Testimony of

Philip McBride Johnson

Before the Committee on Agriculture, Nutrition and Forestry

United States Senate

September 23, 1999

Mr. Chairman and Members of the Committee:

I can remember the 1968 amendments to the Commodity Exchange Act when the Department of Agriculture and its Commodity Exchange Authority were in charge. The dominant commodity was soybeans and financial futures - now 70% of the U.S. futures business - did not exist. I attended the birth of the Commodity Futures Trading Commission and have been involved in nearly all of its reauthorizations, especially the 1982 round while I was CFTC chair. I observe this longevity in the hope that my next statement will be taken seriously:

In the 77-year history of futures regulation in this country, now is its most critical moment as traditional market models are swept aside in favor of technological innovations that render current policies both archaic and unworkable.

That point can be illustrated by simply describing what the law addresses now and what it will face in the near future.

Today. The market is a brick-and-mortar physical place, centered on a trading floor where authorized individuals ("members") congregate to trade for themselves and to execute orders received from outside customers. Those who own and control the exchange are also among its most active users. Business flows from customers around the globe into the exchange through a series of intermediaries - through one or several brokerage firms and finally to the floor broker at the trading site - and the funds associated with that activity likewise are relayed through and among these middlemen.

The current law pays particular attention to the intermediation functions. Is the customer being deceived by his salesperson; is the broker handling his orders competently and honestly; is his money adequately protected against misappropriation; do his orders get best execution on the floor or are they exploited there? Disclosure of risks; supervision of sales practices; segregation of customer funds; audit trails on the trading floor; and a variety of other conventions have evolved from that model.

Current law also focuses on the owner-user dilemma. If the markets are to be truly "public," owner-users must not subordinate the good of the market to the chance for a quick profit. For this reason the law specifies who may serve on the governing board and key committees at the exchanges, and dictates when recusal from voting is required.

On the other hand, a pool of organized members is a rich resource for other purposes, such as operating a self-regulatory program and capitalizing the guarantee fund of a clearing system.

Coming. The "market" of the future will use electronic systems to connect buyers and sellers, either through a central order-matching computer or between users' computers through interactive software. It will operate as a for-profit business entity, owned by public shareholders who generally do not trade, and governed by a board elected annually by the stockholders from a distinguished list of public figures. Because buyers and sellers will be able to communicate through their own keyboards with the central system or among themselves, there will be far less need for intermediaries about which the current law worries so much. By definition, the "floor trader" and the "floor broker" will vanish, but other intermediation services like brokerage houses will be impacted as well. It is quite likely that the system provider, once it has confirmed the end users' credit standing, will deal directly with them or permit them to deal directly with each other.

The system will be gloriously indifferent to who wins and who loses; it will generate its revenue through volume-related execution fees ("traffic") or other agreed arrangements. As a result, many of the problems associated with the present user-owner system, including deciding between what is best for the market and what is best for the members, should recede and there will be no on-going need for the federal establishment to dictate governance structures or committee qualifications.

However, the present system of "self-regulation" will need to be modified. First of all, the regulation will no longer be about "self" because the system provider (and its executives and investors) will not generally trade the market. Instead, it will concern the end users - who will resemble the "subscribers" to America On-Line - and whether they pose ethical or credit risks. Since the relationship between the system provider and the subscriber will be a purely arms-length contractual one, there will be limits to what the system provider can do to respond to detected abuses. Revoking access is one obvious remedy, but the traditional weapons of fining power or forfeiture of a pricey "seat" on the exchange will not be available as options. And, lacking a cadre of members to volunteer their services for self-regulatory duties, the system provider will not be able to organize "business conduct committees" or other aspects of the traditional programs.

Existing legislation falls far short of what is needed in the world of e-trading ahead.

• •It pivots around the concept of a "board of trade" that, using plain English, means an association of traders. The e-trading facility will not be owned, controlled or operated by the trading community.

• •It envisions a trading hall where large numbers of individuals congregate; a computer keyboard and screen, operated from the office or from home, will suffice in the future.



• •It is concerned with potential abuses in the order handling process, such as trading ahead of customer orders or executing them noncompetitively; whereas, the e-trading module will execute every order under the same protocols and without either bias or preference; moreover, a precise "audit trail" will be generated automatically.

• •It assumes that customers must rely on a chain of middlemen in order to complete their transactions; rather, direct one-on-one dealing will become commonplace.



• •It expects the exchange to be a membership organization that can call upon its larger members to operate and to fund a clearinghouse to address credit risks; more traditional sources of capital - including banking and insurance - will probably backstop e-trading.



• •It envisions a large pool of "members" providing the human resources needed to conduct a traditional self-regulatory program; instead, the e-trading facility will be manned by a few administrators and technicians, and its remote public shareholders will have no role in day-to-day affairs.

Even so, it would be premature to revoke the existing legislation. The U.S. markets continue to operate trading floors and continue to be member-run. The transition to electronic trading, and the structural changes that are expected to accompany that event, could be two or more years away. Moreover, some of the traditional features will survive. For example, end users are likely to continue to seek trading advice from knowledgeable market professionals, and the popular "commodity pools" which allow market participants to limit their potential market liability should remain in demand. Existing registration requirements for those functions will not lose their relevancy.

At the same time, however, addressing e-trading issues during the next reauthorization could be too late if the normal interval is maintained. What is needed - now - is a step toward the policy framework of the future. This assessment flows not merely from trends in the U.S. but the fact that foreign futures markets, which are increasingly competing with our own, have almost universally converted to electronic trading platforms. The U.S. markets may find it necessary to accelerate their own conversion in order to compete. Otherwise, trading could shift to foreign jurisdictions and, as we know, the power to make policy gravitates to where the activity is centered. No one would welcome, for example, the Bundesbank making critical decisions about our U.S. Treasury Bonds simply because futures trading in that security has migrated to Frankfurt.

I have attached to this testimony a matrix of existing Act provisions with an indication whether they will remain workable in the coming e-trading environment. While the analysis is necessarily somewhat subjective, I estimate that more than half of the statute's major provisions will be ill-suited to that environment. Many, based on assumptions and structures already identified as outmoded, simply will not work at all while others, despite best efforts, will prove to be awkward and inefficient. The task of revising existing law under these circumstances would be monumental.

Instead, I recommend that the Committee consider drafting a new, separate "chapter" or "title" for the Commodity Exchange Act that will work when and as the American markets complete their conversion to screen-based, publicly-owned electronic trading systems.

The content of the new provisions could be quite a bit simpler than the traditional approach. After all, the problems associated with trading floor operations, many of the concerns about reliance on intermediaries, and conflicts between what is best for the market or best for the members, should recede. The major new issues will be (1) the fairness and reliability of the trading system itself; (2) monitoring of the market against intentional disruptions; (3) managing credit risks; and (4) whether to impose regulatory requirements on end-users. The word "whether" is used because it has never been federal policy to regulate ultimate customers except against market disruptions.

Misconduct by end users, such as lying to each other or evading their financial obligations, could be captured by existing state fraud laws. Less clear is whether market manipulations are adequately addressed at the local level. If it were the decision of the Congress to establish a new regulatory program for market end users, the structure of the new trading systems suggests - as noted earlier - that any organized self-policing of the market will have to be conducted elsewhere. At the risk of building an even greater dynasty for Bob Wilmouth, I would nominate the National Futures Association for that task.