Testimony of

C. Robert Paul

General Counsel

Commodity Futures Trading Commission

Before the United States Senate

Committee on Agriculture, Nutrition & Forestry

Subcommittee on Research,

Nutrition, and General Legislation

March 20, 2000

Chicago, Illinois

Thank you, Chairman Fitzgerald. I am pleased to be here to testify before you on behalf of Chairman Rainer and appreciate the opportunity to discuss recent efforts at regulatory reform.

Chairman Rainer has identified three public policy goals that the CFTC should focus on in regulating derivatives markets: first, creating a comfortable climate for competition in all sectors of the industry; second, removing any regulatory barriers that hamper these markets from fully exploiting innovations in technology; and third, decreasing the level of systemic risk in domestic and international derivatives trading. To achieve these goals, it is imperative to modernize the way we regulate futures markets.

Accordingly, a staff task force of the Commission has developed a new regulatory framework that would change the regulatory structure for derivatives. The proposed framework is intended to promote innovation, maintain U.S. competitiveness, reduce systemic risk, and protect derivatives customers. Any proposal ultimately adopted will not be tailored to the desires of any special interest or driven by jurisdictional concerns. We want to find solutions that serve the public interest.

The new framework is a work in progress; it is a staff document on which there has been no Commission action. The CFTC will hold at least one public hearing on this proposal in order to get as much input as possible from markets and participants. But we also recognize that time is not our ally. In spite of the difficulty of developing answers to questions of regulatory architecture, we must work together expeditiously to reach conclusions suitable for these markets and the public interest. Technology offers us tangible benefits that are either immediate or imminent: faster and better execution; significantly lower transaction costs; cross-market clearing, netting and offsetting systems; and increased liquidity. The U.S. futures industry must embrace technology without reservation to build stronger markets if they expect to remain competitive.

Flexibility is the hallmark of the new framework. The staff's proposal recommends that the Commission replace the current one-size-fits-all regulation for futures markets with a structure that would instead apply broad, flexible "core principles," which are tailored to match the degree and manner of regulation to a variety of market structures. Under this proposal, multilateral trade execution facilities would operate in one of three categories, taking into account the nature of the underlying commodities and the sophistication of customers. While the framework invites change, it does not impose it on established futures exchanges. Existing exchanges operating as contract markets may reorganize under the terms of the framework, but they are not compelled to do so.

The framework offers three basic categories of exchanges or trading facilities correlating to a spectrum of regulation: recognized futures exchanges, recognized derivative transaction facilities and exempt multilateral trading facilities.

The category of recognized futures exchange ("RFE") would include multilateral transaction execution facilities that permit access to any type of customer, institutional or retail, and that trade any type of contract, including those that are based on commodities that have finite deliverable supplies or cash markets with limited liquidity. So these markets would include the current futures markets trading contracts on physical commodities. Because these markets trade products that may have a greater susceptibility to price manipulation and because the presence of non-institutional traders participating here raise deeper concerns for customer protection, RFEs would be subject to a higher level of Commission oversight than markets in either of the other two categories.

Nonetheless, the proposed RFE offers significant regulatory relief compared to the current requirements applicable to designated contract markets. Restrictive or prescriptive rules would be replaced with 15 broad "core principles" governing the RFE, including principles relating to market surveillance, position reporting, transparency, fair trading standards, and customer protection. Any board of trade, facility, or entity that is otherwise required to be designated as a contract market would be eligible to qualify as an RFE.

The second category, the derivatives transaction facility ("DTF"), would be subject to a lesser degree of Commission oversight. A facility is eligible to become a DTF if: (i) the contracts traded on the facility are for underlying commodities that have nearly inexhaustible deliverable supplies or for which there is no underlying cash market (e.g., weather derivatives); (ii) the contracts are determined by the Commission on a case-by-case basis to be appropriate for inclusion in this category; or (iii) only commercial traders are permitted to trade on the facility, regardless of the nature of the underlying commodity. A DTF could permit access by non-institutional traders only if those trades were intermediated by a CFTC registrant, or the DTF could choose to limit access only to institutional participants.

A DTF would be required to adhere to seven core principles, including principles relating to market oversight, transparency, and recordkeeping. Because DTFs will either trade commodities that do not raise concerns about manipulation or because they will be limited to institutional or commercial participants, DTFs are not required to adhere to core principles that apply when those conditions are not met. Consequently, the DTFs are not required to comply with core principles relating to position monitoring, customer protection or dispute resolution, among others, that apply to RFEs.

Finally, the third category, the exempt multilateral transaction execution facility ("Exempt MTEF"), would operate on an unregulated basis. This is a self-effectuating exemption for transactions among institutional traders in commodities with virtually inexhaustible deliverable supplies or supplies that are otherwise sufficiently large and deep to render a contract traded on them unlikely to be susceptible to manipulation.

These markets would be exempt from all requirements of the Act and Commission regulations except for anti-fraud and anti-manipulation. Moreover, if a designated contract market has an eligible contract and chooses to trade it on an exempt-MTEF, the MTEF would have to continue to provide pricing information to the public. The terms of the exemption would also provide that transactions consummated in reliance upon the exemption are not void as a matter of law if the exemption's provisions are violated. Exempt MTEFs would not be permitted to hold themselves out to the public as being regulated by the Commission.

Thank you again for the opportunity to testify before you today.