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


Chairman Gramm, Senators, fellow panelists, ladies and gentlemen, I am Scott Gordon, Chairman of the Board of Directors of the Chicago Mercantile Exchange (CME). The Exchange welcomes this opportunity to share its vision of the implications of regulatory and technological changes on options, futures, and equities markets.

Your invitation asked the key questions that Congress and the regulators need to address, "What regulatory and market structures would enhance the value of our markets?" You also described the historical context and background against which these questions should be answered. You described a world in which United States markets lead the world in "liquidity, depth, versatility, efficiency, and integrity." Unfortunately, our leadership in liquidity and depth is confined to local products. EUREX, a combination of German and Swiss exchanges with much broader authority to trade security derivatives, has lately been the world leader in overall volume. Other exchanges dominate in their local products and in certain international products. A wave of clearinghouse and exchange mergers is sweeping Europe. I begin with these unhappy facts so that no one in this room is under the misguided impression that U.S. exchanges and derivative markets are resisting weak competition from a position of strength and dominance.

The Chicago Mercantile Exchange anticipated the impact of advances in computational power, network speed and service, and changes in market structure: we positioned the Exchange to play a preeminent role in the new marketplace. We made a major investment in screen based trading beginning in 1988. We spent years negotiating with foreign regulators to secure access to offshore markets. We spent tens of millions rewriting our clearing system. We used technology to expand the capacity of our existing trading floor and prepare our members for the electronic age. Last year, we began reshaping the organizational structure of the Exchange to enhance our response time and options. Our demutualization vote will take place on June 6, 2000: I am confident our members will embrace the restructuring plan.

If we had not foreseen and planned to respond to change or failed to invest sufficiently to carry out our plans, then the regulatory regime, no matter how accommodating, would be irrelevant. But, we have planned, and we have invested and we are on the way to reinventing ourselves: rationalization of the regulatory regime is the last piece in the puzzle. I will not detail our business plans in this forum except to say that they cannot be effectively implemented without significant change to the present philosophy of market regulation. Industries that want to use our technology and expertise in Business-to-Business trading and risk management enterprises cannot begin to fathom why they should be registered or regulated if they elect to use transaction systems that are more transparent and efficient. They do not agree that they should submit to regulation in exchange for the safety and soundness of clearing.

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 the Shad/Johnson Accord. 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. If legal certainty legislation explicitly permits us to operate markets that take advantage of such exclusions, without falling prey to another set of regulators, we will enthusiastically support it.

We also are firmly of the view that enacting relief for one segment of the market 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.

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. The tone of the CFTC's proposal 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.

Our willingness to support reform of the CEA for the benefit of the OTC market is in stark contrast to the securities industry's resistance to accept Shad/Johnson reform. 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.

The CME's success managing stock index futures and options bolsters its petition for the right 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. We created a tremendously useful product, equity indexes, in the face of overwhelming opposition. The SEC and its regulated 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.

The division of responsibility between the SEC and CFTC that I propose below will eliminate competitive barriers that do not serve public market users. Our proposal permits futures exchanges and securities exchanges to compete on their relative merits.

I would like to put my conclusions in context by briefly reviewing industry, legislative and regulatory history, discussing business conditions and trends, and giving you a clear statement of our overall position. Bottom line, I urge that the CFTC Staff Task Force 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. These reforms should be included in any bill to provide legal certainty for derivative transactions.

Historical Overview

Thirty years ago, the Commodity Exchange Authority, the predecessor of the CFTC, had a few small offices in the basements of the Department of Agriculture and the Chicago Board of Trade. U.S. exchanges were governed by a statute that offered freedom to make appropriate business decisions without advance approval from sincere, but inexperienced regulators.

The CME launched a new exchange and opened the door to financial futures trading. We created the International Monetary Market without federal regulation and without a single problem for which federal regulation was necessary. We had two years of freedom before the reach of the Commodity Exchange Act was expanded in 1974 to include financial derivatives. The freedom that allowed the creation of a revolutionary financial derivative market has slowly, but surely, been eroded by the Commodity Exchange Act and its ever growing clutter of amendments, regulations, guidance, interpretations and informal policies. Futures exchanges have grown and prospered, but at enormous cost.

The competitive costs and consequences of over enthusiastic regulation were far less significant even seven years ago than they are today. When exchanges were real-estate-bound aggregations of market makers, the coincidence of the natural business day with the logical trading day for local products created a strong home court advantage. Eurodollars and U.S. Treasury Bonds were going to be traded on a U.S. time zone exchange. Competition might come from the over-the-counter market, but foreign exchanges had no chance at the U.S. product base. Cheap communications, dispersal of market makers and replacement of brokers with simple algorithms ended the local monopoly and inspired international competition.

Two years ago, MATIF, the French exchange went from pit based to screen based in two weeks. This year, EUREX, an all-electronic exchange, is the world's volume leader. LIFFE, the principal London exchange, is converting to screen based trading as rapidly as it can come to terms with the technology. It has transferred most of its futures and financial option business to a screen based market. The traditional pit based exchanges in Chicago have listed their leading products on 24-hour electronic trading systems: many are listed for trading during traditional pit trading hours.

Legislative and Regulatory Framework

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 CEA's original purpose was to force all derivative agricultural contracts 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 under the aegis of the Commission.

The basic premise for the transfer of responsibilities from the Department of Agriculture to the Commodity Futures Trading Commission was well understood at the time. As Philip McBride Johnson, former chairman of the CFTC, recently observed:

"Unlike the USDA, which had acted as regulator because of the nature of the assets underlying the futures contracts, the premise for the CFTC was its opposite, namely, that a central regulator with exclusive authority over activity in futures contracts, irrespective of the nature of the underlying asset, would produce a more cost-effective and uniform regulatory program. Indeed, had it been decided otherwise, the futures industry today might answer to dozens of different public agencies at the federal, state and local levels." P.M. Johnson, Mulling the Millennium, Futures & Derivatives Law Report 6 (March 2000)

In retrospect, 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 swap 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 that amendment.

Business Conditions and Trends

Regulatory policy in the futures industry was crafted on the presumption that the business was not portable. Recent massive business shifts have demonstrated the fallacy of that presumption. The dominance of U.S. futures exchanges has eroded, and U.S. regulatory constraints bear some responsibility. Some governments have quickly and accurately balanced legitimate business needs against customer and market protection. London's exchanges have been freed from the pre-approval process. Singapore's regulator expedites approvals when international competition is at stake. U.S. exchanges have been kept waiting for regulatory relief. In contrast to the treatment of exchanges, the CFTC speedily exempted most of the OTC derivatives market from oversight and regulation immediately after authorizing legislation in 1992. Growth in the OTC market has been staggering compared to growth of exchange traded derivatives. Foreign exchanges have caught and surpassed U.S. markets.

Advances in communications and information management have changed the face of the industry and outrun regulatory systems. A number of jurisdictions recognized this change and designed their tax and regulatory policies to capture business. The importance of international financial transactions to London spurred it to adopt a regulatory system that facilitates the operation of futures markets. In London, recognition of the realities of international business flows combined with a "…benign political attitude permits an accommodating tax and regulatory framework and a relatively predictable and sensible legal system." London profited from the restrictive policies in the USA, which reinforced London's comparative advantage as a benign location.

Twenty- five years ago, New York State, New York City and the New York Stock Exchange learned this lesson in a less technological environment. Each acted as if the local monopoly on securities trading was secure. Market users found a remarkably simple solution. They boarded the subway, traveled under the river to New Jersey and completed their transactions on the station platform less than a mile away. Burdensome transfer taxes and restrictions on certain block trading practices were avoided. Eventually the New York Stock Exchange and its overseers recognized market realities and removed these restrictions.

International networks have replaced the subway. Encrypted communications and secure fund transfers coupled with international depositories and clearing organizations have written finis to local market monopolies. Not even the almighty dollar anchors business transactions to this jurisdiction. The vast store of capital on deposit in Europe has eliminated the local advantage. Investment capital moves based on the London inter-bank offered rate, not U.S. interest rates.

The U.S. futures industry operates in a global economy where the primary competitors are unregulated, like the over-the-counter market, or regulated by governments and agencies intent on promoting domestic financial markets, like Germany, London, Singapore, Brazil, and now France. We must follow those examples or watch further erosion of market share.

To the extent that business can easily relocate, foreign jurisdictions continue to compete to attract that business by lowering regulatory costs. For example, fund management has moved offshore. The April 1999 issue of Futures magazine includes a comprehensive review of the competitive situation and the consequent flight. More than forty jurisdictions have competed for the fund business, and it is gone.

The transfer of informal markets is advanced. The OTC market has no fixed jurisdictional home. If regulation is over zealous here, the center for the transaction moves. If equity swaps carry a legal risk in the U.S., they can as easily be completed in England. No U.S. firm will refuse to participate because it has to book a transaction in London rather than New York.

The process of moving organized markets from this jurisdiction is beginning. Futures exchanges that depend on trading floors are not portable. The CME has established linkages and offset agreements that permit its contracts to be traded offshore. One U.S. exchange has a trading floor in Ireland. Nonetheless, U.S. futures markets have, for the most part, maintained their physical ties to this country and operated under the full burden of Commission regulation. Practical considerations have constrained the markets from moving to more hospitable climates. The CME has a staff of one thousand: fifty-five hundred traders and their employees fill our two floors each day. It will not be easy to transport this structure to Bermuda or the Cayman Islands.

The costs to move an open-out-cry market offshore serve as a limit on foreign jurisdictions seeking to move the marketplace through regulatory incentives. Those costs do not limit efforts to attract the business away from U.S. markets to offshore venues. U.S. customers are not constrained to do business on U.S. based exchanges. They have ready access to real time price information. If an offshore venue permits a desirable form of trading with lower fees and no taxes, and U.S. exchange cannot overcome that advantage with superior liquidity, business will transfer. Since liquidity flows with the business, eventually all business will be lost. A foreign jurisdiction cannot import a U.S. physical exchange, but it has the capacity to export its electronic exchange to the U.S.

A screen based electronic exchange does not need a local nexus in a well-regulated commercial center. An electronic exchange can easily extend its operation across borders into major commercial centers without offering any physical presence to which jurisdiction can attach. Location in a friendly jurisdiction with reliable banking laws becomes more feasible each day. Technology needs can be outsourced. Other management and employment needs can be satisfied in most jurisdictions that financial firms choose to avoid burdensome regulation. Connection to the trading engine can be accomplished over the Internet or other public networks. Terminals need not be owned, installed or maintained by the exchange or its agents. It is quite plausible to construct a trading system using personal computers, owned and operated by traders. Moreover, even the user interface can be downloaded over the network in the form of Java applets.

An electronic exchange can even avoid the consequences of secondary regulation that results from regulation of its members. An electronic exchange can operate without intermediaries or members. With no members, no equipment, and no physical presence it is difficult for a regulator to gain a firm grasp or even assert jurisdiction. EBS and Reuters operate enormous non-intermediated trading networks. The original plan for FutureCom, a proposed Internet cattle trading futures market, provided for a non-intermediated trading process. Internet gambling demonstrates the feasibility of avoiding local regulation and reaching customers of all sizes. These examples are not a subtle announcement that the CME is on its way to Grand Cayman. However, they clearly illustrate that regulation of electronic exchanges must be a delicate undertaking that carefully balances costs against benefits. Carelessly regulated exchanges can and will move or be decimated by fierce competition from electronic exchanges in jurisdictions that actively promote their markets' efforts to win market share.

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 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). The Commission will not discriminate against open out-cry markets in favor of electronic systems. The Commission has made a fresh start.

Resolution of Shad/Johnson Issues

Eighteen years ago, the Shad-Johnson Accord resolved a jurisdictional conflict between the SEC and the CFTC. It included a temporary ban on most equity futures contracts. 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. 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. futures 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. The public is not served by artificially constraining an efficient market. 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."

Today, Shad-Johnson is a bar to useful competition. The SEC used Shad-Johnson to bar futures on the Dow Jones Utilities and Transportation Averages because that index did not "reflect" the utilities and transportation sectors, respectively. The United States Court of Appeals 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 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 amend the Securities Acts 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:

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 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. We are prepared, however to deviate somewhat from the strict logic behind this principle in order to resolve the most contentious objections. 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.


One year ago, the Chicago Mercantile Exchange, with the Chicago Board of Trade, 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 seeking 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:

We continue to believe that the joint exchange proposal is the best formulation for regulatory relief. However, we are also well aware how important it is to enact comprehensive regulatory reform this year. We are prepared to join an industry consensus. 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.

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