Testimony of William J. Rainer, Chairman,
Commodity Futures Trading Commission
Before the Senate Committee on Banking,
Housing and Urban Affairs
May 8, 2000
Good morning Chairman Gramm and Members of the Committee. I appreciate the opportunity to appear before you today on behalf of the Commodity Futures Trading Commission to discuss market structure issues.
The emergence of electronic trading is the most important force shaping the structure of the futures markets today. One manifestation of this trend is the stream of inquiries from entities interested in operating new exchanges. Another is the significant presence of international electronic futures exchanges in this country.
The major domestic futures exchanges are responding aggressively to these competitive challenges. Among other steps, they are moving to demutualize and are forming or have formed strategic alliances with exchanges in other countries.
Collectively, these developments should result in markets with a greater choice of products and trading facilities, lower transaction costs, and faster execution times, among other potential benefits. Such improved markets serve the public interest through more efficient risk management, enhanced transparency, and additional price-discovery vehicles.
* * *
From 1985 through 1997, the Commission designated but two exchanges, and both were unsuccessful: the Pacific Board of Trade, designated in 1986, is inactive, and the Twin Cities Board of Trade, designated in 1991, never began trading.
Within the past six months, in a dramatic reversal, the Commission has received serious inquiries from at least six prospective startup exchanges. The National Futures Association, an independent self-regulatory organization, has received overtures from at least three other prospects.
As further evidence of the growth of electronic trading, a proprietary exchange software provider who spoke at our recent Technology Advisory Committee meeting indicated that his company receives one or two inquiries a day from firms interested in forming business-to-business (B2B) exchanges. While the vast majority of these B2B exchanges will begin as cash or spot markets, we believe the addition of futures trading for a certain percentage of them could follow naturally.
Those entities that have contacted the Commission seek designation as contract markets or similar trade execution facilities, and are aiming at a broad spectrum of market participants. While specific concepts are confidential, I can state that the ideas presented to us include proposals to trade both products now listed on established exchanges and futures on tangible and intangible commodities for which there are no established derivatives markets today.
Some proposals anticipate restricted markets offering B2B transactions, while others would open trading to a variety of institutional and retail participants. One inquiry is based on the concept of a derivatives transaction facility (DTF). This concept has been included in the regulatory reform proposal recommended by the Commission's staff. It envisions a more lightly regulated trading facility that is (i) geared primarily toward the needs of institutional or commercial users who are capable of protecting their own economic interests and (ii) limited to trading products that raise few, if any, manipulation concerns.
A proposed new exchange that is a matter of public record is the pending application by the Merchants' Exchange of St. Louis, LLC, for designation as a fully automated contract market to trade barge freight futures. If approved, the MESL will be the third all-electronic exchange designated by the Commission, following FutureCom this year and the Cantor Financial Futures Exchange in 1998.
* * *
The causes for this sea-change bear restating: the remarkable advances in information technology and the demonstrated commercial viability of electronic futures exchanges. New electronic systems more than likely will mount a strong competitive challenge to existing exchanges. These new exchanges do not face the formidable entry barriers of the past. New entrants will not incur the expense of a physical facility with a dedicated trading floor, the challenge of attracting locals or market makers to a certain location, or the necessity for staff to support pit trading.
The established exchanges dominate the domestic industry, although that dominance no longer can be taken for granted. The demutualization plans proposed by the exchanges suggest that they recognize the need to adapt to today's competitive environment. The proposals reflect the view that it is in the exchanges' interest to abandon their traditional model--non-profit membership organizations--to streamline decisionmaking, to pursue new business strategies, and to create a more viable vehicle for financing activities.
* * *
What is the CFTC's role in the midst of this rapid change? As a matter of sound public policy, the Commission encourages competition while remaining neutral as to the outcome. The Commission must strike the appropriate balance between providing necessary oversight of these markets and allowing them the room to develop increased efficiencies; to reduce, perhaps dramatically, transaction costs; and to enhance liquidity from resultant higher volumes.
In this new arena of fierce competition driven by technology, the CFTC's mandate to serve the public interest demands that we acknowledge the differences among futures contracts and permit exchanges to select the regulatory burden that is commensurate with the nature of the products they wish to trade and the types of customers they intend to serve.
Flexibility is the hallmark of the staff's proposed new framework. The plan would replace the concept of a one-size-fits-all designated contract market with two new kinds of trading facilities: recognized futures exchanges (RFEs) and the earlier-mentioned derivatives transaction facilities (DTFs), each of which would be subject to a different level of Commission oversight. The framework also contemplates a category of trading facilities that would be almost wholly exempt from the provisions of the Commodity Exchange Act, thus operating on an unregulated basis.
Consistent with its existing statutory mandates, the Commission intends to revamp the way in which it approaches market regulation, as well as to improve the implementation of that regulation. The technological changes outlined earlier are compressing time in all aspects of the futures industry, including the time to bring new products to market.
The CFTC is not immune to these forces. We must be able to remove unnecessary delays that act as an artificial drag on competition within the marketplace. The CFTC must improve the speed with which it will approve new entities for trading. In a business where the economic window of opportunity is now measured in weeks, not months, unnecessary regulatory delay may be equivalent to denial.
Taken together, these market and regulatory changes should produce a more efficient and innovative futures industry that will prove beneficial to our economy.
* * *
I would like to discuss another issue that is of keen interest to the many participants involved in the reauthorization of the CEA: the Shad-Johnson Accord. The CFTC favors its repeal, subject to resolving the challenging regulatory issues presented by futures as to which the underlying commodity is a security.
The CFTC appreciates this Committee’s interest in this issue. One development that has fueled optimism about reforming the Accord is the close cooperation between the Senate Banking Committee and the Senate Agriculture Committee and the Commission commends both Chairman Gramm and Chairman Lugar for that achievement.
The CFTC has long been convinced that the Shad-Johnson Accord, codified in 1982, should be reformed. I believe that participants in the U.S. financial markets should have the opportunity to decide for themselves if these products serve an economic need, provided that important regulatory issues between the agencies can be resolved.
I concur with the statement in the Report of the President’s Working Group on Financial Markets that single stock futures have elements of both a traditional futures contract and a security. Consequently, it is necessary that the statutory mandates of both the securities laws and the commodities laws be addressed in crafting a system under which the products can be traded.
I also believe that it is important that these products be offered to the market in the most economically efficient manner, without unnecessary regulatory burdens that could render them untenable for use in the United States.
The President's Working Group recommended that the CFTC and the Securities and Exchange Commission (SEC) work together and with Congress to find the solution. This recommendation was seconded by the Chairs of the Senate Agriculture Committee, the Senate Banking Committee, the House Agriculture Committee and the House Commerce Committee, who asked the agencies to engage in a collaborative effort to reach a solution. Pursuant to that request, senior staff members of both the CFTC and the SEC have been working for several months to try and address these difficult issues.
In that time, we have made very important strides, although I acknowledge that we have not been able to resolve all issues as quickly as we might have hoped.
Specifically, the staffs have developed the concept of notice registration to try to avoid duplicative regulatory requirements for the exchanges and intermediaries already registered with either agency. We have also reached tentative agreement on listing standards, harmonized margin requirements, trading rules, and establishing the authority of the SEC to pursue insider trading involving these products.
Additionally, both agencies are seeking to have these products trade in a highly competitive environment by allowing single stock futures to be traded on both futures and securities exchanges.
Differences do remain between ourselves and the SEC. It is difficult to find the regulatory formula that meets both agencies' statutory objectives without imposing burdens that render the products unusable and without creating unfair advantages for one exchange over another.
In our letter of March 2, 2000, the agencies agreed to "provide a comprehensive legislative proposal … before Congress adjourns." It is my hope that we will be able to do so well in advance of that date. Again, let me express my continuing appreciation for this Congress’ important role in resolving this difficult matter.
Thank you again Mr. Chairman for the opportunity to testify before you today on these important matters. I would be pleased to answer any questions that the Committee may have.