License to deal: mandatory approval of complex financial products.

• Author: Omarova, Saule T.
• Position: II. Product Approval Regulation in Practice: Pharmaceutical Drugs, Chemicals, and Commodity Futures C. Product Approval in Commodity Futures Regulation: Focus on Market Manipulation and Speculation through Conclusion, with footnotes, p. 100-140

3. Product Approval in Commodity Futures Regulation: Focus on Market Manipulation and Speculation

   1. Commodity Futures Regulation--Overview

   A futures contract is a form of derivative instrument. (192) Commodity futures are standardized bilateral contracts that obligate one party (the buyer, or "long") to purchase, and the other party (the seller, or "short") to deliver a specified quantity of a specified asset, or underlying commodity, at a specified future date and at a specified price. (193) In the United States, the Chicago Board of Trade ("CBOT") began listing grain futures in the mid-1860s. (194) In the early twentieth century, rampant speculation in commodities and commodity futures, and the spread of "bucket shops," (195) led the farming community to lobby for federal regulation of futures trading. (196) In 1921, Congress enacted the Future Trading Act, which sought to outlaw bucket shops. (197) After the statute was declared unconstitutional by the Supreme Court, (198) Congress enacted the Grain Futures Act of 1922. (199) The statutory scheme for regulation of futures was revised several times after 1922. (200) In 1974, Congress enacted the Commodity Exchange Act (the "CEA"), (201) and created the CFTC as an independent federal agency overseeing the markets for commodity futures and options. (202)

   The CEA, administered by the CFTC, regulates the offer and sale of futures contracts and commodity options, the operation of futures exchanges, and the activities of various futures market participants. Under the broad statutory definition of "commodity," almost all futures contracts are subject to the CEA. (203) In contrast to disclosure-based securities regulation, the CEA establishes broad categories of permissible and impermissible transactions. Unless specifically exempted, commodity futures and options must be offered and sold on futures exchanges or other organized contract markets. (204) Contracts entered into in contravention of the statutory requirements are illegal and unenforceable, and participants in such illegal transactions are subject to a wide array of civil and criminal penalties. (205)

   The CEA's key policy objectives are:

   To deter and prevent price manipulation or any other disruptions to market integrity; to ensure the financial integrity of all transactions subject to this chapter and the avoidance of systemic risk; to protect all market participants from fraudulent or other abusive sales practices and misuses of customer assets; and to promote responsible innovation and fair competition among boards of trade, other markets and market participants. (206) Preventing fraud and price manipulation in the U.S. futures and related cash commodity markets has always been the central driving force behind the federal regulatory scheme. (207) The CEA emphasizes that futures serve "a national public interest by providing a means of managing and assuming price risks, discovering prices, or disseminating pricing information." (208) As a result of this special "utility" function, "futures trading occupies a somewhat unique economic position in the eyes of the law." (209)

   2. Pre-CFMA Regulatory Regime: Contract Designation and the Concept of Economic Purpose

   Before the enactment of the CFMA in 2000, one of the most significant provisions of the CEA was section 5a(a)(12) that required the terms and conditions of all futures contracts to be pre-approved for trading by the CFTC. (210) This requirement reflected the statute's original concern with excessive speculation that negatively affected the underlying commodity markets. As the leading treatise explained:

   At nearly every turn, the Act reiterates the utility of futures trading for (1) hedging against price risks, (2) the discovery of prices through vigorous competition, and (3) the actual pricing of commercial commodity transactions. While futures contracts offer, certainly, an investment opportunity as well, that feature seems in the Act to be subordinate or secondary in importance to the commercial uses that those markets offer. ... [I]t does not appear that a futures contract with a pure investment purpose must necessarily be foreclosed, but the history of administration of the Act leaves little doubt that a futures contract without a commercial purpose faces long odds of ever being approved by the Commission. (211) This dichotomy between commercial and "purely investment" purposes of futures contracts reflects a fundamental tension in the CEA regime. The CEA has never contained an explicit requirement of commercial utility as a condition of contract designation. Prior to 1974, the statute did not specify whether or not futures contracts with purely investment (as opposed to bona fide commercial hedging or price discovery) purposes should be approved for trading. (212) In 1974, the House of Representatives passed a bill, H.R. 13113, which sought to prohibit authorization of any contract unless that contract served a bona fide economic function, either as a price discovery mechanism or as a device for those in the related cash commodity markets to hedge their commercial, as opposed to investment, risks. (213) The industry objected to this prospective economic purpose test, arguing that it was difficult to predict the ultimate uses of a new product. (214) In response to industry pressure, the Senate rejected an explicit "economic purpose" test for approval of futures contracts and substituted it with a more vaguely stated "public interest" test. (215) As adopted, the CEA contained the Senate's provision that conditioned approval of futures contracts on the affirmative demonstration by the board of trade that "transactions for future delivery in the commodity for which designation as a contract market is sought will not be contrary to the public interest." (216)

   At the same time, however, the Conference Committee report that accompanied the original enactment of this provision in 1974 noted that the "broader language of the Senate provision would include the concept of the 'economic purpose' test provided in the House bill subject to the final test of the 'public interest.'" (217) The newly established CFTC interpreted this language as requiring that every futures contract had to meet both the broad "public interest" and the more specific "economic purpose" tests. (218)

   The key requirements for contract designation were set forth in sections 5 and 5a of the CEA. (219) In essence, the statute required the exchange applying for designation to make an affirmative showing that the contract provided for delivery of the underlying commodity at a location where there was a sufficiently active and liquid cash market and where the exchange had official inspection facilities. (220) This provision aimed to ensure the existence, at a point of delivery, of a liquid cash market in which the "shorts" could buy the necessary quantities of the underlying commodity for delivery and the "longs" could resell the commodity after taking delivery. (221) Clearly, this language contemplated an actual delivery of the underlying commodity, thus tying the futures instrument to a commercial activity: trade in the underlying commodity.

   The new contracts also had to pass the statutory "public interest" test. (222) Despite the open-ended nature of this standard, the CFTC's view was that, as a practical matter, only futures contracts that had commercial utility and had potential to facilitate bona fide commercial hedging or price discovery in the underlying commodity markets could also pass the "public interest" test of Section 5(g). As a practical matter, it was assumed that futures contracts that had no economic purpose other than financial investment were not viable in the long run, as trading in such futures would be especially vulnerable to speculative ups and downs. (223) Thus, futures exchanges were expected to design and list for trading contracts that had "a solid base of commercial hedging or pricing participation." (224)

   In addition to the substantive review of the terms of the proposed contracts, the CFTC had to scrutinize the exchanges' internal policies, procedures, and practices to ascertain their ability to monitor trading in the proposed futures contract. If the CFTC was not satisfied with an exchange's ability to ensure market integrity and limit the potential for market manipulation and other trading abuses, it could deny designation. (225) Thus, the statute linked the viability and functional utility of a futures contract to the exchanges' self-regulatory capacity.

   As part of the contract designation process, the CFTC had statutory authority to mandate changes in the specific terms of the proposed futures contracts if such changes would "tend to prevent or diminish price manipulation, market congestion, or the abnormal movement of such commodity in interstate commerce." (226) The exercise of power, however, was subject to strict procedural constraints, which showed Congressional reluctance to allow the regulator to substitute its judgment for that of an exchange. (227) Even though the CFTC did not use this power often, it functioned as a credible threat prompting exchanges to be responsive to the regulator's comments. (228)

   The statute imposed other procedural requirements on the CFTC, including various timeframes for approval decisions (229) and requirements to consult with other federal regulatory agencies. (230) In addition, the CFTC had to publish in the Federal Register notice of proposed exchange rules and amendments that were of "major economic significance" and afford all interested persons an opportunity to submit comments on the proposals. (231) Applications for contract designation were typically viewed as having such significance.

   To assist exchanges in preparing applications for product approval, the CFTC adopted Guideline No. 1, which detailed the information to be submitted to the agency. (232) Reflecting the CFTC's original position...