The Commodity Futures Modernization Act of 2000, signed into law on Dec. 21, made sweeping changes in the U.S. exchange-traded and over-the-counter derivatives markets.
It amended various laws to let the U.S. financial regulatory regime keep pace with the rapidly evolving derivatives markets and advances in financial engineering. It also allowed financial markets and market participants to remain competitive with their foreign counterparts.
A primary goal of the legislation was to supply legal certainty for most OTC derivatives transactions.
Title I excludes the transactions from coverage under the Commodity Exchange Act and the jurisdiction of the Commodity Futures Trading Commission, or CFTC. This ended the possibility that an aggrieved counterparty might use the acts prohibition on the sale of off-exchange futures contracts to dodge its obligations.
Moreover, the law appears to give additional protection with respect to derivatives that are offered, sold, or traded by commercial banks.
Title IV is called the Legal Certainty for Bank Products Act of 2000. It is clear from this name that Congress intended the broadest possible exclusion from the commodity law for transactions entered into by commercial banks. The exclusions extend not only to traditional banking instruments (such as deposits and loans) and relatively new products but also to any products that banks may develop, offer, and sell in the future.
The law was enacted in part as an amendment to the Gramm-Leach-Bliley Act, which was intended to foster competition by dismantling many legislative and regulatory barriers between sectors of the financial services industry. This raises the nagging question of whether Congress has created an unlevel playing field for derivatives dealers by giving a measure of legal certainty to bank products and transactions that derivatives offered by other OTC derivatives dealers lack.
This does not appear to be the case. Though Title IV contains specific exclusions from the commodity law for bank products and transactions, they merely serve as belts and suspenders to the broad exclusions contained elsewhere in the law for all derivative dealers (including investment banks, insurance companies, and energy concerns).
In fact, any advantage that banks have under Title IV is subtle and has more to do with the regulators respective jurisdictional borders than with relations between the regulators and the regulated. This potential advantage is based upon who has the authority to make regulatory determinations concerning the applicability of the exclusions provided by the law.
The various exclusions for swaps, other derivatives, and hybrid instruments are drafted as amendments to the Commodity Exchange Act. As such, the CFTC alone has the authority to determine which transactions meet the conditions and requirements for the various exclusions in Title I.
Title IV, however, is a stand-alone statute. And though, like Title I, it excludes certain transactions from the commodity law, it does not amend it. Title IV clearly defers to the authority of the federal banking regulators, particularly the Federal Reserve Board, to determine what are appropriate banking activities and how they should be supervised.
The exclusion given existing bank products is based, in large part, upon the certification by an appropriate banking agency that the product in question is a bank product. In addition, if the CFTC wants to regulate a hybrid instrument that is not predominantly a bank product, it must consult with the Fed before doing so.
(Notably, the law does not contain a similar provision requiring CFTC consultation with the Securities and Exchange Commission with respect to hybrid instruments that are predominantly securities.)
If after such consultation, the CFTC decides to regulate a hybrid instrument, the Fed can seek review of the decision in the U.S. Court of Appeals for the District of Columbia. Functional regulation notwithstanding, it is hard to imagine that the Fed, with its enormous power as the superregulator under Gramm-Leach-Bliley, would often be on the losing side of such a dispute.
This demarcation of regulatory boundaries with respect to derivative products and transactions will presumably extend to the jurisdiction of congressional oversight committees as well. The commodity law and the CFTC have always been, and will probably continue to be, overseen by the House and Senate Agriculture committees. Any future tinkering with the exclusions in Title I will be within the purview of these committees.
However, since Title IV addresses only bank derivative products and transactions and does not amend the commodity law, any change in these provisions should fall within the purview of the Senate Banking Committee and the new House Financial Services Committee.
Once again, this difference in process could have enormous implications for the likelihood of substantial change in the respective titles, including the possibility that the swaps exclusions could be broadened to include retail transactions.
Banks may find that the processes established by, or embedded in, Title IV will bring them certain advantages. But for now Title IV is a victory for bank regulators, the Senate Banking Committee, and the House Financial Services Committee.
Mr. Harris is a partner at Arthur Andersen LLP in New York.
