By Robert Hunter

The recent Congressional hearings on Commodity Futures Trading Commission reauthorization, before the House Agriculture Committee’s Subcommittee on Risk Management, had all the makings of great Washington theater going in, and the four-day affair did not disappoint. Anti-regulatory types had been frothing at the mouth for the chance to argue for drastic changes in CFTC authority, and they did so in force. But a more compelling battle quickly emerged in the center of the debate, one that pitted the U.S. futures establishment against the rest of the U.S. exchange world.

In a strong show of unity, the Chicago Board of Trade and the Chicago Mercantile Exchange proposed in tandem a radical overhaul of the CFTC and major changes to the Commodity Exchange Act (CEA). The proposal’s sweep is grand. Among its components:

• Exchange regulation should be modernized by increasing exchange autonomy, eliminating prior approval requirements and transforming the CFTC into a supervisory, oversight agency.
• Access to financial exchange markets should be expanded for customers of banks and broker-dealers that trade other derivatives contracts.
• The product restrictions in the Shad-Johnson Accord—which, among other things, assigned regulation of most futures to the CFTC and options to the SEC, and prohibited single-stock and narrow index futures—should be removed, allowing for single-stock and narrow-index futures.
• All entities performing exchange-like functions—trade execution or clearing—should be similarly regulated.
• Privately negotiated over-the-counter derivative instruments should be granted legal certainty through exclusion from the Commodity Exchange Act.

While many in the financial world stand behind these ideas, U.S. stock and option exchanges came out strongly against single-stock futures. William Brodsky, chairman and CEO of the Chicago Board Options Exchange, was quick to attack. “We oppose attempts to repeal or weaken [Shad-Johnson’s] prohibition on futures on individual stocks and narrow-based stock indexes and limit the SEC’s ability to review proposed stock index futures contracts,” he said. “In our view, repeal or weakening of the Shad-Johnson Accord provisions would entail grave risk to the underlying securities markets without providing appreciable benefits to investors.” Brodsky cited the lack of insider trading rules in the CEA and the lower margin requirements of futures compared with equities as particularly destabilizing forces.

James Cochrane, vice president of the New York Stock Exchange, raised similar concerns. “Unlike other futures contracts,” he growled, “futures on individual stocks and narrow-based indices serve no real economic purpose. CEOs are unhappy about futures trading on their stocks because it adds volatility…While pork belly contracts serve a useful economic purpose, futures on stocks do not.”

Pointing out the subtext of such statements, subcommittee chairman Thomas Ewing (R-Ill.) questioned the motives of the two exchanges. “We want a system that works and is safe for America,” he said. “Often people [come to Congress and] testify just to gain personal business advantage, and that makes our job difficult.”

But the SEC joined the two exchanges in attacking the CBOT–CME plan. In addition to the issues raised earlier, the regulator blasted the CBOT–CME provision that would give the SEC authority over insider trading. Then the commission tipped its hand, perhaps revealing its ultimate agenda. “This attempt to strengthen oversight of these futures is an ill-conceived quick-fix that would create more problems than it solves,” said Annette Nazareth, director of market regulation at the SEC. “A delegation of insider trader oversight would seem to represent the first step of an incremental merger of the SEC and CFTC. While the commission has not taken a position in favor of, or against, such a merger, if after a thorough review Congress determines a merger is appropriate, it should complete the combination in a quick, efficient manner…”

Born’s last stand

The exchanges did not dominate the proceedings. Once again, over-the-counter market leaders—including representatives from the International Swaps and Derivatives Association, the Securities Industry Association, the Bond Market Association and the End-Users of Derivatives Association—aligned against outgoing CFTC chairperson Brooksley Born’s calls for regulation of OTC derivatives. In her final appearance before the subcommittee as chairperson, Born made her case one last time.

The testimony was undoubtedly the end of an era. With the naming on June 2 of Republican CFTC commissioner and anti-regulatory stalwart David Spears as acting chairman, it’s unlikely that such sentiment will have a place in the CFTC of the future, whatever form it takes.

The Financial Accounting Standards Board has proposed to delay implementation of FAS 133 for one year to allow financial institutions to concentrate on preventing year 2000 problems.

The board received more than 80 letters in recent months from big-time U.S. corporations—including Walt Disney Co., Dell Computer Corp., Chase Manhattan and a host of major insurers—asking for more time to get ready for the new hedge accounting rule changes. FASB granted a delay in 1997 that pushed implementation back from December 31, 1998, to fiscal years beginning after June 15 of this year to accommodate Y2K issues. The new proposal would push that date back to fiscal years beginning after June 15, 2000.

Some companies also complained that the language in the new standard is unclear in places and leaves too much room for interpretation. Another year for preparation, they argued, would give them time to sort through some of the vagaries.

The board accepted comments on the deferral proposal until June 19. At press time, no decision had been made, but the extension was expected.

The day after the departure of Commodity Futures Trading Commission chairperson Brooksley Born, the CFTC reversed its earlier position on foreign terminals and announced it would immediately begin processing applications, which will be treated on a case-by-case basis. The ruling opened the door for Liffe, the Sydney Futures Exchange, and the New Zealand Futures and Options Exchange to apply for regulatory exemption.

Back in March, Born proposed a controversial new procedure to exempt foreign boards of trade from U.S. regulatory activity while allowing them to place trading screens within the United States. This came after she set a moratorium on new applications after approving Eurex’s request in 1996—a move the three other CFTC commissioners did not support. The March plan stipulated that foreign boards of trade must be subject to bona fide regulatory regimes comparable to the CFTC, that foreign trading systems include the ability to conduct pre-execution credit and trading or position-limit screening, and that foreign boards demonstrate the technological soundness and security of their trading systems.

The plan drew ire from all sides. Foreign exchanges complained that the rules were unnecessarily restrictive, while U.S. exchanges bristled at the news that the plan did not require reciprocity from the home countries of foreign exchanges—effectively creating an uneven playing field. Even more ominously for Born, other CFTC commissioners—most notably Barbara Holum—attacked the proposal.

The June 2 lifting of the moratorium thrilled Liffe. “We are grateful the commission acted in such a timely manner to lift the moratorium, and we look forward to the commission approving our specific request,” said George Anagnos, vice president for U.S. business development at Liffe.

But the Chicago Mercantile Exchange was furious. “We have previously testified at length and in detail, listing the many devices and procedures that could be employed by foreign exchanges to divert business from U.S. exchanges,” sniffed CME chairman Scott Gordon. “Until the CFTC grants U.S. exchanges regulatory parity or agrees to preclude foreign exchanges from engaging in conduct that violates the Commodity Exchange Act, U.S. exchanges will be placed at a devastating competitive disadvantage.”

The Bank for International Settlements’ Basle Committee on Banking Supervision announced in a report last month that it is busy constructing a new capital adequacy framework to replace the outdated 1988 Accord.

The new framework is based on three pillars—minimum capital requirements, a supervisory review process and effective use of market discipline.

The first pillar, minimum capital requirements, will be built on the foundation of the current accord, but will use a broader approach. The Basle committee plans to replace the existing approach used in applying risk weights to exposures to sovereigns with a system that will use external credit assessments by ratings agencies to determine risk weights. The approach will likely be applied to banks, securities firms and corporates as well. “The result,” the report reads, “will be to reduce risk weights for high-quality corporate credits, and to introduce a higher-than-100-percent risk weight for certain low-quality exposures.” The report also notes that “for some sophisticated banks, the Committee believes that an internal ratings-based approach could form the basis for setting capital charges.”

In addition, a new method to address asset securitization, and the application of a 20 percent credit conversion factor for certain types of short-term commitments, are also proposed. The committee is also examining the capital treatment of certain credit risk-mitigation techniques, and is entertaining proposals to devise a “sound and consistent approach for credit derivatives, collateral, guarantees and on-balance-sheet netting.”

The second pillar of the new framework, the supervisory review of capital adequacy, is intended to ensure that a bank’s capital position is consistent with its overall risk profile and strategy. An important point: supervisors, says the committee, “should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios.” Moreover, the new framework will stress the importance of bank management developing an internal capital assessment process and setting capital targets commensurate with the bank’s risk profile and control environment.

The third pillar, market discipline, “will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold adequate capital.” The committee intends to issue a guideline on public disclosure to strengthen the capital framework later this year.

The committee seeks comments from interested parties by March 31, 2000, and plans to implement some proposals shortly thereafter.

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