Are the CFTC’s Days Numbered?
In the final movement of Gustav Mahler's Sixth Symphony, his hero is hit by what the Viennese composer calls "three hammer-blows of fate" that ultimately lead to his demise. Shortly after composing the symphony, Mahler, too, fell prey to three tragic events, the last of which was the diagnosis of a heart condition that ultimately led to his death. Thus, Mahler's three symphonic hammer-blows are often viewed as eerily prophetic of his own untimely demise.
For the Commodity Futures Trading Commission (CFTC), February must have seemed a bit like the last movement of Mahler's Sixth. In that one month, the regulator of U.S. futures markets received three hammer-blows that may presage the agency's demise, which, unlike Mahler's, might not be so untimely.
As the customer base of futures exchanges has evolved from small retail customers to large wholesale and institutional participants, the CFTC's traditional justification for its "Ma and Pa Kettle" approach to futures regulation hardly applies. To combat the onset of its obsolescence, the Commission has been thrashing around to find new territory to regulate and new ways to regulate its existing constituents. In the process, the CFTC has created mountains of red tape, clouds of legal uncertainty, and serious anti-competitive biases in the market. Last February, the CFTC's behavior finally provoked three hammer-blows of fate – from the Congress, the Federal Reserve, and the Supreme Court. The question that must be asked is whether the "public interest" is served by the CFTC at all anymore.
The first hammer-blow to the CFTC was the introduction of legislation on February 4 by Senators Lugar, Leahy, and Harkin. Around the same time, a House bill to reform the CFTC was introduced by Rep. Ewing. Although the passage of those bills remains far from assured, both signal a current wave of strong congressional intent to clip the CFTC's wings and attenuate its power to regulate the futures industry.
That off-exchange financial activities are not regulated by the CFTC is not for lack of effort by the Commission. In recent years, the CFTC regularly sought jurisdiction over swap contracts, even when those transactions are negotiated privately between sophisticated commercial enterprises. These attempts by the CFTC to gain new turf caused concern and anxiety among market participants, legislators, and even other regulators.
This was demonstrated on February 21, when the CFTC received the second hammer-blow in a rare public rebuke – albeit indirect – from Federal Reserve Chairman Alan Greenspan. "The application of [CFTC regulations] to off-exchange transactions between institutions seems wholly unnecessary – private market regulation appears to be achieving public policy objectives quite effectively and efficiently," Greenspan said.
The final hammer-blow was delivered by the Supreme Court on February 25, when the Court ruled in Dunn v. CFTC that the Commission does not have jurisdiction over off-exchange currency options. For years, the CFTC has claimed otherwise. The Court decision thus robs the CFTC of a regulatory constituency the agency has long asserted was its own.
That the CFTC regularly tries to tighten its grip on the futures participants it regulates at the same time it evokes tenuous legal and economic reasoning to justify a need for a larger regulatory domain is what precipitated the three hammer-blows in February. The rejection by the Court of the CFTC's arguments in Dunn illustrates the weakness of the Commission's policy position.
In 1994, the CFTC filed suit against William C. Dunn and Delta Consultants, Inc., alleging that Dunn and his firm defrauded customers of about $95 million in off-exchange currency options. The defendants argued that the CFTC had no jurisdiction over them. The District Court disagreed and granted various forms of relief requested by the CFTC, and the Second Circuit Court of Appeals upheld the District Court's ruling on June 23, 1995. The high court's decision in Dunn overturns the lower court decisions.
The policy question in Dunn is less about the alleged fraud than the CFTC's authority to regulate firms like Delta Consultants under the Commodity Exchange Act (CEA). Dunn claimed that the CFTC did not have that authority, citing the "Treasury Amendment" to the CEA. The Treasury Amendment was adopted in 1974 after the Treasury Department argued to Congress that the foreign exchange market did not warrant CFTC regulation – one reason being that banks, the main participants in currency markets, were already heavily regulated. The amended CEA thus now excludes all "transactions in foreign currency" from CFTC regulation unless those transactions are "conducted on a board of trade."
The CFTC has never gracefully accepted Congress's decision to keep the agency away from off-exchange currency transactions. No doubt wary of the sacrosanct bank participants, the Commission has tried to stay a player in regulating currency markets by bringing enforcement actions against non-bank dealers like Dunn, justifying itself using ostensible definitional ambiguities in the CEA.
Apart from pointing at the broad authority the CFTC believes it has to police markets for fraud, the CFTC usually asserts jurisdiction in such cases by claiming either that the transactions in question are not "transactions in" foreign currency or that the firms involved fall under the murky definition of "boards of trade." In Dunn, the CFTC took the former tack and argued that "options on" currency – rights to buy or sell currency on or before a future date at a fixed price – are not "transactions in" currency until the options are exercised. Thankfully, the Supreme Court demonstrated a sounder knowledge of financial economics, stating, "That reading of the text seems quite unnatural to us, and we decline to adopt it."
The CFTC tried to bolster its argument in Dunn by citing the legislative histories behind options and futures regulation and by arguing that Congress never meant to exclude transactions with retail customers from the CEA. Again, the Court was unsympathetic. Justice Stevens notes in the majority opinion, ". . .we give only slight credence to these general historical considerations. . .We think the history of the Treasury Amendment suggests – contrary to the CFTC's view – that it was intended to take all transactions relating to foreign currency not conducted on a board of trade outside the CEA's ambit."
When Mahler received his third hammer-blow after being diagnosed with a heart condition, he did not accept his fate gracefully. He even tried to cheat fate by renumbering his symphonies to avoid the pattern that befell Beethoven, Bruckner, and Schubert, all of whom died after composing their ninth symphonies. It didn't work. Mahler, too, died soon after completing the symphony he titled the Ninth.
In the same way, the CFTC can cheat fate no longer. The markets the CFTC was originally intended to regulate are now so dominated by institutional participants that CFTC-style regulation is no longer warranted, and, as Greenspan so eloquently put it, market discipline has proven more than adequate to police voluntarily off-exchange transacting. As for the much-touted but utterly tiny "retail" segment of the currency market, no case has been made to show why CFTC regulation would in any way improve on existing common law remedies against fraud. Any way you cut it, the raison d'etre of the CFTC is vanishing fast.
The CFTC should accept its obsolescence quietly rather than rail against fate. While Mahler tried to avoid the inevitable, he, at least, continued to compose beautiful music. If the CFTC continues to try and sustain its ebbing life by regulating old markets more harshly and grabbing new markets that Congress never intended it to touch, the agency will only create more of the same regulatory and legal cacophony it has composed so expertly in recent years.