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U.S. House of Representatives,
Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to notice, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives King, Lucas, Manzullo, Biggert, Kanjorski, C. Maloney of New York, J. Maloney of Connecticut, Mascara, and Jones.

    Chairman BAKER. Good morning. I would like to call this hearing of the Capital Markets Subcommittee to order.

    I know that other Members have indicated they will be attending within a few moments. Mr. Kanjorski, the Ranking Member, has made it known to me he will be here within the next few minutes, and I thought, as best we could try to keep on schedule, we would go ahead and begin with our testimony.

    The purpose of this hearing this morning really is to begin an inquiry as to the effects—or potential effects—of technology on the delivery of banking products and effect on capital markets. The growth in internet access by consumers to products has been really rather phenomenal. Last year, for example, online trading accounted for about 35 percent of all customer transactions, up from about 15 percent only in 1997.
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    Of those banks which are now accessible via internet, about 40 percent of commercial bank assets and 60 percent of national bank assets are now accessible through internet means. In my own personal case, I maintain an internet bank account, simply because of the novel nature of it, and because of the ease of convenience. Traveling a great deal, you can set up the monthly automatic payment of your accounts.

    And I was first attracted to this by one of the early banks in Georgia, where you could actually pay up to 20 accounts a month for no service charge at all, which I found phenomenal. The consequence of this technological development for the consumer is indeed, I think, very, very appealing.

    Further, I have been told by those in the banking industry that activity engaging a teller within the bank lobby—these are very generalized figures—may cost as much as $1.30. When you do an ATM transaction, that average cost will drop into the mid-60, 65-cent range. And when you are doing it via computer that cost drops to about 4 cents.

    Given the extraordinary competitiveness in the markets today, it would seem very clear to me from a business perspective why the banking community would be very interested in seeing rapid deployment of internet access to banking services as well as securities activities.

    Compounding, however, the considerations of all the issues that are swirling around privacy, one of the biggest restraints in polling data from consumers is the concerns that once online, their accounts may not be properly protected or their personal information made easily accessible by an inappropriate party. And it seems to be the biggest restraint in escalating what is already phenomenal growth in this use.
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    And that gets me, I guess, to the point of this panel, is what the regulators may feel is an appropriate redirection in light of what could a very complicated transactional process, where someone accessing the internet to pay for a service, either a securities product or an insurance product located anywhere in the world, much less in the United States, and how that consumer would have recourse given a complication in an internet transaction.

    Further, I am also very much interested in knowing that our regulatory structure does not inhibit unnecessarily the growth of these services and products. It seems to me that this is the free enterprise dream, where any size institution and any consumer who has access to the computer, may truly be the ultimate shopper.

    I am not anxious to have my wife discover the phenomenal opportunities that exist with an internet banking account and all the shopping services that are already available. She is a master in the traditional methods already.

    So with that explanation, let me welcome our distinguished regulatory panel and introduce first the Chairperson of the Commodity Futures Trading Commission, Brooksley Born. Welcome back again, Ms. Born.


    Ms. BORN. Thank you very much, Mr. Chairman, and Members of the subcommittee. I very much appreciate the opportunity to testify concerning the changes that technological advances are bringing to the futures and derivatives markets and the ways in which the Commodity Futures Trading Commission is responding to them.
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    I ask that my written testimony be included in the record.

    Chairman BAKER. Without objection.

    Ms. BORN. Technological advancements are no doubt the single biggest source of change in the derivatives industry. Many foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems. As technological enhancements fuel the development of these systems, customers increasingly will gain access to these markets without having to trade through an intermediary, and the role of intermediaries may diminish.

    Technology is also contributing to changes in exchange governance and organization. New exchange ownership structures are emerging that are intended to improve exchanges' ability to engage in effective strategic planning and implementation. Membership organizations are being abandoned by some foreign exchanges in favor of public stock ownership, raising serious issues concerning whether such demutualized, profit-oriented exchanges can adequately continue to perform the self-regulatory role exchanges traditionally have played.

    In the face of these developments abroad, U.S. futures exchanges confront the question of whether open-outcry trading will remain a viable alternative in the 21st Century. It remains true that the very liquid and efficient trading floors in Chicago and New York can still execute more trades per minute than currently operating electronic futures trading systems. Moreover, U.S. exchanges are employing new technologies to increase the efficiency and to reduce the cost of open-outcry trading. Some exchanges and their members are experimenting with the use of automated order-routing systems, wireless communication, and handheld trading units. Advanced computer software is being used to enhance exchanges' market surveillance activities.
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    U.S. exchanges have also improved their existing electronic trading systems and have successfully integrated electronic and open-outcry trading in some contracts. The Chicago Mercantile Exchange pioneered this innovation when it offered concurrent electronic and open-outcry trading of the ''E-mini'' version of its S&P 500 futures contract. That development also opened the way for some firms to offer online trading access to the E-mini on Globex2, which is CME's electronic trading system. The Chicago Board of Trade also now features concurrent electronic and open-outcry trading in many of its financial contracts.

    New, fully electronic U.S. exchanges are also being launched. In September 1998, the Cantor Financial Futures Exchange became the first fully electronic-based U.S. exchange, trading four futures contracts on U.S. Treasury bonds and notes. When its recently adopted rule changes become effective, it will provide for direct electronic access by members and certain other traders. Another aspiring U.S. exchange, FutureCom, has not previously been designated as a contract market in any contract, but has an application currently pending before the Commission to become the first internet-based futures exchange in the world. Using the internet to transmit trade and financial information would facilitate direct access by the public and would result in the elimination of a significant role for intermediaries.

    The Commission has spent considerable time and effort in addressing the difficult and rapidly evolving regulatory issues associated with this technological innovation in the futures industry. The Commission must adapt its regulatory framework to accommodate a variety of proposed alternative trading systems, including internet-based exchanges, nonintermediated exchanges, and proprietary exchanges. At the same time, however, the Commission must ensure that it has sufficient regulatory tools to protect against fraud, customer abuse, market manipulation, and financial disruption in this new electronic age. The recent actions of the Commission in approving the CFFE electronic system and the side-by-side electronic and open-outcry trading at the Chicago Exchanges are a significant beginning in examining the regulatory implications of electronic trading.
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    While automated trading systems may diminish certain regulatory concerns that the Commission has relating to trading abuses in open-outcry trading, automated trading raises other regulatory issues such as system capacity and security, which are not applicable to the open-outcry environment. Similarly, the need for fitness standards and customer protection measures, which underlies the Commission's current registration scheme for commodity professionals may become less significant with greater direct access and diminished discretion associated with automated trading. I should caution that we have insufficient experience with electronic systems accurately to identify all of the risks they pose at this time.

    Technology today can effectively provide access from a customer's personal computer to trading on exchanges around the world. In response to these developments, last week the Commission issued proposed rules regarding the placement in the U.S. of trading terminals for foreign electronic exchanges. The proposed rules would provide an exemption from the contract-market-designation requirement and related requirements under the Commodity Exchange Act and the Commission's regulations to boards of trade established in a foreign country, which wish to make their products accessible from within the U.S. via automated trading systems, as long as such boards of trade are subject to generally comparable regulation in their home countries. Such exemption would avoid duplicative and inconsistent regulation, encourage other countries to allow access to the automated trading systems of U.S. exchanges, and stimulate global competition and open markets in the futures industry.

    Computerization has also facilitated the explosive growth in the OTC derivatives market. Some OTC derivatives market participants are now interested in the development of automated trading and clearing systems that would closely resemble the regulated exchange-traded markets. The Commission has just Tuesday of this week granted a petition from the London Clearing House requesting an exemption from the Commission's regulations to permit clearing of swaps transactions for the first time. The London Clearing House wishes to establish ''SwapClear,'' a proposed facility for clearing swap transactions that otherwise satisfy the terms and conditions for swap transactions under the Commission's regulations. Swap clearing operations may provide substantial benefits to the OTC derivatives market, including imposing controls on excessive extensions of credit, reducing counterparty credit risk, and increasing transparency.
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    As the OTC derivatives market continues to grow and evolves to resemble traditional futures and options exchanges, new regulatory concerns about the market arise, and increased parity and treatment of the OTC and exchange markets is needed. The benefits of functional market oversight apply equally to exchange-traded and OTC derivatives, even though the nature of and participation in the OTC derivatives market warrant a different degree or kind of regulation from exchange-traded derivatives markets.

    There is no basis to claim that entity-based supervision of OTC derivatives dealers alone is sufficient to oversee this market. While such supervision is very important to the safety and soundness of many of the large dealers, we cannot overlook the fact that many participants in the OTC derivatives market—including many hedge funds and other highly leveraged institutions—are not subject to Government oversight or supervision. Equally important, an entity-based regulatory approach does not provide oversight of the market generally, which may be particularly dangerous in a market that is currently as massive and opaque as the OTC derivatives market and that can be the source of systemic financial risk. Institutional supervisors quite properly focus on the trees, market regulators look at the forest. Both are necessary. This dual approach to regulation has been demonstrated to protect the public interest for more than 60 years.

    Thank you very much, and I would be happy to answer any questions Members of the subcommittee may have.

    Chairman BAKER. Thank you very much. We certainly appreciate your testimony.
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    Our next witness is the Commissioner of the Securities and Exchange Commission, Laura Unger. Welcome, Ms. Unger.


    Ms. UNGER. Thank you, Mr. Chairman. We call our place the Commission too. So just so you know. I do appreciate the opportunity to testify before the subcommittee on behalf of the SEC to discuss the impact of technology on the capital markets.

    As you indicated in your opening statement, technology has changed the world faster than many of us could have imagined, and continues to change it at a pace that is both exciting and daunting. More and more information is available to us every day. Nowhere can the effect of technological change be seen any clearer than in the securities markets. These markets handle trading volumes that were unimaginable a decade ago. Investors have benefited from these changes, both in terms of choice and in terms of cost. Investors have access to the markets more than ever before, and they have this access more cheaply and more efficiently.

    One of the most noteworthy results of the wide availability of new technology is the rise of online investing in the last five years. The internet is dramatically transforming how individual investors participate in the market. Estimates for the number of online accounts range anywhere from nearly four million to over seven million accounts.

    The rise of internet trading is all the more astonishing when you consider that the first online brokers did not appear until 1995. Today, about 14 percent of all orders entered occur online through any one of the hundred or so online brokers. Over 30 percent of the volume in NASDAQ and NYSE stocks result from trades entered over the internet.
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    However, the internet's impact on trading by small investors is much more pronounced. Nearly 37 percent of all individual investors trades are entered online, up from 17 percent in 1997. The internet has brought significant benefits to investors in terms of cost savings and access information.

    Online commissions have dropped 70 percent over the past two years, from an average of $52.89 a trade—they are not quite free yet—but they are $15.75. Retail investors are increasingly taking advantage of these low transaction fees.

    In a way, the internet is the wild card that makes it difficult to predict what the securities markets will look like five or ten years from now. By some estimates, 21 million will have online accounts by the year 2003. According to a study published in February 1999, the key economic factors that will have a large impact on the growth of electronic commerce will be ease and cost of access, convenience, and the appeal of mass customization.

    Despite changes in the way securities business is done, however, the fundamentals of the securities laws—competition, efficiency, and investor protection continue to be the same. By and large, technology has made achieving these goals even easier. It has also raised our expectation about what is possible.

    In the wake of these trends, our challenge and the securities industry's challenge, is to meet these expectations. The Commission recognizes these challenges and as a result I have begun to convene a series of roundtables to explore the impact of online trading on the markets and investors.
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    I will report to the Commission on my findings and we will work, as regulators, to ensure that our scheme of securities regulation will continue to promote the deepest and most liquid markets in the world, as well as the safest for investors.

    I thought it would be helpful to briefly outline some of the issues the Commission is facing right now, which might provide some insight into the future.

    We have observed at least three trends affecting the market resulting from online trading. First, as you know, customers can collect, sort, and analyze vast amounts of data with the internet. To a great extent, this is leveling the playing field in terms of information access between retail and institutional investors. The ability to receive information almost instantaneously has fueled an insatiable demand for it from investors.

    Research reports are quickly becoming a commodity that online firms must offer in order to compete. Investors also want access to real-time quote information to monitor their market positions. The internet gives investors the ability to customize the information they receive by using ''pull'' technology to set the parameters of their preferences.

    A second important trend is the convergence of discount and full service brokers. The popularity and affordability of online discount broker-dealers have made them formidable competitors to the offline world.

    A third trend is the rise of new market intermediaries. Nontraditional intermediaries, such as financial portals and chat rooms are competing with market professionals for investors' attention to become their ''destination of choice'' on the web.
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    So far, we have taken a number of significant steps to take into account changes brought about by technology. In November, the Commission issued a proposal under the Securities Act of 1993 which would allow companies to take greater advantage of many of the internet's benefits when offering and selling securities. The proposal would allow seasoned companies to talk freely to investors before they sell them securities. This is a sea change from the way the rules work today. Currently, issuers go into a ''quiet period'' before an offering for fear that any discussion will be viewed as an illegal offer or illegal prospectus otherwise.

    However, the wide availability of information on the internet makes it very difficult to impose an information blackout before an offer. The proposal would recognize this and permit companies to use the internet to broadcast their road shows to both retail and institutional investors, to hold ''chat room'' discussions about their offerings, and to use electronic mail to answer investors' questions.

    Last December, the Commission adopted a new regulatory framework for exchanges and alternative trading systems, which will take effect next month. The Commission believes that this new framework provides us with an appropriate means to regulate the securities markets as we enter the new millennium.

    It allows new competitors to take advantage of technological developments without being overly burdened by regulation. It links established competitors with significant volume to the national market system, and it enables existing exchanges to adopt business structures that may enhance their ability to respond to competitive challenges.

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    Because of the securities industry's increased reliance on technology, and of course the potential for problems associated with Year 2000, on March 2 of this year, the Commission proposed new rules regarding a firm's operational capability. The proposed rules would specifically require registered broker-dealers and transfer agents to have sufficient operational capability, taking into consideration the nature of their business, to assure the prompt and accurate processing of securities transactions as well as the transfer and processing of securities.

    In July of 1998, the Commission created the Office of Internet Enforcement to coordinate and oversee our existing efforts relating to the internet. Among other things, the office supervises our 125-person cyberforce who spend time each week surfing the internet looking for questionable securities-related activities.

    The Commission has brought 66 internet-related cases since 1995. We are seeing the old scams from the offline world migrate to the online world. The only difference now is that you can talk up a fraud much more quickly, broadly, and cheaply. However, you also leave footprints in cyberspace that make it easier for the Division of Enforcement to follow your trail.

    My written testimony has much more detail about the issues that I have touched upon today, and I thank you for allowing me to testify. And I look forward to any questions.

    Chairman BAKER. Thank you very much, Ms. Unger. We appreciate your testimony.

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    Our next witness is the Senior Deputy Comptroller for Economic and Policy Analysis, at the Office of the Comptroller of the Currency, Mr. James Kamihachi.


    Mr. KAMIHACHI. Thank you, Mr. Chairman.

    Mr. Chairman and Members of the subcommittee, I am pleased to represent the OCC at this hearing on the impact of technological advances on the financial services industry and capital markets. The policy implications of technology-driven changes in the financial sector deserve careful review. I commend you for holding this timely hearing.

    I am the Senior Deputy Comptroller for Economic and Policy Analysis. One of my responsibilities is to explore many emerging retail technology delivery systems banks are developing. In addition, I oversee staff with expertise in the models that banks use to measure and manage their financial risks. Those financial engineers participate directly in the OCC's exams of the most sophisticated national banks.

    Banks' new uses of technology benefit consumers as banking becomes more convenient and less costly. It also holds the promise of allowing banks to profitably serve more customers and of making our payments system much more efficient.

    Today, banks are investing in new technology as never before. Last year, the banking industry spent nearly $19 billion on information technology, outpacing both the insurance industry's $17 billion and the securities industry's $12 billion on information technology spending.
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    There is no question that technological innovation is changing the nature of the banking business. But the sheer volume of existing and emerging financial products and services makes it difficult to gain a clear picture. It is important to keep in mind that few technology-driven products have become ''breakthrough'' products, like credit cards and ATMs, that fundamentally changed the way consumers do transactions. The reason is that breakthrough products depend on the convergence of many incremental innovations, which typically occur over a long period of time.

    The dilemma facing Government is to avoid stifling innovation that creates the foundation for breakthrough products, while meeting its responsibilities to address market failures. Thus, public policy affecting the pace and impact of technological advances on financial services must be very carefully drawn.

    Where market failures arise, Government has a responsibility to act. As bank supervisors, our job is to prevent undue risk-taking to ensure a stable banking system. Our supervisory responsibilities include maintaining the safety and soundness of the national banking system, protecting consumers, and avoiding financial crime. In adapting our supervision to accommodate the sophisticated technologies banks use, we have increased our specialty training of examiners in this area. We are also hiring Ph.D. economists, bringing to twenty the number we will have to support examination teams, two for every three of the largest national banks. And we have issued guidance for banks and for examiners on risk management procedures for new technologies. For example, our broad guidance on technology risk management and on PC banking delineate the major risks that banks should think about. We have also issued guidance tailored to particular technology products or concerns, including electronic stored-value cards, credit scoring models, and on criminal threats to the information system infrastructure of banks.
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    In conclusion, Mr. Chairman, continuing technological innovations are crucial to the vitality of the banking industry. Bank regulators must meet their responsibilities to see that innovations do not compromise the safety and soundness of the banking system, that consumers are adequately protected, and that criminal activities are deterred. But in so doing, we must avoid unnecessarily distorting or hindering advances that could lead to marked improvements in how the system meets the needs of our economy and of our communities. The OCC is working hard to ensure that we understand new developments in financial markets, that we maintain the expertise needed to oversee new products and applications, and that we supervise effectively banks' management of technology risk.

    Thank you.

    Chairman BAKER. Thank you very much. We sure appreciate your participation this morning.

    Our next witness is the Director of the Division of Insurance of the FDIC, Arthur Murton. Welcome, sir.


    Mr. MURTON. Thank you. Mr. Chairman and Members of the subcommittee. I appreciate this opportunity to present the views of the FDIC on technology and the future of the financial services industry.
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    The application of technology to the delivery of bank products and services, as well as to the management of bank operations, has been a driving force behind many of the trends now shaping the industry. New developments in technology will open new opportunities for banks to expand their services. It will also bring competition and new sources of risk.

    The growing use of the internet for commerce will strengthen this trend. Most banking services are available online. Customers can pay bills, check balances, and transfer funds between accounts. Increasingly, bills will be presented online. While stored-value cards have met with mixed success so far, it seems hard to bet against the day when it is commonplace to download value from a PC.

    In addition to changing the nature of transaction services, it is likely that the internet will further sever the link between where people live and where they save and borrow. While people have shopped for CD rates over the phone for years, the ease and search capabilities of the internet could greatly expand this practice. Likewise, more and more people are obtaining mortgages and personal loans online.

    Technology also underlies financial innovation and the growing use of risk management models, both of which suggest a future where greater amounts of data and sophisticated analytics will be used by banks of all sizes to design new products and control their exposures.

    Technology is also driving globalization, industry consolidation, and the blurring distinctions among financial services providers. These trends taken together suggest a future industry that may be increasingly bifurcated, that is, a few large, complex institutions and a large number of small ones.
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    In many ways, these institutions may appear much as they do now. What could vary considerably, however, is the degree to which they can extend their electronic reach far beyond their physical branches. The trends underway pose challenges not only for managers of financial firms but also for policymakers and regulators whose job it is to ensure that the financial system continues to contribute to economic growth and well-being.

    The challenge is to allow the industry to evolve in response to market and technological developments while maintaining financial stability and public confidence. To ensure that the deposit insurance system keeps pace with these changes, the FDIC faces challenges in a number of key areas; resolving troubled institutions, supervision, and harnessing market forces to help its risk exposure.

    I would like to finish by discussing the last of these. As banks get larger and more complex, the case for supplementing supervisory risk assessments with market judgments becomes more compelling. One market approach that has received attention over the years is to require banks to issue subordinated debt. Under some proposals, deposit insurance premiums and corrective actions could be imposed on banks that cannot roll over their subordinated debt or could be tied to the rates that the market charges.

    Under these proposals, mandatory subordinated debt can be viewed as a way to generate market signals of bank risk and to provide an additional buffer between bank losses and deposit claims.

    To get a more direct measure of the risks it faces, the FDIC could enter into risk-sharing arrangements with market participants. Financial innovation has produced risk-sharing instruments such as credit derivatives and insurance derivatives that may provide models for this.
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    There are at least two potential advantages to a market-guided approach to deposit insurance. First, the pace of change in financial markets may leave little alternative to a market-guided approach. To the extent that the evolution of financial markets outstrips the evolution of the regulatory framework, the potential grows for counterproductive gaps between market and regulatory approaches to assessing risk.

    Second, as we learned from the resolution and liquidation efforts of a decade ago, well designed and well executed public-private partnerships can enhance the FDIC's ability to perform key parts of its mission, particularly when the tasks at hand are similar, if not identical, to tasks performed by the private sector. Assessing risk is one such task.

    The FDIC recognizes that the deposit insurance system must keep pace with the changes underway while maintaining the bedrock of public confidence we currently enjoy. We look forward to working with others to meet this challenge.

    Thank you.

    Chairman BAKER. Thank you, Mr. Murton.

    Ms. Born, I note with great interest the potential establishment of the first internet-based exchange and the consequences of that for the intermediaries. Do you think that the role intermediaries now play is vital to consumer protections, for instance suitability, as an example of concern. With the elimination of the intermediary, what does that represent in the way of risk to the consumer?
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    Ms. BORN. Well, the Commission is concerned about that, and that is part of the reason why the examination of FutureCom has taken some time. Also, of course, we have not had all the information we need from the petitioner who is asking for contract designation until very recently.

    It will create a nonintermediated exchange. The Commission's regulatory scheme has heavily relied on the fitness and ethics training and knowledgeability of futures-commission merchants, who are our registrants, to protect against fraud and other abuses in these markets.

    I am personally concerned. We have not yet had presented to us by the staff the FutureCom application, but I am sure that all the Commissioners will look very carefully at that aspect of it.

    Chairman BAKER. But given the huge success of the phenomenally large day-trading market, looking past the next five years, do you really think the floor-based exchanges can remain a competitive force in the market, given the power of this technology?

    Ms. BORN. I certainly think we are seeing tremendous shift from floor-based trading to more electronic-based trading. That certainly has happened abroad very quickly. It is beginning to happen in this country over the last four or five years. I think the fact that you have electronic trading doesn't necessarily mean there is no role for an intermediary.

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    The proposed rules we came out with on placement of foreign terminals in the United States, the terminals of foreign electronic exchanges in the United States, has an aspect to it that deals with what the role of an intermediary should be for regular retail customers who are trading on their own PC's. And it has a provision that is out for public comment now that would require that the transactions be controlled by the FCM in that there would be position limits or credit limits that the FCM would be imposing, that the FCM would be responsible to make sure that the system was secure and fit for its purposes, and a few other limited—but still, I think, significant aspects of intermediary activity.

    Chairman BAKER. Thank you.

    Ms. Unger, you indicated that some of the concerns for fraud that have existed in traditional markets now seem to be navigating their way through to the electronic market—but that footprints are created that make detection of that—or ultimately finding the responsible party—not necessarily easier, but it is a course that can be pursued. Do you have concerns, though, that there will be the casual retail investor entering into transactions which they don't fully understand the risk they are taking and forgetting the fraudulent or outright illegal conduct?

    The relationship between the casual ''I read a good article about company X,'' you know, ''I want part of the IPO,'' whatever it is it's the hot button for that given week—and markets are being affected where historically you couldn't have the vast movement of resources in such short periods of time that I'm afraid you can have now.

    And that the day-trader phenomenon is having an effect on valuation of markets. I am more concerned about that effect than I am fraudulent conduct in the overall e-trading environment.
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    Ms. UNGER. That's a loaded question, but I think I will start with separating the difference between online trading and day-trading. We at the Commission, and I think people in the industry, are beginning to really separate the two phenomena because they are really very different.

    Online trading is someone at their PC, you or I or your wife, trading in their account. And they are able to do it still through an intermediary, still through a broker, but they are able to place their trades whenever they want, at night or during the day, and those trades are executed in that account. They are paying less commission for that account at the discount broker.

    The full service firms are just beginning to enter that market, but now it is really dominated by the discount firms.

    Then there is the phenomenon of day-trading, where you have a whole different arrangement really. The individuals form limited liability companies. They trade, they pool their money because there is usually a cash requirement. They are able to avoid the margin requirements that way. Instead of a 50 percent margin requirement, there is no margin requirement because they are trading as a proprietary account as opposed to a retail account.

    There are a lot of sales—advertising, perhaps—misconceptions about the fact; or overzealous advertising, perhaps, that says, you know, ''anyone can come to this firm and we will make you money, lots of money. Just sit in the room. We will tell you when to trade. We will facilitate the capital that you need to make those trades. And this is what you need to make money.'' And sometimes they take a percentage of the commission.
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    So that is very different from online trading. With respect to day-trading, I think we are more concerned at the Commission about day-trading than we are about traditional online trading.

    They are very different issues that the Commission would look at in the context of those two types of trading activities. In the context of day-trading, you are right, we are not so sure that investors really understand the market well enough and the volatility that you mention, particularly in the area of internet-related stocks.

    It is kind of ironic, but it is the internet that is driving this in many respects, but it is people trading on the internet and trading intra-day that are part of this day-trading phenomenon that really want to get their hands on internet stock and they want to be the next investors in Amazon.com or something like that.

    So, there is a lot of volatility in that particular sector of the economy and in the market, and that is where they are focusing a lot of their money and attention in trying to make a quick profit off the intra-day swings in the prices.

    So we are concerned. Chairman Levitt put out a letter January 27—or a statement rather—that warned investors of the fact that you can lose money as quickly as you can make it, and that you really need to understand that if you put in an order for an IPO, for instance, and at the time you put in the order it's priced at $20, it could go up to $100 before your order is filled unless you put in a limit order.

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    So you need to be aware of things like that. And there have been instances reported in the press of that happening. So lot of it is education. And we are inspecting the day-trading firms and coordinating with the SROs to see and make sure that they are operating within the existing regulations.

    Chairman BAKER. My concern is that we have an enormously powerful economy and a lot of folks are pulling money out of traditional savings accounts to pump into the kind of environment the day-trading groups might promote, even borrowing money to engage in what they think is a train that has left the station and they don't want to miss the last car. And that with the certainty, I will say, of some downturn.

    I'm not saying that is going to happen this afternoon——

    Ms. UNGER. You are not saying a ''rational exuberance.''


    Chairman BAKER. That is correct. Just someone wakes up and certain circumstances occur where we have in Wall Street parlance a ''correction.'' I love that term. It means when you are losing your money it is a ''correction.''


    And we see, say, a 20 percent adjustment to the current market values, that I am worried about the public reaction when you have individuals who have, in fact, very much overextended themselves on the belief that this is their ticket out of their current economic difficulty. And some may be led to believe that they are insulated from loss.
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    I don't know on what basis individuals would make such a claim, but I am really worried about the level of understanding of individuals putting, for their particular financial circumstance, great money at risk for which they don't have the resources to absorb the loss when it ultimately does occur.

    Do you have any sense about—I know we have data indicating percentages of growth, and, you know, when you get down to $8 a trade, you are really getting down to a level where a lot of people are going to pay attention—do we have any idea who the world of this current new investment pool looks like? Where is the money coming from?

    Ms. UNGER. We do. We believe it is about 3,000 individuals who are engaged in these day-trading activities. And there are about a hundred firms that are conducting the day-trading activities as well. We can't—we don't regulate investors, unfortunately, although some people think that we should. We regulate the brokers. So what we are doing is, we are really concentrating our inspection efforts, and as I said, coordinating with the SROs, with the NASD, to go into and inspect these hundred or so firms, make sure they aren't violating the margin requirements, that there is adequate supervision, that there isn't a registration issue in terms of pooling together people's money, that their advertising is aboveboard and not fraudulent or misrepresenting the potential profits or whatever, and the suitability issue that was mentioned before, and that is where we are focusing our attention.

    But again, we were having a conversation in my office about this when setting up the next roundtables that we are doing. Saying, you know, ''Where were these people before? Were they day-traders participating in the investment community before? Were they different types of investors? What's the sort of personality profile?'' I think they were used car salesmen.
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    And, you know, we have seen students. I have read articles about someone who used to work at a taco stand. You know, they get on the internet and they make a few correct predictions and then they establish a following. And so it sort of snowballs.

    But what we can do is we can look at the firms and make sure that they are operating within the regulations, and we can go out there and be proactive in terms of investor education.

    And the more we can say about investor education, the better. And we do have information at our web site, like Chairman Levitt's statement is on our web site. And we are trying to go out there and say as much as possible. You know: ''If you put in an order and you press the button and you don't get your confirmation back right away, that doesn't mean that no one has gotten the order.'' And then people end up entering multiple orders because they don't understand how it works. Or the phenomenon, you know, the IPO, where it ends up, you think it's going to be $10 or $20 a share and it is $100 a share and you can't afford that.

    So those types of things we are trying to heighten awareness about. And I know Chairman Levitt has also raised that at town meetings and that kind of thing.

    But if you have any suggestions about how we can expand our scope of investor education, we would certainly be amenable to hearing those.

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    Chairman BAKER. I think I will get back to you later.

    Ms. UNGER. OK.

    Chairman BAKER. Mr. Kamihachi and Mr. Murton as well, as to technology and banking risk, do you sense that the explosion of technology and the access to internet-based accounts in any way creates a higher concern of risk to the system or is it just the opposite that because you are on the net that you do have footprints that are created that you can get in these institutions quickly or is transparency of what they are doing a real concern?

    Mr. KAMIHACHI. I think that is an important but very complex question. Where you are talking about consumers' access to their accounts to do transactions or to pay bills, that sort of thing, there are some fundamental differences between these retail accounts and wholesale accounts. For wholesale accounts, there is limited access to the system, but for retail accounts you have to open access or they wouldn't be effective. And so they are much more vulnerable to security break-ins. And that is one kind of concern that we have.

    Chairman BAKER. I really meant not only from that end, but from a regulatory standard looking into that internet-based account. There are banks that don't have a brick and mortar location. Does that internet-based financial institution really represent any new or different type of risk that a conventional institution would not present from a regulator's perspective?

    Mr. KAMIHACHI. In some respects, yes. In some respects, no. We only have one national bank that's been authorized so far, CompuBank, that operates on an internet-only basis. One thing bankers tell us is that if you operate only on the internet, your customer base can be different. The customer who can't get a loan face-to-face in their hometown tries over the internet. Of course, you have some people who are just seeking better rates, better deals. You have to have much more careful credit controls in an internet situation.
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    Security controls and reliability can be a problem in any bank, but if you are only doing business on the internet, there are particular issues. What happens if your system goes down? How does a customer get access to you? There needs to be some way in which a customer can call you. It's not very helpful if you send customer service advice over the internet if you can't make your connection.

    The application of CRA is an issue which the agency is thinking about. How do you define the assessment area if you are in one location but doing business nationwide? That's not unique to an internet bank, but it is an issue.

    Chairman BAKER. Thank you.

    Mr. Murton.

    Mr. MURTON. I would agree with the points that Jim made. I would also, perhaps, mention in terms of safety and soundness that there may be some issues with deposit and funding volatility as people access their banks through the internet more. It may be that they are more willing to move funds around in reaction to various things. And that may pose a challenge for banks and the management of liquidity.

    Chairman BAKER. On that point, I can recall the days when it used to be ''open an account and we will give you a toaster.'' And you would see people moving from one bank to the next, but they had to physically drive up and do the transaction. If you take the free sausage or free toaster concept and apply it to the internet, given the speed with which these modifications can be made, is there any concern that you could see some innovator in the marketplace come in with his new offering and everybody runs to his location in a 24-hour period? Is that a likely concern? Or is it something to be worried about?
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    Mr. MURTON. I think it is an issue that banks may have to face, knowing that the customers they are attracting online may be willing to move to other places.

    Chairman BAKER. There is no bank loyalty when you go to an internet site?

    Mr. MURTON. Unless they are able to develop that loyalty through some other means over the internet.

    Chairman BAKER. Thank you.

    Mr. Maloney, I have gone way too long. No questions?

    Mr. Manzullo.

    Mr. MANZULLO. Sorry I didn't have the opportunity to listen to your testimony. I will read it, and if I have any questions at that point, I hope you will be available for me to give you a call by telephone.

    I have read some of the testimony in today's hearing, and I just want to state that based upon what I have seen so far, maybe I could give you some consolation for any further regulation.

    That may be good news to you. I don't see any smiles on your faces. I see a smile over here. But based upon what I have seen so far in this emerging area, I think as long as we are dealing with companies that are responsible and reputable and make full disclosures via this incredible system of internet that it would take a very dark day for me to say we need another layer of regulation.
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    Chairman BAKER. Thank you, Mr. Manzullo. And thanks to each of the witnesses for your testimony. We would like to reserve the right for Members to advance questions after the hearing. And we certainly appreciate your willingness to testify. Thank you.

    I would like to invite our second panel of participants to come forward as well.

    Good morning and welcome. I would like to welcome our second panel. And our first witness this morning to present testimony is the Vice Chairman of State Street Corporation, Mr. Dale Carleton. Welcome, Mr. Carleton.


    Mr. CARLETON. Thank you. Mr. Chairman and Members of the subcommittee. Thank you for the opportunity to appear before you. My name is Dale Carleton. I am vice Chairman of State Street Corporation, where I oversee the activities of our financial markets group.

    Chairman BAKER. If I could ask, just pull the mike a little closer, we are having a little——

    Mr. CARLETON. Certainly. These activities include currency and fixed-income trading, securities lending, cash management, trade banking, asset liability management, and investment banking. I will be speaking briefly today and respectfully ask the subcommitee's permission to submit a longer written statement for the record.
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    Chairman BAKER. Without objection, for all the witnesses.

    Mr. CARLETON. Thank you. I have been asked to describe how technology in the changing nature of financial intermediation in the United States has impacted and will continue to change traditional financial firms. State Street is an excellent case study in this regard.

    We trace our roots in New England back over 200 years, yet we are today at the cutting edge of global financial change, providing information-driven financial services to institutional investors worldwide.

    In my view, technology networks linking customers and counterparties will define the future of the global financial services industry. And it will open great new opportunities for those firms, most of them American, that have embraced the concept and are prepared to make the necessary investment in technology and human expertise to compete successfully.

    Finally, I will suggest some broad public policy parameters to protect and encourage the further development of this dynamic industry.

    State Street Bank is one of the oldest banking institutions in the United States, with roots dating back to 1792. Over the past two centuries we have evolved from a New England banking institution to a truly global financial services company with 17,000 employees doing business in 85 countries.
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    A series of strategic decisions taken over the course of several decades have led us to focus on high tech assets servicing and investment management for institutional investors, first in North America and then expanding worldwide.

    Our transformation began in 1924, when the Massachusetts Financial Services Company asked State Street to handle custody, accounting, and recordkeeping for an innovative new product, the mutual fund. In the late 1960's and 1970's, State Street was an early leader in using technology to automate securities settlement and safekeeping processes and to eliminate physical bottlenecks associated with mutual fund transactions and administration.

    Our early investment in electronic processing technology also placed us in advantageous position when the 1974 Employee Retirement Income Security Act, or ERISA, created a regulatory framework for private pension and benefit plans. These new funds needed to be managed and serviced.

    So State Street focused on developing technology to service the institutional investors who managed these vast investment pools, settling trades, and providing recordkeeping for pension fund sponsors and their beneficiaries.

    The passage of ERISA, of subsequent legislation providing for the creation of 401(K)'s, and the step-by-step deregulation of the banking and securities industries over the 1970's and 1980's, have indeed led to the accumulation of vast pools of investment assets. This accumulation of pooled investment assets has redefined American finance.

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    Pension assets have grown from less than $400 billion in 1975 to over $7 trillion today. Mutual funds, today worth more than $5 trillion, have exceeded commercial bank deposits. And with every passing year, the proportion of our capital market assets as a percentage of our GDP rose.

    During the 1980's, continuous reinvestment in technology has allowed State Street to focus even more sharply on servicing the institutional investors who manage these vast new investment pools. While doing so, we gradually withdrew from many areas of full service banking, retail branches, credit cards, and the like.

    Today we are continuing to reinvest in technology that enables us to deliver an integrated array of financial information products and services to meet our customers' increasingly sophisticated investment needs.

    Our services to pension funds and mutual funds encompass investment management, recordkeeping, portfolio accounting, and administration services. Among the capabilities that we are building are integrated service delivery platforms dedicated to cash management, risk management and the trading of currencies, equity, and fixed income instruments to help investors control risks while maximizing their returns.

    State Street provides custody accounting and recordkeeping for $4.8 trillion in customer assets. And we manage some $485 billion worth of investments. We are the largest custodian of pension assets in the United States. We have over $1 trillion in pension assets under custody globally.

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    We are the largest provider of services to U.S. mutual funds, and we are expanding to service collective investment all over the world. More than 90 percent of our revenue comes from servicing institutional investors and investment management.

    State Street has become an information company supported by technology. In much of our business, we act as principal or true financial intermediary in a complex, interconnected chain of financial transactions between securities depositories, broker-dealers, banks, stock exchanges, telecommunications and utilities providers.

    Increasingly our efforts in technology are driven by the need to allow customers to process electronically on an end-to-end basis. State Street and companies like us play an essential role in the global, near real-time transmission of financial information through our institutional customers to tens of millions of individuals who invest in mutual funds or participate in defined-benefit or defined-contribution plans.

    Investors today want to know precisely where and how their assets are being deployed globally at all times. So we have built multicurrency systems that deliver information to our investors around the clock, at all stages of the investment cycle, from pretrade information to trading and execution services to post-trade accounting, recordkeeping, and analysis.

    Electronic trading is a prerequisite for global financial institutions. It makes entire markets more efficient to the ultimate benefit of individual investors. U.S. finance today is an enormous digital network. State Street is committed to making this network function continuously worldwide.
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    Over the past five years, State Street has spent on average approximately 20 percent of its total annual operating expenses on information technology to meet this goal. This evolution is only beginning. Electronically-driven financial services are still at a very early stage of their development.

    Online trading with the use of the internet as a platform for financial institutions for financial information has enormous potential for upside growth. It remains unclear how electronically delivered financial services will impact wholesale trading, counterparties, traditional banking, and full service brokerages. This has global implications.

    All over the world, finance is becoming oriented toward securities markets. Government control of industry is giving way to private ownership. Closely-owned enterprises that for decades have depended upon relationships with local commercial banks are increasingly going to global markets for finance capital. Growth in cross-border investing is a key theme we follow at State Street.

    In the rapidly changing world of business today, companies need agile, swift-moving capital for startups, restructurings, mergers, and acquisitions. Capital markets are responding with cross-border alliances, securities listings on multiple exchanges, and around-the-clock trading. The vision of globally internetworked markets cannot come to pass without steady flows of dependable, accessible financial information.

    An important technology challenge facing our industry today as we look to this electronic future is achieving electronic connection with customers and counterparties to help facilitate global straight-through processing. State Street plays a leadership role in the international initiatives focused on this goal.
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    The only way the financial industry can accommodate the global boom in financial information is by achieving an end-to-end and seamless digital trail of data leading from investment research, to trades, to post-settlement and recordkeeping.

    We are actively working on this challenge to help our customers to aggregate and manage the data flows of their customer bases by giving them more information. In the quest to achieve this end-to-end information management and to be a trusted provider of financial information to the markets, a corporate culture of risk management and expertise is critical.

    By risk management, we mean traditional market and transaction risk as well as information risk. Markets simply will not function unless all participants have faith in the quality and veracity of the information on which their decisions are based.

    The electronic delivery of financial services and information promises great things for the U.S. and world capital markets. For example, the development of automated trading systems, we believe, could enable even more efficient securities trading than is possible today and more efficient allocation of capital for enabling investors to execute trades that are inhibited today by existing structures.

    Another benefit could be to reduce intra-day volatility by allowing a greater numbers of intended trades to take place more rapidly and more efficiently.

    U.S. financial firms have a great opportunity to share their expertise, practices, and solutions focused on electronic connections with customers in many different markets. Indeed the United States is a world leader in technology-driven financial services, a competitive advantage for our Nation that public policy should do everything to enhance.
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    This involves support for free trade in financial services so that U.S. financial companies can gain access and compete freely around the world. It includes coherent regulation of emerging electronic marketplaces so they can grow without being burdened by excessive red tape or taxation at an early stage of development.

    It includes passage of financial modernization legislation that recognizes the blurring of boundaries between banking, insurance, and securities industries, which is already taking place in the marketplace.

    Public policies that encourage investment in financial technology, computing, information networks, and development, will pay real dividends for the Nation by helping U.S. financial firms to compete and win in global markets.

    Further, Government can play a crucial role by providing regulatory framework the drives full disclosure. Investors need to make well-informed choices. As finance grows steadily more complex, well structured regulation ensures that consumers and institutional investors continue to have faith in the information that is the life-blood of healthy capital markets.

    Thank you.

    Chairman BAKER. Thank you very much, Mr. Carleton.

    As you might well note, we have just had indication that votes have started on the floor. It would be my intention to proceed with our next witness, to allow you to conclude, and I will briefly recess the hearing to make what appears to be two votes, and come right back.
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    So I would like introduce our next witness, who I understand is standing in this morning. Mr. Bill Lupien, the Chairman of OptiMark Technologies, has unfortunately notified us of illness—and is it Katovich?

    Mr. KATOVICH. Katovich.

    Chairman BAKER. Katovich. I apologize. Mr. Katovich, please welcome, we are certainly happy to have you here in your capacity with OptiMark Technologies.


    Mr. KATOVICH. Thank you, Mr. Chairman. Good morning. My name is John Katovich. I am the Senior Vice President and General Counsel of OptiMark Technologies. OptiMark is a developer of advanced electronic trading systems headquartered in Jersey City, New Jersey. Its patented trading system is currently in operation on the Pacific Exchange and will be introduced as the central electronic order-matching facility of the NASDAQ stock market in the third quarter of this year. OptiMark is currently under contract to deliver its technology to securities markets in Canada and Japan as well.

    As Mr. Chairman has said, Mr. Lupien, the Chairman and founder of OptiMark Technologies, was going to address you this morning but was taken ill this morning and asked that I present the remarks that he had prepared for this subcommittee.

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    Mr. Lupien has been active in the securities industry for over 35 years. He was a specialist on the trading floor of the Pacific Exchange for 17 years. He was instrumental in the design of the world's first electronic trading system, called SCOREX, back in 1968. And as a director of the Pacific Exchange, he was actively involved in the design of the intermarket trading system, which is the system that links all of the Nation's securities exchanges electronically.

    From 1983 to 1988, Mr. Lupien was President and Chairman of Instinet Corporation, which is the dominant electronic trading network in the world today.

    We would like to thank Chairman Baker and the Members of the subcommittee for inviting OptiMark to participate in today's discussions. Continued economic expansion, capital formation, and the impact of technology have led to the most dynamic landscape that domestic and global markets have ever experienced. Striking the right balance between regulation and free market economics is critical to the long-term prosperity and global dominance our capital markets have historically enjoyed.

    Today, we will touch on that rate of change and the role we believe regulation can play to ensure enhanced capital formation, fairness in use, and the highest levels of investor protection.

    Technology is changing today's capital markets at the speed of light, literally and figuratively. As quickly as new fiber-optic lines are laid, innovations in trading technology are changing the way buyers and sellers come together, changing the role of financial intermediaries, and improving the direct access that investors have to the market.
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    The internet has made online trading a reality for millions of Americans. Five years ago, very few people had heard of the internet, much less used it. Today, as you have heard, it is estimated that approximately 30 percent of retail order flow reaches the market via the internet.

    In the same way that businesspeople, students, and Government employees use e-mail and the internet as cornerstones of their daily lives, so too are we witnessing a transformation in the access to, and execution in, the capital markets both at home and abroad.

    The speed at which U.S. broker-dealers are implementing new online trading services also provides proof that direct connections from the user straight through to settlement of a transaction will be the standard in the very near future.

    Before long, such ''straight-through processing,'' as we call it now today, will provide trade entry, execution, settlement, and clearing within a matter of seconds, reducing systemic credit risk and enhancing market liquidity. The amount of information flowing to the user has also increased dramatically, and new applications are being developed every day to help the investor distill, integrate, and utilize information to drive their investment decisions.

    Low-cost access to market liquidity and information has actually reduced the barriers to competition, which the established exchanges and market centers had once enjoyed. We see this domestically with the rising number of so-called ''alternative trading systems'' and the electronic linking of once-marginal regional exchanges into consolidated trading blocks, particularly in Europe.
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    The European markets enjoy an aggressive regulatory approach to the use of technology and are already making moves toward global alliances to trade securities on a unified technological platform around the world, 24 hours a day. Several foreign securities exchanges have demutualized in recent years, to the empirical benefit of their shareholders and the capital markets.

    As you have heard, this Tuesday the SEC approved the limited U.S. operation of a UK-based electronic trading system called Tradepoint. On Tuesday prior, as you heard, the CFTC proposed new rules that would allow foreign futures exchanges to place electronic trading terminals in the United States.

    It is against this background that the U.S. capital markets will compete for market share in the global economy. If our regulatory principles and mandates are forward-thinking and progressive, we will help define the direction and nature for these global electronic markets. If not, we will be outmaneuvered by overseas competition, and we will be forced to compete on the grounds or restrictive and protectionist policy.

    There will always be tension, and we would argue a healthy tension, between the objectives of innovation and regulation. Regulation, based largely on statutory precedent is by definition retrospective. Innovation, by contrast, is prospective, forward-looking. This structural conflict has often served to impede innovation in the securities market.

    We would suggest to this subcommittee that our regulators be encouraged to act with foresight, flexibility, and speed in achieving regulatory objectives. This will lead to higher levels of service, lower costs, and the ability to compete internationally.
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    Innovation has been a defining characteristic of American success. In the 1975 amendments to the Securities Exchange Act, Congress directed the SEC to take a more active role in the regulation of new and innovative developments in the securities industry. And during the past 25 years, the SEC has become a much more involved entity in every aspect of securities trading. But this approach, however well-intentioned it may be, has at times served to restrict innovation and market development.

    Last December, however, the SEC issued new regulatory directives addressing many of the issues surrounding electronic trading and the need to modernize our market infrastructures and promote innovation. ''Regulation ATS,'' as it is known, provides for demutualized exchange governance, multi-tiered regulatory environments for electronic markets, and perhaps most significantly, it grants the exchanges the ability to develop and deploy pilot electronic systems without first obtaining Commission approval.

    Regulation ATS is the most significant and positive piece of regulatory structure promulgated in recent years. But directives and rulemaking by Government agencies alone may not be sufficient to ensure the competitive success of our capital markets.

    Chairman BAKER. Mr. Katovich, I am sorry to interrupt you. I am down to about three minutes. So I am going to have to run. We will stand in recess for about ten minutes, and I will be back as soon as possible. Thank you.


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    Chairman BAKER. If I may, I would ask our hearing to reconvene and our witnesses to proceed to the table, and apologize again, Mr. Katovich, for having interrupted you midstream, but I certainly do appreciate your courtesy and would recognize you to complete your remarks.

    Mr. KATOVICH. Thank you, Mr. Chairman. I will continue where I left off.

    I was talking about directives and rulemaking that Government agencies currently provide. And the point that I was going to make is that those alone may not be sufficient to ensure the competitive success of our capital markets.

    We need to ensure that regulation and rulemaking address the needs of issuers, investors, and competitive market structure, not the parochial interests and commercial concerns of a privileged few. Established institutions in the securities industry have regularly and effectively used existing regulation to stifle innovation and competition.

    A relevant and compelling example is provided by the recent experiences of our own company, OptiMark Technologies. The OptiMark trading system is an innovative approach to matching the interests of buyers and sellers utilizing supercomputers and advanced mathematical algorithms. The OptiMark system was designed to integrate with existing market structures and is deployed as a facility of its exchange partners.

    The SEC approved the Pacific Exchange's application to utilize the OptiMark trading system in an unprecedented 67-page order, which the Commission delivered in just three months from the date of filing. This order clearly defined the Commission's strong support of market-structure innovation through the use of technology. Despite the SEC's strong support of the Pacific Exchange's and our intentions, the exchange became embroiled in a 15-month debate on how and, indeed, whether the Nation's other securities markets would allow this innovative technology to integrate with the national market system
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    The cost of these delays that revolved around the competitive exchange access issues alone exceeded $20 million. And while OptiMark had adequate reserves to weather those delays, other innovators have neither the resources nor the stamina to endure similar quasi-regulatory roadblocks.

    In conclusion, our markets are undergoing an unprecedented period of transition brought about by advances in technology and communications. Today the U.S. financial markets may well be the envy of the world. And we believe this is in large measure due to the foresight of the framers of the 1934 Securities Act and the 1975 amendments to that act.

    As we move into an environment of global economic marketplaces featuring direct investor access, the nature and role of the regulatory process is critical. We need to ensure that investors have the highest levels of protection, while facilitating innovation and improvement of market structures through the use of technology. While care must be taken to prevent abuse stemming from such innovation, it is equally important that we implement thoughtful regulation so that our fear of abuse does not hamper success.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you very much, sir. I do appreciate your remarks.

    Our next witness is a professor at Pennsylvania State University, Mr. Ian Domowitz. Welcome, Professor Domowitz.
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    Mr. DOMOWITZ. Thank you very much, Mr. Chairman. And thank you for inviting me to speak here today. I am an academic who specializes in the study of trading markets, but I have also worked as a market practitioner in the sense of using, designing, and working on the building of electronic markets. As with others, my testimony deals with one of the most important developments in the trading services industry today, the impact of advances in computer and telecommunications technology on the cost of trading and the development of market structure.

    The effects have been fundamental, something that you hinted at yourself. The cost of providing exchange trading services has declined significantly. The means by which they can be delivered to investors has changed radically, and the natural industrial structure of the trading services industry has been transformed.

    All classes of market participants, exchanges, broker-dealers, investors and regulators are affected by these developments. The most important single shift in trade-execution services is the birth of an industry, and the introduction of an element of true competition in that industry. We are not accustomed to thinking about exchange services as an industry, yet exchanges and other entities providing trade-execution services are firms, regardless of their precise governing structure. These firms now offer different technologies for trading.
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    Through these alternative technologies, transaction services are produced. Traders are consumers of trade services. They choose the technologies and associated transaction-services bundles, taking explicit costs, implicit costs, and considerations of liquidity into account.

    You may expect developments associated with any newly competitive industry. There will be a flurry of new entrants, such as the recent crop of so-called ''ECN's''—exploiting market niches in the trading community. These niches will not be limited to stocks. The analog of ECN's can be expected in the areas of futures trading, options trading, and the trading of fixed income securities.

    Such entry is already underway in some areas, in a big way.

    The first mover advantages of traditional exchanges are being eroded by lower costs of providing trade-execution services and accompanying penetration pricing. Strategic investment in new trade-execution technology will abeit successful entry into this industry, improving traders' ability to customize orders. These entrants will continue to use technology to offer various means of submitting and executing orders without traditional human intervention.

    The economic paradigm for this industry should mostly parallel that of telecommunications. After all, an exchange is simply a communications system, with trade execution attached to it. As such, you may expect mergers between trading services providers as well as joint venture arrangements, which might fall under the rubric of what has sometimes been called ''competition through cooperation.''
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    Supporting evidence for the statement is available already through developments in Europe for example. Merger activity should not necessarily be viewed as anti-competitive, however. It stimulates research and development, better trading technologies with an associated lowering of costs to the trader and investor.

    In fact, there are factors that suggest a very competitive environment, without the need for regulatory intervention in the sense of regulating rates or market structure. A competitive environment need not require the existence of many firms offering the service as common economic theory might suggest, but it does require ease of competitive entry. Such ease now is abetted by massive declines in automated system development costs, the elimination of distance costs, and the expansion of securitized products.

    The effect of such competition on the pricing of trading services will be to eliminate existing cross-subsidization in the industry. In terms of public policy, we have historically viewed such developments as positive for consumers in areas other than trading services.

    Regulatory challenges will remain, however. Technology will, for example, create a different environment in terms of globalization of trade activity, something that's been hinted at earlier today. Policymakers now face the issue of permitting foreign exchanges direct access to the U.S. marketplace, for example.

    Self-regulatory organizations will begin to oversee the activities of trade-execution firms that operate on a for-profit basis as opposed to membership organizations operating under a not-for-profit umbrella. The issue of conflict of interests indeed can arise.
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    This last point deserves some further elaboration. The behavior of exchanges is conditioned not only by the competitive environment but also by the incentive structure deriving from their internal governance arrangement. The traditional mutual structure of an exchange is a remnant of the preautomation era, when space limitations inherent to trading floors necessitated the rationing of direct access to members. As members then became intermediaries for all nonmember order flow, exchange behavior came to be partly directed by the interests of members and maintaining intermediation profits.

    As trading automation has facilitated virtually unlimited access, it is logical that new automated entrants have chosen not to be governed as intermediary cooperatives but rather as for-profit joint stock companies selling execution services on a transaction basis.

    Outside the U.S., member-based exchanges are increasingly trying to replicate the incentive structures of such companies by demutualizing or divorcing ownership from membership. The historical record of such initiatives is short, but experience suggests that innovation such as foreign remote membership and direct investor access are more easily implemented when intermediaries are minority owners and that demutualization may therefore serve to improve the performance of the exchange as a commercial enterprise.

    I expect such developments to have some direct benefits for the retail as well as for the institutional investor. Although the entrance of electronic markets is not the same as so-called ''internet trading,'' these markets appear to offer trade-execution services at lower costs. At the minimum, to the extent that this lowering of costs is past on to the investor, I believe that the retail investor indeed will benefit.
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    Again, thank you for your attention. I will be happy to respond to any questions you may have.

    Chairman BAKER. Thank you, Professor. We certainly appreciate your participation here this morning.

    Our next witness is the President and CEO of Cantor Fitzgerald, Mr. Howard Lutnick. Welcome, Mr. Lutnick.


    Mr. LUTNICK. Thank you, Mr. Chairman, Chairman Leach and Congressmen Manzullo and Lucas. Cantor Fitzgerald operates an electronic trading system in the United States, and it is the most successful trading system for the market of U.S. Government securities. Once one understands that the U.S. Government securities market trades twice as much, $50 billion a day at Cantor Fitzgerald versus the NASDAQ stock market at $25 billion a day, one realizes that any comment that electronic trading systems cannot handle liquidity, are not a good place for liquidity to exist, will know for a fact in the United States that that is not true.

    So to start with, electronic trading systems can and do, do the work of all the people who yell and scream in pits. The reason I am interested in talking today is about the future. The future of marketplaces and of exchanges is one of the end of monopolies.

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    Currently, the exchanges in America, each of them have their own particular monopoly. There is only one marketplace for U.S. treasury futures. There is one place for euro-dollar futures. There is one place for cattle futures, one place for wheat futures, one place for soybeans, and so on, and so on. That structure is going to end, and electronic commerce is going to be the end of it.

    So, number one, we have competition. And as I think we all believe in this room, competition is fantastic. It will drive innovation, both from current market participants and the new market participants. It is going to drive down costs, and, most importantly, it is going to drive access, wholesale information and access to the real users.

    An example I like to use is that for some reason in the agricultural futures business, farmers have become customers. One would think that a farmer who is a producer would be the ultimate insider. I mean, they know their crop, they know their product better than anyone else in the world. Why is it that they have become customers of members of exchanges?

    In electronic environment, the information that the exchange creates will be displayed on a computer screen. That computer screen will be made available to each farmer so that those farmers will have the same information as everyone else has in the market. And whether they succeed to the level that they hope to will be a matter of their decisions, their information, and their choices. And that empowerment, that enablement of what technology is all about is how I think the future will operate.

    So what Cantor Fitzgerald has done, in partnership with the New York Board of Trade, a traditional futures—open-outcry futures exchange—is we took our system and used the same infrastructure that has been so successful in America up until today and moved that into the futures market, into the exchange business. And what we did was, we didn't try to disintermediate the banks and broker-dealers. In fact, what we try to do is empower them, and say, ''the electronic system will match buyers and sellers and you, in turn, can provide that access, if you wish, to your customers electronically.''
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    If the customers wish to continue to call their banks, broker-dealers or FCM's, they can do so. But the fact is, any FCM or bank or broker-dealer can enable over the internet their customers, the farmers, and all Americans to have the same access. Because once that information is available electronically, its dissemination because of the internet is easy, quick, and fast.

    And because it is all electronic, what can happen? You can trade very quickly, instantaneously, very efficiently. We have a first-come, first-served model, which is simply rewarding the first person who comes in with the best price. In traditional exchanges, if each of us on this panel were willing to pay $10, then any seller could choose to sell to either of us at $10, and they would be selling in a fair, open-outcry price of $10.

    There would be no reward for me to pay $10 and one penny. And so what an electronic system with a first-come, first-served model would do would be to reward the participant who goes out electronically and says ''I am willing to pay $10 and one penny,'' and if you are a seller, you will sell to me first before even if you are friends with the people to my left and to my right.

    Price will be first.

    How can one get price to be first? There must be absolute credit assurance period. Because E-bay, a very popular example of an auction market discussed, works very well for Pez dispensers, which is why it was created. Because if I were to buy a Pez dispenser and someone delivered me a different one or a broken one, and I lost $12. OK, I'm a big boy, I can afford to lose $12. Who am I going to complain to?
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    You can't have the U.S. financial markets on that sort of anecdotal credit. And that is how E-bay works. If I had a bad experience with someone, I would type in my internet ''I had a bad experience.'' And that sort of anecdotal evidence would follow that player around by some makebelieve name that they put on the internet. And, of course, they could become another player and a different name, get another credit card and off they go.

    The fact is, what we want to do is use the credit providers, the banks, broker-dealers, and futures commission merchants of America and have them guarantee entrance into these markets. Not disintermediate them, but, in fact, use them as the gateway for Americans to come into the wholesale markets. And that is a model that works today, but it works with too many people touching it, and therefore it is too expensive.

    If they make a phone call to another phone call, another, another, and another. And we have all seen these day-traders or anyone who wants to trade on the internet, they have the ability to buy and sell when and if they choose. That should work for futures. That should work for stock options. That should work for every single agricultural commodity in the United States. There should be a cash market electronically available. There should be a futures market electronically available. And that same information in everybody's hands.

    It is an empowering event. It's a strong event. And it an incredibly positive event. And so any assistance that you can give to the marketplace to compete would be well served, to encourage competition and end the monopolies that currently exist, and encourage competition, and encourage innovative ways of doing business.

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    Cantor Fitzgerald has a very successful business model up until now, but that business model may be attacked from who knows where. And someone else will come up with a really neat and exciting idea that we have not thought of, and either we will keep on our toes and stay competitive or we will become a relic of the past as well. And I think that is what is tremendously exciting about the future of marketplaces.

    Any global or national commodity—electricity you will certainly see trade this way. Your phone minutes certainly will be traded this way. And don't let the issue of day-traders, people who take inordinate amount or risk, change the model for all Americans. The fact is, if you harness information and distribute that information instantaneously to everybody who cares about that information, and give them really, really inexpensive access, wow, you have made America a fantastic place for farmers, for those who trade whether they are financial professionals, like State Street, or anyone who wants to buy and sell a stock or a bond.

    Everybody is on the same wholesale playing field, and the only difference is how much commission do I pay? If I am the institution, I pay a low commission because I trade a lot, and if I'm small, I pay a slightly higher commission. But we all know what it costs us to get into the wholesale market. And that is extraordinary.

    I appreciate the time you have had to let me speak. Thank you very much, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Lutnick. We appreciate your comments very much.

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    Our last witness on this panel is a senior fellow of The Brookings Institution, Mr. Steven Wallman. Welcome, Mr. Wallman.


    Mr. WALLMAN. Thank you, Mr. Chairman, Chairman Leach, and Members of the subcommittee. I would like to second a lot of what you heard on the first panel and also what has been heard today from the preceding commentators.

    The view I have starts with the proposition that technology has been a great advancement unequivocally with regard to the financial services markets. The issues that people present with regard to the potential downside, day-trading and others, I think are in a real way very much swamped by benefits that technology has provided in terms of lower costs, better information available to more people, more education, more investor protection, more efficiency in the markets, more competition in the markets.

    And it has been truly extraordinary in terms of the overall level of benefits that have been provided. That said, I think there are also some real challenges from technology's advances in the markets that has new impacts on regulation and the regulatory structure.

    I would like to focus a little bit on those today. I would like to first mention that technology in a real way, obviously, challenges some of the core concepts on which regulation is based. Some of the obvious ones are, for example, the issue of regulating in a world that is in essence physically placed, a sovereign jurisdictional issue. We here can make rules that affect the United States and participants in the United States. The internet on the other hand, of course, is something that is global and it allows for access anywhere from anyplace to reach any other place.
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    It is hard, in many cases, to determine who is accessing a site. It is hard, in many cases, to determine where the site is. We are already confronting some really serious issues and questions as to what to do when you have a site hosted presumably somewhere outside of the United States that allows people in the United States to engage in trading of securities that are not registered in the United States.

    And we can go with one of two routes. We can either attempt to maintain a jurisdictional notion that says we are going to preclude that kind of trading. We will then shortly, I think, see people simply getting on the internet, avoiding broker-dealers in the United States, and using foreign intermediaries in order to engage in the trading that they wish to engage in.

    At that point, U.S. investors will lose the protections of the United States securities laws. All with the point of trying to say that we are going to maintain those protections for U.S. investors by refusing to allow some of the foreign intermediaries to offer foreign securities because they are not fully registered here. But the result is that we have lost all protection for U.S. investors because they will simply circumvent the usual requirements for going through intermediaries in this country.

    Moreover, we will lose market share. Intermediaries in this country will lose trades that increasingly will go abroad. We have already seen that overwhelmingly in the institutional sector. Institutions increasingly are placing money directly abroad, not using U.S. intermediaries, and it is clear that with the internet we can start to see that very quickly with retail investors as well.
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    I would also like to mention that one of the things that regulators rely on are basically gateway institutions, choke points—exchanges, for example—that they can regulate, or broker-dealers that they can regulate, as you heard on the first panel, which have the indirect capabilities of then regulating hundreds of millions of investors and other participants in this country.

    If you can determine how an exchange will act as an exchange, if you can determine how five thousand or so broker-dealers will act as broker-dealers, you can indirectly regulate a few hundred million Americans who otherwise invest in the equity markets.

    Again, what technology is doing, as we have just heard, starts to change some of the capability of being able to rely on those gateway institutions in order to indirectly regulate large, wholesale investment activities. As the internet and other forms of electronic communication continue to allow people to go directly to the other side of the trade—and what we will see in the next phase of technology are other things, such as smart-agent technology, XML tags, and things of that nature, which will, notwithstanding the best of intentions of some people to avoid disintermediation, allow for, in fact, intermediation—you will start to see people no longer having to worry about gateway institutions at all. And the regulatory leverage that comes from being able to regulate gateway institutions and their indirect regulation of investors and others starts to dissipate.

    In addition, reputational capital starts to diminish as you get more and more participants in the marketplace with lower barriers to entry and lower costs. Reputational capital invested by any one participant becomes less. One of the great leverages that regulators have had has been the ability to, if you will, threaten action against participants in the marketplace. Since the marketplace has traditionally relied on trust and confidence of various participants, if you can threaten that trust and confidence, you can have a great impact.
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    If you start to have entities with lower barriers to entry and lower reputational costs are involved, that threat becomes less important.

    One other point: small, incremental changes. We have heard touched on by some on this panel the idea of, for example, SEC and other regulatory agencies' involvement with regulation and their attempt at keeping up to speed with changes in the marketplace.

    It is very hard, and it is increasingly difficult, to keep up to speed with changes in technology. Nothing is changing quicker than information technology, and much of what we have in financial services is basically the regulation of information. That is, in essence, what financial services really is about—it is really information regulation.

    Given that technology and information technology is changing so rapidly, the idea of having regulatory change that moves at an incremental, step-by-step pace is really one that becomes slightly archaic. If we are going to avoid having only incremental change on the regulatory side being the main drag on innovation, we need to think about a new way of regulating. And that, I think, is going to be increasingly ''regulating to standards and to goals''—the kind of thing you heard here earlier with regard to the ATS release. Also in 1995 and 1996, the SEC's issuance of its electronic releases, for example, really allowed for the blossoming of information being provided over the internet to securities investors, and allowed for online trading really to take off as it has.

    Just two other quick points, and then I would like to outline one regulatory concept that I think is worthy of some consideration. There are within the range of how regulators regulate and how laws are written very much of a sense of definitional concepts. One defined a bank, a securities firm, an insurance company, a futures commodity merchant. And based on those definitions, you end up with an entire regulatory scheme, and a whole series of regulatory agencies overseeing those entities.
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    For a long time, we have had an easy matrix, which has been regulated entities in various industries engaging in sales of securities or banking products or futures or insurance that related specifically to the kinds of entities that they were. Banks sold banking products, securities firms sold securities, and so forth.

    What increasingly is happening is that those kinds of definitional and product lines are breaking down. We are getting increasingly hybrid products that could come to the fore that transcend either banking products or securities or insurance or futures. They are the kinds of products that promise to serve investors and financial services consumers quite well.

    They are also the kinds of products that today are basically precluded because of the regulatory scheme from coming into existence. The idea of product definitions and product regulation—and functional regulation as it has been thought of traditionally is really product regulation—is something that I think we need to review in the future if we are going to be in a position to allow true innovation.

    Just as an example, within a range of definitions, you can look at the current definition, for example, of an investment adviser. Increasingly, there are computer programs that are available to people that in essence do what an investment adviser does. They help pick stocks, they help provide allocation, they add asset information, and they help provide advice.

    The issue is, if we are going to define things like that as investment advisers, what do we do with the regulatory structure? How do we regulate them? And are we really going to be serving any public policy goal by attempting to suggest that a computer program needs to be regulated as an investment adviser when it does something similar to what an investment adviser does?
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    So we need to rethink in a real way that notion of regulating by product definitions. And I would suggest that people consider an idea, which I know will be considered politically not viable, but let me throw it out for consideration purposes. And it is just an idea. But that is one of the luxuries that one has at the moment.

    And that is the notion that instead of thinking about things in a product definition way, instead of thinking about securities versus banking products versus insurance and futures, think about them all as financial services. And to think about them as financial services that can be provided to financial services consumers. And then to think about why it is that we care about regulating this whole area in the first place. And to recognize that traditionally there have been four regulatory goals. There has been consumer protection, insolvency concerns, systemic risk concerns, and market regulation.

    And instead of thinking about each of them as separately applied to particular products or to particular entities selling particular products, to think about those regulatory goals, those stand-alone goals, as relating generally to financial services. If one can rethink the system that way, then what you end up with is no longer worrying about whether or not something is a security or a future, for example, which has become increasingly difficult to do.

    But you start to think about them as financial services, and then the question is, who are they sold to? And if they are sold to large institutions, you don't have to worry about the consumer protection side of it as much. If they are sold by a small entity and there are small amounts involved, systemic risk is not much of a concern. Insolvency may still be a concern. Market regulation may still be a concern.
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    But the beauty of this approach is that overnight we create literally tens of thousands of new competitors in the financial services sector generally. We allow for innovation on a broad scale instead of people having to try to fit a hybrid product into one model of securities or insurance or futures regulation. They are now simply capable of selling it as a financial services product.

    We allow innovation to go forward, and we allow technology basically to push and press forward innovation in a way that allows people to provide whatever satisfies financial consumers needs as opposed to fitting in specific definitional characteristics.

    That said, there are a lot of issues that surround this proposal and a lot of others. I have outlined some of them in the longer witness statement. Let me just conclude by saying that I think for a long time our overall policymaking has to some degree been held hostage to its past in terms of the thinking. The current structure that we've got was really imbued with a terrific amount of genius and foresight, but it was imbued with that over half a century ago.

    It is thankfully a structure that in my view that has served our interests extraordinarily well. But the times have changed. Technology has been the main driver of changing that.

    I think the least that we can do to ensure that the efforts of those who labored so hard in the past to build something which they viewed as a monument to the future and which has done extraordinarily well for half a century, is not now viewed as an anchor to the past, something that stops innovation and stops us from being able to compete on a global scale.
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    There is no other country in this world that has the kind of complete separation of various entities—futures, banking, securities, and insurance—as do we. And I think over time, unless we can change the paradigm, in part the way the United Kingdom has just done with its Twin Peaks proposal, breaking out basically their financial services regulation into consumer protection and systemic risk—the Australians are starting to think about it, and others as well—I think we will unfortunately find that the regulatory structure becomes a potential drag to innovation.

    And with that, let me finish. Thank you.

    Chairman BAKER. Thank you, Mr. Wallman. I appreciate your remarks, and don't necessarily view the concepts of your testimony as fringe, as some might consider it. Let me make a few observations, and then question for the panel to respond to.

    I agree that we appear as much the case on our financial modernization issues in H.R. 10 that we have been debating now for a better part of a decade. We are going from a rationed access system to the unlimited access system, whether we like or not. Or, in the case of securities, at least modified open-outcry to electronic base of transactions. Now I don't think it necessarily means a displacement of the intermediary's role, ironically because the electronic capacity will also deliver such inordinate quantities of information that the casual user will throw up his arms and say, ''What do I do?''

    So that rather than being an intermediary with maybe two or three items on his call sheet to promote, you will have the end user with thousands of sheets of paper trying to sort through them to figure out what best fits their portfolio needs, but may ultimately execute the order directly, and relying on the intermediary more as an adviser, and perhaps to a greater extent, the securer of that transaction. So when the Pez machine shows up nonfunctional, he has some recourse.
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    What troubles me is that, Mr. Wallman, your last several comments that the regulatory system in place did not in any way envision, perhaps as late as 1995, no one could have envisioned what we see in 1999. And that with the scope of operation that electronic systems now make available to us, that you could well engage in transactions with someone that you do not realize behind the home page is located in Europe.

    We become blind to the franchise value that used to be the hallmark of doing business. It also means that the very small enterprise can now engage in, perhaps, a very successful offering with, perhaps, limited capital and resources because the acquirer really doesn't know how that firm stacks up because it has a wonderful, talking home page.

    I think this is all a grand, a very exciting economic potential for our country, but I also, at the same time, worry that it opens us up to rather significant risk—I hate to use the word systemic—but rather large and perhaps uncontrollable risk from a regulatory perspective.

    I like the idea of looking at end-purpose as opposed to product type. Nowhere is that more obvious than CFTC and the futures question. And the idea that people trade not knowing whether their product is properly regulated or not and assume great liability for doing so may well be another reason for some of the offshore development we have seen.

    First question—and maybe Mr. Carleton maybe you would be an appropriate person. Given the scope of State Street Bank's interest in 80-plus countries, what do you see in the current regulatory system that results in unreasonable delay, higher cost, unreasonable interference in innovation of new product that really is a disservice to your ultimate customer, given the scope of what you do?
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    Do you think we need a simpler standard of a single sort on an international level? And my view—and maybe you can respond to this as well, the American system, at least in this arena, seems to be lagging a bit behind our international competitors. Is that a fair assessment?

    Mr. CARLETON. Thank you, Mr. Chairman. I believe so.

    Chairman BAKER. And pull that mike a little closer to you.

    Mr. CARLETON. I might start by putting in perspective where State Street is. Our focus is fundamentally on institutional investors. So it is not the retail consumer. It is not the day-trader as we have heard talked about earlier. And our focus has been not so much on creating products that have electronic delivery capabilities, but more on creating a process that permits our clients, our institutional investors, to increase levels of expected yields, reduce costs, and reduce risks.

    So the platforms and the products that we have developed using both the internet and private proprietary networks are really designed to do that. I think where the regulatory issue comes in, and it is probably less of an issue for us because we are not actively involved in trading and underwriting equities, like some other financial institutions, but it gets back to the whole financial modernization work that as you say has been underway for at least ten years, and whether or not regulations in this country prohibit, if not so much State Street, more broadly other financial institutions from doing what their competitors in the 85 other countries can already do to some extent.
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    I think the country is well ahead of many of our counterparts overseas in Asia and in Europe in terms of our ability to mastermind and develop and implement electronic capabilities. And we are well ahead I think in terms of having a consumer base that understands the value of that. But I think we are behind in terms of our ability to deliver a broad spectrum of products and services without the necessary red tape that it sometimes takes to get something up and running.

    An interesting observation, though, is Japan not too long ago, asking a group of people about investment practices and typically it is the postal system. And if you ask a group of people: ''how many are involved in mutual funds?'', you might see one or two hands, and if you ask: ''how many of your parents invest in mutual funds?'', you will probably see no hands.

    Well, that is a market that is untapped. Now you turn around and look in this market here, most of the investors in my earlier comment about moving money out of banks and off deposits is going into the stock market, is going into mutual funds. It is a very common investment vehicle here.

    So I think we are well ahead in terms of people understanding the investment process, and I think we can probably do a little bit of catch-up in terms of the regulatory platform that permits us to access and deliver a more broadly desired spectrum.

    Chairman BAKER. Thank you. Mr. Lutnick, in light of your comment, would you care to give you perspective on current regulatory structure in light of product development or unneeded interference in providing the ability to move forward with your business plan? How, what is your view? And I take it from your remarks, you feel obvious modifications are necessary, but tell me more.
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    Mr. LUTNICK. Well, Cantor Fitzgerald has a computer system that trades, or creates a marketplace for U.S. Treasuries. So what we thought—not very maverick— ''wouldn't it be nice to put the U.S. Treasury futures contract right next to the U.S. Treasury cash bond, next to each other on the same system?'' And to do that, we had to seek additional regulatory oversight from the CFTC. And we did that.

    And so, what you find is that there is a real overlap of regulatory oversight that one could easily say, and rightfully so, that financial futures are very, very closely linked to the securities markets and to treat them separately is disjointed.

    But one would unfortunately also have to say that once one does one futures market, the U.S. Treasury futures contract, there is virtually no difference between the U.S. Treasury future and corn, wheat, and soybeans, and the agriculturals because a futures contract has primary underlying characteristics that are all the same. So the fact is, there is that overlap.

    And so, I think the right answer is that as electronic marketplaces move forward, that the regulatory environment should seize upon the opportunity that that gives a perfect audit trail, knowing exactly who bought it, who sold. And try to create a framework that encourages competition because that is just an absolute good. Competition is a superb thing, and it fosters a level playing field.

    Chairman BAKER. So you are basically, as I am understanding it, saying that on a given home page with a list of products, for the single home page you might have seven, eight regulators looking at that page because of the diversity of the product offerings that you are trying to market through that service. Whereas, some other regulatory system, given particularly the nature of the similarity between futures, might lend itself to more opportunity and consumer benefit if we had a simpler way of getting that product on that home page without those regulatory steps. Is it?
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    Mr. LUTNICK. It would be impossible for me to argue with that.


    Chairman BAKER. I knew it the moment I saw you, you would be an excellent witness.


    Let me recognize Mr. Kanjorski, the Ranking Member who has arrived, and yield to him.

    Mr. KANJORSKI. We sort of arrived at the future without anticipating just how varied the future would be. I appreciate that this panel is made up of mostly people who are involved in transactions. Let me ask a few questions.

    Mr. Wallman, you create a concept that if we were beginning the practice of financial services industry, it would probably be correct. But, you recognize how much strain there is within our system right now with insurance regulation being on the State-by-State level as opposed to Federal regulation. There is a huge vested group out there that is not about to want to see that change.

    The thing that sort of scares me about it, and I would like the board to answer is, what are your experiences on, for instance, securities and multi-national market kiting that may occur? If that is a simple arbitrage instead of dealing with the New York Stock Exchange on a registered stock, why not buy it in the London Exchange? Then, one could make another purchase, say, on the Frankfurt Exchange, but even more than that, play the arbitrage number of currency at that very moment in your trading. How are we going to protect against that, or should we? Two, what is going to stop us from setting up multi-transactions internationally to take a very small base product and run it up over a matter of 100 or 200 transactions that can occur in a matter of fifteen or twenty minutes, until a very large multiple effect when the trader does not have that wherewithal?
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    It is just like kiting checks, running it back and forth, but now you can do that electronic transfer so quickly. Who is to attest to that? Is that occurring today?

    Mr. LUTNICK. Well, I will start with the latter and then move forward. Cantor Fitzgerald's trading system has a limit, a credit limit, attached to it so that the credit-providing intermediary, let's say whether it was Schwab.com or Chase Bank, could literally authorize an account. And say you can only buy up to 10 or you can only lose up to $5,000. And it is so robust and electronic now that you can literally e-mail or beep the credit-risk manager associated with that particular account when they get to 80 percent or 90 percent, and those can be changed on the fly. And that is a much higher level of credit and audit oversight than you could get when people talk to each other on the phone.

    Mr. KANJORSKI. I understand that. But I could plan on buying a security that is listed on the New York Exchange and that has a differential on the London Exchange at the precise moment. I could make the purchase on the London Exchange. I can figure out the currency difference at that point, take that credit, and make a buy-back on the New York Exchange at a much higher amount. I can still have all the support for that system and go right back around the world in various exchanges where I could take maybe $1,000 in issue value and run it up to $1 million over a couple of hours using electronic transactions.

    It is all hiding the money in transactions in securities, and one, there is not any protector. Two, it is an electronic product. And, three, we do not even have national or international conventions to deal with the responsibility and the protections that are out there.
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    Mr. LUTNICK. Maybe I don't understand your question precisely, but at the institutional level, the fact that two of the same products, two stocks in different markets are slightly out of whack, when one would be slightly higher than the other, the market, institutional market participants live to make that, a particular differential, go away. And so they will sell the expensive and buy the inexpensive.

    Mr. KANJORSKI. Before it goes away? What I am doing, though, is running up my collateral. I am finding those moments when there is imbalance, both in the security that I am trading with, any type of security, and with currency rates as they differentiate around the world. Because I can do it at the speed of light, I can literally build. So, my account moves from $1,000 in value to $100,000, even though it really has not changed. It is just transactions that we have moved at the moment that no one can deny that this last exchange is worth $100,000 if you take the currency and the collateral involved because of the mathematics. It is worth at that precise moment $100,000, but we are doing it with $1,000.

    It is not any different than the old experience with kiting checks. You start a check and keep running it through banks and you can run up a tremendous amount of potential collateral that really does not exist. You have just made it. But at that very moment, if you try to go through those transactions, in fact that collateral exists, until there is a collapse or until there is a significant change either up or down and you are caught at a disadvantage.

    That is the only time you discern that there is a failure. How are we going to prevent this from happening? Is it happening today?
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    I know we have the arbitrageurs out there, but do we have multidegreed arbitrage occurring in the 80 countries of the world that are dealing with this?

    Mr. LUTNICK. We deal in multiple of countries and multiples of products, and I can't recall an instance where a market participant who wasn't worthy of credit access to be able to do that, was granted credit to these markets. And I think that was part of what my comments were, which is that it is the credit-guaranteeing intermediaries that stop that. And they won't let someone who only has $1,000 buy $100,000 worth of product because if they did, the credit-granting intermediary would stand the risk of the loss, not the market at large.

    It would be limited to the company that allowed a very economically weak participant into the market, and you certainly couldn't do that with U.S. stocks.

    Mr. KANJORSKI. You are absolutely right on one transaction. But, if you do the arbitrage of the security and the currency, the last transaction made, according to the person looking at that credit, the account is good for that credit.

    Mr. LUTNICK. We grant credit on a gross basis. So the fact is, you wouldn't let someone with $1,000 buy a $1 million of anything, no matter how many times they did it because inevitably one side could fall over.

    Mr. KANJORSKI. You mean, an individual trader is not capable of having multi accounts internationally to trade through? Is that what you are saying?

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    Mr. LUTNICK. Because there are different regulatory schemes in different markets, I am sure anyone with the——

    Mr. KANJORSKI. I can understand going to Mr. Wallman's world of the future, but the main point gets to be consumer protection. I am watching people today trading as day-traders on the markets that have a net worth of $50,000 or $100,000 and they seem to be without fear; whether they have gone to gambling or what, I am not certain.

    If greed is something that is coming out in our society, it is coming out in a very bad way. I see national advertisements on television on how to get present value for structured settlements, something that is horrendous. The whole purpose of the court approving a structured settlement is to protect a consumer that is determined to use that for support. I won't mention the court ''judge'' that is advertising this, but any day that you can go on national television and say, ''Call us up, and we will give you a discount rate and buy out your future on that settlement,'' this is wrong.

    It is sort of frightening, because they are dealing with the least sophisticated people, the least capable people, and the people in the greatest need. And, I see that is a call, a clarion call, in our society that the market is not protecting the disadvantaged and the weak because they are not criticizing it.

    It would seem to me that major people who are involved in the trading market would say ''this is unconscionable. Why do we not do something about it, or why do we not at least call people's attention to the tremendous advantage?''

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    People that have both AIDS and life insurance are selling that future off. Now it is a watch-to-death, if you will, for profit. Nobody seems to see any reason to worry about it. As a matter of fact, some people could make the argument that they are able to get present cash value on an insurance account, and therefore, that is serving the public purpose. I am not sure, because I cannot even argue one way or the other, but there does not seem to be in the marketplace those people who are determining reasonable values and standards to condition themselves.

    What we are talking about here is opening up the field that we cannot even discern the difference in regulation, whether it should be State-regulated insurance or national insurance. We are talking about a worldwide market with products that defy description. We do not even know what they are; we just call them ''financial services.'' We have opened up to people who are unsophisticated in the nature they trade with this. It seems to me there is going to be a filtering process, that the least-able-to-lose are going to end up being the losers again, when and if the bubble busts.

    Mr. WALLMAN. Mr. Kanjorski, just a couple of quick observations because I think you are exactly right with regard to a number of the observations. Some of the things that technology is able to do with regard to your first point is that, to the extent we can get more immediate clearance and settlement, it is harder to do the equivalent of check kiting. If you've got the ability to know precisely what somebody, in fact, has, as opposed to what they claim to have in a certain account, then it is easier to do the appropriate credit checks. That is starting to happen, but we aren't there yet, certainly not on a worldwide basis.

    In addition, the more that you can get information transcending various national borders, so that if somebody, in fact, has an account in Japan and they've got an account in Europe, and they've got one in the United States, they don't have the ability to claim the same collateral for all three accounts because you've got more linkages between the credit authorizations, then that problem starts to go away as well.
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    But you are exactly right with regard to another point, too, which is the issue of, for example, viatical settlements and some of the other kinds of concerns that people have had with regard to selling off life insurance products at the end of somebody's expected life and things of that nature.

    Part of the current regulatory system is what allows that. Because we have product definitions and product regulations, and then we define insurance regulation at the State level, and we have certain regulation there, and securities at the Federal level and securities are defined differently than futures, defined differently than insurance, you end up with things slipping between the cracks, you end up with a lack of focus on consumer protection. We have a great agency that does a great job nationally on consumer protection, the SEC, with regard to fraud. We don't have the equivalent sort of financial services agency with national reach with regard to insurance, for example.

    And because of the fact that we have simply a different definitional sense of one product versus another, even though, and you are exactly right, the population that is potentially susceptible to insurance fraud one might argue, is actually more in need of national protection and national concern than with regard to securities because of the population and demographics and the amount at stake, you are in a position where unless we can rationalize that better and get to a broader-based consumer protection concept for financial services more generally, we will continue to have these gaps in protection. And we are not protecting some of the people who need that protection the most.

    At the same time, because of the way the definitional regulatory structure works—the functional regulation as people define it, but that is really product regulation—you end up with bars on innovation for people who are trying to do good things. Things that could span two or three different definitional product categories are hard to get through even though consumers, financial consumers, want them and even though people would like to provide them completely aboveboard and completely reasonably, but you can't get through the regulatory structure to provide those.
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    So you have both the downside of insufficient consumer protection and the downside of bars to innovation from a structure that is relying on a hundred-year-old series of definitions.

    Mr. KANJORSKI. It is in fact though that electronic commerce, as it is confused products in terms of breaking down the lines between them. Have we not, as a Government, lost jurisdiction if you are only considering one nation? We are faced with the fact that this is really a global, or worldwide problem. We need an international convention to deal with this as opposed to any single nation. If we put limits on the Federal or national level, we drive those businesses that still operate through the air overseas. I think we have always been faced with that challenge. I know with some of the exchanges, when we try to be too rough on them, they say that they will just pick up and go to another country.

    I think some cities have that same problem. If they try to tax or control in some way, or some State does, they say that they will get up and leave, and they can do that. I think that if these entities can leave for anywhere now in the whole globe, they are going to pick the best jurisdiction. Is it not time that we as a Nation start thinking about devising some international conventions and trying to weaken some of the favoritism of our regulation that we have always had for the last hundred years or so?

    Mr. WALLMAN. I think so. We've got an interesting example in this country, which was we used to rely very heavily on State regulation with regard to, for example, securities. And Congress passed a few years ago the National Securities Markets Improvement Act, which, in essence, preempted some of the State laws with regard to securities protection for investors, not because they were ill-conceived, not because they were bad-intentioned, or they weren't working appropriately, but because we don't have a State-level securities-offering system anymore. We have a national level of securities offerings. And it made more sense to regulate it at the national level and stop some of the burdens of having a dual regulatory structure.
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    I think that that example is something which is going to play out increasingly on a global scale. And we are going to see, as the first point I mentioned the ability to regulate on a sovereign basis within countries' borders starting to erode within the internet, which in particular, is able to transcend any country's borders. We are going to have to face the question of whether you want international regulation of various sorts here. It is not simply a question of course in financial services. People fight wars over things that relate to religion, freedom of speech, and things of that nature, and the internet is going to make great changes there.

    Mr. KANJORSKI. And money.

    Mr. WALLMAN. Yes. So that is where the rubber will really meet the road. Clearly, it will have an impact in financial services too.

    Right now you've got the securities regulators, the banking regulators, and others who do meet internationally, and do have a whole series of international understandings, conventions, or arrangements and treaties on both a bilateral and multi-lateral basis covering a number of these matters.

    One interesting observation though, is at some point we do also have to consider the downside of too much international standardization; which is, if you start to have too little diversity in various systems, as we have found out in biological systems or computer systems or anything else, if you start to have complete standardization, it is easy for various problems, viruses if you will, to make their way through a system. It becomes much easier to have contagion with regard to a structure if everything looks the same and it is all homogeneous than if you've got diversity.
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    And the downside to international standardization of everything is to some degree it lacks diversity unless the international regulations are done very well.

    Mr. KANJORSKI. Just one question. Do you think the Congress is responding to this problem in a sufficient way? Or are we so far behind the times, as the Chairman indicated, that we are just getting around to H.R. 10? What could we do to catch up to speed and be handling this problem? Is there something any one of you want to give us as advice as to what Congress or the President could do to jumpstart meeting the challenges for electronic commerce?

    Mr. CARLETON. I might try one comment. As I was thinking of your question earlier, I was thinking in the context of the foreign exchange market that I am somewhat familiar with, where you can have an investor that can transact in any currency with a counterparty in any country in any time zone. And when you put that into the context of is there is a way we can have some sort of international regulation for that activity, I guess I come back and say no. It just doesn't seem practical.

    But rather, what we do, and what I believe the other banks that we act as counterparties with do, they have a concept of presettlement risk, similar to what Mr. Lutnick talked about, a limit for what you will do with a given customer on a given point in time. And we monitor that. You can monitor it end of day, continuously during the day. And the onus then is on that financial institution to know its customer and know the limit to which he is willing to trade. And in the case of foreign exchange, it is always unsecured trading because your settlement time zones are different. You could have as much as a 36-hour gap between the time you send money out and the time you receive it into your foreign currency account.
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    So it is really a credit decision that gets made. You establish credit limits, and you monitor exposure on a net presettlement basis. And I think the concept could work as we do with some of the fixed income securities we trade by putting those fixed income settlements into that presettlement calculation as well. And I know this is an issue that some of the regulators have focused on, at least with financial institutions, or banking institutions over recent months and years.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Ms. Biggert.

    Ms. BIGGERT. Thank you, Mr. Chairman. I would like to ask the question of Mr. Lutnick, and since I apologize for not hearing the testimony, maybe this would apply to some of the other members of the panel. Do you think that the audit trail for the trades is better in the open-outcry system or in your electronic trading system? And I presume that you at one time had the outcry trading system. I don't know if you still do, but——

    Mr. LUTNICK. We had a system that was similar to open-outcry, and then we converted to a fully electronic system. And it is a John-Henry-versus-locomotive argument. The electronic trading system has a perfect audit trail because with one atomic clock you will know exactly who hit what button when, and you can go back and see what each participant bid in slow motion or any motion you want. Whereas, to try to recreate an open-outcry environment is just going to be anecdotal, with a variety of witnesses sort of testifying as to what someone said or didn't say.
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    And so I think there is no contest. The audit trail in open-outcry is just not up to the test of what an electronic system could do.

    Ms. BIGGERT. Do you have like a—do you still have pits or anything? Or is this all done electronically and you don't have an exchange so to speak?

    Mr. LUTNICK. Well, Cantor Fitzgerald, in conjunction with the New York Board of Trade, created the Cantor Exchange. And what we have is those people who used to be in the equivalent of the pit now sit in front of a computer and they are called terminal operators. And then starting April 6, we just received approval from the CFTC, we will then enable all users of futures who are clearing members, members of the exchange or customers of clearing members, to have electronic access to those markets.

    So basically, instead of calling our people and having them scream and yell, you can call if you wish, but all they will do is stand in front a keyboard, or sit in front of a keyboard actually, and input it. And then of course, if you prefer, you can have a keyboard yourself and do it yourself. So everybody is on the same playing field. There is no value whatsoever for sitting in my offices as opposed to sitting in your home or your office. The information that our terminal operators have is exactly the same as the information that everyone who sees the electronic information will have.

    So it really takes the information out of the exchange, and makes it available for all of the customers of the exchange to see. It is really a fantastic and exciting change.
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    Ms. BIGGERT. Thank you. But are there any dangers to electronic trading or electronic banking to the market? Are there any downside of the electronic?

    Mr. LUTNICK. Well, we have run the U.S. Government securities market electronically since 1996 and what we have done is put in a number of safeguards, the credit monitor, not allowing a particular keyboard or particular customer to do more than they are authorized to, not allowing the keyboard to do any particular transaction of more than a certain size. So this concept of leaning on the keyboard and buying $6 trillion, which there were those problems in Europe, and the European Exchange can answer your questions about that this afternoon, but in our marketplace and in our exchange, we have a limit to what any particular customer can do. And they have to set those limits prior to transacting.

    So an electronic system can put these controls on; whereas, in an open-outcry environment, if someone wants to go crazy and walk in and start screaming and yelling, the only way they can stop them, and this has happened at the Chicago Exchanges, they get some security guards and they drag the nut out of the room. And however much financial damage he has done he's done.

    In an electronic environment you can actually hardwire it so that keyboard just won't buy and sell too many.

    Ms. BIGGERT. OK.

    Mr. KATOVICH. Mrs. Biggert, if I may?
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    Ms. BIGGERT. Yes.

    Mr. KATOVICH. I would add that to us, one of the biggest challenges about electronic trading is allowing those who already have significant interest to keep electronic innovative trading systems away from their own markets and thus cause fragmentation of the market. To us, that is a great challenge that the regulators have to deal with today.

    There is not going to be an end to the innovation that is occurring. I think that is clear to everyone. What is dangerous is if that innovation is not allowed to integrate with the rest of the marketplace.

    Ms. BIGGERT. Is there ever a problem too with somebody, let's say a broker that is using electronic trading, and they get a buy or a sell order from a customer and instead of placing that order immediately they place their order and then the customer's order?

    Mr. KATOVICH. In the early stages of electronic trading development, that was the case much more than it is today. I think what people have learned is that it is very important to put a number of safeguards in place, onto the system, as we did with OptiMark that make sure: ''Are you sure you want to do this?'' ''Are you sure again?'' ''Yes, yes.'' Hit the button.

    In the old days, it was so new that would happen and mistakes were often made.
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    Ms. BIGGERT. At some point this could be where, you know, if they know that the price is going to be better before they place the order of a client. I mean it is illegal, obviously, but is that caught with the electronic trading?

    Mr. KATOVICH. I think we have done a very good job with that. Because of the systems that we have put in place, you have such a good blueprint. That was one of the things that the SEC was very impressed with when the OptiMark system was approved was that it took a huge burden off of them because they know that they can go back and recreate every step from the time the entry was made until the time of execution, or not. And by doing that, it allowed us to open up the markets even more because now, especially with credit limits in place, as we have mentioned before, even nonmembers can have access to the system without risk because of that credit limit. And because of the blueprint of everything from start to finish, I think we can relieve many burdens that the regulators think they have to have today and allow them to focus on bigger picture issues.

    Ms. BIGGERT. Are there still regulatory challenges though that haven't been solved?

    Mr. KATOVICH. I think the biggest challenge the regulators face today is how to deal with the current structure and how they are going to have to integrate innovation into that current structure. The current structure definitely wants to impede a lot of the innovation that is going on.

    Mr. LUTNICK. See, my view would be that, that for the regulators, competition will make regulation easier because it is not as much a rule that will promote change but that competition will promote change. The difficulty of competing with an open-outcry environment is you have to not only build a building, but you have to get each participant to hire a replica of what they have to compete, in effect, with themselves. And that is why the exchanges of the United States are all monopolies. Because to make each participant hire an additional 20 people to create another market of the one they already have would be crazy and very expensive.
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    But once technology starts, it creates a world of innovation. And then you will see that if the current market participants, they will have a choice, they can move and come up with another innovative approach, which satisfies the customers, or they will become a relic of the past. And new innovation will come on top of that. And so I think what you will find is that competition will drive the markets of the United States, if encouraged, will drive the markets to the proper way of doing business and let the free markets and competition do it. And what you will see is an incredible cut in cost of transacting business in America and much better information everywhere.

    Ms. BIGGERT. I think that we will probably hear just a little different perspective from the next panel.


    But I certainly think that, you know, creativity is very important. Thank you very much. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Ms. Biggert.

    Mr. Maloney.

    Mr. MALONEY OF CONNECTICUT. Thank you, Mr. Chairman. I was struck by Mr. Wallman's discussion of the paradigm shift, but I also noted Mr. Carleton talked a little about Japan. And Japan, obviously, is having a tremendously difficult time making what is a fairly simple paradigm shift in its banking industry, going from a system that is not transparent in the least, opaque I think is a good word. It's having difficulty even getting translucent, never mind transparent. So the difficulties we have in making paradigm shifts shouldn't be underestimated, and I think Mr. Kanjorski approached that when he talked about what to do about the insurance industry, which doesn't even exist on the national level as a regulatory situation.
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    So my question is to Mr. Wallman, and I look at your testimony about this shift of product-oriented regulation to goal-oriented regulation. My question is, do you have advice as to how we manage, how we, from a legislative point of view, can help manage that paradigm shift? Let's assume that you are right, that we should move to a goal-oriented regulatory approach, how do we get there? And you might not have that answer in your back pocket this afternoon, but I would be interested, as your research evolves, you taking a look at that.

    That is the real issue for us on this subcommitee. There are really two issues, which are: where should we get to?; and the second issue is, can we get there from here? And financial modernization is sort of an interesting example of that, which is what people have been talking about for 25 years. This commitee did a bill a couple of weeks ago, we can call it ''financial modernization,'' but we really should call it ''financial catch-up,'' because the market is already well beyond what the bill already does.

    So that is my question. It is really a request for additional discussion of how do we, in fact, move the process so we can get to a better system? We can't just jump, obviously. That is the experience. We are not able to just jump from A to B, we have to go through some process.

    Mr. WALLMAN. Just a quick observation, and I would note that I think the process gets broken down into two steps. The first is to have some consensus and view on where you want to go. And then there is—I think there can be—the leadership necessary to figure out a way to get there.

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    With regard to this, my intent here was not to suggest that we have all the answers right now and to suggest that this be put into legislative form tomorrow, but to start the debate on whether or not we have a better idea of where we want to go. If it is a better vision, and I think it can be shown to be unequivocally a better vision, but if it is in fact a better way to go, if it is in fact the place we want to end up, and if we can get enough people on board with that view, then I think we can actually figure out a way and a path to get there.

    The concern I've got is that so many times, because the path is not clear, people don't even think about where they want to head. They just sort of say: Boy, this road is pretty tangled. So we are not even going to figure out if this is where we want to go.

    And I thought it needed in this case to start at the other end. We need to sort of have a sense of where do we want to go, not just where can we get to at the moment. And my guess is, given the leadership in this country, and in financial services in particular, and in the Congressional committees that care about this issue, and given its importance to this country, if we conclude there is a better place to be, we will figure out a way to get there.

    Mr. MALONEY OF CONNECTICUT. Well, I hope you are right, but the experience is that the difficulty of the journey can be very, very acute. And any advice about the individual steps would be welcome.

    Mr. WALLMAN. I think we can get that from some others that have gone through some similar exercises in the past. I would just note that unlike other things though, cars, refrigerators, hard assets, financial services are really exactly the paradigm example of something that is international in scope. It is trivially easy to move the data and the information necessary to engage in financial services to any place, anywhere. And to do it at almost no cost. It is frictionless.
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    If we don't modernize appropriately, and if we don't allow innovation to occur here, it will occur somewhere else. And capital will flow to where it needs to get the services it needs. And if we are in a position where we put burdens here, the comments that have been made earlier by the Chairman and others are precisely correct, people will simply go overseas to get the services that they need. That would be a shame.


    Mr. DOMOWITZ. I really would like to chime in on this in one sense. I mean I'm not sure I agree completely with the concept of regulatory flight. And if you are asking for a series of steps, I do have a concrete suggestion. And this came about from meeting with the CFTC's Trading Markets Division last fall. They were very interested in precisely the same question.

    They asked it somewhat differently. They wanted to know what were the new metaphors that should be used in framing regulation. Now, when I say I don't believe in regulatory flight completely, it means that I believe in reputation effects, that there are certainly some segments of the consumer and public in the large that will indeed choose the safer haven for whatever reasons, for the same reason that someone keeps CDs instead of mutual funds, or instead of corporate bonds.

    Now, in terms of steps, the concrete suggestion, given the global nature of the trading business and the developments being discussed here today, is to think about metaphors that get you out of the regulation of trading-market structure. In other words, divorce trading-market structure from other areas of legitimate regulatory concern, such as consumer protection. If you do, even if the regulations are stiffer in the United States, just as a point of argument, then those that prefer greater consumer protection will stay, if you don't simultaneously regulate market structure in such a way as to stifle the type of innovation that has been suggested at this table today.
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    Now this actually a very simple thing to do. The fact that the CFTC and the SEC are involved in trying to regulate market structure as in electronic markets versus floor markets versus dealer markets, and even the type—I mean, is OptiMark a good system? That has been debated. Is a particular type of automated auction a ''good system''?

    There has been talk of actually regulating along these lines. The markets are very capable of deciding that question. The market, indeed, may not be capable of helping out with the consumer protection side. If you get rid of one, and concentrate on the other, then I think you can do what you need to do here at home and not fear the type of regulatory flight that has been suggested.

    Mr. MALONEY OF CONNECTICUT. Thank you very much.

    Thank you, Mr. Chairman.

    Chairman BAKER. Mrs. Jones, did you have a question?

    Mrs. JONES. Mr. Chairman, thank you very much. And gentlemen, I apologize for my delay, but you know what our life is like up here. I am at least glad to get here to say something, first of all, to thank you for coming here this afternoon to present to our subcommitee. Just a couple of general questions.

    I am interested in—I am a lawyer by trade, and one of my friends used to say that before e-mail and fax machines, a lawyer had time to think about what he or she was going to do in a transaction before the deal was right in front of them. But the real question I have is, as we talk about the cost of doing business over the net, and right now we as a country enjoy the opportunity to talk to our cousins in Germany or wherever the heck they are without any cost, in the trading area, who assumes that cost? Is that another commission from another amount of money that comes from the deal if someone trades? How do you foresee that being handled down the line as individuals engage in this process?
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    Mr. LUTNICK. I would use an example of a commodity of diamonds.

    Mrs. JONES. OK.

    Mr. LUTNICK. Which would be that each of us who would purchase a diamond knows full well that we don't have the opportunity at anywhere the price that we paid. If there were a market created where one could buy and sell diamonds, what would we would be freed of is the fact that we bought it and we were never able to sell. So now we would be able to sell an asset that we purchased and buy something else, whether it is another diamond or something else.

    And what you are taking out, is you are taking the enormous profit of an information advantage away from the particular party who had that knowledge, in this case the diamond dealer, and you are giving that money back to the ultimate consumer. And when you give that money back to the ultimate consumer, you free that consumer, who may well instead of just buying one diamond their whole life, they may sell diamonds and buy diamonds and they may end up buying diamonds all the time. But you are enabling taking a single profit from one big profit to a very small profit, but then what you are obviously going to have is many, many more transactions.

    And what you might find is the dealers actually make more money. And so it is a sort of paradigm shift.

    Mrs. JONES. Let's carry this thought just a little bit further. Suppose we are talking about companies who make electricity, just for example, but they don't own the wire to transmit the electricity, my question is, as a consumer, and I am sitting at my PC and I don't own the wire, who is paying the cost of the wire? It is just like ATMs used to be free, they are no longer free. Who is paying that charge in our open world in trading?
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    Mr. LUTNICK. The view that we have for electronic trading of electricity, which will happen, it will be delivered to you from the variety of sources, and there will be an end cost to yourself. The buyer of it will pay for the creation, the generation, the transmission, and the distribution. Those who have the wires to your house will therefore have a benefit. They will get a small toll for carrying through to you. But think of the opportunity you will have, if you believe in green energy, you can now say I pay a little more but I want to encourage that type behavior. So I want to go to a green generation plant as opposed to something else.

    And therefore, you can drive with your economic dollars decisions that you wish. If you want to buy the cheapest, most efficient energy, then you will be encouraging that producer to do it again. And you will also encourage people to run new wires, just like telephones now.

    So it may come over your cable box and it may come over the internet, it may come over your phone lines, but if there is a dollar to be made, someone who will sit happily across from you will tell you that they will know a way to get it and they will innovate to get there. And that has got to be good for costs and consumers.

    Mrs. JONES. Mr. Chairman, as much as I would like to ask each of these gentlemen a question, I want them to come back again and won't say I was so long-winded. Thank you very much. I yield the balance of my time.

    Chairman BAKER. I think they are delighted with that decision too.
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    I want to thank the members of the panel for their testimony and their willingness to put up with a lengthy agenda today. Thank you very much for your participation.

    And would like to ask the participants of our third panel to please come forward.

    I would certainly like to welcome each of you to our hearing today and compliment you on your long-suffering patience. I am told that we are not likely to have any floor votes to interrupt our panel. So we may be able to conclude without any further interruptions.

    Our first witness this afternoon, Mr. Frank Rose, Vice President for Research and Strategic Analysis for the Chicago Board of Trade. Welcome, Mr. Rose.


    Mr. ROSE. Mr. Chairman, Members of the subcommittee, thank you for the opportunity to meet with you this morning. In response to your request, I would like to discuss technological trends in the futures industry, the impact of these trends and my expectations regarding the nature of the industry five to ten years in the future.

    Chairman BAKER. You can pull that mike a little closer. Thank you.
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    Mr. ROSE. In 1998, 4 percent of the volume in U.S. futures exchanges was traded electronically. Five years ago, less than 1 percent of volume was traded electronically. This contrasts sharply with the picture at overseas futures exchanges, where electronic trading accounted for 48 percent of volume last year, up from 32 percent five years ago.

    Globally, one of every three futures contracts was executed electronically in 1998. As new exchanges are created, available technology allows them to put electronic trading systems in place more cheaply and easily than the open-outcry trading system that prevails at most existing futures exchanges.

    Communications technologies allow ready global access to these electronic markets. The movement toward electronic trading is clearly an important trend, which is having a dramatic effect in our industry.

    The business has always gone to and will always go to where the liquidity is, be it on a trading screen or in a trading pit. We are continually working to make our open-outcry markets more efficient through technology. Our goal is to reduce as much as possible the cost of participating in our markets in order to attract more orders and to build more liquidity.

    One means of achieving lower costs is through the electronic routing of order-flow information into and out of our pits; that is, a move to a paperless trading floor. To do that, we have implemented electronic order-routing systems to convey orders electronically, directly into and out of our pits from locations either on or off our trading floor, thus reducing costs and errors and improving market efficiency.
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    Implementation of these systems, which is a major priority at our exchange, also allows us to enhance our already excellent audit trail monitoring capability. During 1998, over one-half million orders were routed electronically via these systems, a tenfold increase over 1997. On average, 10 percent of the customer order flow is currently being routed electronically. However, in certain contracts, as much as 80 percent of customer orders is being routed electronically.

    We are aggressively working to enhance these systems and expand their adoption, mandating that small orders and certain types of brokers must utilize electronic systems.

    While we remain firmly committed to open-outcry and to making open-outcry as efficient through the use of state-of-the-art technology, we are also committed to providing our users screen-based electronic markets if they want to use them. Our electronic trading system, Project A, was launched in October 1994, initially to serve as a market platform for low volume products and products that customers want to trade overnight when our pits are closed.

    We have repeatedly enhanced and upgraded this system, and it now trades Chicago Board of Trade products 22 hours a day, virtually around the clock.

    The value of having this marketplace available outside U.S. business hours was again demonstrated last fall. Last October 28th, Asian and European stock markets declined sharply due to concerns with the Asian economy. This precipitated a flight to safety and Project A traded 164,000 contracts that day, most of it in the overnight hours. The availability of U.S. Treasury futures and options on our Project A system facilitated the overseas markets' efforts to shift portfolios quickly and cheaply.
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    Our most active products, our Treasury futures and options, now trade on Project A. In fact, beginning in September 1998, we began Project A trading of our Treasury products during the same hours as they trade in our open-outcry markets. This side-by-side trading of Treasury products gives our customers a choice of market platforms during the most active hours of the U.S. business day. And, when our pits close for the day at 2 p.m. Chicago time, Project A trading continues for use by customers in the Far East and Europe.

    Five hundred and seventy-four Project A terminals are currently deployed around the world. We have Project A terminals in North America, London, Paris, and Tokyo now, and plan to install them soon in other parts of the world. While Project A volume accounts for only 4 percent of total Chicago Board of Trade volume, last year, volume on Project A more than doubled.

    Project A is the largest and fastest growing electronic trading system for futures in the United States. If it were a stand-alone exchange, it would be the fifth largest futures exchange in the U.S. and the eighteenth largest in the world. We have every reason to expect continued rapid growth in the future.

    What will the futures markets look like in the next century? How will technology change them?

    I expect there will be some equilibrium struck between open-outcry and electronic trading. Each of these trading mechanisms has inherent advantages, and, depending on the preferences of market participants, prevailing market conditions, and the characteristics of the products that are traded, open-outcry will be the venue of choice for some markets while electronic platforms will be the choice for other markets.
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    I expect liquidity will continue to be a critical criterion in this decision. We may find, for example, that for certain products, the liquidity provided by market-makers in a pit, or as they are called, ''locals'', cannot be matched on the screen. Open-outcry trading will then dominate for those products. For other products, screen trading may develop adequate liquidity through the participation of dealers in the underlying cash market or the development of cadres of ''electronic locals'' who adapt their market-making skills to the screen.

    Screen trading may also develop adequate liquidity by virtue of the expanded access that electronic markets may provide. If liquidity on the screen matches liquidity in the pit, other factors, such as trading fees and commissions will determine which market form dominates.

    Costs of trading will continue to be a critical factor in determining what our markets look like in the future. Costs of trading matter, although they matter to some market participants more than others. And market participants have different sensitivities to the different components of costs.

    The two principal components of trading costs are the bid-ask spread and the combination of fees charged by the exchange and brokers. The ''bid-ask spread'' can be viewed as the price charged by market-makers for supplying an immediate transaction upon demand. A liquid market will provide a narrow bid-ask spread, that is, have a lower liquidity cost, than an illiquid market.

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    Large institutional users who trade in our markets continuously to manage their price risks often pay more attention to the bid-ask spread, that is the liquidity, which is a major component of total costs.

    They tend to view the fees as a cost of business, which is necessary to obtain the price protection that they need. They will move to the most liquid markets—that is, those with the smallest bid-ask spread—even if the trading fees are slightly higher.

    Other market participants who perhaps are less active in the markets and will be more sensitive to the explicit trading fees that are paid out of pocket. They may continue to trade in illiquid markets; that is those with larger bid-ask spreads if their out-of-pocket costs are lower. Thus, the sensitivity of market participants to the various components of costs in the trading of different products will be an important determinant of market forms in the future.

    Another cost which is a critical determinant of the future structure of our industry, is regulatory cost. If regulatory differences impose heavier costs on our markets than on alternative foreign and over-the-counter markets, our customers will go there.

    Federal Reserve Board Chairman Alan Greenspan acknowledged this in a recent speech when he said, ''The largest banks, in particular, seem to regard the regulation of exchange-traded derivatives, especially in the United States, as creating more burdens than benefits. As I have noted previously, the fact that OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives.''
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    Chairman Greenspan went on to point out that the opportunities for regulatory arbitrage created by differential regulation can seriously undermine regulatory standards as well as underlying safety and soundness objectives that regulators and market participants alike wish to achieve.

    I also expect access to our markets will look quite different five or ten years hence. Now at the Chicago Board of Trade, all trades must be executed through a member. Channeling all business through our members allows our self-regulatory and clearing processes to ensure that financial integrity is maintained. The exchange certifies the members and monitors their trading practices and financial condition. The members, in turn, monitor their customers.

    The AAA-rated Board of Trade Clearing Corporation stands behind all trading at the Chicago Board of Trade, and as a result no customer has ever lost money as a consequence of a default in our markets. These procedures and safeguards provide the cornerstone of financial integrity, which defines our markets.

    I have given you a snapshot of our developing electronic order-routing systems and global trading system, which improve order flow and channels of distribution. Those activities will undoubtedly also drive changes in our market access policies. The technological tools that are now available, the internet for example, provide tremendous opportunities for markets to be taken directly to their users.

    However, any adaptation we make in our access policies at the Board of Trade will necessarily require that we implement new systems to maintain the financial integrity of our markets. We will not facilitate greater access to our markets at the cost of financial integrity.
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    Over the next five or ten years, we expect that our markets will continue to grow. Total volume at the Chicago Board of Trade increased nearly 16 percent last year. Some of the world's futures exchanges and the over-the-counter risk management market enjoyed even higher growth rates.

    As I noted previously, our electronic trading more than doubled last year. The need for risk management will increase, market practitioners will become ever-more sophisticated, and the pie will get bigger. The market shares of open-outcry and electronic trading will be different than they are now. Markets of all forms will incorporate the full array of available communications and trade-execution technology.

    I expect that we will see a variety of market platforms from traditional open-outcry trading to electronic systems to websites with varying order-entry capabilities. Exchange-based markets will continue to provide the market transparency, financial safeguards, certification of participants, marketing, and R&D that our customers value.

    The precise look of our markets in the next century is impossible to gauge; but that they will look different than they do today is certain.

    I will be pleased to answer your questions.

    Chairman BAKER. Thank you very much, Mr. Rose.

    Our next witness is Craig Donohue, Senior Vice President and General Counsel, Chicago Mercantile Exchange. Welcome, Mr. Donohue.
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    Mr. DONOHUE. Thank you, Mr. Chairman, and Members of the subcommitee. I am pleased to address you today.

    The Chicago Mercantile Exchange welcomes this opportunity to offer our view of the regulatory implications of the rapid and seemingly inexorable shift from local, floor-based exchanges to international, globally operated electronic exchanges.

    This hearing is particularly timely and important in view of our regulator's efforts to deal with the expansion of trading network facilities and the proliferation of electronic trading devices.

    The CFTC is struggling with the regulatory issues raised when foreign screen-based exchanges target U.S. customers by means of terminals located in the United States. At one extreme, it is argued that terminals are simply sophisticated telephone connections to a foreign exchange and that no basis for regulation exists. At the other end of the spectrum, the screen is regarded as an electronic version of a physical trading floor which should be regulated to the same extent as a traditional open-outcry exchange.

    The Commission's proposed rule is currently subject to public comment, and the Commission is following the expected path. It is trying to ensure that U.S. customers and its own jurisdiction are protected. Perhaps the Commission can be viewed as protecting U.S. exchanges from the activities that diminish their ability to fulfill their statutory function.
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    Unfortunately, regulation cannot keep pace with technology. Most of the Commission's good intentions are likely to be undone by technological workarounds and technological improvements. In the long run, the only way to protect U.S. exchanges from rivals operating in more supportive jurisdictions is to change the underlying philosophy of regulation of derivative exchanges in this country.

    We, along with the Chicago Board of Trade, will be working hard to ensure that the next reauthorization of the Commission results in a new regulation and a new regulatory direction. In fact, it might be instructive to look to our history for a model.

    Thirty years ago, our governing agency, the Commodity Exchange Authority, the predecessor to the current CFTC, had a few small offices in the basement of the Department of Agriculture and the Chicago Board of Trade. U.S. exchanges at that time were governed by a statute that offered freedom to make appropriate business decisions without advance approval from sincere but inexperienced regulators.

    Unfortunately, that freedom coincided with a time when our product base was very narrow and the world was ill-prepared for the blossoming of futures and derivatives trading. Nonetheless, the CME at that time was able to launch a new exchange and open the door to financial futures trading. We created the International Monetary Market without Federal regulation and without creating a single problem for which Federal regulation was necessary.

    We had two years of freedom before the reach of the Commodity Exchange Act was expanded in 1974 to include all commodities as well as financial instruments. The freedom that allowed the creation of a revolutionary financial derivative market has slowly but surely been eroded by the CEA and its ever-growing clutter of amendments, regulations, guidance, interpretations, and informal policies. Futures exchanges have grown and prospered, but at enormous costs.
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    The competitive costs and consequences of overenthusiastic regulation were far less significant even five years ago than they are today. 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 for U.S. exchanges. Pork bellies 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 brokers with simple algorithms ended the local monopoly and inspired international competition.

    In February, EUREX, an all-electronic exchange was the world's volume leader. MATIF, the French exchange, went from pit-based trading to screen-based trading in approximately two weeks. LIFFE, the principal London exchange, is converting to screen-based trading as we speak and as rapidly as it can come to terms with the technology.

    It expects to transfer its futures and financial options contracts to a screen by the end of the year. LIFFE has restructured to make its business attractive to investors, and it plans to cut 700 jobs from its workforce and eliminate much of its real estate holdings. Within two months, the traditional pit-based exchanges in Chicago, the Chicago Board of Trade and the CME, will have fully listed their leading products on 24-hour electronic trading systems. The Chicago Mercantile Exchange will join the Board of Trade in side-by-side trading other major flagship products, the euro dollar contract.

    Gerry Corrigan, one of our directors, testified here on March 3, 1999, regarding the increasing scale and global mobility of pools of risk capital, made possible by the very technological advances that have increased the efficiency of our financial markets. He stressed that the changes driven by technology could neither be reversed nor slowed. Mr. Corrigan's group is focusing on practices of dealers and leveraged investors. Much of the Counterparty Risk Management Policy Group's work on credit and market risk management will be directly relevant to our clearinghouse operations. But the regulation of electronic exchanges raises novel issues.
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    The mobility of risk capital that Mr. Corrigan spoke about does not permit dealers and brokers to delocalize from major financial centers. Those businesses are labor-intensive and must service their customers at the customer's location. Technology does not permit banks, brokers, and dealers easily to divorce their regulators. Other participants in financial markets, however, have managed to escape. Commodity pools, hedge funds, and investment companies have fled to more tolerant jurisdictions. The first attempt at a screen-based futures exchange was actually based out of Bermuda.

    A screen-based electronic exchange does not need a local nexus in a well-regulated commercial center. An electronic exchange can easily extend its operation across borders, into major commercial centers without offering any physical presence to which jurisdiction can attach.

    Location in a friendly jurisdiction with reliable banking laws becomes more feasible each day. Technology needs can be easily outsourced. Other management and employment needs can be outsourced as well. Connection to the trading engine can be accomplished over the internet or other public networks. Terminals need not even be owned, installed, or maintained by the exchange or its agents. It is quite plausible to construct a trading system using personal computers owned and operated by the traders that trade on that system. Moreover, even the user interface the trader uses can be downloaded over a network.

    An electronic exchange can even avoid the consequences of secondary regulation that results from regulation of its members. An electronic exchange can operate without intermediaries or members. With no members, no equipment, and no physical presence, it is difficult for a regulator to gain a firm grasp or even to assert jurisdiction. EBS and Reuters operate enormous nonintermediated trading networks. The original plan for FutureCom, a proposed internet cattle trading futures market that was discussed earlier, provided for a nonintermediated trading process.
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    Internet gambling demonstrates the feasibility of avoiding local regulation and reaching customers of all sizes. Internet Forex margin trading is a growing enterprise that is often a legitimate business but that follows the same practices, in some cases unfortunately, as gambling enterprises.

    These examples are not a subtle announcement that the CME is on its way to the Grand Cayman Island. However, they clearly illustrate that regulation of electronic exchanges must be a delicate undertaking that carefully balances costs against benefits. Carelessly regulated exchanges can and will move or be decimated by fierce competition from electronic exchanges in jurisdictions that actively promote their markets' efforts to win market share.

    Mr. Chairman and Members of the subcommitee, I thank you for this opportunity to address you. I will be happy to answer any questions that you have.

    Chairman BAKER. Thank you, Mr. Donohue.

    Our next witness is the General Counsel of Eurex Deutschland, Mr. Volker Potthoff.


    Mr. POTTHOFF. I am General Counsel for Eurex and as well I serve as General Counsel of Deutsche Borse AG, which is the operating company of the Frankfurt Stock Exchange. This Frankfurt Stock Exchange is in existence since 1585. This is quite long. Irrespective of that fact, we believe in technology, as I will outline later.
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    First of all, I would like to express my deep appreciation that I am able to appear here and that I was invited as a witness to testify at this hearing. I think it is not self understanding for somebody coming from Europe to testify in this hearing. I appreciate that very much.

    I will focus briefly on four items, first I will tell you a little success story about Eurex. But this is not only a success story about Eurex, it is about electronic trading in general. Second, I will briefly touch on the effects on the community, on the customers of an electronic exchange in terms of cost efficiency. And third, I would touch on the enhanced possibility to regulatory oversight of electronic trading. And thirdly, I will deal with the question of how to regulate, in our opinion, internationally operating exchanges.

    Let me first tell you from which background Eurex is coming. We are a European exchange, the result of a merger of a Swiss derivative exchange, SOFFEX, and the German derivative exchange, DTB. And we have a very competitive environment in Europe. And that might be still a little bit different from what is happening in the United States so far, because we have the monetary union. And with monetary union, fierce competition among financial services providers forces us to enhance technology, forces us to look at costs reductions for our members, and forces us also to form alliances because what we will see in Europe in the near future is a lot of exchanges will just disappear.

    Eurex has remote membership access network, as we call that, and I think that is one of the big advantages of an electronic exchange. You don't need physical presence at the place where the exchange is located. We have so-called computer access points at seven different locations, such as Amsterdam, London, of course, Madrid, Paris, Helsinki, Chicago, and Zurich. Eurex has 312 members as of December 1998, and 144 of those are not located in Germany or Switzerland. So this is quite a remote membership network.
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    The average trading volume in 1998 was nearly 1 million contracts. This totaled into 250 million contracts in the year 1998. This has even increased in the beginning of 1999, where we now trade about 1.3 million contracts a day. And this for the last two months has brought us up to the number one position in the world. The product range is not only fixed-income products but also index and equity index products as well as equity options.

    Now let me focus a little bit on the efficiency of global electronic trading. I think there is a clear tendency that we see, and this has already been mentioned, towards electronic trading, in the cash market and in the derivative market. In the derivative market in Europe it is going faster because derivative exchanges do not have such a long tradition as in the United States. And so, for example, DTB was founded in 1990 and started as a fully electronic exchange because it was a quite recent exchange.

    We have seen that electronic exchanges allow for more cost efficiency on the member side, and I do not want to elaborate too far on that because that has already been mentioned in the previous panels. But it is really a drastic cost reduction on the side of the members, which are financial institutions in Europe, mainly banks but also investment firms, broker-dealers, FCM's comparable.

    Eurex has since one year multi-currency transaction capabilities. That means it will not only settle in national currency, meaning at that time deutschmarks, but also in euros and in Swiss francs, and other currencies would be technically available for settlement.

    The clearing house is a subsidiary of Eurex Frankfurt, called Eurex Clearing AG. And it is fairly the same clearing procedures as we find them at other commodity and futures exchanges because we have the clearing risks taken by general clearing members. We have direct clearing members and we have nonclearing members. I do not want to elaborate on that too far. It is in my written statement.
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    What is the big advantage about this electronic processing? It is that you have the full transparency. That also from a credit risk point of view, clearing members can monitor not only on daily but on an hourly basis, but on an all-time real-time basis the risk positions that their nonclearing members, which some will take at the derivative exchange.

    So in terms of risk management, this means major enhancements. Electronics helps with certain systems in place, and on the members side credit-risk systems, which then alert the general clearing member if, for example, certain position limits are met or even went over.

    Also, on the regulatory side, this is a big advantage because the regulators, such as the self-regulators at the exchange, but also the oversight regulatory authorities, can monitor all the trades. They have a track record, an audit trail where they see from the order entry until the execution and clearing what has happened, and of course this facilitates the oversight over electronic exchanges.

    Let me at last focus on one point, which of course, as it has been mentioned before, is very important for us; how to deal with the globalization in terms of regulation.

    Yes, Eurex is a European exchange having terminals in the United States due to a no-action letter that we received from the CFTC in 1996. Presently we are freezed until the new rule that the CFTC has just released as a proposal will come into force. So we have currently about 20 members trading directly from the U.S. and there are many more members standing in line and waiting for being admitted as members but they can't right now because the CFTC said it would be a competitive advantage to one exchange if it is enabled to place terminals in the United States while others are waiting outside. And so we have to wait on the outcome of this rule.
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    We have also a little bit of an odd situation, if I may say, in the United States due to the fact how U.S. regulators regulate us. For example, our index, the German share index future is regulated by the CFTC, and so we are able to trade this because we have received this no-action letter whereby the option on the future is subject to supervision by the SEC, and the SEC so far has not moved on the issue but is, as we understand, about to move on the issue of foreign terminals being placed in the United States.

    For somebody coming from abroad, that is quite an odd situation, and it is our members interest in the big bias in the United States, also local traders, to get connection to Eurex and trade a wide range of products.

    I would like to elaborate just a minute on the European approach that has been taken in supervising exchanges or so-called regulated markets. What we have there is the investment services directive that provides for the home country regulators' control. And that means there is reliance on certain standards. Of course, we have minimum standards in the financial industry in Europe, but there is a reliance on the home regulator. And then there is what we call the European passport, any exchange can install trading terminals in other European countries without obtaining any permission.

    And of course this is in reliance on each other's regulation. And that is something we would propose as an approach in the international field. Of course we understand that there has to be certain comparability. But I tell you, in the future the regulation of markets, and that has been said before, will not be so much on the market side. To regulate markets with different customs and have one set of rules is just impossible.
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    It will be on the intermediaries' side, because the intermediaries are taking the risk. And they are advising the customers. And so we think there will be a little shift. Electronic trading is just not open-outcry, and probably we need other different safeguards.

    Thank you very much again for the opportunity to speak.

    Chairman BAKER. Thank you very much, sir. Certainly appreciate your participation.

    And I would like to give your insight as well—when Eurex was started it was a wholly electronic-trading-based system as opposed to some combination of open-outcry with electronic. What was the perspective—or what was the thinking behind the creation of Eurex in that fashion?

    Mr. POTTHOFF. Well, at that time, I mean, it was an initiative more or less by the banking community in Germany. And saying, you know, we believe in technology in the future, and we set up this exchange as a fully electronic exchange.

    Why? Because we saved cost. Not only the trading cost, but what has been forgotten so far to mention is the staffing. If you have to have people, employees, running around in the pit on the floor, you have more people involved in this, and banks looked at the cost and said no, it is much easier to have one trader or many traders sitting in a room and trading electronically.
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    Chairman BAKER. Very simple. Thank you.

    Mr. Donohue and Mr. Rose both: Given the dramatic changes that occurring in electronic delivery systems, what do each of you think your exchanges look like in the next five years? What changes do you expect in the way business is conducted?

    Mr. DONOHUE. I would agree with Mr. Rose's comments that he made during his remarks that I think what we will see in both of our markets, but certainly at the CME, is an increased reliance on electronic trading. Some of our products will lend themselves quite naturally to an electronic trading system where customer orders will provide the liquidity necessary for people to want to trade on that system without necessarily having a large pit with risk-taking independent traders who provide the liquidity that you currently find in open-outcry markets.

    Other of our contracts, I think principally in the agricultural area and possibly certain other areas, will continue to be dominated by open-outcry trading. But I think we will see an evolution more toward electronic trading. But I don't think open-outcry trading will disappear altogether.

    Chairman BAKER. And what would be your thinking as to why in certain product lines, I would assume, that open-outcry would remain the preferred methodology? Is it the role of the intermediary in providing information to the customer? Or is it the security the system provides? What is it you think that makes certain products more likely to remain in that form?
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    Mr. DONOHUE. Well, different products, obviously, have different attributes and different customer bases. In our agricultural products, for example, there is at this point in time very little interest among the end-user base in electronic trading. It's not something that they would become accustomed to and that they have widely adopted or accepted. Additionally, they find that the pricing mechanism provided by open-outcry is actually quite favorable, and they are not looking for an improvement that electronic trading would provide.

    On the other hand, in our euro contract, which is heavily dominated by banks and large financial institutions, they are looking for a level of efficiency that they believe they may be able to achieve. Not all customers, of course. Some customers will obviously continue to prefer open-outcry, and that is why, like the Board of Trade, what we have done is put together really a side-by-side kind of trading platform, where we will offer that product for trading not only in the pit, but also electronically.

    And, ultimately, it will be the customers that will choose, and some may continue to prefer one form of trading over another.

    Chairman BAKER. Thank you.

    Mrs. Jones.

    Mrs. JONES. Thank you, Mr. Chairman.

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    Good afternoon, gentlemen. Again, thank you for appearing here before our subcommitee this afternoon with regard to this issue.

    Mr. Donohue, let me go to you first. In some of your testimony, you talked about when things are appropriately regulated. In this area, as we move into electronic trading or further into electronic trading, what do you see as an appropriate regulation, and in what area? And where to you think we slide into the wrong direction?

    I know that is an open question, but give me a shot.

    Mr. DONOHUE. I think that for us the point that we are trying to make is that for the U.S. futures markets to remain viable and competitive, we need to have a more level playing field with the type of regulation that we find in other countries. The foreign exchanges, through their electronic trading systems, will have a tremendous competitive advantage if we don't change the regulatory structure that we have here in the United States.

    Mrs. JONES. This is cross-examination. For example?

    Mr. DONOHUE. For example, let me give, if I may, just a brief historical example. And for those of you who aren't familiar with the way our markets operate, I will give a brief description.

    A dozen years ago, the way that orders were transacted on the floor of the exchange is that a customer would call a member of the exchange, a clearing member of the exchange, say, for example, Goldman Sachs, and they would place an order to buy 1,000 contracts in the euro dollar pit. And that order would be written up, time-stamped, and then actually hand-delivered by a messenger into the pit, which could take many seconds, or minutes, depending on the volume of trading going on at any one time.
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    Around that time, innovative people began to engage in a practice that we call ''flashing'' of orders, where instead of having somebody manually run an order into a pit, through hand signals, they would begin communicating with people in the pit, the order would be executed almost instantaneously, the customer would receive a fill, and because markets are always moving and prices are always changing, there was a real economic advantage for people to engage in that kind of behavior. And it made the market more efficient and more effective.

    Mrs. JONES. OK. Take me quicker. I'm a quick study.

    Mr. DONOHUE. OK.

    Mrs. JONES. OK. Go on.

    Mr. DONOHUE. Today, that same issue is in place, which is that we have regulatory requirements, for example, in the United States where you have to enter a customer's account number into an electronic trading system if you are a U.S. electronic trading system before that trade can be entered and executed. That is not the case with respect to foreign exchanges such as Eurex, such as MATIF, and certain other systems.

    The time that it takes to enter that account number, which could be a 10- or 12-digit account number and mean real money to a market.

    Mrs. JONES. OK. Assume then that that regulation was put in place as a safeguard for both the customer and the seller or the trader, how do you cut that out? What do we do? What is the safeguard?
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    Mr. DONOHUE. Well——

    Mrs. JONES. Cut that requirement out, I mean.

    Mr. DONOHUE. Yes. First of all, our markets are increasingly institutional. And an argument exists that it may not be necessary to have that requirement in place. But there is a philosophical difference between the regulators here in the United States and the regulators in other countries as to whether those kinds of protections are warranted. One could argue that an institutional customer trading the types of products that we trade doesn't need the protections of a rule like that that is designed to prevent post-trade order allocations where winners are allocated to you and losers are allocated to——

    Mrs. JONES. I am using up all my time on this, but since I'm already almost done in, I might as well finish down this. I understand that dealing with someone in the field is different than dealing with someone who knows nothing about the area. But what is the track, or how do you safeguard even someone in the field if you cut that regulation out? You go back and track it based on the electronic trading if there is a dispute? Is that what you are suggesting? That it is already done because the computer records it?

    Mr. DONOHUE. Well, the exchanges have developed tremendous audit trail capability that will detect that kind of fraud, and they are capable of detecting that kind of fraud so that it can be punished and deterred in the future.

    Mrs. JONES. Bear with me, Mr. Chairman, just for one—seeing as we have so many Members here asking questions.
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    Let me get your name and say it correctly. Mr. Potthoff.

    Mr. POTTHOFF. Correct.

    Mrs. JONES. What happened to all the people who used to trade in open-outcry in your country after you put all the machines in? What kind of jobs did they go to?

    Mr. POTTHOFF. Well, first of all, when electronic derivatives trading was started, nobody lost jobs, because before no derivative trading was existing at all in Germany.

    With regard to our cash market, yes. We have some professionals, called floor brokers, that, if we shift completely to electronic trading, right now on the cash market we have an electronic system as well as floor trading, but it is the clear intention to shift, at least in the blue chip market, to electronic trading.

    Yes, they will have to find new opportunities, and that is competition. And they will find new business. For example, they start as IPO advisers or something like that, but they will not be floor brokers any longer. That is correct.

    Mrs. JONES. Understood. I mean, what other kinds of jobs do you anticipate these people will have, because in our country that tends to be what pushes the cart in many instances is what will happen to the people who will lose their jobs as a result of technology?
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    Mr. POTTHOFF. Well, it is a shift in the industry. And, for example, the new market, fast growing market, we have found a lot of small firms right now. Before it was a monopoly of banks that were in the new issuance business and so on. A lot of new firms came into play. We have new players, which we never expected before, because it is a different kind of business. And also in the electronic field, we have electronic IPO's, as you have in the United States, things like that. We have virtual issuing houses and stuff like that. So you have a shift in the industry. But others lose jobs. That is correct.

    Mrs. JONES. Last question, Mr. Chairman.

    Mr. Rose, it's not that I don't like you, but I am out of time. But I need to ask this question of Mr. Potthoff. What will the changes—are you familiar with H.R. 10? Anybody in our country really knows what H.R. 10 is? We have been beating it up for the past twenty years. But you are familiar with our financial modernization?

    Mr. POTTHOFF. Yes.

    Mrs. JONES. What will that allow you to do that you were not able to do in our country previously, if anything?

    Mr. POTTHOFF. Well, it is a difficult question because we have really to look at this in detail. And, as you know, the devil lies in the detail. We waiting, we waiting for further steps, especially the SEC should be taking in terms of the cash market. And also what the CFTC is doing right now. We are pretty limited, and may I support my colleagues here from the United States. When I compare the regulatory system over here with other systems in Europe, for example, what you have to go through when you change a rule of your exchange is really a bureaucracy and a burden that is for you a competitive disadvantage because, for example, in Europe you go to your regulator, you have to inform the regulator. But for normal rule changes, you don't start discussions over a couple of months about, you know, a minor rule. It may be with big rules, yes.
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    But I think there is a lot of bureaucracy, especially in regulating the markets. And if you look into electronic markets, I tell you sometimes there is a lack of understanding how these electronic markets work. If you start bureaucracy in a very competitive environment, you have to move very quickly. And if you move slow, you are at a disadvantage. And that is why I wanted to support your exchenge, even though it may be to my disadvantage.

    Mrs. JONES. Mr. Chairman, thank you very much for the opportunity to inquire. Gentlemen, thank you very much for coming.

    Chairman BAKER. Thank you Mrs. Jones.

    Ms. Biggert.

    Ms. BIGGERT. Thank you, Mr. Chairman. Being from the State of Illinois, I am really happy to welcome two of the panelists from Chicago, and certainly have a lot of the traders in my district. I would also like to welcome the gentleman from far away. But I do have a few questions.

    Mr. Rose, you state in your testimony that you and the CBOT will be working hard to ensure that in the next reauthorization of the CFTC that there will be—hopefully that the results will move in a new regulatory direction. Could you elaborate on that?

    Mr. ROSE. Yes, very briefly. I know the reauthorization process is scheduled to begin shortly in the Agriculture committees of Congress. I think a number of the issues that we have talked about today are going to be important issues for those committees to address. The loss of intermediaries in some markets will result in some protections lost or changed. This is an issue for discussion.
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    In this era of cost-consciousness, it will be very important that regulatory costs be minimized to the maximum extent possible. The level playing field issues are very important. They have been and they will continue to be. And they are even more important when you are talking about not only exchange markets, but also off-exchange markets, foreign exchanges and electronic systems. The variety of market forms adds complexity to that level playing field discussion.

    So while the Board of Trade and the other exchanges will be working to develop their specific positions, which they will bring forward in a few months, I think those are key themes that will be important in the reauthorization discussions.

    Ms. BIGGERT. Could you just elaborate briefly on how does your current regulatory structure impede your ability to move forward with new and innovative ways of trading?

    Mr. ROSE. One of the main concerns of ours is that we be given the opportunity to compete with alternative market forms that are being created. We would just like to have the opportunity to compete with a level playing field across the markets. We think the liquidity and the market services we provide will allow us to compete sucessfully if we are not impeded from a regulatory standpoint.

    Ms. BIGGERT. In the last panel, I asked about the audit trail in the electronic system, and was that better than the open-outcry system. Could you just comment on both of those since, obviously, you use both of them?
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    Mr. ROSE. Yes. We have spent a lot of time over the last several years enhancing our audit trail system. Our system integrates a number of databases at the Board of Trade to accurately determine when trades were executed, who traded with whom, was there any abuse, and so forth. This system of overlaid databases allows us to check and cross-check and come to a precise picture of what is happening in our marketplace.

    We are quite happy with our audit trail now. As we get more into electronic order-routing and the development of our Project A system, we will be able to enhance those systems further. But I think what we have now is quite good.

    Ms. BIGGERT. Mr. Donohue, could you comment on that also.

    Mr. DONOHUE. Yes. I certainly think there is very little disagreement that electronic trading systems and order-routing devices offer an audit trail that is in some respects superior to that found in open-outcry trading. I would simply point out though that that is one factor of many that a customer would look at in terms of basing a decision on where to trade and what kind of a system to trade on.

    For example, at the Board of Trade, they have had in place for some time already side-by-side trading of their Treasury bond futures contract, not only on Project A, but also in the trading pit, and yet you see the preponderance of volume has remained in the trading pit. And I think that is because people believe, appropriately so, that that market is well-regulated and that the exchange and the Commission have the ability to reconstruct trading activity, and the same would be true of us as well.
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    So I would agree that electronic trading does provide a superior audit trail, but I think it should be placed in context in terms of the overall business decisions.

    Ms. BIGGERT. Thank you. Then there was a lot of talk about liquidity. Are there certain products that would provide better liquidity in an electronic exchange? Is that a business decision made, whether to go into electronics? Or to the open-outcry?

    Mr. Rose, I think you had something on that.

    Mr. ROSE. Perhaps I could illustrate that with a simple example. In 1995 we launched a recyclables exchange, an internet-based recyclables exchange, where buyers and sellers of recycled materials were able to find each other on the web and trade with each other if they chose to. If the product specifications that the buyer wanted were the product specifications that the seller had, they could come together, ''paper-to-paper'' in the parlance of the industry. For that, you don't need a pit. The screen does fine.

    For a product like Treasury bonds—a very complex market, very sophisticated users, very complicated strategies—nuances abound there in terms of getting a trade done properly to satisfy the customer's needs. Such a product wouldn't lend itself as well to a simple electronic matching type system. You need to have the human intervention. You need to have that crucible of the pit. You need to have the competition among the market-makers to keep that bid-ask spread narrow for the best service to the customers.

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    Ms. BIGGERT. And is there any difference with trading agricultural products on the electronic exchanges? Is that something that would benefit the farmers to go to something like that? Or is that a product that would be best in an open pit, open-outcry?

    Mr. ROSE. With respect to the electronic order-routing systems that I mentioned previously, they are being adopted more quickly in the agricultural markets. Note that this is not electronic trading; this is electronic order-routing, the conveyance of the order into our pit electronically. It is happening more quickly on the agricultural side because there are larger numbers of small customers, farmers and others, who want to do their hedging activities in our agricultural pits. Electronic order-routing expedites the flow of order information in and out of our pits for the small-sized customers there.

    So that is a benefit for the agricultural community. It is not a change in the execution process itself, but in the conveyance of the orders into the execution process.

    Ms. BIGGERT. Thank you.

    Mr. Potthoff, you talked about international, the global market. Do we need to have some sort of international reliability standards for electronic trading?

    Mr. POTTHOFF. Yes. I think so. It is a minimum harmonization, so to say. Certain principles should be common principles. And there is an attempt by the IOSCO to set up principles for electronic trading. And I think that is a good starting point. And if you would look at the CFTC rule proposal, they also apply these standards, IOSCO standards, on foreign boards of trade. I think that is a starting point.
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    And it is the international collaboration that is important, exchange of information. Otherwise, you will not be able to provide for consumer protection.

    Ms. BIGGERT. Should we have then, an international body? I don't know, would IOSCO be an international body that could solve disputes for trading issues, something like the international Chamber of Commerce where we have the international arbitration. Would this have to be a body then that would, you know, another agency that would look at these international concerns?

    Mr. POTTHOFF. In my opinion, it would reach too far to have them settle disputes. What they can do is to exchange the experiences and exchange information, for example, on market manipulation, perhaps set up principles. The IOSCO, I mean, combines the most prestigious regulators, securities regulators in the world. So that is a good forum, but disputes, I think, probably you have to rely on home jurisdiction then.

    Ms. BIGGERT. Good. Thank you.

    Then, one more question, Mr. Rose and Mr. Donohue. What's been your experience in competing with the foreign exchanges such as Eurex?

    Mr. DONOHUE. If you mean in terms of the regulatory aspect of it, I would like to try to take a minute to address that issue, because one of the things that I think people should appreciate is that for the European exchanges that are predominantly at this point, or soon will be completely electronic exchanges, the proposed rulemaking that the CFTC has developed really requires them to come here and make an application and if they can demonstrate compliance with basic standards, they will be able to then distribute their terminals here in the United States, and really have access to the entire U.S. market.
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    Mr. Volker mentioned this before and I would just like to revisit it. What people need to understand is that for the U.S. exchanges to access foreign markets with their electronic trading systems, we must go jurisdiction by jurisdiction. It is not one-stop shopping. We can't access all of Europe through one application. We have to go to Italy, France, Germany, the Netherlands, Spain, and on and on and on. And furthermore, within a country we will sometimes have to go state-by-state.

    For example, right now, I have an application pending to put a terminal in Frankfurt. And so I have to make application to the local government and the state. And so, I think that people should be aware that this isn't just an issue of European exchanges having easy access to the U.S. markets. It is a two-way street, and there is also an issue for U.S. markets. You know, all of us are trying, we are all in the same situation, which is that we see electronic trading becoming a more dominant force in the industry. We all want to achieve greater access and distribution for our products. So we want to get our electronic screens disseminated throughout the world.

    And I think if I can just make that one point that we have an issue to face as well. We have got to go and establish really essentially the same kinds of capabilities in those foreign jurisdictions, whether it is a country in Europe or whether it is a state within a country in Europe. We have to demonstrate that we have a regulatory capability level and that our systems have integrity and they have capacity to handle the volume of trading, and so forth.

    Ms. BIGGERT. Thank you.

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    Mr. Rose, do you have anything to add to that?

    Mr. ROSE. No.

    Ms. BIGGERT. OK. Thank you all very much.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you Ms. Biggert.

    I want to express my appreciation to you for your patience and participation here today. Your input has certainly been helpful and instructive to the subcommitee. Mr. Potthoff, I certainly want to acknowledge your international travel to be with us this afternoon. Your effort is appreciated.

    The subcommitee has heard a wide-ranging number of subjects that I think are of interest to future consideration of our regulatory system. Whether to look not only at its adequacy for consumer protection perspective, but to further analyze its capacity as an anchor to innovative product delivery is of significant concern, I think, to most Members who heard the day-long presentations, it would be our interest in the Capital Markets Subcommittee to note this is merely a beginning of what I perceive will be a long process in coming to an appropriate understanding about regulatory and legal modifications that might be warranted in light of the fast pace of market developments.

    Certainly, we would hope that changes that might be needed would not take the decade-long period that apparently financial modernization has had to struggle through. But it is evident that within the last five years, electronic commerce has made quite a mark on the landscape and that our current regulatory system is perhaps a bit inadequate to deal with the realities of these changes.
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    Having said that, I look forward to working with all of our witnesses who might have further information to provide to the subcommitee at a future time.

    Thank you so much, and our hearing is adjourned.

    [Whereupon, at 2:10 p.m., the hearing was adjourned.]