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| Philip Johnson |
Philip McBride Johnson, head of the exchange-traded derivatives practice at Skadden, Arps, Slate, Meagher & Flom. From 1981-83 he served as chairman of the Commodity Futures Trading Commission, where he negotiated the Shad-Johnson Jurisdictional Accord, a blueprint for the regulation of financial derivatives, with his counterpart at the Securities and Exchange Commission. McBride Johnson also served on five of the CFTC's advisory committees, created the derivatives law committees for both the American and International Bar Associations, served twice on the board of the Futures Industry Association, wrote the leading legal treatise in the field and assisted in the creation of the world's first futures contracts on a security and the formation of the first centralized stock option market
DW: The rules for offering foreign stock index futures have not been finalized and some have suggested the SEC and the NASD are tacking on so many requirements that these products may be dead in the water. What do you think?.
Prior to the CFMA (Commodities Futures Modernization Act), only large stock index futures (Dow Jones Industrial Average, Standard & Poor's 500, etc.) were permissible even on U.S. markets, and the Securities and Exchange Commission had to concur before the CFTC could allow even those contracts. A quirk in the statute, actually an oversight, inadvertently made all foreign stock index futures illegal, regardless of size, but the CFTC and the SEC cobbled together a "no-action" procedure for big foreign stock index futures and about 25 of them were OK'd.
After the CFMA, the statutory quirk was not fixed but the SEC lost its right to reject any large stock index futures contract. As a result, the CFTC has continued its no-action program for large foreign stock index futures but without SEC involvement.
The matter you mention has to do with smaller stock index futures that, after the CFMA, are jointly regulated by the CFTC and the SEC. The agencies have tackled the issue for domestic exchanges but, although the CFMA gave the two agencies only a year (until 12/5/2001) to address small foreign stock index futures, they have chosen to ignore it.
I do not think this is the CFTC's fault. The SEC, on the other hand, has always been suspicious of foreign stock markets. For instance, stock options fall within [the] SEC's jurisdiction and, in the past, while the SEC has allowed domestic options exchanges such as the Chicago Board Options Exchange to sell their stock options to retail investors, the SEC has restricted [the] sale of foreign stock options only to large institutions under some pretty Byzantine conditions. I got this relief for Hong Kong (Hang Seng) options and it was an ordeal.
Technically, the neglect by [the] CFTC and [the] SEC of smaller foreign stock index futures is a violation of law but no one seems keen on litigating the issue.
DW: Eurex is making a big splash in Chicago. Does it need to register as a clearing house because of its link with the CBOT?
Whether Eurex succeeds or fails will depend on two main things: will institutional investors and bond dealers (the principal users of T-futures) be willing to re-direct business into a market that is initially illiquid simply to save transaction costs and, if transactions costs are really Eurex's only advantage, whether the Chicago Board of Trade lowers its costs sufficiently to overcome that problem.
Eurex seems to think that the ability to clear Bunds and bonds at the same clearing facility will also be a winner but I am skeptical.
My guess, and it is nothing more than a guess, is that Eurex struggles for a couple of years and then gets "sold" to one or more of the Chicago exchanges.
On the legal issue, as long as Eurex used The Clearing Corporation, it should not need a clearing license of its own. If it transfers clearing into Frankfurt, as planned, it might then need to register.
DW: A recent National Association of Insurance Commissioners white paper said weather derivatives should be classified as insurance contracts rather than derivatives. Do you agree with its conclusions and do you think the same arguments could be used for classifying credit derivatives as insurance?
The NAIC white paper is as great a threat to the derivatives community as anything in my career. Melodramatic? Right now, the CFTC has "exclusive" regulatory jurisdiction over all non-security futures and options, which includes all "hard" commodities, weather, power, events, credit, you name it. This single-regulator program saves the community millions, if not billions, a year and, equally important, avoids being bombarded with demands from different sources that are likely to be conflicting and inconsistent.
If NAIC says that these products are "insurance," they are right! If insurance is defined as a means to shift or re-distribute risk, futures and options are among the best there are. I have often characterized these instruments as insurance in my writings.
The problem is not with what to call these products, but with the consequences of regulating them as insurance. First, sellers and underwriters of insurance often need to be licensed as such under state laws that contain minimum financial standards and other restrictions that most future speculators cannot or would not want to meet. Second, suddenly we have 50 regulators instead of one. I am sure that an insurance attorney could show a dozen other ways that insurance regulation is incompatible with open competitive derivatives markets.
My firm and I have advised several reinsurance companies issuing catastrophic loss bonds, or CAT bonds, to institutional investors that contain put options that, in effect, allow the reinsurer to transfer some of their casualty losses to the institutions if a defined event occurs. I am aware of some state insurance regulators that have asserted that the institutional investors themselves need insurance licenses because they are "writing" loss coverage to the reinsurers.
DW: Taking your point about self-regulation further, where should the regulation end now that more and more over-the-counter derivatives are being converted into listed contracts? This has lowered the bar on counterparties (in terms of credit rating and sophistication) and might mean that regulators should pay more attention to the OTC market.
One remarkable feature of the CFMA is that the OTC derivatives markets are virtually unregulated while the organized exchanges are awash in federal rules. Things--including trading foreign stock index futures--can be done through OTC swaps and other instruments while they are barred on the organized exchanges. For example, if you tried to buy a KOSPI futures contract in Korea you could go to jail under U.S. law, but you are perfectly free to do a KOSPI swap with another qualified OTC trader and no consequences would follow. Or, while the CFTC and the SEC allow U.S. exchanges to list only certain single stock futures and only certain small stock index futures, futures on any stock or any index can be done between qualified traders in the OTC futures market (and at whatever margin is agreeable).
As for your specific question, my understanding is that, while some OTC products are seeking listings, a lot of exchange-type transactions are being replicated in the OTC market as well. The principal incentives for listing appear to be firstly that some major players like institutions that have a "fiduciary duty" to their investors or clients are nervous about the lack of regulation in the OTC market and the criticism or liability they could face if anything goes wrong; and secondly that the risk of default, which an exchange clearing system seeks to eliminate. Both very good reasons.
What intrigues me is not whether or why OTC products get listed but rather what will happen if a successful clearing system for OTC products develops. By eliminating credit risk, the OTC markets could be opened widely to the general public, but with few of the regulatory safeguards found on the organized exchanges where the presence of retail investors is cited as warranting greater regulation.
