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CME Cautions Against 'One-Size-Fits-All' Regulatory Regime

September 7, 2009
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While acknowledging the need for some harmonization, the world's largest operator of derivative exchanges last Wednesday said meshing the Commodity Futures Trading Commission's (CFTC) and the Securities and Exchange Commission's regulations into a "single set of one-size-fits-all rules administered by separate agencies will do substantially more harm than good."

The "significant [and] intrinsic differences" between the derivatives markets, which are regulated by the CFTC, and the securities markets, which are regulated by the SEC, "are likely to be eviscerated by a one-size-fits-all regulatory regime, undermining the value of both markets," said Craig S. Donohue, CEO of CME Group, which operates the Chicago Mercantile Exchange Inc., the Chicago Board of Trade (CBOT), the New York Mercantile Exchange and the Commodity Exchange Inc.

"To avoid stifling innovation and competition in the U.S. marketplace...we believe that the 'harmonization' discussion between the CFTC and SEC must take account of the basic fact that these markets are highly dissimilar in many critical aspects and that the regulatory framework, by necessity, should be different," he said during a first-ever joint CFTC-SEC hearing, which explored harmonizing the agencies' regulations. Donohue said he supports harmonization where there are regulatory gaps.

"You would wind up hurting both markets if you try to fit a square peg in a round hole," agreed Johnathan Short, senior vice president of Atlanta-based IntercontinentalExchange (ICE), a major energy trading platform.

SEC Chairman Mary Schapiro acknowledged the differences in the agencies' regulatory regimes, saying, "I believe some of these differences are necessary." CFTC Chairman Gary Gensler and Schapiro are to make recommendations to Congress by the end of the month on changes in statutes and regulations to better harmonize the oversight of the futures and securities markets (see NGI, July 27).

"We are concerned that 'harmonization' may be interpreted to mean abandoning the [less restrictive] principles-based regulation of the Commodity Futures Modernization Act [CFMA]," from which the CFTC derives its authority, in favor of the more-restrictive rules-based regulation of the SEC, Donohue said. "The CFMA has facilitated tremendous innovation and allowed the U.S. exchanges to compete effectively on a global playing field," but CME fears that the "reaction against excesses in other segments of the financial services industry will generate pressure to force a retreat from the principles-based regulatory regime adopted by CFMA."

The pros of the principles-based regulation "are easily overlooked in the turmoil following the collapse of the housing market and major investment banks. We have said it before, but it bears repeating: derivative transactions conducted on CFTC-regulated futures exchanges and cleared by CFTC-regulated clearinghouses did not contribute to the current financial crisis. Moreover, it was not unintentional gaps in the regulatory jurisdiction of the SEC and the CFTC that caused the meltdown," Donohue said.

Annette L. Nazareth, a partner with the law firm of Davis Polk & Wardwell LLP and former SEC commissioner, said harmonizing the agencies regulations and statutes will be a difficult task.

"Though born in the same jurisdiction, the regulatory regimes for securities and futures have distinctly disparate statutory parents. Until Congress or the administration is willing to make some difficult policy choices, the SEC and the CFTC will continue to struggle to find common ground under very different statutory mandates and regulatory philosophies.

"In an ideal world, Congress would reconcile the key issues legislatively and merge the agencies so that they would harmonize the innumerable differences from within. That notion has not been embraced by Congress in the recent regulatory reform effort, however. In serveral key areas of regulation, the differences in statutory mandate and philosophy between the agencies are profound. These differences must be recognized and reconciled before any real harmonization can be achieved. Yet harmonization is essential to maintain the efficiency of our financial markets and our competitiveness in the global arena," Nazareth said.

Of all the CFTC and SEC commissioners, only SEC Commissioner Luis A. Aguilar advocated merging the two agencies. SEC Commissioner Elisse B. Walter didn't go that far, but she acknowledged that the existing bifurcated approach to regulation for futures and securities is outdated. "More cross-agency pollination would be beneficial" for both the CFTC and the SEC and the markets that they oversee, she said.

CFTC Commissioner Michael Dunn noted that the once "clearly delineated" line between what is a commodity and what is a security has been "blurred," thus requiring more cooperation by the two regulatory agencies. CFTC Commissioner Jill Sommers echoed that sentiment, saying that "there is a growing list of derivatives that straddle [the] jurisdictional lines" of the CFTC and SEC.

Jurisdictional issues between the two regulatory agencies have been simmering for decades, but they have been "stuck down at the staff level," said CFTC Commissioner Bart Chilton. "We're two agencies," he noted, but hopefully "we'll start acting like one government." And "shame on us if we can't resolve" the issues without the "need of adult supervision" from the Treasury Department, Chilton added.

William J. Brodsky, CEO of the CBOT, recommended that Treasury be used as a tie-breaker in the event of jurisdictional disputes between the SEC and the CFTC. He also called on the CFTC to look into bringing the full over-the-counter derivatives market "under the [regulatory] tent."

The panelists expressed some support for cross-margining, which would allow traders to apply the same margin funds to different trading positions -- futures or option contracts and stocks -- even when different clearinghouses are clearing each side of the position.

"We're all in agreement that cross-margining arrangements could be beneficial and useful," but there are a number of hurdles, said CME's Donohue. "I think you [have] to ensure proper risk management at any clearinghouse," said one panelist. "Cross-margining across futures and securities-related investments is critical to maximizing the benefits of portfolio margining both for customers and for the U.S. markets as they compete with London and other developed financial markets abroad that utilize a cross-margining system," Nazareth said.

On the second day of the CFTC-SEC hearings, a legal expert called on Congress to address the role of "primary regulator" in its financial reform legislation, identifying the products and markets over which the CFTC should have primary jurisdiction and the ones over which the SEC should be the primary regulator, to avoid the kind of jurisdictional head-butting that the CFTC and the Federal Energy Regulatory Commission (FERC) engaged in following the implosion of hedge fund Amaranth Advisors LLC, a legal expert said Thursday.

"I believe this principle of a 'primary' regulator should apply...broadly to regulations, enforcement and oversight for the security and commodity markets. There should be a primary regulator for a given product and market; the other regulator should be consulted where necessary or appropriate, but should generally defer to the primary regulator," said Kenneth M. Raisler, head of the law firm of Sullivan & Cromwell LLP's commodities, futures and derivatives group.

"The primary regulator should be responsible for enforcement, audit and oversight of the products and markets for which it is the primary regulator...Given that the current legislative proposal from the Treasury Department gives both agencies expansive rulemaking authority to define market products and participants, both agencies can craft rules that follow the 'primary' regulator principle," he said.

Because the primary regulator approach isn't used now, the line diviiding the CFTC's and FERC's jurisdiction in the futures and physical markets remains blurred, according to Raisler.

"Although Amaranth's alleged [manipulation] misconduct occurred in the futures market, FERC contended that it had jurisdiction because the activity was intended to, and did, affect the markets for physical commodities regulated by FERC. Conversely, the CFTC [took] the position that it has the jurisdiction to prosecute manipulation or attempted manipulation in the physical market because of the possible effect on futures markets. The jurisdictional lines between the two agencies [still] remain unresolved and unclear," he noted.

The CFTC challenged FERC's authority to pursue manipulative activities in the natural gas futures market after FERC brought an enforcement action in July 2007 against failed hedge fund Amaranth Advisors for manipulation of the gas market (see NGI, July 30, 2007). Amaranth argued that the CFTC, not FERC, had exclusive jurisdiction over its activities in the futures arena, while FERC's jurisdiction was limited to the physical gas market. A series of court decisions blocked attempts by Amaranth and its former traders to enjoin FERC from proceeding with its enforcement action against them (see NGI, Nov. 5, 2007).

FERC and the CFTC last month entered into separate settlements requiring failed hedge fund Amaranth Advisors, affiliates and former trader Matthew Donohoe to pay a total of $7.5 million in penalties to settle two-year-old claims that they manipulated or attempted to manipulate gas futures prices, but the jurisdictional spat continues (see NGI, Aug. 17).

To avoid similar disputes the "SEC and CFTC should make clear which agency has jurisdiction over which businesses, products and activities and the manner in which market participants will be regulated," Raisler said. "Ultimately, duplicative regulation and overlapping regulatory jurisdiction will require market participants to comply with multiple registrations, financial and reporting requirements [that] may result in regulatory arbitrage and will result in regulators examining substantially similar information -- leaving both agencies spread thin," he noted.

John C. Coffee Jr., professor of law at Columbia University Law School, called on Congress to increase the financial penalties in CFTC enforcement cases. Under the Commodity Exchange Act, the CFTC can impose a maximum criminal sentence of 10 years and a maximum fine of $1 million. In contrast, the Securities Exchange Act allows the SEC to levy a maximum criminal sentence of 20 years and a maximum fine of $25 million.

"The $1 million ceiling on a criminal fine in the case of the CFTC seems archaic...Legislation to update these trivialized financial penalties seems necessary," Coffee said. He also believes the CFTC, like the SEC, should be able to impose administrative penalties for misconduct involving fraud, deceit, manipulation or a deliberate or reckless disregard of a regulatory requirement.

The SEC currently can impose administrative penalties ranging from $100,000 to $500,000 without going to court, but the CFTC has to go to court to seek penalties in enforcement cases.

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