TESTIMONY OF

DAVID P. BRENNAN,

CHAIRMAN,

BOARD OF TRADE OF THE CITY OF CHICAGO

September 23, 1999

Mr. Chairman, members of the Committee, I am David Brennan, Chairman of the Board of Trade of the City of Chicago. The Board of Trade is pleased to appear before you today at this critical time in the history of the U.S. futures industry. The range of challenges and issues facing our industry has never been greater or more important. We commend you for your consistent, dedicated and patient leadership on these issues of national and international economic significance.

Since this is the first time I have testified before this Committee, let me give you some personal background. I have worked in the futures industry my whole life as has my father and before him my grandfather. In the early part of this century my grandfather traded grains on the floor of the Chicago Board of Trade, the center of agricultural price discovery for the world. My father's generation took the CBOT into the world of financial products and I am proud to say I was responsible for overseeing the construction of the CBOT's new trading floor designed to include every technological enhancement then available. I was also one of the CBOT members who developed the concept for our electronic trading system, Project A, the most actively-traded electronic futures system in the U.S. since its debut in 1992.

Today, however, change does not take generations. The level and amount of change in our industry is unprecedented and often instantaneous. Traditional methods of doing business are being challenged by new methods. Many of those new methods are enjoying considerable success. Real competition exists among an ever-increasing array of players to serve the ever-increasing risk management needs of businesses around the world. New markets are springing up and new instruments are being created every week, if not every day.

In the past decade, four inter-related phenomena have changed U.S. exchange markets dramatically:

1) Professional customers predominate - Over 95% of all exchange trades are for well-capitalized, sophisticated market participants or professional traders. The vast majority of small retail customers participates in futures trading through professionally-managed funds, not direct trading on exchanges.

2) Globalization - As our economy has become more globalized, the need for risk management services has also become global. U.S.-based market participants trade markets around the world and foreign businesses trade our markets. National borders do not limit any market's customer base.

3) Competition - Exchanges are not the only risk management game in town. Foreign exchanges and over-the-counter derivatives offer viable alternatives to U.S. exchanges for most market participants. New competitors have sprung up to form, or new parties are talking about forming, new exchanges to compete directly with U.S. exchanges.

4) Technology and Electronic Trading - Markets today may use technology to provide execution facilities, order entry systems or access to market data, or all three. Overseas, electronic trading has won the day over open outcry markets. In the U.S., exchanges offer side-by-side electronic and open outcry trading in the same contracts. New electronic trading markets spring up almost weekly to announce plans to compete with traditional exchanges.

When combined, these factors illustrate the revolution that has occurred and is occurring in derivative markets. Faced with these massive changes and entering a new millennium, we have to ask: Has government regulation kept pace with these changes?

The answer, unfortunately, is "no." Despite all that has happened in the past decade while this market revolution was ongoing, our regulatory debates have been dominated by the same tired old issues: dual trading, audit trails, speculative limits, delivery points, large trader reporting, contract approvals, jurisdiction, and the role of self-regulation. These debates go on as if no matter what the outcome, centralized, open and competitive markets will continue to be around to serve the identified national interests. But that is not the case. While we debate the old issues, a new competitive landscape is emerging that threatens the very survival of centralized markets and the public interests they serve.

Does any of this make sense today? In a world of professional global markets where regulatory inconsistency and technology have torn down barriers to entry by new competitors, should we still be debating:

Whether the U.S government should require U.S exchanges to spend millions of dollars on incremental audit trail improvements to protect professionals and financial institutions from dual trading brokers?

Whether U.S. exchange audit trails must be based upon government mandated ink pens and trading card forms or timing windows to record the trades of those who elect to use open outcry markets?

Whether U.S. exchange market participants should have their trading restricted by speculative limits when any party seeking to evade those limits could engage in an OTC or foreign exchange derivative transaction to obtain the same risk exposure?

Whether the government should require traders in U.S. exchange markets to file position reports with the government for surveillance purposes, thereby creating an incentive for traders to use foreign or OTC markets to trade comparable contracts but without the need to file government reports?

Whether the U.S. government should be telling U.S. exchanges what delivery points to adopt to accommodate the new global market, while at the same time contemplating whether to allow foreign exchanges to trade the same contracts on terminals in this country and set their own delivery points?

Whether currency futures or swaps traded on an exchange need full government regulation while the same products traded through an electronic dealer need none?

Whether the government should tell U.S. exchanges what contracts and rules they can adopt to respond to competition from OTC and overseas markets which are free, without any government's imprimatur, to begin offering new products or trading systems to the marketplace?

These are but a few of the regulatory issues that have been dominating our dialogue with the government for the past decade. They are really yesterday's questions for yesterday's markets. They are as outdated and out-of-touch as using chalk boards to disseminate market quotes. They represent what we once wanted government to do in the context of markets and competitive realities that no longer exist.

The Chicago Exchanges have tried to take a fresh look at what government's role should be. We have offered an approach for the markets of tomorrow in all derivatives, whether agricultural or financial, whether open outcry or electronic.

First, we considered which derivatives should be regulated and which should not. In our view, privately-negotiated, tailored derivative transactions between two counterparties do not need regulation. Each party should be responsible for its own protection and each party should be able to pursue available legal remedies in the event of a problem. In contrast, a publicly-offered derivative should have some form of government oversight. We consider a derivative would be publicly-offered where one party makes an offer to multiple counter-parties so long as one of those counter-parties could accept the offer by clicking a button on a computer or shouting out "I accept" without any further negotiation.

In short, publicly-offered derivatives would be those offered on or through "execution facilities." Exchanges, like the CBOT, were the first execution facilities years ago; now there are a variety of execution facilities in existence, largely as a result of new technology and electronic trading systems. The use of an execution facility for a transaction should trigger coverage under the statute. And, execution facilities themselves should be primarily self-regulating subject to some form of government oversight. Similarly, any clearinghouse for derivatives, whether publicly-offered or privately-negotiated, should be primarily self-regulating subject to some form of government oversight.

Before describing that oversight, let's consider the concept of self-regulation. Historically, the Commodity Exchange Act and its predecessor the Grain Futures Act were grounded in the principles of strong self-regulation and day-to-day management by exchanges subject to government oversight and, only in extreme cases, action. Over time, each opportunity to amend the CEA -- whether due to reauthorization or not -- resulted in more and more mandates being heaped on exchanges, in effect giving regulators a strong and often decisive voice in exchange management decisions.

Many times over the years, the Chicago Board of Trade and other exchanges opposed those new mandates and testified that exchanges have powerful economic incentives to self-police effectively. We explained that if market participants believe an exchange is so lax that it compromises the market's integrity, they can and will take their business to our competitors. But some said, "we can't trust those incentives because it costs a lot to start a new market and we can?t be sure that the threat of competition for existing markets is real." As a result, the statutory and regulatory mandates flowed and the book containing the Commodity Exchange Act and the regulations of the Commodity Futures Trading Commission got thicker and thicker.

Mr. Chairman, let me tell you those days are over. The competition that exists for U.S. exchanges is very, very real. One new competitor has already cloned our most successful contracts and seeks to cream skim our best customers. Others maintain that many instruments currently being traded as government security forwards or when-issued contracts already compete with our most successful contracts. Other new competitors can clearly be seen on the horizon. Just last month two new potential electronic derivatives exchanges have been announced. Another new competitor -- Derivatives Net?s Blackbird system -- has commenced, or could commence any day, electronic trading in interest rate swaps and other products that may be indistinguishable as a practical matter from already exchange-traded products, but without any form of CFTC regulation.

Viewed from this competitive landscape, the incentives for exchanges to self-regulate effectively and to respond to the demands of market participants have never been greater. All U.S. exchanges know that if we lose the trust of our market participants, we will lose our business. It is that simple.

Tolerating fraud or abusive practices, allowing any form of price manipulation, favoring one set of competitors over another, or skimping on financial integrity protections are a proven recipe for disaster, especially in today's market environment where the barriers to entry have been lowered. No exchange would want that as its epitaph.

Given those realities, the Chicago Exchanges' legislative approach is based on a bedrock principle -- any reform of the Commodity Exchange Act must be premised on self-regulation, not government regulation. To that end, we believe the operators of an execution facility or a clearinghouse should be subject to clear performance standards designed to prevent manipulation or fraud and to preserve financial integrity, a great strength of our markets. No specific statutory or regulatory prescriptions should be enacted telling the execution facility or clearing house how to achieve those objectives. If the government believes that the self-regulatory organization is not satisfying the statutory performance standard, it may initiate proceedings based upon fact, not suspicion, ultimately to make the necessary changes or suspend or revoke the self-regulatory organization's right to do business. The government would retain its current powers to take action in true market emergencies, to take enforcement actions itself against any fraud or manipulation and to maintain financial integrity of firms and markets.

Under this streamlined approach, execution facilities would be able to list new products immediately without waiting for government review or approval. That way, the market, not the government, would decide what new trading instruments are effective risk management tools. The CFTC's July proposal in this regard confirms that exchanges should be empowered to make the business decision on what contracts to list and to implement that decision immediately without any form of required government pre-screening. (The proposal, however, conditions this grant of authority to exchanges in ways that, in a practical sense, totally undermine the Commission's stated objective.) Similarly, self-regulatory organizations would be able to implement new trading and other forms of rules and procedures immediately without prior government approval. Sensibly-managed execution facilities would be expected to vet any proposed rule changes with its market users so that new trading techniques and practices would serve the business needs of market participants. If the government concluded that a new rule or practice created an intolerable risk of fraud or manipulation or endangered a market's financial integrity, the government could take steps to remedy the perceived deficiency.

Execution facilities and clearing organizations could be membership organizations or could be proprietary in nature. The statute needs to be amended to accommodate both models. Public directors would be required for each entity and inappropriate conflicts of interest would be barred.

This more enlightened, modernized approach to regulation provides for government oversight without curtailing the autonomy and innovative spirit of self-regulatory organizations. By striking the balance in this manner, our U.S. markets should be able to thrive competitively without compromising any important market protections. We look forward to working with this Committee and others in Congress toward the enactment of this streamlined regulatory approach.

In addition to streamlined regulation and legal certainty, the Board of Trade has called on Congress to lift the Shad-Johnson restrictions and allow futures exchanges to trade futures on all stock indexes and securities. Competitive fairness should compel this reform. The options markets and the swaps markets offer their customers risk management tools and investment alternatives involving both stock indices and single stocks. The futures exchanges simply request the same rights.

Shad-Johnson was enacted as a temporary, but admirable, statutory framework 17 years ago. During that time, stock index futures were born and have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements. Shad-Johnson solved a political problem that emerged when the financial innovation known as stock index futures butted-heads with two different, but comparable, forms of regulation -- the Commodity Exchange Act and the federal securities laws. Shad-Johnson was never designed to be a permanent statute that could not be amended to account for new market developments.

Today, however, some would use the provisions of Shad-Johnson as immutable barriers to competition. For its part, the Securities and Exchange Commission through statutory misinterpretation and, what a court has found to be "arbitrary and capricious" and "suspect" application of its powers, has denied futures exchanges the right to trade futures on stock indexes that reflect price movements in substantial market sectors. Indeed, the SEC has even taken the position that futures could not be traded on the Dow Jones Utilities and Transportation Averages because they did not "reflect" the utilities and transportation sectors, respectively. While a recent court decision has overturned and vacated that SEC decision, Board of Trade v. Securities and Exchange Commission, No. 98-2923 (7th Cir. August 10, 1999), the plain truth is that the options exchanges began trading options on these indexes in September 1997 and now two full years later, as the SEC exhausts its legal appeals, the Board of Trade is still unable to list those products. The reason for this disparity? As the court of appeals found: "The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves. . . . . The Securities and Exchange Commission, which regulates stock markets, has sided with its clients." Slip Op. at 4. In that way, Shad-Johnson has become a barrier to competition, not a mechanism for permitting market innovation.

Of course, Shad-Johnson also bans single stock futures. That ban was understood by Congress to be temporary in 1982 since, as the recent Seventh Circuit decision underscored, the ban "was a political compromise; no one has suggested an economic rationale for the distinction." Slip Op. at 4. In the absence of such a rationale, Congress should lift the single stock futures ban and allow the marketplace to decide whether these instruments would be useful new risk management tools. Many exchanges around the world trade single stock futures; no reason exists to deny U.S. futures markets the opportunity to offer this product as well.

In the past when these issues were debated, the SEC and securities exchanges have objected that futures markets in these instruments would become a haven for insider trading on securities. The argument was that an insider at, for example, Company X who wanted to profit from inside information would trade futures on Company X stock to avoid detection and prosecution. Responding to that stated concern, the Board of Trade and the CME's proposal contemplates authorizing the SEC to enforce its insider trading prohibitions for single stock futures just as it would for single stock options. Thus, to the extent the SEC's insider trading enforcement powers would deter the insider at Company X from trading Company X options, it should also deter him from trading Company X futures. Complementing the SEC's powers in this area, the exchanges' Intermarket Surveillance Group, comprised of U.S. futures and securities exchanges, would provide an additional self-regulatory deterrent to insider trading.

Lifting the Shad-Johnson restrictions will not lead to more insider trading abuses. It will lead to more competition and risk management choices for market participants. No substantive reason exists for excluding the US futures markets from this competition. Shad-Johnson's product restrictions should be reconsidered by Congress and removed.

Mr. Chairman, the Chicago Board of Trade knows that any legislative reform alone will not be enough to respond successfully to the new competitive realities we face. Instead, those reforms are an essential part of a multi-faceted plan we have adopted. Through successful implementation of that plan, the members of the Board of Trade will demonstrate that we are ready to take bold action on their own to compete and win in the new global, technologically-driven marketplace. I would like to call two specific aspects of our plan to your attention.

First, on June 24, 1999, the members of the Chicago Board of Trade voted overwhelmingly to approve an Alliance with the German-Swiss electronic exchange known as Eurex. The Alliance will develop Board of Trade/Eurex trading system software consisting of a back end trading engine, a common front end application programming interface (API), a common graphical user interface (GUI) and interfaces to external systems. The Alliance will also develop software to facilitate the automated order routing system for the Board of Trade's open outcry markets. In addition, the Alliance will develop a common network in the U.S. and Europe, including shared access points and communication lines that will link the Board of Trade's trading engine, located in Chicago, and the Eurex trading engine located in Frankfurt, Germany.

We believe this Alliance will bring many competitive benefits and efficiencies to the market place. We expect the Alliance to provide the Board of Trade with electronic trading and enhanced order routing functionality by the middle of next year.

Second, the Board of Trade recently announced that we have begun the process of preparing a for-profit exchange-restructuring plan. Under this plan, we would demutualize our memberships by separating the ownership and trading rights of each membership and then monetize that ownership component through private or public investment, while preserving the existing trading rights.

In my view, the unprecedented competitive environment we face dictates that we consider alternative business structures, just as Congress must consider alternative regulatory structures. The Board of Trade must attain the resources and flexibility to assure that our customers continue to prefer the Board of Trade's markets to those of our competitors. Our current governance structure constricts us in making decisions and mobilizing financial resources with the speed required for today's markets. That structure worked well for 150 years, but it would not be how any of us would structure a successful new market place today. The Board of Trade is facing the competitive realities of the new global market and will make the necessary changes.

So should Congress. The Board of Trade can restructure itself as a business entity. We need your help, however, to restructure the CFTC as an oversight entity that will allow us to do our business and preserve this vital U.S. industry that provides tens of thousands of jobs throughout this country.

We urge you to join us in responding to the new market realities by enacting a new even-handed, equitable regulatory approach based on oversight, not overkill, and fair and open competition, not unfair, anti-competitive barriers. I know that change is never easy. Complications and bumps in the road will emerge to hamper progress. But we should not be deterred from reaching our common goals.

Just as the Board of Trade will strive to revamp its business operations, we know, Mr. Chairman, that you and this Committee will continue to look at new regulatory structures that will allow the U.S. to retain its preeminent place in the global derivatives markets. Those structures should treat all market participants equitably, so that competition is based on serving customers' need, not regulatory arbitrage. Thank you for your work in the past and for your commitment to our future.