Published on November 26, 2007
MODERNIZATION OFUS FUTURES MARKETS ANDPOLICY IMPLICATIONSFOR TURKEY: MODERNIZATION OF US FUTURES MARKETS AND POLICY IMPLICATIONS FOR TURKEY Ferhat OZCAM April 22, 2003 Philadelphia, PA Overview OfUS Futures Markets: Overview Of US Futures Markets History Futures contracts for agricultural commodities have been traded in the US for more than 100 years and have been under Federal regulation since the 1920s. In the last 20 years, futures trading has expanded rapidly into many new markets such as electricity, seafood, dairy products, crop yields, and weather derivatives. Commodity Exchange Act CEAct is the main law regulating futures market in the US. The bases identified in the CEAct for regulating the futures markets are the markets' price discovery and risk shifting functions. Commodity Futures Trading Commission The CFTC was created by Congress in 1974 as an independent agency to regulate commodity futures and option markets in the US. Overview OfUS Futures Markets: Overview Of US Futures Markets Self-Regulation The regulatory structure established by the CEAct and CFTC regulations relies heavily upon self-regulation by the SROs. The CFTC designates and supervises contract markets (i.e., the futures exchanges) and registered futures associations (i.e., NFA). Although sometimes criticized for leaving too much compliance responsibility with the market itself, this aspect of US futures regulation has been recognized as both a material factor in the competitiveness of US financial markets and a means of limiting the cost of governmental intervention and oversight. Market Structure: Market Structure Financial Integrity of Marketplace Open, Competitive and Fair Transaction Execution Transparency Review of New Products and Exchange Rules Market and Trade Practice Surveillance Customer Protection Structural And Technological Change in Global Futures Markets : Structural And Technological Change in Global Futures Markets New Technologies The emergence of new computer and communication technologies is playing a critical role in the restructuring and redefinition of the trading environment of the futures industry. Electronic trading vs. pit trading. The ultimate platform or platforms on which futures trading is based will depend on demand from the market and the ability of exchanges to adapt themselves to those demands and offer customers the greatest value. To the extent that pit trading efficiently offers value to customers, that system will endure. To the extent, however, that electronic systems can replicate the advantages of the pit and offer them at a lower cost to customers, then that trading system will prosper and grow. Structural And Technological Change in The GlobalFutures Markets : Structural And Technological Change in The Global Futures Markets Exchange Consolidation By merging and forming alliances, exchanges hope to capture scale efficiencies by combining similar functions from separate exchanges, such as administration tasks and clearing. They also hope to create a larger customer base by providing better access to a greater variety of contracts than previously available at either of the exchanges. CFTC Study: 1999: CFTC Study: 1999 Both total US and total foreign futures and option trading volume have increased significantly. The US share of total worldwide futures and option trading activity appears to be stabilizing as the larger foreign markets have matured. The most actively traded foreign products tend to fill local or regional risk management needs and few products offered by foreign exchanges directly duplicate products offered by US markets. The increased competition among mature segments of the global futures industry, particularly in Europe, may reflect industry restructuring and the introduction of new technologies, particularly electronic trading. The distinctions in regulatory regimes between various countries do not appear to have been a significant factor in the competitive position of the world's leading exchanges. Challenge: Challenge Neither trends in the locus of trading activity nor regulatory developments suggest an erosion of US futures markets' global competitive position. However, the continued application of new technologies and the trend toward exchange consolidation are likely to change significantly the competitive structure of global futures markets in the coming years. Commodity Futures Modernization Act of 2000 : Commodity Futures Modernization Act of 2000 Create different categories of exchanges with different regulatory requirements Authorize futures trading on single stocks and narrow-based stock indexes Provide legal certainty for swaps and hybrid instruments Provide for the trading of wholesale OTC derivative transactions free of oversight and regulation by the CFTC Legal certainty for bank derivative products Close a regulatory gap by giving the CFTC limited jurisdiction over retail OTC foreign currency transactions Flexible Trading Structure: Flexible Trading Structure Intermediated Exchanges There are three categories of intermediated exchanges Contract markets Derivatives transaction execution facilities Exempt boards of trade Electronic Trading Facilities There are also two categories of principal-to-principal electronic trading facilities that are very limited in what they can trade Electronic trading facilities for exempt commodities Excluded electronic trading facilities Contract Markets: Contract Markets Designated contract markets are most like traditional futures exchanges. They may list for trading contracts based on all types of products and may allow access to their facilities by all types of traders, including retail customers. Contract markets must comply with 18 core principles that set in Section 5(d) of the CEAct. Derivatives Transaction Execution Facilities: Derivatives Transaction Execution Facilities DTEFs are trading facilities that limit access to institutional or otherwise eligible traders. DTEFs are available to eligible traders for futures and option contracts on commodities that have a nearly inexhaustible deliverable supply, are highly unlikely to be susceptible to the threat of manipulation, or have no cash market, security futures products, and futures and option contracts on commodities that the CFTC may determine, on a case-by-case basis, are highly unlikely to be susceptible to the threat of manipulation. A registered DTEF must adhere to 8 core principles set in Section 5a(d) of the CEAct. Exempt Boards of Trade: Exempt Boards of Trade Transactions by eligible contract participants in selected commodities may be conducted on an XBOT under the CEAct. Exempt boards of trade are subject only to the CEAct's anti-fraud and anti-manipulation provisions. An exempt board of trade is prohibited from claiming that the facility is registered with, or recognized, designated, licensed or approved by the CFTC. The commodities eligible to be traded on an XBOT are those that are based on underlying commodities that have: A nearly inexhaustible deliverable supply; A deliverable supply that is sufficiently large, and a cash market sufficiently liquid, to render any contract traded on the commodity highly unlikely to be susceptible to the threat of manipulation; or No cash market. Electronic Trading Facilities for Exempt Commodities: Electronic Trading Facilities for Exempt Commodities These facilities can only trade exempt commodities, trading can only be done by eligible commercial entities on a principal-to-principal basis, and the trading facility must be electronic. Exempt commodities are defined as those commodities that are neither “excluded commodities” nor agricultural commodities - e.g., energies and metals. The term ''excluded commodity'' means an interest rate, exchange rate, currency, security, security index, credit risk or measure, debt or equity instrument, index or measure of inflation, or other macroeconomic index or measure, etc. Excluded ElectronicTrading Facilities: Excluded Electronic Trading Facilities These facilities can only trade excluded commodities, trading can only be done by eligible contract participants on a principal-to-principal basis, and the trading facility must be electronic. The types of commodities that qualify as excluded commodities are listed in the Act and primarily involve financial commodities, indexes, and contingencies. Security Futures : Security Futures Shad-Johnson Accord 1982 The CFMA lifts the 18-year the Shad-Johnson Accord's ban on single-stock futures and narrow-based security indexes (security futures products). Joint Regulation by the CFTC and SEC The amendments give the CFTC and the SEC joint regulatory authority over security futures products. In order to trade security futures products, contract markets and DTEFs must also be registered as limited purpose national securities exchanges. Securities exchanges, ECNs, and NASD must also be registered as limited purpose contract markets or DTEFs. Security Futures : Security Futures Different Aims Joint regulation could pose some challenges for the two agencies. The SEC’s traditional focus on investor protection and full disclosure is different from the CFTC’s emphasis on facilitating price discovery and commercial hedging. The ability of two agencies to cooperate and fulfill the mandates of the CFMA will be tested as the agencies fill in the specifics of the regulatory structure through rulemaking. Swaps andHybrid Instruments : Swaps and Hybrid Instruments Swaps The CFMA provides legal certainty for swaps by excluding from the Act any OTC transaction (other than in agricultural commodities) that is entered into between eligible contract participants and subject to individual negotiation. Hybrid Instruments Hybrid instruments that are predominantly securities or banking products are also excluded from the Act. The CFMA provides a relatively simple test for determining what predominately a security or banking product is. OTC Derivatives: OTC Derivatives Until the CFMA, off-exchange futures trading was punishable by up to 5-years imprisonment and a $1 million fine. After the CFMA, however, it was perfectly legal to trade most futures anywhere after qualifying as an eligible contract participant. For the first time in the history of federal futures law, trading away from the regulated markets is now permissible under certain conditions. Legal Certainty forBank Derivative Products: Legal Certainty for Bank Derivative Products The CFMA provides protection with respect to those OTC derivatives that are offered, sold, or traded by commercial banks. Congress intended the broadest possible exclusion from the commodity law for transactions entered into by commercial banks. 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 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. Foreign Currency Transactions : Foreign Currency Transactions The Treasury Amendment, which was added to the Act in 1974, exempts certain commodities -including foreign currencies- from the Act unless they are traded on a board of trade. The courts have interpreted the Treasury Amendment to exempt all off-exchange transactions in these products from the Act. The CFMA amends the Treasury Amendment to provide that only certain regulated entities can be parties to off-exchange foreign currency futures and options transactions with customers who are not eligible contract participants. Those regulated entities are: - banks and other financial institutions, - broker-dealers and their associated persons, - futures commission merchants and their affiliated persons, - insurance companies and their regulated subsidiaries and affiliates, - financial holding companies, and - investment bank holding companies. Futures Market inTurkey: Futures Market in Turkey Regulatory Framework The Capital Market Law: Article 22/j “Duties and Authorities Article 22 – The principal duties and authorities of the Capital Market Board are indicated below: … j) To make regulations on the specifications and sale and purchase principles of any derivative instruments, including futures and options contracts based on economic and financial indicators, capital market instruments, commodities, precious metals and foreign currency; the rules and principles relating to supervision, obligations and activities of those who shall be employed at the exchanges and markets where these instruments shall be traded; and the principles for margining, clearing and settlement system;” Futures Market inTurkey: Futures Market in Turkey Regulatory Framework The Capital Market Law: Article 40 “Exchanges and Other Organized Markets Article 40 – … Exchanges formed as legal entities exclusively for the trading of futures and options contracts based on economic and financial indicators, capital market instruments, commodities, precious metals and foreign currency and for the capital market instruments composed of all kinds of derivative instruments may be established upon the suggestion of the Board and proposal of the Related Minister and with the approval of the Council of Ministers. The establishment, organization, operations, supervision, membership rules and principles of these exchanges shall be determined by regulations promulgated by the Related Ministry. If these exchanges are established as joint stock corporations, they may not distribute more than 20 percent of their annual profit. Capital market instruments in the scope of this subparagraph are exempt from the stamp tax.” Futures Market inTurkey: Futures Market in Turkey Current Market Structure Istanbul Gold Exchange Futures and Options Market in the IGE was launched on August 15, 1997. The gold futures contracts are available for 100 troy oz and 1 kg of gold of 995 fineness. But few contracts were traded in this market and it is inactive for a long time. Futures Market inTurkey: Futures Market in Turkey Current Market Structure Istanbul Stock Exchange On August 15, 2001, the first futures contract on TL/USD rate for $ 100,000 was launched. But after a few contracts were traded, the market became inactive. Futures Market inTurkey: Futures Market in Turkey Future Plan: Izmir Futures and Options Exchange, Inc. The Capital Market Law: Article 40 Decree of Council of Ministers on October 19, 2001 Joint stock company The foundation of the exchange named Izmir Futures and Options Exchange, Inc. then completed as a legal entity but has not yet begun its operations. The exchange will apply to the CMB in order to commence operation following the completion of technical infrastructure. Policy Implicationsfor Turkey: Policy Implications for Turkey Single Exchange vs. Flexible Trading Structure Two unsuccessful contracts were tried to launch within relatively matured cash markets, i.e. IGE and ISE. These exchanges have been operating relatively for a long time and have expertise in their markets. So, it shouldn’t be expected an institutional failure in the success unless there is an evidence. So it shouldn’t be relied solely on a separate futures exchange for the success of futures markets. Where the market structures require, flexible trading structures ought to be considered. Article 40 of the Capital Market Law allows establishing such trading structures. In fact, the challenge by these trading structures is not far with the speed of technological developments. Later, it may be easier to consolidate these trading structures by market forces internally or by regulation externally. Policy Implicationsfor Turkey: Policy Implications for Turkey Over-the-counter Market There is a substantial over-the-counter contract market in Turkey especially among banks. The Capital Market Law does not explicitly states that whether these transactions are in the scope of the Capital Market Law or not. From the standpoint of prudential supervision, it is natural to be taken into account these transactions by the respected regulatory agencies But this raises both the financial risks of individual transactions and regulatory arbitrage issues stemming from lack of uniform regulation. So, the status of the over-the-counter transactions and the banks’ position with regard to these transactions should be clarified.