TESTIMONY OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES, AND
GOVERNMENT SPONSORED ENTERPRISES
COMMITTEE ON BANKING AND FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
March 25, 1999
Mr. Chairman and members of the Subcommittee, thank you for providing me with an opportunity to testify concerning the changes that technological advances are bringing to the futures and derivatives markets and the ways in which the Commodity Futures Trading Commission ("CFTC" or "Commission") is responding to them.
It is difficult to imagine a time of greater change in the futures industry. Electronic trading systems are replacing floor trading at exchanges around the world. The ultimate role of intermediaries in these new systems is not yet clear. Moreover, instantaneous international communication and transactional capabilities are creating truly global markets. Domestic exchanges and industry professionals are eager to offer their products and services to customers abroad, while foreign exchanges are just as eager to offer their products to U.S. customers. As futures exchanges are grappling with these technological developments, the number and type of derivatives products offered over-the-counter ("OTC") continue to mushroom as the volume of transactions in that market increases exponentially. Furthermore, technological and market developments are driving many OTC derivatives market participants to express an interest in adopting trading and clearing systems that would cause the OTC market to resemble exchange-traded markets more closely.
Technological advancements are no doubt the single biggest source of change in the derivatives industry. In October 1996, in my first speech as Chair of the CFTC, I addressed the need for the U.S. futures industry to embrace technological innovation and to use that innovation to continue to be the world leader in futures exchanges. Since that time, many foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems. As technological enhancements fuel the development of these systems, customers increasingly will gain access to markets without having to trade through an intermediary, and the role of intermediaries may diminish.
Technology is also contributing to changes in exchange governance and organization. New exchange ownership structures are emerging that are intended to improve exchanges' ability to engage in effective strategic planning and implementation. Membership organizations are being abandoned by some foreign exchanges in favor of public stock ownership, raising serious issues concerning whether such demutualized, profit-oriented exchanges can adequately continue to perform the self-regulatory role exchanges traditionally have played.
In the face of these developments, U.S. futures exchanges confront the question of whether open outcry trading will remain a viable alternative in the 21st Century. It remains true that the very liquid and efficient trading floors in Chicago and New York can still execute more trades per minute than currently operating electronic futures trading systems. Moreover, U.S. exchanges are employing new technologies to increase the efficiency and to reduce the costs of open outcry trading. Some exchanges and their members are experimenting with the use of automated order routing systems, wireless communication, and handheld trading units. Advanced computer software is being used to enhance exchanges' market surveillance.
U.S. exchanges have also improved their existing electronic trading systems and have successfully integrated electronic and open outcry trading in some contracts. The Chicago Mercantile Exchange ("CME") pioneered this innovation when it offered concurrent electronic and open outcry trading of the "E-mini" version of its S&P 500 futures contract. That development also opened the way for some firms to offer on-line trading access to the E-mini on Globex2, CME's electronic trading system. The Chicago Board of Trade ("CBT") also now features concurrent electronic and open outcry trading in many of its financial contracts.
New, fully electronic U.S. exchanges are also being launched. In September 1998, the Cantor Financial Futures Exchange ("CFFE") became the first fully electronic-based U.S. exchange, trading four futures contracts on U.S. Treasury bonds and notes. It uses a computerized trade matching system operated by Cantor Fitzgerald Securities, which also pioneered the use of automated trading systems in its role as an interdealer broker in the cash U.S. Treasury securities market. CFFE's trade matching system executes trades according to an algorithm also used for cash Treasury securities trading and designed to reward traders who improve prices or provide market liquidity. Presently, CFFE members transmit orders by telephone to terminal operators ("TOs") working on behalf of CFFE and may instruct them to post bids or offers, to hit posted bids or to take posted offers. TOs must keypunch members' exact instructions into the CFFE system immediately upon receipt.
The Commission recently permitted the CFFE to implement rule changes which will provide for direct electronic access by members and certain other traders. Specifically, CFFE's new direct-access rules will allow CFFE clearing members and their affiliates, Coffee, Sugar & Cocoa Exchange ("CSCE") members, New York Cotton Exchange ("NYCE") members, and CFFE members designated as market makers to enter orders for proprietary and customer accounts through terminals provided by CFFE. In addition, authorized customers of CFFE clearing members will be able to access CFFE products, subject to position limit and credit checks, through an interface with their clearing members.
In addition to its innovative trading system, CFFE represents a novel alliance between the NYCE, which performs all of CFFE's regulatory responsibilities, and Cantor Fitzgerald Securities, which performs all of the trade execution functions. While CFFE memberships are held by members of NYCE and NYCE's affiliate exchange, CSCE, CFFE has significantly reduced the need for intermediaries by making trading privilege licenses available to market participants fully guaranteed by clearing members for the relatively modest sum of $2000. CFFE is owned 90% by NYCE and CSCE members and 10% by NYCE and CSCE themselves.
Another aspiring U.S. exchange, FutureCom, has not previously been designated as a contract market in any commodity, but has an application pending before the Commission to become the first Internet-based futures exchange in the world. FutureCom, as proposed, would be structured unlike any existing exchange. All its members would be clearing members, would have their trading accounts held by the exchange and would be directly linked to the trading system. Members' account balances and positions would be updated in real-time, and members would be prevented from entering any orders for which they did not have the requisite margin in their accounts. Each FutureCom member would be directly financially responsible to FutureCom for its own trades. FutureCom would not be owned by its members, as all U.S. exchanges other than CFFE are, but would instead be organized as a limited partnership among the organizers of the exchange and would be run on a for-profit basis.
FutureCom's use of the Internet and its membership structure would create a new model for participation in U.S. futures exchanges. Using the Internet to transmit trade and financial information would facilitate direct access by the public and would result in the elimination of a significant role for intermediaries. Since each FutureCom member would provide for its own access to the Internet and thus to FutureCom, functions traditionally performed by a futures commission merchant ("FCM") would not be needed by a member to access and trade on FutureCom. The radically different proposed structure of FutureCom has presented the Commission with the challenge of how best to apply laws and regulations designed for an intermediated, open outcry trading environment to an electronic direct access system. The Commission staff has been working with FutureCom to determine whether it can provide the necessary regulatory protections for the trading public and the market itself in light of the unique aspects of the proposal. There are still unresolved issues surrounding FutureCom's application, and therefore it has not yet been presented to the Commission by the staff. However, I believe that it is inevitable that an exchange, whether based in the U.S. or abroad, will eventually emerge that uses the Internet as its communication medium and offers direct access to customers around the globe.
While automated trading systems may diminish certain regulatory concerns that the Commission has relating to trading abuses in open outcry trading, automated trading raises other regulatory issues such as system capacity and security which are not applicable to the open outcry environment. Similarly, the need for fitness standards and customer protection measures which underlie the Commission's current registration scheme for commodity professionals may become less important with greater direct access and diminished discretion associated with automated trading. I should caution that we have insufficient experience with electronic systems accurately to identify all of the risks they pose at this time.
The Commission has spent considerable time and effort in addressing the difficult and rapidly evolving regulatory issues associated with technological innovation in the futures industry. The Commission must adapt its regulatory framework to accommodate a variety of proposed alternative trading systems, including Internet-based exchanges, non-intermediated exchanges and proprietary exchanges. At the same time, however, the Commission must ensure that it has sufficient regulatory tools to protect against fraud, customer abuse, market manipulation and financial disruption in this new electronic age. The recent actions of the Commission in approving the CFFE electronic system and the side-by-side electronic and open outcry trading at the Chicago exchanges, along with the work of the staff on the FutureCom application, are a significant beginning in examining the regulatory implications of electronic trading. We also continue to make progress in permitting electronic media to be used for certain recordkeeping, disclosures to customers, reports to the Commission, and communications of industry professionals both with the Commission and with their customers. However, we have a great deal more to do.
Because electronic exchanges do not incur some of the costs or have the physical limitations associated with floor-based trading, the number of futures exchanges in the U.S. operating electronic trading systems seems likely to increase. Furthermore, electronic exchanges will be able to launch new contracts easily and inexpensively, leading to increased development of new products for trading which may meet previously unaddressed market needs. The same reduced costs will make it easier for exchanges to enter into direct competition by trading identical contracts. In such cases, competition among exchanges, whether electronic versus open outcry or electronic versus electronic, will probably be based on the differences between their trading systems. The most obvious current examples of this are the virtually identical contracts traded by CFFE and CBT. The competition between them apparently centers on the trading mechanisms. CFFE uses a trade-matching algorithm which accords special treatment to large orders and aggressive trading, while CBT's contracts are traded by open outcry and on a computer system, Project A, that uses a trade-matching logic which matches trades on a strict time and price priority basis.
The pace of innovation by U.S. exchanges is driven not only by competition among domestic exchanges and their respective trading systems, but also by competition from overseas exchanges, which has been enhanced by technology that can effectively provide access from a customer's personal computer to trading on exchanges around the world. In response to these developments, last week the Commission issued proposed rules regarding the placement in the U.S. of trading terminals for foreign electronic exchanges. This rulemaking tackles cutting edge technological issues. It also addresses the difficult issue of how best to accomplish our regulatory mandate of protecting U.S. customers in an increasingly global market.
At present, the only foreign futures exchange with electronic terminals in the U.S. is Eurex, an international exchange based in Frankfurt, Germany. The Commission's Division of Trading and Markets issued a no-action letter in 1996 stating that the Division would not recommend that the Commission commence an enforcement action against Eurex, then known as Deutsche Terminbörse, if it were to place its terminals in the U.S. offices of its members and if it abided by certain conditions. Since that time, several other boards of trade that have heretofore operated outside the U.S. have requested similar relief. As a result, the Commission determined that it was appropriate to address, through the Commission's rulemaking process, the subject of the use in the U.S. of automated trading systems that provide access to boards of trade whose primary operations otherwise take place outside the U.S.
The proposed rules seek to avoid imposing undue or duplicative regulatory requirements on exchanges by deferring where appropriate to the foreign regulator of the exchange seeking access to the U.S. market. The procedures set forth in the proposed rules are intended to provide an exemption from the contract market designation requirement and related requirements under the Commodity Exchange Act ("Act") and Commission regulations to boards of trade established in a foreign country which wish to make their products accessible from within the U.S. via trading screens, the Internet, or other automated trading systems, provided they are subject to generally comparable regulation in their home countries. Such exemption would avoid duplicative regulation, encourage other countries to allow access to the automated trading systems of U.S. exchanges, and stimulate global competition and open markets in the futures industry.
The proposed rules would provide that a foreign exchange could petition for an exemption pursuant to Section 4(c) of the Act and would have to provide the Commission with information permitting the Commission to find the following:
(1) the petitioner is an established board of
trade that wishes to place within the United States an automated
trading system permitting access to its products but the activities of
which are otherwise primarily located in a foreign country that has
taken responsibility for regulation of the petitioner;
(2) the petitioner's home country has established a regulatory scheme governing the petitioner that is generally comparable to that in the U.S. and provides basic protections for customers trading on markets and for the integrity of the markets themselves;
(3) except for certain incidental contacts with the U.S., the petitioner will be present in the U.S. only by virtue of being accessible from within the U.S. via its automated trading system;
(4) the petitioner is willing to submit itself to the jurisdiction of the Commission and U.S. courts in connection with its activities conducted under an exemptive order;
(5) the petitioner's automated trading
system has been approved by the petitioner's home country
regulator following a review of the system that applied the standards
set forth in the 1990 International Organisation of Securities
Commissions' report on screen-based trading systems (as may be
revised and updated from time-to-time) or substantially similar
(6) satisfactory information-sharing arrangements are in effect between the Commission and the petitioner and the petitioner's regulatory authority.
The Commission's exemption order would include certain terms and conditions applicable to the petitioner.
The Commission expects to receive a substantial number of comments on this proposal and will consider them very carefully when drafting the final version of these rules. In addition, the Commission will hold a public meeting on April 20, 1999, to present a Roundtable of invited interested persons to discuss the proposed rulemaking.
Computerized trading not only would allow foreign exchanges to reach the U.S. market directly, but also has permitted enormous growth in the OTC derivatives market. The volume of trading in that market has exploded in the last five years and now is estimated by the Bank for International Settlements to be $70 trillion in notional value worldwide. In addition, this virtually unregulated market has grown in diversity with the development of a multitude of new products, entry by new market participants and increased interest in new market mechanisms. Last year the Commission issued a concept release to initiate a study of the changes in the OTC derivatives market and of whether the Commission's current regulation of that market requires updating in light of significant market developments. Although Congress eventually passed a six-month moratorium preventing the Commission from acting on its study to date, many of the regulatory issues identified in the concept release became front-page news last September when a very large hedge fund, Long-Term Capital Management L.P., nearly defaulted on $1.25 trillion in notional value of OTC and exchange-traded derivatives contracts.
The LTCM episode demonstrates the unknown risks that the OTC derivatives market may pose to the U.S. economy and to financial stability around the world. It also illustrates the lack of transparency, excessive leverage, and insufficient prudential controls in this market as well as the need for greater coordination and cooperation among domestic and international regulators.
I welcome the heightened awareness of these issues and believe it is critically important for all financial regulators to work together closely and cooperatively on them. We must urgently address whether there are unacceptable regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants. To that end, the President's Working Group on Financial Markets, which consists of the Secretary of the Treasury and the Chairs of the Federal Reserve System Board of Governors, the Securities and Exchange Commission and the CFTC, is currently working on two studies relating to the regulatory responses needed for hedge funds and the OTC derivatives market. In addition, the G-7, the G-22, the International Organization of Securities Commissions, the Basle Committee on Banking Supervision, and many foreign governments are focusing on regulatory issues raised by LTCM and other highly leveraged institutions.
While there appears to be an emerging consensus among many market participants and government authorities about the need for greater transparency in the OTC derivatives market, more study is needed to determine how best to enhance transparency. In my view, at the least, hedge funds and other large highly leveraged institutions should be required to provide their investors, counterparties and creditors with disclosure documents and periodic reports concerning their OTC derivatives positions, exposures and investment strategies. In addition, serious consideration should be given to requiring OTC derivatives market participants to file large trader position reports with one or more federal agencies charged with oversight of the OTC derivatives market. If such reporting and disclosure requirements had been in place in the U.S., some of the difficulties relating to LTCM might have been averted.
As mentioned earlier, some OTC derivatives market participants are now interested in the development of automated trading and clearing systems that would closely resemble the regulated exchange-traded markets. For example, in June 1998 the Commission received a petition from the London Clearing House ("LCH") requesting an exemption from the Commission's regulations to permit clearing of swap transactions for the first time. LCH wishes to establish "SwapClear," a proposed facility for clearing swap transactions that otherwise satisfy the terms and conditions for swap transactions imposed by the Commission's regulations. Within the last few days the Commission has issued an order granting the petition. The order exempts certain swap agreements submitted for clearing through SwapClear from most provisions of the Act and Commission regulations and provides a similar exemption to specified persons who engage in certain activities with respect to such agreements.
The Commission's review of LCH's petition focused on those areas of greatest regulatory concern, including SwapClear's admissions criteria, product eligibility requirements, margining system, and other risk management procedures; the applicable regulatory regime; and the reporting, recordkeeping, and information-sharing arrangements. SwapClear will be subject to regulation by the Financial Services Authority of the U.K. with which the Commission has satisfactory information-sharing arrangements. The exemptive relief granted by the Commission is limited to certain non-fungible forward rate agreements and interest rate swap agreements which are entered into by "appropriate persons" as defined in the Commission's regulations and the material economic terms of which have been negotiated individually. The products eligible for clearing are limited to those which have not been traded on or through a multilateral transaction execution facility. The Commission believes that the relief provided by the order is appropriate because, inter alia, a swaps clearing operation may provide substantial benefits to the OTC derivatives market, including imposing controls on excessive extensions of credit, reducing counterparty credit risk and increasing transparency.
As the OTC derivatives market grows and evolves through the eventual use of trading and clearing systems, the structure and nature of that market will change. As it begins to resemble traditional futures and option exchanges, new regulatory concerns about the market will arise, and increased parity in treatment of the OTC and exchange markets will be necessary.
The Commission and its predecessor agency have overseen the nation's futures markets for more than 75 years. Government oversight of these derivatives markets traditionally has been exercised according to the nature of the market, the market participants and the products involved. This exercise of functional market oversight creates consistency of regulation without regard to the entity trading the product. It fosters market and product expertise by the regulator which can then be applied even-handedly to all market participants. A market-based approach also allows the regulator to address comprehensive market issues such as market integrity, manipulation, fraud, and systemic risk.
The benefits of functional market oversight apply equally to exchange-traded and OTC derivatives. While the nature of and participants in the OTC derivatives market may warrant a different degree or kind of regulation from the exchange-traded derivatives markets, the size and nature of the OTC market create a potential for systemic risk to the nation's financial markets. Moreover, as OTC market participants seek to clear swaps and express interest in various forms of screen-based trading, the differences between exchange-traded and OTC derivatives markets will be significantly reduced.
There is simply no justifiable basis to claim that entity-based supervision of OTC derivatives dealers alone is sufficient to oversee this market. While such supervision is important to the safety and soundness of many of the large dealers, we cannot overlook the fact that many participants in the OTC derivatives market -- including many hedge funds and other highly leveraged institutions -- are not subject to government oversight. Equally important, an entity-based regulatory approach does not provide oversight of the market generally, which may be particularly dangerous in a market that is currently as opaque as the OTC derivatives market. Institutional supervisors focus on the trees; market regulators see the forest. Both are needed. This dual approach to regulation has been demonstrated to protect the public interest for more than sixty years, since it was adopted as a response to problems underlying the Great Depression.
Thank you. I would be pleased to answer any questions members of the Subcommittee may have.