SPEAKERS CONTENTS INSERTS
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REVIEW THE COMMODITY FUTURES TRADING COMMISSIONS' AUTHORITY TO PROVIDE U.S. FUTURES EXCHANGES WITH REGULATORY RELIEF
SUBCOMMITTEE ON RISK MANAGEMENT,
RESEARCH, AND SPECIALTY CROPS
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
AUGUST 5, 1999
Serial No. 10632
Page 2 PREV PAGE TOP OF DOCPrinted for the use of the Committee on Agriculture
COMMITTEE ON AGRICULTURE
LARRY COMBEST, Texas, Chairman
BILL BARRETT, Nebraska,
JOHN A. BOEHNER, Ohio
THOMAS W. EWING, Illinois
BOB GOODLATTE, Virginia
RICHARD W. POMBO, California
CHARLES T. CANADY, Florida
NICK SMITH, Michigan
TERRY EVERETT, Alabama
FRANK D. LUCAS, Oklahoma
HELEN CHENOWETH, Idaho
JOHN N. HOSTETTLER, Indiana
SAXBY CHAMBLISS, Georgia
RAY LaHOOD, Illinois
JERRY MORAN, Kansas
BOB SCHAFFER, Colorado
JOHN R. THUNE, South Dakota
WILLIAM L. JENKINS, Tennessee
JOHN COOKSEY, Louisiana
KEN CALVERT, California
GIL GUTKNECHT, Minnesota
Page 3 PREV PAGE TOP OF DOCBOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
CHARLES W. STENHOLM, Texas,
Ranking Minority Member
GARY A. CONDIT, California
COLLIN C. PETERSON, Minnesota
CALVIN M. DOOLEY, California
EVA M. CLAYTON, North Carolina
DAVID MINGE, Minnesota
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
TIM HOLDEN, Pennsylvania
SANFORD D. BISHOP, Jr., Georgia
BENNIE G. THOMPSON, Mississippi
JOHN ELIAS BALDACCI, Maine
MARION BERRY, Arkansas
VIRGIL H. GOODE, Jr., Virginia
MIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
BOB ETHERIDGE, North Carolina
Page 4 PREV PAGE TOP OF DOCCHRISTOPHER JOHN, Louisiana
LEONARD L. BOSWELL, Iowa
DAVID D. PHELPS, Illinois
KEN LUCAS, Kentucky
MIKE THOMPSON, California
BARON P. HILL, Indiana
WILLIAM E. O'CONNER, JR., Staff Director
LANCE KOTSCHWAR, Chief Counsel
STEPHEN HATERIUS, Minority Staff Director
KEITH WILLIAMS, Communications Director
Subcommittee on Risk Management, Research, and Specialty Crops
THOMAS W. EWING, Illinois, Chairman
BILL BARRETT, Nebraska,
NICK SMITH, Michigan
TERRY EVERETT, Alabama
FRANK D. LUCAS, Oklahoma
SAXBY CHAMBLISS, Georgia
RAY LaHOOD, Illinois
JERRY MORAN, Kansas
Page 5 PREV PAGE TOP OF DOCJOHN R. THUNE, South Dakota
WILLIAM L. JENKINS, Tennessee
GIL GUTKNECHT, Minnesota
BOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
GARY A. CONDIT, California,
Ranking Minority Member
CALVIN M. DOOLEY, California
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
SANFORD D. BISHOP, Jr., Georgia
JOHN ELIAS BALDACCI, Maine
VIRGIL H. GOODE, Jr., Virginia
MIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
BOB ETHERIDGE, North Carolina
CHRISTOPHER JOHN, Louisiana
LEONARD L. BOSWELL, Iowa
KEN LUCAS, Kentucky
MIKE THOMPSON, California
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C O N T E N T S
Ewing, Hon. Thomas W., a Representative in Congress from the State of Illinois, opening statement
Smith, Hon. Nick, a Representative in Congress from the State of Michigan, opening statement
Stabenow, Hon. Debbie, a Representative in Congress from the State of Michigan, prepared statement
Bowen, Christopher, senior vice-president, general counsel, New York Mercantile Exchange
Erickson, Thomas J., Commissioner, Commodity Futures Trading Commission
Holum, Barbara, Commissioner, Commodity Futures Trading Commission
Newsome, James E., Commissioner, Commodity Futures Trading Commission
Salzman, Jerrold, counsel, Chicago Mercantile Exchange
Spears, David D., Acting Chairman, Commodity Futures Trading Commission
Page 7 PREV PAGE TOP OF DOC Young, Mark D., partner, Kirkland & Ellis, on behalf of the Chicago Board of Trade
Answers to submitted questions
Bowe, James J., president and chief executive officer, New York Board of Trade, letter of August 12, 1999
Royal, Carl A., senior vice-president and special counsel, Chicago Mercantile Exchange, letter of June 25, 1999 to Jean A. Webb, Commodity Futures Trading Commission
REVIEW THE COMMODITY FUTURES TRADING COMMISSIONS' AUTHORITY TO PROVIDE U.S. FUTURES EXCHANGES WITH REGULATORY RELIEF
THURSDAY, AUGUST 5, 1999
House of Representatives,
Subcommittee on Risk Management,
Research and Specialty Crops,
Committee on Agriculture,
The subcommittee met, pursuant to call, at 2:03 p.m., in room 1302, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Members present: Representatives Smith, Moran, Jenkins, Gutknecht, Ose, Hayes, Fletcher, Dooley, Pomeroy, Baldacci, Goode, Stabenow, Etheridge, John, Boswell, and Lucas of Kentucky.
Staff present: David Ebersole, senior professional staff; Stacy Carey, subcommittee staff director; Ryan Weston, professional staff, Callista Bisek, assistant clerk; Hunter Moorhead, legislative assistant; and John Riley, minority consultant.
Page 8 PREV PAGE TOP OF DOCOPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. The meeting of the Subcommittee on Risk Management, Research, and Specialty Crops, to review the Commodity Futures Trading Commission's authority to provide U.S. futures exchanges with regulatory relief, will come to order.
I want to welcome all of the witnesses here today as the subcommittee reviews the regulatory exemptive authority the Commodity Futures Trading Commission is afforded under the Commodity Exchange Act.
It is important to note that the subcommittee focus today is not about foreign exchange terminal access to the United States. I believe foreign terminals should have access and fair access.
Today's focus has more to do with an ongoing struggle for the Commission to provide workable, non-symbolic regulatory relief to the U.S. futures exchanges. The subcommittee wants the Commission to act with due diligence to ensure that domestic U.S. futures exchanges are being given equitable time and effort on their deregulatory petition.
We are living in a time of tremendous technological change and fierce business competition. This should be considered a good problem because it is the result of a strong, innovative, and growing economy, except for many in the agricultural sector.
It is not the intent of this subcommittee that Government regulation should empower one business structure or entity to flourish or struggle at the expense of another. It is our job to ensure that fair and equitable laws are passed and proper and thorough regulations are implemented to carry out these laws.
The Commission staff recently released a statement detailing its intention to review the application of foreign exchanges for placement of screen-based terminals in the United States. In that statement, the Commission staff will work to review and make decisions on these applications within 21 days.
Page 9 PREV PAGE TOP OF DOC Three U.S. futures exchanges recently submitted a petition to the Commission requesting regulatory relief under section 4(c) of the Commodity Exchange Act.
The basis of this section of the act is to allow regulatory relief in order to promote responsible economic or financial innovation and fair competition. Any exemption granted must, of course, continue to be consistent with the public interest.
The Commission has recently published two proposed rules. One creates a pilot program that would allow the exchanges to list new contracts without Commission approval.
The other would streamline procedures for reviewing exchange rules and allow future exchanges to change some rules and make some rules amendments automatically, as long as they met certain requirements.
While these proposed rules may address some of the concerns in the exchanges' 4(c) petition, the subcommittee is concerned about whether there has been adequate input from the affected parties to make these proposed rules effective and far-reaching enough, if adopted.
We hope that by receiving input from the commissioners reviewing the petition and by receiving input from the exchanges that filed the regulatory relief petition, the subcommittee will be able to determine how this process has proceeded thus far and what additional actions the Commission will need to take to ensure proper and adequate regulatory relief.
We are not here today to discuss what has been done or what can be done. We are here to discuss what will be done and when it will be done.
Does anyone else wish to give an opening statement?
OPENING STATEMENT OF HON. NICK SMITH, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MICHIGAN
Mr. SMITH. My concern, Mr. Chairman, is that the profitability of some of the exchanges sometimes doesn't give the due regard to production agriculture that I would like to see.
Page 10 PREV PAGE TOP OF DOC As we look at the justification for the reason we started these future markets was we find that that was specifically for farmers, for production agriculture. Now, as we see less flexibility in the size of the contracts, we see greater difficulty on the part of individual farmers, especially small farmers, delivering and taking delivery on these contracts, it makes it more difficult for many small farmers throughout the Midwest, at least throughout my area of Michigan, to utilize these contracts as much as they should.
So as we look at the possibility of fewer and less regulations, I want to try to help assure that the protection for farmers is still there and that these future contracts, as they pertain to agricultural products, have a direct relation to the real market price.
Thank you, Mr. Chairman.
Mr. EWING. Thank you, Mr. Smith.
Any other opening statements may be submitted for the record at this time.
[The prepared statement of Ms. Stabenow follows:]
PREPARED STATEMENT OF HON. DEBBIE STABENOW, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MICHIGAN
Mr Chairman, thank you for bringing the subcommittee together today to consider the important issue of regulatory relief for U.S. futures exchanges. This year, the subcommittee has focused its attention on the reauthorization of the Commodity Exchange Act. The issue of foreign terminals and their regulation has been raised during our consideration of the CEA. The recent Commodity Future Trade Commission announcement regarding its intent to act on the ''no action'' requests from foreign boards of trade to open additional terminals, has set the course for a closer examination of CFTC regulatory practices.
As we all know, the Chicago Board of Trade, Chicago Mercantile Exchange, and the New York Mercantile Exchange filed a joint petition to the CFTC requesting regulatory relief under section 4(c) of the CEA. Section 4(c) authorizes the CFTC to exempt a designated contract market for any provision of the CEA, aside from Shad/Johnson and the exchange trading requirements, so long as the exemption is ''consistent with public interest.'' The petitioners are concerned that the new foreign terminals will operate at a regulatory advantage and that section 4(c) should be invoked to level the playing field.
Page 11 PREV PAGE TOP OF DOC I am pleased to welcome the Commissioners of the CFTC as well as representatives from the Chicago Board, Chicago Mercantile Exchange, and the New York Mercantile exchange as witnesses at today's hearing. I am eager to hear testimony from today's panels. I am particularly interested in information from the petitioners regarding the impact of the new foreign terminals on their own commodity and futures exchanges. Furthermore, I have reviewed the letter sent to the subcommittee from the CFTC and would like more information about efforts to provide regulatory relief.
Mr. EWING. Due to time constraints, as always, we're asking all the witnesses to operate under the 5-minute rule, as well as all of the members of the committee in their questioning of the witnesses.
The Chair asks that witnesses help us meet our time constraints by summarizing their oral testimony as quickly as possible. Your entire written statement will be included in the hearing record.
The Chair would also ask witnesses to remain available throughout the hearing to comment on issues that may arise later in the proceedings. I'm very pleased to welcome all of the sitting members of the CFTC today and I think it would be appropriate to recognize that Thomas J. Erickson, Commissioner, has just taken his seat on the Commission. We welcome you.
You've moved up a whole row. You used to sit behind the chairman and we know that you come to this new position with a great deal of experience and knowledge and we welcome you.
I also want to welcome James E. Newsome, who is a relatively new Commissioner; Barbara Holum, who has been at the Commission for a while, has a great deal of knowledge; and David D. Spears, who is also Acting Chairman of the Commission at this time.
So I assume we will start with you, David.
STATEMENT OF DAVID D. SPEARS, ACTING CHAIRMAN, COMMODITY FUTURES TRADING COMMISSION
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Mr. SPEARS. Thank you, Mr. Chairman and members of the subcommittee. I am pleased to appear before you today to testify regarding the competitive concerns of the U.S. Futures Exchanges.
As you've already stated, Mr. Chairman, I would ask that the written testimony of the Commission, including attached survey of foreign regulatory systems, prepared by the Commission's Office of International Affairs, be entered into the hearing record.
Pursuant to your request, the other Commissioners and I will also present individual testimony. Mr. Chairman, exchange competitive concerns were expressed most recently in a June 25, 1999 joint petition by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange, requesting an exemption from certain statutory and regulatory requirements.
At the outset, let me assure you that the Commission is firmly committed to ensuring the global competitiveness of the U.S. futures industry in general and the U.S. futures exchanges in particular. That is a paramount concern of the Commission.
I have also attached, as appendix A to my individual testimony, a list of some 27 major regulatory reform measures taken by the Commission over the last several years.
With respect to the petition itself, the Commission staff intends to circulate, within a few days, a proposal to publish petition for comment in the Federal Register.
Even before the exchanges' petition was filed, the Commission began to address a central concern raised by the petition; i.e., the ability to list contracts for trading on a more expedited basis. On July 20, 1999, the Commission announced a 2-year pilot program to permit the immediate listing of new contracts for trading for a specified period of time prior to Commission approval.
Last week, the exchanges issued a joint statement commending the Commission for this initial action.
Page 13 PREV PAGE TOP OF DOC Besides responding to the contract approval issue, Commission staff believes a substantial portion of additional kinds of relief requested by the exchanges in their petitions already provided for by the Commodity Exchange Act and existing regulatory scheme.
I've also attached, as appendix B to my individual testimony, a document prepared by the Commission's Trading and Markets Division staff, addressing actions by the Commission under its existing authority, that are responsive to many of the regulatory parity concerns raised in the petition.
In addition to regulatory issues raised by the exchanges' petition, I also believe it is important to address some of the assumptions underlying the request.
First, the petition assumes that foreign exchanges will be permitted unlimited access to the United States by having to be designated as a contract market under the act. In fact, the no action relief presumes that the foreign exchanges are seeking only limited access to the U.S. market and includes volume reporting requirements and other conditions.
To the extent that any foreign exchange substantially changes the nature of its contacts with the United States, the Commission could reexamine the relief granted and even require it become designated as a U.S. contract market.
Second, a careful analysis of the major foreign regulatory regimes suggest that the international playing field may not be as uneven as sometimes thought. Third, the Commission is required by statute to recognize the general public interest in futures markets, as well as the needs of market users, including futures Commission merchants, other Commission registrants, and customers, ranging from pension funds to small country grain elevators and individual investors.
Some have expressed a key desire to have free and open U.S. customer access to foreign boards of trade. Consistent with this trend toward globalization, U.S. futures exchanges currently have over 125 trading terminals operating in seven foreign jurisdictions.
Page 14 PREV PAGE TOP OF DOC Finally, the Commission recognizes the role of Congress in regulatory relief issues. Some of the exchanges' suggestions for regulatory change may well relate to fundamental customer protection and market integrity measures that have formed the cornerstone of the U.S. futures regulation for decades. Those protections should not be weakened or withdrawn absent a determination by Congress to change the Commission's statutory mandate.
Another very significant issue raised by the petition is a proposal that would reduce U.S. regulatory protection to the lowest level of regulation offered by any jurisdiction gaining access to U.S. markets in trading contracts that clone domestically-traded products.
In effect, a U.S. contract market could select the least restrictive elements from various regulatory systems around the world and create a regulatory patchwork that would embody the least restrictive regulatory standards of all of the major foreign financial regulators.
The Commission looks forward to receiving comment on these and all other issues raised in the exchanges' petition and believes that it is important to reserve judgment on these issues until it has heard from the entire regulatory community through the public comment process.
In closing, I want to stress that the Commission stands ready to cooperate with Congress throughout the reauthorization process and to work closely with industry to resolve this and all issues that may arise during that process.
On a personal note, Mr. Chairman, as I enter my third month as Acting Chairman of the Commission, I'd like to take this opportunity to publicly acknowledge the cooperation of my fellow Commissioners and the hard work and dedication of the Commission's professional staff.
Thank you. I'd be happy to answer any questions at the appropriate time.
Page 15 PREV PAGE TOP OF DOC [The prepared statement of Mr. Spears appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Spears. Ms. Holum.
STATEMENT OF BARBARA HOLUM, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
Ms. HOLUM. Thank you, Mr. Chairman and members of the subcommittee. I do thank you for the opportunity to testify concerning the joint petition of the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange.
The views I am expressing are my own.
In 1992, Congress, in its wisdom, granted the Commission authority under section 4(c) of the Commodity Exchange Act to exempt certain markets and products from the requirements of the act. This provided the Commission the necessary flexibility to encourage and allow market innovation and development.
However, a conference report cautioned against using the newly adopted provisions to promote wide-scale deregulation of the markets. As I have stated publicly, I remain committed to the principles of market integrity and customer protection and to preventing systemic risks so that our markets remain safe, sound, and competitive in the evolving global marketplace.
There has been a dramatic change in the futures trading landscape which can be attributed primarily to the proliferation of electric cross-border trading vehicles. The Commission has played an active role in the continuing efforts of the International Organization of Securities Commissions to promote international regulatory harmony and to prevent protectionist policies.
In 1990, the Commission chaired a committee which wrote the original 10 principles for the oversight of screen-based trading systems. In fact, the Commission, for years, has played a key role in efforts to develop international benchmarks for oversight of the global markets and to increase the coordination and cooperation among the various international regulatory bodies.
Page 16 PREV PAGE TOP OF DOC On June 25, 1999, three U.S. exchanges submitted a petition under section 4(c) of the act in response to the Commission's order of June 2, lifting the moratorium on placement of foreign terminals in the United States.
The exchanges seek authority to, one, list new contracts without approval and, two, adopt new rules 10 days after submission to the Commission without approval, and, three, to adopt trading rules comparable to competing foreign exchanges rules immediately upon notice to the Commission without approval.
Perhaps a chronology of events leading up to this point may be useful. In 1989, a U.S. exchange received recognition in the United Kingdom as an overseas investment exchange, which permitted that exchange to offer its products through electronic terminals located in the United Kingdom. In May 1990, another U.S. exchange was permitted to place electronic trading terminals in France. In 1999, the Japanese authorities permitted a U.S. exchange to place terminals in Japan.
Today, U.S. exchanges have over 125 trading terminals in seven foreign jurisdictions. By comparison, not until February 1996 was the first foreign country, Germany, permitted to place electronic trading terminals in the United States.
In 1997, a moratorium was imposed on reviewing other applications for placement of foreign terminals in the United States.
On June 2, the Commission lifted the moratorium, and on June 23, 1999, a U.K. futures exchange was permitted to place terminals in the United States.
Simultaneously, with the lifting of the moratorium, the Commission determined to address the regulatory parity issues facing our U.S. exchanges. To that end, the Commission's Global Market Advisory Committee, which I chair, appointed an ad hoc committee on regulatory parity to form specific recommendations.
The ad hoc committee adopted three resolutions to address regulatory parity and presented a report to the full GMAC in July 1999. It is significant to note that the Global Markets Advisory Committee is comprised of 30 members representing U.S. exchanges, financial intermediaries, market-makers, the National Futures Association, and the Futures Industry Association, the Managed Funds Association, and attorneys representing foreign and domestic market users, among others.
Page 17 PREV PAGE TOP OF DOC The primary mission of this committee is to obtain input on international market issues that affect the integrity and competitiveness of U.S. markets. The committee's report and resolutions, along with comments received at the full meeting, will be presented to the Commission for its consideration.
This series of events, roughly covering a 10-year period, now brings us to the exchanges' section 4(c) exemption petition, which is substantively similar, though not identical to the ad hoc committee resolutions.
The issues raised by the exchanges' petition present important and fundamental policy questions which we are considering carefully.
The United States boasts the safest and soundest futures markets in the world. I believe and many agree that this can be attributed to a regulatory regime that is grounded in the principles of market integrity, financial integrity and customer protection.
In the course of discussion at the various committee meetings, brokers, traders and end users alike have indicated that they would oppose radical deregulation of the exchange-based markets. At the same time, our markets have evolved and, in fact, may not need many of the regulatory safeguards designed for a different market, serving a different customer base.
As a commissioner and as chairman of the Global Markets Advisory Committee, I am committed to do whatever is required to ensure that our exchanges remain competitive. Our exchanges have been and should remain at the forefront of this industry. We cannot stop the technological advances that are rapidly redefining the way the industry does business.
As we enter the next millennium, we must not attempt to micro-manage our markets. Such an approach could stifle innovation, impede productivity, create regulatory gridlock and harm U.S. competitiveness.
Page 18 PREV PAGE TOP OF DOC With reauthorization of the Commodity Exchange Act now underway, it is an optimal time for all of us to consider whether broad revision of regulatory mandates would constitute an appropriate response to the changing competitive landscape of the global marketplace.
I thank you, and would be pleased to answer any questions which you might have.
[The prepared statement of Ms. Holum appears at the conclusion of the hearing.]
Mr. EWING. Thank you. Mr. Newsome.
STATEMENT OF JAMES E. NEWSOME, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
Mr. NEWSOME. Thank you, Mr. Chairman and members of the subcommittee. I'm pleased to testify before you today and I thank you for the opportunity to discuss important issues related to regulatory relief of the U.S. futures exchanges.
As I stated in testimony before your subcommittee in May, this continues to be an area of major significance and concern to me. As I have stated repeatedly as I came to the Commission a year ago, I come from a business background and believe strongly in fair competition.
These are the foundations which form the bases of my decisions as a regulator. Accordingly, in looking back over speeches and testimony I have delivered in the past year, I find consistent reiteration of my beliefs that our exchanges need significant regulatory relief.
Well before any discussions of foreign exchanges and no action requests, I was making rounds to agricultural groups, to industry participants, and to our domestic exchanges, listening to their concerns and finding out what areas of regulatory relief could be addressed immediately and then what areas the Commission needed guidance from our oversight committees.
Page 19 PREV PAGE TOP OF DOC In my testimony in May, I stated that I had convened a meeting of representatives from the three largest domestic exchanges to discuss the issue of regulatory relief. They provided to me a list of items to address some of their concerns and I have shared that list with this committee.
In the intervening months, I have made consistent strong efforts to try and get certain items on that list accomplished; specifically, relief from pre-approval of contract market designation rules, a payment order flow advisory, a market-maker program advisory, and a final resolution on dual trading orders.
I chose those items from the exchanges' list as ones that could and should be addressed immediately, without changes in existing authority and without further direction from Congress. However, as you know, regulatory relief issues have become enmeshed in matters relating to no action relief for foreign exchanges.
During the past months, I have consistently stressed my belief that the Commission should address the domestic exchanges' concerns regarding these four issues prior to acting on foreign exchanges' requests; not for any protectionist reasons, but simply for the reason that we have the authority, ability and information necessary to act promptly and accordingly should do so.
I welcome the opportunity we now have to address the joint 4(c) exemption petition from the three largest domestic exchanges. I believe this should be a matter for comment on the public record, which, combined with responsive comments to the Commission's recent release on proposed designation pre-approval procedures, will greatly enhance our ability to make correct determinations regarding appropriate regulatory costs and benefits in this and other areas.
As to other items on the exchanges' list, for example, large trader reporting, price reporting, account identification and segregation of customer funds, it was my determination that these issues address core provisions of the Commodity Exchange Act and that input from many sectors, and especially from our oversight committees, is not only appropriate, but necessary, prior to Commission action.
Page 20 PREV PAGE TOP OF DOC I continue to believe this is the correct approach given the fundamental nature of these issues and their relationship to customer protection and fraud and manipulation functions of the Commission.
I look forward to receiving input on these matters.
Our domestic exchanges deserve the benefit of true competition and a level playing field, as do the industry participants who use these markets. While this does not mean I believe in protectionism, it does mean that I wholeheartedly support efforts to revamp the act and our regulation to give the Commission, as an oversight agency, the flexibility to allow for development or improvement of technological advancements and to enable domestic exchanges to compete without unnecessary hindrances, as regulation under which they operate should have clear benefits which outweigh the cost of that regulation.
If I may, let me reiterate a final point I have made repeatedly in the past year. If the cost of doing business is too high, businesses will go where costs are lower; outside of the sphere of the United States policymaking authority.
We cannot afford to lose the exchanges. We cannot afford to lose other industry participants and we cannot afford to lose the ability to make policy determinations that affect the global economy due to being overly regulatory.
With that in mind, I commend your efforts, Mr. Chairman, to bring more rationality to the regulatory structure affecting domestic exchanges, and I will continue to work with you, with industry, and with other regulators to achieve that goal.
[The prepared statement of Mr. Newsome appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Newsome. Mr. Erickson.
STATEMENT OF THOMAS J. ERICKSON, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
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Mr. ERICKSON. Thank you, Mr. Chairman and thank you for the warm welcome to the committee. I appreciate being here today.
In case anyone is wondering, the chairs are not more comfortable in this row as opposed to the row directly behind me.
Mr. Ewing, Mr. Condit and members of the subcommittee, I am pleased to appear before you to discuss the Commodity Futures Trading Commission's ability to address competitive concerns of the domestic futures exchanges.
My remarks this afternoon amplify a few of the points in the Commission's testimony summarized by Acting Chairman Spears. Before doing so, however, I would first like to spend just a few moments discussing the legal requirements of the Commodity Exchange Act.
The Futures Trading Practices Act of 1992 authorizes the Commission to exempt any agreement, contract or transaction, or class thereof from the exchange trading requirement of section 4(a) or any other requirements of the Commodity Exchange Act, except section 2(a)(1)(b).
The Commission may exercise this broad exemptive authority by rule of regulation or order. In enacting section 4(c), Congress directed the Commission to make certain determinations in granting exemptions. For example, the act requires that an exemption be consistent with the public interest, which the conference report deems to include the prevention of fraud, the preservation of the financial integrity of markets, as well as the promotion of responsible economic or financial innovation and fair competition.
Moreover, the Commission must determine that any exemption will not have a material adverse effect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory duties under the act.
Again, according to the conference report, Congress intended that the Commission look at the potential impact of the new product on such regulatory concerns as market surveillance, financial integrity of participants, protection of customers, and trade practice enforcement.
Page 22 PREV PAGE TOP OF DOC Congress directed the Commission to use this authority sparingly and stated it did not intend to prompt a wide-scale deregulation of markets falling within the ambit of the act.
The fact that the Commission must make these determinations is not an impediment to the Commission's ability to consider petitions for exemption. The act is enormously flexible. In fact, I'm certain there are aspects of the Commission's existing regulatory framework which, after careful analysis and consideration of changes in the market, may prove to be unnecessary.
In order to conduct such a review, I believe the Commission must have the benefit of public comment on any petition received under section 4(c).
This process is essential for the Commission to make the determinations necessary to exempt markets or transactions from provisions of the act. As discussed more fully in the Commission's statement, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange, submitted to the Commission a petition requesting broad relief from Commission regulation.
Parenthetically, I might note that I received the petition having had only 4 days to warm my chair at the Commission, but as a result, most of the decisions with respect to foreign terminals and the regulatory relief were already in place.
I was pleased, however, that I arrived in time to participate in the Commission's action to propose a 2-year pilot program allowing pre-designation of new contracts. Just last week, I met with Exchange officials in Chicago. My message was to them then and is today that there must be a direct dialog between exchanges and the Commission on issues facing exchange markets.
Absent that dialog, I fear the Commission could end up doing its level best in addressing yesterday's problems. It's not much help to an industry that it continues to innovate.
Page 23 PREV PAGE TOP OF DOC In my view, there is no question that the Commission can and should consider the issues presented in the exchanges' petition. To do so thoroughly, I believe the Commission must have the benefit of public comment and must encourage continued dialog.
Therefore, I fully support publication of specific and general requests included in the petition submitted by the exchanges.
The subcommittee has also asked for comment on the introduction of foreign terminals into the United States. As I told members of the Senate Agriculture Committee at my nomination hearing on May 5, the Commission, the regulated industry and the public interests are better served, I think, by rules that are clear and not unnecessarily burdensome and apply equally to all petitioners and that provide legal certainty to transactions.
The more we use the no action process to resolve questions concerning new trading systems and instruments, the more we contribute to legal uncertainty. The no action process has its place, but in significant areas, such as foreign terminals, reasonable workable rules would prove to be a far better, long-term solution.
I am hopeful that the no action process will be an interim step to providing the legal certainty through the Commission's promulgation of rules.
I thank you for the opportunity to testify today on this very important issue, and I look forward to responding to your questions.
[The prepared statement of Mr. Erickson appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
Ms. Holum, you said in your testimony, I missed exactly who you were referring to when you said opposed deregulation of the exchanges.
Ms. HOLUM. There are many participants in the market who appreciate the customer protection provisions of the act and I don't think anyone is interested in totally deregulating these markets, because in many instances, I think that's why these markets have been so successful.
Page 24 PREV PAGE TOP OF DOC That's not to say that I am opposed to taking a very close look at the regulations and making drastic changes.
Mr. EWING. So you didn't name a group. You just said there are those.
Ms. HOLUM. No, I didn't. There are those.
Mr. EWING. I missed that, and that's what I was trying to get at.
Mr. Erickson, you indicate that you believe the current act is pretty flexible.
Mr. ERICKSON. Yes, sir.
Mr. EWING. Do you think it's been administered in a way that reflects that flexibility?
Mr. ERICKSON. Having not been at the Commission to participate in the previous deliberations, it wouldn't be fair for me to necessarily give a view on those actions.
But I do think, looking forward, as we address these issues, what's required is that we do need a direct dialog on issues. My concern is in this regard that we can end up doing our level best, as I said, to address problems that might have addressed problems 5 years that the markets had.
So looking forward, I think we do have the flexibility. I'm not sure that that's necessarily been the relationship in the past.
Mr. EWING. Well, I guess maybe the question would be fairer to you to say that charges have been made in the past of the inflexibility of the act and, in fact, I think many casual observers feel it is a very rigid, inflexible act. I think that has to do with the way it's been administered.
Page 25 PREV PAGE TOP OF DOC Mr. ERICKSON. That may, in fact, be the case, because I do think that in 1992, Congress gave the Commission enormous flexibility to address issues that will be coming ahead. I think that the Commission has the ability to look at the market as a whole and make determinations about what the regulatory interest is.
I think that we can address and take up issues, for example, with respect to the new technology that we're seeing in markets and move to electronic trading.
Mr. EWING. Do you believe that under this act, we could move to a oversight responsibility as compared to pre-approval of everything the exchanges do?
Mr. ERICKSON. I think in some cases, I think the Commission's action with respect to pre-designation on contracts is an important step, because that will, in fact, give us the ability to have a 2-year pilot program, where we can actually see the utility of having that tool available for exchanges.
With respect to rules, I think I am interested very much in seeing the public comment. I do know that there is a multiplicity of economic interests in the markets and rule changes sometimes can have economic effects on the participants in the market.
So I would be interested in the public comment on that.
Mr. EWING. Did you say that you thought that we should have the pre-approval process for contracts, except in the case of pilot programs?
Mr. ERICKSON. No. Under the pilot program, the choice is the exchanges'. The exchanges can select either the pre-designation under the pilot program or one of the other two processes that are currently available under fast track or the normal procedure.
And I think that pre-designation is an important step and I hope that it will be used and I hope that it will help the Commission in making determinations on the question that you're raising today.
Mr. EWING. Would you explain what you mean by pre-designation?
Page 26 PREV PAGE TOP OF DOC Mr. ERICKSON. That is shorthand for what the Commission's action was on July 21 or 20, I can't remember, allowing the exchanges to list contracts the day after they notify the Commission, which I think gives the exchanges some additional flexibility in being able to respond to competitive forces that they see.
Mr. EWING. Was that with a pilot program?
Mr. ERICKSON. It is. It's a proposal. It's out, I think, now for 30-day comment period and it would be a 2-year pilot program and I'm looking forward to the comments.
I appreciated very much the exchanges' initial welcoming of the pilot program and like I've said before, I think that we may not get everything right the first time, but hopefully we can continue to proceed.
Mr. EWING. I really don't want the audience to think I'm picking on the newest Commissioner.
Mr. ERICKSON. It's OK.
Mr. EWING. But another question that came up from your testimony. When you talk about dialog between the Commission, you, as Commissioners, and the exchanges, do you really think there has been that kind of meaningful, frank, useful dialog or do you think there could a better way to phrase that.
Can we improve on that dialog a great deal so that the exchanges have a better idea of where they stand with the Commission on issues that are important to them?
Mr. ERICKSON. I hope to be able to contribute to that. I think it's very important for me, as a commissioner, to have information that's contemporaneous with what the market is going through today.
And I can't speak for the previous conversations or the other conversations that commissioners have had with exchanges or other market participants, but that is, in fact, something I believe very strongly and hope that that, if it hasn't been the case, that it can be the case.
Page 27 PREV PAGE TOP OF DOC Mr. EWING. Mr. Dooley.
Mr. DOOLEY. No questions.
Mr. EWING. Mr. Lucas.
Mr. LUCAS. No questions.
Mr. EWING. Mr. Fletcher.
Mr. FLETCHER. Thank you, Mr. Chairman.
Looking over this, and you're going to have to bear with me and the fact that much of this information is new, there's obviously three requests that have been made by the exchanges in their petition.
Really, just if you could make it very clear to me, and maybe, Mr. Spears, we'll start with you. Does the Commission feel that it has the authority to grant these petitions? If not, what do they need, and, if not, why aren't we moving on it?
Mr. SPEARS. I'll try to answer that with a little bit of background, as well. Yes, I would say we do have legal authority to act on the petition. In order to grant a 4(c) petition of this magnitude, we have to make certain determinations as to findings of the act. In order to make those determinations, we need to receive public comment.
It's our intention to publish the petition in the next few days in order to get that public record and comment.
As to the three basic requests that you identified, we at the Commission have made a sincere effort to address the first one, which was the contract approval, with our 2-year pilot program that Chairman Ewing discussed with Commissioner Erickson. As to the rule approval, rule changes, that's an issue that, as Commissioner Holum alluded to, there is considerable discussion within the industry regarding the impact on rule changes, because somewhat different than a contract approval; where in contract approval, you have a new contract, there is no open interest and outstanding interest in that contract.
Page 28 PREV PAGE TOP OF DOC It's a brand new contract, starting up brand new. With a rule change on existing contract, you may have existing open interest, public interest concerns that would be raised about changing rules in the middle of a contract.
With regard to the third request, which is basically identified in my testimony, an issue where an exchange canwould like to have the ability toif there is a direct competition on a foreign contract, would like to adopt that type of regulatory scheme for that particular contract.
One issue there would be if you carried that to its fullest extent, you would end up having a patchwork of various regulatory schemes for various contracts within a single exchange.
So we have to be very careful that we don't find ourselves going to the lowest denominator as to the lowest regulatory scheme, that has been a cornerstone to the customer protection and market integrity issues of the U.S. exchanges.
I hope I answered your question. It was kind of a long-winded answer, and I apologize for that.
Mr. FLETCHER. I think you did. I've still, obviously, got a lot to learn on this subject. But let me ask you. In the testimony, it was stated that in the U.K., and I assume that doesn't stand for University of Kentucky, it allows listing of contracts without prior approval. And if this works there, are there problems that you think that we have such a difference that it wouldn't work here?
Mr. SPEARS. The United Kingdom is somewhat different in that they do not have a formal contract approval. They have a very active informal process. It's my understanding that an exchange in the United Kingdom will not list a contract unless they have already seen informal approval from the regulator. It's a lot smaller. There are less exchanges in the United Kingdom. It's a lot more informal process.
Page 29 PREV PAGE TOP OF DOC I believe it's correct that the foreign regulator meets with each of the exchanges at least monthly, an open dialog, have a discussion regarding what contracts they plan to list and there is informal approval given. And the U.K. regulators assured us that there would be no contract listed on an exchange in their country unless they approved it first, although it may be informal approval.
Mr. FLETCHER. Just in closing, I certainly believe that we ought to have the flexibility. The way markets are changing these days throughout the global economy, obviously, I think it's very important to have the rapidity and the flexibility to act and make sure that we do stay very competitive and that our exchanges still lead the world economy.
So, Mr. Chairman, I yield back the remainder of my time.
Mr. EWING. Thank you, Mr. Fletcher.
I want take a moment to tell all of you that, as you probably know, we are losing our staff director, Stacy Carey. And this will be her last hearing. So she is coming down easily by darting in and out of the room and letting Ryan take over.
But, Stacy, we want to thank you for all your good work.
Mr. EWING. And maybe you'll do like Mr. Erickson and come back as a member.
Mr. SMITH. She's not going to work for CFTC, Mr. Chairman.
Mr. EWING. No, I don't think so. But they would have been smart to hire her.
Mr. SPEARS. She's very welcome.
Mr. EWING. She would do well wherever she goes. Mr. Smith.
Mr. SMITH. Of course, our familiarity is with agriculture. Your oversight is much greater. What is the percentage of agriculture versus non-agriculture, as far as your oversight of trade?
Page 30 PREV PAGE TOP OF DOC Mr. SPEARS. Currently, the volume on the U.S. exchanges is roughly around 15 percent agriculture and 85 percent non-agriculture.
Mr. SMITH. Does the Blackbird system of trading meet the MTEF requirements, the multi-lateral transaction execution facility? Does it meet that and how and when do you decide whether it's appropriate to have oversight?
Maybe you should explain the Blackbird system of exchanges.
Mr. SPEARS. The Blackbird system is a systemyou said MTEF, multiple transaction execution facility. Currently, let me tell you the action the Commission staff took recently.
Commission staff, just last week, made a comprehensive request for more information regarding the Blackbird system. At this point in time, we are awaiting receipt of that information from the people who do have a Blackbird system and we would then, at that point in time, make an appropriate determination if it is that type of multiple transaction facility, as you've alluded to.
Mr. SMITH. So when the Blackbird system lists new products, what do you do as a Commission? Right now, do you consider you have oversight? Does it depend on what the product is, the new product that they're listing?
Mr. SPEARS. It would depend, in part, on the product they're listing, but we have not yet made a determination as a Commission where we have oversight of the system. There are still too many questions to be answered. We're still seeking information regarding the system in order to make that determination.
Mr. SMITH. Has the Commission taken a stand or made recommendations in terms of the legislation that we're considering for making changes in the regulatory oversight of the Commission? Do we know where every member stands? I sort of got an inkling from your testimony, but has the Commission ever taken a position on the proposed legislation?
Page 31 PREV PAGE TOP OF DOC Mr. SPEARS. Let me try to go back. Staff just informed me that, and I agree, that I may not have answered your question properly.
If it is an MTEF, then we do have actual jurisdiction over that Blackbird facility, but we're waiting to make a determination whether or not is an MTEF or not. So hopefully that answers more directly your question regarding Blackbird.
Mr. SMITH. Well, yes. If it is MTEF, you absolutely do. But if it isn't, you're sort of wavering, it seems like, a little bit.
Is that right? You make a decision based on what the product is?
Mr. SPEARS. Yes. What the product is and what the appropriate level of regulation would be based on that.
Mr. SMITH. Has the Commission taken a stand on the proposed legislation before us?
Mr. SPEARS. Which proposed legislation?
Mr. SMITH. Well, I was thinking of the proposed legislation that the chairman of this subcommittee hashas that been made public yet?
Mr. EWING. No.
Mr. SMITH. So you couldn't do that. I'll jump from the chairman's proposal to the exchanges' proposal.
Have you reviewed the exchanges' proposal and have you taken a position on the exchanges' proposal?
Mr. SPEARS. On the 4(c) petition, we've reviewed it, analyzed it, and, as I said, we'll be publishing for public comment, hopefully in the next few days, their petition, to get a full record of the public comment in order to make a determination as to how we act on that petition.
Mr. SMITH. And does the Commission, in analyzing where we should be going in this country, have you reviewed what your counterparts in other countries are doing in terms of regulatory oversight and how do youcan you give us a brief description of the comparison?
Page 32 PREV PAGE TOP OF DOC My impression is they have somewhat less oversight, but on the other hand, they have copied a lot of the things that you have suggested in this country, they have emulated in their country.
Mr. SPEARS. My document may be very helpful to you. Attached as part of the Commission's written testimony was a survey completed by our Office of International Affairs of a number of foreign regulatory jurisdictions, and it goes through in detail and lists out a comparison of what they do on contract approval, pre-approval, rule approval and those kind of things, and there is an executive summary to that document, at the front of that extensive document.
To try and answer your question, there is a variety of different types of regulatory schemes across the world. As I mentioned before, in the answer to one question, the United Kingdom has a very informal process. Another example might be Eurex, the German regulatory authority. I believe it's correct that actually a regulatory official sits on the board of the Eurex exchange and is there in the day-to-day decisions of the Eurex exchange.
So there is a general theme of regulation across the world which is becoming, as you alluded to, they look to our country as a model for that. But it varies and differs greatly by country.
Mr. SMITH. Would any of the other Commissioners have any comment either on the Blackbird or the comparison of our system versus other countries or otherwise?
I have no further questions, Mr. Chairman.
Mr. EWING. Mr. Gutknecht. I'm going to come back to you, Mr. Baldacci. I thought I had hit everybody on this side. Mr. Gutknecht has to go, and with your permission, we'll skip to him and then come right back.
Mr. GUTKNECHT. Thank you, Mr. Chairman. I will be brief. First of all, I want to say a big thank you to Mr. Doug Leslie and Fred Lindsey of your staff who helped do a little research for me about what's happening with the basis.
Page 33 PREV PAGE TOP OF DOC There has been a tremendous variance, at least in the upper Midwest, between the cash price quoted in Chicago and what actually is happening at the local elevators. I'm not completely satisfied, but I think they did a very professional job in getting me some good information about that.
Second, I want to say that you have a very difficult job and now the more we learn about that, trying to balance all the needs of the various people who use the exchanges and the companies who are involved, as well as the needs of agriculture, when you put that all together in a business that's changing at the speed of light and things that happen on other parts of the planet, and trying to regulate all that and make sense of it, it is a very difficult job.
But I want to come back to something that Mr. Smith talked about in his brief opening statement. That is, originally, the whole purpose here was to serve the farmer in agriculture. Do you have any marketing research in terms of the percentage of the transactions? How many of them actually involve real farmers who grow this stuff?
Mr. SPEARS. I don't know of any numbers that come to my head directly. Let me ask our staff if they have any feel for numbers.
Mr. GUTKNECHT. Well, I guess more of a comment than a question. I think it is important that we become as friendly as possible. One of the purposes, I think, of this subcommittee is trying to figure out how we can get our farmers, our producers to better utilize futures markets, to take some of those big bumps out of the road.
That is at least what I think part of our charge is. I think we should work together with you to make the various commodity exchanges more user-friendly. For example, now, this is a dumb question, but for example, if I were a pork producer in southeastern Minnesota and I took out a contract to sell hogs for January delivery, where would I deliver them?
Mr. SPEARS. There are specified delivery points on the contract, and I don't know specifically, off the top of my head, what those delivery points are for the hog contract.
Page 34 PREV PAGE TOP OF DOC Mr. GUTKNECHT. We and you and the exchanges need to work with the folks out in production agriculture to make it easier for them to use it. I think that there is aanytime people don't understand something completely, there is a sense of mistrust, and I think we have to work together. Really, it's more of a comment than a question, but I want to work with you and hopefully you'll work with us so we do a better job explaining to our producers how they can use futures.
I was one who really pushed the whole idea of a dairy options pilot program.
Mr. SMITH. If the gentleman would yield.
Mr. GUTKNECHT. Yes.
Mr. SMITH. Does the gentleman consider ADM a producer?
Mr. GUTKNECHT. Well, in some respects, I guess they are. But the only point I wanted to make is I think you're doing a great job. It's a tough job. But I hope you never forget, at the end of the day, the reason you're here and, in some respects, the reason these exchanges were started was to make it easier for farmers to use them. In some respects, I think we fall short of that.
So thank you very much, Mr. Chairman.
Mr. EWING. Mr. Gutknecht, my staff tells me there is a dairies option program.
Mr. GUTKNECHT. There is, I know, but it's very difficult to get our dairy producers to use them.
Mr. EWING. I see.
Mr. GUTKNECHT. It's like pulling teeth to get them to, because it's just complicated enough that they're afraid of it.
Mr. EWING. Mr. Pomeroy. I'm sorry. I went through all the Members here and you had stepped out. So we're glad to have you.
Page 35 PREV PAGE TOP OF DOC Mr. POMEROY. I figured it was choice by merit and you were getting to me in due time.
I used to run an agency that was charged with regulating a financial services component and I know that it's easier to watch and second-guess than it actually is to do the financial regulating. So I say that as an outset. What you do is hard, even harder to explain it.
Part of our oversight role is the classic Monday morning quarterbacking and we get to do it for a living. We can be absolutely unabashed about it. The could have, should have, would have business, that's our stock in trade.
So with that as a predicate, let me just observe that in light of the fact that U.S. exchanges have had foreign electronic desks or presence for about 10 years, is that correct?
Mr. SPEARS. Right.
Mr. POMEROY. And that Eurex, the German exchange, had an electronic presence on our shores for about 3 years, is that correct?
Mr. SPEARS. Correct.
Mr. POMEROY. It would seem to me that the Commission might have engaged in this kind of inventory for the following purposes, and I do think this is an excellent inventory.
Even in conjunction with looking at foreign exchanges, also done an introspective analysis of your requirements and identified, of all the things required, what is the heart of it, what really is essential, what's not essential.
And in comparison with the major requirements of other countries, harmonized, taken parts of ours that were not deemed to be essential and provided regulatory relief in those areas. On the other hand, prepared for the review of the application of foreign domiciliaries by whether or not they had the requisites that we still maintain here.
Page 36 PREV PAGE TOP OF DOC I have not said that artfully, so I'll try to say it again. You identified, both for us and for other countries, what you think are the most important parts, the essential parts. You discard the non-essential parts and then you evaluate the application of a foreign exchange by whether or not its regulatory entity has its essential parts, just as we require the essential parts.
It seems like we're playing catch-up. We're further along on the approval of foreign exchanges than we are this analysis at harmonization and discarding the non-essential parts of our code, and that raises the specter that we're going to have domestic exchanges more rigorously regulated than foreign exchanges doing business on our shores and in non-essential areas.
So I'm glad about the review underway, but I think it's belated. And if we're trying at this date to restructure things in kind of a rational framework in terms of how this ought to unfold, I very much agree with Mr. Newsome that we ought to, first of all, tidy up what we do and keep which we need to keep and discard the rest and then evaluate foreign exchanges by whether or not it's compatible with our scheme.
I'd like, across the panel, you to react to that, starting with Mr. Spears.
Mr. SPEARS. I would agree, as well.
Mr. POMEROY. What kind of timeframe can this happen?
Mr. SPEARS. Hopefully, we can, as we publish public record over the course of the next 30 to 60 days, with the publishing of the petition, we can start to get that kind of input to make those kind of determinations. But there are things already currently within the 4(c) petition to answer Mr. Ewing's question directly, that as I laid out in my testimony, that our staff feels that the exchanges currently can do now and that would be such things as payment order flow, delay pricing, block trading, expedited audit identifiers.
Page 37 PREV PAGE TOP OF DOC Mr. POMEROY. But you don't even need new regulations to do that. You think that's implicitly allowed.
Mr. SPEARS. That's something the exchanges could give us as far as rules now.
Mr. POMEROY. Publication and publicizing a clarification letter or something would take care of it.
Mr. SPEARS. Yes, sir.
Mr. POMEROY. Excellent. Ms. Holum.
Ms. HOLUM. Thank you, Mr. Pomeroy. I would agree with Chairman Spears that we have started the process. I would agree with you that we are late and technology is changing the way all of us do business so rapidly and I think the Commission is just coming out of the period of feeling that we had to have a rule and a regulation to cover every possibility in the marketplace.
It seems to me that we can't do that. We'll get into regulatory gridlock, and we need to be flexible enough to provide necessary oversight to follow the changes in the marketplace and encourage innovation.
I think that's where this Commission is heading for now.
Mr. POMEROY. I strongly agree with you. Regulation is reactionary and it's appropriately so. It can't be anticipatory. Nobody is smart enough to regulate by figuring everything out and dealing with it in advance. You've got to see what happens and then respond quickly.
So that, I think, is an appropriate way to proceed. Mr. Newsome.
Mr. NEWSOME. As I addressed this in my testimony, I won't go back into that. I guess just another comment to add to it. I think as we look at the scheme and those individuals and systems in the marketplace, we just need to make sure that the market determines those that succeed and fail instead of undue regulatory burdens from the Commission.
Page 38 PREV PAGE TOP OF DOC Mr. POMEROY. When I regulated insurance companies, it was very difficult, but if they were in solvency trouble, they were mine. If they were simply being poorly managed, but weren't in solvency trouble, they weren't mine.
No one elected me to be the manager of the insurance industry. I was the regulator of the insurance industry, and so it is with those contract approvals.
Mr. ERICKSON. Thank you. I would ally myself with the comments of my colleagues here. I would also just like to add a couple of points.
One is, as we're reviewing the foreign terminals under the no action process, one of the points that we're looking at is to see if those electronic trading systems meet the standards of the IOSCO principles on screen-based trading, which are internationally subscribed to basics for electronics systems.
Those, I think, would generally apply for our own domestic markets, as well. I think we have a ways to go in providing the necessary relief for these new technologies with our own domestic markets. There is a little bit of a difference as far as many of our domestic markets continue to be open outcry, not the electronics systems that we're seeing come in under the no action process for foreign terminals right now.
So there is a little difference in the market structure, I think, but otherwise, we do need to continue to make progress in identifying those areas for electronics systems where we need to.
Mr. POMEROY. Just one follow-up question. I see my time has elapsed. Do you see it as a regulatory purpose to preserve open outcry or will the market ultimately determine that?
Mr. ERICKSON. I think the market will determine that, no matter what. I don't see my job as trying to pick winners or losers, and I think we need to make the accommodations necessary for the market to continue to innovate. That's why we need the information in order to make reasonable decisions.
Page 39 PREV PAGE TOP OF DOC Mr. POMEROY. I agree with your point on non-action letters. I mean, I think we owe it to let people know what the ruling is and why rather than non-action. I thought your testimony made a good point in that regard.
I yield back, Mr. Chairman.
Mr. EWING. Mr. Baldacci.
Mr. BALDACCI. Mr. Chairman, thank you for holding these hearings and also for the panel for being here.
I guess just to continue to make the point about the questions that have been raised about the unfairness of placing these terminals, foreign trading establishments here and not with the same requirements that we are requiring of our exchanges and creating a competitive disadvantage.
I appreciate your testimony in terms of that maybe there are more similarities between the regulatory processes that you put the exchanges through and what foreign countries do with their trading establishments. But I was not convinced by the example cited in the testimony in Germany and in England that were presented.
I think that, frankly, the old axiom of whatever is being done to us overseas, we should be doing to those that want to be able to practice on our shores. It would be something that could be adhered to.
And I appreciate the chairperson's attention to trying to bring things more into the 21st century and not trying to micro-manage each individual economic situation into a rule, but I just have to say I am to a point of maybe that we're getting to a place where the exchanges ought to be empowered more and the CFTC should be more of an oversight as to how the exchanges are operating and to allow the flow to be able to be better developed in the safety procedures based on the safety and public protection, based on more of an oversight role rather than micro managing role.
Page 40 PREV PAGE TOP OF DOC I just feel, in the few years that I've been here in Congress, that this issue has not gotten any clearer and, frankly, as I've been talking with my colleagues, I'm actually beginning to understand some of this stuff, which is always a little bit dangerous when you're in this field.
But I just think that when you get to a point of shoring up the exchanges and modernizing the exchanges and being able to allow those exchanges to be able to do business worldwide and to being in more of an oversight role would be the kind of a role that I guess I would like to see the Commission, the CFTC play.
I guess then it would be up to our committee to work on developing that model as we get ready. But I don't have any particular questions. I appreciate your responses and your presentations and testimony, and thank the chairman, and yield back the balance of my time.
Mr. EWING. Thank you very much. Mr. Jenkins.
Mr. JENKINS. Thank you, Mr. Chairman. I'm sorry that I missed the testimony of these witnesses and I haven't reached the level of understanding that Mr. Baldacci has yet, so I don't have any questions at this time. Thank you.
Mr. EWING. A question for any of you on the panel. Do you believe agriculture and non-agriculture contracts require different levels of regulation? Start with you, Mr. Spears.
Mr. SPEARS. I guess I personally believe they require similar regulation. I think that you have to look at the individual market itself and there may be certain components that could have some variances. But I think the overall scheme of regulation should be the same both for agriculture as well as other products.
Mr. EWING. Ms. Holum.
Ms. HOLUM. I would certainly agree with that. However, there are I wouldn't say less or more regulation, but there are different regulatory schemes that apply to each individual contract that seem to be working very well, whether they're agriculture or non-agriculture.
Page 41 PREV PAGE TOP OF DOC Mr. EWING. Mr. Newsome.
Mr. NEWSOME. I guess I would tend, Mr. Chairman, instead of saying ag versus non-ag, to look at those that are physically delivered versus those that are not, and that, I think, draws part of that same ag/non-ag line that you're talking about.
I think currently we adequately address the majority of the problems. I certainly think that as we go down the road, that that's an area that we need to continue to look at as we split more into what I would call retail markets versus more sophisticated markets.
So definitely I think that's something we need to keep an eye on.
Mr. EWING. Mr. Erickson.
Mr. ERICKSON. I would concur with the comments of the other Commissioners. I do think that there are some natural divisions along the lines of physical and non-physical delivery markets.
I do also tend to think that the markets all serve similar economic function and they are financial instruments. So I think that part of it is the physical/non-physical. It's also the sophistication of participants. It may be even trading systems, as far as what the level of regulatory interest might be in those instances.
Mr. EWING. Thank you. Are there other members that have additional questions?
Mr. POMEROY. Mr. Chairman.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. The exchanges will be testifying on the next panel. Just for our background, when might their application or their petition, when will that be ruled on? How quickly could that be turned around?
Mr. SPEARS. It's my intent to have that petition circulate within the next few days for sign-off by the Commission and then there will be a comment period, probably 60 days, where the public can build a record and the Commission could have a record of public comments to make a decision as to the comments.
Page 42 PREV PAGE TOP OF DOC As to how fast we would act on it once we have the comments and determine on the comments we get how the public perceives the petition and what various sectors of the public say.
Mr. POMEROY. Is there a moratorium presently in effect on the approval of foreign exchanges?
Mr. SPEARS. No, sir.
Mr. POMEROY. Will there be other foreign exchanges approved during the pendency of this petition?
Mr. SPEARS. That would be something thatthose no action letters are issued by trading and market staff and I fully expect a continuation of additional no action letters to be issued during that time period.
Mr. POMEROY. And the effect of a no action letter is what?
Mr. SPEARS. The no action letters would be where other foreign exchanges would be allowed to list those contracts in the United States.
Mr. POMEROY. As I mentioned in my prior remarks, that is a little backward. It's 180 degrees backwards. So I hope that you can quickly make that right. I hope that petition gets action as quick as possible.
Mr. SPEARS. Understood.
Mr. POMEROY. Thanks, Mr. Chairman.
Mr. EWING. Just a couple more questions to be sure we have covered everything.
Does the Commission believe that it has ample legal authority to approve each of the three areas of relief requested by the exchanges in their petition, Mr. Spears?
Mr. SPEARS. As I said, we have ample legal authority on the petition. In order to do that, we have to build a public record and get public comments in order to make the appropriate determinations that need to be made per the act.
Page 43 PREV PAGE TOP OF DOC Mr. EWING. You have the authority.
Mr. SPEARS. Yes, sir.
Mr. EWING. Anyone else want to differ with that?
Ms. HOLUM. No.
Mr. EWING. The Commission's written testimony stated that it is the Commission's intent to publish the exchange petition soon. When do you expect that to be published and how long will it take you to act on it?
Mr. SPEARS. As I said, we would expect the petition to be published in the next few days and then I would expect the petition to have a 60-day comment period to receive the appropriate comments to build a public record and make a determination, and then our action would be based on the comments that we received.
Mr. EWING. So you really don't have a timetable after the 60 days. Do you know what the normal period of time is?
Mr. SPEARS. I don't know what the normal period of time would be, but it would be my intention, as the acting chairman, to make sure that action would be as quick as possible.
Mr. EWING. The Commission has put forth two new proposed rules that may partially address exchange requests to have pre-approval of new contracts and to give the exchange the ability to expeditiously adopt new rules or rule changes.
Have you consulted with the exchanges in regard to those proposed pilot programs?
Mr. SPEARS. Yes.
Mr. NEWSOME. When you get to be acting chairman, that's where
Mr. SPEARS. I don't want to hog everybody's time here. We have had ongoing dialog with the exchanges and we'll continue to have that dialog. As you know, they participate in our various advisory committees that we have, the advisory committee that Chairman Holum chairs as far as GMAC. I chair the agriculture advisory committee.
Page 44 PREV PAGE TOP OF DOC We meet with the exchanges regularly. As I said, it was a sincere effort to address their concern and if there are initial issues or concerns regarding that proposed pilot program, we'll be happy to try and address them as we receive the comments and take action accordingly.
Mr. EWING. Does anyone else want to add to that?
Mr. EWING. I think we all realize that there is a great deal of the financial markets out there that are not regulated, not regulated by CFTC or maybe partially regulated under some agency, but not directly regulated like the CFTC regulates the futures exchanges.
Do you believe that the U.S. exchanges should be permitted to establish subsidiary operations that are unregulated to better compete with the over-the-counter industry? Mr. Newsome.
Mr. NEWSOME. Mr. Chairman, that is something that I know I haven't spent a lot of time thinking about and I don't know if our fellow Commissioners have. My initial opinion would be, as private sector businesses, that they ought to have the authority to set up subsidiaries to compete on level playing fields with anyone within the business.
Mr. EWING. Anyone else? Tom?
Mr. ERICKSON. I think it is an excellent question. It's something that we as regulators will be wrestling with. I'm sure that other regulators will be dealing with similar issues. I think we may have a few cases of first impression coming our way as exchange alliances continue and plans such as what you're suggesting come to fruition.
I think we'll need the benefit of public comment and also some fair consideration within the Commission and the regulatory community and Congress.
Ms. HOLUM. Also, I think if the Commission moves toward a more oversight function rather than a micro-managing function, that the exchanges will find the regulatory relief that they need to make them more competitive with the over-the-counter markets.
Page 45 PREV PAGE TOP OF DOC Mr. SPEARS. I would just add that I'd also look forward to discussing that issue with you at the reauthorization process and looking forward to the Congressional input on that issue, as well as the public and Commission input.
Mr. EWING. You don't think the law, though, prohibits that at this time, or do you have a comment?
Mr. ERICKSON. I don't think, upon first blush anyway, that there would be any preclusion from other kinds of arrangements. It's an issue that we'll be wrestling with in a lot of contexts, such as demutualization of the exchanges themselves; how do we, as a regulator, respond to those changes, and I think we can.
Mr. EWING. Anybody else?
Mr. EWING. I appreciate your comments and I know those aren't easy questions to answer, but I would say to you that as we move through the process of reauthorization for your agency, I think that is really the crux of what we have to decide and what the Congress will have to decide.
These exchanges know their function in the area that they have functioned, but they see enormous amounts of the market being handled differently; not totally differently, but differently and outside of the same system they're involved in.
To be competitive, I think they feel there has to be a level playing field and that's, I think, the responsibility of the Congress working with the Commission.
Thank you all very much for coming.
Mr. SPEARS. Thank you, Mr. Chairman.
Mr. EWING. I want to welcome the second panel. Mr. Mark D. Young, partner, Kirkland & Ellis, on behalf of the Chicago Board of Trade; Mr. Jerrold Salzman, counsel, Chicago Mercantile Exchange; and, Mr. Christopher Bowen, senior vice-president and general counsel, New York Mercantile Exchange.
Page 46 PREV PAGE TOP OF DOC Welcome, all of you. We'll start with you, Mr. Young.
STATEMENT OF MARK D. YOUNG, PARTNER, KIRKLAND & ELLIS, ON BEHALF OF THE CHICAGO BOARD OF TRADE
Mr. YOUNG. Thank you, Mr. Chairman. Good afternoon, Mr. Chairman and members of the subcommittee. I am Mark Young, a partner in the law firm of Kirkland & Ellis, appearing on behalf of the Chicago Board of Trade.
The Board of Trade's chairman, David Brennan, and CEO and president, Tom Donovan, regret that they were able to attend in person today, but wanted you to know how much they appreciate your commitment to the ongoing efforts to modernize regulation of the U.S. futures exchanges.
The subject of today's hearing, the exchanges' June 25 petition, is one important part of our regulatory relief effort, and I understand that a copy has already been included in the record of that hearing; if not, I'd just like to tender a copy for that purpose.
Before I go on to talk about anything else relating to that petition, we've heard a lot in prior hearings and today about the concept of fairness, and that concept comes into very high relief today when we hear the CFTC describe how they're going to treat the exchanges' petition.
The petition was filed 40 days ago today. It has not yet been prepared for a Federal Register notice, but we understand that that's going to happen soon. When it does go to the Federal Register, it will go for a 60-day public comment period. In contrast, when the Commission proposed what it called breathtaking reforms in both the rule approval and contract market designation area, the Commission put those proposals out, including their pilot program, for 30 days of comment.
I think that 30 days should set the standard for the Commission's consideration of the exchanges' petition, as well, and I would hope that the Commission would reconsider and put our petition out for 30 days of comment, since the issues largely overlap, as I'm going to discuss today.
Page 47 PREV PAGE TOP OF DOC Now that I've talked about an area in which we disagree with
Mr. EWING. Mr. Young, which petition went for 30 days?
Mr. YOUNG. The Commission put out two proposals, one in the rule approval area and one in the contract market designation area, what Commissioner Erickson called pre-designation. Those both went out for 30-day public comment.
Acting Chairman Spears said today that the thinking at the Commission now is to put the petition out for 60 days of public comment. We think 30 is better than 60 and consistent with the comments of members of the subcommittee. I would hope that the Commission would reconsider and put the petition out for 30 days of public comment.
Mr. EWING. Thank you for the clarification.
Mr. YOUNG. Now that I've talked about areas where we disagree, at least on procedure, I want to focus, because I think it's important to do so, on an area where we agree with the Commission, and there are a number of them.
First, U.S. futures exchanges today face more competition than ever before. Technology, innovation and globalization all contribute to those significant competitive forces and new competitors are emerging at an incredible rate.
Second, one factor in this new competition is cost. How much does it cost to run a marketplace? How much does it cost to do a trade? Those questions are critical today.
Regulation imposes costs. Some of those costs stem from exchange self-regulation; what a market knows it must do to provide a fair marketplace with integrity and financial security.
Some of those costs stem from government regulation and mandates.
Fourth, U.S. exchanges have more government regulatory costs by a fairly substantial margin than their existing and emerging competitors. That imposes a heavy competitive handicap on U.S. exchanges.
Page 48 PREV PAGE TOP OF DOC Fifth, U.S. exchanges provide benefits of centralized and transparent price discovery in a fair, open and safe environment. They should be allowed to meet their new competition on a level playing field.
Sixth and finally, as a result, U.S. exchanges need regulatory relief. None of the commissioners I heard testify today disagree with that conclusion.
Having agreed on the goal, the problem is to define what relief is needed. The exchange petition is a first step to answering that question. We say that exchanges should be able to list new products and adopt new rules without waiting for the Commission's approval. Other countries give their exchanges that latitude. We want the same treatment.
Even the Commission, through its inaction to date on the Blackbird swaps trading system, which I've described in my written testimony, in effect, allows new markets to list any new product without prior or subsequent review, and I would add, parenthetically, that we understand that the Blackbird system has begun trading and did visit the Commission before they started to trade.
So all our petition asks for is the same treatment the Commission and other regulators afford our competitors.
Now, in the past months, the Commission's response to our petition has been to issue its own proposals. Both are well intentioned and well short of the mark. Both continue to hold on to the idea that the Commission ultimately must approve new contracts and new rules.
Why? The Commission never really says, other than to assert that its review provides unidentified benefits. What are those benefits and if they exist, are they worth the cost both in terms of government resources and competitive harm? The Commission provides no answer to those questions, nor could it.
Developing sound products that provide useful risk management tools is the business of the exchanges, not the Commission. If the exchanges do not do a good job, the new products will fail in the marketplace, which we know provides the ultimate verdict for any new product.
Page 49 PREV PAGE TOP OF DOC Implementing fair trading rules and procedures so that market participants have confidence in a market is the business of the exchanges, not the Commission. If the exchanges do not do a good job, market participants will go elsewhere to trade.
The Commission has observed that in other countries, foreign exchanges often discuss new contracts or rules with their regulator before implementing them. That same practice could occur here under the exchanges' petition. If an exchange believed that consultation with the Commission would lead to better products or results, it would be foolish not to do so.
But in foreign countries, the decision whether to consult is made by the exchanges and only the exchanges. U.S. exchanges should be able to make the same decision and they would under our petition.
Mr. Chairman, as I explained in my written testimony, the relief sought in the petition is but one phase of our overall effort to transform and modernize the regulation of exchanges. We know that you and Senator Lugar have embraced the idea of making the CFTC an oversight agency, not an exchange manager. We strongly support that objective.
The trick, of course, is defining what is oversight. To the exchanges, CFTC approval of our products and new rules is not oversight. It is akin to having the CFTC empanelled as a super-exchange board of directors and affords the Commission the opportunity to second-guess business judgments the exchanges have already made. That is not oversight, Mr. Chairman, that is overkill. We cannot afford that kind of excessive government involvement in the fast-moving global competitive environment we face.
We urge the Commission to take action to approve our petition immediately. We thank you for your continued leadership in an effort to achieve true regulatory reform under the Commodity Exchange Act.
[The prepared statement of Mr. Young appears at the conclusion of the hearing.]
Page 50 PREV PAGE TOP OF DOC Mr. EWING. Thank you, Mr. Young. Mr. Salzman.
STATEMENT OF JERROLD SALZMAN, COUNSEL, CHICAGO MERCANTILE EXCHANGE
Mr. SALZMAN. Mr. Chairman, members of the committee, I'm Jerrold Salzman. I represent the Chicago Mercantile Exchange, and I have since 1967. I've participated in it on behalf of all the legislative debates that have wound up shaping the Commodity Exchange Act, and I think I can fairly say that I've never heard five Commissioners come in here and testify before a committee so positively in favor of what the exchanges needed and wanted, nor have I ever heard a committee so in tune with what's necessary to let the exchanges prosper into the future.
We can only hope that all of this gets carried through into reality and that the actions of the Commission actually match its words.
As Mark has told you during his testimony, the actual numbers that we see when we look at the facts don't always match the words. We did file our petition 40 days ago. Rather than simply publishing it and getting on with the question of whether or not it's going to be approved, it's, in our opinion, been languishing, and when it does get published, we're very concerned that we're going to get the same treatment we got with our last petition, which is instead of a simple publication of the petition, asking for public comment, we got, what was it, Mark, 124 or 146?
Mr. YOUNG. I think only 106.
Mr. SALZMAN. One-hundred five questions clearly prejudicing how that petition is going to be treated, while, at the same time, the Commission, with no question, no public comment, essentially exempted the entire over-the-counter market and a number of other transactions.
Page 51 PREV PAGE TOP OF DOC So that's what we've been faced with in the past. We hope that these expressions we heard at the table today mean we're not going to be faced with the similar sort of treatment into the future.
I'm going to actually not yield back all of my time, but give away most of my testimony, because Mark covered it very clearly, most of the things I was going to say.
I do, however, want to comment generally that we are going to have a real problem in the future if the Commission doesn't follow through on its testimony here today. In the past, the Commission generally has had a pension to exempt everyone from its regulatory grasp other than the exchanges that have been historicallyhave had the historical misfortune to have been, quote, designated contract markets.
In addition to the OTC market, which I discussed, and foreign exchanges, a number of electronic derivative exchanges are now operating or about to be operating in the United States without registration or exemption.
It's very difficult for me to imagine how there isn't enough information to decide whether Blackbird is or isn't an MTEF, at least on the documents it's published. It does have a web site and, of course, you do have to have a password to get in to tell what it's doing, but from all the reports I've had, it's operating a multi-lateral transaction execution facility and derivative contracts, including FRAs, a contract that we, after 367 days of waiting, have finally received approval to trade.
Of course, after waiting 367 days to trade a new contract, the fact of the matter is it's not clear that the market that we thought was there is still there or that our competitive opportunity hasn't evaporated.
So just to give you a little history of what we're facing from the Commission up until two weeks ago, in any event, we certainly have been put upon.
Now, I am a little concerned that the Commission is being taken advantage of by some of these new exchanges. As you know, the Commission got itself in some significant controversy with its actions with regard to the OTC concept release, but also came under incredible pressure with regard to its release in connection with foreign terminals. Therefore, we think some of these exchanges think they can sort of bluff the Commission into not taking action against them, without getting an adverse reaction.
Page 52 PREV PAGE TOP OF DOC The exchanges have come running to Congress saying, ''Oh, look, the Commission is trying to extend its jurisdiction again.'' But I don't think that is the case here. What we have is an act that's relatively clear in terms of at least exchanges dealing in derivative products.
The Commission has an obligation to give them an exemption under the act, under 4(c), or to make sure that they are properly designated as are the exchanges before you today. It's not a discretionary duty.
So I don't think the Commission should be gun-shy. I think it has to investigate quickly and move forward with those exchanges.
I see my red light is on. So I will simply thank the Commission on behalf of my chairman, Scott Gordon, who was unable to be here today because of certain announcements he was making in Chicago today. We very much appreciate where this committee is going and the intelligence of its questions.
Thank you very much.
[The prepared statement of Mr. Salzman appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Salzman. Mr. Bowen, I want you to understand up front that there was no prejudice in going to the two Illinois exchanges first, from this member from Illinois.
Mr. BOWEN. From all the agriculture questions, I think that might be appropriate.
Mr. EWING. All right. We're ready to hear from you.
STATEMENT OF CHRISTOPHER BOWEN, SENIOR VICE-PRESIDENT AND GENERAL COUNSEL, NEW YORK MERCANTILE EXCHANGE
Page 53 PREV PAGE TOP OF DOC
Mr. BOWEN. Thank you, Mr. Chairman. Mr. Chairman, members of the committee, my name is Christopher Bowen. I'm senior vice-president and general counsel of the New York Mercantile Exchange. NYMEX chairman Dan Rappaport has asked me to express his regret that he is unable to attend today's hearing due to prior commitments.
I also wish to thank you at the outset for the opportunity to participate in today's hearing regarding the 4(c) petition filed jointly by NYMEX with the Chicago Board of Trade and the Chicago Mercantile Exchange.
The regulatory relief sought in the 4(c) petition is urgently needed in order for the U.S. exchanges to function effectively in a competitive environment and to respond quickly to changing market demands. While the derivative products offered by OTC markets, foreign exchanges and domestic exchanges are often very similar, the current level of regulation imposed on these three markets varies dramatically. With respect to swaps, in 1993, the CFTC promptly exercised its new exemptive authority, exempted eligible swap transactions from virtually all requirements of the Commodity Exchange Act, except for fraud and manipulation prohibitions. Since then, the swaps markets have thrived.
With respect to foreign exchanges, CFTC staff has recently issued a no action letter that permits one foreign exchange to place computer terminals for its electronic trading system in the United States, followed by a promise that three more foreign exchanges will receive no action letters within 21 days.
As a matter of public policy and given the importance of the issues involved, we believe that the CFTC should issue consistent standards through rulemaking and disagree with the use of the staff's no action process.
It should also be clearly noted that underlying the no action approval is the recognition by the Commission that foreign exchange products can be offered to U.S. customers and be considered, quote-unquote, safe, without the full panoply of regulatory requirements currently imposed on domestic exchanges.
Page 54 PREV PAGE TOP OF DOC United States exchanges thus face the daunting challenge of competing with OTC markets and with foreign exchanges, while strapped with the heavy burden of regulation under regulatory regime not imposed on those other derivative providers.
The weight of this regulation on U.S. exchanges imposes major costs and limits our ability to respond quickly to competition through innovative products and practices.
Turning to the petition, the exchanges seek regulatory relief in three areas. First, we seek the elimination of prior CFTC review of contract terms, because we believe strongly that each exchange's reputational risk is a major driving force that ensures that its own processes will be detailed and thorough.
In addition, through its clearing function, an exchange puts its own and its members capital at risk. In our experience, detailed CFTC review and approval of contract terms and conditions provides marginal, if any value, and that's costs, uncertainty and delay to the rollout of new contracts.
Second, our petition would allow exchanges to adopt new rules 10 days after submitting them to the Commission. The CFTC would still have the authority to stay or to delay rules if a finding was made that the rule would be subject to fraud, would make trading readily susceptible to manipulation, or would threaten the market's financial integrity.
Third, our petition would allow U.S. exchanges to implement trading rules and procedures comparable to those of a foreign exchange, upon certification to the CFTC that the rule was being used in a contract which directly competes with the U.S. contract.
This would ensure regulatory parity and would preclude a situation where a foreign exchange, with a much more flexible regulatory environment, could exploit that advantage by implementing innovative trading practices designed to catch U.S. business or by launching a contract which directly competes with that of the U.S. exchange.
While the CFTC has taken two steps to address the regulatory parity issue, these efforts have not been sufficient and make no guarantee of speedy relief to the exchanges. First, the CFTC recently proposed a new rule to establish the 2-year pilot program, which they have been speaking about, where exchanges could launch a new contract 1 day after providing notice to the CFTC.
Page 55 PREV PAGE TOP OF DOC This proposal, however, contains a number of limitations such as continuing to require the contracts receive CFTC approval would create uncertainty and would affect the viability of a new contract.
Second, a recommendation regarding relief to the domestic exchanges has been presented to the CFTC's Global Markets Advisory Committee by a subcommittee of that group. To date, the CFTC has taken no action and it's unclear how and when the CFTC will address these recommendations.
In conclusion, NYMEX urges this committee, the Commission and Congress to provide urgently needed flexibility to exchanges. We also urge the CFTC to act quickly and favorably on our petition, with the same expeditiousness now shown in the review of a no action request by foreign exchanges.
Mr. Chairman and members of the committee, NYMEX thanks you for your consideration and we pledge our full support to work with you and your staff to address these issues.
[The prepared statement of Mr. Bowen appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Bowen.
I think you have all addressed the issue of the timing, the comment period, the swiftness with which the CFTC acts on some business and delay that appears to be in your situation.
Do you find that is something that is prevalent whenever the exchanges go there? Does it always seem to take more time when the futures exchanges have something pending?
Mr. YOUNG. I don't know that I'd say always, but I'd say there is a pattern and it's a pattern that's gone on for almost a decade.
Mr. SALZMAN. I think we have to give the Commission credit for loosening up on routine matters. They have made a concerted effort, where something is a copy of something they've done before, not to take the full time period. But every time we come up with something truly innovative, we're in for the long haul because everybody has to try and understand what it is, what it's going to do.
Page 56 PREV PAGE TOP OF DOC Eventually it gets approved without any change, but the second we make it public, it's open to all of our competitors and even under the Commission's new rules, after we spend a year working on it with them, many of our competitors can do it in 10 days.
So I would say yes, it's fine, until you do something innovative, and then it's not fine.
Mr. BOWEN. I absolutely have to agree with Jerry. I think they've made a concerted effort to make routine matters better. But in terms of any sort of significant action, particularly in trade practice areas, it's taken sometimes a matter of years to get things through the Commission.
Mr. EWING. So besides the time and cost, and time is cost to your exchanges, waiting for that approval, is the loss of competitive advantage, is that a major issue?
Mr. SALZMAN. We truly believe it is. We believe that we spend months thinking up clever new kinds of contracts. The cleverer it is, the longer it takes to get approved. Nonetheless, it has to be immediately published and then it's available to anybody else.
The fact is, as you said, time is money and we once took a look at how much we've lost by reason of the delay between the time we filed the contract and the time it was approved, just figuring out what the average trading volume was during the first 8 months after it was approved, and it turns out to be a very significant amount of money.
Mr. YOUNG. Mr. Chairman, in many cases, the timing is very critical and it has been in past years. But to me, that's really not as germane as how it's going to be in the future. In the future, in a more global, more technologically efficient marketplace, those time considerations are going to be absolutely essential. To be held up for a year waiting for a contract approval is simply not in keeping with a modern marketplace.
Mr. EWING. That's a very good point. Is there a reason that the comment period for what the CFTC has put out for publication and what you have petitioned for, the suggested 60 days, can you give me a reason why one should be 30 days and one would be 60? I know I'm asking the fox to talk about the chicken house, but realistically, for us here on this side of the table, is there a reason that you can think of?
Page 57 PREV PAGE TOP OF DOC Mr. YOUNG. No, I can't, Mr. Chairman. I could say the following to you. They could have published the petition after they received it and if they had, they would be in a position today, after 30 days of public comment, to approve the petition. That's No. 1.
Number two, they could have included the petition verbatim with either the rulemaking proposal that they adopted or the contract market designation proposal that they put out for public comment.
So either of those they could have attached our petition to and there would have beenwe would have been within the 30-day public comment period that would be ongoing.
I cannot think of a reason why they could not do this in a 30-day public comment period. I know that they have looked at many reforms within 30 days and I know that, as their testimony indicates, indicated to you today, these are issues that we have been talking about and kicking around for many, many years.
Mr. EWING. Anyone else?
Mr. SALZMAN. Well, we usually apply three initials to that process, which is NIH, it's not invented here. That is, that which they invent is easy for them to put out for publication. That which comes from an outside source has to be contemplated for a long time before it's put out for outside publication.
But the reason you're putting it out for outside publication is to get public comments. So why would you hold something up or why would you hold it for a long time?
The public has been debating the elements of our petition for four months. Everybody knows what's in our petition. They're ready to comment. Let's get it out there.
Mr. EWING. Mr. Fletcher.
Mr. FLETCHER. Thank you, Mr. Chairman. I appreciate the testimony from both panels and certainly it's been very informative to me. We shortly have to vote. Let me ask you if I could justMr. Chairman, maybe there's four or five questions we have here from the committee, if we could give those to you and have you all answer those in writing, first of all, in light of time.
Page 58 PREV PAGE TOP OF DOC Second, just for my information, if you could take a real simple down-to-earth example of a contract that you might have that you would want to get approved and how what we currently have in place would impede you from really acting on that contract versus maybe something in England or Germany.
Mr. SALZMAN. Well, I tried to give the example of an FRA contract. This is a littlein fact, it's quite complicated. I'll give the Commission that. The FRA contract is a different kind of way of trading our Eurodollar contract. It's essentially the same thing, but there's different convexity because of the pay-out. So just take that as a given.
I don't know what it means, but that's what they say to me every time. So that's where we are. But it's essentially the same thing.
It is a contract that's traded in the cash market. It's a contract that's traded in the derivative market. But because of the way the payment flows are organized in this new contract, it's quite different than anything ever done on an organized exchange before.
As I said, it took 357 days to approve that contract. In the meantime, we had an organization called EBS, which operates an electronic trading system in Europe, which has not yet come into the United States, which trades this thing in the thousands every day, and we have certain exchanges or what I consider to be exchanges that are supposedly operating in the U.S. trading it right now.
So the problem is because we're an organized exchange, because we've been designated in the past, because there is focus on our actions, we have to follow this process and explain to everybody at the Commission a new concept, so they're comfortable, but nobody else does.
Mr. FLETCHER. Thank you very much, Mr. Chairman. I yield back the time. I do submit these five questions, if you could answer those for us, it would be appreciated. Thank you very much.
Page 59 PREV PAGE TOP OF DOC Mr. EWING. Thank you, Mr. Fletcher, for submitting those questions. A couple more questions.
Do you believe that the current act authorizes the Commission to give you the regulatory relief that you need?
Mr. YOUNG. Yes, there is no question about that.
Mr. SALZMAN. The answer is yes, but I am going to say, as I think I've said before in some of your roundtables, that there are a lot of things in the act that the Commission can turn and look at and there are some things in the legislative history that the Commission can turn and look at and say we must be really cautious before we give 4(c) relief to designated contract markets, but we can give it to everybody else easily.
So as long as those things are in the act, if the Commission is reluctant to act, and I heard today they weren't, but if they were, they have an excuse for not acting, which always makes us nervous.
Mr. YOUNG. Mr. Chairman, it's not often that I disagree with Mr. Salzman. This disagreement is of a very subtle nature, but I think that some of the statements that he was referring to appear in the legislative history of the 1992 statute, and those statements are coupled with other statements that say to the Commission to apply its exemptive authority to exchange markets and over-the-counter markets in a fair and evenhanded manner.
And if certain statements in that legislative history are going to rise to the level of statutory provision and law, then I think all statements in that legislative history should rise to the level of statutory provision and law.
I would, therefore, stand by my answer that there is no legal reason for the Commission not to be in a position to approve our petition as we've written it.
Mr. BOWEN. I don't mean to sound like a tie-breaker, but I actually agree with Mr. Young on this point. I see no reason why they shouldn't have the authority to do this.
Page 60 PREV PAGE TOP OF DOC Mr. SALZMAN. Well, I actually agreed with that, too. I was just saying I don't even want them to have an excuse in the statute for not doing it.
Mr. EWING. I would have been very disappointed if the three lawyers had all agreed. Some argue that the use of exemptions under section 4(c) should be limited because of report language in the 1992 Futures Trading Practice Act that states the use of this authority should not lead to wide-scale market deregulation.
Are these provisions in the exchange 4(c) petition, would you think they should would lead to wide-scale deregulation and do you think that may counter the answer that we just had to the question that the act gives the authority to really change the way they operate?
Mr. YOUNG. No, Mr. Chairman. The conference report language is very important, but it's not statutory language and that does not appear in the statute.
Second, I don't consider this to be wide-scale deregulation, especially in light of what that language actually says, which is wide-scale deregulation of markets within the ambit of the act. It talks about markets within the ambit of the act, not exchanges.
The Commodity Exchange Act can apply to markets beyond exchanges, beyond formally organized exchanges, and the Commission has already exempted, in a very broad manner, many of those markets. We don't have any problem with that. We're simply asking for fair and evenhanded treatment.
Mr. SALZMAN. This is not disagreement with Mark, but what I would say is that the relief we seek in the petition is not deregulation of the exchanges. The fact that we don't have to do things in advance and the fact that we don't have to get approval in advance doesn't mean we're deregulated. We're still absolutely bound by the provisions in the act and to the extent that the act requires us to take steps that prevent manipulation, that still binds us.
To the extent that we have to protect our customers, that still binds us. We are not deregulated. We are simply taken out of the stream of having to wait 357 days to get something done.
Page 61 PREV PAGE TOP OF DOC Mr. BOWEN. Right. I think that deregulation basically implies that there is sort of no basis to regulate someone, where I think the language that we contemplate here is just sort of getting rid of a lot of the regulations that we're subject to. And being subject to the core principles of the act, that's what we want, that's what we think the CEA is intended to do, anti-fraud, anti-manipulation.
We intend to do nothing with those. We always want to be subject to those. So I think deregulation is really a misnomer in that instance.
Mr. EWING. Gentlemen, as you know, there is a vote and I will bring this hearing to a close, so that you won't be waiting.
I would make a couple of observations. I notice that the commissioners have, as I had asked, stayed to hear your testimony. I notice they were taking notes, too. So you may be in more trouble.
I think it's an excellent way to open lines of communications and I am pleased that they have done that. I think that's a positive sign, and I certainly encourage further dialog between the regulated and the regulator, which certainly makes my job and this committee's job much easier. I think all of the steps that we have been taking to find the path to reauthorize the CFTC are moving in the right direction.
Sometimes we sidestep, sometimes we may take a step back, but the progress has been forward. I thank the exchanges, I thank the commissioners for working with me and the committee in that regard.
I can only say that we're going just to continue to move ahead in the weeks ahead in hopes that before this time or by this time next year, we will have have settled the issue of reauthorization and everyone will know where they're going and what their responsibilities are.
Thank you very much. The subcommittee is adjourned.
Page 62 PREV PAGE TOP OF DOC [Whereupon, at 3:55 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
Testimony of David D. Spears
Mr. Chairman and Members of the subcommittee, I am pleased to appear today on behalf of the Commodity Futures Trading Commission to testify regarding the competitive concerns of United States futures exchanges, as expressed most recently in the June 25, 1999, joint petition by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange (the Exchanges). That petition requested an exemption from certain statutory and regulatory requirements for all boards of trade that have been designated by the Commission as contract markets. According to the Exchanges, the petition was filed in response to the Commission's June 2, 1999, Order, which withdrew the Commission's proposed rules governing the use of automated trading systems in the United States by foreign boards of trade. This Order also directed our Division of Trading and Markets to begin immediately processing on an interim basis no-action requests from foreign boards of trade seeking to place trading terminals in the United States. The Order also committed the Commission ''to simultaneously initiat[ing] processes to address the comparative regulatory levels between U.S. and foreign electronic trading systems so as not to provide one with a competitive advantage.''
The Exchanges state that their petition for exemptive relief should be granted in order to avoid unfair competition from foreign exchanges that have been or will be permitted to establish automated trading systems in the United States. Since these foreign exchanges will not be required to obtain Commission designation as contract markets in order to operate in the United States, the exchanges contend that foreign exchanges will not be subject to the same statutory and regulatory requirements that apply to the U.S. exchanges. Through their petition, the Exchanges are seeking the ability to respond, without delay, to any new contract, contract amendment, advantageous trading practice or less costly regulatory measure offered or likely to be offered by foreign exchanges through their U.S.-based trading terminals.
Page 63 PREV PAGE TOP OF DOC At the outset, let me say that the Commission is firmly committed to addressing the competitive concerns of U.S. futures exchanges. Ensuring the global competitiveness of the U.S. futures industry in general, and U.S. futures exchanges in particular, is a paramount concern of the Commission. Staff intends to circulate to the Commission the Notice of Petition for Exemption and Request for Comment within the next several days with an eye toward prompt publication in the Federal Register. I should add that the Exchanges' petition is in part similar to a number of resolutions debated and passed at a July 8, 1999, meeting of our Global Markets Advisory Committee (GMAC), Ad Hoc Committee on Regulatory Parity. On July 21, 1999, the GMAC discussed the Ad Hoc Committee's resolutions.
Even before the Exchanges' petition was filed, the Commission began to address a central concern raised by that petition, i.e., the ability to list contracts for trading on a more expedited basis. On July 27, l999, the Commission proposed a two-year pilot program to permit the immediate listing of certain new contracts for trading for a specified period of time prior to Commission approval. This procedure would establish a method for the Commission's review of new contracts while preserving the public's opportunity to comment on them, and providing U.S. contract markets flexibility in responding expeditiously to the competitive challenges of the global marketplace. Indeed, only last week, the Exchanges issued a joint statement commending the Commission for this initial action.
This most recent action is consistent with a long line of Commission actions since 1997 streamlining the contract approval process. For example, in April of 1997, the Commission implemented new fast-track procedures relating to the review and approval of applications for contract market designation. In addition, the Commission has periodically revised its Guideline on Economic and Public Interest Requirements for Contract Market Designation, which provides guidance to U.S. exchanges in meeting the statutory requirements for contract market designation.
Page 64 PREV PAGE TOP OF DOC Before I discuss some of the regulatory issues raised by the Exchanges' petition, I also believe that it is important to address some of the assumptions underlying their requests.
First, the petition assumes that foreign exchanges will be permitted unlimited access to the United States without having to be designated as contract markets under the Commodity Exchange Act (act). In fact, the no-action relief scheme constructed for foreign exchanges is based upon the presumption that the foreign exchanges are seeking only limited access to the U.S. markets. For example, under present no-action relief afforded Eurex, less than 5 percent of its volume is generated through terminals in the United States and it otherwise has very limited contacts to the United States. The Division of Trading and Markets (T&M) has found that the limited entry of these foreign exchanges does not necessitate full fledged U.S. contract market regulatory treatment because these exchanges are otherwise competently regulated by their own home regulators. So, for example, when T&M recently granted a no-action request from the London International Financial Futures and Option Exchange (LIFFE) to make its electronic trading system available in the United States, it imposed over four pages of conditions that, among other things, require LIFFE to adhere to regular periodic reporting requirements apprising the Commission of its contacts in the United States. To the extent that LIFFE substantially increases the quantity or modifies the nature of its contacts within the United States, the Commission has the discretion to re-examine the relief granted to LIFFE and even require it to become designated as a contract market under section 5 of the act.
Second, a careful analysis of the major foreign regulatory regimes suggests that the international playing field may not be as uneven as is sometimes thought. For example, as indicated in an attached survey by the Commission's Office of International Affairs (OIA), while it is true that in the United Kingdom contracts are not required to be presubmitted to the regulator, in fact, U.K. authorities have advised that most contracts are submitted in advance and are closely examined by the U.K. Financial Services Authority. In Germany, while the exchange admits contracts to trading, standard conditions of these contracts must be in accordance with exchange rules approved in advance by the relevant regulator. The OIA survey describes the relevant provisions of foreign regulatory systems in greater detail.
Page 65 PREV PAGE TOP OF DOC Third, the Commission, when addressing the legitimate competitive concerns of the Exchanges, is also required by statute to recognize the general public interest in futures markets and the needs of market users, including futures commission merchants and other Commission registrants, who act as intermediaries between customers and the exchanges, and the customers themselves. Those customers, in turn, range from pension funds and other large institutional investors to small country grain elevators and individual investors. Before the Commission can act on the claims made by the Exchanges in their petition, it must hear from all members of the interested public through the comments on the petition. This latter point is noteworthy because, during public meetings relating to this issue, important elements of our regulated community have expressed concerns about some of the points raised by the Exchanges' petition. Indeed, some have expressed a keen desire to have free and open U.S. customer access to foreign boards of trade. The need for free and open U.S. customer access to foreign boards of trade evidences the globalization of all futures exchanges, both foreign and domestic. Consistent with this trend, U.S. futures exchanges currently have over 125 trading terminals operating in seven foreign jurisdictions.
Finally, but certainly not least, the Commission recognizes the role of Congress in regulatory relief issues. Some of the Exchanges' suggestions for regulatory change may very well relate to fundamental customer protection and market integrity measures that have formed the cornerstone of U.S. futures regulation for decades. The Commission believes those protections should not be weakened or withdrawn absent a determination by Congress to change the Commission's statutory mandate.
Two additional issues raised in the petition include requests for relief from the Commission's large trader reporting requirements and the procedures for the prior review of exchange rule changes. Another issue raised by the petition is a proposal that would reduce U.S. regulatory protection to the lowest level of regulation offered by any jurisdiction gaining access to U.S. markets when trading contracts that clone domestically-traded products. In effect, a U.S. contract market could select the least restrictive elements from various regulatory systems around the world and create a single regulatory patchwork that would embody the least restrictive regulatory standards of all of the major foreign financial regulators.
Page 66 PREV PAGE TOP OF DOC The Commission looks forward to receiving comments on these and all the other issues raised in the Exchanges' petition and believes it is important to reserve judgement on these issues until it has heard from the entire regulatory community through the public comment process.
I want to emphasize that the Commission stands ready to cooperate with Congress throughout the reauthorization process, and to work closely with the industry to resolve this and all issues that may arise during that process.
The Commission has undertaken a number of major regulatory reform initiatives to modernize and streamline the regulatory regime it administers. Many of these initiatives resulted from industry proposals that were first raised during the legislative debate that occurred in this subcommittee two years ago. Some of the many proposed and final rules issued in the last two and a half years include:
Rule amendment adopting harmonized financial reporting requirements for CFTC registrants who are also registrants with the Securities and Exchange Commission (''SEC''). (62 Federal Register 4,633 (January 31, 1997).)
Rule amendments to permit filing by large traders of CFTC Form 40, Statement of Reporting Trader, only when requested by the Commission rather than annually. (62 Federal Register 6,112 (February 11, 1997).)
Rule amendments establishing streamlined ''fast-track'' procedures for processing contract market designation applications (62 Federal Register 10,434 (March 7, 1997)) and exchange rule amendments. (62 Federal Register 10,427, 10,434 (March 7, 1997).)
Rule amendments permitting futures commission merchants (''FCMs'') to file required financial reports with the Commission electronically. (62 Federal Register 10,441 (March 7, 1997).)
Page 67 PREV PAGE TOP OF DOC Rule amendments allowing commodity trading advisers (''CTAs'') and commodity pool operators (''CPOs'') to file required disclosure documents with the Commission electronically. (62 Federal Register 18,265 (April 15, 1997).)
Rule interpretation permitting streamlined procedures for allocation of customer orders which are bunched for execution by CTAs. (62 Federal Register 25,470 (May 9, 1997).)
Advisory permitting FCMs to deliver monthly statements, trade confirmations and other account statements solely by electronic media to customers who consent to electronic transmission in lieu of receiving paper documents. (62 Federal Register 31,507 (June 10, 1997).)
Rule amendments authorizing CTAs and CPOs to provide risk disclosure documents to their consenting customers via electronic media. (62 Federal Register 39,104 (July 22, 1997).)
Rule amendments to eliminate Commission-mandated risk disclosure for certain categories of financially sophisticated customers. (63 Federal Register 8,566 (February 20, 1998).)
Rules establishing a pilot program to lift the ban on the trading of agricultural trade options. (63 Federal Register 18,821 (April 16, 1998).)
Approval of innovative exchange programs such as NYMEX's market maker program (63 Federal Register 27,058 (May 15, 1998)) and NYMEX's proposed exchange of futures for swaps. (Commission Order, January 7, 1999).
Rules to eliminate the short option value charge against the capital of FCMs. (63 Federal Register 32,725 (June 16, 1998).)
Rules to permit futures-style margining of commodity options. (63 Federal Register 32,726 (June 16, 1998).)
Page 68 PREV PAGE TOP OF DOC Rule amendments granting increased flexibility concerning exchange trading hours. (63 Federal Register 33,848 (June 22, 1998).)
Proposed rules to streamline further the contract market designation process under Commission Guideline 1. (63 Federal Register 38,537 (July 17, 1998).)
Rule amendments to permit post-execution allocation of bunched orders of sophisticated customers of a CTA or investment advisor. (63 Federal Register 45,699 (August 27, 1998).)
Rule amendments to modernize the Commission's rules relating to procedures for administrative enforcement proceedings. (63 Federal Register 55,784 (October 19, 1998).)
Rule amendments allowing two-part disclosure by CPOs to customers. (63 Federal Register 58,300 (October 30, 1998).)
Rule amendments establishing a streamlined procedure for firms or persons seeking no-action determinations, exemptions and interpretations from the Commission's staff. (63 Federal Register 68,175 (December 10, 1998).)
Rule amendments to ease the Commission's speculative limit rules. (64 Federal Register (May 5, 1999).)
Rule amendments to change the Commission's recordkeeping requirements to permit expanded use of electronic storage media. (64 Federal Register 28,735 (May 27, 1999).)
Rule amendments regarding registration, exemption and disclosure by introducing brokers (''IBs''), CPOs and CTAs trading foreign futures and option contracts on behalf of U.S. clients and pool participants. (64 Federal Register 28,910 (May 28, 1999).)
Advisory on alternative execution procedures, or block trading, for the futures industry. (64 Federal Register 31,195 (June 10, 1999).)
Proposed rule amendments to streamline the contract market rule review and approval procedures for terms and conditions. (64 Federal Register 38,159 (July 15, 1999).)
Page 69 PREV PAGE TOP OF DOC Advisories on alternative methods of compliance with requirements for disclosure of exchange disciplinary information and access denial actions. (64 Federal Register 39,912 and 39,915 (July 23, 1999).)
Proposed rule amendments to establish a pilot program to permit the listing of futures and option contracts on U.S. exchanges prior to CFTC review and approval. (64 Federal Register 40,528 (July 27, 1999).)
Proposed rule amendments to provide a uniform method for computation, documentation and disclosure of the past performance of trading programs offered to the public by CTAs. (64 Federal Register 41,843 (August 2, 1999).)
TO: The Commission
FROM: Division of Trading and Markets
RE: Many of the Specific Issues Raised in the Joint Petition for Exemption
Submitted by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange Pursuant to section 4(c) of the Commodity Exchange Act Can Be Currently Addressed Without Any Exemptive Relief under section 4(c)
August 4, 1999
By letter dated June 25, 1999, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange (collectively referred to as the Exchanges) submitted a joint petition to the Commission, pursuant to section 4(c) of the Commodity Exchange Act (act), requesting an exemption from certain statutory and regulatory requirements for all boards of trade that have been designated by the Commission as contract markets.
Page 70 PREV PAGE TOP OF DOCThe Division of Trading and Markets (Division) believes that many of the specific issues raised in the Exchanges' petition can be addressed through the existing regulatory regime without any need for exemptive relief under section 4(c) of the act. In order to illustrate this point, the Division has compiled below a list of specific actions which the Commission has taken in many of the areas in which the Exchanges seek relief.
II. MANY OF THE SPECIFIC ISSUES RAISED IN THE EXCHANGES' JOINT PETITION FOR EXEMPTION CAN BE CURRENTLY ADDRESSED WITHOUT SECTION 4(C) RELIEF
The Exchanges' petition cites eight particular statutory and regulatory requirements that they believe must be addressed to create regulatory parity with foreign exchanges. Most prominently, the Exchanges are seeking an exemption for all boards of trade already designated as contract markets by the Commission from the contract market designation requirements for new contract submissions, set forth in sections 5 and 6 of the Act, and the contract market rule review and approval process, set forth in section 5a(a)(12) of the Act. The Commission, however, has already addressed the Exchanges' stated need to list contracts in a prompt and expeditious manner by issuing its recent proposed rule authorizing the trading of certain new contracts prior to Commission approval.See 64 FR 40528 (July 27, 1999) (notice of proposed rulemaking). Comments on the proposed rulemaking must be received by the Commission on or before August 26, 1999.
It should be noted that under existing procedures for the review and approval of new contracts, U.S. contract markets* initial launch date for such contracts is often well after designation and many contracts are not listed for trading until months or even years later. In this regard, of the 201 new contracts that were approved by the Commission during the period 1996 through 1998, about one-fourth (46) have not yet been listed for trading. For the other 155 contracts, the average period of time between designation and listing was approximately three months (87 days). Only 29 contracts were listed for trading within ten days after Commission approval. These facts, combined with the Commission*s proposed rule providing for the immediate listing of certain new contracts prior to Commission approval, should ensure a procedure that preserves the benefit of the approval process while allowing for exchanges to meet any competitive threat.
Page 71 PREV PAGE TOP OF DOC Aside from the contract approval issue, the Division believes that as many as six of the remaining seven areas of requested relief can be currently addressed through the existing regulatory regime.
A. PAYMENT FOR ORDER FLOW AND LIQUIDITY PROGRAMS
According to the Exchanges' petition, U.S. contract markets may disadvantaged by the ability of foreign exchanges to pay for order flow and/or provide inducements for market makers or customers to trade their products.In their petition, the Exchanges list *payments for order flow* and *inducements to make markets or trade* as two separate areas of requested relief. For purposes of this Memorandum, the Division has combined these two areas together into a single discussion.
If U.S. contract markets are precluded from responding to such programs for regulatory reasons, the Exchanges state that the concentration of liquidity in certain contracts may move to the foreign exchanges where it cannot be easily recaptured.
The Act, however, does not generally prohibit U.S. contract markets from making payments for order flow. Indeed, the Commission has already approved or allowed into effect numerous proposals establishing incentive programs at various contract markets, including the Coffee, Sugar & Cocoa Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange.See, e.g., Coffee Sugar & Cocoa Exchange Registered Market Maker Program (approved by the Commission on April 30, 1991); Chicago Board of Trade Modified Market Maker Program for the Wilshire Small Cap Index Futures Contract (allowed into effect without prior Commission approval on June 18, 1993); Chicago Mercantile Exchange Principal Market Maker Program (approved by the Commission on April 20, 1995); New York Mercantile Exchange Specialist Market Maker Program (approved by the Commission on July 8, 1998).
These programs, which historically have been used to encourage market participation in specified new or low volume contracts, often provide market makers or other trading entities with monetary compensation either as a flat retainer whereby the market maker is paid a fee for its presence in the trading pit, as a discount on trading volume that meets or exceeds certain specified thresholds, or as a payment per transaction. Other programs provide market makers and, in certain cases, their customers with trading priorities that they would not otherwise obtain under traditional open and competitive execution procedures.
Page 72 PREV PAGE TOP OF DOCB. GUARANTEED PRICING OR EXECUTION QUANTITY
According to the Exchanges' petition, in contrast to foreign exchanges, U.S. contract markets are unable to adopt certain trading methodologies that provide guaranteed price and/or execution quantity. The Exchanges state that their customer business will be unfairly diverted to those foreign exchanges that permit such practices.
However, the Commission has taken an active role in encouraging contract markets to develop alternative execution procedures for their markets. In a recent Commission Advisory on Alternative Execution, or Block Trading, Procedures for the Futures Industry,See 64 FR 31195 (June 10, 1999); 64 FR 34851 (June 29, 1999) (corrections).
the Commission announced its intention to consider contract market proposals to adopt alternative execution, or block trading, procedures for large size or other types of orders on a case-by-case basis under a flexible approach to the requirements of the act and the Commission's regulations. The Commission recognized that such procedures could utilize any combination of competitive and noncompetitive trading practices.As noted in the Advisory, the Commission uses the term *noncompetitive transactions* to refer to those transactions that are negotiated and executed by counterparties other than through open outcry or other competitive means, but in accordance with the written rules of contract market that have been submitted to and approved by the Commission.
Under this approach, each contract market will retain the discretion to permit alternative execution procedures and will be able to develop procedures that reflect the particular characteristics and needs of its individual markets and market participants. Commission staff expects to receive such a proposal from a contract market in the immediate future.
In addition, the Commission has already approved or allowed into effect numerous contract market proposals which provide for the noncompetitive execution of orders or which implement guaranteed price or quantity execution procedures.See e.g., Chicago Mercantile Exchange Rule 549 (*Large Order Execution*) (approved by the Commission on September 27, 1991); Chicago Mercantile Exchange Rule 554 (*Large Lot Trading of Currency and Currency Cross-Rate Futures Contracts*) (approved by the Commission on March 18, 1993); New York Cotton Exchange FINEX Division Rule 1.10-B (*Block Order Execution*) (approved by the Division pursuant to delegated authority on June 11, 1993); New York Futures Exchange Rule 312 (*Block Order Execution*) (approved by the Division pursuant to delegated authority on March 31, 1994); Chicago Mercantile Exchange Rule 521 (*All or None Transactions*) (approved by the Division pursuant to delegated authority on May 2, 1996).
Page 73 PREV PAGE TOP OF DOC
As a most recent example, on January 7, 1999, the Commission approved New York Mercantile Exchange Rule 6.21A which authorizes the noncompetitive exchange of futures contracts for qualifying swap agreements (EFS transactions) pursuant to the terms and conditions of a three-year pilot program.See Commission Press Release No. 4228-99 (January 11, 1999).
C. PRICE REPORTING
In their petition, the Exchanges state that many significant market participants would rather withhold relevant information about their transactions, including price and/or quantity, until they have been able to act in another market or execute additional transactions. The Exchanges state that, although the act does not require real time price reporting, the Commission has precluded U.S. contract markets from delaying price reports to accommodate certain market participants. The Exchanges are concerned that if competing foreign exchanges decide to delay the reporting of certain types of transactions, such as block trades, to the general marketplace, these exchanges will unfairly capture market share from U.S. contract markets.
The Division believes that price reporting generally is integral to the price discovery process and to the assurance of open and competitive futures markets. However, in the very areas that serve as the basis for the petition, the act authorizes and the Commission has permitted significant exceptions to the general policy of having immediate dissemination of transaction information for certain noncompetitive transactions. For example, subject to contract market rules, exchanges of futures contracts for physicals (EFPs) may be negotiated and arranged outside of the trading hours of the relevant contract market and then reported to such contract market by the next business day. Although EFP volume is published by the relevant contract market, EFP price information (for the futures or the physical legs) is generally not released to futures market participants or the general public. Similarly, pricing information regarding EFS transactions at the New York Mercantile Exchange also would not be released. Moreover, in the block trading area, to which the Exchanges particularly refer in their petition, as noted above the Commission recently issued an Advisory on Alternative Execution, or Block Trading, Procedures for the Futures Industry. Through this Advisory, the Commission indicated its willingness to consider contract market proposals adopting alternative execution procedures for large size or other types of orders. Such procedures could include the delayed reporting of certain transaction information.
Page 74 PREV PAGE TOP OF DOCD. ACCOUNT IDENTIFIERS
According to the Exchanges' petition, neither the act nor the Commission's regulations specifically require account identification information to be entered into a trading terminal prior to the execution of a customer order. However, the Exchanges state that the Commission has imposed such a requirement as a condition of approval for the electronic trading systems operated by U.S. contract markets. The Exchanges state that U.S. contract markets are unfairly burdened by the Commission's account identification requirement and that they will lose market share to the competing foreign exchanges that are not subject to such a requirement.
The Division believes that account identifiers are critical to the contract markets' audit trail requirements and help to prevent the improper allocation of trades among accounts and other fraudulent trading abuses. Despite the importance of account identification, the Commission has implemented significant yet appropriate exemptions to this requirement. For example, in May of 1997, the Commission approved a National Futures Association interpretive notice, which established standards and procedures for allocating bunched orders pursuant to a predetermined allocation scheme.See 62 FR 25470 (May 9, 1997) (approved National Futures Association Interpretive Notice to Compliance Rule 2-10 relating to the Allocation of Block Orders for Multiple Accounts).
Under the notice, a futures commission merchant (FCM) may omit including account numbers on order tickets provided that the FCM has a pre-determined allocation scheme. In August of 1998, the Commission amended Regulation 1.35(a1) to allow bunched orders for certain eligible customers to be placed on a contract market without specific customer account identification, either at the time of order placement or at the time of execution.See 63 FR 45699 (August 27, 1998).
Under the amendment, bunched orders placed by eligible account managers on behalf of eligible customer accounts can be allocated at the end of the day on which the orders are executed.
Page 75 PREV PAGE TOP OF DOC Finally, experts have advised that recent technical advances have eliminated the need to enter full account numbers into electronic trading terminals, and that selection defaults and short codes can instead be used.
E. SYSTEM PERFORMANCE, CAPACITY AND SECURITY
According to the Exchanges' petition, the Commission has precluded U.S. contract markets from launching new products on their electronic trading systems pending the Commission's review and approval of system performance, capacity, and security tests. The Exchanges state that their foreign competitors will not be subject to the same review and approval process.
The Commission's review of newly created electronic trading systems has been and continues to be based on the principles developed by the international regulatory communityspecifically the International Organization of Securities Commissions (IOSCO). Moreover, in connection with Commission staff's review of no-action requests from foreign exchanges to place their trading terminals in the United States, the recognition and acceptance of the IOSCO principles by foreign jurisdictions is one of the important, necessary conditions for the grant of such relief. Thus, domestic and foreign exchanges are subject to similar requirements in this regard.
Testimony of James E. Newsome
Thank you Mr. Chairman and members of this distinguished subcommittee. I am pleased to be here to testify before you today, and I thank you for the opportunity to discuss important issues relating to regulatory relief for U.S. futures exchanges. As I stated in testimony before your subcommittee in May, this continues to be an area of major significance and concern to me.
Given my background and experience, I tend to look at issues from the private sector point of view, that is, as a producer and businessman rather than as a regulator. Accordingly, I am acutely sensitive to circumstances that produce anticompetitive or unfair results. As I have stated repeatedly since I came to the Commission in August of 1998, I am pro-business and believe strongly in fair competition; those are the foundations which form the bases for my decisions as a regulator. Accordingly, in looking back over speeches and testimony I have delivered in the past year, I find consistent reiteration of my belief that our exchanges need significant regulatory relief. Well before any discussions of foreign exchanges and no-action requests, I was making rounds to agricultural groups, to industry participants, and to our domestic exchanges, listening to their concerns, and finding out what areas of regulatory relief could be addressed immediately, and in what areas the Commission needed guidance from our oversight committees.
Page 76 PREV PAGE TOP OF DOC In my testimony in May, I stated that I had convened a meeting of representatives from the three largest domestic exchanges to discuss the issue of regulatory relief. They provided me with a list of items to address some of their concerns, and I have shared that list with this committee. In the intervening months, I have made consistent, strong efforts to try to get certain items on that list accomplished, specifically, relief from pre-approval of contract market designation rules, a payment for order flow advisory, a market maker program advisory, and a final resolution on dual trading orders. I chose those items from the exchanges' lists as ones that could and should be addressed immediately, without changes in existing authority and without further direction from Congress.
However, as you know, regulatory relief issues have become enmeshed in matters relating to no-action relief for foreign exchanges. During the past months, I have consistently stressed my belief that the Commission should address the domestic exchanges' concerns regarding these four issues prior to acting on foreign exchange requests, not for any protectionist reasons but simply for the reason that we had the authority, ability, and information necessary to act promptly, and accordingly should do so. Given the posture in which we now find ourselves, I will continue to press for this relief as quickly as possible, and I welcome input from this committee on the ongoing effort.
Also, I welcome the opportunity we now have to address the joint 4(c) exemption petition from the three largest domestic exchanges. I believe that this should be a matter for comment on the public record, which, combined with responsive comments to the Commission's recent release on proposed designation pre-approval procedures, will greatly enhance our ability to make correct determinations regarding appropriate regulatory costs and benefits in this and other areas.
As to other items on the exchanges' lists (for example, large trader reporting, price reporting, account identification, and segregation of customer funds), it was my determination that these issues addressed core provisions of the Commodity Exchange Act, and that input from many sectorsincluding industry participants, agricultural producer groups, and especially our oversight committees is not only appropriate but necessary prior to Commission action. I continue to believe this is the correct approach, given the fundamental nature of these issues and their relationship to the customer protection and fraud and manipulation prosecution functions of the Commission. I look forward to receiving input on these matters.
Page 77 PREV PAGE TOP OF DOC Our domestic exchanges deserve the benefits of true competition and a level playing field, as do the industry participants who use these markets. This does not mean I believe in protectionism for the exchanges. However, it does mean that I wholeheartedly support efforts to revamp our act and regulations to give the Commission, as an oversight agency, the flexibility to allow for development or improvement of technological advancements and to enable domestic exchanges to compete without unnecessary hindrances. Any regulation under which they operate should have clear benefits, which outweigh the costs of that regulation. I believe this calculus is critical in fashioning an appropriate regulatory framework. Furthermore, I believe our domestic exchanges are among the most dynamic enterprises in the world, and I will continue my efforts to allow them to compete without undue regulatory burdens.
If I may, let me reiterate a point I have made repeatedly in the past year: if the cost of doing business is too high, business will go where costs are lower, outside of the sphere of United States policymaking authority. We cannot afford to lose the exchanges, we cannot afford to lose other industry participants, and we cannot afford to lose the ability to make policy determinations that affect the global economy due to being overly regulatory. With that in mind, I commend your efforts to bring more rationality to the regulatory structure affecting domestic exchanges, and I will continue to work with you, with the industry, and with other regulators to achieve that goal. I thank you, and would be happy to answer any questions you may have.
Testimony of Thomas J. Erickson
Chairman Ewing, Ranking Member Condit and members of the subcommittee, I am pleased to appear before the Subcommittee on Risk Management, Research and Specialty Crops to discuss the Commodity Futures Trading Commission's (the Commission) ability to address the competitive concerns of domestic futures exchanges. As you know, this is my first opportunity to testify before this subcommittee as a Commissioner and I look forward to discussing this most important issue. My remarks this afternoon amplify a few of the points in the Commission's testimony summarized by Acting Chairman Spears. Before I do so, however, I first would like to spend a few moments discussing the Commission's legal authority.
Page 78 PREV PAGE TOP OF DOC The Futures Trading Practices Act of 1992 authorizes the Commission to exempt any agreement, contract or transaction, or class thereof, from the exchange-trading requirement of section 4(a) or any other requirement of the Commodity Exchange Act (the act), except section 2(a)(1)(B). The Commission may exercise this broad exemptive authority by rule, regulation, or order. In enacting section 4(c), Congress directed the Commission to make certain determinations in granting exemptions. For example, the act requires that an exemption be consistent with the public interest, which the Conference Report deems to include ''the prevention of fraud and the preservation of the financial integrity of markets, as well as the promotion of responsible economic or financial innovation and fair competition.'' Moreover, the Commission must determine that any exemption ''will not have a material adverse affect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory duties under [the] act.'' Again, according to the Conference Report, Congress intended that the Commission ''look at the potential impact of the new product on such regulatory concerns as market surveillance, financial integrity of participants, protection of customers, and trade practice enforcement.'' Congress directed the Commission to use this authority sparingly and stated that it did not intend ''to prompt a wide-scale deregulation of markets falling within the ambit of the act.''
The fact that the Commission must make these determinations is not an impediment to the Commission's ability to consider the issues raised in petitions for exemption. The act is enormously flexible and allows the Commission to view the markets as a whole and to delineate lines of regulatory interest. In fact, I am certain that there are aspects of the Commission's existing regulatory framework which, after careful analysis and consideration of changes in the market, may prove to be unnecessary. In order to conduct such a review, I believe the Commission must have the benefit of public comment on any petition received under section 4(c) of the act. This process is essential for the Commission to make the determinations necessary to exempt markets or transactions from provisions of the act.
Page 79 PREV PAGE TOP OF DOC As discussed more fully in the Commission's statement, the Chicago Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange on June 25, 1999, submitted to the Commission a petition requesting broad relief from Commission regulation. Parenthetically, I might note that I received the petition having had only four days to warm my chair at the Commission. As a result, most process decisions with respect to foreign terminals and regulatory relief were already in place. I was pleased, however, that I arrived in time to participate in the Commission's action to propose a two-year pilot program allowing predesignation of new contracts. Just last week, I met with exchange officials in Chicago. My message to them was, and is today, that there must be direct dialogue between exchanges and the Commission on issues facing the exchange markets. Absent that dialogue, I fear the Commission could end up doing its level best in addressing yesterday's problems - not much help to an ever-changing industry.
In my view, there is no question that the Commission can and should consider the issues presented in the exchanges* petition. To do so thoroughly, however, I believe the Commission must have the benefit of public comment and must encourage continued dialogue by Commission staff and the domestic futures exchanges. Therefore, I fully support publication of the specific and general requests included in the petition submitted by the exchanges.
The subcommittee also has asked for comment on the introduction of foreign trading terminals in the United States. As I told members of the Senate Agriculture Committee during my nomination hearing on May 5, 1999, the Commission, the regulated industry, and the public interest are better served by rules that are clear, that are not unnecessarily burdensome, that apply equally to all petitioners and that provide legal certainty to transactions. The more we use the no-action process to resolve questions concerning new trading systems and instruments, the more we contribute to legal uncertainty. The no-action process has its place, but in significant areas such as foreign terminals, reasonable, workable rules would prove to be a far-better long-term solution. I am hopeful that the no-action process will be an interim step toward providing legal certainty through the Commission*s promulgation of rules.
Page 80 PREV PAGE TOP OF DOC I thank you for the opportunity to testify before you on this most important issue, and I look forward to responding to any questions you may have for me.
Testimony of Barbara P. Holum
Mr. Chairman and members of the subcommittee, thank you for the opportunity to testify concerning the joint petition of the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange. The views I am expressing are my own.
In 1992, Congress in its wisdom granted the Commission authority under section 4(c) of the Commodity Exchange Act to exempt certain markets and products from the requirements of the act. This provided the Commission the necessary flexibility to allow market innovation and development. However, a conference report cautioned against using the newly adopted provisions to prompt wide-scale deregulation of the markets. As I have stated publicly, I remain committed to the principles of market integrity and customer protection and to preventing systemic risk so that our markets remain safe, sound and competitive in the evolving global marketplace.
There has been a dramatic change in the futures trading landscape, which can be attributed primarily to the proliferation of electronic cross-border trading vehicles. The Commission has played an active role in the continuing efforts of the International Organization of Securities Commissions (IOSCO) to promote international regulatory harmony and to prevent protectionist policies. In 1990, the Commission chaired the IOSCO committee, which wrote the original ten principles for the oversight of screen-based trading systems. In fact, the Commission for years has played a key role in IOSCO's efforts to develop international benchmarks for oversight of the global markets and to increase the coordination and cooperation among the various international regulatory bodies.
Page 81 PREV PAGE TOP OF DOC On June 25, 1999, three U.S. exchanges submitted petitions under section 4(c) of the act in response to the Commission's Order of June 2, 1999, lifting the moratorium on placement of foreign terminals in the United States. The exchanges seek authority to: (1) list new contracts without pre-approval, (2) adopt new rules 10 days after submission to the Commission without approval, and (3) adopt trading rules comparable to a competing foreign exchange's rules immediately upon notice to the Commission without approval.
Perhaps a chronology of events leading up to this point may be useful. In 1989, a U.S. exchange received recognition in the United Kingdom (UK) as an overseas investment exchange, which permitted that exchange to offer its products through electronic terminals located in the U.K. In May 1990, a U.S. exchange was permitted to place electronic trading terminals in France. In 1993, the Japanese authorities permitted a U.S. exchange to place terminals in Japan. Today, in 1999, U.S. exchanges have over 125 trading terminals in seven foreign jurisdictions.
By comparison, not until February 1996 was the first foreign country, Germany, permitted to place electronic trading terminals in the United States. In 1997, a moratorium was imposed on reviewing other applications for placement of foreign terminal in the United States. On June 2, 1999, the Commission lifted the moratorium and, on July 23, 1999, a U.K. futures exchange was permitted to place terminals in the United States.
Simultaneously with the lifting of the moratorium, the Commission determined to address the regulatory parity issues facing our U.S. exchanges. To that end, the Commission's Global Markets Advisory Committee, which I chair, appointed an ad hoc Committee on Regulatory Parity to form specific recommendations. The ad hoc committee adopted three resolutions to address regulatory parity and presented a report to the full GMAC in July 1999. It is significant to note that the GMAC is comprised of 30 members representing U.S. exchanges, financial intermediaries, market users, the National Futures Association, the Futures Industry Association, the Managed Funds Association, and attorneys representing foreign and domestic market users, among others. The primary mission of GMAC is to obtain input on international market issues that affect the integrity and competitiveness of U.S. markets. The committee's report and resolutions, along with comments received at the full GMAC meeting, will be presented to the Commission for its consideration.
Page 82 PREV PAGE TOP OF DOC This series of events, roughly covering a ten year period, now brings us to the exchanges' section 4(c) exemption petition, which is substantively similar though not identical to the ad hoc committee resolutions. The issues raised by the exchanges' petition present important and fundamental policy questions, which we are considering carefully.
The United States boasts the safest and soundest futures markets in the world. I believe, and many agree, that this can be attributed to a regulatory regime that is grounded in the principles of market integrity, financial integrity and customer protection. In the course of discussion at the various GMAC meetings, brokers, traders and end-users alike have indicated that they would oppose radical deregulation of the exchange-based markets. At the same time, our markets have evolved and in fact may not need many of the regulatory safeguards designed for a different market serving a different customer base.
As a Commissioner and as Chairman of GMAC, I am committed to do whatever is required to ensure that our exchanges remain competitive. Our exchanges have been and should remain at the forefront of this industry. We cannot stop the technological advances that are rapidly redefining the way the industry does business. As we enter the next millennium, we must not attempt to micro-manage our markets. Such an approach could stifle innovation, impede productivity, create regulatory gridlock and harm U.S. competitiveness.
With reauthorization of the Commodity Exchange Act now underway, it is an optimal time for all of us to consider whether broad revision of regulatory mandates would constitute an appropriate response to the changing competitive landscape of the global marketplace.
Thank you. I would be pleased to answer any questions members of the subcommittee may have.
Testimony of Mark D. Young
Page 83 PREV PAGE TOP OF DOC Chairman Ewing, members of the subcommittee, I am Mark Young, a partner in the law firm of Kirkland & Ellis, appearing today on behalf of the Board of Trade of the city of Chicago. Board of Trade Chairman David Brennan and Chief Executive Office and President Thomas Donovan regret that prior business commitments have prevented them from appearing here in person. The subject of today's hearingthe petition for regulatory relief filed by the three major U.S. futures exchangesraises critical issues for the Board of Trade and all U.S. futures exchanges. The Board of Trade commends you, Mr. Chairman, for your diligent oversight and continuing interest in these matters.
On June 25, 1999, the Board of Trade, Chicago Mercantile Exchange and New York Mercantile Exchange filed with the Commodity Futures Trading Commission a petition for exemptive relief under section 4(c) of the Commodity Exchange Act. The petition seeks regulatory relief in three areas for U.S. futures exchanges. The Petition requests that these exchanges be allowed:
(1) to list new products immediately without prior CFTC approval;
(2) to enforce new rules immediately without prior CFTC approval (subject to a 10 day CFTC vetting period) and
(3) to put into effect immediately any trading rules necessary to respond directly to competition from any foreign exchange operating trading terminals in the United States.
Some may tell you, Mr. Chairman, that the genesis of this Petition is found in the CFTC's decision to grant foreign exchanges the right to locate computer trading terminals in the United States without suffering regulation as a U.S. exchange. Historically, that is not really true. The truth is that U.S. futures exchanges have been seeking the bulk of this relief since at least 1992 when Congress enacted section 4(c) to grant the CFTC power to exempt any futures contract from virtually any statutory provision consistent with the public interest. That exemptive power was designed, in the words of the 1992 Conference Report, to apply in a fair and even-handed manner to products and systems sponsored by exchanges and non-exchanges alike.
Page 84 PREV PAGE TOP OF DOC Yet, since 1992, the CFTC has never approved meaningful regulatory exemptions for exchanges. It isn't that the exchanges haven't asked. As early as 1993, the exchanges sought to achieve true autonomy and regulatory parity by requesting an exemption from most CFTC regulation for markets where only professionals would trade. That exemption would have paralleled an exemption the CFTC granted the swaps markets. The CFTC killed that exchange petition by inaction without offering any form of real rationale. Instead, it adopted the Part 36 pilot program, creating a substitute regulatory structure for exchange markets open only to professionals. Like the CFTC's recent agricultural trade options pilot program, no one ever tried to use Part 36 and it was, by all accounts, a dismal failure.
Over the years, listing new contracts and implementing rule changes without prior CFTC approval have been two consistent elements of the U.S. exchanges' campaign to modernize regulation. Up until now, the CFTC has resisted those changes, claiming that its prior approval of new contracts and rules provided essential, albeit unquantifiable, public protections. The Commission's case has never been strong. That is why the Chicago Exchanges included contract listings and rule approvals as two of the important areas Congress should address in any measure it enacts to reform the Commodity Exchange Act.
Today, the Commission's case is demonstrably weaker than ever before. What makes the Commission's case weaker? Foreign competition is one answer. After all, many foreign exchanges now regularly list new contracts or implement new rules without having to wait for prior government approvals. Thus, the relief that is sought in the Exchange Petition would bring U.S. regulation into line with modern regulatory systems adopted by foreign regulators for their exchanges.
In addition, derivatives markets continue to evolve rapidly and dramatically. They are global and largely professional. New technologies have shattered the regulatory molds based on old labels, thereby increasing competition by reducing barriers to entry and allowing new markets and products to avoid costly CFTC oversight. And the CFTC itself regularly tolerates new markets that compete with the U.S. exchanges without imposing any product restrictions or trading practice review on those new markets. At the same time, the CFTC sees nothing unfair in continuing to need to approve all U.S. exchange products and rule changes. That CFTC approach typifies the out-of-touch policies fostered by the current regulatory regime which, if unchecked, would lead to the demise of U.S. exchanges and the public benefits these centralized markets provide.
Page 85 PREV PAGE TOP OF DOC Consider these facts. Today a group called Blackbird or DerivativesNet offers an electronic trading system in interest rate swaps and forward rate agreements. Blackbird has 20 or so market participants. Each participant may list bids or offers on the Blackbird trading system that others may hit or lift to create an executed trade. The CFTC is aware of Blackbird's existence and its operations. Blackbird has made no effort to be approved as an exchange or comply in any other way with the CFTC's regulations.
Why? Under the CFTC's Part 35 Rules, swaps are exempt from virtually all requirements under the Commodity Exchange Act if all of four eligibility conditions are met. Blackbird must therefore meet all four tests to be exempt from the Commodity Exchange Act. One of those tests is whether its swaps will be entered into through what the CFTC calls a ''multilateral transaction execution facility.'' If so, the swaps are not exempt and Blackbird as the operator of the facility would be subject to the statute's regulatory requirements.
Is Blackbird a ''multilateral transaction execution facility?'' First, is it an execution facility? The answer is yes. Participants in the Blackbird system can execute trades against live bids and offers on the system. Indeed, that is the whole point of the Blackbird system. Second, is Blackbird's execution facility multilateral? The answer again is yes. Since any Blackbird participant can execute a trade against any other participant, the trading is multilateral, as opposed to bi-lateral where one central counterparty is always involved.
So Blackbird unambiguously is operating a multilateral transaction execution facility and should therefore be disqualified from relying upon the CFTC's swaps exemption. Has the CFTC advised Blackbird that it may not rely on the swaps exemption? No. To date, the CFTC has taken no action. That means Blackbird, barring CFTC action, is free to operate without complying with any of the statutory requirements exchanges must face.
What does that mean? As a practical matter in the context of the Exchange's Petition, it means Blackbird may list any new product and adopt any new trading rule all without any CFTC prior approval. Blackbird could even list the same kind of standardized and fungible contracts that are now traded on exchanges. If Blackbird as the new kid on the block, can be allowed to exercise that kind of autonomy and independent business judgment, why not the 151 year old Chicago Board of Trade? The CFTC offers no answer. But the existence of Blackbird and the CFTC's apparent indifference to the implications of its activities confirms that the CFTC does not believe it needs to pre-approve the new contracts or rules for all trading systems, just those of U.S. exchanges. No reason has been, or could be, offered to support imposing that kind of disparate treatment on U.S. exchanges.
Page 86 PREV PAGE TOP OF DOC The CFTC also has decided to allow foreign exchanges to locate computer trading terminals in the United States without requiring those exchanges to comply with the CFTC regulation U.S. exchanges must face. Fair enough? Only up to a point. Many foreign exchanges may implement new trading rules and procedures immediately without any form of prior government approval in their home country. That gives the foreign exchanges a potentially unfair advantage. Consider the following. Say a U.S. exchange develops a new trading innovation and submits it to the CFTC for prior approval. The foreign exchange monitors those CFTC filings, seizes the U.S. exchange's innovation as a good one, and adopts rules to implement it immediately. The resultat best the CFTC's review of the U.S. exchange's innovation gives the foreign exchange a head start; at worst, the CFTC disapproves the U.S. exchange's innovation and cripples its ability to compete.
Let me be clear here. The Chicago Board of Trade is not asking the CFTC to approve the new trading rules and practices of the foreign exchanges. All we are asking for is the same treatment foreign exchanges receiveno prior government approvals.
That request becomes even more critical when, and if, foreign exchanges locate trading terminals in the United States to compete directly with products traded on U.S. exchanges. Should that occur and should a foreign exchange adopt a trading practice that gives it a competitive advantage, a U.S. exchange must have the ability to address that competitive threat immediately. Our petition seeks that reform so that regulatory arbitrage won't decide market share. The merits of the marketplace will.
The CFTC has made some recent strides to remove regulatory restrictions in the product approval area. Specifically, the CFTC now is proposing to allow U.S. exchanges to list new products without prior CFTC review or approval subject to certain conditions. With the exception of those conditions, this is a significant action by the Commission. It is the first time the CFTC has acknowledged that exchanges, with every incentive to develop risk management tools the marketplace wants, can list new products for the market without prior government review or approval.
Page 87 PREV PAGE TOP OF DOC Of course, the CFTC's conditions are the problem. Condition One is the exchange must still submit to the CFTC an application to trade the already trading contract within 45 days. Condition Two is whenever a new contract is listed, the exchange must tell the world that the contract is listed but could be disapproved or changed by the CFTC at any time. Those two conditions place exchanges in an untenable competitive posture, and actually create additional risks for market users, rather than helping to manage it. Imagine two exchanges listing on the same day the same new contractone, a foreign exchange with terminals in the United States, the other, a U.S. exchange. The foreign exchange lists its contract's terms; the U.S. exchange, however, lists its new contract with the asterisk ''CFTC approval pending.'' Which one will market participants choose? Why would any firm expose itself or its customers to the legal limbo of a contract that the CFTC could modify or disapprove after a position is established? Why introduce regulatory arbitrage into the competitive equation at all? Again, the CFTC's proposed step-in-the-right-direction approach does not satisfactorily answer these questions.
The Exchanges' Petition should be viewed as an important step in our ultimate campaign to reform regulation under the Commodity Exchange Act. The Board of Trade continues to adhere to the legislative principles we endorsed in March with the Chicago Mercantile Exchange. All derivatives execution facilities and clearing facilities should be subject to CFTC oversight under a streamlined regime based upon performance standards, not agency mandates. We are not asking that any privately-negotiated, over-the-counter derivatives be CFTC regulated. Nor are we asking that any foreign exchange with terminals in the United States be subject to the same CFTC regulation we face. We accept those competitive realities. All we ask is that Congress and the CFTC give the exchanges an opportunity for fair competition, given those realities.
Mr. Chairman, for these and many other reasons, the Exchanges' Petition should be granted. It is simply a matter of fairness and equity. Yet to date, more than one month after the Petition has been filed, the CFTC has not even published the Petition for comment in the Federal Register. That is not fair. That is not equitable. If the CFTC is delaying publication in an effort to hold on to the old ways of doing business, that approach is intolerable . The financial world has changed and the CFTC must unbridle the U.S. exchanges to allow them to compete in that new world. We hope that these hearings will spur the CFTC to approve our Petition as an important first step toward modernizing U.S. derivatives regulation.
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Statement of Christopher Bowen
Mr. Chairman, and members of the committee, my name is Christopher Bowen. I am senior vice-president and general counsel of the New York Mercantile Exchange (NYMEX or the Exchange). NYMEX is the world's largest exchange for the trading of energy and metals futures and options contracts. I wish to thank you for the opportunity to participate in today's hearing on issues surrounding the Commodity Futures Trading Commission (CFTC or the Commission) and the Commission's ability to provide badly needed regulatory relief to U.S. futures exchanges. In particular, NYMEX, with the Chicago Mercantile Exchange and the Chicago Board of Trade (collectively, the Exchanges) jointly submitted a petition for exemptive relief pursuant to section 4(c) of the Commodity Exchange Act (act or CEA). We are grateful to Chairman Ewing and the members of this committee for their support and interest in seeing that the U.S. futures industry is not hamstrung by an outdated regulatory regime which inhibits its ability to respond quickly to the needs of today's global marketplace.
THE NEED FOR REGULATORY RELIEF
Regulatory relief, particularly the relief sought in the section 4(c) petitions filed by the Exchanges, is necessary for the U.S. exchanges to function effectively in an extremely competitive environment. Those sources of competition, the over-the-counter (OTC) derivatives markets and the foreign exchanges, and the regulatory treatment afforded both, require that domestic exchanges be provided with a regulatory framework that fosters innovation by permitting the Exchanges to respond quickly to changing market demands.
THE CHANGING COMPETITIVE ENVIRONMENT AND THE EXPERIENCE OF THE OTC MARKETS
In recent years, someone seeking to obtain a derivative product has been able to choose among a number of possible providers. These providers include firms operating in the OTC derivatives markets, foreign futures exchanges and U.S. futures exchanges. In many instances, these products have become increasingly similar. Indeed, transactions routinely occur in OTC markets for energy derivatives where the parties to the transactions will buy and sell a NYMEX look-alike, i.e., a product whose essential business terms mirror the terms and conditions of a NYMEX futures contract. NYMEX, which has been serving its customers for more than 125 years, strongly supports the right of market users in a free market society to make choices among products based upon their best interests.
Page 89 PREV PAGE TOP OF DOC However, while the derivative products offered by OTC markets, foreign exchanges and domestic exchanges are often very similar, the current level of regulation imposed on these three markets varies dramatically. In early 1993, the CFTC acted promptly to exercise the new exemptive authority granted to it by Congress in the Futures Trading Practices Act of 1992 and issued Part 35 to its regulations, which exempt eligible swap transactions from virtually all requirements of the act and of Commission regulations, save those pertaining to fraud and manipulation. In the 6 years since part 35 took effect, swaps markets have thrived.
EXPERIENCE OF THE FOREIGN EXCHANGES
More recently, CFTC staff issued a no-action letter that permits the London International Financial Futures Exchange (LIFFE) to place computer terminals for its electronic trading system in the United States. On July 23, 1999, the CFTC's Division of Trading and Markets issued a no-action letter to LIFFE that essentially permitted LIFFE to place computer terminals in the United States without registering as a U.S. contract market. At the same time, the director of that division issued a statement that suggested that its review of requests for no-action relief submitted by three other foreign exchanges would be completed within the next 21 days.
In the CFTC rule proposal that was withdrawn earlier this summer, the proposed rules pertaining to foreign terminals included a provision on comparability. Specifically, that proposal required demonstration that the petitioner's home country had established a regulatory scheme that was generally comparable to that in the United States and that provided basic protections for customers trading on markets and for the integrity of the markets themselves.
Although the proposed rulemaking was withdrawn, it is revealing that a tacit premise underlying the proposed comparability provision was the apparent recognition by the Commission that not all of the regulatory burdens currently imposed upon domestic boards of trade are truly necessary in order to provide basic protections for customers trading on markets and for the integrity of the markets themselves. This conclusion also appears to underlie the recent CFTC staff no-action letter to LIFFE.
Page 90 PREV PAGE TOP OF DOC Thus, at present, U.S. futures exchange face the daunting challenge of competing with OTC markets and with foreign exchanges while strapped with a heavy burden of regulation under an outmoded regulatory regime that is not imposed on these other providers of derivatives products. The weight of this regulation on the U.S. futures exchanges imposes additional costs on domestic exchanges. Of equal significance, the current level of regulation limits the ability of domestic exchanges to respond quickly to competition through innovative products and practices.
NYMEX believes that an important lesson can be learned from the experiences of the OTC markets. These markets have functioned outside of the traditionally defined system of regulation in an efficient manner and have significantly contributed to the promotion of the public interest without significant systemic problems. The greater freedom to design new products has permitted OTC markets to respond quickly to changing market demands. This principle is embodied in our section 4(c) petition.
THE NO-ACTION RELIEF PROCESS IS NOT APPROPRIATE
Several months ago, the CFTC issued proposed rules to establish a procedure for an electronic exchange operating primarily outside the United States to petition the CFTC for an order that would permit use of automated trading systems that provide access to the exchange from within the United States without requiring the exchange to be designated by the CFTC as a U.S. contract market. The proposed rules provided that the CFTC could issue an order under section 4(c) of the act that would have allowed a member of the exchange or an affiliate thereof to operate automated trading systems that provide access to the exchange in the U.S., subject to specified conditions.
In the Federal Register release for this rule proposal, the Commission noted the importance of the issues involved in the rulemaking, and stated its belief that it was not appropriate to grant interim relief either before the Commission's adoption of final rules or pending the Commission's review of a board of trade's petition. On this point, NYMEX agreed with the Commission. Because of the critical importance of electronic access to exchange markets, our strongly held belief is that there is a critical need for consistent standards in the process. In addition, NYMEX has also been concerned that an extended process of ad-hoc determinations by staff could further complicate the Commission's efforts to revisit this area in a later rule-making, particularly when such ad-hoc no-action letters are made in secret by staff without any opportunity for comment and scrutiny by the general public with regard to either the information submitted by foreign exchanges or to the structure of the letters themselves.
Page 91 PREV PAGE TOP OF DOC However, following the close of the comment period, the CFTC's rule proposal was withdrawn by the Commission. This action increased the concern among exchanges that the regulatory parity sought by U.S. exchanges might be eclipsed by speedy action by the Commission to allow the entry of foreign futures exchanges to the U.S. marketplace without addressing the needs of the domestic markets. Accordingly, the Exchanges filed their section 4(c) petitions with the Commission.
EXCHANGES SEEK REGULATORY PARITY THROUGH EXEMPTIVE PETITION
In the petition, the Exchanges seek regulatory relief in three areas:
1. Exchanges should be able to list new futures and options contracts without pre-approval by the Commission;
2. Exchanges should be able to adopt new rules and rule changes after submitting them to the Commission ten days prior to their taking effect; and
3. Exchanges should be allowed to implement trading rules and procedures comparable to those of a competing foreign board of trade, provided that the rules and procedures are limited to only the contracts that are in direct competition to those of the foreign board of trade.
ELIMINATION OF PRIOR REVIEW OF CONTRACT TERMS
Consistent with earlier testimony before this committee, in our petition for exemption, as outlined above, we seek the elimination of prior CFTC review of contract terms. Two significant reasons support the case for exemption. First, we believe strongly that each exchanges self-interest, including protecting against the reputational risk associated with problems involving its products, is a major driving force that ensures that its own processes will be detailed and thorough. If an exchange develops contracts that are not well-conceived or drafted, its credibility will quickly erode. More importantly, if it offers contracts that are susceptible to manipulation, its own members are as likely as any member of the public to lose from such manipulation. In addition, through its clearing function, the exchange puts its own capital on the lineand at riskas well. Second, in our experience, detailed CFTC review and approval of the specific terms and conditions of the contract has not been necessary, provides marginal, if any, value, and adds cost, uncertainty and delay to the roll-out of new contracts.
Page 92 PREV PAGE TOP OF DOC NYMEX conducts an intensive review process in developing a new contract that includes consultations with virtually all segments of the affected industry for that contract, consultations with the financial community and numerous forums for open debate in which reasonable views can be expressed and considered. The contract development process allows all potential users to protect themselves in ways that diminish the need or the utility of detailed CFTC prior review. The process allows potential users to shape the terms and conditions and voice their concerns over any provisions that they believe do not match cash market practices or other commercial concerns in areas where they have expertise. Of equal importance, the process allows for a full airing of the terms and conditions prior to trading.
All potential market participants are afforded the opportunity to educate themselves and to make their own decisions regarding whether to trade or not to trade a new contract. In view of the powerful economic forces that drive exchanges to be thorough and vigilant in developing a new product, the Commission, in granting the exemption, should be confident in allowing exchanges to list contracts for trading and implement rules without detailed prior review. In this regard, NYMEX finds it significant that CFTC staff issued a no-action letter to LIFFE even though British exchanges are not subject to a pre-approval process for their contracts and rules.
ELIMINATION OF PRIOR REVIEW FOR CERTAIN RULES AND PROCEDURES
Again, as noted in prior testimony before this committee, we recognize that futures contracts provide a price discovery function, and the prices for these contracts are widely disseminated. Accordingly, such trading affects the public interest, and the CFTC has a role to play in safeguarding certain regulatory concerns. We continue to believe that the extent of CFTC-mandated jurisdiction over contract markets to impose and enforce standards and procedures, including reporting and record keeping requirements, and to require rules and products to be subject to its prior approval, should be founded on, and limited by, its primary statutory duties: to ensure financial integrity, customer protection, market integrity and price transparency.
Page 93 PREV PAGE TOP OF DOC Currently, any rule or by-law to be adopted by an exchange must pass through a CFTC filing process, a waiting period, and too frequently an extended review process. As it pertains to an exchange's fiduciary obligations of fair dealing and honesty that it owes to its customers and members governing equal access to the marketplace, the prudential management of risk, and the protections which assure that markets are free from manipulation and reflect fundamental value, we accept the role of the Commission. Under the proposed exemption, the Commission would have the authority to stay or delay rules if a finding was made that the rule would be subject to fraud, would render trading readily susceptible to manipulation, or would threaten the financial integrity of the market.
On the other hand, innovative trading practices developed by an exchange should not be subject to prior review. These activities or practices by the exchange, which do not implicate the core protections mentioned above, should be free from Commission oversight and should be left to the discretion and sound business judgment of the exchange so long as such activities and practices are fully disclosed to the public.
In granting the requested exemption, we believe that the Commission would strike the appropriate balance in terms of maintaining the agency's core mission, while also providing exchanges with badly needed flexibility. The reform, as embodied in the Exchanges' exemption petitions, would retain CFTC's historical role as a true oversight agency and at the same time would provide exchanges with flexibility to adjust their markets so as to remain attractive to what is a predominantly institutional customer base.
REGULATORY EQUILIBRIUM WITH FOREIGN BOARDS OF TRADE
The third critical component of the petition would allow domestic exchanges to address direct regulatory disparities with foreign boards of trade that list contracts available to U.S. customers that are directly competitive with contracts offered by U.S. exchanges. Under the terms of the proposed exemption, exchanges could implement trading rules and procedures comparable to those of the foreign board of trade immediately upon submission to the CFTC of:
Page 94 PREV PAGE TOP OF DOC The text of the rules and procedures being adopted; and,
Certification that the foreign board of trade employs comparable rules and procedures for trading a contract which is directly competitive to a contract offered on the domestic exchange.
Granting the Exchanges' exemption request would avoid a potentially damaging situation for U.S. exchanges where a foreign board of trade, with a much more flexible regulatory environment, could seek to exploit that advantage by implementing innovative trading practices designed to capture U.S. business or by launching a contract which directly competes with that of the domestic exchange.
EXISTING ATTEMPTS TO ADDRESS REGULATORY PARITY ARE INSUFFICIENT
While NYMEX recognizes that the CFTC has taken steps to address the regulatory parity issue, we respectfully submit that these efforts are not sufficient or make no guarantee of speedy relief to the Exchanges. Two recent Commission efforts are of note.
On July 27, 1999, the Commission published in the Federal Register for public comment a proposed rulemaking that would establish a 2-year pilot program under which exchanges could launch a new futures or option contract one day after providing notice to the Commission. The comment period on this proposed rulemaking ends on August 26, 1999.
This proposal represents a significant departure from the Commission's prior position that contracts must be reviewed and approved by the CFTC prior to being listed for trading. NYMEX believes that this proposed rulemaking may be suggestive of a greater willingness to work with the industry to address a badly outmoded regulatory regime. When viewed in this light, this proposal may be seen as good first step.
A full analysis of this proposed rulemaking would fall beyond the scope of the current hearing. However, it is worth noting that this proposal, if enacted in its present form, contains a number of restrictions, conditions and limitations that would severely undercut the attractiveness of using the new program. First, under this pilot program, exchanges would still need to apply for Commission approval within 45 days of the launch, and Commission approval would still be necessary to continue trading the contract. The time frame for Commission review and approval would depend upon the nature of the contract; however, in some circumstances, Commission review could continue for 180 days (and even longer if requested by Commission staff). Second, under the pilot program, an exchange could not list any contract months for futures or option contracts for trading where either the delivery month or the option expiration, as applicable, would be beyond one year. Third, amendments to contracts would still require prior CFTC approval.
Page 95 PREV PAGE TOP OF DOC Finally, as noted, the proposal makes clear that this would be a two-year pilot program. Accordingly, there would be no assurance that the pilot program would be continued at the end of that time frame. In addition, the Commission has not provided guidance on how it would evaluate the pilot program. Taken together, these restrictions and limitations could create considerable uncertainty concerning whether a contract would be approved by the CFTC and whether the CFTC might dictate amendments in the terms of the contract that could affect the valuation of the contract. This level of uncertainty also may well affect the viability of a new contract.
Moreover, a recommendation regarding relief to the domestic exchanges has been presented to the Global Markets Advisory Committee by a subcommittee of that group. While we support the efforts of the subcommittee, to date no action has been taken and it is unclear how the CFTC will treat these recommendations and whether the CFTC has developed a timetable for action.
We note that similar concerns have been expressed by this committee. As you know, Chairman Ewing and members of this committee sent a letter to Acting Chairman Spears on July 1, 1999 concerning the issuance of no action letters to foreign boards of trade wishing to establish electronic terminals in the United States. In that letter, the committee summarized many of the Exchanges concerns when they wrote:
We are concerned that the issuance of such no action letters from the CFTC will leave U.S. futures exchanges at a competitive disadvantage. Our apprehension does not result on the issue of foreign futures exchange access to the U.S. markets but rather from the fact that the CFTC is effectively endorsing a level of less regulation for foreign exchanges which is not available to U.S. exchanges . . .
We share your concern and we hope that the CFTC will act decisively on our section 4(c) petition and that the CFTC will move with the same expeditiousness that is now shown in the review of no-action requests by foreign exchanges.
Page 96 PREV PAGE TOP OF DOC NYMEX is dedicated to continuing to enhance our future ability to serve effectively and efficiently a demanding marketplace. However, under the present regulatory regime, a pressing need exists for modernizing the current system of regulatory oversight, both in the domestic marketplace and in areas where actions in foreign boards of trade have the potential to affect United States commerce.
We urge this committee, the Commission, and the Congress to provide urgently needed flexibility to exchanges to develop and provide innovative risk management products and trading methods, and to support harmonization of the regulatory structure over foreign boards of trade offering instruments with pricing impact in United States commerce. The Commission is in a position to address a crucial need by expeditiously approving the exchanges' exemption petition.
Mr. Chairman and Members of the committee, NYMEX thanks you for your consideration and pledges its full support to work with you and your staff to address these issues and any others that may be of concern to you.
Testimony of Jerrold E. Salzman
Mr. Chairman, members of the committee, I am Jerrold Salzman; I have represented the Chicago Mercantile Exchange since 1967 and have participated, on its behalf, in all of the legislative debates that have shaped the Commodity Exchange Act. I am testifying today in place of Scott Gordon, chairman of the board of directors, who asked me to express his regrets that he was unable to attend. On May 19, 1999, Scott Gordon presented the Exchange's views on the implications of rapid, inexorable shift from localized, floor based exchanges to international electronic exchanges
Competitive Inequities: His theme was the staggering competitive costs and consequences of over enthusiastic local regulation in the age of international electronic exchanges. Five years ago, when exchanges were real-estate-bound aggregations of market makers, the coincidence of the natural business day with the logical trading day for local products created a strong home court advantage. Eurodollars and U.S. Treasury Bonds were going to be traded on a U.S. time zone exchange. Competition might come from the over-the-counter market, but foreign exchanges had no chance at the U.S. product base. Cheap communications, dispersal of market makers and replacement of skilled brokers with simple algorithms ended the local monopoly and inspired international competition.
Page 97 PREV PAGE TOP OF DOC The dominance of U.S. futures exchanges has eroded. Their ability to compete with the over-the-counter (OTC) market, markets governed by other regulators and foreign exchanges has been hampered by U.S. regulatory policy. The OTC market is happily selling its customers futures on individual stocks and customized narrow indexes. Option exchanges permit their customers to acquire synthetic futures. Futures exchanges have been stymied.
Foreign regulators have quickly and accurately balanced legitimate business needs against customer and market protection. Clever foreign regulators crafted their tax and regulatory policies to capture business. In London, recognition of the realities of international business flows combined with a ''benign political attitude permits an accommodating tax and regulatory framework and a relatively predictable and sensible legal system.'' London's exchanges have been freed from the pre-approval process. Singapore's regulator expedites approvals when international competition is at stake. U.S. exchanges have been kept waiting for regulatory relief. In contrast to its treatment of U.S. exchanges, the CFTC speedily exempted most of the OTC derivatives market from oversight and regulation immediately after authorizing legislation in 1992.
Chairman Gordon tried to convince this committee that the Commodity Futures Trading Commission should not permit foreign exchanges to operate electronic exchanges in the United States unless U.S. exchanges can compete on an equal footing. This is not a new goal. It is perfectly consistent with the clearly expressed intent of Congress dating back to 1982. In connection with the 1982 CEA amendments, Congress stated its intent that the Commission adopt rules to protect all United States residents and that any regulations adopted not result in either domestic or foreign products having a competitive advantage over the other. S.Rep.No. 384, 97th Cong., 2d Sess. 46 (1982). Further, the Senate Committee on Agriculture, Nutrition, and Forestry concluded that ''[i]n instances where a foreign exchange competes in the U.S. market with domestic futures contracts, the adoption of regulations governing foreign futures should diminish any competitive advantage which a less extensively regulated foreign product may have over domestic futures contracts.'' As a short term solution, Scott Gordon urged that the Commission be forcefully reminded to exercise its power under section 4(c) of the Commodity Exchange Act simultaneously with any action paving the way for the admission of foreign exchanges. The long run solution is to use the legislative reauthorization process to rationalize the Commission's authority.
Page 98 PREV PAGE TOP OF DOC Exchange 4(c) Petition: In conjunction with the Chicago Board of Trade and the New York Mercantile Exchange, we crystallized our position in a formal petition to the Commission. On June 25, 1999, we wrote to Acting Chairman Spears:
Dear Chairman Spears:
The Chicago Board of Trade, Chicago Mercantile Exchange and New York Mercantile Exchange (collectively, the Exchanges) are submitting the enclosed petition to the Commission pursuant to section 4(c) of the Commodity Exchange Act. This petition is made in response to the Commission's order dated June 2, 1999, which instructed CFTC staff ''to begin immediately processing no-action requests from foreign boards of trade seeking to place trading terminals in the United States.'' That order also committed the Commission ''to simultaneously initiate processes to address the comparative regulatory levels between U.S. and foreign electronic trading systems so as not to provide one with a competitive advantage.''
The Exchanges need the regulatory relief requested in this petition in order to compete on equal terms with the foreign boards of trade that will be able to offer competing products via direct electronic access to persons in the United States. The petition seeks exemptive relief in the following areas:
The Exchanges should be allowed to list new contracts for trading without Commission pre-approval.
The Exchanges should be allowed to adopt new rules or rule changes upon submitting them to their members and to the Commission 10 days in advance of their effective date.
The Exchanges should be allowed to implement trading rules and procedures comparable to those of a competing foreign exchange, provided that such rules and procedures apply only to the contracts that are subject to direct competition from the foreign exchange.
We understand that the Commission is acting swiftly in considering the no-action requests made by foreign boards of trade to place trading terminals in the United States. We believe that immediate action on this petition is essential. If the Commission permits foreign exchanges to install trading terminals in the United States before the Exchanges achieve regulatory parity, the Exchanges would be placed at a severe competitive disadvantage.
Page 99 PREV PAGE TOP OF DOC Our request and petition have been ignored. Since Scott's testimony, the Commission acted favorably on LIFFE's no-action request despite obvious questions about its authority to forego the normal exemptive process. It has yet to publish the exchanges' 4(c) petition for public comment.
Rather than give the U.S. exchanges the real relief sought by their petition, the Commission has offered its own solutions, which create the appearance of positive movement, but which fail to resolve the deep competitive concerns that drove the exchanges to seek relief.
New Contract Applications: The Commission's proposal for new contract applications represents a significant departure from its dogma that new contracts must be approved in advance. This implicit recognition that exchanges and market users are the best judge of the merits of new contracts is, unfortunately, hedged in a way that impairs its value.
It is a 2-year pilot program, with no assurance that it will be continued or expanded when it is due to expire and with no explicit evaluation criteria.
The new contract application process is merely delayed for 45 days. CFTC approvalbased on its arbitrary standardsis still required. The threat that a listed contract might be disapproved or amended perpetuates the competitive problem. The market is unlikely to embrace a new concept shrouded in a cloud of legal uncertainty.
The exchange may not list any contract months for trading that are more than one year out until the CFTC approves the new contract.
Contracts listed under the pilot program could not be amendedeven for minor tweakswith prior CFTC approval.
Amending Contract Terms: The Commission has adopted expedited procedures for reviewing certain amendments to contract terms. The current proposal modifies those procedures in minor ways. The proposal expands the categories of rule amendments eligible for automatic approval to include routine changes to an index (other than a stock index) compiled by a third party; typographical, renumbering and other types of non-material changes; certain changes to trading hours and trading months; and certain changes to discretionary option strike price listing procedures. Although the CME welcomes any movement in the direction of eliminating CFTC pre-approval of rule changes, the categories being proposed for automatic approval are so limited that only rule changes of trivial importance will be affected.
Page 100 PREV PAGE TOP OF DOC All other amendments to contract terms and conditions will continue to require some degree of CFTC review before they can become effective. Depending on the nature of the amendment and whether the CFTC deems that the amendment raises novel or complex issues, the review period can be 3 days, 10 days, 45 days, 75 days or 180 days. The inability of U.S. exchanges to amend their rules promptly to meet a competitive threat places them at a severe disadvantage to their less-regulated competitors.
Worse, the CFTC's current rule approval procedures have consistently rewarded imitators at the expense of innovators. By the Commission's own admission, the U.S. exchanges have been the chief innovators, with foreign exchanges merely applying U.S.-made concepts to their local markets. The so-called expedited procedures for new contracts and rule amendments make it easy to clone an existing product, but have done little to speed the process of innovation. The CFTC's most recent proposals are more of the same. An innovative new concept will face legal uncertainty for an undetermined period of timethe CME's Eurodollar FRA futures application recently took 357 days to be approvedbut once approved cam be mimicked in ten days or less.
Exemptions, No Action Letters and Blind Eyes: The Commission's penchant to exempt everyone from its regulatory grasp other than the exchanges that have had the historical misfortune to have been ''designated contract markets'' will devastate those exchanges. In addition to the OTC market and foreign exchanges, a number of electronic derivative exchanges are operating or about to begin operations in the United States without registration or exemption from registration. It is appropriate to think of these as stealth exchanges since the first of the breed arrogantly named itself after the secret spy plane, Blackbird.
These new exchanges are taking advantage of the obvious reluctance of the Commission to put itself in a position where it might again be criticized for trying to expand its jurisdiction. The Commission is still smarting from the adverse reaction to its OTC Concept Release and its proposed foreign terminal rules. There is, however, a very substantial difference in this case. The CEA clearly requires the Commission to shut down any derivative exchange that is neither exempt under 4(c) nor designated in accordance with the statute. This is not a discretionary duty. Yet the Commission is so gun shy that the claim that the products traded are not futures, but standardized swaps and derivatives, has been enough to induce paralysis. The simple fact, however, is that the CEA applies to all contracts of sale of any commodity for future delivery. It doesn't matter if it is called a swap, a derivative or a future.
Page 101 PREV PAGE TOP OF DOC A Solution: One year ago, the Chicago Mercantile Exchange, with the Chicago Board of Trade, undertook to craft Amendments to the Commodity Exchange Act that would resolve this definitional problem and afford every segment of the U.S. derivatives industry a fair chance to thrive in the Twenty-First Century. We proposed five principles and a long list of detailed proposals. With much work we were able to find a way to rationalize the CEA to restore internal consistency in concert with sound public policy. Within our framework, each segment of the industry, other than security exchanges, got exactly what it had been publicly seeking. Our proposal went farther than the OTC request for codification of the swaps exemption. We proposed that privately negotiated swaps could be cleared without losing their exemption. We were diligently following advice of congressional leaders that we needed to gain sufficient support from the derivatives industry to insure passage of much needed reform legislation.
Initially, the principles we proposed were widely accepted and the details were intensely discussed for the purpose of fine-tuning. Our goal seemed attainable. Lately, there has been a major loss of momentum in the process. During the course of two roundtables organized by Chairman Ewing, we have come to understand the resistance to our proposal. You see, we classified exchanges that would be subject to CFTC jurisdiction in a fair and logical fashion. We then proposed a level of regulation that would permit such exchanges to operate in a true business-like fashion with sufficient oversight to protect any important national public policy concerns. The rest of the industry initially accepted the approach because it only seemed to apply to the traditional futures exchanges.
But technology has changed everything. The traditional futures exchange was a brick and mortar edifice with shouting traders, milling clerks and flashing quote boards. We haven't had a new exchange like that since 1986. Modern exchanges are incorporeal. The only reminder of the past is the flashing quotes and now those are on our computer screens, not wallboards on the floor surrounding a trading pit.
Page 102 PREV PAGE TOP OF DOC It is now within the grasp of most financial institutions to acquire and operate trade execution systems that duplicate the trading function of exchanges. Free standing clearinghouses stand ready to process and guarantee the executed transactions. As a result, every broker, dealer, Internet site operator and trade association seems poised to create an exchange or join and expand the operation of an existing exchange. There is a major story almost every day announcing a new alliance to operate an exchange or a quasi exchange.
The same firms that applauded the proposed level of regulation for the existing derivative exchanges are aghast that they would be subject to CFTC jurisdiction and regulation if they create their own electronic exchanges. Thus we have been treated to a bizarre spectacle as every segment of the derivatives industry tries to explain why its proposed or projected exchange is not really an exchange and should not be treated like the CME, CBT or NYMEX. It is time for reform of the CEA that will treat all exchanges consistently and permit business to thrive.
Thank you again, Mr. Chairman, for the opportunity to explain our position on these complex and important questions.
August 12, 1999
THE HONORABLE THOMAS EWING
Chairman, Subccommittee on Risk Management
Research, and Specialty Crops
Committee on Agriculture
Washington, DC 20515
DEAR CHAIRMAN EWING:
The Board of Trade of the city of New York, Inc. (NYBOT) appreciates this opportunity to submit testimony for the August 5, 1999 subcommittee hearing record regarding the authority of the Commodity Futures Trading Commission (CFTC) to provide U.S. futures exchanges regulatory relief.
Page 103 PREV PAGE TOP OF DOC The CFTC has a great deal of flexibility to address many of the regulatory concerns expressed by exchanges. In particular, for years exchanges have asked that they be allowed to list a new contract, issue rules and amend rules without prior CFTC approval. On July 27, 1999 the CFTC proposed to use its section 4(c) exemptive authority to establish a 2-year pilot program to allow designated exchanges to list for trading new contracts without waiting for CFTC approval. This proposal is an important step forward. However, the exemption has so many conditions that it is of limited practical value.
An exchange would be permitted to list a contract for trading before it is approved by the CFTC, with the caveat that listing would be ''pending CFTC approval.'' The exchange would have to file for contract designation within 45 days of listing; the CFTC could refuse to approve or require alterations to the contract*s terms and conditions in order to gain approval; changes required by the CFTC could be applied to months with open positions; and amendments to contracts listed under the pre-approved procedures could not be implemented without going through the regular, lengthy CFTC rule approval process. With such uncertainty surrounding a new product, it would be nearly impossible to attract business. Therefore, it would be impractical for an exchange to try to launch a new contract under this proposed process.
The conditions and limitations in the July 27 proposal contrasts with the CFTC's broad exemption from nearly all the provisions of the act granted to swap transactions. The swap exemption was approved immediately after the CFTC was granted section 4(c) authority, while time and again the CFTC has not been willing to use its exemptive authority to provide a level playing field for exchanges. Thus, we can only conclude that it will take congressional action to alter the CFTC's role from that of ''front line regulator to an oversight agency,'' as you have suggested, and the NYBOT endorses.
The CFTC could have approached the July 27 proposal very differently. It could have proposed to grant relief to an exchange that meets certain market surveillance, trade monitoring and other criteria, by letting such an exchange list new contracts without CFTC approvalnot ''pending'' CFTC approval. By such action, the CFTC would not have lost oversight authority. Among other things, it would have maintained its power under aection 8a(7) of the act to alter or to supplement any exchange rule to the extent found necessary or appropriate.
Page 104 PREV PAGE TOP OF DOC In the July 27 proposal the CFTC states that it has found that ''appropriate contract design is the best deterrent to market manipulation, price distortion or market congestion and that contract approval assures that contracts meet these widely-accepted design criteria.'' We do not agree.
First, although contract design is important, it is not the ''best'' deterrent to manipulation. An effective market surveillance system at an exchange is the best way to avoid manipulation. Thus, it is most important that an exchange has a self-regulatory track record to ensure that trading will be conducted in a fair and orderly manner.
Second, it is in an exchange's self-interest to design the best contract possible. The NYBOT conducts extensive research and consultations when deciding whether and how to design a new product. We look at cash market practices, the interests and needs of potential market users, pricing patterns, deliverable quantity and historical information on production and consumption. Our goal is to develop a product that can be used effectively by a wide range of market usersa necessary ingredient for a successful market.
Third, all new product initiatives must receive the approval of our Board of Directors comprised of experienced world leaders in commodity trading as well as a core of public directors. Their review and approval of a new product ensures its structure is consistent with cash marketing practices.
Fourth, in our experience public comments received by the CFTC and the CFTC's own review typically do not identify problems with contracts. However, the comment period can provide competitors an opportunity to try to delay approval or to express other disagreements that are not relevant to whether the contract can be manipulated.
The NYBOT has a keen interest in eliminating the prior approval and contract designation requirements. Our coffee, sugar and cocoa markets have faced significant international competition for decades. Our main competitor is in the United Kingdom (U.K.), where exchange contracts can be listed or changed and rules can be enacted without prior regulatory approval. Although an exchange may discuss a new product with its regulator before the product is introduced, there is a big difference between the informal discussions in the U.K. and the formal CFTC contract designation and rule approval process. With the U.K. system, because there is no public review process, the proprietary interest of the exchange is not jeopardized. Nor is the contract introduced ''pending approval'' of the U.K. regulator.
Page 105 PREV PAGE TOP OF DOC Striking a balance between exchange self-regulatory duties and CFTC oversight authority must apply to all contract marketswhether agricultural, energy, metal, financial or any other type of commodity. The Federal Reserve Board assessed the character of a futures contract when it had to decide whether to allow bank holding companies to own futures commission merchants (FCMs) engaged in agricultural futures. The Fed concluded that futures are financial instruments no matter what the underlying commodity, and thus bank ownership of FCMs was allowed. We urge the subcommittee to consider futures as financial instruments that are not differentiated in their regulatory treatment due to the nature of the underlying commodity.
Similarly, we are concerned about a trend at the CFTC to expedite review of cash-settled contracts, while subjecting contracts with delivery terms to a longer review process. Currently, for example, cash-settled contracts are eligible for the CFTC 10-day fast track approval procedures, while contracts with delivery terms are not. Differentiating regulatory treatment of futures contracts based on settlement features is not justifiable.
Mr. Chairman, thank you for considering the NYBOT's remarks as you proceed with the development of legislation. We appreciate the painstaking review you have undertaken as part of the CFTC reauthorization process.
JAMES J. BOWE
President and CEO