CFTC Jurisdiction Over OTC Derivatives

Part I: Introduction

Use of over-the-counter (OTC) derivatives – customized instruments purchased primarily by sophisticated participants in financial markets to manage risk – has exploded in the last decade. The International Swaps and Derivatives Association reported that OTC derivative contracts with a notional value of $29.035 trillion were outstanding at the end of 1997, an increase of 543% over the value outstanding at the end of 1992 and of 3354% over the value outstanding at the end of 1987.

Unsurprisingly, as the use of derivatives has grown, so have incidents of their misuse. Particularly dramatic examples of the havoc that can be wrought by the misuse of derivatives include the Orange County bankruptcy in 1994 and the collapse of Barings Bank in 1995. While previous derivatives disasters had largely involved exchange-traded derivatives, in the fall of 1998 a financial crisis arose – the near-collapse of Long Term Capital Management, a prominent Wall Street hedge fund – that was fueled in part by investment in OTC derivatives.

Although the use and misuse of OTC derivatives has grown dramatically in the past decade, one fact about these financial instruments has remained relatively constant: disagreement amongst federal regulators and industry participants as to who, if anyone, has regulatory authority over OTC derivatives. The Commodity Futures Trading Commission (CFTC) and the American futures exchanges (whose products compete economically with OTC derivatives) have maintained that the 1974 amendments to the Commodity Exchange Act grant jurisdiction over OTC derivatives to the CFTC. Other interested federal regulators, including the SEC, Federal Reserve, and Treasury Department, as well as OTC derivatives dealers, have generally maintained that the Commodity Exchange Act does not apply to OTC derivatives, and that such derivatives are therefore not subject to direct federal regulation.

The CFTC rekindled this debate in 1998 by issuing a concept release intended to "reexamin[e] [the CFTC's] approach to the over-the-counter derivatives market." The CFTC's seemingly innocuous "reexamination" prompted a swift and angry response from the other federal financial regulatory agencies, and ultimately led to passage of legislation temporarily depriving the CFTC of authority to alter its existing regulatory approach to OTC derivatives. However, this stopgap legislation did nothing to answer the underlying questions concerning OTC derivatives: does the Commodity Exchange Act give the CFTC jurisdiction over OTC derivatives, and if so, is this grant of regulatory authority appropriate?

This paper considers whether the Commodity Exchange Act does grant regulatory authority over OTC derivatives to the CFTC. Part II describes the Act's structure, and explains why it might be read to confer such authority. Part II also describes the legislative and administrative actions that have been taken to exempt OTC derivatives to date from substantive regulation under the Act. Part III summarizes the arguments made by the CFTC's proponents and opponents as to why the Act should or should not be read to confer regulatory authority over OTC derivatives to the CFTC. Part IV considers the persuasiveness of these arguments, in light of Congressional intent as revealed by the legislative histories of the 1974, 1982, and 1992 amendments to the Commodity Exchange Act. Part V considers the Supreme Court's decision in Dunn v. Commodity Futures Trading Commission, a 1997 case that concerned the CFTC's jurisdiction over a narrow class of OTC derivatives, foreign currency options. Although the Court did not address the question of CFTC jurisdiction over OTC derivatives generally in Dunn, several aspects of the decision suggest how the Court might approach that question in a future case.

The paper concludes, in Part VI, that while current law does not provide a clear cut answer to the question of CFTC jurisdiction over OTC derivatives, the CFTC does seem to have the stronger legal position in its ongoing debate with the OTC derivatives industry. However, the OTC industry has powerful policy arguments in support of its claim that the CFTC should not engage in substantive regulation of the OTC market. Federal legislation is needed to clarify the legal status of these instruments. This legislation should generally maintain the regulatory regime for OTC derivatives established to date; although regulators will need to incorporate the lessons from the near collapse of Long-Term Capital last fall, particularly those pertaining to systemic risk, in fine-tuning the OTC legal regime.