To: Clients and Friends
From: Cadwalader, Wickersham & Taft
Date: January 4, 2001
Re: Commodity Futures Modernization Act of 2000
On December 21, 2000, President Clinton signed into law the Commodity Futures
Modernization Act of 2000 (CFMA),1 which overhauls the Commodity Exchange Act (CEA) and
amends securities, banking and bankruptcy laws to update the regulatory structure and to clarify the
legal status of derivative products. The CFMA provides greater legal certainty for over-the-counter
(OTC) derivatives and creates a new, less burdensome regulatory framework for boards of trade that
are regulated by the Commodity Futures Trading Commission (CFTC).
The general prohibition against trading a futures contract in the United States other than on
a CFTC-regulated market is retained. However, the New Law also retains the CFTC’s authority to
provide exemptions from all or parts of the CEA and establishes specific exclusions and exemptions
for OTC derivative products and transactions executed on electronic platforms between well-
capitalized, institutional or commercial counterparties.
The CFMA repeals those parts of the 1982 amendments to the CEA and the securities laws
(sometimes referred to as the “CFTC-SEC Jurisdictional Accord”) which prohibited the trading of
In this Memorandum, we refer to the CEA as in effect prior to the effectiveness of the CFMA as “the Old Law” and to
the CEA as in effect upon the effectiveness of the CFMA as “the New Law.”
futures contracts on individual nonexempt securities and narrow-based indexes of securities. Instead,
the CFMA establishes a complex framework for trading “security futures products” on futures or
securities exchanges. Trading in these products cannot commence for a year or more, giving the
CFTC and SEC time to make the necessary regulatory changes.
This memorandum gives a preliminary summary of the main features of the CFMA and the
most profound changes it has made in the Old Law, but barely scratches the surface. In the 280-odd
pages of the statutory text, there are many important provisions that need to be closely reviewed by
entities involved with or engaged in the derivatives industry.
The language of the CFMA is lengthy, detailed, often confusing and sometimes internally
inconsistent. Unfortunately, there are no congressional reports to assist in interpreting the meaning
of its provisions. In many cases, those provisions will require clarification by the CFTC, other
regulatory agencies, and/or the courts.
1. Background/Development of the Legislation.
For at least five years, House and Senate agriculture committees have heard from futures
exchanges that they are losing business to overseas exchanges and OTC markets because of the lack
of flexibility in and excessive requirements of CFTC regulations. At the same time, OTC derivatives
dealers expressed concern that the legal status of their transactions could be jeopardized unless they
received a clear-cut exemption or exclusion from the CEA.
After holding several round-table discussions with banking, securities, futures and
agricultural industry representatives, in 1998 congressional agricultural committees asked the
President’s Working Group on Financial Products (PWG) to find a solution. The long-awaited
PWG report, issued in November 1999, recommended, among other things, exemptions from the
CEA for OTC derivatives and for electronic trading platforms when the transactions are between
sophisticated counterparties. The PWG report also acknowledged the need to reduce the regulatory
burdens for futures exchanges in financial products that involve sophisticated participants in order to
provide a “level playing field.” These principles formed the core of proposed CEA amendments
introduced in 2000.
However, the PWG report failed to resolve the interagency struggle over the CFTC-SEC
Jurisdictional Accord, which blocked an exemption from the CEA for equity swaps and equity-
linked hybrid instruments and prohibited the trading of futures contracts on individual nonexempt
securities and narrow-based indexes of securities. This debate held up the proposed CEA
amendments until the PWG was able to produce a satisfactory resolution in September, 2000. Once
that was settled, the last hurdle was Chairman Phil Gramm of the Senate Banking Committee, who
finally allowed the bill to move forward after it was peppered with stronger prohibitions against
CFTC involvement in bank-related activity. During these many delays, Congress was able to
address concerns of other interest groups, such as the treatment of domestic agricultural
2. Definitions of Certain Market Participants, Trading Facilities and Transactions.
The CFMA has added a number of new defined terms to the CEA, and has modified some
of the definitions in the Old Law which have been carried forward into the New Law. Since it
would not be possible to appreciate or understand the significance of many of the substantive
amendments to the Old Law adopted in the CFMA without taking note of these new and modified
definitions, this memorandum will summarize some of the definitions that are most important.
The term “eligible contract participant” (“ECP”) has been added. It is substantially similar
to the definition of “eligible swap participant” in Section 35.1(b)(2) of the CFTC Regulations, with
certain modifications. The modifications include (1) substituting for certain entities listed in the
Regulation a newly-created category called “financial institutions,” which encompasses trust
companies, foreign banks and domestic banks, as well as their regulated subsidiaries and affiliates,
and (2) adding to the category of eligible individuals those who have total assets exceeding
$5,000,000 and who enter into a transaction to manage risk.
Another new term added by the CFMA is “eligible commercial entity,” which is defined to
include: (1) an ECP who has demonstrated ability to make or to take delivery of the underlying
commodity, incurs risks in addition to price risk or is a dealer that provides risk management or
market-making services in the underlying commodity; (2) certain ECPs (not including individuals,
state or local governmental entities and certain collective investment vehicles); and (3) such other
persons as the CFTC may designate.
A “trading facility” is defined as a person or persons providing facilities for executing
transactions in response to bids and offers from multiple participants. If a trading facility (1) permits
trading effected by or on behalf of a person who is not an ECP, or on other than a principal-to-
principal basis, or (2) adopts rules that govern conduct beyond trading and has disciplinary
sanctions, then it is an “organized exchange.” The definition of “board of trade” in the Old Law is
changed and now means an organized exchange or other trading facility.
The term “excluded commodity” has a wordy definition that includes a wide range of
financial interests, indexes, measures of value and occurrences not in the control of the parties to the
transaction, such as weather. It does not include any tangible commodities.
An “exempt commodity” is a commodity that is not an excluded commodity or an
agricultural commodity, and would include such things as energy products and metals. The term
“agricultural commodity” is not defined.
A “derivatives clearing organization” (“DCO”) is defined as a system or organization that
enables each party to the transaction to substitute the credit of the clearing organization for the
credit of the parties, provides for multilateral settlement or netting of obligations or otherwise
provides clearing services to mutualize or transfer credit risk from such transactions among
participants in the clearing organization. This definition excludes a system or organization that
provides for settlement or netting bilaterally without a central counterparty or through an interbank
payment system, or for obligations resulting from spot market transactions.
3. Multiple Levels of Trading Facilities
Under the Old Law, there was essentially only one category of market that was subject to the
provisions of the CEA, namely, the designated contract market. The New Law, however, recognizes
several categories of markets, including the designated contract market, the derivatives transaction
execution facility (“DTEF”), the electronic trading facility, and the exempt board of trade. The
CFTC had adopted extensive regulatory reform rules which would have created comparable
categories of markets, 2 but those regulations have been effectively superseded by the CFMA and have
been withdrawn by the CFTC. 3
The detailed contract market designation and operations sections of the Old Law (sections 5
and 5a, respectively) have been deleted and replaced by new provisions. The new provisions impose
decreasing levels of CFTC regulation as the threat of manipulation decreases and as access to the
markets is limited to ECPs or eligible commercial entities.
a) Designated Contract Markets. A board of trade seeking designation as a contract market
will have to demonstrate to the CFTC that it has in place certain rules and procedures that
provide for the prevention of market manipulation, fair and equitable trading, the manner of
operation of the trade execution facility maintained by the board of trade, the financial
integrity of transactions (including clearance by a DCO), disciplinary procedures for rule
violations, public access to rules and contract specifications, and the ability to obtain certain
necessary information. A board of trade designated as a contract market on the date of
enactment of the CFMA is automatically considered designated as a contract market under
the New Law.
Under the Old Law, a board of trade had to be separately designated as a contract market for
each commodity on which it proposed to trade futures contracts. Under the New Law,
however, a board of trade need only be designated once and without reference to specific
To maintain designation, a contract market must comply with 17 “core principles,” that
show continued high standards of self-regulation.
Futures contracts on agricultural commodities enumerated under section 1a(4) of the New
Law 4 (and options thereon) may be traded only on a designated contract market, unless and
until the CFTC prescribes rules and regulations permitting them to be traded on a DTEF.
65 Fed. Reg. 77962 (December 13, 2000). The CFTC Regulations also created what was called a “recognized futures
exchange,” but it has no counterpart in the New Law and therefore no longer exists.
65 Fed. Reg. 82272 (December 28, 2000).
The commodities enumerated in the New Law are the same as those enumerated in the Old Law.
In the case of futures contracts (and options thereon) on commodities enumerated in Section
1a(4) traded on a designated contract market, each rule amendment that materially changes
the terms and conditions in any such contract or option must be submitted to the CFTC for
prior approval, if the amendment applies to contracts and delivery months which have
already been listed for trading and have open interest. These restrictions do not apply to
non-enumerated agricultural commodities, such as coffee, sugar and cocoa, or any other
Subject to the special rules described above for enumerated agricultural commodities, any
contract market may list for trading any new contract, and may elect to approve and
implement any new rule or rule amendment, by simply certifying to the CFTC (and the
Secretary of the Treasury in the case of futures contracts on U.S. government securities or
options on such futures) that the new contract, or the new rule or rule amendment, complies
with the New Law and the regulations thereunder.
b) Derivatives Transaction Execution Facilities. A board of trade may register with the CFTC
as a DTEF if it meets certain requirements as to the underlying commodities and restricts
access to certain eligible traders. The requirements as to any such underlying commodity are
as follows: (A) it has a nearly inexhaustible deliverable supply; or (B) the deliverable supply
is sufficiently large so that the contract is “highly unlikely to be susceptible to the threat of
manipulation;” or (C) the underlying commodity has no cash market; or (D) the contract is
a “security futures product” (the definition of which is described in Section 7 of this
memorandum) and the DTEF is a registered national securities exchange; or (E) the CFTC
determines, based on certain factors, that trading in the contract (or option) is “highly
unlikely to be susceptible to the threat of manipulation;” or (F) the underlying commodity is
not an agricultural commodity enumerated in section 1a(4) of the CEA and trading is
limited to eligible commercial entities trading for their own account. Access to a DTEF
must be limited to ECPs or to persons who trade through an FCM that is registered with the
CFTC, is a member of a registered futures association (or, in the case of securities futures
products, a registered securities association), is a clearing member of a DCO and has a net
capital of at least $20,000,000.
A DTEF has to comply with fewer and less onerous core principles than a designated
contract market. It may list any new contract or instrument and may implement any new
rule or rule amendment just by providing a written certification to the CFTC that such
contract, instrument, rule, or rule amendment complies with the New Law.
c) Exempt Boards of Trade. A board of trade may elect to be exempted from all provisions of
the CEA, except antifraud and antimanipulation provisions, if it meets certain criteria and
submits to the CFTC a notice that it so elects. To qualify for the exemption, the board of
trade must limit trading to futures contracts and options meeting the following criteria: the
underlying commodity must have a nearly inexhaustible deliverable supply or a sufficiently
large deliverable supply and liquid market to render the contract highly unlikely to be
susceptible to the threat of manipulation, or must have no cash market; trading must be
limited to ECPs; and the underlying commodity must not be a security or a group or index
4. Derivatives Clearing Organizations (“DCO”).
In general, the thrust of the CFMA is to eliminate or to reduce the burden of federal
regulation on markets trading commodity futures contracts and options. A major exception to this
basic principle, however, is that the CFMA imposes a new regime of federal regulation upon
commodity clearing organizations, which heretofore have only been subject to relatively minimal
The New Law requires designated contract markets to provide for the clearance of
transactions by a DCO. Other trading facilities may, but need not, provide for the clearance of
A DCO must register with the CFTC if it performs clearing functions related to a futures
contract, option on a futures contract or option on a commodity, unless the contract or option is
excluded or exempted under the New Law or is a “security futures product” cleared by an agency
registered with the SEC. To register and to maintain registration, the applicant has to demonstrate
compliance with 13 core principles regarding: financial, operational and managerial resources;
ability to manage risks; adequate settlement procedures; protection of member and participant
funds; default rules and procedures; compliance and disciplinary procedures; system safeguards;
eligibility standards for participants and transactions; reporting and recordkeeping; providing
information to the public and to the CFTC; and information-sharing arrangements. An existing
clearing organization is considered registered to the extent that it clears for a board of trade that was
designated as a contract market before enactment of the CFMA.
5. Exclusions and Exemptions from the CEA
Several exclusions and exemptions from the CEA are provided for certain trading facilities,
types of commodities and market participants having specified characteristics.
a) Revised Treasury Amendment. Transactions in foreign currency, U.S. government
securities and the other financial products enumerated in the old Treasury Amendment are
excluded from the New Law, except (1) futures, options on futures and options on
commodities (other than foreign currency or securities) executed on an organized exchange,
and (2) currency options executed on an organized exchange that is not a registered national
securities exchange. Moreover, the CEA does apply and the CFTC has jurisdiction if a
transaction in foreign currency (other than an option executed on a registered national
securities exchange) is entered into with a person that is not an ECP, unless the counterparty
is a financial institution, a registered broker/dealer, an FCM, or one of a number of certain
other regulated persons or entities, or an affiliate thereof. Thus, the revised Treasury
Amendment makes clear that the CFTC may assert jurisdiction over the offer and sale of
OTC foreign currency futures or options contracts through non-regulated entities at the
b) Excluded Derivative Transactions. In general, a transaction between ECPs in an excluded
commodity that does not take place on a trading facility is excluded from the CEA.
c) Electronic Trading Facilities. Principal-to-principal transactions in an excluded commodity
between ECPs for their own accounts that are transacted on an electronic trading facility are
excluded from regulation under the New Law. A board of trade registered with the CFTC
may establish and operate an electronic trading facility that is covered by this exclusion.
d) Exclusion for Qualifying Hybrid Instruments. The treatment afforded to certain hybrid
instruments under Part 34 of the CFTC Regulations is carried forward and expanded. The
term “hybrid instrument” is defined to mean a security having one or more payments
indexed to a commodity.5 A hybrid instrument is excluded from the New Law if (1) the
issuer receives payment in full substantially contemporaneously with delivery of the
instrument; (2) the purchaser or holder is not required to make any payment to the issuer in
addition to the purchase price; (3) the issuer is not subject by the terms of the instrument to
mark-to-market margining requirements; and (4) the instrument is not marketed as a futures
contract or option on a futures contract. There is a similar exclusion for bank-issued hybrid
instruments. Under this exclusion, hybrid instruments qualify for exclusion from regulation
under the New Law without having to meet the numerical criteria set forth in Part 34 of the
CFTC Regulations or the CFTC’s Statutory Interpretation Concerning Certain Hybrid
Instruments. 55 Fed. Reg. 13582 (April 11, 1990). Also, the difference in treatment
between hybrids having payments indexed to the prices of commodities and hybrids having
payments indexed to the prices of securities does not exist under the new statutory exclusion.
e) Exclusion for Swap Transactions. The treatment afforded certain swap transactions under
Part 35 of the CFTC Regulations is carried forward and expanded. This statutory provision
differs from the Part 35 exemption, particularly by eliminating the restriction on the use of a
clearing system, eliminating the phrase prohibiting transactions from being “fungible” and
changing the category of “eligible swap participants” in the Regulation to ECPs, having the
broader scope described above in Section 2 of this memorandum. Any swap transaction
(other than a transaction on an agricultural commodity) is excluded from the New Law if (1)
the parties to the transaction are ECPs; (2) the transaction is subject to individual
negotiation by the parties; and (3) the transaction is not executed or traded on a trading
This definition is somewhat different from the one currently appearing in Section 34.2(a) of the Commission
facility. The swaps exclusion differs from the general exclusion for other derivative
transactions described in paragraph (b) above in two ways: (1) it covers a broader range of
commodities, since the exclusion for derivative transactions is limited to “excluded
commodities” (which are only non-physical values, rates, indices and measures), and (2) it
requires that in a swaps transaction, but not a derivative transaction, there must be individual
negotiation between contract participants. Under this exclusion, there is no longer any
difference in treatment between securities-related swaps and other types of swaps as currently
exists under the CFTC’s Part 35 Regulations and the CFTC’s Policy Statement Concerning
Swap Transactions. 54 Fed. Reg. 30694 (July 21, 1989).
In addition, the CFMA amends the federal securities laws by excluding from the definition
of “security” any swap, including “security-based swaps” entered into between eligible
contract participants, the material terms of which are subject to individual negotiation. The
antifraud and antimanipulation provisions of these laws, including with respect to insider
trading prohibitions, are made applicable to transactions in security-based swaps.
f) Transactions in Exempt Commodities. Except for antifraud, antimanipulation and clearing
organization provisions, the New Law does not apply to (1) a transaction in an exempt
commodity between ECPs that does not take place on a trading facility or to (2) principal-
to-principal transactions between ECPs executed on an electronic trading facility, although
the facility must make certain notifications to the CFTC regarding the commodities it
intends to trade and the ownership structure.
g) Prohibition of the Application of the New Law to Certain Products; Enforceability of
Contracts. A strongly worded section is added to the CEA to drive home the point that it
shall not be construed that any product not specifically mentioned in the CEA, or any
transaction specifically excluded or exempted from the CEA, is subject to the CEA. Further,
a stand-alone Title IV of the CFMA states that no provision of the New Law applies to
defined banking products offered or entered into in the United States before December 5,
2000, and that the CFTC shall exercise no regulatory authority over identified banking
products, including hybrid instruments that are predominantly banking products or swap
In addition, no exempted or excluded agreement, contract, transaction or hybrid instrument
shall be void or unenforceable, and parties to such agreements shall not be able to rescind
any such agreement or recover any payment made pursuant to such an agreement, based
solely on the failure of the product to comply with the terms or conditions of an exemption
or exclusion from the CEA or any CFTC regulation.
h) Preemption of State Antigambling and Antibucket Shop Laws. The CFMA also has a
sweeping provision which preempts the applicability of state antigambling or antibucket
shop laws with respect to any excluded electronic trading facility or any excluded or
exempted agreement, contract or transaction, whether or not it is otherwise subject to the
CEA. This amendment to section 12(e)(2) of the Old Law clarifies and expands its scope.
Lastly, the CFMA expands the preemption of state antigambling and antibucket shop laws in
section 28(a) of the Securities Exchange Act of 1934 to make it applicable to any security,
whether or not it is listed on an exchange.
6. Multilateral Clearing Organizations.
The CFMA amends the banking laws to define the term “multilateral clearing organization”
as a system or organization used by more than two participants in which the bilateral credit
exposures of participants are replaced by a system of guarantees, insurance or mutualized risk of loss.
Multilateral clearing organizations for OTC derivative instruments may only be operated by a
national bank, a state member bank or an insured state non-member bank, or an affiliate of any of
the foregoing, or a corporation chartered under section 25A of the Federal Reserve Act, e.g., an Edge
Act corporation, unless the clearing organization is registered by the CFTC or SEC or is supervised
by an appropriate foreign financial regulator.
7. Futures Trading on Securities.
Under the New Law, a designated contract market or DTEF may list for trading futures
contracts (and options on such contracts) on any commodity (including exempt securities and
broad-based securities indexes) without prior CFTC review or approval, except for security futures
products. However, in the case of a stock index futures contract traded on a foreign exchange, it
appears that the CFTC staff must first issue a no-action letter to permit the offer or sale of such a
contract in the United States, as has been the case under the Old Law.
The most complicated provisions in the CFMA are amendments to the securities laws and
the Old Law to provide for trading of “security futures products,” which are defined in essence as
futures on a single security or a narrow-based security index (except for securities exempted under
the Securities Exchange Act of 1934 as in effect on the date of enactment of the Futures Trading Act
of 1982, other than a municipal security) and options on such futures. A “narrow-based security
index” is defined as an index having nine or fewer component securities or, according to specific
statutory formulae, an index in which one or a group of the securities predominate in the weighting
of the index.
There is also a definition of an index that is not narrowly based, which includes a securities
index underlying a futures contract traded on a designated contract market before the date of
enactment of the CFMA. For foreign contracts, an index is not considered narrowly based if (a) no
more than 18 months have passed since the date of enactment of the CFMA and it is traded on a
foreign board of trade, the offer in the United States of futures contracts on the index was authorized
before the date of enactment of the CFMA and the conditions for such authorization continue to be
met, or (b) the index meets rules that are required to be published jointly by the SEC and CFTC
within one year of enactment of the CFMA.
Under the CFMA, security futures products may be traded on futures or securities
exchanges, and participating exchanges must file rules with both the SEC and CFTC. However, it is
unlawful for any person to trade a security futures product until the later of: (a) one year after the
date of enactment of the CFMA or (b) such date that the National Futures Association (NFA) is
registered as a national securities association for the limited purpose of regulating activities of
members registered as brokers or dealers in security futures products pursuant to the securities laws.
There is an exception for a security futures product transaction between ECPs on a principal-to-
principal basis for their own accounts, which may be entered into on or after the later of: 8 months
following the date of enactment of the CFMA or such date that the NFA has registered as a national
A board of trade that has been designated as a contract market or registered as a DTEF with
the CFTC may register as a national securities exchange for the sole purpose of trading security
futures products by filing a written notice to be prescribed by SEC rules. The registration will be
effective contemporaneously with submission of the notice, unless the registration would be subject
to suspension or revocation. Similar expedited registration procedures and related exemptive relief
will be available for FCMs whose securities-related activities are limited to transactions in security
futures products and for broker-dealers whose futures-related activities are limited to transactions in
security futures products, and their respective employees.
Specific SEC rules will apply to the trading of security futures. For example:
a) Listing standards for security futures must be no less restrictive than listing standards
for comparable options.
b) The product must be cleared by an agency that has in place provisions for linked and
coordinated clearing with other securities clearing agencies that permit the product to
be purchased on one market and offset on another.
c) The products are subject to a prohibition against dual trading.
d) The Federal Reserve Board is directed to issue margin rules that, among other things,
must be consistent with margins for comparable option contracts. (This authority may
be delegated to the SEC and CFTC, in which case the agencies must issue margin rules
e) Each market trading such futures must pay an assessment of $0.02 for each round turn
transaction until FY 2007, and $.0075 from fiscal year 2007 onward.
Because of the numerous requirements for cooperation and coordination between the CFTC
and SEC, the need for rulemaking on various aspects of the law and the many new requirements that
will be placed on markets in these products, it is expected to be quite some time before security
futures get off the ground in the United States.
8. Tax Issues.
New tax laws were enacted (H.R. 5662) that, with some exceptions, will treat gain or loss on
security futures contracts the same as gain or loss on the disposition of property. In general, the
capital gain or loss from the sale or exchange of a security futures contract will be short-term capital
gain or loss. More favorable long-term capital gain treatment is not available. Cadwalader will be
providing a separate Memorandum on Title IV of H.R. 5662, dealing with the tax treatment of
security futures contracts.
* * * * *
Kindly direct any questions or requests for additional detail concerning the matters addressed
in this memorandum to David Mitchell at (212) 504-6285 or Edmund Schroeder at (212) 504-
6916 in our New York office, or to Ellen Levinson, Cadwalader’s Government Relations Advisor, at
(202) 862-2256 in our Washington, D.C. office.