Testimony of

James J. McNulty

President and CEO

CHICAGO MERCANTILE EXCHANGE

Before the

Subcommittee on Research, Nutrition

and General Legislation

Senate Committee on Agriculture,

Nutrition and Forestry

March 20, 2000

Testimony of James J. McNulty

On behalf of the

Chicago Mercantile Exchange

Introduction

Chairman Fitzgerald, committee members, ladies and gentlemen, I am James J. McNulty, president and chief executive officer of the Chicago Mercantile Exchange since February 7, 2000. Obviously, I come to this hearing with a very short history at the Exchange. However, I have had 25 years of experience in the full range of financial markets. I have traded or supervised trading in all financial futures and options; I am sensitive to the needs and expectations of over-the-counter markets; I appreciate the impact of technology on the future of the financial services industry. I hope my testimony reflects that sensitivity.

The CME is exceptionally encouraged by the CFTC Staff Task Force Report, A New Regulatory Framework. The Commission has been both responsible and responsive to the concerns of all elements in the financial services industry. We are pleased by the tone of the proposal, which is consistent with a progressive regulatory philosophy that depends on oversight and competition among markets rather than prescriptive regulation of protected market spaces. The CFTC staff, under Chairman Rainer, has demonstrated a deepening understanding of the complex technological and competitive issues facing our markets and a commitment to providing much needed regulatory relief. I will discuss our view of the details of the report and suggestions for implementing it below.

We are less sanguine about reform of the Shad/Johnson Accord. Eighteen years ago the Shad/Johnson Accord divided jurisdiction between the SEC and CFTC and included a temporary ban on most equity futures contracts. That temporary ban lasted 18 years during which time single stock futures have thrived in the OTC market in the form of equity swaps and on option exchanges in the form of synthetic futures. Recently the President's Working Group and congressional leaders called for an end to the ban.

On December 17, 1999, Chairman Lugar (Senate Agriculture Committee) and Chairman Gramm (Senate Banking Committee) asked Chairmen Rainer and Levitt for a "detailed report addressing the desirability of lifting the current prohibition on single stock futures together with any legislative proposals . . . no later than February 21, 2000. On January 20, 2000, Chairmen Combest, Ewing and Bliley asked the SEC and CFTC to create a "joint legislative plan for repealing the current prohibition on single stock futures . . . no later than February 21, 2000." On March 2d, Chairmen Levitt and Rainer responded by presenting "the current views" of the agencies.

Of course, we are pleased that the agencies have agreed that it is appropriate that U.S. exchanges be permitted to compete in world markets and offer U.S. customers the opportunity to manage risks by means of equity futures contracts. We are also pleased that they have found a way to accommodate their jurisdictional and regulatory concerns on several important issues. But it is far too late in the game to be satisfied with signs of progress. We share Senator Lugar's "disappointment" that the agencies were unable to resolve all of their jurisdictional concerns within the time frame requested.

The agencies have not committed to submitting the requested comprehensive legislative proposal in time to include it in the regulatory reform bill that will be considered during this session. If that bill permits the over-the-counter market free reign in equity swaps and permits OTC dealers to set up electronic markets to trade single stock equity futures as has been proposed, we will be placed at an even greater disadvantage than we suffered in the past. We favor legal certainty for the OTC market, but it is essential that regulatory parity and complementary relief be given to the futures exchanges contemporaneously with the relief granted to our direct competitors. We agree with Senator Lugar's assessment that, "delaying the resolution of this issue until October puts into serious doubt whether Congress can enact legislation this year to re-authorize the Commodity Exchange Act and to implement the President's Working Group findings on over-the-counter derivatives."

I would like to put my conclusions in context by briefly reviewing legislative and regulatory history, discussing business conditions and trends, discussing our reaction to some key points of the report, and giving you a clear statement of our overall position. Bottom line, I urge that the Report be the basis for a legislative overhaul of the CEA and that elimination of the Shad/Johnson prohibition against single stock futures be an integral part of that legislative package.

Legislative and regulatory framework

The history of the Commodity Exchange Act is often misconstrued to support arguments that derivative contracts traded by banks, broker - dealers, or unregulated OTC dealers are beyond the jurisdiction of the Commission. In fact the CEA's purpose was to force all derivative agricultural contract to be executed subject to the rules of a designated contract market. When the CEA was amended to create the CFTC, its scope was broadened by amending the definition of a commodity to include "all other goods and articles, except onions . . ., and all services, rights and interests in which contracts for future delivery are presently or in the future dealt in." This change brought all derivative contracts under the aegis of the Commission.

In retrospect, it is clear that Congress did not foresee development of an immense off-exchange market for individually tailored and negotiated, "contracts for future delivery" among sophisticated counter-parties, i.e., "swaps." While such contracts are literally governed by the CEA, they were not candidates for exchange trading nor was there good reason to ban them. In 1989, the Commission declared that it would not enforce the CEA against swaps transactions between qualified parties. The Commission was unable to exempt such contracts from the exchange trading requirement of the CEA before the 1992 addition of section 4(c) to the CEA. The Commission hastily granted unambiguous regulatory relief to the swap market after the amendment.

The current regulatory structure places U.S. regulated futures exchanges at a significant disadvantage to off-shore competitors and the domestic OTC market. Overly detailed regulation of futures exchanges increases direct costs and time to market of innovative products. Our business space is constricted by the artificial constraints imposed by Shad/Johnson. OTC competitors are converging with futures markets in all respects other than regulatory burdens. Although the CFTC exemption that permits the OTC market to do swaps business precludes mimicking futures exchanges, we see auction markets for standardized futures contracts cloaking themselves in the mantle of the OTC market and avoiding any regulatory response.

Business Conditions and Trends

Regulatory policy in the futures industry was crafted on the presumption that the business was not portable. Recent massive business shifts have demonstrated the fallacy of that presumption. The dominance of U.S. futures exchanges has eroded. Their ability to compete with the over-the-counter market and foreign exchanges has been hampered by U.S. regulatory policy. Some governments have quickly and accurately balanced legitimate business needs against customer and market protection. London's exchanges have been freed from the pre-approval process. Singapore's regulator expedites approvals when international competition is at stake. U.S. exchanges have been kept waiting for regulatory relief. In contrast to the treatment of exchanges, the CFTC speedily exempted most of the OTC derivatives market from oversight and regulation immediately after authorizing legislation in 1992. Growth in the OTC market has been staggering compared to growth of exchange traded derivatives. Foreign exchanges have caught and surpassed U.S. markets.

Advances in communications and information management have changed the face of the industry and outrun the policy that had been used by the CFTC to shape the regulatory landscape for financial products. A number of jurisdictions recognized this change and crafted their tax and regulatory policies to capture business. Because of the importance of international financial transactions to London, it adopted a regulatory system that facilitates the operation of futures markets. In London, recognition of the realities of international business flows combined with a "…benign political attitude permits an accommodating tax and regulatory framework and a relatively predictable and sensible legal system." London profited from the restrictive policies in the USA, which reinforced London's comparative advantage as a benign location.

Twenty- five years ago, New York State, New York City and the New York Stock Exchange learned this lesson in a less technological environment. Each acted as if the local monopoly on securities trading was secure. Market users found a remarkably simple solution. They boarded the subway, traveled under the river to New Jersey and completed their transactions on the station platform less than a mile away. Burdensome transfer taxes and restrictions on certain block trading practices were avoided. Eventually the New York Stock Exchange and its overseers recognized market realities and removed these restrictions.

International networks have replaced the subway. Encrypted communications and secure fund transfers coupled with international depositories and clearing organizations have written finis to local market monopolies. Not even the almighty dollar anchors business transactions to this jurisdiction. The vast store of capital on deposit in Europe has eliminated the local advantage. Investment capital moves based on the London inter-bank offered rate, not U.S. interest rates.

The U.S. futures industry operates in a global economy where the primary competitors are unregulated, like the over-the-counter market, or regulated by governments and agencies intent on promoting domestic financial markets, like London, Singapore, Brazil, and now France. We must follow those examples or watch further erosion of market share.

CFTC Task Force Report

On February 22, 2000, Chairman Rainer sent the report of the CFTC Staff Task Force, titled A New Regulatory Framework to Senator Richard G. Lugar, Chairman of the Senate Committee on Agriculture Nutrition and Forestry and Representative Larry Combest, Chairman of the House Committee on Agriculture. The report reflected comments from exchanges, agricultural groups, FCMs and participants in the OTC market.

The report suggests use of the Commission's exemptive power to create a regulatory environment that will permit the industry to accommodate itself to real world conditions. The goal was to move the agency toward an oversight standard and to limit regulation to the extent necessary to accomplish legitimate regulatory goals. The degree of regulation will be directly related to the characteristics of the product (whether it is manipulation proof) and the type of customer that has direct or indirect access to the market (markets with retail customers must endure more regulation). The Commission will not discriminate against open out-cry markets in favor of electronic systems.

The staff proposes a self-executing exemption from everything other than fraud and manipulation prohibitions for exchanges that trade manipulation proof products, like the Bonds and the Eurodollar, and that limit access to institutional traders (MTEF). This will permit the CBT or the CME to set up an unregulated subsidiary without any CFTC approval or regulatory oversight. That subsidiary will be protected from other regulators and state lawmakers by the Commission's exclusive jurisdiction and the preemption provision of the CEA. This proposal offers the regulated exchanges a fighting chance to respond to exchanges, like Blackbird, that are now operating outside the CEA with the tacit consent of the Commission.

Any exchange that meets the requirements for an MTEF exemption could become a Derivative Transaction Facility (DTF) and subject itself to slight CFTC regulation. The CFTC believes that there are significant benefits, such as eased access into foreign countries and greater appeal to certain customers, of being "recognized" and lightly regulated by a federal agency. In addition, a DTF is open to retail customers that are intermediated by an FCM.

The staff also recommends that an exchange operated for commercial users of the traded products may qualify for DTF treatment even if the underlying products are not free from the risks of manipulation. This exemption is tailored to the burgeoning internet trading systems for electricity, pulp, etc commercial products that are used by businesses. Many of these exchanges are now focussed on spot transactions, but expect to transition to forwards and futures in the near future. The facilitation of growth of these niche markets as unintermediated, stand-alone operations increases competition.

All designated contract markets qualify as Recognized Futures Exchanges (RFEs). An RFE will be subject to oversight regulation requiring performance in accordance with 15 core principles rather than the prescriptive regulation that now characterizes the Commission's approach.

Clearing

The staff proposes that clearinghouses "that clear transactions executed on an RFE or DTF be authorized by the Commission." This proposal appears to give CFTC regulated clearinghouses the exclusive right to clear such exchanges. However, staff recommends that the Commission find a way to "authorize" without regulating DTF clearinghouses authorized by the SEC, Federal banking regulators, or an approved foreign authority.

Staff proposes to permit bank regulators, the SEC, or approved foreign regulators to govern clearinghouses that clear exempt products or exchanges, like Blackbird. A clearinghouse that clears agriculture derivatives or an exchange with direct or indirect retail customers must be regulated by the CFTC. This feature of the proposal raises significant competitive concerns.

The proposal permits exempt futures exchanges (MTEFs) to clear their futures contracts through SEC, bank, or foreign regulated clearinghouses. The staff has recommended that the Commission extend this leeway to institutional futures exchanges (DTFs). We will be concerned if SEC and bank regulated clearinghouses are able to clear cash, securities and futures under one roof while that privilege is denied to our clearinghouse.

Intermediaries

The CFTC staff responded positively to our call to permit broker-dealers and banks to send institutional business to designated contract markets without subjecting themselves to duplicative CFTC registration. Unfortunately, staff proposes to limit this relief to the DTF category of futures exchange. It is not clear that retail customers would be subject to increased risk of any sort if institutional customers could more easily participate in the same market. We would argue that retail customers will benefit from a broadening of the market and the increased liquidity and transparency that usually follow.

Swaps

The exemption for OTC dealers engaged in bilateral transactions with "appropriate persons" is retained. However, OTC dealers engaged in bilateral transactions under Part 35 would be permitted to clear the contracts without losing the exemption. The Part 35 swap exemption is superseded with respect to products like the bonds and the Euro. To the extent that the underlying commodity is manipulation proof, OTC dealers need not rely on Part 35. They will be permitted to set up the equivalent of an exempt exchange and trade fungible products through the facilities of an MTEF.

Treasury Amendment

The CFTC proposal should end all arguments in favor of expanding the scope of the Treasury Amendment. The proposal will permit anyone to set up an institutional futures market involving non-manipulable products and completely escape CFTC regulatory jurisdiction. Brokers will be able to operate electronic systems to deal with their institutional customers. Groups of brokers can set up futures exchange look alikes and escape regulatory jurisdiction. In essence, the CFTC offers the OTC market complete legal certainty for exchange trading and clearing of all manipulation proof products except equity swaps. This is as far as Congress should be prepared to go. Proposals to permit exempt retail futures exchanges in Treasury Amendment products are contrary to the intent and purpose of the CEA. We support the CFTC proposal as an alternative to the PWG proposal to amend the Treasury Amendment.

Timing and Content

The Task Force recommends that the Commission convert its proposal into a proposed rulemaking subject to a 60 day comment period and public hearings to "provide a full public airing of the important public policy issues . . . ." If those recommendations are followed, final rules implementing the proposal are unlikely to be adopted sooner than six months. Senator Lugar has indicated that the Commission's recommendations may provide a basis for drafting amendments to the CEA. We agree that the time is right to act and that legislation based on the principles of the report is better than rulemaking.

The Report is limited to matters fully within the Commission's exemptive powers. It does not consider Shad/Johnson reform. We believe, however, that any legislation that incorporates legal certainty for the OTC market should simultaneously deal with Shad/Johnson relief for organized markets. The President's Working Group has proposed to override Shad/Johnson restrictions that now limit OTC transactions. The PWG proposes to exclude swap agreements that "reference non-exempt securities" from the CEA. We are confounded by the irreconcilable contradiction between the Working Group's conclusion that over-the-counter swaps, including equity swaps, should be excluded from the CEA while refusing to endorse revisions to the Shad/Johnson Accord for regulated markets. There is no principled reason to support unregulated, over-the-counter trading in a product while refusing to permit identical products to trade in the well regulated, price-transparent and liquid environment provided by the CME.

Resolution of Shad/Johnson Issues

Eighteen years ago, the Shad-Johnson Accord resolved a jurisdictional conflict between the SEC and the CFTC. It was not intended as a permanent barrier to innovation and growth. Stock index futures have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements. The options markets and swaps dealers offer customers risk management tools and investment alternatives involving both sector indexes and single stock derivatives. Futures exchanges have been frozen out.

The reasons advanced against reform of Shad-Johnson disguise competitive and/or political concerns. Today, Shad-Johnson is being used as a weapon against competition. The SEC, through statutory misinterpretation and, what a court has found to be at best "arbitrary and capricious," and at worst "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. The SEC has 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 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.

Congress intended the Shad-Johnson ban on single stock futures to be temporary. The court of appeals found that 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. customers and markets the same opportunity.

An appropriate division of responsibility between the SEC and CFTC for futures trading of contracts currently prohibited by the Shad/Johnson Accord may be directly derived by determining how a futures contract can be used to avoid prescriptions of the Securities Acts. In all such cases, it is reasonable to amend the Securities Acts to treat a futures contract as if it were an option on a security for enforcement purposes. We agree that the integrity of the Securities Acts require that futures contracts should not be used to avoid the following prescriptions of the Securities Acts:

Federal Reserve margin setting authority and oversight;

Insider trading;

Short swing trading;

Front running (a program is already in place);

Manipulation of securities prices;

Protection of pricing and integrity of tender offers (Section 14);

Protection of pricing and integrity of public offerings;

Avoidance of the economic risk of compelled holding of a security, e.g., lockups (although the OTC market regularly permits persons who are locked into a security position to eliminate the risk of that position);

Trading during a regulatory market halt;

Circuit breakers;

Trading suspensions or halts;

Emergency declarations;

Any similar prescription to be identified.

The CME's goal is freedom to list and trade futures contracts now forbidden by the Shad/Johnson Accord without being subjected to multiple regulators and without changing the fashion in which we have conducted our business for more than 100 years. Remember, we created a tremendously useful product, equity indexes, in the face of overwhelming opposition. The SEC and its client exchanges opposed futures on indexes with all of the same arguments that they now raise against futures on individual securities. Nonetheless, equity indexes are among the most popular contracts on securities exchanges as well as futures exchanges. Futures trading of equity indexes has enhanced customer opportunity with none of the ill consequences predicted by the SEC or securities exchanges. In fact, their business has directly benefited.

This division of responsibility between the SEC and CFTC, which I have proposed, will eliminate competitive barriers that injure public customers. It will not protect futures exchanges or securities exchanges against any legitimate competitive advantages of the other. We are prepared, however to deviate somewhat from the strict logic behind this principle in order to resolve the most contentious objections. For example, it is clear that the option exchanges now have sufficient power and authority to employ a risk based margining system. Competitive concerns have stopped them from acting prudently and in the best interests of their customers. However, because equivalent margin is a "deal-breaker," we are prepared to accept margin equivalence between a short option traded on an option exchange and a futures contract on the same stock traded on a futures exchange. Moreover, we are prepared to limit futures contracts on individual securities to those that meet option listing standards.

Conclusion

One year ago, the Chicago Mercantile Exchange, with the Chicago Board of Trade, undertook to craft amendments to the Commodity Exchange Act that would enhance competition and customer opportunity. We proposed five principles and a long list of detailed proposals. With much work we were able to find a way to rationalize the CEA to restore internal consistency in concert with sound public policy. Within our framework, each segment of the industry, other than security exchanges, which seek protection from legitimate competition, got exactly what it had been publicly seeking. Our proposal went farther than the OTC request for codification of the swaps exemption. We proposed that swaps could be cleared without losing their exemption. We were diligently following advice of congressional leaders that we needed to gain sufficient support from the derivatives industry to insure passage of much needed reform legislation. We proposed a five-part plan:

Convert the CFTC to an oversight agency;

Reform Shad/Johnson constraints;

Expand access to futures markets;

Provide legal certainty to OTC markets; and

Level the regulatory playing field.

We continue to believe that the joint exchange proposal is the best formulation for regulatory relief. However, we are well aware that legislative and industry consensus in favor of a good plan trumps our theoretically better plan. We are prepared to join the consensus and give up our plan in favor of the CFTC staff proposal if we can secure Shad-Johnson relief and fix some of the minor flaws of the CFTC plan, noted above. We believe that the CFTC Staff Report can be the basis for legislation that will be fair and even-handed. Our goal was and remains equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. If we can get to that goal by the path of the CFTC's proposal, then let us proceed with all haste.