Hearing on "Maintaining Leadership in the Financial Marketplace of the Future"



9:00 a.m., Monday, May 8, 2000
3rd Floor Conference Center - Federal Reserve Bank of Chicago
230 South LaSalle Street, Chicago, Illinois

Good morning. It is a pleasure for me to appear before you today on behalf of the Chicago Board Options Exchange. I have had the opportunity to work 15 years in the futures industry and 17 years in the securities industry. This has provided me with the unique experience to participate over the years in discussions on market structure issues from both the securities markets and futures markets perspective. While I believe that both industries have created the world's most liquid markets, I am concerned that certain key equity market structure issues, if not properly addressed, could have a detrimental impact on healthy competition and on investor protection. Of particular concern is the potential impact on U.S. equity markets as a consequence of removing the Shad-Johnson prohibition on single stock futures without regulating the products under proper securities laws protections.

The markets are undergoing tremendous change. Technological advances are driving an evolution in financial markets worldwide. Increased information and access to markets through technology are forcing all market participants to innovate and adapt. In an environment of fierce competition on a domestic and global scale, markets such as CBOE need to be able to compete on an equal basis without being hamstrung by regulatory responsibilities that are not applied to their competition. Unfortunately, attempts in Congress to revise the Shad-Johnson Accord, if not done properly, would perpetuate and worsen the fragmented regulation of securities derivative products and prevent the securities options markets from competing on a fair and equal basis.

As a result of the system of divided regulation between securities and futures, the two markets are not regulated in an equivalent manner. 1 The disparities have led to regulatory arbitrage, which in turn produces competitive inequality between equivalent markets and undermines the ability of the SEC to provide effective oversight of the securities markets. These disparities and resulting regulatory arbitrage are especially pronounced when comparing securities options and futures on equity products, both of which are economically equivalent derivative products, and have exacted a heavy competitive toll on the U.S. options markets. Unfortunately, based on what we have seen, recent attempts in Congress to revise the Shad-Johnson Accord to permit futures on individual stocks would perpetuate and exacerbate the potential for regulatory arbitrage and an unlevel playing field, rather than repair an already broken and inefficient system of allocating regulatory responsibility for equity products.

The Shad-Johnson Accord created and then institutionalized a bifurcated system of regulation of equity derivatives. The lack of a unitary system of regulation of equity derivatives markets has resulted in unequal regulation between competing markets to the competitive detriment of securities products. The regulatory disparities also provide the potential to undercut the investor protection provisions of the federal securities laws. This is readily apparent in the regulatory and legal differences in margin, tax, and transaction fees between securities and futures, all of which make the options product more expensive to use than futures. For example, the margin for $100,000 worth of S&P 500 futures would be around $6,000, while the margin for an option on that future (which is regulated under the commodities laws) would be $5,000. In contrast, the margin for options on the S&P 500 (which are regulated as securities) would be $15,000 plus the premium paid. In other words, for equivalent products, the margin for securities options is three times the amount of futures margin. Additionally, a federally imposed transaction fee is added to the securities option, but not to the future or option on the future. A stock futures customer would also receive 60/40 tax treatment, but a securities option customer would not. This means that 60 percent of a customer's gain on a futures position would be taxed at favorable long-term capital gains rate but all of a securities option's customer gain would be taxed as ordinary income. A different federal tax treatment for economically equivalent instruments creates an intolerable tax arbitrage.2

In addition to regulations imposing additional costs, securities options are also subject to a host of market integrity and investor protection provisions not applied to futures. These include, but are not limited to, regulations pertaining to best execution, disclosure, sales practices, facilitation of a national market system, common clearing, and insider trading. Most of these regulations serve important investor protection purposes, so I do not want to suggest that options should be exempted from these provisions. Quite the contrary: it is difficult to fathom how stock futures, which are a direct surrogate for stock and the economic equivalent of stock options, could be permitted to trade without being subject to these investor protection rules.

Everyone would admit that the system of bifurcated regulation is seriously flawed and results in competitive inequities. Yet, the futures industry wants to compound this mistake by revising Shad-Johnson to permit single stock futures to be regulated as commodities. This would worsen the competitive inequities because it would allow a direct stock surrogate to trade as a future. It would rely on an obsolete framework of divided jurisdiction to apply a commodities regulatory structure to a product that is a direct economic substitute for stock.

I strongly believe that the Senate Banking Committee should not allow the perpetuation of anti-competitive, unequal regulation in equity products by permitting single stock futures without submitting the product to equivalent securities regulation. Any analysis of the issue of single stock futures must begin by removing the regulatory disparities between equivalent equity products and creating a level playing field. The logical approach would be to merge the SEC and CFTC into a single agency. It would place all equity products under one consistent set of regulations. We are the only major country in the world that does not have a single regulatory body that oversees all equity products. I recognize that a merger of the SEC and CFTC would be difficult to accomplish, but it is long overdue. Short of such a merger, any publicly traded product such as single stock futures that acts as a surrogate for stock should be subject to the same parameters that have governed the trading of securities. Under the current securities law investor protection safeguards, U.S. securities markets have earned the confidence and trust of record numbers of individual investors: stock ownership now accounts for one third of all household wealth. This should not be jeopardized by further splintering the oversight of our equity markets. Over 70 million U.S. investors in the securities markets depend on policymakers in Washington to ensure that market integrity is not undercut by regulatory arbitrage.

I do not want my position to be construed as a criticism of the CFTC. Indeed, in recognition of our rapidly changing markets, Chairman Rainer launched a thorough re-examination of CFTC regulation, and he is to be commended for that effort. The CFTC decided to shift more of its functions to an oversight capacity, and there are some lessons here for the SEC. Our markets can not afford to get caught up in bureaucratic reviews and delays. In order to meet today's global challenges, we need to bring products to market quickly and make rule changes promptly.

The CFTC initiative, though, heightens my concern over split regulation. The CFTC's approach may go too far in reducing regulatory responsibilities, especially if applied to markets with substantial retail participation, as we can expect to find in a market for stock futures. More importantly, even when the SEC and CFTC are undertaking forward-thinking initiatives, we must concern ourselves with the fact that the two do not move in lockstep. If regulation acts as a cost of doing business, then different regulations will always produce different costs. Permitting stock futures without resolving the disjointed, unequal regulation of equity derivative markets would compound this problem a hundredfold and be a serious mistake.

What disturbs me greatly is the process by which the Shad-Johnson Accord is being amended. The issue of single stock futures is much broader than the discrete subject of CFTC reauthorization and involves the more fundamental issue of regulation of the entire equities market. Clearly it should be considered in the larger context of equities market structure and investor protection. The futures exchanges should not be permitted to force an imprudent and unsound approach to equity market structure regulation via Shad-Johnson into CFTC reauthorization.

If we are unwilling to approach single stock futures in the context of an agency merger, then, as noted above, the only fair approach would be to regulate stocks, stock options, and stock futures under the same set of basic rules by the same agency. While the Agriculture Committees' draft bills have the best of intentions in this regard, they fall far short because they perpetuate disparities between securities and equity futures in costs, regulation, and oversight in key areas. Permitting futures on individual stocks without regulating them under the same basic rules as equity securities would be like waving a wand and saying that Southwest Airlines would no longer be regulated by the FAA but instead be regulated solely by a new agency called the Federal Transportation Board ("FTB"). Under FTB oversight, Southwest Airlines could compete with United on intercontinental flights, but Southwest Airlines would have no federal tax on its tickets, not be subject to FAA regulations, and have no restrictions on landing slots at major airports. No one, except perhaps Southwest Airlines, would seriously suggest that Southwest Airlines should be exempt from the regulations applied to its competition, United Airlines. We are committed to working with Congress to review Shad-Johnson, but any review must start with competitive equity and investor protection as its underlying principles.

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I also would like to touch upon other current market structure issues that, if not properly resolved, could significantly impair the ability of CBOE to compete fairly with other markets here and around the world. The first of these issues is how best to update and expand the systems that link securities markets in light of recent improvements in communications and information technology. At the behest of the SEC, all the options exchanges have recently been working together to develop a linkage plan. 3 The goal of any linkage plan should be that it foster, rather than stifle, fair and vigorous competition among markets, while at the same time assuring that customers always receive the best execution of their orders. Although the exchanges have been able to agree on most elements of the linkage, the rules governing how brokers are to direct customer orders among exchanges have become a sticking point.4 CBOE, the Amex and the new International Securities Exchange all agree that competition among exchanges will be encouraged if brokers are able to direct customer orders to whichever exchange they believe offers the best service to them and their customers, so long as the orders are executed at the best price. This kind of vigorous competition, in turn, permits market forces rather than government regulation to bring about more efficient trading systems and procedures and reduced costs, which not only benefit investors but also permit U.S. markets to retain their global leadership.

The Philadelphia Stock Exchange and Pacific Exchange, however, are urging the SEC to adopt rules that would mandate brokers to direct customer orders to the one exchange that was first to quote at the best price for an option, without regard to the other areas of service in which exchanges compete. In effect, this approach would combine all exchange markets into a single "black-box" system, where orders are matched based on price, and competition in other spheres would be eliminated.

The SEC has not decided the issue yet, but its hesitation in rejecting the idea of imposing a single black-box design on the options markets is very troubling to me. If such a solution is imposed on U.S. options markets, it will retard, not promote, the integration of new technology into the way markets operate. In this respect, I agree with Federal Reserve Board Chairman Greenspan, who in recent testimony urged the SEC to exercise restraint in directing the evolution of the markets, and instead to use regulatory policy to foster competition. 5 Chairman Greenspan stated that, "It has never proved wise for policymakers to try to direct the evolution of the markets, and it strikes me as particularly problematic at this juncture." I also agree with Chairman Gramm, who in applying the Hippocratic oath to regulations, said that regulators' first obligation should be to do no harm. I made the same plea to the SEC in my recent comment letter on the SEC's market fragmentation release. 6 Instead of trying to impose by regulation a single design for the structure of U.S. markets, the SEC should address such questionable practices as payment to brokers for their customers' order flow and internalization of customers' orders by brokers. The SEC should focus on the conflicts these practices introduce between the duties brokers owe to their customers and the brokers' own self-interest.

Payment for order flow refers to the practice where a market maker or an exchange pays a per share amount to a broker for directing its customers' orders to that market maker or exchange. The broker keeps this payment for itself, instead of passing it on to its customer. When payment for order flow first surfaced in the stock market several years ago, many market participants and other observers analogized it to an unlawful bribe or kickback, because it presented a conflict between the brokers' obligation to obtain best execution of its customers' orders and the broker's self-interest. Nevertheless, in 1995 the SEC chose not to declare the practice unlawful, but instead adopted a rule requiring brokers to make "fine-print" disclosure of whether payment for order flow is received. Chairman Levitt himself has been critical of the practice, observing in a recent speech that, "Unfortunately, much of today's payment for order flow disclosure, while factually accurate, is just not clear to investors." 7

Until recently, the options markets have been free from the taint of payment for order flow. Recently, however, with heightened competition among options exchanges, the practice has begun to rear its ugly head in the options markets. Most options exchanges and many firms have been reluctant to embrace payment for order flow, but as the practice increasingly appears to be having an influence on order routing decisions, unless something is done to stop it, every market will have to pay for order flow in one way or another just to remain competitive. If this happens, not only will investors be the losers, but competition between markets will be predicated on paying for business, not on providing the best markets and services.

In closing, let me say that these are challenging times for those of us involved in running our nation's securities markets, as well as for those in government who oversee their regulation and who make the laws under which they operate. As we face the challenges ahead, I believe the important role of government should be to maintain a streamlined, but sound, regulatory environment and a level playing field, so that investors can continue to be protected while markets are encouraged to innovate and compete. Merely lifting the Shad-Johnson prohibition on single stock futures without fully addressing the regulatory disparities between futures and securities does neither. It would perpetuate regulatory arbitrage and worsen the competitive inequities between securities and futures on securities. Let us not, in an attempt to act on Shad-Johnson, undermine the efficiency and fairness of our securities markets, which are the envy of the world. We cannot afford to sell the American investor short through regulatory arbitrage nor burden securities markets with an unlevel playing field.

1 -- The differences in regulation arise from the different focus of the two governing bodies of law. The commodities laws are designed for a primarily institutional marketplace, while the securities laws cover markets with substantial retail participation. It is likely the single stock futures would be marketed extensively to retail investors.

2 -- For products such as options and futures which are marked-to-market daily, a difference in tax treatment could cause great confusion for investors because essentially similar products would produce drastically different tax results.

3 -- Securities Exchange Act Release No. 42029 (October 19, 1999).

4 -- Securities Exchange Act Release No. 42456 (February 24, 2000).

5 -- Testimony of Chairman Alan Greenspan, "Evolution of Our Equity Markets" before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, April 13, 2000.

6 -- Letter dated April 27, 2000, from William J. Brodsky, Chairman and Chief Executive Officer, CBOE, to Jonathan G. Katz, Secretary, SEC, regarding Release No. 34-42450.

7 -- "Best Execution: Promise of Integrity, Guardian of Competition," speech by Chairman Arthur Levitt, U.S. Securities and Exchange Commission, before the Securities Industry Association, Boca Raton, Florida, November 4, 1999 ("Boca Speech").

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