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Committee on Financial Services

United States House of Representatives

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Testimony of

Terrence A. Duffy

Vice Chairman

CHICAGO MERCANTILE EXCHANGE

Before the

Committee on Banking and Financial Services

U.S. House of Representatives

April, 11, 2000

 

Testimony of Terrence A. Duffy

On behalf of the

Chicago Mercantile Exchange

Introduction

Chairman Leach, committee members, ladies and gentlemen, I am Terrence Duffy, Vice Chairman of the Chicago Mercantile Exchange. Our Chairman, Scott Gordon, asked that I express his regrets that he was unable to attend. I have been a member of the Chicago Mercantile Exchange since 1982. I was first elected to the Board of Directors in 1994 and am serving my third term as Vice Chairman. I am President of TDA Trading Inc. and an independent floor broker and trader. I have led the CME’s efforts to embrace new trading technologies. I appreciate the impact of technology on the future of the financial services industry and I am sensitive to the needs and expectations of over-the-counter markets. I hope my testimony reflects that sensitivity.

Chairman Leach asked that we focus on financial derivatives and present our view on the regulatory challenges and opportunities created for futures exchanges by the report of the President’s Working Group on Financial Markets.

The current regulatory structure places U.S. regulated futures exchanges at a significant disadvantage to offshore 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 was intended to preclude 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.

We realized at an early date that the Commodity Exchange Act should be amended to permit privately negotiated over-the-counter, financial derivative transactions without fear that the contract would be invalidated as an illegal off-exchange futures contract. We supported the provision of the Futures Trading Practices Act of 1992, by which Congress granted the Commission power to exempt swaps and other derivatives from the exchange trading and other requirements of the CEA.

We have responded to changing conditions in the OTC market and are currently proposing amendments to the CEA that would transform the exemption for OTC transactions into an exclusion and greatly expand its scope to permit clearing and electronic trading of financial derivatives among sophisticated parties without running afoul of the CEA. In this, we support the principles of the Working Group. While we support the goal of legal certainty for the OTC we do not agree with the special interest provision of Working Group Report that permits certain entities to run unregulated futures exchanges.

We also are firmly of the view that enacting the Working Group’s suggestions in isolation will unbalance the financial services industry at the expense of many participants and their customers. We have proposed a holistic approach to the problem that will bring legal certainty to the OTC market, regulatory relief to exchange markets and resolve the Shad/Johnson restriction for the OTC and exchange markets at the same time.

While we are critical of the special interest provisions in Treasury’s proposal, 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 thePWG Report, and giving you a clear statement of our overall position. Bottom line, I urge that the CFTC Staff 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. We agree that clearing should have an appropriate regulatory framework, but cannot agree with any proposal that would limit the range of clearing services that our clearinghouse can provide. The CME’s clearinghouse has been the clear industry leader in risk management and technological innovation. It is inappropriate to limit the scope of its services by legislation.

Legislative and regulatory framework

Chairman Leach’s recent remarks before the Institute of International Bankers confirm this Committee’s deep understanding of the arcane issues roiling the financial services industry and its efforts to permit U.S. based financial service enterprises to compete in the global marketplace. However, our views of the history of futures regulation are subtly different.

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 original purpose of the commodity laws 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, including OTC derivatives, under the aegis of the Commission.

In 1974, Congress expanded the Commodity Exchange Act to apply to futures trading in all commodities, including financial futures. This was a direct response to the CME’s creation of the International Monetary Market, an unregulated exchange for the trading of financial futures. At that time, there was no OTC market for unique, privately negotiated contracts for future delivery executed between sophisticated parties. It is fair to conclude that Congress did not consider the implications of its amendment for a nonexistent OTC market. In consequence, the explicit language of the CEA required that all derivatives be traded through the facilities of designated contract markets.

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 Futures Trading Practices Act of 1992, drew a relatively clear line between swap agreements that should be exempted from the Commodity Exchange Act and those that were clearly within its scope. Congress directed the Commission:

"promptly following the enactment of this subsection . . . exercise the exemptive authority granted under paragraph (1) . . .with respect to classes of swap agreements . . . that are not part of a fungible class of agreements that are standardized as to their material economic terms . . . "

Congress made a clear determination that unique, private agreements, even if they were "contracts of sale for future delivery" should not be subject to the requirements of the CEA. We supported that amendment. Congress did not find that standardized, fungible, contracts for future delivery, traded by a push of a button on an electronic trading system, were outside the legitimate scope of the CEA. Such a finding would have effectively gutted the statute.

Given this history and the explicit Congressional findings, it is not fair to suggest that the CFTC is attempting to expand its jurisdiction by offering an exemption for trading systems that would clearly have been deemed futures exchanges under any prior reading of the CEA. No serious student of the markets has ever had the temerity to suggest that a fungible, standardized, exchange traded contract of sale for future delivery is not a futures contract simply because both traders are banks.

Congress’ direction to exempt swaps was constrained by the SEC’s concern that the Commission would use its exemptive powers to override the Shad/Johnson Accord, thereby permitting contract markets freedom to compete. The CFTC was prohibited from granting any exemption from the Accord. Thus, to the extent that a swap based on a security might be considered a contract of sale for future delivery, legal uncertainty was not resolved. Obviously, the cure for this problem is an amendment of the Shad/Johnson Accord. We agree that the swap market should be able to create single stock equity swaps, but we do not think it reasonable to permit such products in an unregulated venue while barring their trading through organized, well-regulated exchanges. We will be proposing statutory language to cure these problems.

We believe that the real concern of the banks and other participants in swap markets is not with legal certainty for swaps that are not part of a fungible class of agreements that are standardized as to their material economic terms. They have moved beyond that issue. It is clear that the major banks, investment banks and broker dealers are intent upon creating electronic trading systems to trade standardized, fungible, financial contracts. They seek to avoid CFTC jurisdiction by reference to their OTC roots rather than by logically distinguishing themselves from traditional futures exchanges. If Congress is intent upon exempting or excluding such entities from the CEA, our concern is that futures exchanges be granted identical relief. These entities do not want to fall within the jurisdiction of the CFTC. They wrap themselves in the language of the over-the-counter market and refer to the contracts as swaps but that does not alter the reality.

The CFTC’s pending exemptive proposal provides most of the relief sought by the OTC market, except that the CFTC lacks power to grant exemptions to the Shad/Johnson Accord. The CFTC proposes to exempt the exact class of futures exchanges that the major OTC participants wish to operate. The CFTC’s proposed exemption is not based on a finding that the product traded, or the trading and clearing mechanism are not within the scope of the CEA. It is a clear determination under Section 4 of the Act that it is not in the public interest to regulate certain markets based on the underlying commodity and character of the traders.

Of course we agree with Chairman Leach’s concern about relying on exemptions in this very important market. We intend to support legislation to codify the CFTC’s proposal. We expect that such legislation will be considered by the Agricultural Committees in the near future and that the issues raised by the banks will be resolved in that legislation. We intend to look very carefully at Chairman Leash’s proposal to try to capture all of the needed amendments in a single bill.

Legislation Embodying PWG Recommendations

On February 28, 2000, the Department of the Treasury submitted a draft amendment to the Commodity Exchange Act that embelishes the recent recommendations of the President’s Working Group on Financial Markets. We are prepared to support Treasury’s proposal to exempt or exclude privately negotiated OTC derivative transactions from the CEA. We are also prepared to support its proposal to exempt or exclude derivative transactions conducted on exchanges that are only open to principals who are eligible contract participants. We believe, however, that it is better public policy to craft an exemption from the CEA, rather than an exclusion. We also are concerned that Treasury’s draft creates some very large loopholes.

Treasury’s proposal will transfer jurisdiction and authority from the CFTC to other regulators. The definition of financial product at section 1a(12) is one of the keys to understanding the limitations on and realignment of the CFTC’s jurisdiction. The definition does not depend on whether a product is or is not readily subject to manipulation. It includes: "any interest rate, exchange rate, currency, security, security index, debt or equity instrument, or widely published index of inflation . . ." It also includes: "any other rate, differential, index, or measure of economic risk, return, or value, other than the price of, or price differential between, one or more commodities not listed [above], that have a finite supply."

A new definition of "trading facility" is included to restrict the Commission’s jurisdiction. A "trading facility" (defined at section 1a(26)) includes a designated contract market and execution systems on which every bid and offer is "open to all participants in such facility or system." Thus, systems like Blackbird, REUTERS, EBS etc. that employ credit screens to determine whether a bid or offer can be accepted appear to fall outside the definition of a "trading facility." Anyone can easily abuse this definition by arbitrarily excluding a single participant from each bid or offer. Newly added section 2a(b) excludes from the Act all transactions in a "financial product" that are between "eligible contract participants" and are not executed on a "trading facility."

Section 1a(10) defines an Excluded Electronic Trading Facility to exclude from CFTC jurisdiction certain enterprises that would otherwise be considered a trading facility. The definition is broader than the underlying definition of a "trading facility." Bids and offers on an excluded electronic trading facility can be open to each participant in the system. An electronic trading facility qualifies as an excluded electronic trading facility if its products are all "financial products" (defined at 1a(12)), and each trader is an "eligible contract participant" (defined at 1a(9)(A)), and agency trading is prohibited.

Section 2a(c) is added to create an absolute exemption from the Act for "any excluded electronic trading facility." This provision permits electronic trading of single stock futures if each participant is an "eligible contract participant" and if brokers and FCMs do not act as agents. It also permits brokers to trade for their own accounts and then do back-to-back trades with their customers.

The existing Treasury Amendment is repealed and replaced with a more expansive exemption for the trading of foreign currency, government securities, security warrants, security rights, resales of installment loan contracts, repurchase transactions in a financial product or mortgages or mortgage purchase commitments. The CFTC’s jurisdiction over these products is limited to trading on organized exchanges but does not extend to options on foreign currency traded on a national securities exchange. The limitation of jurisdiction to "organized exchange" trading effectively exempts everything other than traditional futures exchanges.

Section 1a(24) limits "organized exchange" to a subclass of "trading facilities." Therefore, if an execution system for any Treasury Amendment product, including currencies and government securites, is not classified as a trading facility, it is not subject to CFTC jurisdiction regardless of its customer base or the fact that it allows agency trades. If an electronic or pit based execution facility precludes even one participant from accepting a bid or offer, it is not a "trading facility" and is exempt for trading Treasury Amendment products. This is, purely and simply, special interest legislation with no rational policy basis.

If an exchange falls within the definition of a "trading facility," it will not be classified as an "organized exchange" unless it performs a self regulatory function and permits participation by persons who are not "eligible contract participants" or permits agency transactions. The result of this formulation is that a "trading facility" for Treasury Amendment products, which elects not to perform a self regulatory function, will escape the CFTC’s jurisdiction even if the ultimate customers are retail customers whose orders are executed by agents on the floor of an exchange. In sum, a retail trading facility with self regulation is subject to CFTC regulation while that same exchange avoids regulation by closing its compliance department. Again, no public policy rational has been advanced to support this special interest exclusion.

An exception is made to this general exclusion to permit the Commission to assert jurisdiction over bucket shops doing retail foreign currency futures business. If the operator of the exchange is not a bank, broker-dealer, futures commission merchant or an affiliate of one of those entities, the Commission regains jurisdiction.

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 futures 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). This framework 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. This proposal meets the stated needs of the OTC dealers and 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.

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 has interpreted the Accord in a manner that a court has found to be at best "arbitrary and capricious," and at worst "suspect." The SEC 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 SEC recently confirmed to the GAO that a study of the appropriate means to regulate was to be undertaken 5 years after the accord was reached. "But, according to the officials, it was never done because of the need to complete higher –priority studies following the 1987 and 1989 market crashes." 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 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 and the New York Mercantile Exchange, 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, including our proposal for legal certainty for the OTC market, 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 principles of the PWG and the CFTC staff proposal if we can secure Shad-Johnson relief and fix some of the minor flaws of those proposals. 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.

As always, thank you for your clear focus on these important issues and your commitment to the success of the U.S. financial services industry.



 

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