CFTC Used Its Exemptive Authority to Reduce or Eliminate the Legal Risk Surrounding the Enforceability of Most OTC Derivatives

Before 1993, swaps and other OTC derivatives contracts faced the legal risk of being deemed illegal off-exchange futures and thus unenforceable under the CEA. However, a narrow group of swaps that are ineligible for the exemption continue to face the risk of being illegal futures. In addition, certain unregulated forwards have become increasingly difficult to distinguish from regulated futures, resulting in legal risk. Congress Granted CFTC Exemptive Authority to Reduce the Legal Risk Facing Swaps and Other OTC Derivatives

Following the court’s finding that certain OTC energy contracts were futures and recognizing the broader implications of that decision for other OTC derivatives, Congress granted CFTC exemptive authority under the Futures Trading Practices Act of 1992. In granting its exemptions, CFTC did not determine that the OTC derivatives covered by the exemptions were or were not futures or otherwise excluded from the act’s jurisdiction. It noted that this could result in substantial losses and a market disruption. Issues Remain Related to the Appropriate Regulation for the OTC Derivatives and Exchange-Traded Futures Markets

Notwithstanding CFTC’s success in reducing or eliminating the legal risk of unenforceability that most OTC derivatives faced, issues remain that raise a broader policy question about the appropriate regulation for OTC derivatives and exchange-traded futures, including their markets and market participants. These issues concern the (1) appropriate regulation for the OTC foreign-currency market under the Treasury Amendment, (2) appropriate regulation for the evolving swaps market, and (3) rationalization of regulatory differences between the OTC derivatives and exchange-traded futures markets. CFTC has interpreted the amendment to exclude from the act’s regulation certain OTC foreign-currency transactions between sophisticated participants, but not similar transactions involving unsophisticated participants. Before the recent U.S. Supreme Court decision in Dunn v. CFTC, considerable debate occurred over the meaning of the phrase “transactions in,” which defines the scope of the exclusion. The bill defines board of trade in the context of the Treasury Amendment as “any facility whereby standardized contracts are systematically marketed to retail investors.”

		The Appropriate Regulation for the Evolving Swaps Market Is an Unresolved Issue

The potential for the exempted swaps market to evolve beyond the conditions of the swaps exemption raises the issue of how to accommodate market developments and address attendant risks and other regulatory concerns. In 1995, CFTC also granted the exchanges an exemption from certain regulations to enable them to compete more effectively against the less regulated OTC derivatives market. These options include (1) expanding the act’s jurisdiction to cover specified swaps and other OTC derivatives but tailoring their regulation to the circumstances under which they trade and other appropriate factors; (2) excluding swaps and other specified OTC derivatives from the act’s jurisdiction and providing for their oversight, as appropriate, by other federal regulators; and (3) tailoring the level of regulation for exchange-traded futures to the nature of the market participants and/or other appropriate factors. CFTC has exempted most swaps and other OTC derivatives from virtually all the CEA’s requirements to provide them with greater legal certainty, but a question remains about whether swaps are futures and subject to the CEA. As we discuss, the possibility that swaps are futures continues to be a source of legal risk for equity swaps. 6. 7. 8. 4. 5. 9. 10. 11.
Why GAO Did This Study

GAO reviewed the legal and regulatory issues surrounding the Commodity Exchange Act (CEA), focusing on: (1) the extent to which the Commodities Futures Trading Commission (CFTC) has reduced the legal risk surrounding the enforceability of over-the-counter (OTC) derivatives under the CEA; and (2) issues related to the appropriate regulation for exchange-traded futures and OTC derivatives contracts, including their markets and market participants.

What GAO Found

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.