again, there is an exception for
farm derivatives.) Potentially, therefore, the futures exchanges can reconfigure
themselves into largely unregulated entities, and several such entities have registered with
the CFTC. However, since the enactment of the CFMA the major futures exchanges
have not done so, and continue to operate in (more or less) the same regulatory
environment as before. Both the exchanges and the OTC markets have experienced
strong growth in trading volumes since 2000.
1 Remarks by Chairman Alan Greenspan at the 2003 Chicago Fed Conference on Bank Structure
and Competition, Chicago, Illinois (via satellite), May 8, 2003.

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In the 108th Congress, the House and Senate Agriculture Committees held oversight
hearings on the CFMA.2 At both hearings, CFTC Chairman James Newsome stated his
view that the CFMA had worked well and that the CFTC was able to use more flexibility
in matters such as approving new contracts for trading and accepting the registration of
new exchanges and clearing houses. The new entrants generally sought to introduce or
facilitate innovative electronic forms of trading. His view was that legislative
amendments to the CEA were not needed.
Issues for the 109th Congress
Given the CFTC’s satisfaction with its role under the CFMA, and the growth of
trading volumes and continued innovation in the markets, it does not appear likely that
another thorough overhaul of the CEA is in prospect for 2005. During hearings before
the House and Senate Agriculture Committees in March 2005, however, the CFTC and
industry participants suggested several areas where fine-tuning of the CFMA might be
desirable. These are summarized briefly below.
Security Futures
Security futures are futures contracts based on single stocks or narrow-based stock
indexes. Until the CFMA, these contracts were not permitted, largely because of concerns
that they could be used to manipulate stock prices. The CFMA provided for joint
regulation of the new market by the Securities and Exchange Commission (SEC) and the
CFTC. Perhaps as a result, the process of writing trading rules was slow: the first
contracts were not traded until 2003.
Volumes in security futures trading remain very low. The leading market is
OneChicago, a joint venture between the Chicago Board of Trade (CBOT), the Chicago
Mercantile Exchange (CME), and the Chicago Board Options Exchange (CBOE). During
the first 11 months of 2004, 1.8 million security futures contracts were traded on
OneChicago. This is not much higher than the average daily volume on the CBOE, where
options on individual stocks are traded.
It may simply take time for single-stock futures volume to grow, given the
competition from the highly liquid and well-developed stock options market, which offers
contracts that permit most — if not all — the investment strategies that security futures
do. It is not uncommon for new futures contracts to fail to excite enough trading interest
to sustain themselves; this is a possible fate for security futures.
However, during the reauthorization hearings in March 2005, several witnesses
argued that the dual regulatory regime is cumbersome and hampers trading. CFTC
Chairman Brown-Hruska stated that the CFTC would continue to work with the SEC to
reduce duplicative regulation. Representatives of the Chicago Futures Exchanges called
2 U.S. Congress, House Committee on Agriculture, Commodity Futures Modernization Act,
Hearing 108th Cong., 1st sess., June 5 and 19, 2003, and U.S. Congress, Senate Committee on
Agriculture, Forestry, and Nutrition, Review of Commodity Futures Trading Commission
Regulatory Issues, hearing, 108th Cong., 2nd sess., May 13, 2004.

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for an amendment to the CFMA to allow security futures to trade like any other futures
contract. This would allow the exchanges to set margin requirements on security futures,
as they do on all other futures contracts.3 (At present, margins are set at 20% of the
underlying stocks’ value, a figure that was determined by the SEC and CFTC to be
comparable to margin requirements on stock options, as the CFMA requires, but which
is much higher than most futures margins, which generally are in the range of 4-5% of the
value of the underlying commodity.) By reducing margin requirements, the exchanges
would lower the cost of trading security futures and would likely boost trading volumes.
However, such a move would be resisted by the options exchanges, who would argue
unfair competition, and perhaps by the SEC, which would be concerned about the
possibility of manipulation of stock prices.
Energy Derivatives
Energy markets have seen turmoil in recent years: prices have been unusually
volatile, and there have been several episodes of fraud or scandal. During the California
electricity crisis of 2000, severe shortages were combined with soaring prices, and several
energy trading firms (including Enron) were found to have manipulated the partially
deregulated electricity marketing system that California had established. After the
collapse of Enron, numerous energy firms were found to have made fictitious “wash”
trades, for purposes of manipulating prices and/or falsifying their accounting statements.
Natural gas markets have experienced several price spikes, attributed to the market
reaction to false information about market prices and supplies. Finally, many commercial
users of energy commodities suspect that hedge funds and other financial speculators have
driven prices higher than fundamental economic factors of supply and demand would
warrant, and have called for a limit on the size of speculative futures positions.4
Some observers attribute these problems in the markets to a regulatory gap, arguing
that neither the CFTC nor the Federal Energy Regulatory Commission (FERC) has
sufficient authority or resources to enforce anti-fraud and -manipulation rules. A
particular focus of these arguments is the over-the-counter (OTC) market for energy
derivatives, which under the CFMA is subject to very limited oversight. During the 108th
Congress, the Senate twice voted down measures to give the CFTC more authority to
collect market data from traders in OTC energy contracts.5 Similar legislation – S. 509
– has been introduced in the 109th Congress.
Others, including the CFTC, maintain that regulators already have sufficient
authority to investigate and punish fraud, and that price volatility itself is not evidence of
3 In futures contracts, “margin” is the amount of money that a customer must deposit with a
broker in order to maintain a position in the market. Margin serves to protect the broker and the
exchange from the risk of customer default. If margins are set too high, trading becomes too
expensive and volume drops. If they are too low, exchange members and the clearing house are
vulnerable to credit (or default) risk.
4 See testimony of Oliver Ireland, on behalf of Huntsman Chemical, a member of the Industrial
Energy Consumers of America, before the Senate Committee on Agriculture, Forestry, and
Nutrition, March 10, 2005.
5 S.Amdt. 876 and S.Amdt. 2083. See CRS Report RS21401, Regulation of Energy Derivatives,
by Mark Jickling.

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manipulation. CFTC chairmen have repeatedly rejected the view that new legislation is
needed. In a 2004 speech, acting chairman Sharon Brown-Hruska defended the CFTC’s
enforcement record, pointing to actions taken against false reporting of natural gas prices
and market manipulation by Enron and others: “In my mind, this era in which many acted
with a lack of integrity and violated the law will soon be a part of history — one that will
not be repeated as a result of our enforcement actions.”6
Retail Foreign Exchange Contracts
The Commodity Exchange Act generally prohibits the selling of off-exchange futures
contracts to small “retail” investors. There has been some dispute over whether this
prohibition applies to contracts based on foreign currency rates; in 1974, Congress
exempted contracts based on foreign exchange and Treasury securities from CFTC
regulation (the so-called “Treasury Amendment”). The CFTC has long argued that this
exemption applied only to professional markets, and that it had authority to prevent the
sale of futures-like contracts to small investors. The CFMA addressed this question, and
the CFTC believed it had been given clear authority, but a 2004 federal court case7 held
that certain retail foreign exchange contracts were not futures contracts and could be
legally traded. In 2005 hearings, CFTC Chairman Brown-Hruska questioned whether
additional legal authority or clarification were needed to protect small investors from
fraud.

International Regulatory Issues
To a derivatives trader seated at a computer terminal, it is unimportant whether price
quotes on, say, the dollar/yen exchange rate originate in Chicago, London, or Shanghai.
Telecommunications access is instantaneous, and most exchanges are electronic, making
physical presence on a trading floor not just unnecessary, but impossible.8 The only
barriers to truly global trading are legal and regulatory.
To regulators, however, national borders still matter. The core mission of the CFTC
is to ensure that traders are fully advised of the risks of futures contracts, that an audit trail
is maintained for all transactions, and that markets are not manipulated. Because of
concerns that U.S. traders will not have these same protections in foreign futures markets,
the CFTC has resisted allowing direct electronic access to foreign markets from terminals
in the United States.
The goal of protecting U.S. customers, however, imposes costs on traders who do
not feel the need for government protection. They must approach foreign markets through
an extra layer of intermediaries and maintain margin accounts in each financial center
where they trade, even though their international transactions are part of a single risk
management strategy.
6 Speech by CFTC Acting Chairman Sharon Brown-Hruska, to the International Swaps and
Derivatives Association (ISDA), New York, Nov. 17, 2004.
7 CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004).
8 Among major markets, the only holdouts where traders still meet face to face are the Chicago
futures exchanges.

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A common criticism of regulation is that if it is excessive it will hamper financial
innovation and cause business to move to another financial center where regulators are
more laissez-faire. On the other hand, strong regulation can be a selling point in
international competition. It can be difficult to strike a balance.
The CFTC has taken several actions to facilitate international trading. In February
2004, it approved the application for exchange registration of Eurex US, a subsidiary of
Eurex, the largest European futures market. Eurex US has struggled to attract business,
but this is partly because of competitive fee reductions by the major Chicago exchanges,
which have benefitted all traders.
Another industry initiative is global clearing. Clearing houses hold customer margin
payments and guarantee all contracts against default. Traders who hold related positions
in different national markets must deal with multiple clearing houses; their costs would
be reduced if a single clearing house could handle all their trades. The CFTC has
approved half of a transatlantic clearing initiative: since November 2004, the Clearing
Corporation (Eurex US’s clearing house) has been authorized to clear U.S. traders’
transactions in 16 European futures contracts, based on European government bonds,
interest rates, and stock indexes. This means that U.S. traders can clear both U.S. and
European trades through the same clearing house. However, the CFTC has not acted on
phase two of the transatlantic project: trades executed on U.S. exchanges may not yet be
cleared through a European clearinghouse.

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