FUTURES EXCHANGE DEMUTUALIZATION
Remarks of Commissioner Thomas
Commodity Futures Trading Commission
Brooklyn Law School and New York Stock
April 18, 2000
Electronic trading and other technological advances are eliminating economic barriers to becoming an exchange marketplace. Globalization of markets is expanding the reach of market competitors. Futures and securities exchanges are responding to the heightened competition by reexamining traditional business models and contemplating more effective approaches. Demutualization has surfaced – both here and abroad – as one way to address competitive pressures. This morning I will discuss several issues relating to the demutualization of exchanges from a derivatives market regulator's perspective, and what I believe to be at the heart of change – technology.
To date, the three largest domestic futures exchanges – the Chicago Board of Trade ("CBOT"), the Chicago Mercantile Exchange ("CME"), and the New York Mercantile Exchange ("NYMEX") – have announced plans to demutualize by converting from nonprofit member-owned organizations to for-profit corporations. Each exchange has designed a different restructuring plan, and each is moving quickly toward a membership vote that will decide its future.
We at the CFTC are undertaking an independent effort to analyze demutualization issues within our regulatory framework. At the request of the Commission's Chairman, Bill Rainer, my office is coordinating the work of an interdisciplinary Staff Demutualization Committee to advise the Commission on issues that might implicate regulatory responsibilities under the Commodity Exchange Act ("Act") and to provide futures exchanges with expedited, coordinated responses to questions raised by the demutualization process.
Why the drive to demutualize? Certainly competition is the most frequently cited reason. For example, there is the notion that membership structures are cumbersome and do not allow for nimble decisionmaking. We also have heard from exchanges about their brand-names. Certainly, once they have streamlined decisionmaking, they will be able to extract maximum value out of their brand-names in any number of ways – many of which I am sure you are contemplating within the securities context.
But there is much more. It is not going to be enough to demutualize and be "just another futures exchange." If they do this right, one day soon, exchanges may compete with Goldman Sachs, J.P. Morgan, and even Internet communications corporations. It would not surprise me if an exchange were to become registered as a financial services holding company under the recently enacted Financial Services Modernization Act.
Moreover, exchanges will attempt to use their brand-names as a lever that, when joined with technology, can provide multiple platforms for cash, futures, options, over-the-counter derivatives, as well as debt and equity securities. In other words, all exchanges – those that exist today and those yet to be born, whether they trade cash, derivatives or securities – will seek to provide integrated platforms enabling firms to enter and exit any market at any time.
Futures Exchange Demutualization Plans
Nothing in the Act dictates what business plans are appropriate or inappropriate. In fact, the CFTC has some experience with for-profit structures:
With that as background, I will turn briefly to a discussion of the plans for demutualization by the CME, the NYMEX, and the CBOT.
Chicago Mercantile Exchange (CME)
Last November, the CME announced a two-step plan that would transform it from an Illinois not-for-profit membership corporation to a Delaware for-profit stock corporation. Members of the CME, International Monetary Market division, and Index and Option Market division would receive Class A common stock representing pure equity in the exchange, and all members (including members of the Growth and Emerging Markets division) would receive Class B common stock representing existing trading rights and privileges plus equity rights. The existing 39-member board of directors would be reduced to 19 members over a two-year period, the exchange would be run by a chief executive officer hired by the board, and the 200-plus member committees would be replaced with a more streamlined committee structure. Members likely will vote on the plan this Spring.
The New York Mercantile Exchange (NYMEX)
This past January, the NYMEX announced a two-step plan that would reorganize it from a New York not-for-profit membership corporation to a Delaware for-profit membership corporation ("NYMEX, Inc.") and would create a new Delaware stock-holding company ("NYMEX Holdings, Inc.") to own all of the economic interests and most of the voting control in NYMEX, Inc. NYMEX members would receive common stock in NYMEX Holdings representing equity in the overall organization and Class A membership in NYMEX, Inc. representing trading rights and privileges. NYMEX Holdings would have the sole outstanding Class B membership in NYMEX, Inc. Identical 22-member boards of directors would govern NYMEX Holdings and its NYMEX, Inc. subsidiary unless a majority of stockholders voted to permit separate trading of the common stock and trading rights. A membership vote is expected in this Summer.
Chicago Board of Trade (CBOT)
The CBOT also announced a two-step demutualization plan in January. The exchange, an Illinois not-for-profit membership corporation, would be restructured into a closely held Delaware for-profit stock corporation focusing on open outcry trading and a Delaware for-profit stock corporation focusing on electronic trading. The electronic trading company initially would be a for-profit wholly owned subsidiary of the CBOT and, subject to a second vote, subsequently would become an independent operating company. CBOT members initially would receive shares in the CBOT and eventually would receive shares in both the CBOT and the electronic trading company, but details regarding the distribution of stock are yet to be determined. Restructuring would change the existing management and organizational structure. The first vote is anticipated this Summer.
Implementation of these plans is contingent upon approval by the exchange membership, registration with the Securities and Exchange Commission, and receipt of a favorable ruling from the Internal Revenue Service regarding the tax consequences of the proposed transactions. In addition, many changes attendant to exchange demutualization would require submission of exchange rules to the CFTC.
Regulatory Issues Raised by Futures Exchange Demutualization
Demutualization is a significant change in our markets, which of course attracts the attention of the industry participants and the regulators. To date, much of the regulatory discussion has been influenced by the demutualization of global securities markets. This debate is certainly instructive to the Commission’s own evaluation of the regulatory issues raised by the demutualization of domestic derivatives exchanges. However, there are very real differences, I think, in the applicability of some of these concerns in the derivatives market context.
Conflicts of Interest
The demutualization dialog has raised the question of whether for-profit exchanges require greater scrutiny than nonprofit exchanges. The subtext seems to be that for-profit exchanges will be driven by the interests of shareholders rather than market users. The fear seems to be that concern for the bottom-line would affect an exchange’s willingness to vigorously undertake self-regulatory obligations. A similar concern has been raised about the fairness of disciplinary proceedings in a for-profit environment.
Securities exchanges are attracting particular scrutiny because they would list their own shares. There is the suggestion that this relationship would create an immediate conflict in that the exchange, in effect, would be charged with enforcing self-regulatory organization ("SRO") compliance requirements on itself. Moreover, exchange actions could affect the value of shares in the exchange listed on the exchange. That, in turn, could create the perception that exchange actions were based on equity valuations and not on considerations of marketplace integrity. These conflicts of interest are premised on the self-listing of individual securities. Since self-listing of an equity is not possible for derivatives markets, this "self-listing conflict" is not a factor for us. However, were futures exchanges permitted to offer contracts on single equities, the CFTC might have similar concerns.
The exercise of self-regulatory authority over competitors is another potential conflict of interest that has been raised in the securities market context. There are several permutations of this potential conflict. For example, would an exchange such as the New York Stock Exchange ("NYSE") be free of a conflict in enforcing its market rules on competitors who happen to also be listed on the NYSE? To the extent this is a conflict, it has been a conflict in the nonprofit derivatives exchange environment for nearly two years, without apparent concern. Currently, the CBOT has the authority to enforce its SRO rules on a competitor, namely Cantor Fitzgerald, which operates the CFFE.
The CFTC is examining demutualization plans for potential conflict of interest concerns. I must confess that I am somewhat agnostic on the issue of conflicts. Certainly conflicts exist in mutual organizations, and it is virtually certain that conflicts will exist in demutualized exchanges. Our job will be as it always has been: to identify potential conflicts and to determine whether there is a regulatory interest in addressing them.
Even if conflicts are heightened in a for-profit context, I would hope that futures exchanges would continue to have a self-interest in preserving their reputations for providing fair and efficient markets. Exchanges ultimately would pay a heavy price in sacrificing good will and their reputations in the interest of short-term profits. Self-regulation contributes to brand-name and reputation, and existing exchanges already have invested in developing their own compliance programs.
The CFTC oversees exchanges and will continue to monitor their ongoing fulfillment of self-regulatory obligations. Exchange rule enforcement reviews conducted by the Commission’s Division of Trading and Markets will consider the potential conflicts of interest associated with a for-profit exchange in the same manner that the reviews presently consider potential conflicts associated with nonprofit exchanges. The rule enforcement review process will remain an integral part of the Commission’s oversight program.
Outsourcing Self-Regulatory Obligations
Demutualization has raised the possibility of exchanges contracting with third parties to perform SRO obligations. Nothing in the Act or the Commission’s regulations precludes exchanges from contracting-out their self-regulatory obligations. Indeed, Commission regulations contemplate an exchange contracting with third parties to perform some SRO functions. Whatever approach an exchange chooses, the CFTC will continue to ensure that exchanges meet their SRO obligations.
The CME, NYMEX and CBOT have indicated that their self-regulatory programs will be retained in-house but also have acknowledged that their boards will exercise discretion on a continuing basis with regard to the structure of these programs. Other exchanges may believe that outsourcing would be more cost-effective than retaining SRO programs in-house. Several new exchanges apparently have contacted the National Futures Association ("NFA") to discuss outsourcing self-regulatory obligations, and it appears FutureCom and the Merchants’ Exchange both are negotiating to contract at least some self-regulatory functions to the NFA.
If an exchange opts to contract-out its self-regulatory obligations, the Commission should consider what, if any, requirements would be necessary to ensure that these obligations are fully met. For example, should the contracting exchange be required to describe the outside entity’s relevant experience, the number of individuals that would be dedicated to the task, the surveillance system that would be used to identify potential rule violations, and/or the procedures for addressing these violations? As previously mentioned, adequate Commission oversight will require increasing reliance on the rule enforcement review process with respect to these issues.
The current public dialog also has included the concept of one "super self-regulator" performing self-regulatory obligations for all exchanges – the NFA for the futures industry and the National Association of Securities Dealers Regulation, Inc. for the securities industry. Given existing exchanges’ experience in self-regulation and their apparent commitment to continue to self-regulate, a single super self-regulator for the futures industry may not be preferable to having several SROs. And since we all probably agree that choice and competition are generally good things in most other contexts, there is certainly an argument that a super-SRO just is not good policy. Moreover, requiring exchanges to contract with a super self-regulator may appear to be inconsistent with the Commission’s role as an oversight agency, especially if regulatory concerns do not outweigh the benefits of the current SRO structure.
The CFTC currently has the authority to intervene and require a modified SRO structure if, after demutualization, it appears that exchanges are not adequately performing their self-regulatory functions. Should existing or new exchanges decide to contract-out their self-regulatory obligations, the Commission must continue to have clear authority to hold exchanges accountable for compliance failures and disciplinary violations. Professor Roberta Karmel of the Brooklyn Law School has raised an interesting question about the super SRO model: would delegation of these authorities to a quasi-public bureaucracy be preferable to pulling the SRO functions back within the domain of the federal regulator. A former Chairman of the CFTC, Philip McBride Johnson, recently questioned the role of SROs in a demutualized world with the suggestion that there may be no "self" in self-regulation. Given the possibility that exchanges may soon be contracting-out for any number of essential functions, I might add there may be no "organization" in future self-regulatory organizations.
Funding Self-Regulatory Obligations
Demutualization and potential outsourcing of self-regulatory obligations could raise concerns regarding adequate funding of exchange self-regulatory programs. For example, a for-profit exchange eager to reduce costs could decide to trim its budget by reducing self-regulatory programs. An exchange also could base its payments to third-party vendors on transaction volume or a percentage of the dollar value of transactions rather than paying a set dollar amount. Such a payment structure potentially could dedicate insufficient resources to self-regulatory obligations.
Again, these risks exist in the current system. Adequate SRO funding is essential in carrying out compliance and disciplinary regulatory responsibilities and falls within the Commission’s oversight purview. In particular, the Commission will have to scrutinize any effort to base funding on the quantity or dollar value of transactions. As exchanges add new products and new exchanges attempt to build volume, the possibility exists that funding could be inadequate for even minimal self-regulation.
Demutualization may cause incongruence between CFTC governance requirements and a for-profit corporation’s governance objectives. For example, Section 5a(a)(14) of the Act and Commission Regulation 1.64 require that exchange governing boards include meaningful representation of a variety of market users in order to promote the public interest in the self-regulatory process, as well as foster integrity and impartiality in the boards’ decision making. In contrast, in a for-profit context, the board of directors need not represent any interests other than those of the corporation and its shareholders, and state corporate governance laws include their own requirements concerning the composition of a board of directors. Exchanges will be required to comply with both Commission and state law requirements. However, the Commission will be reviewing its board composition standards and other governance requirements in light of exchanges’ changing management structures and the underlying goals of the requirements.
Finally, the CFTC will be considering the parameters and transferability of exchange designation in the context of each exchange’s demutualization plan. The CME and the NYMEX wish to transfer their current designations as contract markets to the for-profit exchanges created through demutualization. The CBOT plans to treat the subsidiary electronic trading company as a division operating under the CBOT’s current designation and, at some point before taking a vote to spin off the subsidiary, to apply for separate contract market designation for the independent electronic trading company.
The question raised in each case is really one of flexibility. How direct is the linkage between the current exchange and the new for-profit exchange? Is that linkage strong enough to simply transfer designation to new business models?
The Promise of Technology
I would be remiss if I did not say a few words about new technology. For the moment, that means electronic trading. It is easy to do a superficial analysis of electronic trading and come to the conclusion that the U.S. futures exchanges have been slow to adopt new technology and that many of their more nimble foreign counterparts are currently enjoying the competitive and economic advantages of electronic platforms. While there may be a grain of truth to this, I think a more careful analysis indicates the extent to which electronic trading is making inroads in U.S. markets and the promise new technology holds for these markets. There are, today, several electronic trading platforms in use domestically, and I believe a major factor in our exchanges’ push to demutualize is their desire to construct more effective vehicles for exploiting new technology.
Ultimately, I think that the success of a derivatives exchange under any model is dependent on reaping the benefits of technology. In years to come, some may ask: What was the catalyst for ever-expanding markets – the establishment of for-profit exchanges or the accessibility of technology? My response is technology because, irrespective of whether an exchange is mutualized or demutualized, it is the embrace of technology that will yield significant dividends. Demutualized exchanges will only realize their full potential when coupled with technology.
Finally, it is worth noting that almost everything I have talked about this morning concerns the efforts the three largest futures exchanges to come up with new, more competitive business models. But change is sweeping the industry and competition will come from all angles in the electronic economy. Even today, we see examples of smaller futures exchanges looking for partnerships that will enable them to trade electronically. Firms in every sector of the economy are constructing platforms and forming new alliances for business-to-business and business-to-consumer commerce. Once B-to-B and B-to-C platforms are in place, it would require very little for such a venture to compete head-to-head with existing futures exchanges. Clearly, profound changes are in store.
In the end, I view all of the changes we are facing, both on a regulatory level and in the industry in general, as challenges embedded with tremendous potential. We are witnessing the industry’s efforts to harness new technologies, to embrace innovation, and to move forward. As regulators, our job is to ensure that our regulatory framework preserves the public interest in open, fair, and honest markets and to see to it that we do not create obstacles to innovation. Accordingly, whatever new market structures or technologies may be adopted, we can, and are, attempting to formulate an approach that encourages innovation and maintains standards that will continue to instill confidence in our markets.