When Is a Trading Facility Not a Trading Facility Under The Commodity Exchange Act?
| Author | Elizabeth L. Ritter |
| Position | Deputy General Counsel |
| Pages | 01 |
Deputy General Counsel, United States Commodity Futures Trading Commission. The opinions expressed in this article are solely those of the author,and are not intended in any way to represent the views of the Commission or any of its Divisions or Offices.
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MORE THAN A YEAR AGO, the New York Mercantile Exchange ("NYMEX") began clearing a certain unique type of financial product involving options on crude oil and natural gas inventory statistics. What makes these particular options unusual (as opposed to standard exchange-traded options common to the NYMEX and other futures markets around the world) is the pricing system on which they are traded: the Longitude SystemÆ ("Longitude"), developed by a privately-held technology corporation and owned by the International Securities Exchange and Goldman Sachs, Inc., which have been offering these options for several years. Longitude utilizes a Dutch auction-like format, in which prices are derived through the use of a pari-mutuel pricing mechanism, resulting in executable option positions in either oil or natural gas inventory statistics.
At first blush, Longitude appears to be just another trading facility, albeit a sophisticated one, but a trading facility nonetheless.
Market participants send in their bids and offers, which are either taken or rejected.
Prices are derived from those bids and offers, and positions are entered on behalf of the participants.
Certainly sounds like a trading facility . . . or does it?
Enter the Commodity Exchange Act ("CEA"). The CEA provides the basic statutory framework used by the Commodity Futures Trading Commission ("CFTC") to oversee the commodity futures and options industry in the United States. In 2000, Congress amended the CEA in its promulgation of the Commodity Futures Modernization Act ("CFMA"), the most sweeping legislation affecting the derivatives markets since the inception of the CFTC in 1974. In that Act, Congress enacted statutory language to provide legal certainty for over-the-counter ("OTC") derivatives transactions in exempt and excluded commodities, and to provide regulatory relief for exchange-traded derivatives. The CFMA also amended the CEA to include several new definitions intended to effectuate these objectives, including definitions of the terms "excluded commodity," "exempt commodity," and "trading facility."1
By all accounts the CFMA has been a resounding success. The flexibility provided to market participants under this new regulatory oversight regime has resulted in unprecedented growth in on-exchange trading volume and product diversification, while at the same time, over-the counter markets have experienced remarkable increases in volume and profitability. In addition, the changes introduced by the CFMA have permitted unparalleled increases in the number of new entities seeking to trade derivatives products under alternative regulatory procedures.
This "supermarket" of regulatory choices is not, however, without detractions attendant to its virtues-the most obvious of which is confusion. For example, when you set out to buy a quart of cottage cheese and find that you are faced with a veritable cornucopia of choices, including small-curd, large-curd, lowfat, super-low-fat, 1%, 2%, and lactose-free, the results can be overwhelming and discouraging. Particularly when you get home and find that you have inadvertently purchased a quart of vanilla yogurt.
In an effort to provide some clarity for derivatives "shoppers," this article utilizes the current example of a novel financial platform to illustrate the many regulatory choices available under the CEA, and examines under what circumstances those choices may or may not be appropriate. Specifically, this article examines the oil and gas inventory statistics options trading under the Longitude system in light of the statutory provisions of the CEA, as amended by the CFMA, relating to 1) exclusions and exemptions for OTC derivatives; 2) regulatory relief for Page 3exchange-traded products; and 3) new definitions in the CEA for commodities and trading facilities. The article concludes that regulatory relief for these transactions executed on the Longitude system is limited to only one of the new exemptive provisions provided by the CFMA.2
The CFMA amended the CEA to include new Sections 2(d), 2(g), and 2(h). These sections provide exclusions from regulation for excluded derivatives and excluded swaps, and exemptions for transactions in exempt commodities, respectively. Each provision has threshold requirements relating to the specific nature of the transactions and the underlying commodities, the entities on which they're traded, and the sophistication of the parties. These exclusions/exemptions are briefly described below.
Section 2(d), "excluded derivative transactions," provides a general exclusion from CFTC regulation for transactions in excluded commodities entered into between eligible contract participants ("ECPs"), not executed or traded on a trading facility.
Additional regulatory relief is available under this provision if the transactions are executed on an electronic trading facility, on a principal-to-principal basis between ECPs trading for their own accounts or in a statutorily-defined agency capacity.
Section 2(g), entitled "excluded swap transactions," also provides a broad exclusion from CFTC regulation for swap transactions in excluded and exempt commodities, if the contract, agreement, or transaction is entered into by ECPs, subject to individual negotiation, and not executed or traded on a trading facility.
Section 2(h), "legal certainty for certain transactions in exempt commodities," provides two levels of exemptive regulatory relief for transactions in exempt commodities. First, Section 2(h)(1) provides that nothing in the Act, other than antimanipulation and certain antifraud provisions, applies to transactions in exempt commodities between ECPs, not entered into on a trading facility. Second, Section 2(h)(3) provides a similar exemption for exempt commodity transactions, as long as they are entered into between eligible commercial entities on a principal- to-principal basis, and...
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