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Committee on Financial Services

United States House of Representatives

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I am Mark Young, a partner in the law firm of Kirkland & Ellis. I am pleased to appear before this Committee to present the views of our client the Board of Trade of the City of Chicago on H.R. 4203, and related issues.

As background for this Committee, let me put the Board of Trade’s current business situation in perspective. For many years, the U.S. futures markets were the only game in town. Any business that wanted to hedge price risk used the futures exchanges. Competition existed. But that competition was among U.S. exchanges that were all regulated the same way by the same agency under the same law.

In the past decade or so, that has all changed. Banks began to offer risk management products called swaps that are tailored to a client’s specific needs. These products are now so popular that the swaps market is at least six times larger than the exchange markets. At the same time, foreign exchanges copied the U.S. exchanges’ business and set up their own exchanges under much more hospitable regulatory circumstances. Now foreign exchanges and U.S. exchanges directly compete in the global economy for trading capital and market share. Every day, foreign exchanges are gaining ground and one even has surpassed us.

That one exchange, the Swiss-German exchange known as EUREX, also shows the power of electronic trading as an alternative to physical auction market trading. Technology also has been a major contributor to the globalization of these markets by shrinking the world to a global economic village. And electronic trading capabilities have eroded or erased many of the traditional distinctions between banks, brokerage firms and exchanges.

Recognizing these forces, the Board of Trade knows it needs to change to survive competitively. It knows that it must adapt to technology and incorporate all aspects of the new economy into its operations. It knows that it must restructure itself into a lean, mean, thriving for-profit business enterprise that is ready to take on all comers. And it knows that it needs to continue to provide safe and liquid markets at low cost in the most financially secure environment offered anywhere in the world.

Faced with these new market realities, the Board of Trade and other exchanges will change how they do business in order to be better able to compete. Regulation is part of that competitive equation. A trio of recent government reports uniformly conclude that federal law must be changed to give the U.S. futures exchanges a fair chance to compete.

In November of last year, the President’s Working Group on Financial Markets analyzed whether the Commodity Exchange Act’s current provisions adequately addressed today’s derivatives markets. The Working Group’s conclusions are important. It found:

  • The CEA’s seventy-year regulatory structure has not adapted well to today’s derivatives markets;
  • Separate government oversight should be afforded for the important transaction clearing function;
  • Legal uncertainty in the OTC market was contributing to enhanced systemic risk; and
  • U.S. futures markets now suffer two major competitive handicaps that should be rectified – outmoded, costly regulation and a ban on trading of futures on single securities, the so-called Shad Johnson ban.

In February of this year, the Commodity Futures Trading Commission began to address the regulatory disparity facing exchanges. Spurred by the Working Group’s Report and under the leadership of new Chairman Bill Rainer, the CFTC staff task force outlined a streamlined and modernized approach to regulation that relies on effective exchange self-regulation to satisfy performance standards embodied in core principles, rather than government edicts. This enlightened and flexible approach mirrors the regulatory stance regulators overseas have adopted toward their exchanges. The CFTC’s new framework would give U.S. futures exchanges a real opportunity to regain lost ground without sacrificing market or financial integrity.

Just last week, the General Accounting Office submitted its report to Congress on the Shad-Johnson Accord. GAO analyzed whether U.S. securities, foreign futures and over-the-counter markets trade stock-based derivatives that are economically similar to the futures the U.S. exchanges are prohibited from trading by the Accord. The GAO’s answer was "yes." Specifically, GAO found that the "OTC derivatives market offers stock-based derivatives … [that] serve economic functions similar to those served by the stock-based futures that are prohibited under the accord." (GAO Report at 13) To remove that competitive unfairness, GAO recommended that Congress, the CFTC and the SEC work together to lift the ban and provide appropriate regulation for these instruments.

For many years, the Board of Trade has recommended that Congress enact legislation to codify each major element of these reports. Only that kind of comprehensive reform of the Commodity Exchange Act will rectify the current level of regulatory arbitrage and allow competition on the merits, not regulatory disparities, of various derivative products. Therefore the Board of Trade has urged Congress to take action on three fronts:

  • Identify when derivative transactions are and are not subject to the Commodity Exchange Act
  • Modernize regulation of exchange-trading under that Act by transforming the Commodity Futures Trading Commission to an oversight agency
  • Free U.S. futures exchanges to trade securities-based futures that are barred under the supposedly "temporary" Shad-Johnson prohibition Congress enacted in 1982.

Both the Senate and House Agriculture Committees are working on this kind of comprehensive legislation. Its introduction is expected in the near future. The Board of Trade strongly favors legislation that addresses each of these three areas simultaneously. We believe the time is right for Congress to enact such legislation this year.

That is our principal concern with HR 4203. Providing clearing oversight for all derivative transactions is sound policy so long as one kind of clearing entity is not favored over others. HR 4203 would allow banks, futures clearing houses, securities clearing agencies and even foreign clearing facilities to clear OTC derivatives. That kind of institutional regulation approach seems fair and even-handed. But clearing is only one aspect of reform. It should not be addressed in isolation. It should be part of the comprehensive bill.

In any event, one area you may want to reconsider relates to foreign clearing entities. The bill would allow an unspecified "appropriate Federal financial regulatory agency" to certify that the foreign entity satisfies the necessary standards. Leaving that important determination in a statutory jump ball posture could lead to forum shopping at best and legal uncertainty at worst if different agencies reach different results.

HR 4203 also tries to achieve legal certainty for certain so called over-the-counter derivative transactions. This is quite problematic for a number of reasons. First, it serves up a feast of conflict of law problems that would need costly and time-consuming litigation to resolve. Second, the bill infers that it is trying to change the jurisdiction of the CFTC and the coverage of the CEA in all areas except for derivatives involving non-financial commodities with finite supplies. Congress should change an agency’s jurisdiction, and a statute’s coverage, directly and clearly. Otherwise legal uncertainty is bound to be increased, a strange result under a provision designed to end legal uncertainty. Third, the bill attempts to mandate a construction of the CEA that is at odds with its provisions. For example, the bill offers to disguise an electronic board of trade or multilateral transaction execution facility as a "financial electronic trading system" in the hope that some court down the road will not be able to see its true identity. In addition, the CEA determines coverage based largely on the nature of the instrument traded by asking the question: "is it a futures contract?" As a result, any rule of construction that focuses on where something is traded simply misses the mark.

Mr. Chairman, the Board of Trade has made no secret of its strong interest in having Congress enact this year comprehensive reform of the Commodity Exchange Act. The Board of Trade needs that kind of reform as much, if not more, than other stakeholders in this process. We will continue to work diligently with this Committee and others to achieve a fair and forward-looking legislative package that will strengthen our markets and serve well the interests of all market participants. We encourage this Committee to work with the Agriculture Committee to accomplish that goal.


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