Chairman, Board of Trade of the City of Chicago
Before the Senate Banking, Housing and Urban Affairs Committee
Mr. Chairman, I am David Brennan, Chairman of the Board of Trade of the City of Chicago. I thank you for holding this hearing in Chicago and appreciate your interest in the vital issues now facing our nation's great financial markets.
The series of hearings this Committee has organized have centered on the enormous changes the U.S. financial markets are facing and the resulting implications for their structure and the regulatory environment. In these hearings, Mr. Chairman, you have repeatedly focused on three principles that you will use to guide your actions: fees collected for the purpose of funding regulation of the securities markets should not become sources of general revenue; let technology lead, the markets respond and then have regulation follow; and every U.S. law and regulation should be reviewed and subjected to a "value-enhancing test." That is appropriate because in today's financial markets that have virtually no national borders, U.S. markets will only remain competitive if regulation adds more value than cost to our markets.
We agree with and endorse those principles. In the futures markets, fees for funding regulation are established by the private sector to prevent the very problem you and others on this Committee are currently facing. As a result, the futures industry has consistently improved its productivity and efficiency and reduced those regulatory fees while maintaining the highest standards of integrity and customer confidence.
We have urged our regulators and our oversight Committees to avoid trying to dictate technology use, recognizing that allowing a business to respond to market demands rather than government fiat is a much more effective motivator. In addition, with today's rapidly changing technology, government regulation cannot possibly anticipate what will emerge. We hope that philosophy is embodied in any financial market legislation that Congress considers.
Finally, we agree that regulation must not add unnecessary costs if our nation's markets are to be competitive globally. Alan Greenspan summarized today's competitive landscape very well at the last Senate Committee hearing where I appeared. He said:
I cannot claim to speak with certainty as to how our complex and rapidly moving markets will evolve. But I see a real risk that, if we fail to rationalize our regulation of centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of global investors without imposing so many regulatory constraints.
My concerns on this score stem from the dramatic advances in information technology that we see all around us. In markets with significant economies of scale and scope, like those for standardized financial instruments, there is a tendency toward consolidation or even natural monopoly. Throughout much of our history this tendency has been restrained by an inability to communicate information sufficiently quickly, cheaply, and accurately. In recent years, however, this constraint is being essentially eliminated by advances in telecommunications. We have not yet seen clear evidence of a trend toward natural monopoly. But the diffusion of technology often traces an S-shaped curve, first diffusing slowly, but then rapidly picking up speed. Once we reach the steep segment of that S-curve, it may be too late to rationalize our regulatory structure.
Already the largest futures exchange in the world is no longer in the American heartland; instead, it is now in the heart of Europe. To be sure, no U.S. exchange has yet to lose a major contract to a foreign competitor. But it would be a serious mistake for us to wait for such unmistakable evidence of a loss of international competitiveness before acting. As our experience with the vast eurodollar markets demonstrates, once markets with scale and scope economies are lost, they are very difficult, if not impossible, to recapture.
We at the Chicago Board of Trade have been well aware of this threat for more than a decade and have vigorously tried to change our environment. This morning, I would like to give you a perspective on what we have done.
When the Chicago Board of Trade welcomed the new century in 1900, we were the largest of a handful of derivatives exchanges in the world. Our business was simple, and our mission was clear: provide customers with fair, efficient and liquid markets that uphold the highest levels of integrity.
Today, no fewer than 80 derivatives exchanges span the globe, and the industry has been transformed into a multi-faceted and influential market force with daunting competitive challenges at every turn. Each day these exchanges provide trillions of dollars in risk management for businesses, governments and individuals around the world. Traditional exchanges now face an onslaught of new exchanges, electronic trading networks (ECNs), and over-the-counter markets competing for the risk management business we founded in Chicago. The CBOT and other exchanges are exploring ways to appropriately restructure and modernize their organizations to meet that challenge.
Yet one element of futures trading has not changed: our mission to serve customers. As with any customer-driven business, derivatives exchanges can succeed only if their decisions and initiatives are aimed directly at giving customers what they demand and deserve. This will continue to be the case in the new millennium, as exchanges update their strategic plans to respond to the globalization, technology, and changing customer base that characterize today's derivatives markets.
As our economy becomes more global, the need for worldwide risk management services has also grown tremendously. Since 1989, futures volume on foreign exchanges has grown by 425 percent - compared with 93 percent growth for U.S. exchanges. Multinational market participants trade markets in the U.S. and around the world. As we know, national borders do not limit any market's customer base, and successful exchanges are those that take steps to cross borders and create partnerships that will bring more choices and increased efficiency to customers.
The alliance between the CBOT and Eurex, the German-Swiss electronic derivatives exchange, which we will launch in full force in mid-2000, demonstrates how exchanges are combining resources to serve customers and remain competitive in the global market. Eurex has by far the world's most extensive and reliable electronic trading network, with 5,000 screens in 16 countries worldwide. For customers, the alliance will bring CBOT products and Eurex products to the same trading platform. Having one network connection and one platform configuration to install and maintain will deliver cost savings to customers. At the same time, with the CBOT-Eurex alliance, customers worldwide will be able to send orders electronically directly to the CBOT trading floor from their trading screens.
From an electronic trading standpoint, the U.S. exchanges hear the same question at industry conferences and other events throughout the year: when will the U.S. exchanges close their trading floors and begin trading exclusively on an electronic system. At the CBOT, our answer is consistently the same, because it is the same answer any good business would give: we will provide the market the customers choose. Today, the vast majority of our customers (95 percent at the CBOT) choose to trade via open outcry. While they could choose electronic trading at the CBOT or other venues, customers choose the liquidity and overall trading efficiency of the pit - where the low bid-ask spread and access to information flow provide the most effective and cost-efficient markets in the world.
The Chicago Board of Trade will not deny the historical significance and value of our open outcry business, but we do recognize the irreversible growth of and migration toward electronic trading. For this reason, the Chicago Board of Trade provides two premier markets - one for open outcry with electronic order routing that can send orders directly to the floor from screens around the world, and one, with the CBOT-Eurex alliance, for electronic trading on the world's most popular global trading network. As a result, we will continue to provide the most effective markets to meet the needs of our customers.
But more change is necessary to maximize efficiency for customers. For many exchanges, including the CBOT, structure is one of the factors threatening their ability to provide the most effective possible markets. Exchanges serious about serving customers must be more nimble and agile in changing to meet customer needs. By moving from a mutual organization to a for-profit business structure, exchanges could be more proactive, more responsive to customers, and better able to react rapidly to changing technology and market conditions around the world.
When combined, the changing market forces - globalization, competition, technology, and exchange structure - illustrate the revolution that is occurring in derivatives markets. Unfortunately, while these massive changes drive the industry into a new millennium, government regulation of U.S. exchanges has not kept pace to the point that U.S. exchanges increasingly suffer from a severe fairness handicap in serving customers in the fast-moving global derivatives market.
Despite unmatched self-regulation, AAA-rated clearing, and a 151-year record of no defaults, the Chicago Board of Trade must compete while dragging a ball and chain of costly and outmoded regulations that add costs for our customers. Meanwhile, new electronic exchanges, OTC markets, and foreign markets operate freely under the kind of enlightened regulatory touch (or no regulatory touch) we all should enjoy. Clearly customers now have the opportunity to -- and do -- make choices about the kind of regulatory environment they want.
To demonstrate, according to most recent data issued by the Bank for International Settlements, the notional principal underlying OTC derivatives grew by 12.9% from June 1998 - June 1999. For the corresponding time frame, notional principal underlying exchange traded futures contracts essentially remained static - increasing by only 0.1%. U.S. exchange-traded futures volume declined by approximately 5% in 1999 and options-on-futures volume declined over 9%. (These numbers, however, should be understood in the context that 1999 was a slower year for derivatives overall -- both on and off exchange --; some attribute this to both the conversion to the Euro and to the Y2K effect.)
These statistics as well as the 10-year growth rates of U.S. and foreign exchanges discussed earlier confirm that market participants repeatedly choose trading environments with great flexibility and less restrictive regulation with reduced attendant costs. That is why it has long been the CBOT's goal to be able to compete fairly with those other risk management businesses that enjoy such an environment.
At the direction of Commodity Futures Trading Commission (CFTC) Chairman Bill Rainer, a staff task force earlier this year outlined a creative proposal to reshape and modernize the regulatory approach to futures markets. It sets out a framework that, with some modest fine-tuning, should allow the futures industry to compete effectively in the global derivatives market place. It gives the futures industry the freedom to make choices of different oversight regimes, to find the best fit for the business. That emphasis on market choice to facilitate competition is one of the bedrock, and most appealing, principles of the CFTC's new framework. Allowing business to shed the current "one size fits all" brand of regulation will be of immense benefit to exchanges and other derivatives market innovators.
In this effort, the Board of Trade's principal concern was whether exchanges would be afforded the same type of flexible treatment that is now enjoyed by the over-the-counter derivatives markets and overseas exchanges. Since 1993, when the CFTC adopted its swaps exemption, the Board of Trade has made numerous filings urging the CFTC to allow exchanges the same treatment as OTC swaps dealers.
After seven years, the CFTC has agreed. Now, under the category of an Exempt Multilateral Transaction Execution Facility (Exempt MTEFs), an exchange could offer a derivatives market with roughly the same regulatory freedom as a swaps dealer. In short, interest rate futures and interest rate swaps would have similar regulation. Only institutional participants could trade on Exempt MTEFs. The only regulations that would apply would be antifraud, antimanipulation and, potentially, some form of price reporting. If a futures exchange wanted to trade an eligible futures product in an Exempt MTEF, it could do so and still be subject to the CFTC's exclusive jurisdiction. This feature provides maximum regulatory flexibility. Any exchange using the Exempt MTEF approach would be required to conduct that business in a separate affiliate and would not be considered to be a CFTC-regulated exchange.
The CFTC's new framework offers an exchange two other choices if it wants to be considered to be a CFTC-regulated exchange, a status of some potential value in the global marketplace. Basically, the CFTC would allow futures contracts that are "highly unlikely to be susceptible to manipulation" to trade in exchange markets regulated as Derivatives Transaction Facilities (DTFs). It is contemplated that the Board of Trade's Treasury security complex, at a minimum, would qualify to be traded on a DTF. Significantly, DTFs could be open to all market participants, whether institutional customers or retail market participants. Any retail market participant may place DTF orders only through a CFTC-registered intermediary that is a member of the National Futures Association. In addition to those sources of intermediation, institutional market participants could place orders through banks or broker-dealers in good standing with their regulators. This flexibility should allow institutional market participants to use the same intermediaries and brokers for their futures, swaps, and securities business thereby promoting efficiency and lower costs.
Futures exchanges that are already CFTC-registered would need to comply with seven core principles on an ongoing basis as CFTC-recognized DTFs. Each of these areas touches upon a good business practice that any sensible exchange must adopt to be successful. No exchange wants its market integrity tarnished. No exchange wants to give its competitors an opening by running a market that has operational flaws or that favors one set of market participants over another. The CFTC's approach reflects those competitive realities and a greater sensitivity to the competitive incentives that compel exchanges to operate their markets in a way that responds to customer needs and avoids any potential problems with market manipulation or other abusive trading practices.
Significantly, the CFTC is not telling the DTF how to satisfy those core principles. The design and methods of compliance are left to the DTF itself to develop. The CFTC will oversee, not dictate, the DTF's successful implementation of those core business practices.
Generally, for futures contracts on physical commodities, the CFTC allows already approved exchanges to become Recognized Futures Exchanges (RFEs). The CFTC's thinking is that markets involving physical commodities may need somewhat more detailed mechanisms to prevent price manipulation. To that end, the CFTC would require an RFE to meet 15 core principles. Those principles would replace technical rules, like the CFTC's audit trail and conflict of interest rules, with flexible objectives that an RFE must design a way to meet. But the design would be of the RFE's own making, not the government's. By shifting from their current contract market status to an RFE, exchanges could utilize that flexibility and shift in regulatory emphasis.
The CFTC's framework follows years of debate and study on these issues going back to 1993. Past efforts by the Commission to address the competitive disparities exchanges face due to OTC and overseas competition have fallen far short of the mark. This proposal better reflects the market realities exchanges face and offers tailored oversight of the critical clearing function while streamlining the regulatory burdens of futures commission merchants acting as intermediaries.
Comprehensive legislation such as the discussion drafts currently being contemplated by you and Chairman Lugar in the Senate and Chairman Ewing in the House would be a major step toward ensuring the continued success of U.S. risk management markets. By simultaneously addressing regulatory reform for futures exchanges, the legal certainty needs of the OTC markets and repeal of Shad-Johnson product restrictions, we believe such legislation could provide the entire derivatives marketplace with the certainty necessary to stimulate innovation and creativity.
Such a comprehensive bill must harmonize the President's Working Group (PWG) report recommendations on legal certainty with the CFTC regulatory reform proposal. The Senate discussion draft adopts the PWG's suggested dividing line between what is in and what is out of the Commodity Exchange Act generally by excluding principal-to-principal, non-agricultural transactions from the Act. At the same time, it also intends to allow CFTC-regulated entities to compete fairly by operating similar principal-to-principal facilities.
The Senate discussion draft also essentially codifies the CFTC Task Force report, so trading facilities regulated by the CFTC could choose different regulatory frameworks based on commodities traded and participants. Again, the CFTC's new framework would provide much more flexibility for exchanges to decide how to operate their businesses in response to customer demand. It goes a long way toward giving us the flexibility we need in how we trade. But we are still subject to an oddly unnecessary and unreasonable regulation of what we can trade. Futures on individual securities or sector indices are illegal under current law, even though foreign exchanges can trade them and economically identical instruments are offered to U.S. investors every single day, but called equity swaps.
The final section of the draft legislation ends this unfair statutory bar to U.S. futures market innovation. It appropriately eliminates the Shad-Johnson product restrictions that have left U.S. futures markets and their customers behind while every other segment of the financial market has unfettered access to such securities-based products, potential U.S. products that have been held hostage for nearly 20 years in a regulatory turf dispute. It is time to end the ban as the Senate draft bill does and make these products available to the marketplace.
The CBOT also is guided by three principles in looking at legislative and regulatory changes. We are looking for fundamental fairness in drawing regulatory lines, allowing competitive forces to decide which markets and products succeed and allowing business the necessary flexibility to shape itself to respond to current and future customer needs. The comprehensive legislation we seek must provide U.S. futures exchanges with that long-needed flexibility. It also must provide the OTC derivatives industry with the legal certainty it needs to continue to grow and flourish. And it must finally unleash a new product line that will expand available risk management tools for all investors in U.S. markets. To achieve this, all affected market segments need to make significant compromises, but in return everyone will gain increased flexibility and the opportunity to operate under a rationalized legal and regulatory structure. We at the CBOT look forward to working with Congress in passing such comprehensive legislation this year.
Again, thank you for holding this hearing and for offering me the opportunity to testify. I would be pleased to answer any questions.
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