Written Testimony of

David G. Downey, Executive Vice President

Interactive Brokers LLC

Examination of the CFTC report entitled A New Regulatory Framework.

Before the United States Senate

Subcommittee on Research, Nutrition, and General Legislation of the Committee on Agriculture, Nutrition, and Forestry.

MARCH 20, 2000

INTRODUCTION:

Senator Fitzgerald and members of the Committee: Thank you for inviting me to testify before you today and discuss the CFTC's recently released report , titled A New Regulatory Framework.

My name is David Downey, Executive Vice President, Operations Interactive Brokers LLC. (IB), a registered Broker/Dealer and Futures Commission Merchant. IB is a member of the Timber Hill Group of Companies which, along with its affiliated entities, are members of most commodities and securities exchanges in the United States, and several foreign exchanges…in all 30 exchanges in 15 countries on 4 continents. IB provides its customers with electronic order routing and execution of domestic and foreign futures, options, securities and related derivative products through its proprietary screen-based computer and communications technology and the Internet (the IB system).

Background:

The Internet is fundamentally changing the nature of how customers interact with market systems. This applies to almost every industry we can think of, including the financial services industry. The changing nature of this relationship, and the new competitors fostered by the technology revolution, are quickly exposing existing regulations as antiquated and are having a profound impact on the debate of how to regulate in these new times. It is appropriate that regulations are revised such that they do not act as an obstacle for growth while still maintaining a level playing field perspective. Towards that end any regulatory revisions should not weaken the ability to achieve the primary objectives of the CEA: ensuring market and price integrity; protecting against market manipulation; protecting the financial integrity of the markets; and protecting customers from abusive trading and sales practices.

The CFTC's recently released paper is a courageous step in the right direction; thoughtfully crafted and a wonderful launching pad for the discussions. Chairman Rainer and his staff have done a terrific job and should be commended.

I would like to take some time to discuss three particular areas of concern from our perspective: Transparency of prices and the cost borne by the customer; protection against fraud and manipulation through the use of audit trails and the need to open up the clearing house system to the OTC markets.

DISCUSSION

1.Transparency of pricing and real-time access to the data is essential to fair and level playing fields. Enhancement of the price discovery function to the fullest extent that technology permits is clearly in the public interest, and publicly regulated markets which invite participation have an obligation to offer as even a playing field as is possible. This mandates equal access to all, including the size of bids and offers. Imposition of fees that are charged equally to all, but which are practical only for large professional traders to pay is not equal access. This was highlighted at a recent CFTC roundtable where the charges imposed by exchanges for market data were highlighted as a huge problem for futures customers and FCMs who want to give those customers real-time pricing data so that they can fairly compete.

On the securities side the SEC has recognized the seriousness of this issue and issued a lengthy release in December of last year stating the Commission's intent to limit market data fees charged by exchanges. As the SEC notes in the release:

"[N]ew technology has greatly expanded the opportunity for retail investors to obtain access to real-time market information through 'on-line' accounts with their broker-dealers…This information could greatly expand the ability of retail investors to monitor and control their own securities transactions, including the quality of execution of their transactions…" 64 Fed. Reg. 70614

Data fees already are far lower in the securities markets than in the commodities markets but as you can see the SEC release leans toward lowering them even more. Cost recovery may be appropriate but it is important to be sure that data fees are not "at a sufficiently high level that a significant number of users are deterred from obtaining the information".

2. The CFTC's release appropriately recognizes the need to protect the financial integrity of the market and to protect against market manipulation. The release appears to address this with calls for rules and Core Principles that would include data capture or audit trails. We submit that the technology is able to produce audit trails at such a high resolution with such a low investment that it should only be encouraged. However, we did notice that while audit trail language is associated with DTEF and the RFE discussions it is noticeably absent from the Core Requirements for Intermediaries. High resolution audit trails should encompass the life to death cycle of any customer order that is sent to the market. There is much more opportunity for fraud and manipulation up-stream from the transaction facility at the intermediaries processes. We respectfully submit that the CFTC clarify this in any final language to include the responsibility for the intermediaries.

3. Why do we need open access clearinghouses for OTC? First, when examining the soundness of the OTC markets today it is important to understand "Portfolio Risk" in that there is no limit to the amount of risk that may be accumulated in a given participant's portfolio; and, there are no assurances that the parties involved understand the aggregate risk or that the participant can absorb the potential losses. A clearinghouse, serving as the central counter-party, would act to limit portfolio risk with a given participant based on the clearinghouses' own economic self-interest. The clearinghouse would likely achieve this through risk based margins and appropriate standards of financial responsibility (i.e., The owner of a given portfolio would have to have sufficient funds, or free collateral, to post margins to cover anticipated losses under "normal market conditions" and sufficient capital to absorb losses under "abnormal market conditions"). The clearinghouse would use its own independent model based upon prevailing market prices to evaluate the risk of the portfolio.

Second, since positions cannot be netted, no participants, not even intermediaries, can truly hedge their risk positions. In other words, whenever there is a potential default in the system, like LTCM, it is the gross positions that matter not the net. The larger the market becomes, the more participants will have exposure to each other. This necessarily means that almost any large bankruptcy has the potential to have a domino effect through the system, knocking down a lot of players. The time-tested private sector solution to this problem is a clearinghouse. Indeed, it is precisely this role for which clearinghouses were invented (i.e., to assume the position of the opposing side to each and every trade). Accordingly, all parties have exposure to only one counter party…the clearinghouse.

Third, the current OTC structure does not allow for price and open interest transparency which further aggravates matters, for no financially healthy bystander will interject himself without knowing the exact extent to which prices have deviated from the norm and just what magnitude the problem might be. Using a clearinghouse, open interest and marking prices are published by the clearing entity daily. Everyone knows that amount of risk and price dislocations in the system. In addition the clearinghouse has procedures in place for the liquidation of defaulting clearing members. All of these factors act to attract more buyers and sellers to the market which enhances pricing efficiency. There is no practical alternative to the establishment of a clearinghouse.

Conclusion:

The CFTC can only do so much. At certain times it is appropriate for Congress to step up and articulate a vision around which policy will be shaped. We contend that the goal of efficient market places where all market participants compete on a level playing field can be achieved cheaply and easily with available technology. The only thing that has stymied its implementation in the past has been the intentional acts by the economically advantaged groups to cripple the potential of the systems.

We are confident that given the right encouragement by Congress and appropriate regulatory oversight to assure public confidence, the financial markets will embrace new technologies such that the US markets will grow and strengthen. Specifically we need leadership from Congress on a couple of issues.

First we need Congress to set the tone for the regulators and the market on the use of technology and limit attempts to frustrate technology's proliferation. It is our experience that the market centers with rule making and enforcement authority will use it to retard the introduction of technology if it encroaches on the economic advantages of certain participants to the detriment of all users. It is also our experience that the regulators take an accommodating stance with the market centers when these issues arise. Congress needs to make clear to the regulators and the markets that technologies to enhance the workings of the US markets should be allowed absent clear evidence that using the technology will undermine the integrity of the markets. The burden of proof to demonstrate the risks of the technology should be on the market center.

Second, there is clearly systemic risk in the markets for OTC trading since the trades are not processed through a clearing house. History shows that clearing houses proliferated in the futures markets only after they became a requirement for registration as an "approved contract market" under the Commodity Exchange Act. In addition many of the innovations in the nation's securities markets and related clearing mechanisms did not occur until after the 1975 Act Amendments to the Securities Exchange Act.

Only Congress can deal with this tricky issue.