The Commodity Exchange Act

During the past 25 years, technological advances and fundamental changes in the global financial markets have accelerated the development and use of financial products known as derivatives. Derivatives include futures contracts that traditionally have been traded on organized exchanges and are regulated by the Commodity Futures Trading Commission (CFTC). They also include swaps and other over-the-counter derivatives contracts that resemble exchange-traded futures but are privately negotiated between counterparties outside organized exchanges. Because of their resemblance to exchange-traded futures, swaps and other over-the-counter derivatives faced the possibility of falling within the judicially crafted definition of a futures contract. As a result, they faced the legal risk of being unenforceable under the Commodity Exchange Act, which requires that futures be traded on exchanges to be legal and thus enforceable. The Futures Trading Practices Act of 1992 provided CFTC with the authority to reduce this legal risk, which the agency later used. At the same time, developments brought regulated financial institutions into the exchange-traded future markets and over-the-counter derivatives markets, leading to a greater array of derivatives contracts and greater competition among those providing such contracts. Consequently, some of the distinctions among market participants and between exchange-trade futures and over-the-counter derivatives have become blurred--raising questions about the appropriate regulatory structure for these contracts, markets, and market participants. This report discusses (1) the extent to which CFTC has reduced the legal risk surrounding the enforceability of over-the-counter derivatives under the Commodity Exchange Act and (2) issues related to the appropriate regulation for exchange-traded futures and over-the-counter derivatives contracts, including their markets and market participants.

GAO noted that: (1) under the authority provided by the Futures Trading Practices Act of 1992, CFTC exempted most swaps and other OTC derivatives contracts from the CEA's exchange-trading requirement and thus reduced or eliminated the legal risk that they could be unenforceable; (2) in granting the exemptions, CFTC was not required to, and did not, determine that OTC derivatives were futures; (3) as a result, a question has remained about whether OTC derivatives are futures and can be regulated under the act: (4) the possibility that swaps are futures continues to be a source of legal risk for so-called equity swaps that are ineligible for exemption from the act's requirements; (5) legal risk also remains for certain agricultural forwards that are becoming increasingly difficult to distinguish from futures and that may not be eligible for the swaps exemption; (6) although CFTC reduced or eliminated the legal risk of being unenforceable for most swaps and other OTC derivatives, a broader policy question remains about the appropriate regulation for OTC derivatives and exchange-traded futures, including their markets and market participants; (7) the first issue concerns regulation for the OTC foreign-currency market under CEA; (8) the act excludes from its regulation certain OTC foreign-currency transactions, but the scope of the exclusion, called the Treasury Amendment, has been the subject of disagreement among federal regulators and the courts; (9) a recent U.S. Supreme Court decision resolved that the exclusion covers all transactions in foreign currency, including foreign-currency options and futures; (10) as a result, the extent to which the Treasury Amendment excludes transactions involving unsophisticated market participants may still be subject to debate; (11) the second issue concerns the potential for the swaps market to evolve beyond its exemption and raise additional regulatory concerns; (12) CFTC exempted swaps from virtually all CEA requirements, but imposed conditions on the exemption that restricted their design and trading procedures; (13) the swaps market might develop in ways that are inconsistent with these conditions; (14) the third issue concerns the rationale for the regulatory differences between the OTC derivatives and exchange-traded futures markets; and (15) CFTC recently granted the exchanges an exemption to enable them to better compete against the less regulated OTC derivatives market, however, under the exemption, regulation of the two markets will continue to differ substantially.