Peter F. Borish
Michael Braude
Joshua Cohn
Chris Concannon
George Crapple
John P. Davidson III
Joseph B. Dial
Yvonne J. Downs
Bryan T. Durkin
Commissioner Tom Erickson
Robert Fitzsimmons
Douglas Gardner
Anthony Gerardi
Jim Heinz
W.H. Hinkle
Audrey Hirschfeld
Commissioner Barbara Holum
Kent Horsager
Phil Johnson
Anthony Leitner
John W. McPartland, Jr.
Laurence Mollner
Brett Paulson
Kenneth Raisler
Edward J. Rosen
Commissioner David Spears
Steven D. Spence
Phillip Todd
Neal Wolkoff

C O N T E N T S

1. Oversight of Electronic Order Routing and Execution Systems

2. Common Trading Platforms and Common Clearing

3. Open Session

P R O C E E D I N G S

CHAIRMAN RAINER: Good afternoon, everyone. First, let me thank everyone on two counts; one, for being here today and two, for your willingness to serve on this important committee. I think, as time goes on, we are going to learn how important your input to this Commission is and will be and we are very appreciative to be able to assemble such a distinguished group of professionals for our committee. I look forward to your comments today and I am sure that each of my colleagues on the Commission will also.

With that, let me start out by introducing the other Commissioners on the CFTC. First, Commissioner Barbara Holum, to my far left. Commissioner David Spears is right over here. Commissioner Newsome, who is Vice Chairing this committee is on my immediate right. And Commissioner Tom Erickson down on the far right.

We have the distinguished privilege of being taped, I am told, for the archives. If you want a copy of this tape, I am not sure when it will be available, but it is on the record and will be available at some point for anyone to get a copy of this. I think that is correct.

This is excellent timing for this meeting today because of a number of reasons including that we are right in the teeth of writing our proposed regulatory language, which we will be publishing in the Federal Register. I am sure you all are familiar with the fact that we have established a task force to develop a new regulatory structure for the Commission and we are well along that path.

We anticipate proposing new rules for the Commission within several weeks. Input from this meeting today will go a long way toward helping us with our thinking with respect to the topics that we will be discussing today. That is number one.

Number, two, technology is changing every day and having a major impact on our markets. I am absolutely convinced that this business will be quite a bit different a year from today and even more so two years from today. That is somewhat manifested by the fact that I know the NFA is fielding either applications or near applications from seven new potential exchanges, a development that this industry has not seen in many, many, many years, and that is a direct result of innovations in technology and what information technology can do for these markets.

Again, let me thank you for being here today. I would like to turn the meeting over to Jim Newsome.

MR. NEWSOME: Thank you, Mr. Chairman. I won't take very much time with introductions so that we can get down to the business of why we are here. But, before we do that, we had quite a few staff that worked, help setting up this advisory committee and the agenda. I wanted to say special thanks to Marcia Blase and Kristy Parker from my staff, DeAna Dow from the Chairman's staff, Elizabeth Fox and Lawrence Green, also at the Commission, for their assistance in helping us put this together.

Before we get started, I know that most of you know each other, but we have got quite a few people in the audience who may not. So, Ed, let's start with you and circle around the room, briefly, and everyone introduce themselves and tell who you are here representing.

MR. ROSEN: Ed Rosen. I am with Cleary Gottlieb.

MR. HEINZ: Jim Heinz, Managing Partner of Marquette Partners.

MR. HORSAGER: Kent Horsager with the Minneapolis Grain Exchange.

MR. GERARDI: Anthony Gerardi, one of the partners at divine interVentures.

MR. GARDNER: Doug Gardner with the Cantor Exchange.

MR. HIRSCHFELD: Audrey Hirschfeld with the New York Board of Trade.

COMMISSIONER ERICKSON: Tom Erickson at the Commission.

MR. WOLKOFF: Neal Wolkoff with the New York Mercantile Exchange.

MR. CRAPPLE: George Crapple. I am Co-Chairman of Millburn Ridgefield and Chairman of the Managed Funds Association.

COMMISSIONER SPEARS: Dave Spears of the Commission.

MR. PAULSON: Brett Paulson with the Board of Trade Clearing Corporation.

MR. BORISH: Peter Borish, President of Computer Trading Corporation.

MR. LEITNER: Tony Leitner from Goldman Sachs.

MR. SPENCE: Steven Spence of Merrill Lynch and I am Chair of the FIA.

MR. DAVIDSON: John P. Davidson from Morgan Stanley Dean Witter.

MR. McPARTLAND: John McPartland. I am an independent consultant in the field of clearing derivatives.

MR. HINKLE: Hal Hinkle from BrokerTec Global.

MR. DIAL: Joe Dial, E-Markets.

MR. CONCANNON: Chris Concannon, Island ECN.

MR. MOLLNER: Larry Mollner, President of Mariah Trading.

COMMISSIONER HOLUM: Barbara Holum with the Commission.

MR. BRAUDE: Mike Braude, the Kansas City Board of Trade.

MR. FITZSIMMONS: Bob Fitzsimmons, NASD.

MR. TODD: Phillip Todd with E-Pit.

MR. RAISLER: Ken Raisler, Sullivan & Cromwell.

MR. JOHNSON: Phil Johnson, Skadden, Arps.

MR. DURKIN: Bryan Durkin, the Board of Trade.

MS. DOWNS: Yvonne Downs, the National Futures Association.

MR. NEWSOME: Thank you.

We certainly appreciate your willingness to take time away from your business in your office. I know that, in terms of resources it costs you to be here--but I assure you that your advice to us is extremely valuable and we appreciate each of you taking time to be here with us.

In the roundtable we had at the end of last year, it seemed successful and most of you seemed to enjoy the structure that we used in terms of breaking down some agenda criteria and then utilizing people in the group to lead the discussion or get the discussion started.

We are going to follow a very similar format today. We have asked several of you to make some lead comments about agenda items. That will be followed by some further comments by other members of the committee and then it will be opened up for discussion or questions from anyone on the advisory committee. So we plan to follow that format and, hopefully, it will work as well today as it did back in December.

I want to remind everyone of the microphone system. You simply mash the button to turn it on. Please state your name when you start, for the reporter, and when you finish, turn it off because more than a couple of them on at one time provides a pretty strong feedback.

As we look at our agenda today, we have broken it down into three primary areas and we appreciate the comments that many of you sent in to us as we tried to formulate it. All the comments, certainly, were very good. Some were very targeted or very specific and we tried to leave the agenda just a bit broader today, as it is the first official meeting of the advisory committee.

But, certainly, as we get into discussion, feel free to get as specific or as targeted on any of the issues as you so choose. As you can see, the first area that we are going to talk about is the oversight of electronic order routing and execution systems. We have broken down a couple of primary bullet points; order routing systems and execution systems, then, detecting fraud and manipulation in an electronic environment and key customer-protection issues.

We have asked Yvonne Downs to initially start the discussion on this topic so, Yvonne, we will turn it over to you.

Oversight of Electronic Order Routing and Execution Systems

MS. DOWNS: Thank you. We have been asked to talk about two things. First, AORSs, or automated order routing systems, and some of the implications that they pose. Literally, where do they stop and start? I think that leads into the question of who has control because I think one of the questions for, particularly, new exchanges, is who is responsible for the order placements.

I think the other question that this raises is whether or not there is retail business or whether it is the famous B-to-B environment that we hear so much about.

The other issue I think that is thirdly raised from a regulatory perspective from automated order routing systems is the question of risk management. I think that, in the traditional exchanges, risk management has been left at many different layers, some at the clearing-house level, some at the FCM level and some generally left to just commercial users of markets.

The question, I think, that is pressing before us is, just who controls and is there going to be risk management and by whom in this process. I think we need to address it both from an institutional perspective or sophisticated customer perspective and a retail perspective.

With that, I have talked to many different exchanges and I think a lot of it depends on some of the business plans that they have. If they are in the business-to-business environment, there is not a retail component. But they all are planning automated order routing systems.

So the question, then, is where is that risk to the system and who is going to address it. I think that, also, many people still have the traditional business models that we see in futures where there are intermediaries. Then, I think that is where the order routing issues come to and who should be responsible.

Because the intermediaries generally control, I lead off and say that I think that they should be responsible for the risk management and we should look to the intermediaries for that activity. But that is my input. I know that Bryan does some surveillance and deals in order routing at the Board of Trade.

Bryan, what are your thoughts?

MR. DURKIN: We are definitely growing in leaps and bounds in the context of embracing technology and automating our systems on our floor and embracing automated order routing systems. Obviously, at the Board of Trade, we have made it our commitment and we have made it our mission to substantially change and transform what we know today in the context of how business is done in both our traditional open-outcry markets as well as on electronic trading platforms.

All of that has to do with technology. We have 30 percent of our customer order flow coming through to our floor today, and that is quite a change from where we were over a year ago. But it brings a lot of change for how firms are used to doing business and it brings the customer closer to the pit. You, as an individual retail customer now can get on your computer work station, route an order directly into a pit to a broker work-station. As an institution, as an exchange, we would say that the risk management has to be there on the part of the firm to make sure that that business has been credit-vetted before it hits the pit.

As an exchange, I don't think that we should play a role in interceding with a firm and how they do their business in that respect. From an electronic trading perspective, we talk about surveillance and issues with regard to a firm's responsibility. I would like to break it down into how the Commission has looked at principal versus agency transactions.

I applaud the Commission in the context of less regulation for those who are the sophisticated users of our markets. I don't think that it plays quite the role that we have had it play in the past. However, the retail customer is not going to go away. I think that we have shown that business in certain sectors has grown in that respect and we have to have the integrity behind it to monitor and preserve the integrity of the activity that is done for the customer.

MR. RAISLER: May I interrupt for just a second? It may be helpful to me, and maybe others in the room, if you could define what you mean by an automated order routing system because I thought that you and Bryan just referred to two different things, both under, perhaps, the same label.

I think the terms here, and unfortunately, if we are going to use acronyms and the like, are going to be important to us going forward because I think the CFTC, in its history, got into a whole debate about the difference between a terminal and an order routing system. I think before we dive in too deep, we should get a feeling for what the water looks like.

MS. DOWNS: In my opinion, and I would be willing to hear other people's opinions, an automated order routing system is the transmission of an order from the customer into a market. That transmission goes through an intermediary, generally. It does not mean that the intermediary actually does anything with that order. It may do some credit. It may do nothing. It may just literally pass through their accounting and back-office systems. But an order routing system, to me, is the portion from the customer to the market by way of an intermediary.

MR. RAISLER: So, would your point be then that, if in fact, the intermediary receives the information simultaneously, or after the fact, it is something different?

MS. DOWNS: Yes. I view the question as who controls there - - the control into that marketplace and the actual control to the engine. Generally, automated order routing systems do not go directly into engines. They go by way of someone who controls the access to the engine. That is why, I believe, it is from the customer to the intermediary.

MR. RAISLER: So even if reality does not correspond to that element of control, that would be de facto--in other words, if, in fact, the intermediary cannot, as a reality matter, stop a trade from happening, it still would be an automated order routing system?

MS. DOWNS: In my opinion, yes, because I think it is a judgment call the intermediary has on the nature of the business that it is doing, what risk it poses to them and, therefore, just what the reliability is of that order transmission to them is within their control.

MR. RAISLER: I am getting way ahead of myself, but I think that I would argue there are no intellectual, technological distinctions that we are making here.

MS. DOWNS: I don't think automated order routing systems are necessarily technologically drawn. I think it goes to who is accessing the engine and who controls that access. I think there is a big distinction as to the amount of risk to a market, the amount of surveillance necessary to handle potential problems on that market and the risk and credit associated with doing transactions on that market.

I think that that is generally the distinction. I think that is traditionally true pretty much for all the different types of business models I have seen. They draw different distinctions about who can access their engines and who cannot. I don't think any of them have said that automated order routing systems touch their engines.

MR. HINKLE: May I just clarify, Yvonne, when you say "engine," do you mean the matching engine?

MS. DOWNS: Yes, sir; that is what I am referring to. That is kind of where I am coming from. Can I ask--Philip, can you talk about it from your client's perspective what you see, maybe a little bit on the business-to-business versus retail and how you see automated order routing systems affecting the fraud and manipulation aspect of that?

MR. TODD: Sure. There is another approach that I think will become increasingly prevalent and that is for the exchange to have what I would call a "user object," where the end-user has an identity within the exchange engine and that the sponsorship for that customer, while they are on-line, can continue to come from intermediaries who can come in and set parameters that govern what that customer does on-line.

That is another approach. And, of course, that would enable the end-user to connect directly to the exchange servers, place orders directly, have a very high transparency experience while they are on-line and yet still be governed by the appropriate intermediaries who are going to provide the credit-control and risk-control function.

I don't know if that falls under a typical definition of what people mean by an automated order routing system but the Internet and many of the new technologies that are out there absolutely do empower this kind of technology to come into play and many of the B-to-B markets that we talk to are very interested in having this kind of model where the customer comes in directly to the exchange.

MS. DOWNS: Do you think, going forward, we are going to have a lot of retail business associated with these markets or do you think they are going to be business-to-business?

MR. TODD: Initially, I think it is going to be business-to-business but we see no technological reason why a regulated exchange could not also provide direct access to the customers to come in and interact directly with the exchange engine over the Internet or over dedicated proprietary networks.

What that means is that sponsorship by the customer would take a slightly different form than it does now but it would be at least as powerful in terms of the ability to control and monitor what the customer is doing because, after all, if the customer has an identity within the exchange and there is an object that contains data about them that is defined by their sponsor, then all kinds of new information, services and so forth, can be provided directly to the customer or indirectly through their sponsor.

MR. LEITNER: Just a quick question on this retail, B-to-B issue. The E-mini contract--I think we had a presentation at the first meeting about that and the degree to which that is very much a retail product traded in a totally electronic market. I think some of the folks who are the principal intermediaries providing on-line trading capability are definitely seeing that as a retail product.

So I think that, just to tee up Yvonne's points from a point of view where the market may be going, and it may be going in a lot of different directions, and what issues it raises for the Commission and the exchange, I thought that was the perfect example of whether the standards that you have today to govern that, there is a laboratory out there for that particular contract.

I thought that there was quite a bit of concern in wrestling with the degree to which the kind of front-end credit check of the clearing member is brought to bear. It seems to me the regulatory issue, either for the clearing house and, certainly for things that will come up in the second panel, are whether there need to be common standards for risk management at the front end.

Was that your point?

MS. DOWNS: Yes; that is one of my concerns. I know that NFA is currently in the process of a best-practices study that is getting towards its end. One of the questions that has come up there is just what is risk management and where does it need to occur and what are going to be the best practices associated with it.

I think that you have to take it from two angles; what is it in the business-to-business environment--I think we can all define that a little differently, to be honest--and what is it in a retail environment.

I think we kind of know what the retail environment is. I make the argument that, depending on how sophisticated even some of those small business-to-business environments are, you could put them in a retail category. So I think it is going to be interesting to see where risk management needs to evolve from a regulatory perspective when you have what looks like a business but, in fact, are very unsophisticated users, which is where many of the new exchange environments are headed to try and attract and to bring into this environment. That is, generally business-to-business, but they are very unsophisticated in terms of futures.

Any other thoughts on automated order routing systems?

MR. GARDNER: Just to reiterate some of what Philip said and some of what Ken said. The mechanism where the differentiation between an order and an execution in this type of world where, does it stop at the intermediary or not, or where the filter is, I think that the technology and the mechanisms that exist today can allow that type of object or credit filter or whatever, is clearly at the front-end of whatever it is.

The intermediary plays a significant first-level role and should continue to play that, we feel. The differentiation between direct access or flowing it through an intermediary and where that direct access actually emanates from in this world, which is going to be tougher and tougher for us to figure out, whether it be from the U.S. or offshore.

These are going to be things that are going to be very, very important things for all of us to focus on in the next couple of months because that is a key point that we just should keep focus on. It is less the issue of where it emanates from and more the filter and the integrity of that type of a process that I feel is important.

MS. DOWNS: I think we also have to look, though, at the question of whether it is on the front. I will tell you, for outside customers' exposure to a company, yes, they want that filter on the front end. But if they are internally monitoring their risk and the amount of exposure they want to put into a market, they are not filtering that before it hits a trading engine.

Most businesses are willing to take that risk and monitor it either as it is occurring or after the fact. So I think we do have to be conscious of what the relationship is of the customer to the intermediary in determining risk.

MR. BORISH: I think one of the things that we have to try to get away from, if we can, is the notion of labels, sophisticated, unsophisticated, retail, non-retail, because what technology does is, it enables it to merge it. Yvonne is saying that you have a lot of B-to-B but they are unsophisticated and not users.

Who, ultimately, is going to be there to sort of say here is the checklist for who is sophisticated and who is not sophisticated. What we want to do, I think, and we will get to that in this second part--just sort of what the technology does is even the playing field.

If you compare this universe sort of to the equity universe, it doesn't matter-- right? Somebody can have one stock in their portfolio and then, tomorrow, they can decide to trade a stock that has just declined 50 percent in two days. It is not the regulatory apparatus that makes that decision.

The risk management should lie with the FCM or, on the equity side, with the broker.

MS. DOWNS: I don't think technology is a question of sophistication. It is a methodology. It is a means to get there. It has nothing to do with sophistication.

MR. ROSEN: I would like to distill a couple of issues here. First, if you have the technology on the front end to perform a real-time credit filter, you have solved your problem. Let's be honest about it, nobody, for any major system, has the ability on the front end to have a credit filter that, on a real-time basis updates outstanding positions of their clients and we are probably a little bit aways from there.

So there is the ideal. But the more practical question is what is an acceptable mechanism in the absence of the ability to pre-screen with certainty the orders that are coming in.

I just want to say that that issue is not just an AORS issue, that an intermediary is, perhaps, appropriately tasked with the responsibility for monitoring it. On an electronic exchange, it is the same issue that a clearing member has with respect to those members who are not clearing members whom the clearing member clears.

At that level, the ability to screen for credit and have real-time risk-management process has very significant implications for the exchange matching engine and the efficiency of the system and all sorts of issues.

I really believe that the question from a best-practices perspective is what, short of the ability to prefilter with certainty, is going to be an acceptable measure of risk management. Because, once you have gotten there, you have solved your problem.

MR. FITZSIMMONS: If I can jump in. In regards to the filtering, and I think one of the things that I think maybe this committee has to look at is whether it should be mandatory for a customer, whether it be a sophisticated customer or a retail customer, to come in through some sort of a filter because I think you do have to get back into the classification of retail versus sophisticated.

I think what Yvonne was pointing out is that there are many different types of traders out there. There exists, right now, in the electronic environments of a LIFFE exchange or a Eurex in which, you do have members who are not clearing members, that access the matching engine directly without a filter.

Jim Heinz down there, who is at Marquette Partners, maybe can shed some light on this where he may feel that he is at a competitive disadvantage where, if he is not a clearing member of one of these new seven exchanges out there, and he doesn't want to become a clearing member but wants to use the services of a Goldman Sachs or a Merrill Lynch.

But he may strike a deal with them in which he says, "You know, I don't want to go through your screening process because that will slow me up by one-tenth of a second and I will be put at a competitive disadvantage in which I feel like I can't get the edge," and, therefore, the issue is does the CFTC look at it that the intermediary has to screen before the trade goes through or is that a risk that the FCM takes upon itself.

I think that is really what the question is on the table here.

MR. HEINZ: Thank you for putting me on the spot. We are all about direct access. We would never route through Goldman Sachs or anybody else. In fact, I was going to add something. I think we are going to get to that in a little bit, but one of the things that we object to that currently is available out there at the front ends of order routing systems is not just a credit and risk-management screen or filter, but the ability of the FCM or large institution to take the other side of the trade, directly trade against that order flow, in essence a pre-exchange match, which we are definitely opposed to.

So we are all about direct access and a level playing field and I can't envision us ever order routing through any other entity. I might also add, I agree with Peter. I think there is less and less of a distinction between sophisticated and retail. I think that the people out there are much more sophisticated than we all give them credit for and we should recognize that.

MR. HINKLE: Jim, can I ask you a question?

MR. HEINZ: Sure.

MR. HINKLE: In your viewpoint, is it a prearranged match if the counterparty that takes the other side of the trade simply happens to have the contra position already on?

MR. HEINZ: Yes.

MR. HINKLE: So then you would consider trades done in the pit prearranged matches?

MR. HEINZ: No.

MR. HINKLE: I think that is what you just said.

MR. HEINZ: No; what I am telling you is this. If it is 48/49 and I order route through Goldman Sachs, and I hate to point to you--I'm sorry for using your name.

MR. LEITNER: That's okay; as long as you clear it through us. [Laughter.]

MR. HEINZ: It is 48/49 and I order route it through Goldman Sachs, and Goldman Sachs, their proprietary side, wants to trade 1000 with me at 49, and they prematch it with me, what about the guy in Eurex or some other platform that is currently offering at 49, but doesn't get a chance, who was first in there making the market at 49, I don't think that is fair that they would get the trade ahead of the guy who originally made the market at 49.

MR. HINKLE: Then you would like the Archipelago model where it can route you to the best execution no matter where it is, on multiple exchanges, multiple platforms.

MR. HEINZ: Yes.

MR. HINKLE: And you would be satisfied.

MR. HEINZ: Yes.

MR. LEITNER: It is amazing to me that you can't really talk about the front end unless you talk about the back end. The issue here, I think, is that the questions of order handling and the protocols in a particular exchange, to some extent, perhaps, ought to be left to competition to figure out who the winners and losers are.

But the issue of risk management, in terms of an order-routing mechanism where any trader, B-to-B or retail, accesses a market in which there is a clearing mechanism, the integrity of that clearing mechanism is critical from a systemic point of view. For that to have integrity, it means that all of the clearing members need to know what their positions are at all times.

I can never forget the story written up in the Financial Times of a firm, not present at this table, I don't think, who had an error because the guy, the trader, put his elbow down on his clicker and sent in about--until he lifted it up, it was an order for several million dollars worth of contracts, and he wanted to execute ten, or something.

MR. HINKLE: It was actually French francs, and it was in the order of billions.

MR. LEITNER: It was a lot. They self-cleared and that was their error and their problem. But what if it came to somebody else. So the issue of what parameters there ought to be--and, by the way, Ed, speak for yourself. There definitely are filters that some firms are--we are not going to let customers trade without some ability to know, at least in their account, what they have got.

On the securities side, for example, there are circumstances where you cannot let somebody trade if there is a deficit in the account, from a margin point of view. So there is a regulatory barrier on the securities side that would actually require us to make sure that those parameters are not exceeded.

But, on the futures side, the issue, I think, comes down to whether, as a regulatory matter, you place the standard setting on the clearing system or whether you put it on the intermediary directly as a matter of regulation. I think that is a tough question as to kind of where it should be.

Right now, I would suggest the rule already is that the intermediary has that responsibility because of the books and records requirements that are placed on an FCM and the requirement to have systems in place that allow you to monitor risk. So I would suggest that it is already there. The question is whether there also should be standards on the clearing corps to assure that, I think.

MS. DOWNS: I would tell you that, in theory, all of this is true. In practice, there are holes. I think if everybody were to look at their own shops that you would see some of those holes. So I agree that conceptually that is true, but we all know of examples where it doesn't happen on a regular basis.

MR. DAVIDSON: I would just make a couple of suggestions with respect to this discussion. First of all, I think Yvonne's premise that she who provides access ought to be responsible for risk management isn't a bad premise and, if it is an intermediary that provides that access, then, certainly, that intermediary ought to have that responsibility and, in fact, even without filter systems, intermediaries have been doing that in equity markets for a whole lot of years.

I think, on the other hand, there are exchanges that make determinations about who has access. If an exchange does determine that they are going to allow certain other categories of non-intermediary market users to have access, then it is up to the exchange to set a reasonable set of risk-management standards.

Again, I think that is not particularly uncommon. The Chicago exchanges have granted access to their markets to floor members, but with the requirement that some intermediary guarantee their performance. If that intermediary stops guaranteeing that performance, that individual is still a member in good standing but no longer has access to the execution environment until he or she can find some other intermediary or change the requirements dealing with the first intermediary.

That could certainly work in an electronic environment for customers that got direct access but found one or more intermediaries who, ex post, were willing to take the credit risk for all of their transactions until they pulled the plug.

The second thing that I have observed, it seems to me that this discussion does show a real issue with the current regulatory system, particularly the self-regulatory system, in that these kinds of issues are not issues which are well determined by exchanges.

Exchanges inherently have a conflict of interest between the immediacy of access to the execution environment, and it doesn't matter whether we are talking about an electronic marketplace or an open-outcry marketplace or some combination of the two, an exchange has got an inherent conflict there.

Customer credit issues and general market participant credit issues are cross-exchange issues. People don't go out of business because of trading in one particular product. They go out of business because of trading in all of the products that a particular customer happens to have in his or her portfolio in those cross exchanges.

Likewise, the balkanized clearance structure that we have in the United States today also interferes with the ability to see, on a timely basis, information about the participants, the direct participants, who ultimately are making these credit decisions and that doesn't help the process at all.

MR. ROSEN: I would like to agree that I think if a customer has, as its point of access, an intermediary's connection into the network that leads to the matching engine, then, consistent with the intermediary's responsibilities, whenever it handles customer orders for which it is financially responsible, the responsibility for that has to vest in the intermediary.

That is a different question than what is the appropriate and best source of technology to enable them to manage that risk. Coming back to the point that you made, Tony, I agree; there are all sorts of filters. It is not hard to put in a filter to screen an order. I am simply saying that a mechanism that allows you to monitor your aggregate risk on a VAR basis that takes account of what orders that have been routed in, have been executed and cleared and come out so that you actually, really accurately, screen based on a net risk basis.

That doesn't exist today and the question is what screens, less than that, satisfy what I think you referred to as sort of the internal system's internal control responsibilities that an intermediary has not to be blown up or otherwise create problems that put it out of compliance with its regulatory responsibilities.

I think that is the trick, balancing the available technology and what is reasonable to have in a market in which customers don't want all of their orders to be stopped and vetted a second or screened or otherwise require human intervention that gives them less efficient access to the market that technology could provide.

I think that is really the trick here.

MR. WOLKOFF: Neal Wolkoff with NYMEX. I think to the extent that customers of intermediaries are doing business on multiple markets, there is really no exchange that is going to provide a single mechanism to allow for an appropriate measurement of risk across exchanges.

I think that goes to John's point about the benefit of possibly having some sort of a consolidated clearing mechanism where that could be done but, typically, at the large trade house or FCM, that analysis is done routinely internally with proprietary software.

Without looking at the regulatory issues but just looking at the business issues of risk, I would want to point out that there are, in fact, systems, NYMEX-access electronic system included, that do perform pre-execution filtering for value at risk for net position and the like and maintain response time.

It is expensive. It is resource-intensive and to the extent that it were to become a mandatory requirement, because of the expense would probably contribute to some form of a barrier to entry. Whether that is a good thing or a bad thing, I am certainly not here to advocate.

But one point that I will make that makes it very important, certainly to our FCM community that is taking third-party responsibility for these trades, is the extent to which many of the transactions are taking place at non-traditional trading hours.

Remember, one of the purposes and benefits of electronic trading is the ability to allow market access during non-traditional hours. So, to the extent that FCMs typically don't have full-time risk-management staffs, the same kinds of resources available during the evening or, certainly, during the middle of the night, it becomes something of a business requirement that, if you want to ask an intermediary to intermediate, you provide the mechanism for that intermediary not to incur the cost of having the same staff in the middle of the night that they would have when the markets are operating full time.

So there is a fairly compelling business reason for systems to offer that type of pre-execution screening. Technologically, it does exist. It is not a never, but across the board and it is expensive. I just wanted to point that out.

MR. NEWSOME: We are going to try to stick to a pretty tight time frame because I know most of you have flights back out of here this afternoon. But, before we leave this first area, we would ask Phil Johnson to think about it and make some comments.

MR. JOHNSON: I am just wondering whether the same level of angst was witnessed when people stopped sending their orders in by mail and sent them in by telephone. Aside from that, I am supposed to talk about fraud and manipulation. Bad things will not cease to happen simply because electronic trading systems are in use. But the capacity to respond is going to be significantly different. I provided a couple of charts here that I think each of you has now. The first is a brick-and-mortar exchange chart and the second is an E-trading chart. Nothing particularly intellectual about either one of them. There is only one point I would really like to make.

If you look at the brick-and-mortar, the center of the universe is the member. Now, our entire regulatory structure is built up around the assumption that, if there is something wrong, you can manage to resolve it. You can manage to cure it in some way by or through the members of the exchange.

If you look at the E-trading exchange, where did the member go? The member is now down at the bottom of the page, called the subscriber, tethered to the market only by reason of a contractual relationship, which can be terminated at any time.

Suppose something goes wrong in the market today and we have a brick-and-mortar exchange. There are things you can do to members that they are likely to comply with by reason of two incentives. The first incentive is, I have the man's seat, which is worth a million dollars and if he doesn't want to pay a $50,000 fine, that is perfectly all right with me. I have plenty of collateral and I will just liquidate on that.

The other is, I am likely to be across the table from someone who is making their livelihood on that market. Now, let's look at the new subscriber in the electronic-trading environment. He is probably not making his living, just using it as an adjunct to his normal business. Second, I don't have possession of any collateral belonging to that particular subscriber that I can use to make sure that he even shows up for a hearing, let alone pays a fine.

So I think the greatest challenge that we are going to see in the electronic-trading environments is not that the activity is going to change so much but the capacity to respond and the manner in which the response will be done will be quite different.

I do not know a single venture capitalist in the United States and I do not know a single electronic trading system that wants to spend half its budget operating as a collection agency chasing after fines that are assessed against these various subscribers with whom they have absolutely no other relationship except the fact that they are using my exchange the way AOL and I have a relationship or Network Solutions and I have a relationship.

I think the greatest regulatory challenge that we are facing is the fact that we have ownership and use totally uncoupled in the future. That is going to necessitate quite a different structure in terms of trying to make certain that those who do misbehave can be brought to account in a manner that replicates, as best we can, what we have had in the past.

If we cannot do that, then about the most any of us is going to be able to do as an operator of a system is terminate the individual, let the word out that this is not someone you or anyone else wants to do business with in the future, and that is going to be about the extent of it.

So it is response. It is enforcement. It is detection. It is investigation. It is inspection. These are the levers that are going to be much more difficult to pull in the future than they are today.

MR. HINKLE: Phillip, I wonder if I could ask a question. In the way you just laid out the model, do you see there being a difference in the speed of response that might be helpful as you look at the electronic environment, maybe not the comprehensiveness or the threat and negative incentives or disincentives or penalties that can be put upon what you call the subscriber, but at least the speed of the response. Do you see that as potentially a benefit?

MR. JOHNSON: Certainly, in electronic trading systems, the ability to detect problems will probably be at least as fast as it is today under the best systems we have in the brick-and-mortar markets.

So, getting the information should not be a problem so far as I can tell. The question is, what do you do with the information once you have it. And if you, for example, were one of my subscribers and you were living off in Aukland, New Zealand and I called you up and said, "We have reason to believe that you have just front-run one of your customers. Will you please fly to the United States, and bring a lawyer with you, and we are going to have a trial and you are likely to get fined or punished in some other way."

Would you buy a ticket? I don't think you would. I don't know anyone in the world who would do that. That is the biggest danger we have now is that there is no real leverage on the users of these markets anymore to require them, to induce them, to come and submit to any sort of regulatory scheme, other than the government.

So I think there is a wonderful future for the CFTC, Mr. Chairman, but I am not sure that self-regulation in a purely contractual relationship environment works at all.

MR. RAISLER: Phil, could you just comment. You have the model of the brick-and-mortar in a mutualized environment and you have the E-trading demutualized. Obviously, some of the fututres exchanges who are still brick-and-mortar are talking about demutalizing.

Actually, I am not sure I see a difference between a demutualized brick-and-mortar exchange and a demutualized E-trading exchange.

MR. JOHNSON: I think the two levers that I mentioned earlier will still be in place with the demutualized until the equity begins to filter out into the general public. Eventually, the board of directors of an exchange in the future is going to consist of former Chairman Rainer, Liddy Dole, Colin Powell, Michael Jackson and perhaps, one or two other sports heroes.

They are not going to be people who use the market at all. They are going to be public citizens the way they would be if they were to join the U.S. Steel Board or the General Motors Board or anything else.

Initially, with the members simply becoming equity holders, the leverage continues in terms of the capacity to seize the equity interest and to use that as the inducement for them to submit to the jurisdiction of the exchange, to pay the fines and things of that nature.

But as that filters out into the general public, which is the long-term plan of every demutualization plan I know, it is going to become increasingly difficult to maintain the kind of control over these folks that you would like.

MR. DAVIDSON: Your comments are very to the point. I suspect the reality is not quite as stark as you have painted it. Existing brick-and-mortar exchanges have long used denial of access as a means to help enforce things like large-trader reporting over entities that they don't have any direct membership relationship with.

Obviously, that depends on your ability to have a monopoly in a particular product which may ebb away as we change environments. Likewise, I am not sure that either NASD or NFA have a lot of collateral from their members against which they can actually offset whatever fines. They have, if you will, a form of denial of access, denial of registration, which serves that purpose.

But, again, that does not speak to authority over end users.

MR. JOHNSON: The NFA is a good example of where the leverage comes from being able to put someone out of business who is very reliant on being in that business. That is a very, very serious threat in that environment but you are quite right, there is not really any collateral.

The subscriber I am talking about, and I probably agree with you and I am getting a little starker than necessary, but in a pure E-trading environment, the subscriber's relationship would be purely contractual. The capacity to respond would be purely contractual and the result would be a fairly boring termination of service and very little else.

MS. DOWNS: I would just like to make the point that, in electronic systems, although there is a lot of information, two things have to happen. It has to be filtered well so it is meaningful to provide any kind of less regulation but focused regulation, if you will.

And, number two, I think that there needs to be a capturing of the data in a way that makes that possible. I know there is a lot of data and everybody doesn't want to capture it because of the economics of maintaining a lot of data.

And so they have a tendency to want to leave it at different levels. I would make the argument, you have to be able to reconstruct it all to be able to do any kind of reasonable surveillance.

MR. HINKLE: Phil, can I ask you another question? If you take your comments and you think about the case of Eurex, which will soon be the largest subsidiary of maybe a $7 billion public company, would your view be that it should not have access to U.S. markets because its model is the one you are not supportive of?

MR. JOHNSON: I have no trouble with the model at all. I am just suggesting that there tends to be, in discussions, particularly in this transitional period, references to members, references to other things which have their routings in an entirely different dynamic from what we are going to be seeing in the future.

I could see a future in which the electronic trading system is operated exactly like the telephone company and where all of the ethical surveillance will be done at the federal level.

I suspect, Mr. Chairman, you will see fewer registrations in the future and there may be one or two bodies--there may be even dozens of bodies--around who would be able to switch over to the Division of Enforcement for this sort of purpose. So I have no problem with the model whatsoever, but I think what we haven't necessarily focussed on as much as we should is the question of response--not detection but response.

MR. LEITNER: One quick comment. Over the twenty years that I have been close to the securities and futures industry, I have seen the concept of sin redefined several times. I think that the interesting issue, of course, is fraud and manipulation, as they are defined in our act and the ability to sanction those violations, presumably, we will know it when we see it.

I would suggest, however, that, as Jim Heinz was saying, the nature of the environment in which the trading occurs--a Eurex environment is a good example because their protocols and the fact that the entire book is visible and nobody can hide anything, is a different environment.

If you create rules that say that certain things can't happen, then the ability to surveil for that--and the way you define sin is a kind of a different set of issues than if you have a different environment. I think that one of the things that the Commission will have to grapple with is that, as radically different ways of trading emerge in the futures markets, will there be the same need to deal with prearranged trading and so forth.

What is prearranged trading? Is it really good or bad or whatever? We have all these ideas about what is bad in a particular market because that is the way the market evolved on the floor. So we just need to keep in mind that sometimes the idea of what is a manipulation is in the eye of the beholder.

With regard to front running, I still remember, I think it was Andresen's comment, that you can't front run real time.

MR. DURKIN: Could I just make one comment on this issue with regard to Mr. Hinkle's comments on the speed of timing information coming through. I agree with you. I think what we need to dissect here is there is something that we call market supervision versus market surveillance. I do concur with the Eurex model in the context that, as that information is coming through, you set up systems that are real-time, able to take that information in and you have people there that are monitoring what is happening in the market at that point in time.

That goes to your comments, Mr. Leitner, with regards to setting up the right protocols and rules which they have in place that says market supervision has certain control over the conduct that is coming through and the form of trade that is coming through. And they empower their people to address those issues immediately.

They also have a separate surveillance model in place to look at after-the-fact types of conduct. But I agree with you that just because the speed of information is coming through, it doesn't mean there isn't a different way for us to transform our way of monitoring those markets and making sure that the integrity is there.

MR. NEWSOME: Let's change gears because we are a little bit behind time. I want to tell you that, certainly, everyone's comments and thoughts on this topic are very important. What we plan to do--after the meeting, your responsibilities are not over. We are going to go back to some of the bullet points, some of these primary agenda items, send them to you and ask for a written response so that we will have a hard copy.

I think it will be very useful to the Commission to have your thoughts on paper. So even if you didn't get your comments across during this brief discussion, you are going to have the opportunity to do so.

Our next agenda item is common trading platforms and common clearing. We asked Tony Leitner to head the discussion in this area primarily because this agenda item was his idea. So, Tony, we will turn that over to you.

Common Trading Platforms and Common Clearing

MR. LEITNER: Thank you, Commissioner. When we talk about common trading platforms, we are really talking about an electronic environment. I can think of no better way to tee up this issue than to think, as I was talking with Brett Paulson a little earlier, the Chicago Board of Trade is considering merging with the CBOE.

They have always sort of had a sort of incestuous relationship with their members, but I guess they will redefine that and then, potentially, demutualize, I suppose, in the future. They also have a strategic relationship with Eurex. So we have, literally, the possibility of a model, a demutualized model. I think Commissioner Erickson gave a great presentation in the enemy camp at the New York Stock Exchange two weeks ago about the potentialities for demutualized exchanges under the umbrella of an investment-bank holding company in which you had clearing, a securities exchange, an options exchange and a futures exchange all commonly owned, which may be the worst nightmare of some people.

But if you had any kind of organizational structural model empowered under new legislation, how could it be used to the benefit of traders and investors. One way, potentially, that it could be used is to provide essentially a front-end screen on which products which have common characteristics--and if we take, for example, the equity-index product as an example, sticking with the financial futures, or financial products, for a second, we have options on, say, the DJIA or the S&P.

We have futures options on those products. We have futures on those products. And we have the underlying cash market. There isn't, I believe, any technological reason why, on one of these double flat screens that most of our traders have, and I can't wait to get myself, that there will be the visibility and ability to, in fact, place orders simultaneously for various combinations of transactions, to hit the send button and to have those automatically executed at prices that are immediately executable for a displayed size in a particular market and where those products will commonly clear in a single environment and where the intermediary will know immediately exactly what is due or owing on a net basis from his customer.

We will have all the assets in one place and in one account and we will be able to risk manage the entire process much more efficiently than, in any case, we do today. So that is the picture, at least that I have in my mind, about feasibility.

Now, it is not clear that anybody actually wants to do that. But, certainly, the environment around the world where they don't necessarily have different jurisdictional issues as we do here, that is definitely a pattern which is emerging where exchanges currently trade both the equity and futures products and, in fact, cross-margin.

When I talked about common clearing, it probably was a misnomer because it would probably be better to say intermarket clearing, at least in the way we think about it today. We have something called the Intermarket Clearing Corp right now which, with respect to the type of index product that I was talking about, does provide a mechanism for the netting of certain types of products traded on, I guess, the Merc and the CBOE, although it is something available to a fairly small group of users.

So we have kind of the technological capability. We have had some nascent attempts to bring about risk management at the clearing level. What I would like to pose to our discussants with whom we have had no prior discussions, by the way, so I have no idea what anyone is going to say, unlike the well-prepared first panel.

But, since I know, by what they have said already, that they will be not at a loss for words, may I ask Mr. Davidson to lead off with any comments he may wish to have on the subject.

MR. DAVIDSON: Sure. I will start from the back end, if you don't mind, and spend a little bit of time on some of these clearing issues both here and outside the United States. The general issue, if you will, is that direct participants in multiple related markets or in market segments of the same market, are currently forced to deposit collateral to support either margin requirements or clearing fund requirements or whatever the market happens to call that thing with multiple organizations to support what are essentially offsetting risks.

As collateral becomes more scarce and expensive, this feature of the existing clearing and settlement environment is likely to become a material disadvantage for exchange-traded derivatives. The reason for that is that, while OTC derivatives, as a general rule, lack the multilateral netting advantages of a central counterparty found in the exchange-traded derivatives markets, to a growing extent, over-the-counter derivatives are documented in the context of cross-product netting and collateralization agreements so they do not have, to the same extent, this problem of multiple deposits to multiple pockets.

The issue is complicated when you start bringing in the cash markets by the fact that a number of them do not, or do not as yet, even have a central counterparty. Two examples of that are the Deutsche Borse for trading of German equities and the London Stock Exchange for trading of all types of European equities. And there are a number of other examples.

The issue, as Tony suggested, is not a technology problem. We have long had the ability to make intelligent decisions about portfolios and the risk associated with those portfolios, and there is not a lot of evidence that that technology has broken down, even in light of the current market volatility.

To sort of give a brief roundup of where things stand, one can say that this is an issue which crosses all of the product types in which we are involved, that is, interest rate, physical commodity and equity products. I don't have a lot of expertise in anything except equities so I will give you a brief summation of where things stand with respect to equity-related products.

In the Asia-Pacific region, there is virtually no recognition of this problem whatsoever, in Taiwan, Japan or Korea. In fact, the Koreans are about to make the situation worse because they are listing their version of what one would consider the NASDAQ 100 futures contract on a separate exchange requiring separate collateralization.

There is some recognition of the problem in Hong Kong, Australia and Singapore. Neither Hong Kong nor Sidney have yet released any specific means to address these cross product collaterilization and common clearing issues. Singapore has merged its exchanges but first has to deal with the fundamental problem that their equity exchange does not have a central counterparty.

In Europe, there is a lot of recognition of the problem and a great deal of progress. The problem is you need a really powerful thesaurus with a bunch of different iterations of the word "clear" in order to understand who is doing what with whom.

Briefly, ClearNet is a subsidiary of the Paris Bourse and it has agreed to merge with the London Clearing House which may or may not use Clearing 21 software, which is also being peddled to a bunch of uninvolved exchanges.

ClearStream, on the other hand, was created through a merger of a fixed-income international central securities depository formally known as CEDEL and the Deutsche Borse Clearing Corporation which is, in fact, a depository and not a clearing house but does not seem to involve Eurex, as least as far as we can tell at this point in time.

EuroClear has announced a merger with Sicovam, the French securities depository. This new entity will be the preferred settlement agent for EuroNext which is the merger of the Paris, Amsterdam and Brussels exchanges. But, in all the discussion of that particular merger, there is not a lot of clarity with respect to what happens to the Options Clearing Corporation that is a key part of the Amsterdam Exchange.

Just to complete the confusion on the European front, the London Stock Exchange has had serious discussions with the London Clearing House about providing central counterparty services to that market. That, however, could get altered depending on what happens to the London Stock Exchange/Deutsche Borse merger discussions which may have been going on over this past weekend while all of us were hunting for Easter eggs.

In addition, the EuroClear merger gives the surviving entity, which doesn't yet have "clear" in its name, a 20 percent interest in ClearNet but the dance card is too confused to figure out what that means.

Finally, it is clear that--or it is "transparent"--perhaps a better word--speaking to a number of the major international participants that they are pushing hard for a merger of ClearStream and the EuroClear/Sicovam surviving entity which would cause you to have a single location for the settlement of most of these transactions as well as the collateralization of most of them. What real progress has been made in that regard is not clear at this moment.

In the U.S., it is certainly the case that everyone is talking to everyone else, whoever "everyone" and "everyone else" may be, and there has been some progress on some institutional consolidation, particularly on the cash equity side, with the merger of the Depository Trust Company and the National Securities Clearing Corporation to create the DTCC.

There are still, in my mind, three issues that are pertinent and in the way of an ideal solution to cross-product, single-platform, clearing and collateralization in the U.S. The first is that the full consolidation of DTC's participants' fund and the NSCC's clearing fund is not yet on the table due to the conflict of T-plus-one settlement for equity issues and the bank custodians' insistence that they are not principals on trades which they settle.

Second, there is a certain amount of complacency around the existing "cross-margining agreements," not withstanding the fact that they are particularly operationally cumbersome and inefficient. Finally, there is the insistence on the part of some of the exchanges, particularly the Chicago Mercantile Exchange, that clearing ought to be a for-profit venture and the beneficiaries of that profit ought to be other than those who mutualize the risk.

I think that changes the appetite which the risk mutualizing parties have for a solution which involves those participants.

MR. LEITNER: Just a quick question for you, John. Obviously, comparing the U.S. to Europe, what we see on the clearing side is a patchwork quilt which is a legacy of different markets, different legal systems, and the attempt, to some extent, by private enterprise to try to create some rationality.

If you go back to EuroClear and so forth, it was industry trying to create a demutualized environment of the cash market and so forth. In the U.S., not withstanding, some of the points you make about where we are not at, wouldn't you agree, however, that we are much closer?

After all, we have a legal system that recognizes the dematerialization of the cash-market product. We have a regulatory environment, at least on the securities side, for setting standards and, presumably, for modifying those standards for those products. And we have a futures clearing system that, for a lot of things that could be criticized about it, from a risk-management standard, does have the advantage of making sure that, at the end of the day, as a former partner of ours used to put it, "the money is there."

So I certainly get the impression, and I ask whether you would agree with this, that we are a lot closer to the potentiality, at least--to realizing the potentiality of true cross-product netting, as a practical matter, here than there.

The question, to me, anyway, is, what are the jurisdictional/regulatory roadblocks that stand in the way? By the way, let me just mention one other thing and that is we have completely clearly enforceable netting in the clearing system now as a result of the fidicia. That is also a great, I think, level of certainty with regard to the clearing systems here. It may still be somewhat open to question in the European model.

MR. DAVIDSON: I think your points are very well taken. With the exception of institutional inertia, there are a lot more favorable things in the U.S. environment with respect to being able to accomplish this including the UCC regulations, as you mentioned, the regulatory environments with the minor complication of customer-segregated fund requirements--but that is, indeed, a relatively minor impediment--and a legal environment which is friendly to netting and a proposed regulatory environment from the CFTC which is very positively disposed towards allowing clearing arrangements when they make a lot of sense.

I would suggest that the very success of the clearing infrastructure in the U.S., both in the cash markets and in the futures markets where there aren't questions of financial integrity, in fact, have increased the institutional inertia as opposed to working in favor of getting from the participant's perspective a more rational system.

I actually think, in the U.S., the institutional inertia issues are the ones that need to be overcome whereas, outside the U.S., there are a host of differences among the legal jurisdictions. Really, my comments on Europe only begin to address issues in five or six major markets and don't really speak to the non-European community markets which are significant as well.

MR. ROSEN: Tony, can I ask John a question about the institutional inertia issue? It seems to me there are two, maybe diametrically opposed ways of getting at that issue. One, you can try to force and encourage different clearing houses to come together. Another way to come at the problem, perhaps an opposite way of coming at problem, and I would be interested in your views of the efficacy of the two, is to free the clearing member up so as to eliminate the ability of any organization, exchange or market to place a constraint on a clearing member with respect to where it chooses to clear trades so that clearing members could elect any clearing corporation that was able to provide the services to clear the risk associated with products.

And then you let the natural market forces take the risk where the clearing members want to consolidate it instead of trying to force the clearing corporations. Do you have any views on what might be a more efficacious approach?

MR. DAVIDSON: Certainly, looking back in the United States, in the environment in the securities markets where there were multiple clearing corporations and multiple depositories, it used to be the case that each of the regional exchanges had their own clearing corporation and depository and now they all make use of the DTC and the NSCC.

But, in that environment, on the securities side, each member that was a member of those organizations, could decide where it wanted to clear and settle IBM. Just because you traded it on the New York Stock Exchange, you still had the ability to clear it at the MidWest Clearing Corporation if that was your choice.

That is very much based on the notion in the securities market that a security is a product of an issuer, not a product of an exchange. That doesn't seem to be the predominant environment. For some reason, there is this notion that a contract traded on an exchange is, in fact, a product of that exchange and, consequently, the exchange has this ability to direct the clearing relationship of its members.

I certainly think there ought to be the ability to move open interest to whatever clearing organization a particular market intermediary has an interest in utilizing. I would suggest that a single entity is still more efficient, particularly if it operates as a utility. But, again, there is institutional inertia between that objective and where we are today, as well.

The existing contract markets in the current environment, absent some sort of draconian thing like action on the part of Congress, would be required to go along with that change unless some new exchange started up and happened to list all of the products that were not subject to copyright and other sorts of agreements such as stock index futures, in which case, presumably, absent differences in market liquidity, the open interest would move to the clearing arrangement that was best favored by the market participants.

MR. RAISLER: I would just raise a point of order here. This discussion, I think, is very important and actually very interesting to the future of the industry but I am having a little trouble tracking it to technology. I wonder if we could sort of keep that filter there in some way because I think these are important issues.

Consolidation of clearing and where clearing goes is very important but I am not sure where it fits into the Technology Advisory Committee context.

MR. LEITNER: I would say that the key technology issue is the ability to compute, on a real-time basis, or as close to real time as you can get, exposures across markets, and I think there need to be linkages and agreements similar to what exist in the Intermarket Clearing Corp today, the ability to come up with an exposure number.

That ability is there. Technology creates that -- communication technology and computational technology. So I don't think we are dealing with--and I think, frankly, Ken, that these capabilities have been there for a while, so that here, it is more a question of empowerment and a need for the two market regulators to kind of come together to find appropriate solutions that are risk-reducing and, I think, emphatically, cost-reducing.

I mean cost-reducing in two senses; the actual out-of-pocket cost and for some people, even more importantly, the amount of capital required to maintain positions. One of the biggest drains in the current environment is the need to, in fact, come up with capital to support customer positions in different environments.

That is a separate issue from the question of the customer's relation to the intermediary and the capability within the intermediary to look at netted positions. So we have got kind of the market side and we have got the institutional intermediary side in the way the accounts are carried.

There, all I would say is that the FIA has made some, I think, excellent proposals to you already that, hopefully, will be the subject of serious discussion that will require, I think, sitting down with the SEC. I certainly see that there are areas of a potential solution. We have to keep in mind that, from an intermediary point of view, one of the biggest nuts to crack is the different approaches to the insolvency regimes and the SEC's model, which involves an insurance scheme through SIPC and the futures regime that involves segregation.

These things have to be reconciled. I certainly think there are ways to do that and a starting point and a road map has already been proposed. But I would say that, on the clearing side, the institutional will--first, there is what is the model. The second is, what do you need to do to make that model happen.

John, thank you very much for your comments. I think that the summary--if you would, please, as your home work, draw up a diagram, put your European context in a way that we could all see, maybe, with lines and boxes, that would be extremely helpful.

Peter Borish, do you want to take this up now?

MR. BORISH: Yes; since I am totally lost. I am very much confused here. You get down into the specifics and I hope, and I think Ken was trying to say, that you want to have sort of a top-down approach here rather than a bottoms-up approach. I sort of have more questions and then a couple of comments.

First of all, I am not even sure I understand, at this stage, when everybody talks about risk management, what it is. Are people talking about risk management to the person who is making the trade and their capital or is it risk management of the exchange so that somebody that is trading on the exchange doesn't take too large of a position relative to their own capital and, if exchanges are going to be thrown open to competition and there is sort of no natural monopoly for individual products as they can go, if they make the mistake, then I don't see why they can't fail.

Exchanges should fail if they don't have the proper safeguards, which goes a little bit to what Phil is saying. If you are a subscriber and the exchange doesn't enforce its activities, you are going to go elsewhere. If you don't like the way Bell Atlantic works, you go to RCN. If you don't like RCN, you go to AT&T.

I think that the customer will be much more mobile and be willing to vote where its trades go. I think one other thing that is missing in this entire discussion -- we talk about all these products but we don't talk at all about what happens and when, we have futures on individual equities.

I think we all realize that the capitalization of a number of individual equities relative to the capitalization of even the largest futures contracts is much greater, that futures, in themselves, and I am obviously very pro futures, are movements to control volatility. There are more natural buyers in a market when these happen. If you look at all mature futures markets, volatility tends to leave because you have these natural buyers and sellers.

Since, given all the products that we have now, and particularly in options, you can create synthetic futures--that is Options 101. I don't see why we don't have futures on individual equities. I think it would be a benefit which will then throw everything together.

So, as far as sort of my questions, I just throw that out there since I am totally lost. If anybody wants to help me find my way, that would be wonderful because I know a lot of people feel I should do that.

The other comment I have, or the real question, which is on the front-end issue, is, if I have a machine that deals with real-time quotes and that is what I get, and I have my real-time technical analysis and everything and it is like right here, I was tempted to put an order into my desk and sell some bonds right before the close, but I have twenty-eight minutes so I am going to wait because I am very bearish on those things. And I will do that.

But why do I need to go through that intermediary? If I have something as a real-time quote, why can't I just go ahead, have an automatic alert in there. It is 2:58 Eastern Time. I want to sell some bonds on the close. Boom, it automatically gets routed to the exchange, vetted through whatever intermediary.

That is sort of where I want to go. I want to have it efficient. I may want to eliminate my entire trading desk. I know that there are real-time companies that are dealing with that. Right now, there are still sort of breaks along the way and I think that, ahead of time--and I go back to sort of 1984 when we wanted to trade gold overnight and you had to get a letter and it sat there and it said, "You now are allowed to trade 50 lots instead of 10 lots."

If I wanted to trade more than 50 lots, I had to go beg and so forth and so on, to get that increased. I don't see why that can't be built into the system, in which case, then I can do everything I want to do and reapply, sort of like getting my credit raised on my VISA account. If I want to have a bigger credit limit, I have got to go reapply.

In the interim, I can do whatever I want as long as I stay below that level. So that is sort of where I want to see it go. I don't think it really matters what you trade and where you trade, and that competition should throw it open and exchanges will fail. I don't see anything wrong with that, just as businesses fail all the time.

Thanks.

MR. LEITNER: Steve, do you want to take this up now?

MR. SPENCE: Actually, I want to back up a little bit in response to Ken Raisler's question about the operation issues and how that all ties into technology because, in my mind, it all ends up being a significant part of this whole, as being driven by technology.

From the time that Eurex listed futures electronically and started delivering their terminals to customers and the FCM began competing with the exchanges on that level, and the customers, in turn, started looking for us to enhance that capability, broaden that beyond the futures product to list other products out there, they are now looking to us and saying, "Why can't I have this beautiful execution capability across a multitude of my FCM/broker dealers out there on a commingled platform?"

Now, in our session, we are supposed to be focusing on the common platforms for execution as well as common clearing. They are inserting a little piece in the middle there saying, "I also want some common post-trade capabilities out there." I don't want it just for Merrill Lynch. I want it for Goldman Sachs and Morgan Stanley as well, all commingled, basically, on a prime broker, electronically out there.

With that push in the industry, it is hard to not focus beyond that and saying if that is what I have to deliver to survive in two or three years--or maybe six months, who knows--if I have to deliver that in that time frame, if the back end is not more efficient, I am in a lot of trouble as a player in the industry.

So I think it is very difficult to avoid that and it becomes a highlight in my focus on how I can survive out there going forward. I think part of the answer to that is to open up the barriers that exist, some of them self-imposed out there, some of them regulatorily-imposed, so that we can compete.

The FCMs, which we already do compete out there, but, we, within the industry, clearing house versus clearing house, exchange versus exchange, touching upon what Ed was saying, is that if I am a member on an exchange, why does that force me to clear with the clearing house that is tied to that exchange--open competition on the clearing back end.

It might inevitably lead to one consolidated clearing house and, therefore, another monopoly out there but that clearing house, for sure, would be a lot more efficient than what we are seeing out there in industry.

MR. LEITNER: Steven, you have really raised, it seems to me, an interesting issue. I hear different voices. One would suggest that clearing should be portable. The other suggests that, in a way, we need to consolidate it because how else can you narrow down the risk exposure across products and across markets in order to have both the efficient use of capital, which is the back end to the ability to give clients what they really want if you have all their assets.

So if you have captured the assets and then, from your point of view, Peter--your point of view, I think, is you don't care where your assets are. What you want to do is to know how much leverage you can get out of those assets across the products that you want to trade at any given point in time.

So, if that is what the customer is demanding, we, who are intermediaries, are finding ways, ourselves, to let that happen. Right now, we are not in competition with the clearing systems, but there isn't any technological reason, although there are regulatory reasons, why Peter's firm couldn't--why some utility or some clearing system wouldn't offer Peter, if he was willing to give them all his assets, to take account of all his exposures, wherever they were, and essentially net them down and compute how much trading he can do.

As soon as he exceeds his limits, they sell him out and he is out of business. I suppose that that type of system is technologically capable today. The question is kind of whether it is, in fact, capable. I think the answer is no.

This is not a new issue, by the way. In 1987, we all went through this and the question was whether there is better systemic risk management if we have cross-product and cross-margin netting and netting among exchanges versus whether or not the linkage between those clearing systems creates more systemic risk because if any one of them goes down, does that really hurt the system as a whole.

So there is kind of a level of issue here which I think, in the context of this discussion of where technology leads us, and assuming that everybody agrees that technology could enable the cross-product calculation, the ability to net, the legal system is all there and so forth, there is still the question of whether it is a good thing and whether there are any kinds of downsides to it, which is kind of an issue that maybe ought to be addressed at the President's Working Group level because, there, one can also deal with how there might be a division of responsibility for this insolvency dichotomy that we have between the futures and the securities industry which I think is necessary to build the front end.

The last person on this panel to speak is Brett Paulson who will be definitely, I think, talking about the back end because he runs it at the Chicago Board of Trade Clearing Corp.

MR. PAULSON: Thank you. I did want to concentrate mainly on the last bullet in our topic, straight-through processing. Historically, straight-through processing started out thinking about one big computer system or a series of computer systems that were all linked together and that is how you got straight-through processing.

Certainly, it has evolved. Now you can have independent platforms linked together through gateways. It really doesn't matter where you are running on and it allows you to reinvent what the word "straight-through processing" is. I call it taking the cost out of doing business, creating more effective and efficient ways of delivering services by minimizing human intervention.

What people really want to do is put in an order or a trade and get an acknowledgement and a report back in some way, hopefully over the Internet and not paper. So a lot of the things that we have been talking about in terms of doing this and getting cross-exchange pay-collect information, for instance, and all of that, we have developed an intra-day pay-collect system for people who trade at the Chicago Board of Trade.

We also take in pay-collect information for eight exchanges nationally. However, we get that once a day. So, obviously, it loses a lot of value. If we had a standardized way of getting that from every exchange out there, over the Internet, we could be supplying intra-day pay-collect information.

There are a lot of initiatives out there like that. What I am really trying to do is make a commercial for standardization. We need trade-registered data and standardization. We need clearing house to trade matching engine standardization, one way of linking to numerous electronic trading engines.

Spanarase, Trex is popular in Chicago. It is not popular anywhere else so we would certainly be willing to change our trade interface. We have got the technology out there to do that right now. XML has grown a lot of acceptance. It is very flexible. You can use it going forward. I know a lot of industry groups have been doing things with that. I think we need to get more involved with that similar to the securities side.

Secondly, I think we need to link managed networks. A lot of the standardization doesn't work very well if you can't get the information together. We have a proprietary network. The Merc has a proprietary network. We need to work together and link these. If we do the standardization, we do the blocking and tackling that we need to, the larger efforts like cross margining, common clearing, common banking, things like that, will fall into place.

MR. LEITNER: If I could ask, Brett, what do you think are the things necessary--I think this is potentially institutional inertia, again. What do you think are the steps necessary to make happen what you would like to see happen?

MR. PAULSON: We had a good industry group headed up by the FIA for Y2K. Now that that is over, maybe we should start, through industry groups like that, trading some standardization.

MR. LEITNER: Let me throw out one idea for you which is that, as the securities markets move to T-plus-one, which will be--well, two things are happening. T-plus-one and decimalization, both of which are tremendous challenges for the technology of our business.

First of all, I think it makes it even more feasible to think about straight-through processing because that is the only way you can efficiently clear, I think, in a T-plus-one or even T environment. This is time equals risk equation, again, progress from 1987 to now.

So there are SIA committees that are focusing on those issues. Also, within the Operations Division of the SIA, I know there has been a working group that was the same working group that worked on communications protocols in terms of swift messages and standardization.

It would be, I think, very important to make sure that these issues are standardized across markets and the only way to do that is to make sure that the working groups from both industries are clearly talking together. Certainly, from where I have been sitting, I think that that is a historical legacy that we need to overcome.

I don't know what regulators can do to make it happen. I think it takes the will of industry participants, themselves. The real question is what enabling, what inducements, carrots, if you will, can be created, or sticks, in order to make it happen.

I like the carrot approach. The question is what do you get for it. There is also the question, of course, of self interest. I think that one of the things that complicates this is that, because of the changing environment created by technology, marketplaces are trying to figure out what their business plan is and that that is a distraction.

So a lot of these things that we are talking about here, and it is amazing how we focus not on the front-end systems but, really, on everything that happens behind the scenes. There is a large possibility that that will be neglected and yet I think that it is going to wind up driving the front-end solution, if I am hearing what other people are saying.

MR. McPARTLAND: I want to add a dimension to this, if I could. If I could focus the attention on derivatives common clearing, I genuinely see the market going in the opposite direction. It is going to be caused by the introduction of these two new types of exchanges that will be created by the Commission's framework, which I completely support.

But if you just indulge me for two minutes, what I very respectfully refer to as the Door No. 2 and Door No. 3 exchanges, they are going nowhere without a clearing house. To the degree that a traditional designated contract market does not provide clearing services to the Door No. 2 and Door No. 3 exchanges, they are going to start their own.

They are not going to participate in the shared pay-collect system. A Door No. 3 exchange, which is the exchange which is market professionals only, no agency relationship, the market professionals in those markets are not going to want to share any information with Door No.1 exchanges.

They are not going to want to share any information with this Commission. And they may not want to buy clearing services from clearing organizations associated with designated contract markets because, if they are going to be exempt from regulation, there is a certain amount of privileged and privacy attributes that they believe go along with that.

So, even though we have come a long way from where we were before '87 with cross margining and the optimization of collateral, to the degree that Door No. 2 exchanges and Door No. 3 exchanges become very successful and they take big market segments of institutional clients with them, you are going to be long on one exchange and short on another exchange and you are going to have a naked long and a naked short.

It is going to be just like it was back in '87 unless there is something that I don't see.

MR. LEITNER: John, is clearing an expense or a profit center?

MR. McPARTLAND: I agree with John Davidson's comments. I think you need to stop history here and now, that, historically, the clearing members have provided either the real capital or the contingent capital that support the guarantee and, because of that, clearing has been a break-even proposition, that clearing organizations in this country and in almost every other country are not profit motivated because they are owned by their members.

To the degree that a new entity emerges and it could very well be that Door No. 2 exchanges and Door No.3 exchanges start their own. If a clearing organization's ownership structure is not driven by its members, but it goes to a very large parent or goes to a reinsurer and it actually directly insures the market participants, then it can charge a real risk-adjusted fee for its services.

Clearing organizations today, in this country, don't charge nearly the fee of what a for-profit, risk-adjusted return would be for assuming all that risk.

MS. DOWNS: I am just concerned that we are in the traditional sense of what the products are and how they are trading. I have to tell you that I don't think that is where many of the new exchanges are coming from. They are in totally different fields from the traditional financial instruments or products that trade on existing exchanges.

I think your model for standardization is going to people who already have some instruments out there and how they are falling through the system. I think, with the new exchanges, it is going to be totally different.

MR. DAVIDSON: I do think that the regulatory structure that Commission has proposed and is currently putting the finishing touches on is, as a general rule, an excellent regulatory structure. Echoing Mr. McPartland's comments, I would suggest that one element that needs to be very carefully looked at is the regulation of clearing organizations in that environment.

We have capital standards for futures commission merchants. We have a lot of problems with them but they at least exist and they are common to all of that type of market participant. There is no such thing as a capital standard in this country for a clearing organization and that is a reasonably odd thing since they have what looks very much like an FCM-like relationship to their direct participants.

I would also echo the fact that the evolution of organized exchange-like things in this new regulatory environment, absent a utility whose function is clearing that is not inextricably linked with existing exchanges and their own partisan interests, is going to be a very bifurcated environment.

However, the one thing that may change the actual evolution is what happens to new entrants into the existing exchange marketplace and does that result in a movement of where the existing products trade.

MR. ROSEN: I would like to pick up on John's point because I think, for new entrants for exchanges, cost is a very important factor. Time to market is an important factor. I actually think that drives in the direction of utilizing existing clearing facilities.

Tony, you asked the question, is consolidation in clearing a good thing, is it something that we should encourage? Thinking about the bridge between that point and the point that John McPartland was making, there are different ways of accomplishing consolidation.

You can create a single clearing corporation or you can accomplish a virtual single clearing corporation by creating a single pot of collateral and risk by having two clearing corporations who are sufficiently comfortable with each other's credit and risk-management structure who are willing to say, "We will look at your risk on a net basis and we will cross-guarantee so that the aggregate amount of the capital that you need to put up is based on your net risk in both clearing corporations." Then you have operational redundancy rather than collateral redundancy.

The last point I think is worth making is sort of tying your perspective on this, Tony, to Ken's original question about technology. At the end of the day, this is not a software company. This is a regulatory agency. So the question is where does this drive us?

One of the points that you made in the beginning of your discussion was that the regulatory infrastructure, to move in the direction of the netting reductions and clearing consolidations, the technology now making this possible is there. And I agree with you; there are cross-product netting provisions in fidicia and there are, on the horizon, some bankruptcy amendments that will fill some of those holes. I think there may still be some issues.

There are cross-jurisdictional issues that I think it is hard for this Commission to do much about because they are U.S. and foreign. You have got to be a London broker if you are doing securities in London and a U.S. broker-dealer. There are different entities. If you have a single clearing corporation, how are you going to bridge that gap unless you are willing to be both a U.S.-regulated broker-dealer and an FSA-regulated broker-dealer.

But, in the United States, I think--maybe it works out in the end, but I think it is worth doing some drilling down in terms of what--maybe not what are the regulatory absolute obstacles, but what are the regulatory disincentives or impediments to consolidation of clearing across securities and futures because I think there is some work that could usefully be done in that area.

You have two completely different insolvency regimes which, there has been some work at figuring out to deal with in the context of broker-dealers. But you have two completely inconsistent approaches to regulation of clearing organizations and the inefficiencies that a single organization that clears securities and futures would be subject to.

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The Commodity Futures Trading Commission Technology Advisory Committee Meeting

Tuesday, April 25, 2000 1:00 p.m.

The Commodity Futures Trading Commission
Technology Advisory Committee Meeting

Tuesday, April 25, 2000
1:00 p.m.