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REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION
WEDNESDAY, MAY 19, 1999
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to call, at 10:10 a.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Barrett, Smith, Lucas of Oklahoma, LaHood, Moran, Thune, Jenkins, Gutknecht, Combest [ex officio]; Dooley, Pomeroy, Baldacci, Goode, Stabenow, Etheridge, John, Boswell, Lucas, and Stenholm, [ex officio].
Staff present: Lance Kotschwar, chief counsel; Dave Ebersole, senior professional staff; Stacy Carey, subcommittee staff director; Greg Zerzan, Ryan Weston, Callista Bisek, Wanda Worsham, clerk; and John Riley.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. The meeting of the Subcommittee on Risk Management, Research, and Speciality Crops to review the Commodity Futures Trading Commission Reauthorization will come to order.
I want to welcome everybody here today for a most distinguished panel. It is like old home week. This is the way we act every time we come back from a break. We all have to shake hands and get reacquainted. It is nice to have you here with the committee today.
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Yesterday we began hearings regarding CFTC reauthorization. I think that yesterday's discussion was quite beneficial on a number of topics. However, I think it was clear that the regulators who were with us yesterday will be more comfortable discussing specifics about reauthorization once the President's Working Group has issued a report. I strongly urge them to move ahead with that report so that we can have their best thinking.
This morning we are going to hear the thoughts and views of those most impacted by Federal regulation of the futures market. I believe that the input that the committee receives today and tomorrow will be vitally important as we proceed in addressing the regulatory relief, the Shad-Johnson Accord, the Treasury amendment, legal certainty for swaps.
We have been getting good feedback on the Working Group, good feedback on the meetings and on our hearings. Everybody recognizes that this is a complicated issue and one in which, to be successful, we must find consensus among the great majority of the members of the committee, the full committee and the Congress as well as those who will be impacted by that.
I would be glad to recognize Mr. Stenholm, the ranking member of the full committee, for any comments that he might wish to make.
Mr. STENHOLM. Thank you, Mr. Chairman. I have no comments at this time. I look forward to listening to the witnesses.
Mr. EWING. Thank you. If there are any statements from Members, they may be included at this point in the record.
[The prepared statement of Mr. Barrett follows:]
PREPARED STATEMENT OF HON. BILL BARRETT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NEBRASKA
Thank you, Mr. Chairman, for holding this hearing to review the reauthorization of the Commodity Futures Trading Commission. I would also like to thank our witness panel for their participation in this hearing.
Mr. Chairman, as we take note of the testimony given by our witness panel today, we must keep in mind the importance that technology advancements have in this discussion. It is critical that we continue to examine the tools that are being used in the futures markets. It is very important that our U.S. exchanges are capable of competing with foreign exchanges on a level playing field. As Congress, we must also remember that new markets require new regulation.
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Mr. Chairman, who would have ever imagined 10 years ago that trading practices would ever be conducted over the Internet. I can not think of a time when the two words, ''global market,'' has ever been so important to American agriculture. In my large agricultural district, I try to encourage producers to use the futures market as an additional risk tool. As we review each issue, it is essential that we remember our producers as we make decisions on regulations and oversight.
Mr. Chairman, as we review over-the-counter derivatives and agriculture trade options, we must decide whether Government involvement is beneficial to private regulation.
Once this reauthorization is complete, I expect the CFTC to regulate the U.S. futures and related markets and protect the interests of those who use the markets.
I look forward to hearing testimony from each witness here today.
Mr. EWING. We will proceed directly to the panel. I do want to tell you that we like to operate under the 5-minute rule. Everybody's testimony will be made a part of the record, and anything that you wish to put into it today or later can be made part of that record also. But if you can summarize your comments, we can then have more time for the members of the committee to ask questions.
So without further adieu, we will go to the first panel. We have Mr. David Brennan, chairman of the Chicago Board of Trade. He is accompanied by Mr. Thomas Donovan, president and CEO. We have Mr. Scott Gordon, chairman of the Chicago Mercantile Exchange. We have Mr. Daniel Rappaport, chairman of the New York Mercantile Exchange; and he is accompanied by Mr. Patrick Thompson, president of the New York Mercantile Exchange. We have Mr. Jim Bowe, president of the New York Board of Trade. And we have Ronald M. Hersch, senior management director, Bear, Stearns & Company, Inc., and chairman of the Futures Industry Association representing the futures industry.
So with that introduction, we will call on Mr. Brennan to start. Welcome.
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STATEMENT OF DAVID P. BRENNAN, CHAIRMAN, ACCOMPANIED BY THOMAS R. DONOVAN, PRESIDENT AND CEO, CHICAGO BOARD OF TRADE
Mr. BRENNAN. Thank you. Good morning, Mr. Chairman, members of the subcommittee.
I am David Brennan, chairman of the Board of Trade of the city of Chicago. Accompanying me is our president and chief executive officer, Thomas Donovan. We are proud to appear before you today on behalf of the members of the Chicago Board of Trade.
Although this is my first hearing, Mr. Chairman, I know that you have been very actively involved in these issues throughout your chairmanship. We very much appreciate your interest and your leadership. This is a critical time for our industry and our exchange.
We are experiencing unprecedented change. Traditional methods of doing business are being challenged by new methods. Real competition exists amongst exchanges and nonexchanges alike. We are, in effect, all trade execution facilities. New markets are springing up and new instruments are being created daily.
The charts in my testimony illustrate the new competitive realities we face. First, overseas exchanges are growing faster and now trade more contracts than the U.S. exchanges.
Second, while the Board of Trade Treasury bond futures contract has set trading volume records, over-the-counter derivatives have tripled our growth rates.
Third, electronic trading is now a global market force having grown exponentially over the past 3 years while trading by open outcry has shrunk.
More to the point, trading on the German-Swiss owned EUREX system which only uses electronic trading has kept pace with and recently even outpaced both electronic and open outcry trading at the Board of Trade. These charts illustrate the new market realities facing the Board of Trade and other exchanges.
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The simple truth is this. Our competitive existence is threatened today by the combined forces of technology, globalization, innovation, and regulatory disparity. Unless we adapt our business to these new realties, our markets will shrink and then disappear. The members of the Board of Trade won't let that happen. We will adapt. We will do what we need to do to compete effectively.
But no matter what we do on the business side, Mr. Chairman, we will still need your help. Only Congress can fix the current regulatory disparities that hurt our business. We are not asking Congress to protect us from the new market reality.
Fair competition is good for markets and the customers we serve. Right now, however, U.S. futures exchanges face unfair competition. We are heavily regulated, and our competition is not. That fundamental regulatory disparity should no longer be tolerated.
Congress should amend the Commodity Exchange Act to ensure fair competition and end regulatory disparities. The current regulatory structure is outmoded and out of touch. It imposes a heavy regulatory hand on self-regulating futures exchanges while leaving foreign and over-the-counter markets largely unburdened. It treats U.S. exchange markets as if their only participants were unsophisticated when, in fact, over 95 percent of all exchange customers are market professionals or sophisticated institutions. It empowers Government to preapprove and prescribe exchange products, exchange contract terms, exchange rules, exchange governing standards, exchange surveillance systems, and exchange trading systems. In short, it increases our cost and those of our customers, costs our competitors have avoided and are avoiding.
The new market realities require a new market regulation. Government does have an oversight role to play, but oversight should not be confused with overkill. In my written testimony, I have outlined a conceptual approach to reform the Commodities Exchange Act which the Board of Trade and the Chicago Mercantile Exchange have authored.
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To distill it down to one sentence, our position is that we support legislation to preserve the United States as the world's leader for both exchange traded and over-the-counter derivatives. To do that, U.S. exchanges need fair competition and regulatory parity, and the over-the-counter market needs legal certainty.
Mr. Chairman, we know that often in Washington needed reforms are delayed or derailed when the subject matter is perceived as too complex. We can't afford that outcome. The markets are moving fast spurred on by forces none of us control. Our competitive future literally hangs in the balance.
Providing fair competition and removing regulatory disparities are vitally important to the Board of Trade. We look forward to working with you and this subcommittee to achieve those objectives. Thank you.
[The prepared statement of Mr. Brennan appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Brennan. You made the 5 minutes right on the head so you are doing well.
Mr. Gordon.
STATEMENT OF M. SCOTT GORDON, CHAIRMAN, CHICAGO MERCANTILE EXCHANGE
Mr. GORDON. Thank you, Mr. Chairman. I just want to start off by thanking you personally, as well as the other members of the committee for your considerable efforts at trying to encourage us to find an industry solution for the issue of reauthorizing the CFTC.
We are certainly prepared to work with the committee. I am very pleased to be part of the work and the informal working group and will continue to press forward in an effort to find an industry solution. That is clearly the intent of the proposals that we have made. We submitted extensive written testimony. I don't want to go through that.
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I would though like to focus just very, very briefly and as a follow-up to CBT chairman Brennan's comments about the principles that we are trying to espouse. I also want to comment on one of the issues that some of the witnesses have brought up.
It has to do with Shad-Johnson. Let me focus just for a moment on Shad-Johnson. The SEC originally justified the Shad-Johnson Accord as a necessary adjunct to SEC enforcement responsibilities. The limitation on CFTC jurisdiction was deemed necessary to prevent security distributions through the facilities of a futures market and to prevent insiders from using futures contracts to escape the SEC's insider trading prohibitions.
Those goals can easily be achieved without the trading prohibitions that are at the core of Shad-Johnson. Legislation can easily be crafted to bring futures trading within the same insider prohibitions that apply to the equivalent trading on security exchanges. Shad-Johnson already precludes distribution of securities as a consequence of futures trading.
In practice, the accord has operated to limit the growth of the futures exchanges and to protect securities exchanges from competition. The use of the accord to prevent futures exchanges from trading futures and options on the same indices traded on national securities exchanges has been very costly to public customers.
In an ironic twist, an unanticipated consequence of the accord has been to limit over-the-counter competition by threatening the legal certainty of billions of dollars worth of OTC derivatives transactions. Phillip Johnson, one of the authors of the accord and author of a leading treatise on futures law, has unequivocally called for reconsideration.
Clearly, it is time to revise Shad-Johnson. Without the benefit of legislation or formal rule making, the accord has twice been administratively reshaped to inhibit trading security index contracts on futures exchanges.
First, the agency has agreed to conditions that preclude designation of most attractive sector indices as futures contracts. Next, the accord was expanded to give the SEC veto power over foreign stock indices.
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Securities exchanges have taken advantage of the vacuum to gain exclusive listings over a wide variety of sector and foreign indexes that the SEC would veto if designation were sought by futures exchanges. The options exchanges also facilitate a substantial amount of volume of trading in synthetic futures on single stocks.
Neither the trading of synthetic futures on single stocks nor the trading of futures equivalents on narrow and foreign indices have shown any signs of causing the systemic problems that are repeatedly referenced in the testimony that is offered to this committee on behalf of six securities exchanges.
The ostensible result of Shad-Johnson has been to protect securities exchanges from lower cost competitors, the futures exchanges. Public investors have not benefited, they have been denied a choice. Competition from futures exchanges would have increased the number of market makers and added substantial liquidity to such markets.
It is not likely that the options exchanges, which appear to be the beneficiaries, have gained. There is good reason to believe that options exchanges serve a separate retail customer base while futures exchanges attract institutional customers. Rather than diverting customers, futures exchanges enhance the ability of option market makers to narrow their spread without adversely impacting profitability by offering a comparable index through which option market makers can lay off risk.
The use of CME futures and options contracts by options market makers is well documented. The healthy volume of S&P indexes traded at the CME and the CBOT testify to such synergies.
Again, Mr. Chairman, I appreciate the opportunity to testify. I am happy to answer any questions and I look forward to working together with the committee and the Working Group in order to find a solution to this very complex issue.
Mr. EWING. Thank you very much.
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[The prepared statement of Mr. Gordon appears at the conclusion of the hearing.]
Mr. EWING. Mr. Rappaport.
STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK MERCANTILE EXCHANGE ACCOMPANIED BY R. PATRICK THOMPSON
Mr. RAPPAPORT. Thank you, Mr. Chairman.
I am particularly happy to be here today having been before this committee and other committees over the last 4 or 5 years banging on the table trying to express the exchange's position, seeking regulatory parity with the OTC market and, unfortunately, for a long period of time falling on very deaf ears.
I think that coming here today we all realized—when I say we, I mean the domestic exchanges, the regulatory agencies, the Congressional oversight committees—that there has to be regulatory parity between these exchanges and the OTC markets. And it is no longer a serious debate as to whether or not that should occur.
I also think that there is a consensus that the regulatory parity needs to be achieved not through more regulation on the OTC market, but through less regulation on the regulated exchange market. Most recently, there has been a new wrinkle that has come to light in connection with this issue and that is the foreign exchanges.
Foreign exchanges, all of them electronic, seeking to come into the United States to do business and to trade products that the domestic exchanges trade are seeking all sorts of remedies to do business here and some of them seeking no-action relief. Some of them seeking to defer or requesting that the CFTC defer to home regulators.
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I will tell you that the domestic exchanges, I think I speak for all of us or most of us here today, oppose both of those alternatives. The no-action relief that is being sought by foreign exchanges along the lines of the EUREX model, which was granted by the Commission in 1996, had no public comment associated with it, had no Commission review of it at all. And it is a very serious matter that holds out the potential for putting the domestic exchanges at a serious competitive disadvantage.
Deferring to the home regulator is equally unacceptable. There are many home regulators whose sole function is not necessarily to regulate the market but to act more as chambers of commerce, seeking to bring business and jobs into their home jurisdiction. And deferring to the home regulator on the part of the CFTC will again put the domestic exchanges at a very serious disadvantage. I think the crux of the problem has become quite clear to just about everyone.
There is a key to putting together the resolution of regulation of the OTC market, foreign exchanges, and domestic exchanges. That is that the Commodities Exchange Act has outlived its useful life. It no longer is appropriate for the global marketplace, the global electronic marketplace and the competitive electronic marketplace that has developed over the last 2 to 3 years.
So there are a number of choices, and I am happy to be here today to begin that process with you, to participate with you, and help you figure out how to resolve that, and that is to scrap the Commodities Exchange or to tweak it in certain ways in order to make it more appropriate for today's business environment. We are happy to work with you on either one.
In fact, the domestic exchanges have gotten together and had some discussions. NYMEX has gone through the Commodities Exchange Act. We have redlined it, we have crossed out certain provisions, added new ones. We are happy to offer that to you as a basis for beginning discussions.
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We think that anything less than a complete overhaul or scrapping of the Commodities Exchange Act is and will result in a regulatory fiction and be a great disservice to the marketplace. Because to the extent that the regulated exchanges are continued to be regulated by heavy-handed regulatory regime and the OTC marketplace and potentially foreign exchanges are able to sell the same products to the same customers in our own country, the U.S. exchanges will be at a serious competitive disadvantage.
And I think that it will be a short period of time before the U.S. regulators are left without a marketplace to regulate because the foreign exchanges and the OTC market will have dominated the marketplace in a way that we are no longer viable businesses.
Thank you, Mr. Chairman.
Mr. EWING. Thank you.
[The prepared statement of Mr. Rappaport appears at the conclusion of the hearing.]
Mr. EWING. Mr. Bowe.
STATEMENT OF JAMES J. BOWE, PRESIDENT, NEW YORK BOARD OF TRADE
Mr. BOWE. Mr. Chairman, thank you for having me here today.
Members of the subcommittee, it is a pleasure to be here representing the New York Board of Trade to speak with you about revisions to the Commodities Exchange Act. We appreciate in particular, Mr. Chairman, your commitment to review the Commodities Exchange Act to see how it can be revised to meet the challenges facing the futures industry today.
I probably should reference New York Board of Trade since we are only a little less than a year old. It is the holding company for the Coffee, Sugar, and Cocoa Exchange and the New York Cotton Exchange which merged last June. Through the two exchanges and its subsidiaries, including the New York Futures Exchange, FINEX, and Citrus Associates, NYBOT offers an array of products both agricultural and financial as well as options. In addition, in partnership with Cantor Fitzgerald, we created the Cantor Exchange last September through which we are trading the first full-time electronic screen-based system, the Treasury futures contracts.
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NYBOT's priority with respect to the revision of the CEA is to create a level playing field for the U.S. exchanges. The current regulatory structure does not recognize the competitive pressures facing U.S. futures exchanges. Many other venues for risk-management and investment are available; stock exchanges, options markets, OTC markets and foreign exchanges.
The regulatory scheme relating to U.S. futures is outdated and onerous both in absolute terms and particularly in comparison to our competitors. Perhaps we could absorb the inefficiencies when nearly all business was forced to the U.S. futures exchanges, but this is not the case today.
In fact, I believe that in many ways the cost of the futures regulation has provided the success of our competitors at our expense. When devising a regulatory scheme for exchanges, I believe the following principles should serve as guidelines:
First, that the cost of implementing a rule should be reasonable and in balance with the expected benefits.
Second, since there are many differences among exchanges, regulation should be flexible in order to accommodate these differences and to encourage innovation.
And, third, the possible impact of a rule or requirement on the competitiveness of U.S. futures markets must be carefully considered.
In addition, we believe that the CEA should not give a competitive advantage to one trading venue over another. The Shad-Johnson Accord and the Treasury amendment create such distortions. They need to be overhauled or eliminated to allow futures exchanges to offer products on single-stock and narrow-stock indices and to eliminate excessive regulation of exchanges that trade Government securities and foreign exchange products.
CFTC intervention in product design and development must be eliminated. The process of contract designation and rule approval rule severely hampers our ability to compete and prevents our exchange from adjusting quickly to competitive pressures and changes in the marketplace.
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The CEA should be amended to no longer require the CFTC to designate exchanges or markets of new product. Moreover, the CFTC should not determine the economic purpose or viability of an exchange product.
Designing and introducing a new product is a business decision of an exchange. The CFTC and its staff are not in a position to determine whether it is worthwhile for an exchange to invest in developing a market for a particular new product. This is the business decision of the exchange and it is the market that will decide whether a contract survives or not.
Our exchange is particularly sensitive to this problem. In the United Kingdom where our principle competitor of coffee, sugar, and cocoa resides, new futures contracts may be introduced for trading without any Governmental review whatsoever. Moreover, they could offer those products to the general public in the United States while U.S. exchanges must overcome numerous and time consuming regulatory hurdles before they can do the same thing.
There are multiple safeguards in place of exchanges to monitor markets and prevent manipulation which would not be lost by modernizing regulation. The CFTC would still adopt regulations and standards that exchanges and market users must adhere to and could always require an exchange to take emergency action if appropriate. In conclusion, Mr. Chairman, by ensuring that the CEA is relevant to the world in which we live today and if competition and innovation are fostered without risking the public interest, I believe that you will provide a tremendous boost to fair and equitable markets.
I appreciate the challenge that you face as you try to weigh the arguments put before you to determine which recommendations serve the public interest and which ones may impede competitive efforts. Thank you for this opportunity to testify. I would be happy to answer any questions and look forward to working with you on advising the CEA.
Mr. EWING. Thank you, Mr. Bowe.
[The prepared statement of Mr. Bowe appears at the conclusion of the hearing.]
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Mr. EWING. Mr. Hersch.
STATEMENT OF RONALD M. HERSCH, SENIOR MANAGING DIRECTOR, BEAR, STEARNS & CO., INC. AND CHAIRMAN, FUTURES INDUSTRY ASSOCIATION REPRESENTING THE FUTURES INDUSTRY ASSOCIATION
Mr. HERSCH. Good morning, Mr. Chairman, and members of the subcommittee. My name is a Ronald Hersch. I am the senior managing director and director of futures at Bear, Stearns & Co., Inc. I am here today in my capacity as chairman of the board of directors of the Futures Industry Association. FIA is the national trade association of the commodities, futures, and options industry. I like to think of myself as representing a constituency that indeed belongs at this table today, that is the customers of the exchanges.
We welcome the opportunity to appear before you today. In our testimony today, we intend to focus the subcommittee's attention on the two most important issues that face our industry today: legal certainty with respect to transactions entered into in the over-the-counter derivatives market and regulatory flexibility for exchange markets and market intermediaries to commit them to keep pace with the changes in technology and to satisfy the needs of the institutional participants that account for the overwhelming majority of transactions executed on the exchange markets.
The successful resolution of these issues is essential to the continued success of the U.S. exchange and over-the-counter derivatives markets. One characteristic of both the exchange and OTC derivatives markets drives the demand for regulatory reform, institutional customers dominate these markets.
The OTC derivatives markets, of course, are exclusively institutional markets. In 1992, Congress gave the Commission a simple and straightforward charge, Congress directed the Commission to use the new exemptive authority granted in the Commodities Exchange Act to swiftly bring certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner.
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Congress specifically directed the Commission to grant exemptions for regulation for certain swap and hybrid instruments. Although it initially followed this Congressional directive, the Commission seemingly reversed course in May 1998. First, the Commission issued a concept release on over-the-counter derivative instruments which raised the specter of additional regulation of these instruments.
More troubling, the release implied that certain transactions which OTC dealers and market participants believed were exempt from regulation, under the Commission's rules could be found to be unlawful. Later that month in a letter to the SEC, the Commission explicitly stated that certain swap transactions are subject to its statutory jurisdiction.
The Commission's unilateral action confirms our belief that Congress must take additional legislative initiatives to enforce its determination to bring certainty and stability to the OTC derivatives markets.
Second, FIA believes that Congress should amend the provisions of the act that effectively prohibit the Commission from granting an exemption with respect to swaps on equity securities including stock indices. No legal, regulatory, or public policy justifies less legal certainty for equity swap transactions under the act.
FIA believes that the time has come for Congress to direct the Commission to act more boldly in reforming the regulatory structure governing the conduct of business on exchange markets. FIA has previously endorsed specific initiatives that recognized the need of institutional market participants and enhance the efficiency of the exchange markets.
These initiatives would effectively establish a good two-tiered regulatory program, one for retail customers including perhaps smaller commercial customers, and another for institutional customers including certain qualified individuals. Focusing attention on discrete provisions of the Commission's rules, however, has not been successful.
Congress should direct the Commission to develop a comprehensive regulatory program that reflects more accurately both the nature of the institutional customers that trade in those markets and the manner in which these trades are executed. In addition, Congress should amend the act to permit U.S. futures exchanges to offer a more complete range of stock index products.
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The act should also be amended to facilitate transactions in futures on foreign stock indices that are executed on a foreign exchange on behalf of U.S. customers. No public policy is served by excluding certain foreign contracts from trading by U.S. customers especially institutions. This is particularly true since these same customers, including U.S. pension funds, can freely trade in the underlying foreign securities.
Congress must also direct the Commission to move quickly to implement a flexible forward-looking regulatory framework that will better accommodate new technology and increase market access, both United States and international for FCMs and customers alike. Regulation of electronic access to trading in the futures markets requires enormous flexibility so as not to limit innovation.
Such a flexible regulatory approach is consistent with the intent of Congress which in 1992 directed the Commission to cooperate with other U.S. Government agencies to remove trade barriers that may be imposed on the international use of electronic trading systems. This provision of the act reminds us all of the importance of open markets to the success of our financial and economic system.
The only means of assuring the ability of U.S. exchanges to compete is by eliminating the unnecessary regulatory burdens to which the exchanges are currently subject. The scope of the Commission's authority over OTC transactions in foreign currencies and other products specified in the Treasury amendment has been a topic of considerable debate almost since it was enacted in 1974.
This provision of the act excludes from the Commission's jurisdiction derivative transactions in certain enumerated products including U.S. Treasury instruments and foreign currencies unless affected on a board of trade. FIA supports a legislative solution to address several critical issues that arise under that provision of the act that remain unresolved.
In this regard, FIA believes that the exclusion from regulation for products specified in the Treasury amendment is a transactional exclusion. Unless the transaction takes place on a designated contract market, the transaction should not be subject to the jurisdiction of the Commission. In testimony before this subcommittee in 1997, FIA identified certain aspects of the existing regulatory structure that we believed demanded immediate relief.
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Since that time, FIA has worked closely with the Commission and has made progress on certain of these items. We continue to continue working with the Commission on these issues that have not been addressed. Nonetheless, as the reauthorization process continues, we expect to present specific recommendations for your consideration.
Mr. Chairman, the use of derivatives for financial-risk management, the myriad structures of derivatives products, the manner in which they are traded, and the identity of derivative market participants all differ substantially from 1974 and certainly from 1936 when the Commodities Exchange Act was first enacted into law.
We live in a far more complex business environment. And like any business in a technological age, futures and derivative market participants must have the ability to respond quickly and decisively to change in circumstances. If the Federal Government is to continue to support the growth of the U.S. derivatives markets, Congress and the Commission must be prepared to demonstrate greater regulatory flexibility by making appropriate amendments to the act and regulations.
Thank you and I would be pleased to answer any question you or any other members of the subcommittee may have.
Mr. EWING. Thank you very much, Mr. Hersch.
[The prepared statement of Mr. Hersch appears at the conclusion of the hearing.]
Mr. EWING. Mr. Brennan, the picture that I get in my mind when I talk about global competition and the current regulatory system is that we have—maybe not always so neat, but let's call it a neat little package of rules and regulations, hoops that we jump through, all of the things that we do to try to protect the integrity of the market and all of the things that are our goals here, but that this only kind of goes to the borders.
And now we are dealing with more sophisticated exchanges and competition from overseas who have access to your customers, American customers, and that their rules and regulations are very different. Would you comment on that?
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How are the foreign exchanges, how much access do they really have to our customers without the same regulatory protections that those customers receive here in America?
Mr. BRENNAN. Yes, Mr. Chairman.
I think the most important part of that has been the technology and how it has evolved. There is instantaneous access around the world. Foreign markets have access to our customers whether it is through the terminals or the phone lines. When there is the regulatory disparity those transactions can happen much differently under the different regulatory environments. So it is really the technology that drives that.
Mr. EWING. It is technology that is breaking down the boundaries, so to speak, to allow a business customer, a customer in the United States who may have a station, a facility, anything overseas; they can go right through that in those markets which are totally differently regulated?
Mr. BRENNAN. That is correct.
Mr. EWING. Do they do that at less cost than they can do it here in the States?
Mr. BRENNAN. We believe that is true, yes.
Mr. EWING. So it is the access by technology that is just a fact of life; it is there?
Mr. BRENNAN. That is true. Technology has made the world smaller; we all know that. Computer networks being what they are, they can provide the instantaneous access that is happening today, and they can do it cheaper and with less burdens.
Mr. EWING. Mr. Gordon, Shad-Johnson was a major discussion yesterday and continues to be. One of those issues I think at least internally divides those in the securities futures and securities industries. How are the restrictions you have here in the United States through Shad-Johnson impacted by competition overseas in what they can do and I think it is Australia where they are doing more trading on single stocks and narrow-based indices?
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Mr. GORDON. Mr. Chairman, if I may followup on something that Chairman Brennan said. Not only is technology a driver, but the foreign regulators tend to balance both the legitimate business needs of the marketplace with the obvious customer protection and market integrity issues.
They allow the foreign exchanges to do many things that we are not allowed to do here. They work together in a sense with the foreign marketplaces. So both technology and the fact that there are rules, procedures, and practices that the foreign exchanges can do that we can't.
Now, with respect to Shad-Johnson, clearly in other jurisdictions and other locations, the futures markets can do many things that we can't do with respect to stock indexes. So that they can, for example, you mentioned Australia. There are many different venues where they can trade single stocks.
And I believe you will find in most of those locales there is a tremendous synergy between the equity, the underlying equity markets and the futures markets. Although they are oftentimes different marketplaces, they do work together and they both benefit. The customer benefits from their working together.
Mr. EWING. Mr. Rappaport, you talked about the OTC regulation and parity between the over-the-counter market and the formalized exchanges. It is your belief, then, that we shouldn't necessarily look to bringing the OTC under the same regulatory umbrella, but freeing up the formalized exchanges so that they can compete more fairly?
Mr. RAPPAPORT. Yes.
Mr. EWING. What would be your best suggestion for accomplishing that?
Mr. RAPPAPORT. I think for a start, Mr. Chairman, we suggested that the CFTC's focus change from a prior-review agency where everything has to be submitted to the agency before any of the exchanges can take action to a post-review agency where the exchanges are given a lot more flexibility to respond to the competitive pressures in the marketplace and for the CFTC to have its remedies in a post-review regulatory process.
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We think that would go a long way. We think there are certain things that the regulated exchanges should stay with the regulated exchanges, certain levels of regulation, but we think that the CFTC for the most part and the Commodities Exchange Act should be modified to ensure that the regulatory regime stays out of the operational aspect of exchanges and makes a more defined effort to make clearer what the CFTC's real regulatory objective is as opposed to micro-managing the day-to-day affairs of the exchanges.
Mr. EWING. You talked about electronic exchanges that are or seek to come in to our markets. Is that a reality? Are they really there? Are they operating today? Is there anything our regulators can do about that?
Mr. RAPPAPORT. Yes, sir.
They are clearly operating here today. It is definitely a reality. The EUREX, which recently has become the largest exchange in the world, whereas the U.S. exchanges had enjoyed that title for the last 10 years. EUREX, for the first time now, has passed the U.S. exchanges in size. It is the No. 1 exchange.
It is the only foreign exchange operating within the United States under no-action relief that it was granted in 1996 without any public comment, without any review by the commissioners themselves. It was granted by the division of the commission in 1996. That was, in all fairness, a different technological environment than we are operating in today.
What they are seeking now, other foreign exchanges, in particular LIFFE, the London International Financial Futures Exchange, Sidney Futures Exchange, and a number of others—I think actually Sidney has filed for no-action relief, and all of the others would file for no-action relief if they felt there was the opportunity that they were going to get it.
Mr. EWING. What is no-action relief?
Mr. RAPPAPORT. Basically saying that you are exempt for the most part from CFTC jurisdiction. You can come in here and you can operate. It is, for the most part, deference to the home regulator saying that your home regulator looks good, you can come in here and do business, and you don't have to follow our rules and regulations.
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You can imagine what that does to us because their regulatory environment is substantially lighter than ours. There are lots of things that customers don't like to do that the CFTC compels them to do. Therefore, we have to ensure that customers do it. Foreign regulators are not that intensive. Simple things just like putting account numbers on where the trades are actually going when they put the calls in to place the orders.
On foreign exchanges they don't necessarily have to do that, and customers don't like to be bothered with that until the end of the day. Little things like that influence traders. Yes, they are doing it.
In fact, the London Metals Exchange, they have warehouses here in the United States. Their contract calls for delivery of copper in a number of warehouses, most particularly in Long Beach, CA.
Some years ago there was a debacle with the Sumitomo corporation which is one of the largest copper traders in the world. Their copper trader, Mr. Hamanaka, admitted to perpetuating a fraud to manipulate the copper market over a 10-year period and actually it seems inflated the price by over 100 percent.
After the debacle became clear and he admitted what he had done, the price of copper dropped from approximately $1.40 per pound trading now at 70 cents per pound. If that is true, then you can imagine that over a 10-year period U.S. consumers have paid billions and billions of dollars for copper products as a result of the inflated price of the raw material.
That was permitted to go on outside the scope of CFTC jurisdiction even though that copper was for delivery in Long Beach, CA. It is outrageous.
Mr. EWING. That would appear to be and maybe we can, since my time is running out, go into that a little later in my questioning, an example of where a local regulator or national regulations failed to protect us from someone trading overseas here in our markets and might make the point for continued regulation including regulation of all foreign exchanges that operate here in this country.
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Mr. RAPPAPORT. I think that is the clear distinction, in the last statement. Those that actually have product for delivery here or that are based upon products that are priced here.
I think that is really the distinction. If they are only coming to the United States seeking liquidity, say, for their home products, I think that the Commission could consider deferring to the home regulator. But once their products are deliverable here or are based on a price index here, then they are having a significant impact on U.S. commerce.
And I think that the U.S. agencies and the U.S. Congress have a duty to ensure the pricing integrity of those markets.
Mr. EWING. Mr. Bowe, you are not on both sides of this issue, but you are an organized exchange. And you are also an electronic exchange through the Cantor, which certainly I think sent some shock waves through our system a year or so ago.
How is that working? How much has that grown? Are you out-competing everyone else with the electronic exchange?
Mr. BOWE. It is actually interesting—the whole structure of the Cantor exchange and the regulatory review process that we have to go through which has dictated the ability of the system to be effective and to be competitive. When we first filed with the Commission, we had no idea how long it would take to get approval.
I can remember contracts in the past that were innovative that took years to get through CFC review. In particular, one at our exchange when we tried to do trade inflation—tried through a CPI index, it took us 2 1/2 years to get approval back in the 1980's and by then inflation went to deflation.
With respect to the Cantor exchange, we were filing for approval of the whole exchange as well as an electronic trading system. In the developmental process and the costs associated with developing that system, we had to go on a step-by-step basis which we never would have done in an open environment.
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We still have not finished all of the design functional changes to that system that we intended to do when we first started it, but we had to get up and running because we knew once we had CFTC approval we had to open up a marketplace. As a result, the system we put in place last September when we opened was a mirror of the cash market-auction system that Cantor had in place.
And from that point forward, we began the development of what we really wanted which was a futures electronic environment that would mimic how business is done in an open outcry trading ring on the floor of the New York Board of Trade today. We put in about four different levels of systems since last September, probably multiplying our cost two to three times what it would have been had we been able to operate in a free environment, develop the system, and open the marketplace without having to deal with all of the regulatory hurdles.
So we basically went to the commission with the simplest, easiest system that you could possibly imagine because we were afraid that if we went in with a full-blown system we would still be waiting for approval to trade. As far as size, we are only trading a few thousand contracts a day at this point because we haven't gotten the system to the level that we are even selling it hard.
Today most of the efforts we have are with primary dealers who are very active using Cantor's cash system and getting them integrated into trading. In the next few months, we will finish the developmental process and that is when I think that you will see this system really take off.
Mr. EWING. Thank you, gentlemen.
Mr. Stehnolm.
Mr. STENHOLM. Mr. Hersch, going a little further on this last line of questioning, if U.S. regulation is more stringent than the foreign regulation, does that mean that the public interest in the United States is compromised to the extent that foreign terminals are allowed in the United States?
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Mr. HERSCH. No, sir, I don't believe so.
There is one important element that is missing from the argument that has been presented by my esteemed colleagues and exchanges here.
Unfortunately, that element really leaves the Congress of the United States with only one choice on how to deal with this situation. What is missing here is the fact that, as I stated in my opening comments, these markets are essentially used by institutional customers. I mean, the U.S. futures exchanges as well as the foreign futures exchanges.
Mr. HERSCH. Therefore the only choice is for the regulation of the U.S. futures exchanges to be lowered to create an environment where they can compete with these foreign futures exchanges. If I look at my customers, approximately 85 to 90 percent are institutional customers—and of those, I would estimate that between 50 and 75 percent of them all have foreign affiliates. The fact that they have foreign affiliates gives them the ability to close the futures accounts that they have with the U.S. entity of my firm and open that account with a foreign affiliate of my firm and essentially do the same business from a foreign jurisdiction, completely eliminating any U.S. regulatory oversight over their business.
So, because of the nature of the marketplace, it is a fact of life that customers can do the trading in their foreign affiliate. And what does that do for the United States and for the U.S. Futures Commission merchant community? We just lose the business, but we get it through our foreign affiliate or perhaps through a foreign firm that doesn't even have a U.S. counterparty.
What really needs to be done is we need to look at the regulations that exist here; we can't try to be a border patrol and place restrictions on electronic commerce, which is the wave of the future.
Mr. STENHOLM. Why should I not draw a conclusion from your answer, then, that the United States regulations are more stringent than they need to be?
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Mr. HERSCH. That is the answer to your question. Regulations are definitely more stringent than they need to be now. These regulations perhaps were appropriate for many years ago when the predominant users of the U.S. futures market were agricultural commodities and retail customers; while these still are important constituencies, the fact is they don't dominate our market.
Mr. STENHOLM. Which leads me to my next question. For years I have sat here and we have gone through these very complicated questions and answers and we have had the emphasis on agriculture, and my agricultural producers have always worried that the futures market has a very negative effect on the price that they receive for that which they produce. Well, now we have expanded this, and I not only represent the cotton patch but also the oil patch, and now, interestingly, we find from a different industry, and this is a question for you, Mr. Rappaport.
The oil patch has recently suffered from remarkable volatility in oil prices because the NYMEX price is often used as a reference price in oil transaction. Fairness and integrity of the trading at NYMEX is extremely important. How can we do more to ensure that NYMEX prices truly reflect the forces of supply and demand?
Mr. RAPPAPORT. I think we clearly do reflect the forces of supply and demand, and I think unfortunately for some segment of the oil industry, the volatility that you describe in the oil markets most recently has been one way and that has been down. Although there are a lot of professionals who offer lots of esoteric advice on how our markets work and what affects them, it is very, very simple. If there are more buyers than sellers, the price goes up; and if there are more sellers than buyers, the price goes down. It is very simply supply and demand, and the New York Mercantile Exchange is no more a factor in the price of oil than the New York Stock Exchange is a factor in the price of IBM or Amazon.com.
Mr. STENHOLM. The folks in the oil patch don't believe it is as simple as you just made it.
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Mr. RAPPAPORT. They didn't say that when the price was $40.
Mr. STENHOLM. Well, that is different. I have got some other questions but I will yield to members of the committee before I ask a couple more.
Mr. EWING. We plan to do more than one round.
Mr. Combest.
The CHAIRMAN. Mr. Chairman, thank you, and I won't take long. Basically, I would just like to say thank you for holding this series of hearings. This probably is going to be one of the most opportunistic challenges that this committee has. In all the years that the CFTC has been up for reauthorization, I think this is one of the biggest challenges we have. It may also be one of the greatest opportunities we have had to make some changes that do, in fact, need to be changed because there has been such a change in the instruments traded and the technology. So this subcommittee will do a great deal of that work, and Chairman Ewing has been very involved in that, and I commend him for it, and we look forward to dealing with this at some point in full committee as well.
I just want to ask one specific thing as we move forward in this—and I want to commend everybody for their attention and the time that they have spent—there has been a great deal of interest in this obviously. One of the things that has come from the earlier discussions is a proposal that has been put together by the Chicago exchanges, and I appreciate the fact you would do this. It is always hardest to be the first out of the box, but it does address many of the issues that are at the core of a lot of this debate. And as meetings have occurred, other exchanges and others have indicated their awareness of and support of many parts of the proposal that has come forward from the Chicago exchanges.
So to both of them I might ask this question: Of that proposal, do any foreign regulators regulate their financial industry in a manner similar to the structure which has been proposed by the Chicago exchanges? To both of you and to either order. Mr. Gordon.
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Mr. GORDON. Chairman Combest, first of all, we appreciate the time you all have spent on this. I said that earlier, and we look forward to working with you.
With respect to foreign regulators, I think that the template we have offered, these five principles that we have put forward, is exactly what most foreign regulators follow. So, I think the simple answer to your question is yes. I think it is the great majority of foreign locations that do regulate in a manner very, very similar to what we are proposing. As Ron Hersch touched on, there is legal certainty. So really those five principles are almost global in nature. We are just trying to bring it here which is theoretically the largest venue for futures trading.
The CHAIRMAN. Mr. Donovan.
Mr. DONOVAN. Thank you, Mr. Combest. If I could point out one thing. The very first principle that we have in the United States is the principle of prior approval, and it goes right to the heart of oversight versus the micromanagement that we operate under today. If you would look collectively at the charts in Mr. Brennan's testimony, one after another shows the growth in the other sector, whether it is the over-the-counter market or foreign exchanges, in that we have experienced is a direct result of a lower degree of regulation. And the point that we have made repeatedly is that this is a global market and we are going to compete. We have no choice but to compete. We want to compete, but right now, under our current regulatory structure, we can't do it.
But if you would help us get to the point where we remove these restrictions that we operate under today, we will be able to compete in this global regulatory structure because, as Mr. Brennan said, the technology has removed all the barriers. Our customers do business on all the exchanges in the world. They do it in the over-the-counter market, they do it in open outcry markets, they do it electronically. Mr. Ewing said that the Cantor exchange has a foot in both camps. We all do. We trade open outcry markets, we trade electronically.
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Mr. Brennan and I just came back from a trip to London. We visited with at least 20 firms, that we trade on our electronic trading system called Project A. The one question that we were asked in virtually every one of the trading rooms is, ''Will you remove the restriction to input the account number before you execute the trade'' because they can't execute the trades fast enough. We said we would love to but it is not our restriction, it is the CFTC's.
Every other exchange in the world puts the trade in and then inputs the account number, if they even have to do it. That 5- to 10-second disadvantage is enough for business to go somewhere else.
Yet another example of the CFTC not allowing us to compete in a fashion even domestically, Mr. Bowe referred to Cantor. They trade a 6 percent coupon bond. The Board of Trade, which is the premier bond market in the world, wanted to go from an 8 percent coupon bond to a 6 percent coupon bond, the very same thing that was approved for Cantor, and it took us 4 weeks to get the approval of the CFTC. That is unconscionable.
The CHAIRMAN. Thank you, Mr. Donovan. Thank you, Mr. Chairman.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Mr. Chairman, thank you, and I thank this panel. Excellent testimony. I asked one of you, for the benefit of my own tender state of understanding of these matters to speak slow and use small words, and you all presented your information in very understandable ways. I appreciate it.
I think Mr. Bowe hit it on the head when he talks about the challenge of trying to improve the efficiency and, therefore, the effectiveness of the regulatory oversight without compromising the public interest at stake as we make those reforms. Because the evolving nature of what you do is so incredibly technically sophisticated, getting the regulatory overlay right is important but difficult. I think we have to do it, and I think that, Mr. Brennan, as I read your testimony, you talk about being third generation, this business. If we don't attend to this, your own status might be as threatened as the status of some of the third-generation family farmers I represent, a lot of difficulty in agriculture.
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On the other hand, just dereg, where's the lowest common denominator, we are going to go there, that doesn't necessarily work either. The savings and loan debacle still reverberates around here as an example of where we were in a deregulatory mode without knowing what we were doing. To that end, let's try and get at what might be a couple of ways of looking at this.
Mr. Rappaport, you indicate that you want a parity with the over-the-counter markets, that parity to be achieved by taking a deregulatory approach at the exchanges. Well, that seems to miss what I understand is at the heart of the rationale for the different treatment for the over-the-counter market, and that is the individual nature of the transaction—buyer-seller, as opposed to an exchange where there really is not the one party to another party transaction. Would you respond to that?
Mr. RAPPAPORT. Yes. There are some elements of the OTC business and the OTC mode of doing business that are unique and certainly different than the exchange mode of doing business, but I think we should start off where you started which is not compromising the public interest. I think the first question has to be what is the public interest, which public interest specifically are we seeking to support, and is that public interest the protection of—call it price limits or orders of one and two lot orders—or is that public interest the pricing integrity of the commodities being traded on the exchanges that are used as an integral part of United States and global commerce? And I would say that it is the pricing integrity as opposed to some of the other issues or a prior focus of what the Commodities Exchange Act has focused on.
Mr. POMEROY. Although some of these instruments, the creditworthiness of the other party is an essential part of the deal as well.
Mr. RAPPAPORT. Yes, that is true. However, I can't speak for the financials, but I can speak for the energy complex because we have recently done a survey, and most recently, at least based upon the survey that we conducted, the energy trades that are being conducted in the OTC market are not the exotic market variables that we have known in previous years. That marketplace has evolved into a situation where 90 percent of the trades that are taking place in the energy OTC market are exchanged look-a-like contracts, basically the exact same contract that we are trading, just taking place between very sophisticated players with very high or relatively high credit ratings that are willing to assume each other's counterparty credit risk.
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Mr. POMEROY. I do agree with you, there seems to be lap in evolution which is making some of these look like standard traded——
Mr. RAPPAPORT. It is easy to understand why that is true because that is where the money is. The more plain vanilla contract you can offer out to the marketplace, the more appealing it will be to various market participants, the lower your cost will be in trading it, the easier it will be for you as the market maker to manage your risk associated with that.
Mr. POMEROY. And there is some standardization of need. There is a commonly transferrable rationale to a lot of these things which means you can do the same thing again and again.
Mr. RAPPAPORT. That is right, exactly.
Mr. POMEROY. But subject to ultimately some things which distinguish, again, creditworthiness of the party to the deal.
Mr. RAPPAPORT. There are a certain segment of transactions that occur OTC that we believe should remain OTC and outside the purview of exchange jurisdiction.
Mr. POMEROY. I think your assistance there will be helpful in terms of trying to help us define the distinction. Regulation for regulation sake, you are right, is not public interest; but to the extent—I mean parity with the OTC, there are some fundamental differences, and I am not sure parity for parity's sake is appropriate.
Mr. RAPPAPORT. We set out some criteria in our testimony, as has the Chicago exchanges trying to identify those areas. One is if the price is published and relied upon in the marketplace, that should be one criteria that the regulators should look into. To the extent that it is widely disseminated as a published price, then it should come under regulation. To the extent that it is not, then perhaps it should not. To the extent that the contracts are actually cleared through a clearing entity where it poses some systemic risks to the marketplace, then there should be regulation to the extent.
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Mr. POMEROY. Regulation of the clearing entity?
Mr. RAPPAPORT. That is right, regulation of the clearing entity, because to the extent that that clearing entity fails or that customer's funds are in jeopardy, there is a high regulatory interest invoked.
Mr. POMEROY. Thank you, Mr. Chairman. I look forward to the next round.
Mr. EWING. Mr. Smith.
Mr. SMITH. Mr. Chairman, thank you. A tremendous amount to learn. Would each of your organizations consider designating a contact person, with their phone number, to me through the chairman today so that individually we might be able to call and ask additional questions and then followup? We all want to get rid of unnecessary regs. The problem is defining the word ''unnecessary.''
When we started this in 1922 we were looking at agricultural commodities. It was a low price time in the early twenties, and there was price manipulation, and somehow we wanted to develop the oversight to minimize price manipulation and to maximize price disclosure to allow farmers to better react to what they saw as the market for different products. In 1933 we had another downturn in commodity prices, and so we came up with the Commodity Exchange Act in 1936.
We are, again, at low commodity prices for agriculture, and so I think it is important that we learn all of the other aspects of your trading as you evolve, and in many cases, probably agriculture is a less important product right now. To this committee it is important. To me it is important.
I am concerned with saying that we have got to reduce our regulations to accommodate the relaxed regulations in either over-the-counter or foreign exchanges. It seems to me that there is a level of integrity someplace that even the industry should be saying, look, this kind of oversight is reasonable.
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I would like to know a couple things. One, on agricultural trades, I am concerned as a farmer that it is more difficult for me to hedge in terms of being able to deliver or take delivery with the Chicago Board of Trade. And so that is almost prohibited now, which means that I don't have the kind of control that I used to have as a farmer in delivering or taking delivery, and so, Mr. Brennan, maybe you can relate to that.
How much do you see as the kind of commissioners that we have and how much we change the rules and regulations as opposed to how much we should be changing the law as we come up with a definition of what is unnecessary regulation? So I don't know where to go, but I saw everybody nod their head that you will give us a contact today. Mr. Brennan, maybe start with you.
Mr. BRENNAN. I will be happy to give you those contacts. I think we certainly don't want to change the level of integrity in our markets. The integrity of the markets should be an oversight role for the CFTC, but as far as declining market prices or deliveries and things like that, I think that the exchange is just the venue for the buyers to meet the sellers, and we provide the arena. So as far as affecting price, the exchange isn't in the business of affecting the price, but what we need to do is allow the customers and the market participants to come into our markets freely and easily.
Mr. SMITH. But somehow, it seems to me, there has got to be a good connection between the cash market and the trade market, and so that is the challenge: How do you bring those together so that the future trade price has the integrity of really representing the market price? And it seems to me that somehow you can't just be out there trading and buying and selling. Somehow there has got to be a mechanism to bring the cash market into balance with the trade market and make sure that we maintain that integrity of the market. And I am not sure that we are doing that as much as I would like to see in terms of the prices I see from my local elevators and the cost of transporting to Chicago versus what I see on the trades.
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Mr. BRENNAN. Well, we, in effect, at the Board of Trade have specific delivery points and a delivery mechanism, and the convergence between cash and futures markets happens every day in the marketplace, and when it gets out of whack, there are market participants to bring it back into line.
Mr. SMITH. Well, maybe you got the big traders, the huge traders, but it is much more difficult for the normal family farm to take delivery and deliver.
Let me ask another question. Specifically, your reaction to the kind of language we should build into this act to give guidance to the Commission in the rules that they promulgate versus writing in law what they can't do, do you have a reaction as you go down the line on that? How much are you upset by the promulgated rules in the regs that are promulgated versus what is in the law guiding those rules?
Mr. GORDON. Mr. Smith, in general, one of the things we are trying to do is propose that the Commission be an oversight agency, and that—I mean, many have said it up on this panel but that we don't have to submit many of the things we have to submit today for prior approval. Obviously, it is in our best interest to run a market that has complete integrity and serves the public well. For us to be micromanaged is problematic.
So, in terms of language, the two Chicago exchanges have set out five principles, but specific to language, many of these things, as Mr. Rappaport said, should be truly oversight, and I think that would be a good place to start.
Mr. SMITH. But that is a decision of CFTC, right? It is not in the law? It is just the flexibility that is given in the law to CFTC?
Mr. GORDON. No. We are suggesting that the act be amended or modified so that the role of the Commission is explicitly stated as oversight. Obviously, there will be things within the act that are not an oversight function, but many of the things that have become adopted over the years are truly micromanaging what we do.
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Mr. SMITH. Thank you, Mr. Chairman.
Mr. RAPPAPORT. Mr. Chairman, can I make one comment on that point?
Mr. EWING. Go ahead.
Mr. RAPPAPORT. I think the simple answer to your question is, it has not been interpretations that have been taken on by the commissioners that have created the problems for us. I think it is specifically the level of detail that the act and the constraints that the act itself puts on the Commission in performing its duties. It specifically prohibits them from regulating foreign boards of trade in any way, and that has kept them from actually making a regulatory statement in regard to those foreign boards of trade.
Mr. SMITH. So furnish a page and line to help me at least look at that.
Mr. RAPPAPORT. Yes.
Mr. EWING. Mr. Boswell.
Mr. BOSWELL. Thank you, Mr. Chairman. I appreciate, as others, for having this hearing today and it is truly a learning experience. I have had the privilege of visiting the Chicago boards and——
Mr. EWING. Well, you come to Chicago every week, don't you?
Mr. BOSWELL. Regularly, with you, as we go through that maze at the place called O'Hare. I know the Board of Trade is represented by Mr. Blagojevich. How about the Merc? I don't know where the lines are in the streets in downtown Chicago.
Mr. GORDON. Mr. Davis.
Mr. BOSWELL. But anyway, Mr. Blagojevich is very active in visiting with me on a regular basis on behalf of his constituency and I appreciate that. Incidentally, a lot of us are very proud of his participation in recent events in the Baltics, and I trust you are, too. But anyway, we overuse the term perhaps around here ''the level playing field,'' but I think have a sense that this an appropriate term that maybe applies here. I know the regulatory agency it seems to me like they are wanting to adapt, but are we keeping up with the needs, and it seems like maybe we aren't.
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Your testimony, Tom, about the delay, now getting that account number in there, really what difference did that make as far as having a safe transaction?
Mr. DONOVAN. Well, quite frankly, it doesn't make any difference whether it is ahead of time or after the fact as far as the safe transaction.
Let me address something that you just said. We have thrown terms around here for years: level regulatory playing fields, parity, and they are as important today as they have been in the past. The problem is they have been used so frequently we tend to just take them for granted and say, ''well, these are the Chicago exchanges, the New York exchanges, they are in here again talking about this, and we have heard it over and over again.''
I would like to look at a few different words, let's look at ''fairness'' and ''equality,'' basic principles that we have in the United States. We find ourselves right now, U.S. exchanges who really made the futures business, who are really transaction facilities or trade execution facilities. That is also what the over-the-counter market is, trade execution facilities. Foreign exchanges are trade execution facilities also, But we find because we are called exchanges and looked at as an organized entity for transactions to take place that we get a different level of regulation. It is a different level from the over-the-counter markets, different level from the foreign markets.
Yet the very entities that have the best self-regulatory functions, the exchanges, get another layer and another level of regulation from the CFTC. I listen to the testimony and I hear people say, well, if you do business anywhere but on an exchange, a trade execution facility, you don't need regulation; but if you do business on an exchange, which has a selfregulatory function, you need another level of regulation.
I just don't understand it. I think I am at least of average intelligence. I understand fairness, I understand equality. But when we have systems such as we have at the Board of Trade—and many of you have come out and seen it, and we have brought it to the CFTC and we have shown it to your staff. We have a system called the SMART system at the Board of Trade. It is far and away the best electronic surveillance system in the world. Yet we are asked for another level of regulation. We are asked not to limit the CFTC to oversight. We aren't allowed to avoid prior CFTC approval of our rules. We are put at a total competitive disadvantage.
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It is very clear that everyone in this room realizes that the CEA is totally out of date, that we have to deal with it. I want to commend Chairman Ewing and Messrs. Combest and Stenholm and Congress for allowing us to have a meeting in this room towards the end of April, where all parties were brought together, not just the exchanges. There were so many people in the room. There were so many lawyers I would have liked to have seen what the bill was. It probably approached the national debt.
But, quite frankly, this is so complex an issue to deal with, that it is going to take Solomon to take us through this. It is going to take the exchanges and FIA and the representatives of the over-the-counter market really getting together and saying we want to work this out because otherwise the United States loses. We lose it for our individual investors, and we lose it for the U.S. business because the rest of the world is moving.
They have changed their regulation. They have allowed technology. We have the same technology in the United States they have but we e aren't able to use it. We are at a total disadvantage today. I know that is not the intent of anyone here, but something has to be done in this body to give the direction to the CFTC, in law, that it is an oversight agency, because you are not going to be able to think of every little detail that is going to come up in the next couple of years. You are not going to be able to even think of what technology will bring forward.
So you have to deal in principles, and the principle is U.S. exchanges—U.S. business—has to have the freedom to compete, and we only get that through fairness and through equality, and that is allowing the CFTC to be an oversight agency and allowing us to avoid prior approval CFTC authority.
Mr. BOSWELL. Thank you, Tom. Mr. Chairman, I was trying to trigger that response. I didn't realize I would get such an eloquent response, but that is exactly what we need to hear. I would hope that is properly recorded so that members who are not here today can read that response because we have got to have a level playing field. And I don't criticize the CFTC for doing what we tell them to do, but at the same time, we have got to have that level playing field or we are going to lose out in this world arena that we are in. And it is a world arena, and there is no question about it. So I am very appreciative of those comments, and I guess my time is up.
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Mr. EWING. Good job. Thank you.
Mr. Thune.
Mr. THUNE. Thank you, Mr. Chairman. Members of the panel, I would like to return to a line of questioning that I raised yesterday with the commissioners, and that is to suggest that the traditional function of the exchanges has been to provide markets with price discovery, with risk-shifting mechanisms.
And I guess what I would like to know, because I hear all of you saying that in terms of the CFTC's role there, that it should be more oversight, that there should be less regulation, basically to know how do the exchanges themselves, how do you all internally protect against price manipulation? What types of controls do you have in place? Mr. Gordon.
Mr. GORDON. Mr. Thune, we have layers of internal controls. We have a Market Surveillance Division replete with more PCs than probably this committee has, that monitors business on a daily real-time basis. We have every layer of internal rules, some dictated certainly by the act, others that we would do on our own.
Quite frankly, in terms of market surveillance, if there were no act and if there were no CFTC, I daresay we would do the same things we are doing today. The reason is, the lifeblood of our exchange is our integrity, financial integrity. That is why customers use our markets. It is why the brokerage firms that are represented by the FIA put their money at risk to do business on our exchange. Therefore, if we didn't do this, we would certainly be deficient in our responsibilities, certainly derelict, and so we would do it anyway.
So, notwithstanding whatever we do to change the act and notwithstanding whatever we do to modify the practices of the Commission, we are going to do those same things. I mean, we just have layers and layers of internal control; that is, we hold that of the highest—we talk about technology, we talk about lots of different things—that is of the highest import to us because we are prudent businessmen. We could not operate without that.
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Mr. THUNE. Anybody else want to answer?
Mr. BRENNAN. I would just add that the internal monitoring systems are there. We at the Board of Trade have about 110 people working in our Office of Investigations and Audits. It is real-time. Tom talked about our SMART system, the electronic surveillance system that we have. It is an ongoing thing, and it is something that we just do as a matter of course. Thank you.
Mr. BOWE. If I may add, we at the New York Board of Trade, one of our subsidiary exchanges, Coffee Share and Cocoa Exchange, have the benefit of not being regulated until 1975, when the CFTC was formed, because we did not trade any domestic U.S. agricultural products, and vested self-interest dictates that we have to have a strong surveillance program. The board of the exchange is made up of the people that use the market, and it is the price discovery function and the hedging function that was the reason for the exchange to start in the first place. We have always had a history of strong market surveillance because, if we don't, we will lose the markets. If people cannot use the markets and believe in the integrity of the price they get, they are not going to come back. So that from a pure self-interest standpoint, the exchange has to do it.
At our exchange, we take market surveillance so critically that we keep the market surveillance people locked up in a corner. The only people that get to see what they look at are the chief economists and myself, and I am actually involved in market surveillance because we believe it in so strongly as far as watching the markets day-to-day.
Mr. THOMPSON. Mr. Thune, when Mr. Rappaport was answering some questions from Mr. Pomeroy earlier on, we mentioned, I think, some of the unique areas that central marketplaces play in our economy. It is important to make sure that we protect price formation and that price formation be free of manipulation. It is important that because we are a central marketplace and we guarantee each and every one of the trades that occur through the exchange, that we have proper financial surveillance systems as well. And it is important because we are a public access market that allows all to compete in an open forum for the best price available that we protect that auction function very, very dearly.
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And those are the three areas that I think the exchanges would agree throughout that are the areas that should be protected by the act and should be part of contract market designation: that you have proper surveillance mechanisms to assure that the price discovery mechanism cannot be manipulated; and that is the market surveillance that my colleagues here on the panel are talking about, where each and every position in the marketplace is reported to us by our members every day, compiled by our staff and reviewed by our staff on a daily basis. Each week we have market surveillance meetings, commodity by commodity, to determine the makeup of the players in the marketplace on that periodic basis, to see whether or not there is a potential manipulation that might be occurring.
We also do not allow market participants to exceed certain levels in the market which are called ''speculative position limits'' without applying to the exchange directly and justifying with information as to what their cash market activities are as to the level that they might be able to exceed those speculative limits. So it is a very, very hands-on, daily operation that goes on, really, participant by participant and market by market.
The same types of activities go on in the financial surveillance area where we look at each clearing member's positions, to detect debit accounts or deficit accounts, accounts that are not properly margined, and we deal with those on an account-by-account basis on a daily basis.
We know who is in our market, and we do believe and have testified that that level of regulation, because of our role as a central marketplace, is something that we believe is proper and just and something that the exchanges would continue to do, whether required by law or not, but certainly since we would continue to do that, the law requiring something of an industry standard in those areas is perfectly acceptable to us.
The areas that we are talking about where we think there is significant overregulation is in terms of trading practices and innovations that we believe affect our ability to compete and to provide products that the marketplace wants and needs, but wants them and needs them as the market opportunities present themselves, as opposed to going through lengthy approvals and attempting at times to fit round pegs into square holes that simply just do not work in today's flexible world.
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So the areas where we believe that the act is appropriately governing our activities, we are in those areas of systemic risks and manipulative conduct, and we are perfectly willing to live with that level of regulation. It is in product innovations and trading practices that we think the heavy hand of regulation has really stifled us.
Mr. THUNE. Mr. Chairman, I can't stay around for the next round. Can you indulge me one follow-up question?
Mr. EWING. I would.
Mr. THUNE. Since the agriculture commodities constitute such a small percentage both in futures contracts and options on futures, do you see a need—or in realizing that most of the trades are institutional, investors very sophisticated—any need in your proposal for a sort of separate regulatory regime as it applies to agriculture commodities?
Mr. Gordon.
Mr. GORDON. Mr. Thune, the proposals that we have put out, these five principles, actually work for any type of product you want. That is the beauty of this. It is very simple. I mean the devil is always in the details, but we can apply that to both our product lines.
We believe that with an oversight agency and all of the essential elements that we would add ourselves just because we are trying to run a business, that we cover any type of product, large or small, retail or institutional, and that is the intent of our proposal, with our guidelines as we suggested.
Mr. THUNE. And the New York exchanges, I assume, are in agreement on your proposal? I know, it came from Chicago.
Mr. RAPPAPORT. Yes, we have been very involved in discussions with the Chicago exchanges, and the New York Mercantile Exchange is in support of the proposals submitted by the Chicago exchanges.
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Mr. BOWE. As is the New York Board of Trade. With respect to the issue of agriculture market regulation, I probably should know the number, but probably between 80 and 90 percent of the business in the New York Board of Trade today is agricultural products, and we believe definitely that you need the same type of relaxed regulatory scheme in order for us to be competitive. The coffee share and cocoa products are actively competitive with London markets, and over the years we have gone back and forth, each trying to take each other's markets. I guess we won first during World War I when they had a close in London. Since then we have had the world sugar market in New York, but on an annual basis, I would say we go head-to-head with product modifications, product innovations with London, and we definitely need the flexibility for the agricultural products also.
Mr. BRENNAN. Just one comment to echo my colleagues, I think that an oversight framework really works for all markets, whether they be large or small. If we get the oversight regulatory framework, it will work in both areas.
Mr. THUNE. I thank the panel and thank the chairman for his indulgence.
Mr. EWING. Thank you. Mr. Dooley.
Mr. DOOLEY. Thank you, Mr. Chairman, and I thank all the panelists for coming today, and I am still climbing up the learning curve on this issue, and so my questions will be somewhat general in nature. I had the occasion just to finish reading Thomas Friedman's, ''The Lexus in the Olive Tree'', a great book which I think has a lot of applicability to the discussion we are having today. He talks about the globalization and what is happening in terms of the information technology, the world becoming smaller, and really talks about the electronic herd, which is the investment community, and the flow of capital that is now facilitated by the information technology.
What is the public interest, as Mr. Pomeroy brought up, and what is the appropriate role for Government, I am not quite sure I fully understand that yet because this is much different than the savings and loan situation because there is no public exposure. There is no taxpayer exposure, because we are not insuring anything here.
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It seems like with a flow of capital being able to move so easily between borders and among borders, is that the real issue that is important is the issue of transparency, making sure that people do have access to the information that allows them to make decisions which provide greater certainty in terms of what that transaction is going to amount to.
And so I guess I appreciate what I think Mr. Donovan and Brennan all of you are saying about the CFTC being more of a role of an oversight, because I don't know that the Government should have any other role than maybe perhaps ensuring that there is some integrity to the process. But the exchanges themselves, the only thing you have to market is your integrity, and so why do we need the Government necessarily to step in and to provide that function?
And I guess one specific question I have really deals with the over-the-counter issue where, Mr. Rappaport, you said that some of the look alikes, that we ought to perhaps subject them to the same regulatory environment. I guess, why should I care? Why should the Federal Government care if parties want to enter into an over-the-counter transaction and do so voluntarily? Why should we care for that, because you can do the same thing with the value you are adding to the general marketplace because supposedly you have more integrity and that gives you an advantage there. So why is it an issue?
Mr. RAPPAPORT. I think you are absolutely right. I don't think it is an issue. I don't think you should care. I think you are walking down the road of where we would like to be, which is that we are prudent businessmen out there trying to sell a product to the marketplace, and to the extent that we don't offer the right product in the right package, the market is going to go someplace else.
And then the question becomes what is the Government's regulatory interest, if any? And I think you hit the nail on the head, which is the price transparency and the utilization of those prices in U.S. and global commerce, and consumers relying upon that.
So, to the extent that the regulatory regime has the opportunity to come in and remedy any infractions to the extent that it discovers any or the exchanges discover any and pass that information on, I think that is the only role that the regulators should play, and it should basically get out of the way of the marketplace and should realize in the end that it really has no other choice but to do so because the marketplace is moving on with or without that regulatory regime.
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And in our comments, we even quote Chairman Greenspan, who says the same thing; that a marketplace should regulate itself, and there are lots of alternatives in this global competitive market. To the extent the marketplace doesn't regulate itself appropriately, then the marketplace will decide to move someplace else.
And one thing that I just want to be clear about, I didn't say that those OTC transactions that are characterized as look-alikes should necessarily be regulated in the same way that exchange contracts are being regulated. I think that in the end, the real answer is that they shouldn't be regulated at all and that the market should decide whether or not the OTC or the exchange regulated marketplace provides them the best place to shop.
Mr. DOOLEY. I guess I was referring to the five points, and Mr. Donovan, you listed one there: all entities performing exchange-like functions, trade execution or clearinghouse, should be similarly regulated. And I guess I was interpreting that over-the-counter transactions that might mirror some of the things that you might do should be regulated, and I guess I am not convinced.
Mr. DONOVAN. Well, you raised a very good point. First of all, and I should have probably said it more clearly, one of the points we talk about is legal certainty and providing for it where transactions are privately negotiated. We don't believe that should come under the Commodity Exchange Act. The over-the-counter markets where it is a privately transacted, private transaction, should be aside from the Commodity Exchange Act.
However, when it is a group of persons who become a trade execution facility, then we say we should have the same type of regulation because what we are doing is trading in the same venue with the same customer. We are not saying that they should have more regulation. We just should be at that same level of regulation. And you are right: For you to micromanage and to have an interest in the way the exchanges are run isn't the current thinking and the current technology today. Quite frankly, you cannot foresee the future and regulate properly.
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Give flexibility to us to be able to compete with just agency oversight and count on the competitive forces to pick the best market. The customer will go to the market that is best, the cheapest, with the highest degree of integrity. At that point, it just should be oversight, plus the CFTC should have antifraud and antimanipulation authority, and that should be the extent of it.
Mr. DOOLEY. Thank you.
Mr. EWING. Mr. LaHood.
Mr. LAHOOD. Mr. Chairman, I wouldn't pretend to know very much about this issue, but I would make two points.
First, I want to compliment the Chicago Board. As someone who represents a large agricultural district, I know that a lot of the people in my district have benefited greatly by the professionalism of the Chicago Board. And I think the point that was made earlier about the fact that all of you have standing because you are professional and because you rise or fall on the integrity with which you carry out your work, and if you don't have integrity and if you don't carry out your work with integrity and honesty, then you have no standing. And I think that has held all of you in very good stead, irrespective of who supervises your work or who oversees it and what the rules and regulations are. Your standing really does come from the way that you carry out your work and the integrity with which you do it.
With respect to the hearings that we are having here, as I said, I think there are probably very few of the 435 Members of the House who have an intimate understanding, and I want to compliment Chairman Ewing for spending the enormous amount of time that he has spent over the last several years in bringing to reality these hearings today because of the fact that he is an active farmer and knows a great deal about the work that you do.
I think many of us—I will speak for myself. I am taking my cues from the work that you have been doing and, in large measure, the legislation that we shape here in this subcommittee and the full committee, I will be taking my cues from Chairman Ewing, because I do think he does have a comprehensive understanding because of the fact he has been in farming all of his adult life and, prior to that as a young man, and the fact that he really has taken the time to really study this in a comprehensive way.
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And so I am going to conclude by saying I am not really smart enough to know what the right questions are, but in the end, I will be following your lead, Mr. Chairman.
Mr. EWING. Thank you. That gives a little more onerous responsibility but we will try and carry that out.
Mr. Barrett.
Mr. BARRETT. Thank you, Mr. Chairman, and I echo Mr. LaHood's comments. I congratulate you on what you have done up to this point with these reauthorization hearings and the hard work that you have taken or done over the last couple of years on this issue. It is a very, very complex, complicated issue, I think, for all of us, and this is the second hearing, I believe, this week on this issue. You have another one scheduled for tomorrow, and I think from these hearings and subsequent meetings and hearings, we should be able to come up with something which is livable. But I think all of us are struggling somewhat with the issue itself.
It is my understanding that the last reauthorization was in 1995, and I believe that expires September 30 of next year. So this is timely and it is important that we take this early time to begin to work out the problems.
I am sorry that I was late, Mr. Chairman. I couldn't take advantage of what I understand was excellent testimony early on from this Blue Ribbon Panel. But in listening to the dialog here, I was reminded of a question which I asked yesterday of the commissioners, which in the interest of time I will revisit and I would hope for a brief comment or a brief word from each member of the panel.
Should we consider a permanent reauthorization, or should we continue what we are doing right now with the timely and helpful reauthorizations every few years? I would appreciate your thoughts on that. Let's start with Mr. Donovan.
Mr. DONOVAN. My view would be that the fact that the CFTC comes up for reauthorization forces us to address issues like this. Now, thankfully, we have a committee, with the leadership that we have on both sides of the aisle, that really want to address these issues. I want to commend you for the tremendous job you are doing, starting last year, with facing up to the facts that we have to have changes in order for us to allow the U.S. industry and American citizens to participate properly at the global market.
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So, for my purposes, I think the CFTC reauthorization and a forced time to deal with it gives us the opportunity to address these matters.
Mr. BARRETT. You are voting for a review every so many years?
Mr. DONOVAN. Yes.
Mr. BARRETT. Mr. Brennan.
Mr. BRENNAN. I guess I would echo Mr. Donovan's comments.
Mr. GORDON. Mr. Barrett, I think it is contingent on what we come up with. To the extent that we come up with something that looks like it will work in the foreseeable future, I think that we can stay with the permanent reauthorization.
So given that the principles that we have tried to espouse and then going back to try to get something that will apply going forward, I would be comfortable with something permanent. But again, the devil is in the details so we need to make certain that we get the right package, right commission going forward. I think a simple answer would be yes, subject to what we would like to see.
Mr. BARRETT. Thank you. Mr. Rappaport.
Mr. RAPPAPORT. We would agree with the Chicago Mercantile Exchange's view point on that point. I think in the current rule environment given the existing Commodity Exchange Act, this periodic reauthorization may be appropriate along the lines of what the Board of Trade has said.
It gives us the opportunity to express our dissatisfaction. But to the extent that the CFTC drops back under a different regulatory regime, it becomes more of an overview agency as opposed to a micro-managing agency.
Then we would definitely support permanent reauthorization. In fact, we believe that to some extent the periodic reauthorization process has caused some of the problems in that it is debilitating to the CFTC. They expend a lot of resources trying to pull it all together in order to defend their existence every few years.
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The continual need to justify their existence, to some extent as you might imagine, might make them a bit insecure in forcing them to have to, perhaps, prove themselves on different occasions to say that they are justified. And that may actually lead to heavy-handed regulation to show that they are really there and really enforcing the rules that they have been asked to enforce and establishing a record so that when reauthorization comes up, they can say we really did our job.
Mr. BARRETT. Thank you. Mr. Bowe.
Mr. BOWE. We would definitely be in favor of a permanent reauthorization for the CFTC if we can get the CEA right. This whole process, while it is good to raise the issues, I would much rather be dealing with product innovation than dealing with the issues. If we could get the CFTC to be in place as an oversight agency, then the exchanges could really go forward in running our businesses and not have to go through the process which does take a lot of time and effort on everybody's part. We could get the business going instead.
Mr. BARRETT. The final product looks good, permanent is your vote. Mr. Hersch.
Mr. HERSCH. That would be the vote of the Futures Industry Association as well. Depending upon the type of regulation that is put in place, provided that it is flexible and the CFTC provides an oversight role, I definitely think there should be permanent reauthorization.
This entire process that goes on every few years is very time consuming; I think that it is even costly. As I said before, my comments would most closely resemble those made by Mr. Rappaport.
Mr. BARRETT. Thank you very much. Thank you, Mr. Chairman. Thank you again for all of the hard work.
Mr. POMEROY. Will the gentleman yield for just a moment? All one needs to do is look at your necktie to see how seriously you take the chairman's example.
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Mr. BARRETT. They are close.
Mr. EWING. I cannot walk through the hall today that somebody doesn't call me Bill. I have the identity problem, not Mr. Barrett. I would say to my colleagues here left in the committee and if somebody wants to comment on this, I certainly appreciate the accolades.
But I don't understand all that all of these exchanges do. I don't understand all that the securities markets do in America. I doubt there is anybody in Congress that does. My approach to it and I think to reauthorization and to regulation has to be common sense, does it work from a business standpoint, does it protect the customer, the very things that they have repeated.
We don't as legislators, I think, have to totally understand every contract they trade or everything they do, or we will certainly drown in the minutiae of worrying about whether we have done it right. I think it is a general.
I envision us to come up with legislation that will give a general outline for regulation for oversight, for protection that is flexible as our economy and as the business changes. Would anybody want to comment on that? I say that because I feel that sometimes the members feel that while—and throw up their hands that this is too complicated. It is indeed complicated when you take all of the financial markets that have an interest in what the CFTC does and their regulatory authority.
Mr. RAPPAPORT. I would like to make a brief comment. It is very complicated, and I can understand from your position it is very difficult to understand. But I think that some of the questions that we heard here today reflect a very good fundamental understanding of the marketplace.
But from your perspective, I think the fundamental thing that you should focus on is that there are for the most part three marketplaces in the world in our line of business. That is the OTC, the regulated exchanges, and the foreign exchanges.
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And you need to know, and it needs to be clear to you, that you should be creating a regulatory environment that encourages as much business as possible to go on the regulated exchanges. You don't regulate the OTC market; we are not asking you to. The OTC has no duty, no obligation, to basically tell you or us anything if there is a market crisis.
You regulate the foreign exchanges and right now they are operating in our country selling products to our customers and influencing the pricing integrity of commodities in U.S. commerce. They don't have the obligation to tell you anything.
As a matter of fact, in the Sumitomo debacle, when the CFTC first approached the London Metals Exchange—I don't know this for a fact but I have heard—they were told to get lost, leave us alone, we don't answer to you, even though they were trading products that are in the United States.
We are the only ones who have a duty to report to you through the CFTC. We are the only ones who get the market information on our radar screens that will permit us and you to manage through a crisis to the extent that one arises. So it is in your interest to create a rule environment that gets as much business onto the exchanges as opposed to the OTC market and the foreign exchanges in order to preserve the market integrity of U.S. markets.
When you look at everything else, always ask yourself that question, am I creating a rule environment that is promoting or discouraging business to go to the exchanges and am I really kidding myself when the day is done, because if I have created an overburdensome rule environment for the regulated exchanges, isn't the marketplace just trading someplace else, are they trading OTC, or are they trading foreign exchanges? Have I really achieved the regulatory interests of protecting the marketplace, or have I just chased business off of the regulated exchanges?
Mr. EWING. Mr. Rappaport, you make a very good point. I guess from at least this Chairman's vantage point, I don't see my job as trying to direct business to the organized markets over the OTC market, but making it equally available to all out there who want to make that choice on their own.
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Mr. RAPPAPORT. That is all I mean. Create a rule environment——
Mr. EWING. Where they are not discouraged.
Mr. RAPPAPORT. Exactly. That doesn't discourage business from coming to the regulated exchanges and thereby encourages business to go to OTC. I'm not saying go out and be a cheerleader for the U.S. exchanges, just don't handcuff us in a way that we have been handcuffed these past years.
Mr. EWING. Mr. Gordon.
Mr. GORDON. I appreciate your comments about your lack of understanding. I actually think you know more about our industry than many in our industry. But having said that, with many things complex, when you distill it down to the essence, it is easier to understand.
I think that the idea of the five principles that we have brought up are relatively easy to understand. We are trying not to be oversimplistic, but I think that we stay with those five principles, there is something in there for every participant. There is a lot of give and take, and I think going forward, if we just concentrate on the simple part, the complex issues and all of the hype that goes with what people are saying will kind of fall by the wayside.
Mr. EWING. Yes, Mr. Bowe.
Mr. BOWE. I hate to use terms that have been kicked around here a lot in the past, but they seem to work. I think the perspective of the committee really should be one to look at cost and benefit.
What is the cost of regulation? What is the benefit to the marketplace of having that regulation in place? I think you should rely on the exchanges to make that determination from the get-go. We know what regulations are necessary because the people that are in the marketplace, serve on our boards, serve on our committees, and participate with the exchange and helping to regulate the marketplace. Having an overlay of regulation beyond that from the Government just doesn't help us.
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To the extent that there is regulation that is necessary, someone has to figure out what the cost of that regulation is to the exchange marketplace and the benefit to the competition that we have in the OTC market or foreign exchanges and help us to weigh that balance so that we are not losing business, because we are incurring those regulatory costs which really don't provide a necessary benefit to the market.
Mr. EWING. The other participants in our financial markets, the stock exchanges and the big derivatives in houses and bond houses around the country, is their regulatory scheme, the SEC particularly, how would you compare it to the CFTC? Is it one of more oversight or one of more specific hands-on regulation like we have with the CFTC?
Mr. HERSCH. I will take a stab at it.
Mr. EWING. Thank you, Mr. Hersch. You saved me.
Mr. HERSCH. I was waiting to see how long the silence would last. I will do my best. I am a creature of the futures markets so I don't have much experience with the securities markets, although I represent a firm that does a significant amount of securities business.
I will tell you that when I am put in a position to articulate to some of the senior people within my firm the difficulties that are encountered in my business with respect to the micro-management that takes place with the current regulation, they are quite surprised. They don't understand it. And they sympathize with the difficulties that I go through.
That would lead me to believe that the current regulations that apply to business that is conducted in the futures markets is inappropriate and too burdensome. Obviously, with respect to the over-the-counter transactions we are involved in, I would have to echo similarly that they don't suffer the same type of regulation. Otherwise, they wouldn't be trying forcefully to make the case that their markets don't require any further regulation.
Mr. EWING. The over-the-counter markets, I will tell you they are regulated, but not by the SEC or the CFTC. But through bank regulation, generally, I think is the way that they get to their regulation.
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Mr. HERSCH. Mr. Chairman, if I may have one more moment. I would say that your remarks with respect to the type of regulation that you should be proposing are most closely associated with the way that I feel about this issue.
It is not the job, I don't believe, of your committee or the Congress to promote business to any one specific venue; however, I do think that it is very important that you help to create a competitive environment because at the end of the day that is best for the customers.
Mr. EWING. One final question before I go back to my colleagues here. Do we need one regulator of all our financial markets? We will start over here. Mr. Hersch.
Mr. HERSCH. Not to be redundant, I am a creature of the futures market, and I have been around this business for a long time. I believe that the CFTC is an excellent agency. The difficulties that have been encountered from time to time with the CFTC have more to do with the individuals that are there from time to time or the leadership that is there.
But with respect to these markets, the Futures Industry Association has and continues to have an excellent relationship with the commissioners at the CFTC. We believe they are very receptive; they are open minded. What they are trying to do is enforce an act and interpret an act that is very, very difficult to interpret in 1999.
I am very hopeful that this Congress will take action to give them the ability to appropriately regulate our market in an oversight capacity.
Mr. EWING. Mr. Rappaport.
Mr. RAPPAPORT. I think some people that look at the, say, the merging of the SEC and the CFTC have oversimplified the problem. I agree with Ron Hersch. The real problem is not necessarily the agency, but it is the act. And I think that it would be an unmitigated disaster at this point to simply merge the agencies without modifying the act.
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It may be appropriate at some point after modifying the act and living with a less intrusive act after a number of years to consider whether or not it would be appropriate to merge the agencies. But to consider that prior to changing the act, I think would be a disaster.
Touching on the point that you raised before, I think the SEC is noted for strong regulation, but I think it strikes the right balance in that it imposes strong regulation on market participants outside of the exchange environment, but permits the exchanges themselves as self-regulatory organizations to operate very freely.
So if there is a distinction, it is in the SEC's heavy-handed use of regulation versus the CFTC. The CFTC is just the opposite. It heavy-handedly regulates the regulated exchanges and doesn't regulate OTC at all.
Mr. EWING. Mr. Donovan.
Mr. DONOVAN. When you said one agency, I didn't necessarily take it that you meant merging the CFTC with the SEC. But I do think that the issues are so complex that one agency would have a great deal of difficulty dealing with this.
Just going back to the informal hearing that you had with all of the participants and the points of views that they had, I really think that you need an agency that specializes in certain areas of business.
There is a difference between the SEC and the CFTC. Our markets are largely institutional. Even though we are regulated in a way as though it is the individual investor, probably only about 2 percent of our business is individual.
Under the SEC, most of their business is retail. So it is two different mindsets. I will say something, though, with the CFTC. I am starting to see a different mindset on the part of a majority of the commissioners. It is along the same lines of what I see in this room and the participants in this panel. There is a realization not only among the market users, of the exchanges, but also the CFTC along with this committee; that we have to do something and the time to do it is now.
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Mr. EWING. Thank you. Mr. Stenholm.
Mr. STENHOLM. We clearly end up today where we started in this room 2 or 3 weeks ago, in which all of the players were present. I think that is true today. Some of you are at the table and the rest are out in the audience. I think it is going to be very critical that all of the players stay together because there are some very succinct truisms that are present today in spite of the fact that some of my oil producers believe that we ought to eliminate you. Some of my cotton producers believe that we ought to eliminate you.
The truism to this is that we could do it in the United States, but it would transfer off shore. We have, in fact, proven that manufacturing is easily moved out of the United States to the rest of the world where we do not provide competitive marketplaces. That is a truism.
The same is even more true for capital because capital moves a lot faster and a lot easier than bricks and mortar. Therefore, as we begin to function on the answer, I think Mr. Dooley talked about, asked a few questions, what is the public interest?
Clearly, there are times when there is a public interest. I remember a couple of Texans a few years ago in the silver market that ended up having a very public interest. They proved in the long term they could not control the market and manipulate it. But in the short term they did.
Your answer is what you do on a daily basis to make sure that speculative limits are not exceeded are extremely—that there is transparency to somebody with oversight responsibility to see that in the short term manipulation does not occur that has a public interest. That is a critical role to be played.
I think our challenge is going to be what you have stated here today. Clearly, we have a responsibility to harmonize our financial markets, financial regulation in the United States. But we also have an international harmonization, that we can't do one without the other it seems to me; that if we have different rules and regulations applying to foreign competitors than we have to us here we have the same problems that we are having with agricultural policy on a daily basis regarding how we compete when there is an unlevel playing field.
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Everybody talks about that level playing field. My question is this: any comments concerning the International Organization of Securities Commissions, IOSCO it is called, which is an entity in place to attempt to do this.
We also have had some recent success with the Bank of International, BIS, International Settlements in which some of their transparency and openness have been relatively successful in providing the kind of regulatory oversight that you are talking about and I am agreeing with you on.
Any comments along that line? Are we making good progress? Is the efforts of the CFTC, which are part of IOSCO, and SEC, which is a part of IOSCO, is this moving fast enough, too fast, too slow, or irrelevant?
Mr. GORDON. First of all, Mr. Stenholm, I agree with your comments on what we need to do going forward. In answer to your specific question, I think it goes down to the weakest link. The weakest link here is the burdensome layers of regulation that we have.
So to the extent that you ask are we well coordinated globally, the answer is yes and no. Certainly in terms of many things that IOSCO and others work on, information-sharing and antifraud, antimanipulation. Certainly we have made excellent progress on that.
But with respect to the competitive environment and what it does or doesn't do certainly for U.S. citizens, we are way behind the curve just based on this burden that we carry as exchanges. So what we need to do is take the yoke off of us.
We don't need to regulate foreign entities. What we need to do is give ourselves parity with those entities. Then we will truly be coordinated. All of those other things that have already taken place in terms of antifraud, et cetera, will compliment what we are doing. But the yoke that is on the U.S. exchanges is clearly the weakest link in terms of competitive and open markets.
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Mr. STENHOLM. I did not mean to infer by my comment that we will ever be successful in regulating any other foreign countries in this country any more than they will regulate us. I am looking more for the harmonization effort in this area. Thank you for answering that question. Any other comment on that from anyone?
Mr. THOMPSON. Just very quickly. We do see very good programs, generally, through IOSCO in terms of harmonization internationally in certain areas, whether it be in equal access to marketplaces, information-sharing, trying to establish best principles that at least operate as principles to govern overall regulation of those marketplaces.
We will still have some unevenness because of cultural differences, nationalistic differences, and things of that nature which I don't think will ever be completely level and equal.
I do want to echo what my colleagues I think here on the panel have been saying all day. If we in the United States could concentrate our regulatory scheme on the essentials that need to be regulated, particularly for the central marketplaces, financial integrity, market integrity, and access to the option marketplace, if we concentrate on those three principles, I think that the United States will be able to compete very, very well in the global marketplace.
Mr. STENHOLM. Mr. Hersch.
Mr. HERSCH. With respect to your question, there are some very good things that have happened in the past couple of years with respect to information-sharing arrangements in which IOSCO was involved. Also, the CFTC participated in the Windsor agreement which involved information sharing between the major exchanges.
I really want to correct what I perceive here as a misunderstanding or a misperception of the customer's perspective. I don't believe that you can ever expect the United States to enact regulations to the lowest common denominator. It is not going to happen.
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What is missing from the arguments that have been made from some of my colleagues on this panel is these are institutional customers. There is something called disclosure. When institutional customers transact business on certain exchanges, they are aware that the risks of trading on those exchanges and transacting business on those exchanges is not the same as it would be on the U.S. exchanges.
That is something that you need to appreciate when you attempt to come up with a balance of what the regulation should be to keep our U.S. exchanges competitive and what actually might have to be for us to get business done on our exchanges. That is not going to happen.
So certainly an understanding of the market participants being primarily institutional and possibly the importance of firms disclosing to their customers what the risk differences are in terms of the business they transact on different exchanges is something that needs to be looked at very seriously.
Mr. STENHOLM. Mr. Chairman, I ask all of the players in this to give this committee your best shot at coming together in a harmonized proposal for us to take to the floor of the House. If you will do that, I think we will surprise a lot of people with what this committee might be able to do.
I made this same request yesterday to another group on another subject in which, after we spent a few minutes discussing it, I came away very disillusioned as to the possibility that competing interests, in this case in the health care, could ever come together.
I don't have that sense—both yesterday's hearing and today's and looking forward to tomorrow and seeing this discussion—I don't have that sense that it is a hopeless case that we can have a unified front from all of the players or at least some narrowing down the competing faction as to what we do.
But it is going to be up to you at this table and others to see that this be done. But those of you who understand the business, that's critical. You have testified very eloquently today to your understanding of your part of the business, communication in the case whether it is to oil producers or cotton producers.
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Communication and education is extremely important to the legislative process. And that is where these hearings, Mr. Chairman—I commend you for the in-depth set of hearings that you are conducting, and I look forward to continuing to participate and eventually to the markup and a successful culmination.
Mr. EWING. Thank you, Mr. Stenholm. I don't think that anyone could have said it better about what we have to do. We must, if we are going to reauthorize, when we reauthorize, if it is going to be meaningful must join hands bipartisanly and do that in a way that the members of the full House and full committee understand that we have studied it and we think this is best for America or it just won't get done. Your help and your interest and your presence is extremely important to that end goal. Mr. Pomeroy.
Mr. POMEROY. Mr. Chairman, I just want to pile on a little with my kudos. This has been one of the most interesting hearings I have been in as a Member of Congress, period. I really enjoyed this hearing, and I commend you for putting our subcommittee through this drill as we try to get up to speed.
I want to followup on something that Mr. Hersch said that we are just not going to engage in a race to the bottom and those that advocate that harmonization is the race to the bottom are going to be ultimately disappointed. They are not going to prevail; and, in fact, we are going to miss an opportunity on the other hand to identify that which is important, that which we must maintain, and that which we have to realize we shouldn't maintain any longer.
As a former insurance commissioner, I watched the interplay between onshore markets and offshore markets. On the other hand, we never wanted to take in North Dakota the insurance regulatory of Turks and Caicos or of Bermuda.
But if we were regulating in a way that simply was driving business over there. We weren't getting our hands on it at all because we chased it offshore. That didn't serve our purpose either.
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So as our committee grapples with how to rewrite this, we need to understand well the relationship between the regulated market and the unregulated market. And if what we are trying to achieve through regulation is just quickly avoid it by going into an unregulated market either through a swap or foreign exchange, we are missing it. And so we have got to be mindful of that.
On the other hand, we have to be mindful of what public purposes do remain. One of the speakers yesterday said self-regulatory organizations are an adjunct to regulation, not a substitute for it. I think that is an important point and one that I ascribe to, when it relates to the dichotomy between micro-management and micro-regulation and identifying what needs oversight.
For example, Lloyds of London is a self-regulatory organization, it does a heck of a job. But one of the things is that anybody looking at the broader picture—whether or not the names which represents the capitalization of Lloyds were aware of the tremendous exposures that they were signing on to, especially in an evolving off-tort market.
The whole damn thing almost went down. I think they needed an outside regulator in addition to the internal effective self-regulatory mechanism. So I think that we have got to step back from the micro with our regulatory approach but continue to apply the macro.
To that end, it is also important that we understand not just the interplay between regulated and unregulated activity; we also have to understand the interplay between self-regulatory organizations and utterly deregulated environments, unregulated environments. I'm going to be chewing on that one for a while.
I think that we have got to work our way through all of that. It seems to me that the Shad-Johnson issue relative to securities issues derivatives or securities futures are a bit of a separate but very important issue that we have to deal with.
On that one I want to ask some questions of Mr. Gordon. First of all, anyone want to take issue with anything that I have said so far? I am not saying this is the law according to Earl, but is this an appropriate context for us to evaluate this?
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Shad-Johnson. Mr. Gordon, you talk about this being kind of a dated restriction. One of the things that I would be concerned about is the public protections of securities regulation being kind of leaped over to the extent that you are dealing with a much different regulatory overlay in the futures derivative based on that security.
It would seem to me in a securities context there ought to be an even application of the regulation on the security instrument itself and the derivative of that instrument. And if there is a dichotomy so there is a different regulation on the derivative as opposed to the instrument, it seems to me that you have got potential problems occurring. Would you respond to that?
Mr. GORDON. First of all, there is a difference today with respect to many underlying markets and their derivatives. The concerns of some that overturning——
Mr. POMEROY. Not to take issue with that, but I would like further information on those other examples. SEC couldn't come up with any or I wasn't putting my question right yesterday. I would like to learn more about that. Go ahead.
Mr. GORDON. Let me give the broader and then go back to the specific. The concerns of some that amending or modifying Shad-Johnson would somehow cause the antifraud or the concerns about distributing securities through a nonsecurities exchange, those concerns, we think that we can take care of those concerns on a one-by-one basis. They are very technical. We don't need to get into them today, but we clearly are not looking to distribute securities.
If you look at insider trading as an issue that we should all be concerned about, we certainly think that we can address that. We have disclosure rules that others have talked about. So we are not looking to redistribute, no pun intended, the trade from one exchange to another.
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So all of the concerns about modifying Shad-Johnson, we actually think we could work on to give comfort to the other users.
Now, with respect to the underlying contract being regulated different than the derivative contract, that is probably true in every case today. That is true whether it is a Treasury security versus a futures on a Treasury. It is certainly true——
Mr. POMEROY. On the treasuries and commodities you wouldn't have some of the consumer protection issues present themselves like manipulation or insider trading and those kinds of things?
Mr. GORDON. I respectfully disagree. I think you have those concerns on any product literally. When we have those concerns, certainly other marketplaces should have those concerns, I believe, with any product that you could come up with. So it is really the same. If you go down each—foreign exchanges, treasuries, equities, agricultural products—any product area you are going to have those same concerns.
Mr. POMEROY. I know I am out of time, Mr. Chairman, but if I understand your position, it is not that you are for no additional protections on the derivative trading of securities. You just don't think that Shad-Johnson is necessarily the perfect formulation for all time of what those regulations should be.
Mr. GORDON. Well, you are just specific to one of the preclusions inherent in Shad-Johnson, that futures exchanges can't trade futures on individual securities and narrow-based securities. That shouldn't be. That was something that was carved out as a pilot program 17 years ago. The markets were entirely different. It doesn't apply to today. There is no public interest served by that. That's one of the things that we are suggesting. I am not sure—I am sorry. I am not sure if that answered your question. We will have plenty of time to talk.
Mr. POMEROY. Thank you, Mr. Chairman.
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Mr. EWING. In that same vein, would your exchanges be interested, yours in particular, in trading futures on foreign stocks?
Mr. GORDON. We certainly would like to have the ability to trade futures on any number of products. To be honest, it is not something that we have considered. I would like to be able to have the ability to trade. The global exchanges are considering trading dollar-based products. They are starting to do that as we speak. I would like to be able to consider that.
We might, at the end of the day, decide there is no reason to do it. It certainly is not something that is at the forefront of what we are trying to suggest here. We do trade indexes. We trade futures on indexes of foreign markets just like the foreign markets trade indexes on our products. So it might be a natural progression, but it is not something that we are doing today or considering doing today.
Mr. EWING. Mr. Boswell.
Mr. BOSWELL. Thank you, Mr. Chairman. I too want to echo. This has been one of the best hearings I have been able to sit in on since I have been here. I appreciate it very much. We truly have had a good panel today. I think that if we can appreciate that the regulatory agencies have been doing an excellent job under the criteria that we have given them, but we have got to think in terms of 1999 and where we are going.
We are a world economy. I don't think there is any argument there. I like adding the words that was mentioned earlier, fairness of equity and parity. I think it had a very meaningful play of what we are doing. So I agree with Mr. Stenholm.
Please give us your best unified suggestions or efforts, and we will do our best to carry that forth and do what is right for this; and we are all interested, and we all have a lot at stake. Thank you very much.
Mr. EWING. Thank you, Mr. Boswell. I want to recognize that we have two of our commissioners here from the CFTC. I wanted to ask a question. I realize it has nothing to do with these commissioners, but do you believe that turnover has been a problem on the commission, lack of continuity of service in the development of rules and regulations we have had there?
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Mr. RAPPAPORT. Yes, I think it has. I think in any business, or in this case regulatory environment, that a lack of continuity takes its toll in a sense that you develop personal relationships with the people that you work with and you get a sense of what their positions might be even before you speak to them.
To the extent that changes rapidly over periods of time, it becomes more difficult to do business. In addition, as many members of this committee have very candidly stated today, it is a very complex business to understand. It changes very rapidly. It is a much different business than it was 2 years ago. So it takes time for the new people to get up to speed. Even those of us that are involved in it every day have a difficult time understanding all of the implications of the issues. So to the extent that new people come into the regulatory positions frequently, it does take its toll.
Mr. EWING. Yes, sir, Mr. Bowe.
Mr. BOWE. I would like to echo Mr. Rappaport's comments and suggest that is all the more reason to not have the commission approve everything that we do before we could do it. If they are truly in an oversight role, they wouldn't have to come up to the same level of understanding, the same level of detail that they currently have to because they have to affirmatively approve everything that we want to do and it would make it that much easier for the commissioners to act in an oversight capacity versus the burden that we place on them today as they come into a position that is very complex to try to figure out what the issues are and what the balances are and approving what we want to do.
But it would be far easier for the transition of the commissioners over time if all they had to do was worry about the things we are doing wrong instead of worrying about everything that we want to do.
Mr. EWING. Mr. Hersch.
Mr. HERSCH. I think it depends on what part of the turnover, the agency you are talking about. I would suggest that the staff turnover is more of a problem than turnover at the commissioner's level.
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But, really, the problem I think has been leadership. The leadership has to set the tone for the agency. I have many people that work for me and there is turnover of employees all of the time.
Our strategy and our objectives don't change based on staff leaving or coming and going, but it changes when the leadership changes. Even then we try to minimize that as much as we can.
Mr. EWING. Mr. Donovan.
Mr. DONOVAN. First of all, I agree with the point that there is a learning curve. It is a very complex business. But I don't believe longevity is the answer. I believe it is the quality of the commissioner, the work ethic, and the desire to truly have the courage to address the issues. I think that's more important than longevity in any of the positions. And I think it is the leadership that counts at the top.
Mr. EWING. Some have said, indicated, that the current act is inflexible. Also, there are those who would say that actually the act has quite a bit of flexibility and that maybe the commission has not seen that as their role to exercise that flexibility.
A couple ideas are agricultural trade options, allowing profession market exemption. These are things that currently have been allowed or are allowable under the act, but the regulator has seen fit not to go that direction. Would you agree any of you?
Mr. DONOVAN. I would definitely agree. I think that, first of all, the act has to be changed because it has to go to oversight. I will state that again. But definitely, right now, the commission has the authority and the opportunity to make many changes.
I am hopeful that we will see some of that in the very near future. For example, the foreign terminal issue. We know that we have to compete globally, and we know that the United States can't be an island. That means that we have to be able to open up for foreign exchanges to do business here if we are going to be able to do business there.
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However, right now we know that we don't have parity. And last week at the Global Market Advisory Committee, there was a proposal put forward to have an ad hoc committee to address parity. I thought that was a breath of fresh air.
This committee, as soon as it is totally constituted, will come forward with ways to address the parity question in order to resolve the foreign terminal question. At that point, the commissioners will have the opportunity to show us if they truly believe in exercising the authority that they have with their exemptive powers, and I think they will do so.
Mr. EWING. Mr. Gordon.
Mr. GORDON. My answer to the question is just a little bit of both. I think it is more on the part of the act, because although there is some flexibility within the act to do certain things the tenor of the act forces the micro-managing.
So I think I empathize with the commissioners in that respect, that they are not allowed to do certain things. There are certain things that they could do and maybe choose not to do. Many of those things are based on the tenor of the act. That is what needs to be changed to that oversight. If the tenor is oversight, then there is enough flexibility in there for the commission to do what we are suggesting.
Mr. EWING. Anyone else?
Mr. RAPPAPORT. I think the commission has the authority in the same way that we discussed it in our paper under the 1992 Futures Trade and Practices Act, the 4C exemption where it granted the over-the-counter market and exemption for its trading.
I suppose the commission could go out on a limb and grant the regulated exchanges that same creative flexibility. But that may go back to the point that you made before. It would take a lot of nerve to actually release the regulated exchanges from the bounds of the Commodities Exchange Act without some indication from Congress that that is what Congress wanted them to do.
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I think doing it to the OTC market at the time they did it was the appropriate thing to do. Doing it in today's environment after all of the issues that have come to the table and been discussed in public forums, people may feel as though at this point it is beyond that, although there is another point.
I think that you have to distinguish. There is specific prohibitions in the act from regulating foreign boards of trade. That needs to be qualified or remedied to some extent. There cannot be absolute prohibitions any longer of regulating foreign boards of trade if they are coming into U.S. shores to do business.
Mr. EWING. Mr. Hersch.
Mr. HERSCH. Mr. Chairman, if I may just make a correction, or correct a misconception here. This foreign terminal issue continues to be brought up at this hearing. I know this is not the forum for debate on it. I would like to point out that the trading terminals of U.S. exchanges are presently located in many, many other countries.
The Chicago Mercantile Exchange enjoys access to several countries in Europe and the Far East. The Chicago Board of Trade recently got approval to put their terminals in Paris and also has them in London. I don't believe that any action that the CFTC should take should invite any retaliation from countries that either allow terminals in now or are contemplating allowing them in. So we have to be very careful on this issue.
Mr. EWING. Thank you very much. I think that you can tell from the comments that the members of the committee felt that this was worth their while. That is because you have come and been very candid and answered questions very straightforwardly. I want to congratulate you for your time. You are all busy men and have important things to do. But work with us.
I believe that we are making serious headway toward restructuring the regulatory scheme for your industry. We will be calling on you repeatedly in the next year and a half as we move hopefully towards a conclusion of this before the deadline, the reauthorization runs out for the agency.
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I think it is not good public policy to have an agency that is unauthorized and have to go through the appropriations process. You can get all kinds of reauthorization right on the appropriation bills. I would like to see us have that off the table before we get to the budget a year from now.
So there are no further questions. The subcommittee will be back here for all of you players who want to sit in on the next episode tomorrow at 9:30. And the record will stay open for 10 days.
If we have other questions that we feel would be helpful to have answered, we may be sending those to you, and we would ask for your response in writing. Thank you very much and the committee is adjourned.
[Whereupon, at 12:45 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
Testimony of M. Scott Gordon
Mr. Chairman, members of the subcommittee, I am Scott Gordon, chairman of the Board of Directors of the Chicago Mercantile Exchange (CME). The Exchange welcomes this opportunity to offer its view of the reauthorization process and the important issues facing the industry and the Commission. In particular it is important that we carefully assess the regulatory implications of the rapid and seemingly inexorable shift from local floor based exchanges to international 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 trading devices.
The Commodity Futures Trading Commission 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. It is argued that the terminals are simply sophisticated telephone connections to a foreign exchange and no basis for regulation exists. Another view is that the screen is an electronic version of a physical trading floor, which should be regulated to the same extent as a traditional trading pit.
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In the end, all efforts to select a regulatory nexus for screen based trading systems will be overtaken by technology: regulation cannot keep pace with technology. The only effective means to permit U.S. exchanges to compete with rivals operating in more supportive jurisdictions is to change the underlying philosophy of derivative exchange regulation in this country. We, along with the Chicago Board of Trade, New York Mercantile Exchange and others will be working hard to ensure that the next reauthorization of the CFTC results in a new regulatory direction.
HISTORY
It is instructive to look to the origins of derivative exchanges for a regulatory model. Thirty years ago, our governing agency, the Commodity Exchange Authority, had a few small offices in the basements of the Department of Agriculture and the Chicago Board of Trade. U.S. exchanges were governed by a statute that offered freedom to make appropriate business decisions without advance approval from sincere, but inexperienced regulators.
The CME launched a new exchange and opened the door to financial futures trading. We created the International Monetary Market without federal regulation and without a single problem for which federal regulation was necessary. We had 2 years of freedom before the reach of the Commodity Exchange Act was expanded in 1974 to include all commodities including the financials. 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 cost.
The competitive costs and consequences of over enthusiastic regulation were far less significant even 5 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. Eurodollars and U.S. Treasury Bonds were going to be traded on a U.S. time zone exchange. Competition might come from the over-the-counter market, but foreign exchanges had no chance at the U.S. product base. Cheap communications, dispersal of market makers and replacement of brokers with simple algorithms ended the local monopoly and inspired international competition.
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Last year, MATIF, the French exchange went from pit based to screen based in two weeks. In February, EUREX, an all-electronic exchange was the world's volume leader. LIFFE, the principal London exchange, is converting to screen based trading as rapidly as it can come to terms with the technology. It expects to transfer its futures and financial option business to a screen based market by the end of the year. LIFFE has restructured to make its business attractive to investors. It plans to cut 700 jobs from its work force and eliminate much of its real estate holdings. Within 2 months the traditional pit based exchanges in Chicago will have fully listed their leading products on 24-hour electronic trading systems.
THE PRESENT
The Commodity Futures Trading Commission (CFTC) is the principal regulator of each element of the commodity derivative industry in the U.S. The Securities Exchange Commission (SEC) exercises authority over pooled security investments that incidentally trade futures and has a veto over certain securities related futures contracts.
The major industry segments are: (1) exchange markets, floor brokers and traders, and clearinghouses; (2) futures commission merchants; (3) pools and advisers; and (4) over-the-counter markets and participants. The CFTC has concentrated its regulatory program on exchange trading while exempting, to the extent of its authority, the over-the-counter market.
The CFTC, like the SEC, is a high intensity, detail oriented regulator. The generally adverse regulatory climate created by this philosophy has had an impact on CFTC registrants. The impact generally correlates to the ability of the registrant to leave the jurisdiction or service its customers from outside the jurisdiction. For example, CFTC regulation has had a costly and detrimental impact on U.S. exchanges, members and customers. The exchanges, which cannot escape CFTC jurisdiction and have non-regulated competitors on shore and off, have endured increased costs and suffered loss of business. The business conducted on U.S. futures exchanges has shrunk compared to foreign exchanges and the OTC market.
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As of June 1998, the Bank for International Settlements estimated the total notional amount of the OTC derivatives market at about $70 trillion in comparison with exchange traded derivatives of $14 trillion. Between 1986 and 1997, U.S. futures and options trading volume increased 319 percent to 905 million contracts. Foreign futures and options trading volume increased 1,734 percent to 1,025 million contacts. During 1998, the markets regulated by the CFTC traded 39 percent of world volume of comparable exchanges. The explosive growth of LIFFE in London, SIMEX in Singapore, BM&F in Brazil, and EUREX, in Germany, suggests that in the absence of a major readjustment of regulatory attitudes in this country the top four exchanges in the world will be in foreign jurisdictions. EUREX posted record volume of 33.8 million contracts in March, up 74 percent from March 1998. The Chicago Board of Trade reported March volume of 23.4 million contracts while CME March volume rose 4.8 percent from a year earlier to 19.6 million.
CFTC regulations also make it expensive for FCMs to do business on U.S. exchanges and burdensome to do business offshore. However, the regulatory burden is equal among FCMs doing business here. The regulatory costs do not seem to shift business among U.S. FCMs. U.S. pool operators and advisers who are adversely affected by regulatory disparities are sufficiently mobile to move their business offshore.
Regulatory policy in the futures industry was crafted on the presumption that the business was not portable. Recent massive business shifts have demonstrated the fallacy of that presumption. The dominance of U.S. futures exchanges has eroded. Their ability to compete with the over-the-counter (OTC) market and foreign exchanges has been hampered by U.S. regulatory policy. Foreign regulators have quickly and accurately balanced legitimate business needs against customer and market protection. London's exchanges have been freed from the pre-approval process. Singapore's regulator expedites approvals when international competition is at stake. U.S. exchanges have been kept waiting for regulatory relief. In contrast to the treatment of exchanges, the CFTC speedily exempted most of the OTC derivatives market from oversight and regulation immediately after authorizing legislation in 1992.
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Advances in communications and information management have changed the face of the industry and outrun the policy that had been used by the CFTC to shape the regulatory landscape for financial products. A number of jurisdictions recognized this change and crafted their tax and regulatory policies to capture business. Because of the importance of international financial transactions to London, it adopted a regulatory system that facilitates the operation of futures markets. The current leakage of business overseas follows a precedent set over thirty years ago, when the Interest Equalization Tax of 1963 drove bond underwriting business offshore, essentially creating the London Eurobond market.
In London, recognition of the realities of international business flows combined with a benign political attitude permits an accommodating tax and regulatory framework and a relatively predictable and sensible legal system. London Business School, The Competitive Position of London*s Financial Services: Final Report 4-1 (March 1995) (*Report*)
London profited from the restrictive policies in the USA, which reinforced London's comparative advantage as a benign location. Report 4-2.
Twenty-five years ago, New York State, New York City and the New York Stock Exchange learned this lesson in a less technological environment. Each acted as if the local monopoly on securities trading was secure. Market users found a remarkably simple solution. They boarded the subway, traveled under the river to New Jersey and completed their transactions on the station platform less than a mile away. Burdensome transfer taxes and restrictions on certain block trading practices were avoided. Eventually the New York Stock Exchange and its overseers recognized market realities and removed these restrictions.
International networks have replaced the subway. Encrypted communications and secure fund transfers coupled with international depositories and clearing organizations have written finis to local market monopolies. Not even the almighty dollar anchors business transactions to this jurisdiction. The vast store of capital on deposit in Europe has eliminated the local advantage. Investment capital moves based on the London inter-bank offered rate, not U.S. interest rates.
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The U.S. futures industry operates in a global economy where the primary competitors are unregulated, like the over-the-counter market, or regulated by Governments and agencies intent on promoting domestic financial markets, like London, Singapore, Brazil, and now France. The CFTC does not view its role to be a promoter of U.S. futures industry interests in the world economy. Instead, the Commission views its role as the insurer of some ideally perfect regulatory scheme. Its response to more reasonable regulatory environments in foreign jurisdictions has been to wage a campaign, with U.S. tax dollars, to raise the level of global regulation and protect its perceived mandate.
The natural consequence of the cross-border migration of business centers is a reduction in the role of domestic regulators and a resultant diminishment of their power. Domestic regulatory agencies become obsolete if they lose their clients through emigration or lose their absolute power to regulate out of fear of driving business away from domestic markets. The CFTC seems to be following a three pronged strategy to preserve the status quo. First, it seeks to organize the international regulatory community to impose uniform regulatory obligations. If effective, this step would halt emigration of business in response to more attractive regulation in other jurisdictions. Second, it attempts to assert control over entities that want to do business with U.S. residents. Its proposed rules respecting the placement of foreign terminals in the U.S. embody this effort. Finally, it seeks to rally public support with the argument that the business world prefers highly regulated markets because it gives them greater confidence and security.
Unfortunately, the CFTC's strategy will fail and leave U.S. exchanges in a vulnerable position. Its strategy does not take account of the impact of the technological internationalization of financial business on a domestic futures industry burdened by regulation that exceeds international norms. Intense pressure from the international community to keep clear of the perceived excesses of U.S. regulation will undo the Commission's efforts. The Commission has begun the retreat from its attempt to impose quasi U.S. standards on foreign exchanges that operate in this country. Unfortunately, this retreat is likely to grant those exchanges an insurmountable competitive advantage in their planned confrontation with U.S. exchange electronic trading systems.
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THE FUTURE
The Commission's regulatory strategy is unlikely to prevail over the long run, but will do a great deal of damage before it is reversed. To the extent that business can easily be relocated, foreign jurisdictions continue to compete to attract that business by lowering regulatory costs. For example, fund management has moved offshore. The April issue of Futures magazine includes a comprehensive review of the competitive situation and the consequent flight. More than forty jurisdictions have competed for the fund business, and it is gone.
The transfer of informal markets is advanced. The OTC market has no fixed jurisdictional home. If regulation is over zealous here, the center for the transaction moves there. If equity swaps carry a legal risk in the U.S., they can as easily be completed in England. No U.S. firm will refuse to participate on the ground that the legal uncertainty creates a moral issue.
The process of moving organized markets from this jurisdiction is beginning. Futures exchanges that depend on trading floors are not portable. The CME has established linkages and offset agreements that permit its contracts to be traded offshore. One U.S. exchange has a trading floor in Ireland. Nonetheless, U.S. futures markets have, for the most part, maintained their physical ties to this country and operated under the full burden of Commission regulation. Practical considerations have constrained the markets from moving to more hospitable climates. The CME has a staff of one thousand: fifty-five hundred traders and their employees fill our two floors each day. It will not be easy to transport this structure to Bermuda or the Cayman Islands.
The costs to move an open-out-cry market offshore, serves as a limit on foreign jurisdictions seeking to move the marketplace through regulatory incentives. Those costs do not limit efforts to attract the business being done on U.S. markets to offshore venues. U.S. customers are not constrained to do business on U.S. based exchanges. They have ready access to real time price information. At the current time some constraints remain on the ability of a customer to access the trading screens of foreign electronic exchanges. When those constraints are eliminated, customers will be able to transfer their business with a button push. If an offshore venue permits a desirable form of trading with lower fees and no taxes, and U.S. exchange cannot overcome that advantage with superior liquidity, business will transfer. Since liquidity flows with the business, eventually all business will be lost. A foreign jurisdiction cannot import a U.S. physical exchange: it has the capacity to export its electronic exchange to the United States.
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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 outsourced. Other management and employment needs can be satisfied in most jurisdictions that financial firms choose to avoid burdensome regulation. Connection to the trading engine can be accomplished over the Internet or other public networks. Terminals need not 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 traders. Moreover, even the user interface can be downloaded over the network in the form of java applets.
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 assert jurisdiction. EBS and Reuters operate enormous non-intermediated trading networks. The original plan for FutureCom, a proposed Internet cattle trading futures market, provided for a non-intermediated trading process. 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 as gambling enterprises. These examples are not a subtle announcement that the CME is on its way to Grand Cayman. 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.
Many had imagined that electronic markets had a free choice of venue. The first electronic futures exchange created by U.S. investors was ''located'' in Bermuda. The CME has considered whether to move its electronic trading system to a more understanding regulatory environment. In fact, the GLOBEX black box was, for a time, physically in Europe. In response to the emergence of electronic exchanges, the CFTC is attempting to insure that it will retain its jurisdiction regardless of the delocalizaton of exchanges.
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The Commission's first pass at regulation of international exchanges was to propose that they be subject to regulation comparable to the U.S. regulatory regime if they want to do business here and to neutralize any effort by a U.S. exchange to move off-shore. The CFTC's proposed foreign terminal regulations ignited opposition from foreign governments, foreign exchanges, domestic futures commission merchants and several commissioners. It seems likely that the well-organized reaction to the proposed regulations will lift restrictions on foreign exchanges without granting simultaneous relief for domestic exchanges.
If the CFTC submits to the pressure for immediate relief for foreign exchanges, U.S. futures exchanges will face a devastating, unfair challenge. U.S. exchanges will be required to compete in the U.S. under the burden of a heavy regulatory handicap that does not apply to competitors dealing with the same customers. Foreign countries now restrict U.S. exchange overseas operations, and those restrictions will continue even if exchanges from such restrictive jurisdictions are admitted into the U.S.
Under the proposal sponsored by three Commissioners, foreign exchanges would be immune from the same provisions of the Commodity Exchange Act that limit the ability of U.S. exchanges to respond to the competition. For example, foreign exchanges will be able to list new products and change contract terms and conditions without waiting for approval from any regulator. Those foreign exchanges have immediate plans to clone and trade the most important contracts traded on U.S. exchanges and to capture U.S. exchange business by using competitive devices that are not available to U.S. exchanges. Foreign exchanges will be able to pay for order flow, permit pre-arranged trades, facilitate block trades with delayed price reporting, dispense with strict audit trail rules, and allow large traders to escape reporting requirements.
The foreign exchanges and their allies have asserted that permission to admit foreign exchange terminals into the U.S. should not raise any significant regulatory concerns. The argument is that foreign exchanges can now be accessed from the U.S. by telephone and that placement of trading terminals in the U.S. should not cause any change from the status quo. We believe that this argument is wrong.
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Traditionally, physical exchanges, like the Chicago Mercantile Exchange and the Chicago Board of Trade, had a clear and incontrovertible nexus to a jurisdiction. There was one, and only one location, at which the actions that resulted in a bid, offer or sale could take place—the trading pit. It was logical for the local jurisdiction to regulate and equally logical that other jurisdictions, whose customers occasionally transmitted orders for execution on such exchanges, should not. No scholar, regulator or legislator has ever argued that the international transmission of an order to a floor broker, whether by carrier pigeon, telephone or computer modem, should give the customer's home regulator jurisdiction to regulate the foreign exchange. The mode of transmission of an order to a traditional floor based exchange is irrelevant. A computerized order routing system should not have different regulatory implications than a telephone based system.
The same reasoning does not apply to computer based exchanges. Trading terminals, whether called order routing devices or order entry devices, are not, like telephones, devices to communicate information to a pit broker who independently makes all necessary execution decisions. Instead, trading terminals transport the market directly to the trading screen.
Display of the central limit order book on a trading terminal effectively places the terminal user in the center of the pit. The push of the button to bid, offer, hit or take is the outcry and hand signal in the pit. The electrons that start at the button push and race to the order-matching engine make their journey more quickly than the human voice traverses the pit. For regulatory purposes, an electronic trading market is as much present in the jurisdiction from which it is accessed as in the jurisdiction in which it chooses to locate its black box i.e., its central trading engine. The jurisdictions in which the trading terminals are located have at least as legitimate a claim to regulate the market as the jurisdiction that supplies the electricity to power the matching engine.
The ownership of the physical terminal or the path followed by the electrons on the way to the matching engine should not be relevant to the legitimacy of a claim to regulate. One business model, the closed system, is based on single purpose trading terminals and a dedicated network operated by the exchange. In such a system, the exchange is physically present in every jurisdiction from which it can be accessed.
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The closed system model is losing favor to open systems. Most advanced electronic transaction systems have created Application Program Interfaces that permit independent software vendors to place the futures contracts of competing exchanges side-by-side on trading terminals owned by the customer or his broker. The day is fast approaching when anyone with Internet access or a quote terminal will technically be able to access electronic transaction systems located anywhere. There is no sound regulatory philosophy that suggest that an exchange that chooses the closed system model and thereby owns physical property in many jurisdictions should be subjected to a different regulatory burden than exchange that chooses an open system model that relies on terminals owned by customers and brokers. The selection of a business model should be a strategic, rather than a regulatory decision.
The following graphic depicts the CME's electronic trading system, GLOBEX2. It is an open system that permits member firms to choose among the exchange provided workstation (GL), their internal networks and terminals, or a terminal provided by an ISP. For regulatory purposes, a firm's terminals function exactly like terminals owned by the exchange.
Open systems allow customers to chose between clone contracts listed by competing exchanges available for trading on the same terminal. Minor differences between the regulatory environments of the competing exchanges can have enormous impacts on order flow. While every exchange must accept the verdict that will be rendered in a fair competitive environment, no exchange should be forced to compete with severe constraints on its ability to offer equivalent trading facilities.
The conclusion is clear, the Commodity Futures Trading Commission should not admit foreign exchanges without simultaneously acting to permit U.S. based exchanges to compete on the same regulatory terms with the foreign exchanges. The Commission should, in connection with any no-action or exemption for a foreign exchange, exercise its power under section 4(c) of the Commodity Exchange Act to permit the U.S. futures exchanges to operate under the same standards and conditions that govern such foreign exchanges admitted into the U.S.
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The following issues are illustrative of the competitive impact of admitting foreign futures exchanges without simultaneously granting relief to U.S. exchanges. These issues are among the most serious that need to be addressed either by amending the CEA or exempting U.S. exchanges from the CEA to permit timely responses to foreign competition.
Preapproval of Contracts, Contract Amendments and Rules: The competitive impact of permitting foreign exchanges to clone and list U.S. exchange contract inventions while U.S. exchanges are trapped in a lengthy approval process is devastating. The same is true with respect to rules regarding new trading methods or even changes to existing contracts.
Payment for Order Flow: Even if a U.S. exchange has a tangibly better trading environment for customers, the lure of payment for order flow and the difficulty of demonstrating actual damages to customers is likely to decide a competitive battle. If U.S. exchanges cannot counter competitive attacks based on such payments, the focus of liquidity is likely to move. Once moved, it cannot easily be recaptured. Especially if the foreign exchange has no constraint on its ability to respond.
Inducements to Make Markets or Trade: Customer business ordinarily follows liquidity. A short-term program to buy liquidity, if it cannot be matched by the U.S. exchange for regulatory reasons, can change the long-term location of markets without any benefit to customers.
Guaranteed Pricing or Execution: U.S. exchanges cannot permit the type of prearrangement involved in guaranteeing price or execution quantity. The philosophy of the CEA is to discover accurate prices through open competition. Firms that profit more from arranging such trades than the commission that would be earned through bringing a customer to an open outcry market will divert business to the foreign exchange that permits such practices.
Large Trader Reporting: Traders on U.S. exchanges are required to provide daily reports of positions. Many such traders will transfer their business to foreign exchanges to avoid that disclosure.
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Price Reporting: Many significant customers would rather withhold information about their trades until they have been able to act in another market or execute additional transactions. The CEA precludes U.S. markets from delaying price reports for such purposes. If a competing foreign exchange, operating on the same terminal as a U.S. exchange, offers to delay reporting of large block trades, it is predictable where such trades will be registered.
Account Identification: Orders can be entered on foreign exchanges without first typing a multi-digit account identifier. Again, if the same contract can be traded on two exchanges and one slows order entry with technical requirements, it is clear which exchange will get the business.
System Performance, Capacity and Security: In addition to burdening U.S. exchanges by requiring that new contracts and trading rules be approved in advance, the Commission has precluded U.S. exchanges from launching new products until it has reviewed and approved performance and capacity tests. The CME's launch of Eurodollar contracts is conditioned on Commission staff review and approval of test results. Foreign competitors will not be equally constrained under the proposed no action approach or under the proposed rules.
Segregation of Customer Funds: Large customers object to the forced pooling of their funds held by futures commission merchants with the funds of other customers. If foreign exchanges permit customers a choice, and that choice is unavailable to customers trading equivalent products on U.S. exchanges, a serious competitive inequity will be created.
Transaction Taxes, Filing Fees, and Fees for Reviews of Rule Enforcement Programs: The CME is required to pay the Commission $228,000 per year for reviewing its rule enforcement program plus bearing the substantial expense of participating in that review. In addition, CME pays more than $100,000 each year to compensate the Commission for reviewing its new contracts. Finally, CME is being threatened with a transaction tax of $.10 per contract. A foreign exchange that can reach U.S. customers without those burdens will have an enormous advantage.
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The essential problem appears to be that the CFTC has lost sight of the existence of a balance between the desired benefits and costs of regulation, and is out of touch with what the global marketplace considers to be good business practice. What should the CFTC do, given that technological advances are overwhelming its ability to restrict the derivative instruments to which U.S. citizens have access? It could re-structure its regulations so that U.S. derivative exchanges and others with access to U.S. customers can compete in the global marketplace, and it probably has the power to do so under the Commodity Exchange Act. In the long run, the best solution is to use the legislative reauthorization process to rationalize the Commission's authority.
The CME and the Chicago Board of Trade have proposed a legislative framework for rationalizing the regulation of derivatives markets. Our proposal would create a level and fair playing field for all participants in derivatives markets. It would break down the artificial regulatory barriers between different classes of derivative instruments. Finally, it would rescue U.S. derivative exchanges and the CFTC.
Thank you again, Mr. Chairman, for the opportunity to be here today.
Testimony of James J. Bowe
I am James Bowe, president and chief executive officer of the Board of Trade of the City of New York (NYBOT). Thank you for this opportunity to appear before the subcommittee to discuss issues related to the reauthorization of the Commodity Futures Trading Commission (CFTC). Mr. Chairman, we appreciate your commitment to review the Commodity Exchange Act (CEA) to see how it can be revised to meet the challenges facing the futures industry today.
The NYBOT is the holding company for the Coffee, Sugar & Cocoa Exchange, Inc. (CSCE) and the New York Cotton Exchange, Inc. (NYCE). Through the two exchanges and their subsidiaries, including NYFE, FINEX and Citrus Associates, NYBOT offers a variety of agricultural, financial and index products. In addition, the Cantor Exchange, a venture of NYBOT and Cantor Fitzgerald, provides the first electronic, screen-based market for U.S. Treasury futures.
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CREATE A LEVEL PLAYING FIELD
NYBOT's priority is to revise the CEA to create a level playing field for U.S. exchanges. The current regulatory structure does not recognize the competitive pressures facing U.S. futures exchanges. Many other venues for risk management and investment are available—stock and options markets, OTC markets and foreign exchanges. The regulatory scheme relating to U.S. futures is outdated and onerous both in absolute terms and particularly in comparison to our competitors. Perhaps we could absorb the inefficiencies when nearly all business was forced through U.S. futures exchanges—but, this is not the case today. In fact, I believe that in many ways the cost of futures regulation has provided the success of our competitors at our expense.
Thus, we urge the subcommittee to restructure and modernize the regulation of exchanges and to fix the CEA to provide a level playing field for futures exchanges as compared to other available markets. The CFTC's role as overseer should be retained, but without duplicating functions effectively carried out by exchanges or placing unnecessary regulatory requirements on exchanges. This would allow exchanges to adapt to the continually evolving needs of market users and the growing competition from less regulated foreign exchanges and unregulated OTC markets.
When devising a regulatory scheme for exchanges, the following principles should serve as guidelines: (1) the cost of implementing a rule should be reasonable and in balance with the expected benefits; (2) since there are many differences among exchanges, regulations should be flexible in order to accommodate these differences and to encourage innovation; and (3) the possible impact of a rule or requirement on the competitiveness of U.S. futures markets should be carefully considered.
As the subcommittee considers revisions to the CEA, we wish to emphasize that the financial integrity of markets can be protected by the CFTC setting general standards and disclosure requirements, rather than detailed directives to exchanges. The self-regulatory structure of exchanges is well developed and should be allowed to work with greater autonomy. Our goal is to streamline regulations and to control regulatory costs, while still maintaining the standards of oversight and accountability that are necessary for market integrity.
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Market users are, and will continue to be, well protected through the advanced, self-regulatory systems used by U.S. exchanges. If there are grievances, which may occur with any financial transaction, futures market users have and would retain their rights to seek recourse through the exchanges, the CFTC or the courts.
Self-regulatory responsibilities and costs are significant and we take them very seriously. Self regulation and market regulation are the historical foundation of futures exchanges, and the Exchange would continue these successful methods, including:
clearinghouses and settlement procedures to virtually eliminate credit risk;
margin requirements and marking accounts to market;
maintenance of a self-regulatory framework to oversee financial capacity and accountability of members;
market surveillance and emergency authority; and
anti-fraud and anti-manipulation rules and a full compliance regime.
In addition, the CEA should not give a competitive advantage to one trading venue over another. The Shad-Johnson Accord and Treasury Amendment create such distortions. They need to be overhauled or eliminated to allow futures exchanges to offer products on single stocks and narrow stock indexes, and to eliminate excessive regulation of exchanges that trade Government securities and foreign exchange products.
PROVIDE EXCHANGES GREATER AUTONOMY FOR MAKING BUSINESS DECISIONS
CFTC intervention in product design and development must be eliminated. The process of contract designation and rule approval severely hampers our ability to compete and prevents our Exchange from adjusting quickly to competitive pressures and changes in the marketplace.
The CEA should be amended to no longer require the CFTC to designate an exchange as a market in a new product. Moreover, the CFTC should not determine the economic purpose or viability of an exchange product.
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Designing and introducing a new product is a business decision of an exchange. The CFTC and its staff are not in the position to determine whether it is worthwhile for an exchange to invest in developing a market for a particular new product. This is the business decision of the exchange and it is the market that will decide whether a contract survives or not.
During the current required public approval process by the CFTC, marketing time is lost and a competitor can jump in and take advantage by replicating the contract or appropriating an exchange's development ideas. Our Exchange experienced this problem when developing some of our dairy products and we have been reluctant to move ahead with some other innovative contracts.
There is no compelling reason for the CFTC to approve rules governing contract terms and conditions. The CFTC staff cannot determine any better than an exchange which terms and conditions are most suitable. It is simply not feasible for an exchange to propose a new product or significant changes in a product that have not been thoroughly researched, discussed with members and vetted with the relevant market users and industry. Much of the time spent by the CFTC staff in reviewing an application is simply replicating the work of the exchange.
There is never unanimity in the specific design terms of a contract as each commercial market participant has a specific and vested interest. There is no reason to re-argue the issues of contract design before the CFTC after an exchange had made its decision.
Our Exchange is particularly sensitive to this problem. For example, in the United Kingdom, where our principal competitor in coffee, sugar and cocoa resides, new futures contracts may be introduced for trading without any governmental review, whatsoever. Moreover, they can offer these products to the general public in the United States, while U.S. exchanges must overcome numerous and time-consuming regulatory hurdles before they can do the same thing.
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There are multiple safeguards in place at exchanges to monitor markets and prevent manipulation, which would not be lost by modernizing regulation. The CFTC would still adopt regulations and standards that exchanges and market users must adhere to and could require an exchange to take an emergency action. Adequate oversight can be provided by an exchange following general CFTC guidelines for developing contract terms and conditions, and following CFTC regulations for developing exchange rules. Such terms, conditions and rules would still be submitted to the CFTC, permitting appropriate oversight.
In conclusion, Mr. Chairman, by insuring that the CEA is relevant to the world in which we live today and that competition and innovation are fostered without risking the public interest, I believe you will provide a tremendous boost to fair and equitable markets. I appreciate the challenge you face as you try to weigh the arguments put before you to determine which recommendations serve the public interest and which ones may impede competitive efforts.
Thank you for this opportunity to testify. I would be glad to respond to any questions you may have.
RESPONSES SUBMITTED FOR THE RECORD BY JAMES J. BOWE
1. What information are you aware of regarding the relative degree to which U.S. exchanges are regulated in comparison to foreign exchanges?
The coffee, sugar and cocoa markets on the NYBOT compete directly with London markets. The London futures markets are regulated very differently than those in the United States, since the British system gives greater weight to self-regulation and the regulator primarily plays a supervisory role. As an example, in England a contract may be introduced and traded on a futures exchange without prior approval from the U.K. regulator. Thus, the time between development of a contract and it's listing on the exchange is much shorter than in the United States. A contract introduced under the more relaxed U.K. regulatory regime can then immediately be offered to the U.S. public.
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In contrast, in the United States a contract must have prior approval by the CFTC before it can be traded on an exchange. The U.S. exchange must submit an exhaustive, written contract designation application and its contract rules to the CFTC, which conducts a review process that includes a public comment period that alerts competitors to the new product before the exchange has a chance to list it for trading. This review process can take many months. The field can be leveled by amending the CEA to allow U.S. exchanges to introduce contracts without having to justify them to the CFTC and obtain prior approval by the CFTC.
2. To what extent has the International Organization of Securities Commissions served as a forum for the international community to harmonize regulation?
Exchanges are not direct participants in IOSCO and in our view it has not served as a forum for seeking ways to harmonize regulation of exchanges. IOSCO is a forum for international regulators to collect information about policies and practices and to identify areas where they can share or exchange information for regulatory and/or enforcement purposes. It may be used as a forum to identify best practices or principles in specific areas, however, we do not believe that matters so agreed upon (to the extent they even relate to futures exchanges) are necessarily implemented by the IOSCO participants, nor is there any real consequence of failing to do so.
3. To what extent do you believe that any degree of international harmonization might be achieved?
Regulatory systems will always vary from country-to-county and it is unlikely that an international forum of any sort can result in harmonization of exchange regulation. Regulatory differences reflect differences in local practices and culture, and each country's particular path of regulatory evolution. Newly-developed markets, for example, can create systems that reflect current trends, without being held back by out of date regulatory practices. The United States, on the other hand, has a long history of regulation of domestic agricultural futures and it is difficult for regulators to change their practices to adjust to today's international marketplace.
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The only way to start the harmonization process is for the United States to modify its own system to meet the realities of today. We are pleased that the CFTC included in its Order of June 2, 1999 that there will be a review of foreign and U.S. regulation of exchanges, with a view toward addressing competitive disadvantages that U.S. exchanges face. This is an important step, but it is not enough. We believe that it is necessary for Congress to keep this process moving and to address these issues directly by revising the CEA and restructuring CFTC regulation.
Testimony of Daniel Rappaport
Mr. Chairman, and members of the committee, my name is Daniel Rappaport. I am chairman of the Board of Directors of the New York Mercantile Exchange. NYMEX is the world's largest exchange for the trading of energy and metals futures and options contracts. On behalf of NYMEX, I wish to thank you for the opportunity to participate in today's hearing on issues surrounding the reauthorization of the Commodity Futures Trading Commission and the need for changes to the Commodity Exchange Act.
Introduction. In inviting me to testify, this committee asked specifically whether the CEA needs to be modernized to address changes in the United State's and global marketplaces. It does. Indeed, because modernization is long overdue, there is an urgent need for reform.
The Exchange's comments first outline the changes that have occurred in recent years in derivative markets. We then suggest the level of Federal regulation that is appropriate in light of these changes and identify specific regulatory reforms that should be undertaken. Derivative products offered over-the-counter are similar in structure and purpose to exchange-traded futures and options. Like exchange-traded derivatives, OTC derivatives are used for risk shifting and speculation. Our comments focus upon the appropriate level of CFTC regulation of three markets: (1) OTC markets now largely exempted from CFTC regulation under the Commission's Part 35 exemption; (2) futures exchanges now subject to pervasive regulation under the act; and (3) foreign boards of trade seeking to establish delivery points or seeking to place electronic terminals in the U.S.
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NYMEX's regulatory reform proposals have been carefully considered, and we sincerely believe that they can serve as a foundation upon which consensus might develop among all parties interested in reforming the act.
INDUSTRY CHANGES
Technological advancements are possibly the single biggest source of change in the derivatives industry. Electronic trading systems involving a wide variety of designs have become increasingly prevalent at futures exchanges around the world. On the domestic front, a number of possible trading systems have been proposed as alternatives to the traditional open-outcry method of trading, including Internet-based exchanges, non-intermediated exchanges and proprietary exchanges. In addition, instantaneous international communication and transactional capabilities are creating truly global markets.
The volume of transactions of OTC derivative products is increasing exponentially, and the number and type of products offered in OTC markets continues to mushroom. In particular, the volume of trading in OTC markets has exploded in the last 5 years and now is estimated by the Bank for International Settlements to be $70 trillion in notional value worldwide. Furthermore, technological and market developments are driving many OTC derivatives market participants to express an interest in adopting trading and clearing systems that would cause OTC markets to resemble more closely exchange-traded markets.
REGULATORY PHILOSOPHY AND PRINCIPLES
In a speech delivered in early 1997, Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, identified two imperatives that should be followed when evaluating market regulation..Alan Greenspan, Address Before the Financial Markets Conference of the Federal Reserve Bank of Atlanta (February 21, 1997), reprinted in Futures Derivatives & Law Report (April 1997) We believe that Chairman Greenspan's views would be helpful to this Committee in considering reforms of the act. According to Chairman Greenspan, the first imperative is to enunciate clearly the public policy objectives that Government regulation would be intended to promote.
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NYMEX suggests that Congress should use a regulatory approach:
''that fosters risk management and price discovery through the use of centralized markets in a framework that promotes pricing free of manipulative influence, enhances the financial soundness of the marketplace, encourages competition and facilitates the fair and equitable treatment of all market participants.''
Once appropriate public policy objectives have been clearly specified, the next regulatory imperative is to evaluate whether Government regulation is necessary for those purposes. Chairman Greenspan noted that:
''[i]n making such evaluations, it is critically important to recognize that no market is ever truly unregulated. The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether Government intervention strengthens or weakens private regulation. If incentives for private market regulation are weak or if market participants lack the capabilities to pursue their interests effectively, then the introduction of Government regulation may improve regulation. But if private market regulation is effective, then Government regulation is at best unnecessary . . . The degree and type of Government regulation needed, if any, depends on the types of instruments traded, the types of market participants, and the nature of the relationships among market participants.''
Private market regulation would include recourse to traditional legal remedies as well as use of various measures to reduce the likelihood of loss or default. Also in a highly competitive market, reputational risk can be a significant consideration because the consequences of damages to a company's reputation can be great.
It is worth noting that futures exchanges employ additional measures to regulate their own markets. Exchanges have the inherent authority, which long predates the advent of Federal regulation of futures markets, to investigate trading activity and discipline persons for violations of exchange rules. In addition, under the act, exchanges are recognized as self-regulatory organizations. In fact, historically the act has been structured under the notion that the CFTC's function was to serve as an oversight agency of SRO regulation of their own markets.
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The burden of Federal regulation on regulated entities can be quite enormous. There is the direct cost of complying with an often immense array of detailed rules and requirements. There is also the more subtle but no less compelling cost of regulatory delay. For example, suppose that there are two competing markets, and one market is largely unregulated while the other is heavily regulated, the first market may be able to roll out new products or new trading strategies in a fairly short time frame.
On the other hand, in the heavily regulated market, innovative trading practices and products may be held up for months or even years while regulatory staff consider every conceivable hypothetical application or imagined harm. In such circumstances, as Chairman Greenspan has observed, the privately regulated markets in effect provide a market test of the net benefits of Government regulation. Migration of activity from Government-regulated to privately regulated markets sends a signal to Government regulators that many market participants believe the costs of regulation exceed the benefits.
NYMEX suggests that Congress should require regulation of derivative markets by a Federal regulatory agency only to the extent strictly necessary to achieve specified public policy objectives and only where other means of achieving such objectives, such as private market regulation, would be inadequate to achieve these objectives.
OTC AND EXCHANGE MARKETS
Regulatory Relief for OTC Markets: Part 35 of the CFTC's Regulations. The CFTC's exercise of exemptive authority granted to it by Congress in the Futures Trading Practices Act of 1992 provides an illustrative example of the CFTC's contrasting approaches to regulatory relief to OTC and exchange markets. On the one hand, the CFTC used its new authority under Section 4(c) of the act to issue Part 35 to its regulations, which exempt eligible swap transactions from virtually all requirements of the act and of Commission regulations, save those pertaining to fraud and manipulation. Under Part 35, the swap agreement negotiated between sophisticated principals may not be part of a fungible class of agreements that are standardized as to their material economic terms and the creditworthiness of the participants must be a material consideration in determining the terms of the transaction.
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In the 6 years since Part 35 took effect, swaps markets have thrived. In this regard, NYMEX has been steadfast in recognizing the many valuable functions that OTC products provide to users of OTC markets and the innovations that these products have brought to financial markets generally. A light handed regulatory approach has worked well for these markets, and we support the conclusion that the CFTC, in largely leaving these markets alone and thereby permitting them to prosper, struck the appropriate regulatory balance.
At the same time, NYMEX believes that an important lesson can be learned from the experiences of OTC markets. These markets have functioned outside of the traditionally defined system of regulation in an efficient manner and have significantly contributed to the promotion of the public interest without significant systemic problems. The greater freedom to design new products relative to more heavily regulated exchange-traded markets has permitted OTC markets to respond quickly to changing market demands.
The Failure of Regulatory Relief for Futures Exchanges: The Commission's Part 36. On the other hand, the experience of the more heavily regulated futures exchanges, in attempting to obtain regulatory relief from the CFTC, has been considerably more frustrating. Congress' grant of exemptive authority to the CFTC under Section 4(c) is applicable to ''any person,'' does not distinguish between on-exchange and off-exchange products and indeed specifically references boards of trade designated as contract markets. Moreover, the legislative history of the FTPA directed the CFTC to be fair and even-handed in providing regulatory relief for both exchange and non-exchange markets.
However, the Commission's sole exercise of this authority directed to exchanges, Part 36 of its regulations, which was issued in 1995, is narrowly drawn and unnecessarily restrictive. For example, Part 36 applies only to contracts that are cash-settled and excludes any contracts that are currently trading. Part 36 thus excludes from regulatory relief not only all current NYMEX products but, by excluding contracts involving physical delivery, also excludes virtually all contracts that NYMEX might offer in the future. In other words, Part 36 is essentially unusable and thus offers only the illusion of regulatory relief. To date, no futures exchange has utilized the Part 36 exemption.
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Appropriate Level of Regulation of OTC Markets. In terms of regulation of OTC markets, the framework of Part 35 has worked well. The solution to the issue of ''regulatory parity'' between exchanges and the OTC marketplace does not lie in an attempt to re-regulate the OTC markets, which appear to have adequate private market regulation to address the public policy objectives applicable to such markets.
Some commentators have suggested that there is a need to establish legal certainty regarding the applicability of the act to various forms of innovative contracts, which could be accomplished through codification of the existing Part 35 exemption. While such codification would not advance any of NYMEX's own business interests, we nonetheless support it.
At the same time, we would not favor a codification that substantially diverges from the Part 35 framework. Thus, to the extent OTC instruments become more standardized, are centrally traded or cleared or are sold to a broader segment of the public, the core protections of the act should be triggered. Specifically, the existence of any one of the following three functions in a trading mechanism should give rise to regulation as a contract market by the CFTC or give rise to equivalent safeguards:
Clearing - Any trading mechanism that offers financial guarantees for the transaction through clearing which aggregates the financial risk of transactions over many parties to reduce or eliminate counter-party credit risk.
Price Transparency - Any trading mechanism that creates a transparent market where bids, offers and prices are reported to participants and which might be used to form the basis for pricing transactions in the underlying physical or cash markets.
Auction Market Functions - Any trading mechanism that relies on an auction market where price formation depends upon equal and fair access to the marketplace. Regulation serves to assure competitiveness, equal access, and discourages attempts at market control.
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Appropriate Level of Regulation of Futures Exchanges. In terms of regulatory relief for futures exchanges, we would like to see the CFTC, building on the experience gained from the swaps exemption, apply the exemptive authority granted by Congress to exchange-traded transactions with the same creativity and vision that it has displayed for OTC products. Indeed, we would welcome a serious proposal from the Commission offering regulatory relief to U.S. exchanges. However, it's been 6 years since the exchanges first petitioned the CFTC for regulatory relief. We cannot afford to wait any longer for the CFTC to act on its own.
A substantial portion of the explosive growth in OTC markets can be attributed to the attractiveness of customized products, and OTC markets both complement and compete with futures exchanges. Yet, Exchange Member Firms who also serve as OTC dealers have indicated that, with respect to commodity energy swaps, as much as 90 percent of the OTC products are based directly upon the terms of NYMEX futures contracts. This anecdotal evidence supports the conclusion that some part of the growth in OTC markets can be attributed to a migration from futures exchanges. As Chairman Greenspan noted previously, such a migration of activity from heavily Government-regulated to privately regulated markets sends a strong signal that many market participants believe the costs of Government regulation exceed the benefits.
Therefore, we urge Congress to reform the act. Our principal recommendation is that Congress clarify the CFTC's function and maintain the CFTC as a true oversight agency. Specifically, Congress should eliminate the Commission's authority for prior review of contract terms and conditions, as well as rules and procedures not related to its core regulatory interests and replace it with authority to seek remediation of statutory violations by regulated exchanges.
The transparency and deep liquidity offered by centralized, self-regulated U.S. exchanges provide major benefits to U.S. consumers and the U.S. economy. Through its regulatory policies, Congress should encourage businesses to use more transparent markets. The marketplace served by NYMEX and the other futures exchange is predominantly commercial, with negligible retail participation, and commercial market-users demand responsive and flexible markets.
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Thus, Congress and the CFTC must provide the flexibility to exchanges to innovate—to continue to serve the commercial needs of their market users free of the micro-management of regulators and a regulatory mind set that often places risk of the unsubstantiated, hypothetical, theoretical and isolated harm that may occur from an innovation ahead of the benefits to liquidity, risk management, and pricing that are the driving forces of the innovation.
Elimination of Prior Review of Contract Terms. We urge Congress to eliminate prior CFTC review for two reasons. First, we believe strongly that each exchange's self-interest is a major driving force that ensures that its own processes will be detailed and thorough. If an exchange develops contracts that are not well-conceived or drafted, its credibility will quickly erode. More importantly, if it offers contracts that are susceptible to manipulation, its own members are as likely as any member of the public to lose from such manipulation. In addition, through its clearing function, the exchange puts its own capital on the line-and at risk—as well. Second, in our experience, detailed CFTC review and approval of the specific terms and conditions of the contract has not been necessary, provides marginal, if any, value, and adds cost, uncertainty, and delay to the roll-out of new contracts.
In developing a new contract, NYMEX conducts an intensive review process, which includes consultations with virtually all segments of the affected industry and the financial community and numerous forums for open debate in which reasonable views can be expressed and considered. The contract development process allows all potential users to protect themselves in ways that diminish the need or the utility of detailed CFTC prior review. The process allows potential users to shape the terms and conditions and voice their concerns over any provisions that they feel do not match cash market practices or other commercial concerns over which they have expertise. Equally important, the process allows a full airing of the terms and conditions prior to trading.
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This affords all potential market participants with the opportunity to educate themselves and make their own decisions to trade or not to trade a new contract. In view of the powerful economic forces which drive exchanges to be thorough and vigilant in developing a new product, Congress should be confident in allowing exchanges to list contracts for trading and implement rules without detailed CFTC prior review.
Elimination of Prior Review for Certain Rules and Procedures. Many, although perhaps not all, futures contracts provide a price discovery function, and the prices for these contracts are widely disseminated. Consequently, we recognize that such trading affects the public interest and that the CFTC has a role to play in safeguarding certain regulatory concerns. We suggest that the extent of CFTC-mandated jurisdiction over contract markets to impose and enforce standards and procedures, including reporting and recordkeeping requirements, and to require rules and products to be subject to its prior approval, should be founded on, and limited by, its primary statutory duties: to ensure financial integrity, customer protection, market integrity and price transparency.
Under the current regulatory scheme, any rule or by-law to be adopted by an exchange must pass through a CFTC filing process, a waiting period, and too frequently a review process. We accept this scheme as it pertains to the exchanges' fiduciary obligations of fair dealing and honesty that NYMEX owes to its customers and members governing equal access to the marketplace, the prudential management of risk, and the protections which assure that markets are free from manipulation and reflect fundamental value.
By comparison, to the extent that a contract market as a commercial competitive entity develops the means and practices for delivering those products (as long as those commercial practices are fully disclosed and applied in a non-discriminatory way), the contract market should be free from regulatory intrusion or oversight. Therefore, at a minimum, innovative trading practices developed by an exchange should not be subject to prior review. These activities or practices by the contract market which do not implicate the core protections mentioned above should be free from Commission oversight and should be left to the discretion and sound business judgment of the contract market so long as such activities and practices are fully disclosed to the public.
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Other rules do not affect the core of our fiduciary duties, or do so only in the most indirect and tangential ways as not to be material. Such rules fall into the category which we call ''operations,'' a term intended to cover the daily operations of business on the floor. Operations rules include changes to initial contract terms and conditions introduced through an accepted practice of industry input; market innovations that seek to broaden the usefulness of the exchange by inviting off-exchange transactions into the regulated marketplace; the administration of the self-disciplinary process; innovations in trading methods that seek to provide liquidity to newly conceived markets; and in a broad context, rules that eliminate unnecessary impediments to product and market innovations that do not materially impact the fiduciary duties of the exchange to its customers and members and the public. These rules snugly fit into a set of autonomous issues that are either operational or customer-service oriented in nature.
Congress should eliminate prior CFTC review for all such rules. In doing so, we believe that Congress would strike the appropriate balance in terms of maintaining the core mission for the CFTC, while also providing exchanges with badly needed flexibility. It is worth noting that for more than 50 years exchanges were not required to obtain prior approval from the CFTC for new rules or for rule changes. The reform proposed by NYMEX would return the CFTC to its historical role as a true oversight agency and at the same time would provide exchanges with flexibility to adjust their markets so as to remain attractive to a predominantly institutional customer base.
With regard to the proper role of the Commission, we also note that, in recent months, the CFTC has publicized its intent to seek statutory disqualification for certain floor members now at various exchanges, including floor members who entered into settlements with their respective exchanges 5 or more years ago. Clearly, floor members who are the subject of exchange investigations may enter into settlements based upon consideration of a number of factors, including litigation costs. Therefore, as a matter of due process and fundamental fairness, we would suggest that the act be amended to provide that settlements entered into between a Commission registrant and a self-regulatory organization could not be used as prima facie evidence of any lack of fitness in a statutory disqualification proceeding. Instead, the underlying facts should be established through an appropriate evidentiary proceeding.
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Foreign Exchange Activities in the United States-Delivery Points and Electronic Terminals. For the past several years, NYMEX has expressed concerns over the CFTC's lack of sufficient oversight authority over foreign boards of trade offering for sale or selling in the United States futures contracts that permit the delivery of a commodity in the United States, i.e., contracts specifically tailored to allow pricing and risk shifting of commodities in U.S. commerce. This regulatory gap was clearly evident in the Sumitomo debacle, where a former trader for the firm ultimately admitted to fraud and to attempting to manipulate the copper market. Though the scheme included trades conducted on the London Metal Exchange, the fact that the LME had copper warehouses in the United States serving as delivery points meant that trading activity on the LME by the Sumitomo trader affected the pricing of copper in the United States to the detriment of United States consumers. Therefore, Congress should amend the act to provide the CFTC with sufficient authority to review foreign warehouses and to protect the integrity of U.S. markets.
The Exchange believes that the placement of electronic terminals in the United Stated by foreign boards of trade could raise regulatory questions which parallel those experienced in the copper market. In assessing the level of regulation that should apply to a foreign board of trade's activity in the U.S., the Commission's review should distinguish between those products offered by a foreign board of trade which are delivered in the U.S., or are settled by reference to prices derived from U.S. markets, and those which are not.
An application by a foreign board of trade to provide electronic access to products which have little or no impact on U.S. markets, and which are offered to U.S. customers, should be reviewed by the Commission to determine whether U.S. customers are adequately protected. When the regulatory interest being invoked is primarily one of customer protection, the CFTC may choose to place greater reliance on the ''home'' regulator. On the other hand, with respect to products which are U.S.-delivered, or are otherwise U.S.-based, the CFTC generally should require that a foreign board of trade obtain contract market designation for such products so that the standards in effect are consistent with and at least as rigorous as the requirements imposed on domestic boards of trade.
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However, in any instance where a foreign board of trade is not required to obtain contract market designation, Congress and the CFTC should ensure that regulatory parity is maintained between U.S. and foreign exchanges. The principles of even-handedness and regulatory parity between domestic and foreign boards of trade must be implemented-whether for electronic or open outcry systems—or the very existence of a viable domestic risk management marketplace is threatened. It would not be sensible policy to potentially relegate the pricing of strategic commodities and U.S. financial instruments to markets and institutions beyond the reach of Congress and Federal regulators because domestic boards of trade are hindered by regulations to which their foreign competitors are not subject. In an environment where foreign and domestic boards of trade are on an equal regulatory footing, we are confident of our ability to compete where we do it best—in the marketplace.
SUMMARY
As a regulated, public futures market, we have serious concerns regarding our future ability to serve effectively and efficiently a demanding marketplace under the present regulatory regime. A pressing need exists for upgrading uniformity and adequacy of regulatory oversight, both in the domestic marketplace and in areas where actions in foreign boards of trade have the potential to affect United States commerce. We urge this Committee and the Congress to provide urgently needed flexibility to exchanges to develop and provide innovative risk management products and trading methods, and to support harmonization of the regulatory structure over foreign boards of trade offering instruments with pricing impact in United States commerce.
Mr. Chairman and members of the committee, NYMEX thanks you for your consideration and pledges its full support to work with you and your staff to address these issues and any others that may be of concern to you.
Testimony of Ronald Hersch
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Mr. Chairman, Mr. Condit, members of the subcommittee, my name is Ronald Hersch. I am a senior managing director and director of futures at Bear Stearns & Co., Inc. I am here today in my capacity as Chairman of the Board of Directors of the Futures Industry Association (FIA). FIA is the national trade association of the commodity futures and options industry. Our regular membership is comprised of approximately 60 of the largest futures brokerage firms—known as futures commission merchants or FCMs—in the United States. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of our membership, FIA estimates that our members effect more than 80 percent of all customer transactions executed on U.S. contract markets. We welcome the opportunity to appear before you today.
At the outset, Mr. Chairman, I want to congratulate you for undertaking these hearings at this time. Although Congress is not required to take action to reauthorize the Commodity Futures Trading Commission for another 18 months, we all have our work cut out. In our testimony today, we intend to focus the subcommittee's attention on the two most important issues facing our industry. Their successful resolution is essential to the continued success of the U.S. exchange and over the counter derivatives markets.
Legal Certainty. The Act must assure legal certainty with respect to transactions entered into in the over the counter derivatives markets.
Regulatory Flexibility. The Act must provide exchange markets and market intermediaries the regulatory flexibility necessary to keep pace with the changes in technology and to satisfy the needs of the institutional participants that account for the overwhelming majority of transactions executed on the exchange markets.
FIA has both a direct and indirect interest in the proper resolution of these issues. As noted above, FIA's members effect more than 80 percent of all customer transactions executed on U.S. futures exchanges. The economic success of our members, therefore, is tied directly to the success of the regulated futures markets in the United States. Because substantial liquidity is provided to the exchange markets by parties looking to hedge their exposure to over the counter derivatives transactions, the success of the regulated futures markets is inextricably intertwined with, and dependent upon, the continued viability of the OTC derivatives markets.
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One unalterable characteristic of both the exchange and OTC derivatives markets, in particular, drives this demand for regulatory reform. Institutional customers dominate the derivatives markets, and the existing regulatory structure fails to recognize the needs of these participants. In addition to producers, processors and merchants of agricultural and other commodities, now banks (including central banks), pension plans, endowment funds, energy producers and processors, large multinational corporations, investment banks, investment companies and other money managers use the derivatives markets to manage the risks associated with their business operations and cash market transactions. In this regard, a recent survey of its members conducted by the National Futures Association found that ''retail'' customers—defined as individuals with a net worth of less than one million dollars—accounted for approximately six percent of the trading volume on U.S. futures exchanges and approximately three percent of customer equity on deposit. In each instance, institutional customers comprised the balance. The OTC derivatives markets, of course, are exclusively institutional markets.
This market structure is a consequence of the fact that financial instruments, that is, interest rates, currencies and stock indices, are now the principal ''commodities'' underlying commodity futures and options contracts regulated under the act. Volume figures compiled by FIA indicate that in 1998 financial derivatives constituted approximately 70 percent of the more than 630 million transactions executed on U.S. futures exchanges. In contrast, agricultural commodities accounted for less than 15 percent of U.S. futures and options volume. Volume breakdowns for the international markets are similar.
LEGAL CERTAINTY FOR OVER THE COUNTER PRODUCTS
In 1992, Congress gave the Commission a simple and straightforward charge. Acknowledging that the legal status of swap agreements and other OTC derivative instruments under the act was uncertain, Congress directed the Commission to use the exemptive authority granted in new section 4(c) of the act to act ''swiftly'' to bring ''certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner.'' The legislative history of the 1992 amendments to the act makes clear that Congress had determined that private, bilateral agreements that are negotiated by the parties as to their material terms, based upon individualized credit determinations, are not properly subject to regulation under the act.
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Shortly after the 1992 amendments to the act became law, the Commission followed this Congressional directive by adopting regulations effectively exempting certain swap and hybrid transactions from regulation. In May 1998, however, the Commission seemingly reversed course. First, the Commission issued a Concept Release on Over the Counter Derivative Instruments, which raised the specter of additional regulation of these instruments. More troubling, the release implied that certain transactions, which OTC dealers and market participants believed were exempt from regulation under the Commission's rules, could be found to be unlawful. Later that month, in a letter to the Securities and Exchange Commission, the Commission explicitly stated that certain swap transactions are subject to its statutory jurisdiction. As a consequence of the Commission's actions, the legal certainty that the exemptions with respect to swap agreements and hybrid instruments were designed to provide may have been critically undermined.
You will recall that the Commission's concept release was the subject of hearings by this Subcommittee last June. At that time, FIA stated its belief that any decisions with respect to the appropriate regulation of the OTC derivatives markets, if any, cannot be made by the Commission alone. To the contrary, any review of, and decisions regarding, these markets should be coordinated through the President's Working Group on Financial Markets. Any recommendations arising from such review would then be presented to Congress for its consideration. The Commission's unilateral action confirms our belief that Congress must take additional legislative initiatives to enforce its determination to bring ''certainty and stability'' to the OTC derivatives markets.
Separately, FIA believes that Congress should amend the provisions of the act that raise questions regarding the legal certainty of types of equity derivatives products, specifically the restrictions set forth in sections 2(a)(1)(B) and 4(c) of the act. Section 2(a)(1)(B) sets forth the essential provisions of the Shad-Johnson Accord, which allocates authority over equity derivatives transactions between the Commission and the SEC. Section 4(c) authorizes the Commission, among other things, to exempt swap transactions from regulation under the act. However, section 4(c) also effectively prohibits the Commission from granting any such exemption with respect to swaps on equity securities, including stock indices. As a result, even if an equity swap transaction otherwise meets the exemptive criteria in the Part 35 rules, equity swaps lack the legal certainty conferred upon other swaps transactions.
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While market participants may rely on the Commission's Policy Statement Concerning Swap Transactions, the Policy Statement is an expression of views by the Commission and does not have the legal force of an exemption or an exclusion. The economic effect of this reduced level of legal certainty, which perpetuates the risk that a defaulting counterparty will assert a defense of illegality, is that certain equity swap transactions are either effected outside of the United States or not at all. This result has an adverse impact on the competitiveness of U.S. dealers and on the ability of swap end users such as pension plans, mutual funds, and endowments and foundations (which may be required to trade in the U.S. or subject to U.S. law) to satisfy their risk management needs. There is no reason, either legal, regulatory or public policy, that justifies less legal certainty for non-exempt security swap transactions under the act.
REGULATORY REFORM IS ESSENTIAL TO ENHANCE THE EFFICIENCY OF EXCHANGE MARKETS
FIA believes the time has come for Congress to direct the Commission to act more boldly in reforming the regulatory structure governing the conduct of business on exchange markets. As noted, these markets are an integral part of the U.S. financial market structure, on which transactions are effected primarily on behalf of institutional market participants. FIA has previously endorsed specific initiatives that recognize the needs of such market participants and enhance the efficiency of the exchange markets. These initiatives, which would effectively establish a two-tiered regulatory program—one for retail customers, including perhaps smaller commercial customers, and another for institutional customers, including certain qualified individuals—have included various measures intended to alleviate regulatory obstacles that FIA believes are not necessary for the protection of institutional market participants, including procedures to authorize certain off-floor transactions with respect to large orders and the allocation of bunched orders.
Focusing attention on discrete provisions of the Commission's rules, however, has not been successful. Although progress has been made on some of these issues, the Commission's cautious approach has placed the exchanges and the industry in general at a competitive disadvantage. Moreover, the effect of a change in one rule on other rules is not always appreciated. For example, as a result in substantial part of this piecemeal approach to regulatory reform, the Commission's rules do not even contain a uniform definition of the term ''institutional customer.''
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FIA strongly believes that the Commission's regulatory program with respect to the exchange markets should be designed in the first instance to reflect the needs of the institutional customers that account for 94 percent of the volume on those markets. The existing regulations, which were promulgated primarily to protect retail customers and smaller commercial hedgers, are no longer appropriate. Congress should direct the Commission to develop a comprehensive regulatory program that more reflects accurately both the nature of the institutional customers that trade in those markets and the manner in which these trades are executed.
In this regard, we want to emphasize that implementation of such a directive may not be accomplished solely through appropriate report language. As noted earlier, the provisions of the act itself are frequently the source of unnecessary regulatory burdens and substantive amendments to the act may be necessary.
FIA also believes that section 2(a)(1)(B) of the act should be amended to permit U.S. futures exchanges to offer a more complete range of stock index products. Section 2(a)(1)(B) establishes certain criteria that stock index futures contracts must satisfy before the Commission, following consultation with the SEC, may authorize an exchange to trade that product. Under current law, the Commission may approve a stock index futures contract for trading only if it has found that the proposed index is ''predominantly composed of securities of unaffiliated issuers'' and is ''a widely published measure of, and shall reflect, the market for all publicly traded equity or debt securities or a substantial segment'' of the market.
The Commission and the SEC have issued guidelines regarding so-called non-diversified indices, the intended purpose of which is to assure that the index may not be used to manipulate the price of any underlying security in the index. Over the years, however, these guidelines have prevented futures exchanges from offering contracts on a number of indices. Most recently, for example, the SEC denied the Chicago Board of Trade the right to list contracts in the Dow Jones transportation and utility indices. At the same time, however, the SEC, which is not subject to the same statutory restrictions, has authorized the Chicago Board Options Exchange to list options on these same stock indices. The SEC has also authorized the American Stock Exchange and the Pacific Stock Exchange, in addition to the CBOE, to list options on a number of stock indices that, under the Commission and SEC guidelines, could not be listed on U.S. futures exchanges.
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To the extent these guidelines were designed to prevent manipulation of the underlying stocks in any index, FIA submits that the Commission and the SEC should be able to develop procedures to share the necessary information, both between each other and among the relevant exchanges, to address this concern. U.S. futures exchanges should no longer be placed at a competitive disadvantage with respect to the trading of futures and options on futures contracts on stock indices.
Section 2(a)(1)(B) of the act should also be amended to facilitate transactions in futures on foreign stock indices that are executed on a foreign exchange on behalf of U.S. customers. Although section 4(b) of the act specifically provides that the Commission may not require that the terms and conditions of any foreign exchange-traded contract be submitted to the Commission for approval, the Commission, citing congressional report language, has nevertheless determined that section 2(a)(1)(B) of the act prohibits the offer and sale of foreign exchange-traded products that do not conform to the requirements set forth in that section.
Separately, this section precludes the Commission from authorizing transactions in futures contracts on individual securities that are not ''exempt securities'' under the securities acts. Foreign Government debt securities are not exempt securities, and therefore, contracts on foreign debt securities may not be offered for execution either on U.S. or on foreign futures exchanges unless and until the SEC, by rule, determines that they are exempt for these purposes.
In 1992, the Commission, after consultation with the SEC, authorized U.S. FCMs to solicit and accept orders from non-US customers for foreign exchange-traded stock indices and foreign government debt securities. In doing so, the Commission stated that there appeared to be no U.S. customer protection interest advanced by continuing to prohibit U.S. FCMs from offering these products to non-US persons.
This relief was welcome. However, it placed U.S. FCMs in the difficult position of explaining to their U.S. institutional customers why they were prohibited from entering into transactions in certain foreign exchange-traded products, while FCMs could solicit orders for these same transactions from non-US institutions, including the foreign subsidiaries of such institutions. No public policy is served by excluding certain foreign contracts from trading by U.S. customers, especially institutions.
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This is particularly true since these same customers, including U.S. pension funds, can freely trade in the underlying foreign securities. This restriction, therefore, often prevents U.S. customers from hedging foreign stock and Government bond portfolios in the manner they would prefer and impairs their ability to use the most efficient and effective hedging vehicles.
THE REGULATORY FRAMEWORK MUST ACCOMMODATE NEW TECHNOLOGY
Congress must also direct the Commission to move quickly to implement a flexible, forward-looking regulatory framework that will better accommodate new technology and increase market access for FCMs and customers alike. Regulation of electronic access to trading in the futures markets, which for the purpose of these comments includes both order routing and trade matching systems, requires enormous flexibility so as not to limit innovation. Technological change will not be discouraged or slowed by inflexible regulation, it will merely find, and flow to, the jurisdiction in which the change can be implemented most efficiently and expeditiously.
FIA has cautioned the Commission, in developing its regulatory program, to be careful not to permit technological developments to obscure the distinction between exchanges and brokers, that is, between exchange systems pursuant to which transactions are executed and order entry or routing systems that provide enhanced interfaces with exchange trade execution systems. Technology may change the manner in which brokers and customers relate to, and communicate with, each other, but it does not alter the fundamental nature of the relationship, or the respective rights and obligations of the parties.
Similarly, FIA has expressed its belief that the Commission should confine the scope of its rules to exchange execution systems. The development of electronic systems to facilitate OTC derivatives transactions will not change the underlying nature of the private commercial transactions. As such, it must be clear that transactions that otherwise are not subject to regulation under the act should not fall within the Commission's rules simply because aspects of such transactions are effected through electronic means.
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Moreover, any rules governing exchange execution systems should be based only on risks that the Commission reasonably identifies rather than anticipates will result from activity employing new technology. The Commission should be able to articulate the specific risk arising from the use of technology that any proposed rule is intended to address. A general discomfort with or suspicion of the unknown, in the absence of any demonstrable increase in risk to customers, FCMs or the markets in general, is an insufficient predicate for Commission action. Nor is it appropriate to require the industry to demonstrate to the Commission on an on-going basis that any new technology proposed to be introduced is not susceptible to any risk.
REGULATION OF FOREIGN EXCHANGE MARKET TRANSACTIONS MUST DEFER TO HOME COUNTRY REGULATION
As with U.S. exchange markets, the Commission's regulatory program with respect to foreign futures and foreign options transactions must be flexible enough to accommodate new technology. This is especially true since, in contrast to U.S. futures exchanges, the trade execution systems of essentially all major foreign exchanges are exclusively electronic, rather than floor-based. In this regard, again, it is essential that the Commission's rules distinguish between order entry or routing systems controlled by U.S. FCMs and order execution systems controlled by the foreign exchange. Further, because section 4(b) of the act specifically prohibits the Commission from adopting rules that require Commission approval of, or govern in any way, any contract, rule or action of a foreign exchange, particular care must be exercised in adopting any rules relating to the placement of foreign exchange terminals in the US.
FIA notes that, in 1992, Congress adopted section 12(g) of the act, which specifically directs the Commission to cooperate with other U.S. Government agencies to remove trade barriers that may be imposed on the international use of electronic trading systems. This provision of the act reminds us all of the importance of open markets to the success of our financial and economic system. In this regard, we want to emphasize that, while our members strongly support efforts to enhance the ability of U.S. exchanges to compete with their international counterparts, a more level playing field cannot be achieved at the cost of inhibiting the ability of U.S. market participants to conduct business on international markets. The only means of assuring the ability of U.S. exchanges to compete is by eliminating the unnecessary regulatory burdens to which the exchanges are currently subject.
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THE TREASURY AMENDMENT
The scope of the Commission's authority over OTC transactions in foreign currencies and other products specified in the Treasury Amendment has been a topic of considerable debate almost since it was enacted in 1974. This provision of the act excludes from the Commission's jurisdiction derivative transactions in certain enumerated products, including U.S. Treasury instruments and foreign currencies, unless effected ''on a board of trade.'' The 1997 decision of the U.S. Supreme Court in Dunn v. Commodity Futures Trading Commission confirmed that OTC options on foreign currencies are covered under the Treasury Amendment and, therefore, are excluded from the act. However, it did not resolve other, more critical issues that arise under that provision of the act, such as the role of electronic trading, and clearing, on the scope of the ''board of trade'' clause of that provision. Therefore, FIA continues to support a legislative solution that will address these issues.
In this regard, FIA believes that the exclusion from regulation for foreign currencies and other products specified in the Treasury Amendment is a transactional exclusion. Unless the transaction takes place on a designated contract market, the transaction should not be subject to the jurisdiction of the Commission.
MORE SPECIFIC ISSUES
As I indicated when I began my remarks, Mr. Chairman, our testimony today has focused on the two most important issues facing our industry. As this reauthorization process continues, we expect to present more specific recommendations for your consideration. In this regard, in testimony before this Subcommittee in 1997, FIA identified certain aspects of the existing regulatory structure that we believed demanded immediate relief. Since that time, FIA has worked closely with the Commission and has made progress on certain of these items. Others have not been addressed and we intend to continue working with the Commission in developing an acceptable resolution of each of these issues. We summarize them and others here to suggest a few of the more specific issues that we may address with you at the appropriate time.
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Foreign Futures and Options Secured Amount. If an institutional market participant wishes to trade on a particular foreign exchange that does not offer a level of protection to U.S. customer funds comparable to the U.S. system, the Commission has stated that the FCM would be required to use its own funds to margin or secure the transactions of these customers. FIA believes that, as long as an institutional market participant is advised of the risks that can be incurred on particular non-US markets, the customer should be permitted to make the business decision to trade on the market and assume the associated risks.
Foreign Order Transmittal. Institutional clients that trade worldwide prefer to have all of their transactions cleared through one clearing firm. To facilitate this process, U.S. FCMs open and maintain accounts with clearing firms at the various non-US exchanges. Although the account at the foreign clearing firm is maintained in the name of the U.S. FCM, institutional market participants, nonetheless, demand direct access to the foreign clearing firm in order to have a better sense of the futures and underlying cash market.
The Commission's foreign futures and options rules generally provide that a foreign clearing firm that has direct contact with a U.S. customer must be registered in the U.S. as an FCM. The Commission has provided relief from this requirement in circumstances in which the foreign clearing firm is an affiliate of the U.S. firm. However, the terms of this relief may be difficult to meet, and not all U.S. FCMs have foreign affiliates or want to bear the costs establishing affiliates. FIA does not believe that requiring registration of a foreign clearing firm in these circumstances provides any additional level of customer protection. It serves no purpose other than to inhibit the use of these markets by institutional market participants.
Investment of Client Assets. Section 4d(2) of the act provides that customer funds held for futures trading by an FCM or a U.S. clearing organization may be invested only in obligations of the United States, general obligations of any state, and in obligations fully guaranteed as to principal and interest by the United States. Since this provision of the act was first enacted in 1936, the risks associated with other, high quality investment products, such as high grade commercial paper, are far less than they may once have been. This is particularly true when these instruments are held for a limited period of time, such as in connection with an overnight repurchase agreement.
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If limited to institutional market participants, this change could be implemented by regulation in accordance with the exemptive authority granted the Commission under section 4(c) of the act. However, we see little reason not to make this change applicable with respect to all customer segregated funds through an amendment to section 4d(2).
FCM Liability for Guaranteed Introducing Brokers. In 1982, Congress amended the act to provide for the separate registration of introducing brokers. Commission regulations adopted to implement these provisions of the act imposed capital requirements on introducing brokers and, as an alternative, permitted FCMs to guarantee the financial obligations of introducing brokers. Over the years, the Commission, by case law, has extended the interpretation of this guarantee. Today, an FCM that provides a guarantee for an introducing broker may be held vicariously liable for any violation of the act or the Commission's regulations. FIA believes the Commission's interpretation in this regard goes far beyond Congressional intent.
CONCLUSION
Mr. Chairman, 60 years have passed since the Commodity Exchange Act was first enacted into law, and 25 years have passed since the Commission was created in 1974. The use of derivatives for financial risk management, the myriad structures of derivative products, the manner in which they are traded and the identity of derivatives market participants all differ substantially from 1974 and certainly from 1936. We live in a far more complex business environment and, like any business in our technological age, futures and derivatives market participants must have the ability to respond quickly and decisively to changing circumstances. If the Federal Government is to continue to support the growth of the U.S. derivatives markets, Congress and the Commission must be prepared to demonstrate greater regulatory flexibility by making appropriate amendments to the act and regulations.
Thank you. I would be pleased to answer any questions you and other members of the subcommittee may have.
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CHICAGO BOARD OF TRADE-ANSWERS TO SUBMITTED QUESTIONS
What information are you aware of regarding the relative degree to which U.S. exchanges are regulated in comparison to foreign exchanges?
The Chicago Board of Trade tries to monitor disparities in how futures exchanges are regulated in the U.S. compared to the regulation of other major derivatives exchanges based in foreign countries. In addition, we try to identify differences in the regulation of our market intermediaries and end-users that can make it more costly for them to trade in our markets or that otherwise act as disincentives to use of our markets relative to competing foreign exchange markets. Of course, regulatory disparities also exist within the U.S. between the regulation of futures exchanges and competitive OTC derivatives markets and also between the regulation of futures exchanges and securities exchanges offering derivatives products, most notably in the area of product approval under the Shad-Johnson Accord.
For practical reasons, we focus on countries with established, internationally recognized financial markets (e.g., the UK, Germany and Australia). It is difficult to stay current on all the differences in futures market regulation that may exist across all countries. The global nature of today's markets, with over 65 futures exchanges located in over 40 countries, drawing market users from an even broader geographic range, makes that a daunting challenge. Language barriers and changing regulatory requirements add to the challenge. Accordingly, it is more productive to focus our efforts on trying to understand the regulatory structures in place in the countries in which our strongest foreign competitors operate. We also rely on our market-users to apprise us of discrete regulatory disparities and obstacles they encounter in their global business activities that may favor foreign markets and market participants over those in the U.S.
The issue of regulatory disparities is now very timely as the question of what standards should be used to allow foreign boards of trade to operate electronically in the U.S. is being decided by the CFTC. The CBOT identified several areas where U.S. contract markets would operate at a regulatory disadvantage to foreign exchanges in our comment letter on the CFTC's rulemaking proposal (since rescinded) on that topic, which we have enclosed for your information.
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The impact and extent of regulatory disparities are documented in several publications:
London Business School, ''The Competitive Position of London's Financial Services'' (1995) (finding that the cost of regulation for financial trading and brokerage is 57 percent higher in the UNited States than in the UK).
London Business School, ''The Direct and Compliance Costs of Financial Regulation'' (Feb. 1996) (extending the 1995 study by providing a limited update of compliance costs for a small sample of UK firms, but not an update of the earlier cross-country comparisons).
Interim Report from the Co-Chairs of the November 1996 London Commodity Futures Markets Conference, ''Results of Surveys on Contract Design, Market Surveillance and Information Sharing'' (June 1997) (individual survey responses from participating jurisdictions should be available from the CFTC).
IOSCO, ''International Regulation of Derivative Markets, Products and Financial Intermediaries'' (Revised and Updated, December 1996).
CFTC, ''A Study of Global Competitiveness of U.S. Futures Markets'' (April 1994).
While no up-to-date comprehensive report of the differences in regulatory requirements now exists, we do know from our business activities that many of the requirements are substantially less in overseas jurisdictions. If such a report were to be done, the International Organization of Securities Commissions could serve as a useful forum for conducting such a survey. Indeed, an IOSCO working party plans to survey how different countries regulate exchanges' electronic trading systems.
To what extent has the International Organization of Securities Commissions served as a forum for the international community to harmonize regulation?
IOSCO has an important, invaluable role in the process of harmonizing regulation of financial markets. But it is important to understand the nature and limitations of IOSCO's role. We at the CBOT are familiar with those limitations because we are an ''affiliate member'' of IOSCO and participate in activities to the extent available.
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With the cross-national nature of today's markets, IOSCO has emerged as a valuable, collective forum for the international regulatory community to develop and promote common regulatory principles for financial markets. In recent years, in fact, IOSCO has pursued several, high profile standard-setting initiatives, such as the project leading to publication of the IOSCO ''Objectives and Principles of Securities Regulation'' in September 1998. These projects represent an expansion of IOSCO's historic role as an educational forum for the international regulatory community to exchange information on, and promote broader understanding of, the regulatory structures, principles and requirements in place in the countries represented in IOSCO.
But international consensus among government regulators is not enough for harmonization to occur. For that to occur, common standards must be implemented and enforced in a comparable manner within each jurisdiction. (We use the term ''harmonization'' to mean the adoption of common regulatory principles, implemented and enforced in a comparable manner, as opposed to an identical manner, within countries.) This may require statutory changes or changes to agency or SRO rules, orders or interpretations. IOSCO's role in this context is to promote adoption of its recommended standards.
A brief background on IOSCO's structure is useful to understanding IOSCO's role and limitations. IOSCO is comprised of securities and futures regulators and self-regulators from around the world. Under IOSCO's membership structure, government securities regulators may become ''ordinary members'' and government futures regulators may become ''associate members.'' Self-regulatory organizations may also join as ''affiliate members.'' Today, IOSCO has over 160 members in all categories.
IOSCO's primary working committees are the Technical and Emerging Markets Committees, which are made up of the securities and futures regulators, including the SEC and the CFTC. Both committees are organized into several working parties that address specific areas of regulatory coordination.
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SROs have a more limited role within IOSCO. As affiliate members, SROs like the CBOT are allowed to serve only on the IOSCO Consultative Committee. In theory, this Committee serves in a consultative or advisory capacity to the Technical and Emerging Markets Committees and their various working parties. In practice, the working parties have seldom sought input from the Consultative Committee, but the situation is improving as a result of proactive efforts by the Committee to enhance its profile within the organization. Today, over 60 SROs from over 25 countries are affiliate members of IOSCO and serve on the Consultative Committee. The CBOT joined IOSCO as an affiliate member in 1995.
IOSCO holds obvious attractions as a forum for promoting regulatory harmonization for financial markets given its established infrastructure and broad membership base. At the same time, it is important to understand the limitations of the IOSCO structure.
First, IOSCO is primarily an organization of securities regulators. This has several implications for IOSCO's value as a forum for harmonizing regulation of derivatives markets.
Regulatory issues facing the securities markets predominate IOSCO's agenda and work programs.
When dealing with derivatives market issues, IOSCO generally confines its focus to financial derivatives based on securities, currencies or interest rates. IOSCO is reluctant to undertake projects involving derivatives based on physical commodities, such as metals or agricultural products, because of the perception that such instruments are further removed from IOSCO's securities emphasis. As an example of this bias, in November 1996 futures regulators had to come together outside the IOSCO framework to address issues of market surveillance and contract design for physical delivery futures contracts following the Sumitomo copper crisis, even though many of the participating regulators were also members of IOSCO. The CFTC, the UK's Securities and Investment Board, now the Financial Services Authority, and Japan's Ministry of International Trade and Industry organized and co-chaired this international project. It was only after the futures regulators reported on their recommendations at the November 1997 annual IOSCO meetings that the IOSCO Technical Committee became involved, when it agreed to consider the extent to which the proposed regulatory principles could be extended to financial contracts. The Windsor Conference and resultant Windsor Declaration is another example of an international regulatory project that occurred outside of IOSCO. In that case, the CFTC and UK's SIB convened a conference of international regulators in May 1995 to address systemic risk issues in the futures industry raised by the failure of Barings Bank earlier that year.
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IOSCO is likely to retain its securities bias. Reflecting its historical roots as an organization of securities regulators, IOSCO's membership structure favors securities regulators over futures regulators. Futures regulators, like the CFTC, are allowed to join IOSCO only as associate members. In that capacity, they have no formal vote within IOSCO and are ineligible to serve on the IOSCO Executive Committee. In contrast, securities regulators, like the SEC, are allowed to join IOSCO as ordinary members, and in that capacity, are entitled to vote on IOSCO matters and to serve on the IOSCO Executive Committee. Consequently, futures regulators have less formal say within IOSCO than securities regulators in defining IOSCO's mission and goals. In practice, however, the CFTC has been successful in exerting informal influence on IOSCO projects through its proactive involvement on the working parties.
Second, for certain issues, the process of harmonizing regulation of financial markets and financial institutions also requires the involvement of financial regulators beyond the securities and futures regulators that form IOSCO's core membership base. As in the U.S., many countries have a patchwork of regulatory regimes, sometimes overlapping, that apply to discrete markets or to discrete classes of financial institutions. As a consequence, there is often a need for consistency and coordination of regulatory principles across regulatory boundaries as well as across national boundaries. Reflecting this reality, IOSCO, the Basle Committee on Banking Supervision (Basle) and the International Association of Insurance Supervisors (IAIS) have formed a Joint Forum to address issues that cut across their respective areas of regulatory interest. The differing, and sometimes incompatible, regulatory philosophies underlying the different regulatory regimes represented by the Joint Forum's three parent organizations may complicate international efforts to coordinate regulation across financial regulators, just as such differences occasionally complicate inter-agency cooperation within the U.S. through the President's Working Group.
Third, IOSCO also lacks formal, consistent mechanisms for industry participation in its standard setting projects. From the CBOT's perspective, this is IOSCO's major shortcoming. If financial markets are to be regulated, regulation should follow business-driven market changes; without industry input, the regulatory guidelines that IOSCO develops and seeks to promote as international standards may not adequately reflect legitimate business considerations.
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Exchanges and other SROs are at least in a somewhat better position than market participants because we have the opportunity to participate in IOSCO deliberations in an advisory capacity through the Consultative Committee. However, the Technical Committee's working parties have not adopted formalized, effective mechanisms for Consultative Committee participation. Consequently, their work typically proceeds with no meaningful opportunity for the Consultative Committee to offer its views. Although the Consultative Committee (with a broad-based constituency drawn from over 25 countries) is enhancing its advisory role within IOSCO, there is still room for improvement.
One solution might be for IOSCO to formalize a procedure for publishing and soliciting public comment on its proposed guidances. IOSCO has some experience with a public comment process. Last year, for example, the Joint Forum comprised of IOSCO, Basle and the IAIS solicited public comment on a set of proposed consultation documents relating to the supervision of financial conglomerates. More recently, IOSCO and Basle issued a joint consultation paper for comment on ''Recommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Firms.'' (The report was circulated last February for comment by May 31.)
Based on our observations, we have also identified the following concerns, which we believe may apply more generally to international standard setting projects among regulators:
Projects to develop international regulatory standards often, of necessity, reflect a process of compromise and negotiation among government regulators rather than clear unambiguous standards of best practice. An aggressive regulator may be able to exert a disproportionate influence in such negotiations.
As a result of the consensus-building process, standards often tend to be generally worded. General standards may lend themselves to inconsistent interpretations within different countries, as standards are interpreted and implemented by lawmakers and regulators in the manner most consistent with their existing regulatory philosophies and practices.
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International regulatory reports are usually written in English. However, foreign regulators may not always fully understand the nuances and plausible interpretations of the English language used in the report language. In addition, commonly used regulatory terms may have different meanings within different jurisdictions. Consequently, while there may be consensus on how regulatory standards are worded, there may not be consensus on what those standards actually mean. These differences can manifest themselves in how the standards are interpreted and implemented within countries.
Collaborative efforts among regulators tend to perpetuate and reinforce regulatory zeal, often couched as ''strengthening'' regulation, without appropriate recognition of the ability of markets to self-police and self-correct.
In the absence of a formal comment process, international standards may not reflect the views of the industry and market participants directly affected by them.
International regulatory projects also often proceed on short, self-imposed deadlines that further limit the opportunity for industry participation.
As a general matter, the CBOT supports collaborative efforts among government regulators to develop common regulatory principles for financial markets, provided that affected markets and market participants have a meaningful voice in that process. It is important to involve the markets and market participants to ensure that international standards reflect business and market realities and to foster industry support for such initiatives. Industry participation could also provide a counterbalance to the self-perpetuating pressure to increase regulation and the pressure inherent in consensus building among regulators to accommodate differing regulatory approaches, to the detriment of conducting any true critical assessment of the merits of alternative regulatory approaches.
To what extent do you believe that any degree of international harmonization might be achieved?
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Harmonization in terms of common regulatory principles for financial markets, implemented and enforced in a comparable manner within countries, is both achievable and desirable. Such harmonization will only occur, however, if national lawmakers are committed to the goal of regulatory parity. At the same time, harmonization in the sense of common regulatory principles for financial markets, implemented and enforced in an identical manner within countries, is extremely difficult, if not impossible, to achieve. Even when there is apparent agreement on general regulatory principles, the specific regulatory requirements derived from such principles can vary among countries. This problem has been discussed at GMAC meetings, in the context of disparate implementation of the Investment Services Directive in European Union countries.
We believe Congress should reassess the current CEA framework with the goal of achieving regulatory parity between the U.S. and other countries, especially focusing on those with strong futures markets. As mentioned earlier, futures exchanges are located today in over 40 different countries. It is more practical, we believe, to focus on eliminating regulatory disparities between the U.S. and countries with established financial centers, where foreign exchanges represent the greatest competitive threat to U.S. futures exchanges. Although this group may change with time, today we would identify the U.K., Germany, France, Australia, Japan, Singapore, Hong Kong and Brazil. Exchanges representing several of these financial centers are currently seeking to establish or extend an electronic presence in the U.S. without addressing regulatory parity issues and could do so via the ''no-action'' process currently underway at the CFTC.
Regulatory disparities today place U.S. futures exchanges at a competitive disadvantage to other dominant futures exchanges located abroad. Inconsistent regulatory treatment can also impede the business activities of financial services firms that provide intermediation services as brokers, dealers and/or lenders between market users and financial markets around the world.
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The most direct way to achieve regulatory parity is for Congress to continue working with the futures industry to identify and eliminate unnecessary regulation in the U.S. of futures markets and market participants. A degree of harmonization may occur among world financial centers through similar cooperative efforts between lawmakers and business to modernize domestic regulatory structures for financial markets. But this will only occur if the domestic lawmakers are willing to listen to the industry's business concerns, are willing to learn from the experiences in other countries with different regulatory approaches, and are committed to promoting the international competitiveness of their home-based markets through greater international harmonization and elimination of regulatory disparities.
Organizations such as IOSCO can play a valuable role in bringing about harmonization, through promoting understanding of the regulatory differences that exist across countries and developing general principles of regulation for financial markets for consideration by domestic lawmakers. But such efforts should not be viewed as a substitute for sorely needed Congressional action now to modernize the CEA. Further, Congress should carefully evaluate the weight it should give to international standards developed through collaborative regulatory efforts in light of the considerations we identify in the preceding section. In particular, international standards developed without adequate industry participation deserve less deference (and are more likely to generate opposition from markets and market participants) when lawmakers consider adopting them within their jurisdiction.
CHICAGO BOARD OF TRADE
April 30, 1999
JEAN A. WEBB
Office of the Secretariat
Commodity Futures Trading Commission
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Three Lafayette Centre
1155 21st Street
Washington, D.C. 20581
Re: Automated Boards of Trade
DEAR MS. WEBB:
The Board of Trade of the City of Chicago (CBOT) welcomes the opportunity to comment on the above-referenced proposal.
The CBOT does not oppose access from the United States for automated foreign boards of trade. However, the terms on which such access has been proposed would subject U.S. contract markets to an unacceptable competitive disadvantage.
I. Futures and futures options contracts traded on a foreign board of trade should not be traded electronically from the United States unless and until U.S. contract markets have regulatory parity.
As we understand the proposal, futures contracts could be traded electronically on a foreign board of trade which has not been designated as a contract market and which is not subject to the rules applicable to U.S. contract markets. Accordingly, these boards of trade would have lower regulatory costs than U.S. contract markets. Market participants are likely to find trading on these boards of trade to be cheaper and easier than trading on U.S. contract markets, and will encourage those boards of trades to list products already traded at overregulated U.S. contract markets. U.S. contract markets will be unable to respond.
We do not oppose the goal of enabling market participants located in the United States to access foreign boards of trade electronically. But regulatory parity for U.S. contract markets must be a necessary condition of that access. The Commission's exemptive authority under CEA 4(c) should be used to provide contract markets with regulatory parity.
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The Commission's proposal would exempt electronic foreign boards of trade from many of the requirements which govern U.S. contract markets; it would also permit practices which are prohibited on U.S. markets. This imbalance will effectively prohibit U.S. exchanges from offering products which compete with a product already listed by a foreign exchange. It will also encourage foreign exchanges to list the products of overregulated U.S. exchanges.
Before granting an electronic board of trade's petition under proposed Regulation 30.11, U.S. contract markets should have an opportunity to identify areas of regulatory disparity and to petition the Commission under section 4(c) for an exemption from the statutory or regulatory provision which is responsible for the disparity. Once the contract market's petition had been addressed, the foreign board of trade's petition could be granted. Moreover, the contract market would be able to file subsequent petitions if regulatory disadvantages emerged later.
The following summarizes areas in which U.S. contract markets would operate at a regulatory disadvantage with respect to exempted electronic boards of trade accessible from the United States.
1. Preapproval of Contracts, Contract Amendments and Rules. Contract market contract specifications have to be submitted to the CFTC for approval under Regulation 1.41(b). Even the so-called fast track procedure (CFTC Regulation 5.1) puts U.S. contract markets at an insurmountable disadvantage in bringing new products to market. Moreover, CEA 2(a)(8)(ii) provides that when a board of trade applies for contract market designation for futures on a security issued or guaranteed by the United States, the Department of the Treasury and the Board of Governors of the Federal Reserve Board have forty five days to review the application. In addition, the provisions of the Shad-Johnson Accord require contract market applications for stock index futures to be reviewed and approved by the Securities and Exchange Commisson. In sharp contrast, an electronic board of trade operating in the United States under the proposed section 4(c) exemption would be able to list an identical product immediately. It has been shown repeatedly that the first product to market in an environment with regulatory parity has a virtually insurmountable competitive advantage. Where the first exchange to market enjoys a variety of regulatory advantages, competition would be even more difficult.
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2. Account Identification. We understand that, unlike the requirement under which electronic U.S. contract markets operate, trades for customers can be entered on certain electronic boards of trade without account identification. If our hypothetical trader can make a trade ten seconds faster on the exchange which does not require these additional keystrokes, it is clear which exchange will receive his business.
3. Dual Trading. (Regulation 155.5(d)) Restrictions on dual trading are not applied to those who would trade electronically from the United States on an exempted board of trade. Those boards of trade would have no obligation to invest millions of dollars in audit trail technology and could use that money instead to improve system performance. Market participants will determine the relative value of a dollar spent on audit trail and a dollar spent on system performance quickly and clearly.
4. Payment for Order Flow. Payment for order flow is part of the business strategy of some foreign boards of trade. If U.S. exchanges cannot counter competitive attacks based on such payments, the focus of liquidity is likely to move. Once moved, it cannot easily be recaptured. Payment for order flow is permitted in the securities industry if adequately disclosed (SEC Rule 11A(c)3-1) and can be received by commodity pool operators who disclose it under CFTC Regulation 4.23(j)(3). U.S. contract markets are not prohibited from paying for order flow in the United States. Nevertheless, Commission staff has balked at payments for marketmakers, suggesting that such payments might encourage wash trading. If this view is extended to payment for order flow, we will be at a significant disadvantage to our foreign competition.
5. Trade Practices. The CBOT is particularly concerned that an electronic board of trade would be able to allow its users to engage in trade practices which are not permitted under U.S. law. In some cases, users would be attracted by this opportunity, and would encourage the foreign board of trade to list contracts for which the Commission has already designated U.S. contract markets. In addition, if trading can be conducted on a contract market and an exempt electronic board of trade from the same terminal or the same window, it is likely that traders could become confused about trade practice rules at the different exchanges.
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It is our understanding that foreign boards of trade may be subject to more relaxed rules regarding non-competitive trading, block trading and guaranteed order executions.
6. Costs of Maintaining Surveillance and Enforcement Mechanisms. Regulators in other countries do not enforce the self-regulatory obligations of exchanges as vigorously as the CFTC does in its periodic rule enforcement reviews. Obviously, the proposal doesn't provide for rule enforcement reviews of electronic boards of trade by the Commission. In fact, there is not even a process for reviewing the board of trade's compliance with its exemption order.
7. Large Trader Reporting. Traders on U.S. exchanges are required to provide daily reports of positions. Many such traders would transfer their business to foreign exchanges to avoid that disclosure.
The CBOT proposes that contracts traded on or subject to the rules of a contract market should be exempted under section 4(c) from the kinds of regulations described above.
II. An automated order routing system (AORS) should not be subject to additional regulation if it can be used by customers in the United States to access any board of trade to trade non-U.S. based products.
A U.S.-based product is one (a) which is based on U.S. securities or interest rates; (b) which has one or more delivery points in the United States; (c) whose underlying cash market is located in the United States; or (d) which is denominated or settled in United States dollars.
Second, if and when regulatory parity exists, customer orders for U.S.-based products offered by an exempted foreign board of trade could be entered on an AORS located in the United States.
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The proposed regulation of AORS is vague and duplicative of existing Commission regulations. As long as the AORS is not used to enter orders for U.S.-based products, we see no reason to delay their use to access exempt foreign boards of trade.
III. The Commission should not expose U.S. exchanges to retaliatory regulation abroad. The Commission should not address the issue of regulatory disparity by imposing the requirements for U.S. contract markets on foreign boards of trade. This would invite retaliatory regulation abroad.
Although our initial efforts to expand abroad have been received with comparative hospitality by foreign regulators, the threat of retaliatory regulation is not idle. In the U.K., Project A's most successful foreign location, the Financial Services and Markets Bill is pending in Parliament to restructure the financial regulatory system. We have been advised that, if the bill is enacted, we will need to re-apply to the new regulator for recognition as an overseas investment exchange. It is our understanding that a new application will be subject to the same standards that applied to our original application. However, following the publication of the proposal, U.K. regulators have expressed an interest in the application of IOSCO technical standards to U.S. contract markets.
IV. Conclusion
The CBOT welcomes competition when the same rules apply to the competitors. We urge the Commission to ensure that U.S. contract markets can compete on a fair and equal basis against foreign boards of trade in the United States.
Sincerely,
THOMAS R. DONOVAN
"The Official Committee record contains additional material here."
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Next Hearing Segment(3)