The Commodity Futures Modernization Act of 2000 (CFMA) is a United States federal law that ensures that over-the-counter (OTC) derivatives remained unregulated.
The Commodity Futures Trading Commission (CFTC) had desired to have "functional regulation" of the market, but the CFMA rejected this approach. Instead, the CFTC continued to do "entity-based supervision of OTC derivatives dealers". The CFMA's handling of OTC derivatives, such as credit default swaps, has become controversial, as these derivatives played a major role in the 2008 financial crisis and the Great Recession. The Commodity Futures Modernization Act (CFMA) of 2000 is a landmark piece of legislation in the United States that significantly altered the regulation of financial markets. Signed into law on December 21, 2000, the CFMA had several major impacts on the trading of derivatives, futures, and other financial instruments. Key Provisions: Deregulation of Over-the-Counter (OTC) Derivatives: One of the most significant features of the CFMA was that it removed the regulatory oversight of over-the-counter (OTC) derivatives, such as credit default swaps (CDS). Prior to this, derivatives had been subject to varying degrees of regulation. The CFMA clarified that these contracts were exempt from oversight by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).
Introduction Before and after the CFMA, federal banking regulators imposed capital and other requirements on banks that entered into OTC derivatives.GAO 1994 Financial Derivatives Report at 74 to 78 for a description of the then existing bank capital requirements for OTC derivatives and 69 to 84 for a description of then existing overall regulatory requirements. GAO Financial Derivatives Report at 53 to 55 for the later "expanded" regulatory capital requirements and 53 to 69 on the overall "improved" oversight of bank OTC derivatives activities. GAO Risk-Based Capital Report at 118 for a detailed description of bank capital requirement computations for OTC derivatives. The U.S. Securities and Exchange Commission (SEC) and CFTC had limited "risk assessment" authority over OTC derivatives dealers affiliated with securities or commodities brokers and also jointly administered a voluntary program under which the largest securities and commodities firms reported additional information about derivative activities, management controls, risk and capital management, and counterparty exposure policies that were similar to, but more limited than, the requirements for banks.GAO 1994 Financial Derivatives Report at 85 to 89 for the then limited oversight of securities and commodity firms (including SEC "risk assessment" authority). 1996 Financial Derivatives Report at 70 to 71, for the establishment of the CFTC's risk assessment program, and at 44 to 46 and 70 to 76 for the establishment of the Derivatives Policy Group (DPG) and the undertakings and reporting to the CFTC and SEC of its member firms. Banks and securities firms were the dominant dealers in the market, with commercial bank dealers holding by far the largest share.GAO 1994 Financial Derivatives Report at 11 (commercial bank dealers accounted for about 70% of the total volume at the end of 1992). GAO 1996 Financial Derivatives Report at 27 (for the 15 major dealers tracked by the GAO in the two reports (7 commercial banks, 5 securities firms, and 3 insurance companies) commercial banks accounted for about 69% of total volume each year from 1990 through 1995, securities firms about 27%, and insurance companies about 4%). Ekaterina E. Emm and Gerald D. Gay, "The Global Market for OTC Derivatives: An Analysis of Dealer Holding", September 23, 2003 ("Emma/Gay Global Markets Study") (showing in Table 3 that in 1995 the ten largest dealers held 85% of the US volume, with the 5 commercial banks in the listing holding 57.43% of the total and the 5 listed investment banks holding 27.75% and that in 2000 the ten largest dealers holding 92% of total volume with the 4 listed commercial banks holding 61%, the 4 listed investment banks holding 28%, and the two insurance companies (AIG and General Re) holding just over 3%. PWG Report at 16 (noting most dealers were banks or affiliated with securities firms). To the extent insurance company affiliates acted as dealers of OTC derivatives rather than as counterparties to transactions with banks or security firm affiliates, they had no such federal "safety and soundness" regulation of those activities and typically conducted the activities through London-based affiliates.GAO 1994 Financial Derivatives Report at 90 to 91 (concluding "Derivatives dealer affiliates of insurance companies are subject to minimal reporting requirements and no capital requirement" while noting state insurance regulators informed the GAO "derivatives dealer affiliates voluntarily hold capital against derivatives exposures as part of effective risk-management practices.") GAO 1996 Financial Derivatives Report at 80 to 81 (concluding "state insurance regulatory oversight remains unchanged" and noting "although the financial results of derivatives dealer affiliates are part of consolidated insurance company financial reports to regulators, these affiliates continue to have no capital or examination requirements.") GAO 1994 Financial Derivatives Report at 188 (listing AIG, General Re, and Prudential as the three largest insurance company derivatives dealers in 1992.) Emma/Gay Global Markets Study in Table 3 showing AIG And General Re as the largest insurance dealers in 2000. "General Re Securities", Business Week company snapshot ("The Company was incorporated in 1991 [as General Re Financial Securities Ltd.] and is based in London, United Kingdom"). For AIG FP's London-based dealer operation, see note 81 below.
The CFMA continued an existing 1992 preemption of state laws enacted in the Futures Trading Practices Act of 1992 which prevented the law from treating eligible OTC derivatives transactions as gambling or otherwise illegal.Analysis of Commodity Futures Modernization Act 2000 - ISDA . International Swaps and Derivatives Association. It also extended that preemption to security-based derivatives that had previously been excluded from the CEA and its preemption of state law.See notes 43 and 80 below. The CFMA, as enacted by President Clinton, went beyond the recommendations of a Presidential Working Group on Financial Markets (PWG) report titled "Over-the Counter Derivatives and the Commodity Exchange Act" (the "PWG Report"). President's Working Group on Financial Markets, November 1999: Lawrence Summers, Treasury Department Alan Greenspan, Federal Reserve Arthur Levitt, SEC William J Rainer, CFTC
Although hailed by the PWG on the day of congressional passage as "important legislation" to allow "the United States to maintain its competitive position in the over-the-counter derivative markets", by 2001 the collapse of Enron brought public attention to the CFMA's treatment of energy derivatives in the "Enron Loophole". Following the Federal Reserve's emergency loans to "rescue" American International Group (AIG) in September 2008, the CFMA has received even more widespread criticism for its treatment of credit default swaps and other OTC derivatives.
In 2008 the "Close the Enron Loophole Act" was enacted into law to regulate more extensively "energy trading facilities." On August 11, 2009, the Treasury Department sent Congress draft legislation to implement its proposal to amend the CFMA and other laws to provide "comprehensive regulation of all over-the counter derivatives." This proposal was revised in the House and, in that revised form, passed by the House on December 11, 2009, as part of H.R. 4173 (Dodd–Frank Wall Street Reform and Consumer Protection Act). Separate, but similar, proposed legislation was introduced in the Senate and is still awaiting Senate action at the time of the House action.
Background
OTC derivatives regulation before the CFMA
Exchange trading requirement
The PWG Report was directed at ending controversy over how swaps and other OTC derivatives related to the CEA. A derivative is a financial contract or instrument that "derives" its value from the price or other characteristic of an underlying "thing" (or "commodity"). A farmer might enter into a "derivative contract" under which the farmer would sell from next summer's harvest a specified number of bushels of wheat at a specified price per bushel. If this contract were executed on a commodity exchange, it would be a "futures contract". Before 1974, the CEA only applied to agricultural commodities. "Future delivery" contracts in agricultural commodities listed in the CEA were required to be traded on regulated exchanges such as the Chicago Board of Trade.Johnson/Hazen Derivatives Regulation Treatise at 6 to 9. Jerry W. Markham, Commodities Regulation: Fraud, Manipulation & Other Claims Volume 13A Securities Law Series (West Group 1987, supplemented through Release 11, April 2009) ("Markham CF Law Treatise") at pages 27-18 to 27-19 and 28-1 through 28-7. General Accounting Office (GAO) Report, "The Commodity Exchange Act: Legal and Regulatory Issues Remain", GAO/GGD-97-50 , April 1997 ("GAO CEA Issues Report") at 5. CRS Derivatives Regulation Report at CRS-5.
The Commodity Futures Trading Commission Act of 1974 created the CFTC as the new regulator of commodity exchanges. It also expanded the scope of the CEA to cover the previously listed agricultural products and "all other goods and articles, except onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." Existing non-exchange traded financial "commodity" derivatives markets (mostly "interbank" markets) in foreign currencies, government securities, and other specified instruments were excluded from the CEA through the "Treasury Amendment", to the extent transactions in such markets remained off a "board of trade." The expanded CEA, however, did not generally exclude financial derivatives.For the Treasury Amendment, see also Johnson/Hazen Derivatives Regulation Treatise at 9 to 10; CRS Derivatives Regulation Report at CRS-6; and PWG Report at 24 to 27. Before the CFTC, a Commodity Exchange Authority under the control of the Secretary of Agriculture regulated commodity exchanges. Jerry W. Markham,The History of Commodity Futures Trading and its Regulation, (Praeger 1987) ("Markham CF Trading History") at 27 to 60. For background to the reasoning of the PWG Report, see the July 24, 1998 Hearing before the House Committee on Banking and Financial Services ("July 24, 1998, House Banking Hearing") at pages 150-156 for Alan Greenspan's extended critique of the application of the CEA to non-agricultural commodities. The transcript excerpts are in Segment 2 because the July 24, 1998, hearing was the second of two hearings by the Committee concerning H.R. 4062, legislation mentioned in Section 1.2 below that ultimately led to a moratorium on CFTC action to change the regulatory status of OTC derivatives. For how the "board of trade" qualification made it difficult for the CFTC to attack currency trading "bucket shops", see CFTC Chair William Rainer testimony at page 28 of Hearing before the Senate Agriculture Committee on the PWG Report, February 10, 2000, ("Senate Agriculture PWG Report Hearing") and Markham CF Trading History at 238 to 239.