Exchange consolidations: Help or hospice?

Congress obliged. From the date of enactment of the first federal futures legislation, it was not only unlawful, not only criminal, but felonious to engage in futures trading anywhere except on a regulated exchange. There would be no over-the-counter futures market; prison stripes awaited anyone who tried.

And so it remained until the 1980s. In the meantime, however, major regulatory changes occurred in other areas. First, as the futures markets branched out from agriculture into currencies, energy, and metals, Congress began to question whether oversight by the USDA was still the best approach. In 1974 it replaced the USDA with the Commodity Futures Trading Commission (“CFTC”), a five-member independent agency of the United States. But two potential problems had to be solved first. With futures markets offering products to many different industries, most of which were already supervised in their activities at the federal, state and/or local levels of government, the specter arose that the CFTC might have to share jurisdiction with these other authorities depending upon what industry is involved. Second, the CFTC would have inherited a statutory definition of “commodity” (integral to determining whether a futures contract or option existed) that was a long list of farm products, nothing else.10 So, even if the CFTC could overcome the issue of jurisdictional proliferation, its remit would remain only with the agricultural sector and other regulators could emerge if any other industry were affected.

Congress elected to grant the CFTC “exclusive jurisdiction” and also amended the definition of “commodity” to assure that all items in which futures trading takes place fall within the CFTC’s sole authority. This consolidated futures regulation within a single federal agency.

By the 1980s, however, there emerged a new form of derivative that would gradually adopt the generic name of “swaps.” In their early iteration, these instruments tended to be agreements between major banks to hypothetically alter their loan portfolios without actually transferring any of the outstanding loans. To illustrate, Alpha Bank might have a loan portfolio with more fixed-rate borrowings than it would like to have, while Beta Bank would have more variable-rate loans than it wanted. Alpha’s concern was that its emphasis on fixed-rates would deprive it of the opportunity to benefit if interest rates were to rise, while Beta lacked the protection it wanted in case interest rates were to decline. Each would agree to “set aside” a part of its portfolio and to treat it as if the other bank were the owner. Then, periodically, both banks would calculate the change in the yield on the agreed loans. If interest rates had risen, Beta would pay to Alpha the increase on those variable-rate loans while, if interest rates had declined, Alpha would pay the higher amount received on its fixed-rate loans. The same result might have been achieved through the use of interest-rate futures contracts available on CFTC-regulated exchanges but, for reasons discussed below, the private arrangements held more appeal.

It did not take long for the CFTC to wonder aloud whether these “swaps” might actually be futures contracts and, if so, unlawful due to the Commodity Exchange Act’s on-exchange requirement. After all, like futures, the instruments were of limited duration, tracked changes in a stated value, and were typically settled in cash between the parties. After review, and subject to conditions, the CFTC declared that these swaps could be offered privately, a policy that prevailed for about a decade.

But by the end of the 1990s, the use of swaps had migrated to dozens of different industries in very substantial volume, used mainly to hedge against higher operating costs or declining resale prices. The CFTC signaled its intention to revisit the matter generally, setting off a fierce lobbying effort to thwart any change in the status quo and culminating in the Commodity Futures Modernization Act of 2000 that effectively prohibited the CFTC from involving itself in this activity.

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