Statement of Matthew Andresen

President, The Island ECN

Senate Agriculture Committee

September 23, 1999

Chairman Lugar, Ranking Member Harkin, and Members of the Committee:

I commend the Chairman, the Ranking Member, and the Members of the Committee for holding these timely hearings concerning the impact of technology on the derivatives markets. I appreciate the opportunity to appear before this committee to testify about our experiences as an electronic trading system.

INTRODUCTION

I am Matthew Andresen, President of The Island ECN ("Island"). Island is an automated trading system for equity securities. It gives brokers the power to electronically display and match customer orders in equity securities. We function as a pure auction market -- directly matching buy and sell orders. Island was founded approximately three years ago with the intent of providing all market participants - from individual investors to large financial institutions - with the ability to execute securities transactions on a level playing field, at an extremely low cost and without the presence of intermediaries or dealers.

On an average day, Island will trade over one hundred and twenty million shares - approximately 12% of the transaction volume on Nasdaq. All this will be done on a single computer about the size of Chairman Lugar's podium. In the previous three months, Island traded over six billion shares or approximately $350 billion worth of securities. Such dramatic trading volumes can only be accomplished through the presence of sophisticated technology.

Let me now discuss in greater detail the role of technology in fostering greater consumer empowerment in today's financial marketplace.

TECHNOLOGY IN THE MARKETPLACE

In recent years, technological advances have allowed automated trading systems to become significant compliments or alternatives to the traditional open outcry trading methods used on the floors of many of the world's derivatives and securities exchanges. Such advancements are no doubt the single biggest source of change in the financial industry today. Experts no longer talk about "whether" technology will replace traditional exchanges. Rather, they talk about "when" technology will replace traditional exchanges. In fact, on June 28^th of this year, Island filed an application with the Securities and Exchange Commission to become the first virtual national securities exchange.

New trading systems like Island and the explosive growth of the Internet have provided millions of investors with unprecedented access to the markets. Such access has brought many new investors to the markets. Technology and the Internet give investors the ability to directly monitor, manage, and trade their own portfolios. More importantly, investors now have access to a wealth of information, which enables them to make and control their own investment decisions. These developments clearly have had a tremendous impact on the markets by increasing market liquidity, overall transparency, and thereby investor confidence.

At Island, we view the financial industry in three critical components: the order-delivery function; the execution function; and the back-office and settlement function. Many years ago, the financial industry turned to technology to assist it in the performance of the back-office and settlement function. For example, technology has been used for many years to provide account balance information, maintenance of trading positions and the settlement or movement of funds and financial instruments. More recently, the industry began tapping sophisticated technology to perform the order-delivery component. Throughout the financial industry you see orders for derivatives and equities being routed to exchanges and other execution destinations in electronic form. These electronic orders are being delivered over high-speed data cables and via satellite and other digital signals to the floors of the exchanges. Often, order are delivered to small hand-held computers carried in the trading crowds. Further expansion of electronic order-delivery methods has resulted from the rapid growth of on-line or Internet order-entry facilitators, also known as e-brokers.

So, as a result of technological enhancements, the majority of orders are being delivered to marketplaces in electronic form. One hundred percent of the trade information resulting from these orders is now leaving those marketplaces in electronic form. The logical next step suggests that the last and most important component of the industry -- the execution function - can and should be performed by technology. Technology provides a fair, impartial and efficient means of execution. It is this very component of the industry that Island performs close to 400,000 times a day.

TECHNOLOGY OFFSHORE

In the last few years, a number of exchanges, both derivatives and securities exchanges throughout the world, have abandoned their traditional trading floors in search of faster, more efficient trade executions through the introduction of electronic trading systems.

In 1995, the Hong Kong Futures Exchange Ltd. introduced electronic trading for futures using the Hong Kong Futures Automated Trading System. The HKATS provides market participants with direct access to the Hong Kong market place through HKATS workstations placed on individual trading desks. In 1998, the Deutsche Börse AG and the Swiss Exchange joined together to form the Eurex. Eurex is a fully integrated electronic exchange offers decentralized and standardized market access on a global scale. Trading on the computerized Eurex platform is different from traditional open-outcry systems, because it transcends international borders and offers members technical access from any location in the world.

Also in 1998, the London International Financial Futures and Options Exchange ("LIFFE") introduced LIFFE CONNECT to facilitate the electronic trading of several financial products. Recently, LIFFE has actually closed several trading pits and moved trading into the LIFFE CONNECT system.

Recently, Canada's Montreal Exchange joined the GLOBEX Alliance which already includes the Chicago Mercantile Exchange ("CME"), ParisBourseSBFSA, the Singapore International Monetary Exchange ("SIMEX") and the Bolsa de Mercadorias & Futures ("BM&F"). The Montreal Exchange also announced that it intends to use the same electronic trading system developed by ParisBourseSBFSA and used by all of the GLOBEX Alliance partners. The addition of the Montreal Exchange, to the GLOBEX Alliance will create a global trading link providing access to many of the world's most traded financial futures products on a single electronic trading platform. This alliance now spans three of the world's major time zones. Exchanges that once physically existed only overseas now can be accessed from personal computers anywhere in the world, including the United States.

U.S. markets are responding to foreign competition and technological developments by improving their electronic trading systems and successfully integrating electronic trading systems with open outcry trading in selected contracts. The Chicago Mercantile Exchange, for example, offers concurrent electronic and open outcry trading of the e-mini version of its S&P 500 futures contract. Firms offer on-line trading access to the Chicago Mercantile Exchange's E-mini futures contract. Similarly, the Chicago Board of Trade also offers concurrent electronic and open outcry trading in many of its financial contracts.

We are also seeing the introduction of new, fully electronic U.S. exchanges. In September 1998, the new Cantor Financial Futures Exchange ("CFFE") became the first fully electronic-based U.S. futures exchange. CFFE represents a novel alliance between the New York Commodities Exchange, which performs all of CFFE's regulatory responsibilities, and Cantor Fitzgerald Securities, which performs all of the trade execution functions. While CFFE memberships are held by members of NYCE and CSCE, CFFE has significantly reduced the need for intermediaries by making trading privilege licenses available to market participants fully guaranteed by clearing members for the relatively modest sum of $2,000. CFFE is owned 90 percent by NYCE and CSCE members and 10 percent by NYCE and CSCE themselves.

FutureCom is another new, fully-electronic U.S. exchange. FutureCom, has not yet been designated as a contract market by the CFTC, but has an application pending before the Commission to become the first Internet-based futures exchange in the world. FutureCom, as proposed, would be structured unlike any existing exchange.

Using the Internet to transmit trade and financial information would facilitate direct access by the public and would result in the elimination of a significant role for intermediaries. Since each FutureCom member would provide for its own access to the Internet and thus to FutureCom, functions traditionally performed by a futures commission merchant would not be needed by a member to access and trade on FutureCom.

It is inevitable that an exchange, whether based in the U.S. or abroad, will eventually emerge that uses the Internet as its communication medium and offers direct access to customers around the globe.

REGULATION OF ELECTRONIC TRADING SYSTEMS

The historical focus of regulation in the financial markets has been to control informational disparity. Through disclosure, restrictions on certain types of activities and market surveillance, regulators have for years attempted to protect those that do not possess information from those that do. For example, people in a trading crowd on the floor of an exchange may possess more information then the average investor sitting at home. Through surveillance and the implementation of restrictions on the activities of those in the trading crowds, regulators try to level the playing field.

We believe that technology, rather than regulation can create a level playing field. Technology enables the market to deliver more information, not less. Technology permits the individual investor to electronically step into a virtual trading crowd and compete side-by-side with floor traders. Technology also removes the potential for many abuses found in the trading crowds. For example, at Island, we like to say that "you can't front-run real-time!" If all orders delivered to the virtual trading crowd are displayed in real-time to everyone in the trading crowd, no single person has an informational advantage. In addition, the anonymity provided by technology will also remove the inefficiencies resulting from human intervention in the trading crowds. So before we talk about what kind of new regulations we need as a result of the introduction of automated trading systems, we need to first discuss and recognize that automated trading systems actually diminish the need for certain types of regulations.

Furthermore, because more technology results in the electronic capture of information, the market surveillance mechanisms associated with electronic trading systems are actually better equipped to perform the surveillance functions of the traditional exchanges. For example, at Island, we have the ability to take surveillance to the next level. Historically, surveillance has involved analyzing completed transactions for abuses like price manipulation. At Island and presumably most electronic trading systems, we are able monitor orders as well as completed transactions. Order information is imbedded in the data received from every user of the Island system. Therefore, we are able to monitor orders, as well as completed trades, for trading abuses such as price manipulation. So, again, before we talk about more regulation, we need to discuss and recognize that surveillance, the regulator's most powerful weapon, will become more effective as a result of electronic trading systems.

Some suggest that automated trading may raise regulatory issues such as system capacity and security, which are not applicable to the traditional open outcry environment. While system capacity and security are legitimate regulatory issues, we believe that, with regard to these issues, the marketplaces' business interests, such as adequate and continued service, are completely consistent with the regulators' interest to protect all market participants. No electronic trading system will survive if they fail to establish adequate system resources to avoid capacity and security related problems. Every broker that connects to Island performs a due diligence of Island's system capacity and security prior to establishing a connection to Island. While regulators may have insufficient experience with electronic systems to accurately identify all of the capacity and security risks they may pose, the industry has had substantial experience to ensure that the systems they use have adequate capacity and security.

As seen in the CFFE and FutureCom examples, new technology is contributing to changes in exchange governance and organization. New exchange ownership structures are emerging that are intended to improve the exchanges' ability to engage in effective strategic planning and implement new business models. Membership organizations are being abandoned by both U.S. and foreign exchanges in favor of for-profit, public companies. These new ownership structures raise issues concerning whether such demutualized, for-profit exchanges can adequately continue to perform the self-regulatory role exchanges traditionally have played.

Some U.S. securities exchanges have stated that they too are exploring whether such an ownership structure is feasible. In the face of these developments, both Congress and the CFTC and the SEC must examine whether self-regulatory organizations have the appropriate governance structures to perform their regulatory obligations.

Moreover, as technological enhancements increase the direct access to electronic trading systems and investors take advantage of such direct access, the industry must strive to better educate investors concerning the use of appropriate trading strategies. Ironically, the same technology that provides direct access can also provide extraordinary educational tools for the average investor. While issues such as whether direct access trading is appropriate for all types of investors should be examined, we believe that technology, through disclosure, education and monitoring, provides the most effective means to protecting investors.

CONCLUSION

In conclusion, Mr. Chairman, I believe that we are witnessing one of the most dramatic and exciting times in the history of financial markets. We at Island are proud to have been at the forefront of this flourishing financial services industry. As a result, today's investors have better access and information than ever before, allowing them to reap the benefits of new services and lower costs. Your hearing today illustrates how these technological developments in one market can have profound implications for other markets. I look forward to working with you and your colleagues to explore these exciting opportunities.