TESTIMONY

of

Scott Gordon

Chairman of the Board of Directors

Chicago Mercantile Exchange

Before the

Committee on Agriculture, Nutrition and Forestry

United States Senate

February 10, 2000

TESTIMONY

OF

Scott Gordon

Chairman of the Board of Directors

Chicago Mercantile Exchange

Introduction

Chairman Lugar, members of the Committee, I am Scott Gordon, Chairman of the Board of Directors of the Chicago Mercantile Exchange (CME). The Exchange welcomes this opportunity to offer its view of the "Report" of the President's Working Group on Financial Markets. I want to begin by unequivocally expressing our support for the efforts of the CFTC, under Chairman Rainer, to reexamine and reassess the regulatory structure of our industry. The Commission's initial revisions to its thick white book of regulations demonstrates a commitment to bring regulatory burdens into line with regulatory needs. That said, and without criticism of our regulator's endorsement of the Report, it is fair to say that the CME is extremely concerned. It is clear to us that the Report's proposal unjustifiably tilts the playing field against existing exchanges.

The Chicago Mercantile Exchange, the Chicago Board of Trade and the New York Mercantile Exchange have been working for some time to change the underlying philosophy of financial service regulation. During 1999, we presented a five-part program for CFTC reauthorization. We agreed that OTC markets suffer from legal uncertainty that should be resolved by changing the Commodity Exchange Act. We supported legal certainty for privately negotiated over-the-counter transactions, sought major revisions to the Shad/Johnson Accord, and called for rationalization of regulation for the entire financial services industry.

However, we urged that any legislation should be fair and even-handed. Our goal was equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. After careful assessment of the Report of the President's Working Group on Financial Markets, we are disappointed that our efforts to create a fair and level playing field have not been rewardedheeded(?).

While the Working Group recognizes the regulatory disparities and blurred product distinctions that handcuff U.S. futures exchanges in today's competitive global market, the Report does almost nothing to address those issues. This omission is a serious flaw. The Report calls for some changes that are in accord with our principles;, however, its recommendations for regulatory relief and legal certainty will immediately benefit the over-the-counter market and enterprises that operate unregulated exchanges without timely relief for us.

The Report begins with a conservative call for legal certainty for OTC swaps. It veers from that simple principle to a radical realignment of markets and regulators by redefining a swap to include standardized, cleared, futures contracts traded on exchanges regulated by the SEC or by bank regulators. The call for legal certainty for a bilaterally negotiated contract has been converted into a demand for the exclusion from the CEA of exchange traded and cleared financial futures.

Bilateral Financial Derivatives:

The PWG's recommendation for legislative action is:

"An exclusion from the CEA for bilateral transactions between sophisticated counterparties (other than transactions that involve non-financial commodities with finite supplies)"

The PWG minimizes the impact of its proposal, claiming: "This recommendation provides greater legal certainty and removes doubts about enforceability, making the U.S. a more attractive derivatives market." We think the proposal in its current form has far more serious jurisdictional and market fairness consequences than are described.

The exchanges do not object to an exemption from the CEA for true bilateral OTC transactions in financial instruments. We have, however, questioned the purpose of an "exclusion" rather than an exemption. The PWG recommends that excluded swap agreements may be fungible and cleared by a clearinghouse that is not regulated by the CFTC. This recommendation obviously strips the Commission of jurisdiction over instruments that are indisputably futures contracts.

The PWG's proposed exclusion overrides 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.

If equity swaps are excluded from the CFTC and the CFTC's exclusive jurisdiction is eliminated, these products could be claimed by the SEC jurisdiction. The PWG's suggestion that it is deregulating the OTC market needs to be carefully parsed. In fact it may only be stripping the CFTC of its jurisdiction over equity derivatives and paving the way for the SEC to take over the market.

Electronic Trading Systems

The PWG's recommendation for legislative action is:

"An exclusion from the CEA for electronic trading systems for derivatives provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts that involve non-financial commodities with finite supplies."

The Working Group advocates a complete exclusion for certain principal-to-principal transactions executed by means of electronic trading platforms that are indistinguishable from the trading systems used by the CME, the CBOT and NYMEX. The Working Group recommends distinct regulatory treatment of principal-to-principal exchanges and agency exchanges, but does not advance a compelling policy argument to support the distinction. In fact, all transactions at the CME and at the CBOT are also on a principal-to-principal basis. Both exchanges deal work directly only with their own clearing members and not with the ultimate customers of those members. There is no difference between a trade doneexecuted for the member's account and a trade executed for the account of a member's customer.

The existence of an agency relationship between a customer and its futures commission merchant is relevant to the question of the degree to which the firm that places the order, the customer's agent, ought to be regulated. It has no logical bearing on whether the exchange on which the order is executed needs to be regulated.

Moreover, it is often the case that contracts entered into by a principal on a principal exchange are immediately transferred to a customer. The PWG's proposal of distinctly different regulatory treatment for exchanges that permit intermediaries to represent customers and exchanges that require intermediaries to trade for their own accounts and then do a back-to-back transaction with the ultimate customer is not logical. It is clear that the customer of a dealer trading on a principals only exchange is inherently less advantaged than the customer of an intermediary trading on an exchange like the CME.

The PWG concludes the electronic trading systems are good for OTC derivatives without questioning whether it is logical to refer to exchange traded derivatives as if they were still over-the-counter products. The PWG recommends that most financial derivatives, including swaps on single equities, or single stock equity futures in our parlance, be excluded from the CEA if traded on an exchange that requires all trades to be on a principals only basis. The result will be, that dealers and large customers will be able to trade single stock futures on an exchange so long as it is not a futures exchange regulated by the CFTC. In effect, this provision constitutes a de facto transfer of CFTC jurisdiction over exchange traded equity based derivatives to the SEC.

Treasury Amendment:

On the positive side, the Working Group's proposal will seek clarification of the Treasury Amendment to reverse the interpretation that it exempts all transactions by unsophisticated investors in foreign currency futures from the protections of the Commodity Exchange Act. We strongly support this clarification, which we believe will help to control the meteoric growth of Internet-based bucket shops that have been defrauding the American public.

The PWG's exact recommendation for legislative action is:

"A clarification of the Treasury Amendment that clears the way for the CFTC to address the problems associated with foreign currency 'bucket shops' and excludes all other transactions in Treasury Amendment products from the CEA, unless they are conducted on an organized exchange."

That benign sounding recommendation also hides a wholesale realignment of CFTC jurisdiction and a major concession to foreign currency dealers, the bond dealers and securityies dealers. The PWG, while proposing to restore the CFTC's jurisdiction over bucket shops, carves out a special exemption for derivative exchanges operated by an entity that is supervised by the SEC or bank regulators or an entity that is affiliated with such a regulated or supervised entity. This means that an affiliate of a broker-dealer, that is not itself regulated by the SEC, can operate an exchange for foreign currency futures transactions outside the jurisdiction of the CFTC. The PWG's recommendation suggests a philosophy that the CFTC should be stripped of all jurisdiction over any entity that is even tangentially related to a bank or a broker-dealer. This far-reaching proposal to transfer jurisdiction to the SEC and bank regulators is not even explained.

In addition, The PWG's definition of "organized exchange" is "an exchange that is open to retail or agency transactions and that serves a self-regulatory function . . . ." This language permits an exchange, identical to the CME in every way except that it does not maintain a surveillance and compliance department, to trade and clear currency and government security futures without any CFTC regulation. No logical explanation is offered to support this strange position. If the PWG's recommendation were based on regulatory principle, rather than jurisdictional realignment, it would be required to approve complete deregulation of the CME's currency futures if the CME agreed not to exercise any form of self-regulation in that market.

Clearing:

The Report recommends that Congress "enact legislation to provide a clear basis for the regulation of clearing systems that may develop for OTC derivatives." The CME supports the concept but suggests that it be expanded to permit fair competition among clearing systems and to give market users a free choice among providers of clearing services. The Report suggests that SEC and bank regulated clearing houses be permitted to clear both the cash and derivative instruments. CFTC regulated clearinghouses would be limited to derivative contracts. This allocation of power and responsibility will preclude effective competition among clearinghouses and drive business toward those clearinghouses that are entitled to clear the largest base of products. We believe that market users - not Congress or the PWG -- shouldshould make the choice of clearing agency, not Congress or the PWG.

Hybrid Instruments:

The Working Group recommends, "enactment of a provision to clarify that the Shad-Johnson Accord shall not be construed to apply to hybrid instruments that have been exempted from the CEA." This proposal will permit banks to issue CD's whose value fluctuates as if the CD were a fully margined futures contract on a single stock. The CME does not oppose such instruments or their issuance by banks. It objects to banks being able to sell and trade futures contracts on single stocks while that privilege is denied to futures exchanges.

Miscellaneous:

Finally, the Working Group does not deal withaddress one of our objectives for reauthorization. We proposed that access to derivatives exchanges be expanded by permitting banks and broker-dealers to deal in futures contracts without separately registering with the CFTC. We remain convinced that the legislative program we put forward is an important proposal that reflects sound public policy. We will continue to work for legislation that incorporates our proposal.

Conclusion:

Although we are frustrated with the one-sided recommendations in this Report, we will continue to support fundamental fairness in any legislation to reform the U.S. regulatory structure. Congressional leaders have demonstrated their commitment to tackling some difficult market disparities, and CFTC Chairman Rainer highlighted his support for serious reform in a recent speech to industry leaders in Chicago. We hope to work with the President's Working Group and Congress to provide that kind of comprehensive reform of the risk management markets.

The CFTC, under Chairman Rainer, has demonstrated it is prepared to move toward justified exemptions for financial products traded on our exchange. We are concerned, however, that regulated exchanges will remain at a severe competitive disadvantage unless and until parity of regulation is achieved. If the Working Group's recommendations are adopted without corresponding relief for regulated exchanges, the balance will be swung irretrievably against parity of regulation.