James E. Newsome, Chairman
Commodity Futures Trading Commission
Committee on Agriculture
U.S. House of Representatives
November 6, 2003
Thank you Chairman Goodlatte and members of the Committee. I appreciate the opportunity to testify before you today on behalf of the Commission regarding the application filed by U.S. Futures Exchange, L.L.C. (“U.S. Futures Exchange” or “Exchange”) to become a designated contract market, which is commonly referred to as a futures exchange.
As you know, through the Commodity Futures Modernization Act of 2000 (“CFMA”), Congress profoundly altered the manner in which derivatives markets are regulated in the United States by replacing the one-size-fits-all prescriptive rules of the past with broad core principles aimed at promoting responsible innovation and fair competition among exchanges and other market participants. This is an exciting time for the futures business. Due to a number of factors, the industry that we regulate has grown significantly over the past few years. We believe that a primary contributing factor is the modernized regulatory structure established by Congress in the CFMA. This new, flexible approach to regulation has encouraged innovation and the use of cutting-edge technology, and has allowed market participants to implement business plans with much greater ease. It has also resulted in an unprecedented number of new entrants into the marketplace. Since December 2000, when the CFMA was signed into law, the Commodity Futures Trading Commission (“CFTC” or “Commission”) has designated four new exchanges as contract markets and has received three additional applications, including the application filed by U.S. Futures Exchange. Throughout this time the CFTC has been committed to providing a level regulatory playing field for all existing and potential market participants, while being vigilant in its mission to foster markets free of fraud and manipulation, and it will evaluate U.S. Futures Exchange’s application accordingly.
To put things into context, I would first like to outline the legal requirements for contract market designation set forth in the Commodity Exchange Act (“Act”), as amended by the CFMA, and in the Commission’s regulations. I will also outline the substance of U.S. Futures Exchange’s application, including a description of its proposed clearing plans and how it intends to fulfill its self-regulatory responsibilities, and describe the process by which the Commission is evaluating the application. Finally, because questions have been raised concerning the Commission’s authority to address activity occurring abroad that may relate to the Exchange’s operations, I will comment on the Commission’s authority to reach extraterritorial conduct.
Legal Requirements for Contract Market Designation
To become a designated contract market (“DCM”), an applicant must demonstrate to the Commission that it will comply with the conditions set forth in the Act, which consist of eight designation criteria and eighteen core principles, and must provide sufficient assurance that it will continue to comply with those conditions. (The details of the designation criteria and the core principles are attached as an appendix). By statute, the Commission must approve or deny an application for designation within 180 days of its submission, unless the application is materially incomplete, in which case the 180-day period may be stayed. See Section 6(a) of the Act.
By regulation, an application may be considered under a 60-day procedure in appropriate circumstances. See Commission Rule 38.3. Although originally slated for 60-day review, the Commission decided to remove the application from the expedited procedure and is now reviewing it under the 180-day statutory timeframe to ensure that we have an adequate opportunity to fully consider all of the issues.
In order to be complete, an application must include: (1) a copy of the applicant’s rules and any technical manuals, guides, or instructions for users of the market; (2) descriptions of the trading system, test procedures and results, and contingency or disaster recovery plans; (3) descriptions of the applicant’s legal status and governance structure; (4) copies of agreements, including third-party regulatory service agreements, that will enable the applicant to meet the conditions for designation; and (5) to the extent that it is not self-evident, an explanation as to how the application satisfies the conditions for designation.
The Act provides further that an exchange shall have reasonable discretion in establishing the manner in which it achieves compliance with the core principles, and may do so by delegating relevant functions to a registered futures association or another registered entity. In adopting rules implementing the Act, the Commission recognized that some existing exchanges had outsourced certain of these functions to non-registered entities, and determined that such outsourcing is permissible. See 66 Fed. Reg. 42256, 42266 (Aug. 10, 2001). In either case, however, the exchange remains ultimately responsible for assuring compliance.
U.S. Futures Exchange’s Application
U.S. Futures Exchange formally applied for designation as a contract market on September 16, 2003. According to its application, U.S. Futures Exchange is a Delaware limited liability company headquartered in Chicago, and is a wholly owned subsidiary of U.S. Exchange Holdings, Inc., a separately capitalized, wholly owned subsidiary of Eurex Frankfurt A.G. (“Eurex Frankfurt”). Eurex Frankfurt is a wholly owned subsidiary of Eurex Zurich A.G., which is owned in equal parts by Deutsche Börse A.G. and SWX Swiss Exchange. U.S. Futures Exchange will be governed by a Board of Directors elected each year at its annual meeting of shareholders. The Board will appoint a Chairman, and the Chairman may appoint a President, who will serve as Chief Executive Officer of the U.S. DCM.
All trading on the Exchange will be done electronically, through a version of the trading system that Eurex Frankfurt has operated in the U.S. since the year 2000 in a joint venture with the Chicago Board of Trade. The trading system will provide a full audit trail of orders, bids and transactions. Audit trail information will be submitted directly to the National Futures Association (“NFA”), a Commission-registered futures association, which will provide certain self-regulatory services for the Exchange such as conducting surveillance for trade practice violations, market manipulation, price distortions and market congestion. U.S. Futures Exchange staff in Chicago will conduct real-time monitoring of Exchange trading activity. Clearing and settlement services will be provided by The Clearing Corporation (formerly the Board of Trade Clearing Corporation), a derivatives clearing organization (“DCO”) registered with the Commission.
As with all applications for contract market designation, Commission staff is currently reviewing U.S. Futures Exchange’s application to determine whether the operations described and the supporting technical and regulatory services agreements demonstrate that the Exchange meets the eight criteria for designation and the eighteen core principles. With respect to the proposed outsourcing of self-regulatory functions to NFA, in addition to reviewing the terms of the services agreement, prior to designation Commission staff will, among other things, conduct on-site examinations to determine whether appropriate surveillance systems are in place and functional. In the event that the Commission approves the provision of regulatory services by NFA, the Commission will monitor NFA’s performance on an ongoing basis through rule enforcement reviews, as it does for all self-regulatory organizations.
The Commission has published for public comment all portions of the application except for those containing trade secrets or commercial or financial information subject to confidential treatment under the law. In considering whether to approve the application, the Commission will carefully consider all comments received.
There are two issues that have been raised in various forums, including questions from this Committee, that the current application before the Commission does not address: (1) a proposed clearing link with Eurex Clearing A.G. (“Eurex Clearing”), which is the clearing and settlement arm of Eurex Frankfurt; and (2) proposed incentive programs for attracting business to the Exchange.
The application currently pending before the Commission does not request approval of trade clearing or settlement arrangements outside the U.S. As mentioned earlier, the clearing component of the application is based upon the proposed clearing services agreement with The Clearing Corporation. Although U.S. Futures Exchange has publicly announced that it intends to offer a clearing link with Eurex Clearing at some point in time, it has not presented the Commission with any cross-border clearing plans. Neither the Act nor the Commission’s regulations require that an application for designation as a contract market include all future clearing plans that may be contemplated, or future plans in general. The application need only include information demonstrating an ability to satisfy the conditions for designation based upon a current business plan. Because we can consider only the proposal contained in the application, the Commission’s review of the clearing component of the application is currently proceeding strictly on the basis of the proposed clearing services agreement with The Clearing Corporation.
Although the Commission does not know the particulars of the Exchange’s future plans for a cross-border clearing link, the Commission can assure the Committee that any proposal that would permit the clearing of U.S. Futures Exchange positions by Eurex Clearing would require that Eurex Clearing first become a U.S. DCO. See Sections 5(b)(5) and 5(d)(11) of the Act and applicable Part 38 Guidance. In accordance with Commission policy, those portions of any application filed by Eurex Clearing to become a DCO that are not subject to a request for confidential treatment under the Freedom of Information Act or Commission regulations would be released to the public for comment.
It is conceivable that a proposal to enable Eurex Clearing to clear U.S. Futures Exchange positions could be considered under other provisions of the Act or regulations, but any such proposal would require affirmative Commission action, which would not be taken without the opportunity for public comment.
U.S. Futures Exchange has not presented the Commission with any plans for generating volume on the Exchange. Incentives aimed at generating trading volume on futures exchanges, such as “fee holidays” for new products and reduced fees for market makers, have long been viewed as acceptable by the Commission. Most U.S. exchanges offer such incentives in the normal course of business. Commission staff analysis of these programs focuses primarily on whether the incentive will distort open, competitive and efficient trading in the product by making abusive practices, such as wash trading, economically attractive. In addition to the foregoing review, the Commission would review any marketing plan offered by U.S. Futures Exchange, as it would from any other applicant or registrant, to determine whether its implementation would pose an impermissible conflict of interest between brokers and the fiduciary duties owed to customers. I would like to emphasize that the Commission will not allow U.S. Futures Exchange to offer any incentive program that other U.S. contract markets would not be permitted to offer.
The Commission’s Extraterritorial Enforcement Authority
The fact that U.S. Futures Exchange is owned by a German company has led to questions concerning the CFTC’s authority to prosecute foreign individuals. In recognition of the international nature of commodity futures and option trading, Congress has given the Commission broad powers to take actions against persons suspected of violating the Act wherever such persons may be located, and to serve subpoenas seeking the production of witnesses and documents wherever they may be located. See, e.g., Sections 6(c), 6b and 6c(a) of the Act. In addition, the Commission may prosecute any person located abroad who, directly or indirectly, controls a person who commits a violation of the Act. See Section 13(b) of the Act.
To enhance its extraterritorial enforcement powers, the Commission has entered into numerous bilateral information-sharing arrangements (also known as “Memorandums of Understanding” or “MOUs”) with foreign regulators. With respect to Germany in particular, the Commission has enjoyed a long-standing and extensive cooperative relationship with the Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”), our German counterpart, and its predecessor agency. The BaFin’s cooperation has been critical to the Commission’s ability to combat violations in a number of instances, by assisting our Division of Enforcement in obtaining trading and bank records, registration histories, complaint and investigation files, and most recently, obtaining the statement of a witness. The Commission fully expects, based upon its past experience with the BaFin, that should circumstances require assistance from Germany in connection with U.S. Futures Exchange’s operations, such assistance will be forthcoming in accordance with the provisions of the MOU.
It should be noted that, to the extent the Commission may encounter difficulty in pursuing violations of the Act or regulations committed by persons who are located abroad, that issue exists today with respect to activity conducted by foreign persons on existing U.S. exchanges. Furthermore, there is no prohibition on foreign persons serving as senior executives or board members of U.S. exchanges, and a number of non-U.S. citizens have done so.
In closing, I would like to emphasize that U.S. Futures Exchange has applied to become a U.S. exchange that will be subject to the CFTC’s direct regulatory authority. The Commission takes its responsibilities in reviewing applications for contract market designation seriously, and will apply the highest standards of regulatory review prior to approving the application made by U.S. Futures Exchange. We pledge to you that we will review the application, mindful of all comments received, with an eye toward ensuring that all necessary standards are met, and that only sound, ethical business practices are allowed to exist in the U.S. marketplace. I thank you for the invitation to appear today, and will be happy to answer any questions you may have.
Criteria for Designation
The eight criteria for designation as a contract market are as follows:
(1) IN GENERAL.—To be designated as a contract market, the board of trade shall demonstrate to the Commission that the board of trade meets the criteria specified in [the Act].
(2) PREVENTION OF MARKET MANIPULATION.—The board of trade shall have the capacity to prevent market manipulation through market surveillance, compliance, and enforcement practices and procedures, including methods for conducting real-time monitoring of trading and comprehensive and accurate trade reconstructions.
(3) FAIR AND EQUITABLE TRADING—The board of trade shall establish and enforce trading rules to ensure fair and equitable trading through the facilities of the contract market, and the capacity to detect, investigate, and discipline any person that violates the rules. The rules may authorize—
(A) transfer trades or office trades;
(B) an exchange of—
(i) futures in connection with a cash commodity transaction;
(ii) futures for cash commodities; or
(iii) futures for swaps; or
(C) a futures commission merchant, acting as principle or agent, to enter into or confirm the execution of a contract for the purchase or sale of a commodity for future delivery if the contract is reported, recorded, or cleared in accordance with the rules of the contract market or a derivatives clearing organization.
(4) TRADE EXECUTION FACILITY.—The board of trade shall—
(A) establish and enforce rules defining, or specifications detailing, the manner of operation of the trade execution facility maintained by the board of trade, including rules or specifications describing the operation of any electronic matching platform; and
(B) demonstrate that the trade execution facility operates in accordance with the rules or specifications.
(5) FINANCIAL INTEGRITY OF TRANSACTIONS.—The board of trade shall establish and enforce rules and procedures for ensuring the financial integrity of transactions entered into by or through the facilities of the contract market, including the clearance and settlement of the transactions with a derivatives clearing organization.
(6) DISCIPLINARY PROCEDURES.—The board of trade shall establish and enforce disciplinary procedures that authorize the board of trade to discipline, suspend, or expel members or market participants that violate the rules of the board of trade, or similar methods for performing the same functions, including delegation of the functions to third parties.
(7) PUBLIC ACCESS.—The board of trade shall provide the public with access to the rules, regulations, and contract specifications of the board of trade.
(8) ABILITY TO OBTAIN INFORMATION.—The board of trade shall establish and enforce rules that will allow the board of trade to obtain any necessary information to perform any of the functions describe in the [criteria for designation], including the capacity to carry out such international information-sharing agreements as the Commission may require.
7 U.S.C. § 5(b).
The thirteen core principles for contract markets are as follows:
(1) IN GENERAL.—To maintain the designation of a board of trade as a contract market, the board of trade shall comply with the core principles specified in [the Act]. The board of trade shall have reasonable discretion in establishing the manner in which it complies with the core principles.
(2) COMPLIANCE WITH RULES.—The board of trade shall monitor and enforce compliance with the rules of the contract market, including the terms and conditions of any contracts to be traded and any limitations on access to the contract market.
(3) CONTRACTS NOT READILY SUBJECT TO MANIPULATION.—The board of trade shall list on the contract market only contracts that are not readily susceptible to manipulation.
(4) MONITORING OF TRADING.—The board of trade shall monitor trading to prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process.
(5) POSITION LIMITATIONS OR ACCOUNTABILITY.—To reduce the potential threat of market manipulation or congestion, especially during trading in the delivery month, the board of trade shall adopt position limitations or position accountability for speculators where necessary and appropriate.
(6) EMERGENCY AUTHORITY.—The board of trade shall adopt rules to provide for the exercise of emergency authority, in consultation or cooperation with the Commission, where necessary and appropriate, including the authority to—
(A) liquidate or transfer open positions in any contracts;
(B) suspend or curtail trading in any contracts; and
(C) require market participants in any contract to meet special margin requirements.
(7) AVAILABILITY OF GENERAL INFORMATION.—The board of trade shall make available to market authorities, market participants, and the public information concerning—
(A) the terms and conditions of the contracts of the contract market; and
(B) the mechanisms for executing transactions on or through the facilities of the contract market.
(8) DAILY PUBLICATION OF TRADING INFORMATION.—The board of trade shall make public daily information on settlement prices, volume, open interest, and opening and closing ranges for actively traded contracts on the contract market.
(9) EXECUTION OF TRANSACTIONS.—The board of trade shall provide a competitive, open, and efficient market and mechanism for executing transactions.
(10) TRADE INFORMATION.—The board of trade shall maintain rules and procedures to provide for the recording and safe storage of all identifying trade information in a manner that enables the contract market to use the information for purposes of assisting in the prevention of customer and market abuses and providing evidence of any violations of the rules of the contract market.
(11) FINANCIAL INTEGRITY OF CONTRACTS.—The board of trade shall establish and enforce rules providing for the financial integrity of any contracts traded on the contract market (including the clearance and settlement of the transactions with a derivatives clearing organization), and rules to ensure the financial integrity of any futures commission merchants and introducing brokers and the protection of customer funds.
(12) PROTECTION OF MARKET PARTICIPANTS.—The board of trade shall establish and enforce rules to protect market participants from abusive trading practices committed by any party acting as an agent for the participants.
(13) DISPUTE RESOLUTION.—The board of trade shall establish and enforce rules regarding and provide facilities for alternative dispute resolution as appropriate for market participants and any market intermediaries.
(14) GOVERNANCE FITNESS STANDARDS.—The board of trade shall establish and enforce appropriate fitness standards for directors, members of any disciplinary committee, members of the contract market, and any other persons with direct access to the facility.
(15) CONFLICTS OF INTEREST.—The board of trade shall establish and enforce rules to minimize conflicts of interest in the decisionmaking process of the contract market and establish a process for resolving such conflicts of interest.
(16) COMPOSITION OF BOARDS OF MUTUALLY OWNED CONTRACT MARKETS.—In the case of a mutually owned contract market, the board of trade shall ensure that the composition of the governing board reflects market participants.
(17) RECORDKEEPING.—The board of trade shall maintain records of all activities related to the business of the contract market in a form and manner acceptable to the Commission for a period of 5 years.
(18) ANTITRUST CONSIDERATIONS.—Unless necessary or appropriate to achieve the purposes of this Act, the board of trade shall endeavor to avoid—
(A) adopting any rules or taking any actions that result in any unreasonable restraints of trade; or
(B) imposing any material anticompetitive burden on trading on the contract market.
7 U.S.C. § 5(d).