What Is the Commodity Futures Modernization Act (CFMA)?
The Commodity Futures Modernization Act (CFMA), signed into law on Dec. 21, 2000, overhauled U.S. financial regulations in response to rapid growth in over-the-counter (OTC) derivatives. CFMA clarified the roles of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) in regulating an expanded range of futures contracts. It also authorized clearing facilities for OTC derivatives, and legalized single stock futures.
- The Commodity Futures Modernization Act (CFMA), adopted in 2000, addressed rapid growth in financial derivatives such as swaps directly negotiated by financial institutions.
- The law formally exempted over-the-counter derivatives trades between financial firms from routine regulation.
- Mounting derivative exposures helped to precipitate the 2007-2008 global financial crisis
- The Dodd-Frank Act authorized CFTC to regulate swaps dealers, though critics contended it did not go far enough.
Understanding Commodity Futures Modernization Act (CFMA)
Before CFMA, U.S. financial regulation vested oversight of securities trading with the SEC and of commodity futures with the CFTC. The rules did not address derivatives not tied to physical commodities, and rapid adoption of these instruments had placed a growing proportion of the financial arena beyond the regulatory reach of either agency.
CFMA largely followed the recommendations made in 1999 by the President's Working Group on Financial Markets, a roundtable of regulators that included SEC, CFTC, the Federal Reserve, and the U.S. Treasury. The SEC and CFTC had set aside past jurisdictional disputes, agreeing to exempt non-commodity OTC derivatives traded by financial institutions from regulation by CFTC, and to share oversight of single-stock futures.
The Commodity Futures Modernization Act exempted from CFTC oversight most OTC derivatives, including financial swaps between institutions and any "hybrid instrument that is predominantly a banking product."
To qualify as an exempt hybrid instrument under that definition, the derivative's issuer had to receive payment in full on delivery, while the buyer or holder could not be required to make subsequent payments to the issuer such as for margin or settlement. The issuer could also not be subject under the derivative contract's terms to mark-to-market margin requirements, and the derivative could not be marketed as commodity futures.
CFMA put an end to fears OTC derivatives could be challenged or invalidated on the grounds they were illegally traded futures. It also barred state-level regulation. The law encouraged the creation of clearing houses for OTC derivatives.
In addition, CFMA authorized the listing and trading of single stock futures, subject to joint oversight by SEC and CFTC. Single stock futures last traded in the U.S. in 2020, when the last exchange to list them closed. While single stock futures continue to trade overseas, they remain less popular than other equity derivatives, such as options.
Criticism of CFMA and Subsequent Changes
Financial regulators weren't the only ones to note rapid growth in OTC derivatives. While this market grew effectively unregulated before passage of CFMA, the law's hands-off approach. In the wake of the 2007-2008 global financial crisis, the Financial Crisis Inquiry Commission authorized by the U.S. Congress concluded that the pre-emption of derivatives regulation by CFMA "was a key turning point in the march toward the financial crisis."
As early as 2002, Berkshire Hathaway Inc. (BRK-A) CEO Warren Buffett criticized derivatives as "time bombs, both for the parties that deal in them and the economic system."
Buffett's warning rang true in 2008, when the huge and non-transparent derivatives exposures tied to mortgage securities culminated in a financial crash, the collapse of Lehman Brothers, and a government bailout of American International Group, Inc. (AIG) and its Wall Street counterparties.
According to the Federal Reserve Bank of New York, the crisis "exposed significant weaknesses in the over-the-counter (OTC) derivatives market, including the build-up of large counterparty exposures between market participants which were not appropriately risk-managed [and] limited transparency concerning levels of activity in the market and overall size of counterparty credit exposures."
Unregulated derivatives not only helped to conceal such exposures by means of credit default swaps, but also helped to magnify them through collateralized debt obligations, the Financial Crisis Inquiry Commission found.
The 2009 Dodd-Frank Act, intended to curb such excesses, authorized CFTC to regulate swaps dealers, and to move the trading of standardized derivatives to regulated exchanges or swap execution facilities to improve transparency. Critics argued the changes were largely cosmetic.