Commodity Futures Modernization Act (CFMA) Definition

What’s the Commodity Futures Modernization Act (CFMA)?

The Commodity Futures Modernization Act (CFMA), signed into legislation on Dec. 21, 2000, overhauled U.S. monetary laws in response to speedy development in over-the-counter (OTC) derivatives. CFMA clarified the roles of the Commodity Futures Buying and selling Fee (CFTC) and the Securities and Trade Fee (SEC) in regulating an expanded vary of futures contracts. It additionally licensed clearing amenities for OTC derivatives, and legalized single inventory futures.

Key Takeaways

  • The Commodity Futures Modernization Act (CFMA), adopted in 2000, addressed speedy development in monetary derivatives equivalent to swaps instantly negotiated by monetary establishments.
  • The legislation formally exempted over-the-counter derivatives trades between monetary companies from routine regulation.
  • Mounting spinoff exposures helped to precipitate the 2007-2008 international monetary disaster
  • The Dodd-Frank Act licensed CFTC to manage swaps sellers, although critics contended it didn’t go far sufficient.

Understanding Commodity Futures Modernization Act (CFMA)

Earlier than CFMA, U.S. monetary regulation vested oversight of securities buying and selling with the SEC and of commodity futures with the CFTC. The foundations didn’t tackle derivatives not tied to bodily commodities, and speedy adoption of those devices had positioned a rising proportion of the monetary area past the regulatory attain of both company.

CFMA largely adopted the suggestions made in 1999 by the President’s Working Group on Monetary Markets, a roundtable of regulators that included SEC, CFTC, the Federal Reserve, and the U.S. Treasury. The SEC and CFTC had put aside previous jurisdictional disputes, agreeing to exempt non-commodity OTC derivatives traded by monetary establishments from regulation by CFTC, and to share oversight of single-stock futures.

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The Commodity Futures Modernization Act exempted from CFTC oversight most OTC derivatives, together with monetary swaps between establishments and any “hybrid instrument that’s predominantly a banking product.” To qualify as an exempt hybrid instrument below that definition, the spinoff’s issuer needed to obtain fee in full on supply, whereas the client or holder couldn’t be required to make subsequent funds to the issuer equivalent to for margin or settlement. The issuer may additionally not be topic below the spinoff contract’s phrases to mark-to-market margin necessities, and the spinoff couldn’t be marketed as commodity futures.

CFMA put an finish to fears OTC derivatives may very well be challenged or invalidated on the grounds they have been illegally traded futures. It additionally barred state-level regulation. The legislation inspired the creation of clearing homes for OTC derivatives.

As well as, CFMA licensed the itemizing and buying and selling of single inventory futures, topic to joint oversight by SEC and CFTC. Single inventory futures final traded within the U.S. in 2020, when the final alternate to listing them closed. Whereas single inventory futures proceed to commerce abroad, they continue to be much less widespread than different fairness derivatives, equivalent to choices.

Criticism of CFMA and Subsequent Adjustments

Monetary regulators weren’t the one ones to notice speedy development in OTC derivatives. Whereas this market grew successfully unregulated earlier than passage of CFMA, the legislation’s hands-off method. Within the wake of the 2007-2008 international monetary disaster, the Monetary Disaster Inquiry Fee licensed by the U.S. Congress concluded that the pre-emption of derivatives regulation by CFMA “was a key turning level within the march towards the monetary disaster.”

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As early as 2002, Berkshire Hathaway Inc. (BRK-A) CEO Warren Buffett criticized derivatives as “time bombs, each for the events that deal in them and the financial system.”

Buffett’s warning rang true in 2008, when the massive and non-transparent derivatives exposures tied to mortgage securities culminated in a monetary crash, the collapse of Lehman Brothers, and a authorities bailout of American Worldwide Group, Inc. (AIG) and its Wall Road counterparties.

In response to the Federal Reserve Financial institution of New York, the disaster “uncovered vital weaknesses within the over-the-counter (OTC) derivatives market, together with the build-up of enormous counterparty exposures between market individuals which weren’t appropriately risk-managed [and] restricted transparency regarding ranges of exercise available in the market and general measurement of counterparty credit score exposures.”

Unregulated derivatives not solely helped to hide such exposures by the use of credit score default swaps, but additionally helped to amplify them via collateralized debt obligations, the Monetary Disaster Inquiry Fee discovered.

The 2009 Dodd-Frank Act, supposed to curb such excesses, licensed CFTC to manage swaps sellers, and to maneuver the buying and selling of standardized derivatives to regulated exchanges or swap execution amenities to enhance transparency. Critics argued the modifications have been largely beauty.