Testimony of David P. Brennan

Chairman of the Board of Directors

Board of Trade of the City of Chicago

Before the Subcommittee on Research, Nutrition, and General Legislation

of the Senate Agriculture Committee

March 20, 2000

Mr. Chairman, I am David Brennan, Chairman of the Board of Trade of the City of Chicago. Accompanying me today is Tom Donovan, our President and CEO. We thank you for holding this hearing in the derivatives capital of the world, the City of Chicago. We also thank you for the leadership you have shown in this Congress on the vital issues relating to legislation to reform the Commodity Exchange Act.

For many years, the Board of Trade has argued that the Commodity Exchange Act has needed a comprehensive overhaul. Provisions enacted for markets in the 1920's and 1930's must be modernized to reflect the markets of the 21st century. The combined forces of innovation, technology, globalization and new competition have called into question the stability of many elements of our current regulatory architecture. Wholesale remodeling is warranted.

In that effort, the Board of Trade has urged Congress to be guided by a simple, yet elusive, concept. Fairness. In our view, similar derivative products traded in a similar way should be subject to similar regulation. That promotes fair competition. Where regulatory differences do exist, they should be rational and tied to identifiable public policy goals. Regulation for regulation's sake should be discarded. Regulatory arbitrage should be minimized.

The Report of the President's Working Group last November set out the three key ingredients of a comprehensive reform package. First, the US futures exchanges need regulatory relief. By transforming, the Commodity Futures Trading Commission's regulation mission to one of flexible oversight, not rigid mandates, the competitive forces of the exchanges can be unleashed in a fair competitive fight. Second, the over-the-counter market should be granted legal certainty. Privately-negotiated transactions among sophisticated counter-parties do not need federal regulation. Third, the statutory restrictions on securities-based derivatives, known as the Shad-Johnson Accord, should be lifted so that futures exchanges and OTC markets may offer those innovative products just as they are all over the world. The current ban was enacted 18 years ago as a "temporary foreclosure" while the agencies studied the issues. Eighteen years is "temporary" enough. Congress must open this area to full competition as well.

Each of these three elements must be addressed in legislation if reform is to be comprehensive and meaningful. Each of these three areas deals with the competitive future of futures. Each of these three areas presents challenging, but not impossible, issues for people of good will to resolve.

The CFTC's Staff Task Force Report on a New Regulatory Framework typifies the kind of creative thinking that answers some of these challenging questions. CFTC Chairman Bill Rainer directed his staff to consider ways to reshape and modernize their regulatory approach. His leadership and his vision must be commended. The CFTC Report is compelling and comprehensive. It sets out a framework that, with some modest fine-tuning, should allow the futures industry to compete effectively in the global derivatives market place. It gives the futures industry the freedom to make choices of different oversight regimes, to find the best fit for the business. That emphasis on market choice to facilitate competition is one of the bedrock, and most appealing, principles of the CFTC's New Framework. Allowing business to shed the current "one size fits all" brand of regulation will be of immense benefit to exchanges and other derivatives market innovators.

The CFTC Report recognizes three general categories of regulatory interest - execution facilities, clearing organizations and intermediaries. In each area, the CFTC Report sets out new regulatory approaches that attempt to tailor government oversight to the real regulatory issues. I will focus my remarks on execution facilities.

In this effort, the Board of Trade's principal concern was whether exchanges would be afforded the same type of flexible treatment that is now enjoyed by the over-the-counter derivatives markets and overseas exchanges. Since 1993, when the CFTC adopted its swaps exemption, the Board of Trade has made numerous filings urging the CFTC to allow exchanges the same treatment as OTC swaps dealers. Our argument was: the same instruments traded among the same participants should have the same regulation.

After seven years, the CFTC has agreed. Now, under the category of an Exempt Multilateral Transaction Execution Facility (Exempt MTEFs), an exchange could offer a derivatives market with roughly the same regulatory freedom as a swaps dealer. In short, interest rate futures and interest rate swaps would have the same regulation. Only institutional participants could trade on Exempt MTEFs. The only regulations that would apply would be antifraud, antimanipulation and, potentially, some form of market data transparency. If a futures exchange wanted to trade an eligible futures product in an Exempt MTEF, it could do so and still be subject to the CFTC's exclusive jurisdiction. This feature provides maximum regulatory flexibility. Any exchange using the Exempt MTEF approach would be required to conduct that business in a separate affiliate and would not be considered to be a CFTC-regulated exchange.

The CFTC's new framework offers an exchange two other choices if it wants to be considered to be a CFTC-regulated exchange, a status of some value in the global marketplace. Basically, the CFTC would allow futures contracts that are "highly unlikely to be susceptible to manipulation" to trade in exchange markets regulated as Derivatives Transaction Facilities (DTFs). It is contemplated that the Board of Trade's Treasury security complex, at a minimum, would qualify to be traded on a DTF. Significantly, DTFs could be open to all market participants, whether institutional customers or retail market participants. Any retail market participant may place DTF orders only through a CFTC-registered intermediary that is a member of the National Futures Association. In addition to those sources of intermediation, institutional market participants could place orders through banks or broker-dealers in good standing with their regulators. This flexibility should allow institutional market participants to use the same intermediaries and brokers for their futures, swaps, and securities business thereby promoting efficiency and lower costs.

Futures exchanges that are already CFTC-registered would need to comply with seven core principles on an ongoing basis as CFTC-recognized DTFs. These principles are: 1) rule enforcement; 2) market oversight; 3) disclosure of operational information; 4) transparency of data; 5) fitness; 6) recordkeeping and 7) fair competition. Each of these areas touches upon a good business practice that any sensible exchange must adopt to be successful. No exchange wants its market integrity tarnished. No exchange wants to give its competitors an opening by running a market that has operational flaws or that favors one set of market participants over another. The CFTC's approach reflects those competitive realities and a greater sensitivity to the competitive incentives that compel exchanges to operate their markets in a way that responds to customer needs and avoids any potential problems with market manipulation or other abusive trading practices.

Significantly, the CFTC is not telling the DTF how to satisfy those core principles. The design and methods of compliance are left to the DTF itself to develop. The CFTC will oversee, not dictate, the DTF's successful implementation of those core business practices.

Generally, for futures contracts on physical commodities, the CFTC allows already approved exchanges to become Recognized Futures Exchanges (RFEs). The CFTC's thinking is that markets involving physical commodities may need somewhat more detailed mechanisms to prevent price manipulation. To that end, the CFTC would require an RFE to meet 15 core principles. Those principles would replace technical rules, like the CFTC's audit trail and conflict of interest rules, with flexible objectives that an RFE must design a way to meet. But the design would be of the RFE's own making, not the government's. By shifting from their current contract market status to an RFE, exchanges could utilize that flexibility and shift in regulatory emphasis.

The CFTC's framework follows years of debate and study on these issues going back to 1993. Past efforts by the Commission to address the competitive disparities exchanges face due to OTC and overseas competition have fallen far short of the mark. This proposal better reflects the market realities exchanges face and offers tailored oversight of the critical clearing function while streamlining the regulatory burdens of futures commission merchants acting as intermediaries.

It is a sound proposal. It should be incorporated in any legislation Congress considers to reauthorize the CFTC.

In that connection, the Board of Trade offers three constructive suggestions to the CFTC framework. First, the choices should be expanded to allow trading in physical commodities to qualify for DTF treatment. An exchange's principal mission is to provide a trading environment free from manipulation, defaults and other market abuses. That is true whether the underlying commodity being traded is Treasury securities or corn. Working with the CFTC, exchanges have developed surveillance techniques that cut across all markets. Those mechanisms are just as effective in agricultural futures as they are in financial futures. While at some level the surveillance issues facing each type of futures contract are unique to that futures market and its participants, the method of collecting data and monitoring trading activity is the same. Giving exchanges the added flexibility to trade more of their contracts under the DTF construct would enhance exchange competitiveness without sacrificing market integrity.

Second, the Board of Trade heartily endorses the concept of replacing inflexible, micromanageing, government mandates with core principles. The CFTC is right that exchanges and others are best able to design systems to achieve the desired and shared objectives of market integrity, financial integrity and preventing abuses. But what happens if the CFTC decides that the system designed by an exchange is not adequate? The CFTC's framework does not provide any mechanism for enforcing the core principles it sets out. We would recommend that in codifying the CFTC's proposal Congress should add a procedure for resolving disputes between exchanges and the CFTC through balanced negotiations and, if all else fails, special forms of administrative process. Hopefully, this enforcement mechanism would be rarely needed but no one should expect that the CFTC and each exchange would always see eye-to-eye. A fair process should be adopted to anticipate how best to resolve these disputes.

Third, the CFTC's proposed framework does not specify what types of entities must become either contract markets (under current law) or Registered Futures Exchange or Derivatives Transactions Facilities (under the CFTC proposal). Nor does the CFTC define what entities are eligible for exemption as Multi-Lateral Transaction Execution Facilities. With the ongoing explosion in electronic trading systems, many new forms of marketplaces are being created. Market observers have criticized the current statutory definition of "board of trade" as too broad and outdated. If that is true, the CFTC and Congress will need to consider how to distinguish those derivative transaction execution facilities that must be CFTC-regulated from those that are either excluded from CFTC jurisdiction or subject to it as an Exempt Multi-Lateral Transaction Execution Facility.

In effect, harmonization of the CFTC's proposal with the recommendations of the President's Working Group is required. One example illustrates this point. The Working Group would exclude from the Act any centralized electronic trading facility in standardized financial derivatives traded among institutional parties as principals. The CFTC's proposal would seemingly sort that same facility into either the DTF or Exempt MTEF box. Logically, no execution facility can be both excluded from a statute and exempt from most, but not all, regulation under that statute. If the facility is statutorily excluded, it is out; no exemption is needed or could apply to the facility.

As this example shows, lines will need to be drawn to distinguish what is excluded from the Act from what is subject to regulation or exemption from the Act. Otherwise the quest for legal certainty will result in legal confusion that will not serve the marketplace. The Board of Trade has endorsed the goal of legal certainty for the OTC markets. We would be happy to work out a solution to this important conundrum that is fair to all sides.

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The final component of meaningful modernization of the Act is Shad-Johnson reform. The ban on single securities futures should be lifted. Free and fair competition should be allowed. That will make the markets stronger and lead to more efficient risk management for securities market participants.

As recent correspondence from the SEC and CFTC suggests, the regulatory issues raised by futures on single securities or more targeted sector-based indexes can be resolved without transforming those futures into securities for all purposes under the federal securities laws and without requiring the futures exchanges to go through the costly and duplicative process of registering with the Securities and Exchange Commission as national securities exchanges. A more targeted approach aimed at specific areas of regulatory concern will be more than adequate to harmonize regulation.

The best illustration is the area of insider trading and margin. For many years, those two issues were the principal stated areas of concern of the securities exchanges. Fears were expressed that futures on stocks would become a haven for insider traders. Unlike securities, the futures markets have no insider trading restrictions since hedgers always trade on material nonpublic information. To address that concern, last year the Chicago futures exchanges agreed that if they were allowed to offer single stock futures then the same insider trading protections applicable to stock options would apply to stock futures. Similarly, in the margin area, the futures exchanges have agreed that initial margin levels for stock futures and stock options should be the same. That will not be hard to achieve statutorily since the Federal Reserve Board would have ultimate jurisdiction to oversee the setting of margins levels for both stock options and stock futures. Thus, in both the areas of insider trading and margin, the futures exchanges have shown the needed flexibility to resolve the stated primary areas of regulatory concern.

Shad-Johnson reform has been a long time coming. Equity swaps, single stock futures, sector-based stock index futures and even futures on corporate debt all should not be withheld from the market place or be forced to trade overseas or under a legal cloud. The time for Congress to act is now.

Senator Fitzgerald, we need legislation now, not regulatory exemptions or studies. Our competition is moving quickly. We need to be just as agile to keep up. Statutory reform in the three areas I have identified will strengthen the U.S derivatives markets by letting the market decide on the winners and losers under rules that are fair to all. Given the pace of technological change and other market realities, no one can predict how long the exchanges really have to change their way of doing business. But we know we must change, and we will. So must the laws that regulate us. We appreciate your support and leadership and look forward to working with you to fashion legislation to modernize regulation of our markets, provide legal certainty for the OTC markets and remove the Shad-Johnson product restrictions.