[Senate Hearing 106-907] [From the U.S. Government Publishing Office] S. Hrg. 106-907 CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK'' ======================================================================= HEARING before the COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY UNITED STATES SENATE SUBCOMMITTEE ON RESEARCH, NUTRITION AND GENERAL LEGISLATION ONE HUNDRED SIXTH CONGRESS SECOND SESSION ON CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK'' __________ MARCH 20, 2000 __________ Printed for the use of the Committee on Agriculture, Nutrition, and Forestry U.S. GOVERNMENT PRINTING OFFICE 69-315 WASHINGTON : 2001 _______________________________________________________________________ For sale by the U.S. Government Printing Office Superintendent of Documents, Congressional Sales Office, Washington, DC 20402 ? COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY RICHARD G. LUGAR, Indiana, Chairman JESSE HELMS, North Carolina TOM HARKIN, Iowa THAD COCHRAN, Mississippi PATRICK J. LEAHY, Vermont MITCH McCONNELL, Kentucky KENT CONRAD, North Dakota PAUL COVERDELL, Georgia THOMAS A. DASCHLE, South Dakota PAT ROBERTS, Kansas MAX BAUCUS, Montana PETER G. FITZGERALD, Illinois J. ROBERT KERREY, Nebraska CHARLES E. GRASSLEY, Iowa TIM JOHNSON, South Dakota LARRY E. CRAIG, Idaho BLANCHE L. LINCOLN, Arkansas RICK SANTORUM, Pennsylvania Keith Luse, Staff Director David L. Johnson, Chief Counsel Robert E. Sturm, Chief Clerk Mark Halverson, Staff Director for the Minority (ii) C O N T E N T S ---------- Page Hearing: Monday, March 20, 2000, CFTC Report Entitled ``A New Regulatory Framework''.................................................... 1 Appendix: Monday, March 20, 2000........................................... 41 Document(s) submitted for the record: Monday, March 20, 2000........................................... 103 ---------- Monday, March 20, 2000 STATEMENTS PRESENTED BY SENATORS Fitzgerald, Hon. Peter G., a U.S. Senator from Illinois, Chairman, Subcommittee on Research, Nutrition and General Legislation, Committee on Agriculture, Nutrition and Forestry.. 1 ---------- WITNESSES PANEL I Paul, Robert C., General Counsel, Commodity Futures Trading Commission, Washington, DC..................................... 2 PANEL II Brennan, David P., Chairman, Chicago Board of Trade, Chicago, Illinois, accompanied by Thomas Donovan, President and Chief Executive Officer, Chicago Board of Trade, Chicago, Illinois... 14 Crapple, George, President, Managed Funds Association, New York, New York....................................................... 29 Downey, David, Executive Vice President, Interactive Brokers LLC, Chicago, Illinois.............................................. 32 Lind, Barry, Chairman, Lind-Waldock & Company, Chicago, Illinois. 23 McNulty, James J, President and Chief Executive Officer, Chicago Mecantile Exchange, Chicago, Illinois.......................... 15 Wilmouth, Robert K., President, National Futures Association, Chicago, Illinois.............................................. 11 Waye, Jan R., Senior Vice President, Cargill Investor Services, Inc., Chicago, Illinois........................................ 26 ---------- APPENDIX Prepared Statements: Fitzgerald Hon. Peter G...................................... 42 Brennan, David P............................................. 60 Crapple, George.............................................. 77 Downey, David................................................ 87 Lee, Peter................................................... 82 Lind, Barry.................................................. 95 Paul, Robert C............................................... 46 McNulty, James J............................................. 51 Waye, Jan R.................................................. 74 Wilmouth, Robert K........................................... 67 Document(s) submitted for the record: CFTC (report) A New Regulatory Framework, submitted by Jan R. Waye....................................................... 104 CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK'' ---------- MONDAY, MARCH 20, 2000 U.S. Senate, Subcommittee on Research, Nutrition, and General Legislation, of the Committee on Agriculture, Nutrition, and Forestry, Washington, DC. The Subcommittee met, pursuant to notice, at 10:05 a.m., in room 2525, Dirksen Federal Building, 219 South Dearborn Street, Chicago, Illinois, Hon. Peter G. Fitzgerald, Chairman of the Subcommittee,) presiding. Present or submitting a statement: Senator Fitzgerald. OPENING STATEMENT OF HON. PETER G. FITZGERALD, A. U.S. SENATOR FROM ILLINOIS, CHAIRMAN, SUBCOMMITTEE ON RESEARCH, NUTRITION, AND GENERAL LEGISLATION, OF THE COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY The Chairman. This hearing will come to order. This is a hearing on the Subcommittee on Research, Nutrition and General Legislation of the U.S. Senate Committee on Agriculture, Nutrition and Forestry. The purpose of the hearing is to examine proposed regulations that may be coming forth from the Commodity Futures Trading Commission. CFTC has suggested that it is willing to grant broad regulatory relief to futures exchanges and create a new regulatory--framework. I've asked each panelist, instead of reading the prepared remarks, to instead summarize their remarks as best they can. I'm going to set a good example by sparing you the reading of my opening statement which I am now going to ask myself for permission to submit for the record. And with that, Mr. Paul, welcome to Chicago and please, why don't you begin. [The prepared statement of Senator Fitzgerald can be found in the appendix on page 42.] STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION, WASHINGTON, DC., ACCOMPANIED BY PAUL ARCHITZEL, DIVISION OF ECONOMIC ANALYSIS Mr. Paul. Thank you Mr. Chairman. I'm pleased to be here to testify before you on behalf of Chairman Rainer and appreciate the opportunity to discuss recent efforts at regulatory reform. I also want to introduce you to my left, Paul Architzel from our Division of Economic Analysis who headed up the task force that prepared this regulatory framework that we are discussing today. I will try to summarize my written remarks as briefly as possible but I am sure, Mr. Chairman, that you can feel free to interrupt me as I go through this with any questions you may have and I'll leave time at the end to answer any questions you might have. Chairman Rainer has identified three public policy goals on which the CFTC should focus in regulating derivatives markets: first, creating a comfortable climate for competition in all sectors of the industry; second, removing any regulatory barriers that hamper these markets from fully exploiting innovations in technology; and third, decreasing the level of systemic risk in domestic and international derivatives trading. To achieve these goals it is imperative to modernize the way we regulate futures markets. Accordingly, a staff task force of the Commission has developed a new regulatory framework that would change the regulatory structure for derivatives. The proposed framework is intended to promote innovation, maintain U.S. competitiveness, reduce systemic risk, and protect derivatives customers. The new frame work is a work in progress; it is a staff document on which there has been no Commission action to date. The CFTC intends to hold at least one public hearing on this proposal to get as much input as possible from the markets and participants. We want to find solutions that serve the public interest. But we also recognize that time is not our ally. In spite of the difficulty of developing answers to questions of regulatory architecture, we must work together to expeditiously reach conclusions suitable for these markets and the public interest. Technology offers us tangible benefits that are either immediate or imminent, including faster and better execution; significantly lower transaction costs; cross-market clearing, netting and offsetting systems; and increased liquidity. The U.S. futures industry must embrace technology without reservation to build stronger markets if it expects to remain competitive. Flexibility is the hallmark of the new framework. The staff's proposal recommends that the Commission replace the current one-size-fits-all regulation for futures markets with a structure that would instead apply broad, flexible ``core principles,'' which are tailored to match the degree and manner of regulation to a variety of market structures and participants. Under this proposal, multilateral trade execution facilities will operate in one of three categories, taking into account the nature of the underlying commodities and the sophistication of the customers. While the framework invites changes, it does not impose it on established futures exchanges. Existing exchanges operating as contract markets may reorganize under the terms of the framework, but they are not compelled to do so. The framework offers the following three basic categories of exchanges or trading facilities correlating to a spectrum of regulation: recognized futures exchanges, recognized derivative transaction facilities and exempt multilateral trading facilities. And I want to compliment the Chairman on getting those rather accurately in his introduction. The category recognized futures exchange [RFE], or an RFE, would include multilateral transaction execution facilities that permit access to any type of customer, institutional or retail, and that trade any type of contract, including those that are based on commodities that have finite deliverable supplies or cash markets with limited liquidity. Because these markets trade markets that may have a greater susceptibility to price manipulation and because the presence of non- institutional traders participating here raise deeper concerns for customer protection, RFEs would be subject to a higher level of Commission oversight than market in either of the other two categories. Nonetheless, the proposed RFE offers significant regulatory relief compared to the current requirements applicable to designated contract markets. Detailed prescriptive rules would be replaced with 15 broad ``core principles.'' These include principles relating to market surveillance, position reporting, transparency, fair trading and customer protection. Any board of trade, facility, or entity that is currently required to be designated as a contract market would be eligible to qualify as an RFE. The second category, the derivatives transaction facility [DTF], would be subject to a lesser degree of Commission oversight. A facility would be eligible to become a DTF if: (i) the contracts traded on the facility are for commodities that have nearly inexhaustible supplies or for which there is no underlying cash markets (e.g., weather derivatives); (ii) the Commission determines on a case-by-case basis that the contract would be appropriate for this level of regulation; or (iii) the facility limits access to commercial traders only. A DTF would be required to adhere to only seven core principles, including those relating to market oversight, transparency, and recordkeeping. Because a DTF either would be limited to commodities that are not susceptible to manipulation or would limit access to institutional or commercial participants, a DTF would not be required to adhere to certain other core principles applicable to an RFE such as those relating to position monitoring, customer protection or dispute resolution. Finally, the third category, the exempt multilateral transaction execution facility [MTEF], or exempt MTEF, would operate on an unregulated basis. This would be a self- effectuating exemption for transactions among institutional traders in commodities that are unlikely to be susceptible to manipulation. These markets would be exempt from all requirements of the Commodity Exchange Act and Commission regulations, except for anti-fraud and anti-manipulation. Moreover, if a designated contract market elects to trade an eligible contract that serves as a sort of price discovery on an exempt MTEF, the MTEF would be required to continue to provide pricing information to the public. Exempt MTEFs would not, however, be permitted to hold themselves out to the public as being regulated by the Commission. That is a brief overview of the staff's regulatory proposal, and I would be happy to answer any questions. Thank you again for the opportunity to testify before you today. [The prepared statement of Mr. Paul can be found in the appendix on page 46.] The Chairman. Mr. Paul, thank you, and I think you gave a very good, concise explanation of the three different categories that would be available. Let me ask you the threshold question. I believe in the CFTC's report to Congress about these proposals that you suggested that you have the ability to implement it through your own regulatory powers without any help from Congress. Does the CFTC believe that this proposal should or should not be codified by Congress? Mr. Paul. Well, although we believe that we have proper statutory authority under Section 4(c) to adopt these regulations without legislation, we do see a benefit in working with your Subcommittee and Chairman Lugar's Parent Committee in codifying some of the structure. We think that it would perhaps enhance the ability to get meaningful legislation adopted that would greater legal certainty to the markets. The Chairman. If Congress decides to, as we rewrite the CEA, codifying the core principles and having three different layers? Mr. Paul. I am not sure that we would go as far as codifying, suggesting that you codify the core principles, only because that might detract from the kind of flexibility that we hope to achieve through this regulatory framework. But I think what we had discussed internally, and I think already discussing with Congressional staff, is codifying the categories and maybe some of the over-arching concepts without necessarily delving into the kind of detail that you would find at the 15 core principles for the RFE, or the seven core principles for the DTF. The Chairman. This proposal would really not depend on what type of physical exchange you are, whether you are a pit based exchange or an electronic exchange. It would go beyond those areas and an electronic exchange could try to qualify theoretically to be a recognized futures exchange, I suppose. In addition a pit based exchange could at least try to be a recognized derivatives transaction facility. And possibly, if they are just institutional traders trading commodities with inexhaustible supplies and no underlying cash market, a traditional pit based exchange could try to become an exempt multilateral transaction facility. Mr. Paul. I could not have said it any better myself. That is the beauty of this proposal. I think the staff, working with Mr. Architzel, had their different approaches including those that might be based on what the medium is, but we think that kind of flexibility that we put into this proposal is of greater benefit to the markets. We let the markets choose which medium it would like to trade in, and by gearing the regulation, calibrating it according to what products and who the participants are, we think we can achieve regulatory goals without unduly hampering the innovation on the technology side. The Chairman. Now, both of the main futures exchanges in Chicago, the Chicago Board of Trade and the Chicago Mercantile Exchange, are now considering proposals to reorganize themselves internally. The Chicago Board of Trade is considering creating two separate companies, one that would be an on-line company and the other that would be the traditional pit based exchange. Would a change in these regulations affect the way those exchanges might want to be organized? If they decided that they wanted to have an RFE, a DTF and an exempt MTEF, would they have to have three separate subsidiaries? How would this work? Would each have to have a separate legal identity? Mr. Paul. The framework currently would call for separate entities for different type of structures, but we are discussing that, because our interest is making sure that the participants know exactly what level of regulation that they are engaging in. So therefore, I think the original inclination was to have separate entities. But I think that we are considering whether or not we want to provide the kind of flexibility that may be able to allow a single entity to offer different types of markets, as long as it is clear to the participants, to the customers, which entity they are trading and therefore, what level of protection that they might be protected by. Mr. Architzel. Just to clarify. Recognized markets can be traded under the same legal entity. It is only the exempt MTEF that is required to be traded through a separate legal entity, because that level is not regulated. So the exchanges would have the ability to operate both the RFE and the DTF under the same legal entity. The Chairman. OK. So that one legal entity could have the RFE and the DTF, but if you wanted to have the exempt MTEF you would have to have a separate subsidiary or a separate company. Mr. Architzel. Exactly. The Chairman. OK. That clarifies. That is important. Now, to be a recognized derivatives transaction facility, a recognized DTF, you say that there would be two main requirements: First, only commodities with, nearly inexhaustible deliverable supplies, no underlying cash market, or contracts that the CFTC allows on an individual case-by-case basis could be traded. Secondly, commercial traders would be allowed to trade. What do you mean by commercial traders? Mr. Paul. I'll try to clarify that. That is either/or, Mr. Chairman. The Chairman. OK. That is right. So in other words, retail customers and that would not be a problem. If they are dealing with commodities, such as Euro dollars or foreign currencies, commodities a nearly inexhaustible deliverable supply? Mr. Architzel. That is correct. Retail customers are permitted with special enhanced protection. This DTF is intended to be a market mainly for institutional customers. But if the market qualifies as a DTF on the basis of the nature of the commodity, then it is possible for retail customers to access the market if certain conditions are met. Those conditions are that the customers trade through a registered FCM, that the FCM be a clearing member of at least one RFE and that the FCM meet a higher minimum net capital standard. The second group of markets that can be a DTF are markets which are open only to commercial traders. This type of DTEF, which is essentially B-2-B, is only commercial traders is open for any commodity. So these are two very distinct types of markets. The Chairman. OK. So you could envision an agricultural commodity being traded in a DTF provided that only institutional participants are involved? Mr. Architzel. At this point we have not limited the types of commodities that can trade on a DTEF, although the staff report recommends that the Commission seek comment on whether agricultural commodities in particular should be qualified to belong in this category. So that is something that we recommend that the Commission seek comment on. Agricultural commodities have somewhat different characteristics and in the past were sometimes treated differently under the regulations. But certainly any physical commodity could belong in the DTF category and qualify for it, if the market were restricted to commercial traders. The Chairman. Now, let me just talk about commodities with a nearly inexhaustible deliverable supply. Do you fit United States Treasury Bonds in that category? Mr. Architzel. That is a ``moving target'' right now. The Chairman. Because the supply is going down. I mean it is 3.5 trillion outstanding right now, but it is scheduled to go down to zero by 2015. Mr. Architzel. I think that is something that needs to be addressed further. We should have guidelines saying what commodities fit into this category. And as markets change, as commodities change, we could review and revise the guidelines. The Chairman. Now, on the exempt multilateral transaction facilities, would I be correct to surmise that no retail customers could, under any circumstances, be allowed in that? Mr. Architzel. That's correct. The Chairman. That would be totally institutional. Right now the current sections of the CEA that provide the principle regulatory framework for the CFTC are Section 5 and 6 of the CEA. How would the new regulatory framework impact those sections? Mr. Architzel. The core principles summarize and digest most of the provisions in Section 5 and 5a, and would serve as a replacement by and large for those individual sections of the Act. In other words, sections 5 and 5a of the Act, talk about the manipulability of commodities, and there is a core principle that relates to that. So the core principle would serve as an alternative to that provision of the Act. The Chairman. The report recommends, as you have talked about, that the current CFTC regulatory framework be replaced with the derived four principles that are intended to encompass all technology and business organizations. However, the report does not address in detail how these principles are to be implemented or provide guidelines for industry participants to follow. Who will determine how industry participants will apply these principles and how they will be accomplished? Mr. Architzel. The report envisions that the core principles will be accompanied by statements of acceptable practices or best practices, and those would be interpretive statements by the Commission, giving guidance to the industry on compliance with the core principles. We also envision that the interpretive statements would be written in cooperation with the industry and envision that the National Futures Association will be providing input to us on those as well. I think it is important to note, though, because those would be acceptable practices, they would not be exclusive of other ways that facilities could come to us and demonstrate that they are in compliance with the core principles. That is what we are trying to achieve from this framework, as opposed to giving the specific prescription as to how they should achieve these goals, but leave it open to them. But we give them the convenience of knowing if they do things in a certain way that creates a safe harbor. The Chairman. OK. According to your report, non- institutional customers require greater market protection than institutional or commercial customers. Non-institutional customers may be permitted access on both an RFE, a recognized futures exchange, and DTF facility, recognized derivatives transaction facility, although the core principles for an RFE contain provisions for customer protection and dispute resolution for non-institutional customers. The DTF core principles do not contain such provisions. Could you explain the absence of the customer protection and dispute resolution provisions in the DTF core principles? Mr. Paul. Well, I will start and Paul can supplement it. We feel that we can achieve customer protection for the non- institutional customers trading on DTF by regulating the intermediary. And this is frankly a concept that we learned by soliciting comments from the industry. And we think that as long as we have an intermediary that is a registrant of the CFTC, and therefore, is obligated to follow the CFTC rules with respect to risk disclosure, segregation of assets, making sure that they get the information they need on the markets, that we can protect the customer at that level as opposed to doing it at the exchange level. Mr. Architzel. I think the additional thing to note is that although there is not the dispute resolution provision, there would be the availability of the CTFC reparation procedures which is like a small claims court for customers who feel they have been injured by a violation of the Act or regulations. And those would remain available to retail customers, because they would be trading through registrants. The Chairman. You have a lot in your report about the segregation of customer funds. If I read it correctly, institutional customers would be able to opt out of requiring that their funds be segregated; was that how you set this up? Mr. Architzel. That is only if the DTF has rules providing for that. And in doing so, in providing those rules, they would also have to provide for financial disclosure and other types of disclosures to market participants on what the effects would be by having the opt out allowance. The Chairman. If those funds are not segregated and there is a problem, it really gets hard to trace, does it not? How do you determine whose money was taken, misappropriated or misapplied? Mr. Paul. Well, I guess we believe that, that is a risk that we would allow certain customers to take as long as they are fully informed of what the risks are. And that is also why we are not recommending that, that be permitted at the recognized futures exchange level. And just parenthetically, when the task force originally put together this proposal, they had another category between the RFE and DTF known as a recognized institutional futures exchange, which would be somewhere in between the regulatory framework on the spectrum of regulation, and that would be created so that institutional customers could opt out of seg. We found that there was not a real appetite for that in the market. So we thought we would simplify it with just the three big markets we have now. The Chairman. You figured that the big boys who are participating in the markets can take care of themselves. That they would probably demand their funds be segregated or have those kind of protections that they could handle, is that correct? Whereas, a retail customer might not think of that issue, is that correct? Mr. Architzel. This issue has come up over the years. There are foreign exchanges that operate without segregation of customer funds, and generally that is available for larger customers as an option. Over the years our exchanges have said that they would be able to compete more effectively with foreign markets if they were able to make adjustments to. So that is something that we are comfortable with for large institutional customers only, provided that appropriate disclosures are made at the market level. Mr. Paul. One of the reasons, just to finish this thought, one of the reasons why there did not seem to be a keen appetite for the RFE is because the proposal also recommends that we broaden the permissible investment of segregated funds. And that is really why not only customers, but also the intermediaries were reluctant to extend segregated funds any further than they had to because they would get low return on those funds that were segregated, to the extent that we have made it a little broader possibilities as to what they could invest it in and provide better return, the need to opt out of seg is not as acute. The Chairman. OK. Now, the first page of the report recommends that the Commission propose a quote, ``new regulatory framework to apply to multilateral execution facilities that trade derivatives.'' How does the CFTC define, quote, ``transaction execution facility,'' and what is the CFTC's position on the meaning of multilateral? What is the CFTC's position on the meaning of this term in the context of the current swaps exemption? Mr. Paul. Well, that is actually one of the thorniest concepts that we are wrestling with right now, Mr. Chairman. And we are engaged in ongoing discussions both internally and with various representatives of the industry, to come up with a definition that we will include in our proposed rule making, that will better define what a multilateral transaction execution facility is. Beyond that, I think at this point it is such an inchoate issue that I think that we probably cannot give you much further guidance at this time. The Chairman. So that is a work in progress? Mr. Paul. That is where the rubber meets the road on the current proposal. The Chairman. OK. We are going to have to come up with all the details to actually get these regulations or statutory things enacted. The report states that the registration process should be ``streamlined,'' quote, unquote, for futures commission merchants and introducing brokers; however, it does not state in any detail how this is to be done. Would you explain what the report means by streamlining the registration process? Mr. Architzel. The streamlining envisioned there is accepting various types of accounting reports at various stages during the year, rather than requiring a certified audit at the time of actual filing for registration. That is the nature of streamlining envisioned. The Chairman. OK. The report provides for an exempt multilateral transaction facility in which a facility could choose to operate a market exempt from commission regulations except for the anti-fraud and anti-manipulation provisions. This facility would only be available to institutional traders who trade commodities with inexhaustible deliverable supplies, or supplies that are otherwise sufficiently large to render a contract traded unlikely to be susceptible of manipulation. Doe not this exemption operate to deny retail customers access to the most liquid markets? Mr. Paul. Well, Mr. Chairman, the retail customer currently does not have access to all markets. We do not think that we are denying access by virtue of our proposal. In fact, we actually think that we are providing them with access to certain markets they might not currently have through some of the flexibility we have built into the DTF category. So to the extent that retail customers currently trade in designated contract markets, they will be able to continue to do so through the recognized futures exchanges. We think they will probably get access to broader markets through the DTF category, but the exempt MTEF category is really designed to provide a regulatory framework that the over the counter market that currently exists completely outside of our regulation to operate under. The Chairman. They do not have access to that now; namely, the over the counter market involving private contracts. I notice that you suggest that you suspect that many over the counter type markets now might want to become DTFs so that they could have that imprimatur of CFTC regulation. Would you explain your thinking on that a little bit more? Do you see some positive advantages in saying that you are regulated. Do you believe people might have more faith in the integrity of the markets if they know that you have that regulatory check? Mr. Paul. Absolutely. And we believe that there is interest amongst certain types of markets and certain market participants to trade in a regulatory environment. All regulation is not bad. Many market participants seek the U.S. markets because of its high regulatory integrity, because of the sense that the markets and the participants are being looked after. So for those types of markets we certainly don't want to deny them a home if they are looking for some place that they can provide greater comfort to their participants and for their products. Mr. Architzel. It is also noteworthy that the recognition that the Commission bestows on markets, either the RFE or the recognized DTF, corresponds to those minimum regulatory standards that other regulators internationally subscribe to, so that recognition as a DTF carries with it an acknowledgement that, that market meets the minimum international standards. It may therefore make it easier for a market which intends to do business globally to get approved by regulators in foreign countries as well. The Chairman. I see. What would you say are minimum standards internationally, though? What basis is there for saying there are minimum standards internationally? Mr. Architzel. The staff spent a lot of time looking at guidance put out by various organizations of international regulators such as IOSCO, which is an international securities regulatory body. Over the years we have cooperated with those groups to harmonize our rules and regulations. So at this point there is a great deal of guidance put out by these international groups that most international regulators subscribe to. And our core principles correspond with that guidance very closely. The Chairman. Finally, I want to ask you a couple other questions. This is a little bit off the main subject of our hearing, which is your proposed new regulations. Many of the Chicago participants are interested in allowing futures on individual stocks. I know that, that will probably be the subject of several other separate hearings. But I was interested in how the margins are now set on stock index futures. Reading the CEA, it looks like it is really up to the Federal Reserve, but if the Federal Reserve declines to set up margin requirement, the CFTC steps in and sets a margin requirement. What is the margin requirement now on stock index futures and who has set that? Mr. Architzel. The exchanges in the first instance set the margin requirements, and report to us for approval of those. They are currently set at levels which cover very high confidence numbers above 99-percent for market movements on a daily basis in the market. The Chairman. What is the margin requirement? Do you know? Mr. Architzel. I would have to provide that data for you for the record in a written statement. The Chairman. OK. Mr. Paul. And one of the things that we have discussed with the SEC in our negotiations on Shad-Johnson is coming up with some sort of harmonized margin requirement for single stock futures regardless of where they trade. And we have discussed various approaches. The SEC has its own opinion on the subject. I do not want to speak on their behalf, but it seems like I think we are moving toward meeting in the middle on margin requirements that may begin to equity options as being really the closest parallel, but preferably something that is based on---- The Chairman. Are those margin requirements about 50- percent? Mr. Paul. Fifty-percent, Mr. Chairman, is for the actual stock. The equity options, and similar to what the futures exchanges do on index contracts is it is risk based and the span margining system that the Chicago Mercantile Exchange has developed which is probably the best at trying to calibrate, or at least take into account, the volatility of the instrument. And we think that is probably the approach that we should agree on with the SEC on a consistent margin framework for single stock futures, and whether that is done under the auspices of the Fed or done through an memorandum of understanding between the SEC and the CFTC and through the review process of the exchange margins. Those are the kinds of issues that we are trying to hammer out right now. The Chairman. OK. My final question is how long did it take you to come up with this new proposal? I saw you had a task force that put this together. How long have they been working on this? Mr. Architzel. We started in October. The Chairman. And you got it done that rapidly? Mr. Architzel. Yes. The Chairman. That is very good work. I want to compliment the CFTC on their proposals here. They seem to me, at least at first blush, to make a lot of sense. I have heard a lot of positive comment. I look forward to hearing in more detail what some of the others have to say today. But I want to compliment Chairman Rainer on moving the CFTC in this direction, and with the speed with which you acted. I think you have a pretty solid framework for us to work on. So thank you all very much. Mr. Paul. Thank you, Mr. Chairman. The Chairman. Now, we can move to the second panel. On the second panel we have James J. McNulty, President and Chief Executive Officer, Chicago Mercantile Exchange; Mr. David P. Brennan, Chairman, Chicago Board of Trade; Mr. Thomas R. Donovan, President and Chief Executive Officer, Chicago Board of Trade; and Mr. Robert K. Wilmouth, President of the National Futures Association. And again, if I could ask each of you to summarize your thoughts rather than reading the prepared remarks, I would appreciate that. We will submit your prepared remarks for the record. Also, I notice some of you, in your prepared remarks, had a lot about the possibility of futures on individual stocks. That is a little bit beyond the scope of today's hearing. While that is a great topic, I would probably hear from Bill Brodsky over at the CBOT real quick if we get too far down that road. So I want to keep it pretty much on target, on the proposed new regulations that the CFTC has come up with. I would also like to hear from the two exchanges on how these new proposals might affect your own plans for reorganization, both of which you both have underway already. If these regulations came into effect, would you want to rethink in any way your proposals for reorganizing, so that you could take advantage of these separate possible regulatory schemes. I do not know if we have a volunteer to go first. Would Mr. Wilmouth like to go first? Thank you for coming here. STATEMENT OF ROBERT K. WILMOUTH, PRESIDENT AND CHIEF EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION Mr. Wilmouth. Thank you very much, Mr. Chairman. I appreciate the opportunity to present the views of the National Futures Association on the CFTC's proposed new regulatory framework which we think is one of the most important developments in the futures industry since the creation of the Commission itself. And I will confine my remarks specifically to the CFTC's proposed new regulatory framework. We all know that we are facing great competition, both from off shore markets and over the counter markets, and the regulation of the industry must be overhauled and streamlined if regulated markets are going to remain competitive and be attractive. In short, we have to find new ways to reduce regulatory burdens without reducing regulatory protections. One way to achieve that goal is to maximize the use of self-regulation, while returning the Commission to its intended role of overseer of the self-regulatory process rather than as a micro manager. The Commission's proposed framework is dramatic and it is a bold step. The focus on core principles for both exchanges and intermediaries is exactly the right approach. The Commission should tell those that it regulates what they have to do, not how to do it. The answer to the how question changes with every new development in technology. That is why the role of self- regulation will be even greater in the markets of tomorrow. Technology is really tearing down the barrier of entry faster than any government policy ever could. From 1977 to 1999 there were no new futures exchanges formed. In the last 6- months, at least six different enterprises have stated their interest in creating new electronic futures exchanges. All of them are dedicated to using effective self-regulation to insure the integrity of the marketplace, and the public's confidence in those markets. But none of these new exchanges that are in the formation stages are really shackled by the past. Every one of them is looking for more efficient ways to perform their self-regulatory functions, and every one of them has contacted NFA to discuss outsourcing that function to us. My point is simply not that NFA is going to play an even greater role in the years ahead, but that the flourishing number of exchanges and the corresponding changes to the entire industry, including its self-regulatory functions need action now, today. Time is of the essence. And we would urge both the Commission and Congress, Mr. Chairman, to move ahead as aggressively as possible. We certainly recognize that difficult work lies ahead. The comments of Paul Architzel and Robert Paul earlier indicate that. The proposed framework is just that, it is simply a framework. It does not address the details which will have to be resolved to move the proposal from the paper world to the real world. Some of these details should be readily solvable, but those core principles need to be supplemented with interpretive guidelines on which the entire industry can rely. But we suggest first of all how that guidance should not be provided. If we revert to having regulators in Washington dictating to the industry how the core principles have to be followed, we will end up right back where we are now. In addition, NFA is currently involved with the Futures Industry Institute on a best practices study on order transmission and entry, a study directed by the Commission and funded by a portion of the fine that they imposed in a CFTC enforcement action. We are convinced that a best practices approach is an excellent way to supplement the Commission's proposed core principles and provide the guidance that we think is necessary to the industry. Two basic points. When we talk about best practices, we have to consider the basic question of best practices from whose perspective. Best practices in our mind have to be considered from the perspective of the customer. We spent a good deal of time in our current study talking to end users and customers and what they want from best practices is very clear. They want procedures that insure fair treatment and quick execution at the best price. Second point. By definition, best practices have to be developed through direct and active involvement through the industry. The Commission should specify that the core principles will be supplemented with best practices guidance, developed through the industry's self-regulatory process, which includes NFA and of course, the exchanges. Another detail which can be resolved quickly involves the registration process, and you asked a question about that earlier. The Commission's proposal, as you stated, states that the registration process should be streamlined but does not necessarily address how in any great detail. Over the past several years, NFA has made a number of proposals to simplify the registration process, and we have recently updated those suggestions and submitted them to the Commission's staff. If a firm or an individual has gone through a screening process in the securities industry, conducting another background check for registration in the futures industry is clearly a wasted effort. And we agreed with the Commission's proposal, in effect, to passport those firms and individuals into registration. Those passported firms would still, however, be registered and subject to the same core principles as other firms. And there needs to be some mechanism to monitor their compliance with those principles, even if those firms are dealing with institutional customers. The answer again is self-regulation subject to Commission oversight. The Commission's proposal would not require those passported firms to be members of a futures industry SRO. We believe that this is an oversight which needs to be corrected. One of the major questions unanswered also in the current proposal, and you asked this question, is exactly what the Commission means by the term institutional customer. There are at least to my knowledge six different definitions of sophisticated customer in the Commission's rules. NFA proposed a uniform definition of sophisticated customer several years ago that was modeled very closely on the Commission's definition of eligible swaps participant. That definition has served very well for many, many years and should be the basis for the definition of institutional customer in this context. We would recommend that the threshold test for that term be no higher than those currently in place. Another key under the proposal will be the types of commodities which are not readily susceptible to manipulation, and should therefore be subject to less regulation. The answer must be a practical one, dictated by the realities of the marketplace, rather than theories of the classroom. The end users of the markets for petroleum products, for example, may very well have the best perspective on this issue and their views should be accorded great weight by the Commission. And finally, Mr. Chairman, let me reiterate our enthusiastic support for the Commission's overall approach, but let me also note that this exercise of the Commission's exemptive authority does not obviate the need for legislative action. We urge the Commission to move as quickly as possible to resolve the remaining issues and to enact its proposal. And we also urge Congress to support that effort and adopt legislation to codify, as you suggested, the Commission's approach. Thank you very much. [The prepared statement of Mr. Wilmouth can be found in the appendix on page 67.] The Chairman. Thank you, Mr. Wilmouth. Mr. Brennan. Thank you. STATEMENT OF DAVID P. BRENNAN, CHAIRMAN, CHICAGO BOARD OF TRADE, ACCOMPANIED BY THOMAS DONOVAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER, CHICAGO BOARD OF TRADE, CHICAGO, ILLINOIS Mr. Brennan. Good morning, Mr. Chairman. I am David Brennan, Chairman of the Chicago Board of Trade. With me today is Tom Donovan, our CEO and President. We want to thank you for holding this hearing in the City of Chicago, the derivatives capital of the world. Our theme today is that we want Chicago to retain the title as the derivatives capital of the world. To do that, we have to change our way of doing business. And we are. But we also need to change the way Washington looks at our business. To do that we need to modernize the Commodity Exchange Act and tear down the existing barriers to competition. Mr. Chairman you have been a true leader on these important issues in Congress, and we thank you for your insights and your intellect and your leadership. In quite a short time you have proven that you are knowledgeable about our issues and committed to our mutual goals of fair competition and even- handed government oversight. We thank you for your efforts. Another new leader in our industry also deserves praise. CFTC Chairman Bill Rainer is fully committed to rationalizing regulation of exchanges and the industry as a whole. He has brought market experience and creativity to the Agency. We applaud the Chairman's efforts and look forward to working with him on the finishing touches to his new regulatory blueprint. We have submitted a written statement that describes in detail our reaction to the CFTC's New Regulatory Framework. In summary, the Chicago Board of Trade endorses the CFTC's new regulatory approach. We believe the CFTC's proposal will add up to better markets, better competition and better service for the thousands that use our markets. Restructuring Federal regulation and restructuring our business go hand in hand. The CFTC's plan responds to the same market forces--technology, globalization, innovation, and competition-- which have also caused the exchanges to restructure. The Board of Trade is no exception. Our plan would take our existing pit trading and electronic trading business lines and restructure them into two independent for-profit companies. Both will try to attract business by providing liquid trading markets. Both will innovate and invest in technology to provide customers the best service. Both will make every effort to provide customers with a market that they can trust, and both markets will compete. Our plan is designed to give each company and each trading platform a fair chance to succeed. No business could really ask for more than that. Federal regulation is part of that ``fair chance.'' We believe in open markets and fair competition. To us, similar products, traded in similar circumstances should have similar government oversight. That means privately negotiated transactions may be excluded, but all public execution facilities should be treated the same. That is our ``golden rule'' of fair competition. Today that rule is not being met. After almost 80-years, the Commodity Exchange Act has become unworkable. Over-the- counter derivatives, especially in the area of equity swaps, are plagued by legal uncertainty. Exchange markets suffer from extreme regulatory arbitrage, which the CFTC's proposal tries to remedy. For single stock futures, it is even worse. We are barred from competing at all under a law that we were told 18- years-ago would be ``temporary,'' until a regulatory impasse could be resolved. Mr. Chairman, reform of the Commodity Exchange Act must cover each of these three areas. All we have ever asked for is a fair chance to compete. This year's CFTC Reauthorization offers us a real opportunity to reach that goal. With your leadership, we are more encouraged than ever before that we might finally get a fair chance to compete. Again, thank you for the opportunity to be here, and we appreciate your efforts. Thank you. [The prepared statement of Mr. Brennan can be found in the appendix on page 60.] The Chairman. Thank you very much, Mr. Brennan. Mr. McNulty, would you like to proceed? STATEMENT OF JAMES J. MCNULTY, PRESIDENT AND CHIEF EXECUTIVE OFFICER, CHICAGO MERCANTILE EXCHANGE, CHICAGO, ILLINOIS Mr. McNulty. Yes. Thank you, Mr. Chairman, and committee members, ladies and gentlemen. I am James J. McNulty. I am the President and Chief Executive Officer of the Chicago Mercantile Exchange, and I have held this post since February 7th of the year 2000. The Chairman. This is a baptism by fire, your first Congressional hearing. You will have many more over the years. Mr. McNulty. Thank you. Obviously I come to this hearing short of experience in the history of the exchange; however, I have had 25-years of experience in the full range of financial markets. I have traded and supervised trading in all financial futures and options and I am sensitive to the needs and expectations of the over the counter markets, having trading in the bank, investment bank market for the past 25-years. I also appreciate the impact of technology on the future of the financial services industry and I hope that this testimony reflects that sensitivity. The CME is exceptionally encouraged by the CFTC staff task force report, A New Regulatory Framework. The Commission has been both responsible and responsive to the concerns of all elements in the financial services industry. We are pleased by the tone of the proposal, which is consistent with the progressive regulatory philosophy that depends on oversight and competition among markets, rather than prescriptive regulation and protected market spaces. The CFTC staff under Chairman Rainer has demonstrated a deepening understanding of the complex technological and competitive issues facing our markets, and the commitment to providing much needed regulatory relief. I will discuss our view of the details of the report and suggestions for implementing it below. The task force recommends that the Commission convert its proposal into proposed rule making, subject to a 60-day- comment-period and public hearings to provide a full public airing of the important public policy issues. If those recommendations are followed, final rules implementing the proposal are likely to be adopted sooner than 6-months. Senator Lugar has indicated that the Commission's recommendations may provide a basis for drafting amendments to the CEA. We agree that the time is right to act and that legislation, based on the principles of the report, is better than rule making. We are less sanguine about reform of the Shad-Johnson Accord. Eighteen-years ago the Shad-Johnson Accord divided jurisdiction between the SEC and the CFTC and included a temporary ban on most equity futures contracts. That temporary ban lasted 18-years, during which the single stock futures have thrived in the OTC market in the form of equity swaps and on options exchanges in the form of synthetic futures. Recently the President's working group and Congressional leaders have called for an end to the ban. Of course, we are pleased that the agencies have agreed that this is appropriate and that U.S. exchanges would be permitted to compete in world markets and to offer U.S. customers the opportunity to manage their risk by means of equity futures contracts. We are also pleased that they have found a way to accommodate their jurisdictional and regulatory concerns on several important issues. But it is too late in the game to be satisfied with signs of progress. We share Senator Lugar's disappointment that the agencies were unable to resolve all of the jurisdictional concerns within the time frame requested. Our goal is freedom to give our customers what they want and need. Remember, we created tremendously useful products, equity indices, for example, in the face of overwhelming opposition. The SEC and its client exchanges opposed futures on indices with all of the same arguments that they now raise against futures on individual securities. Nonetheless, equity indices are among the most popular contracts on securities exchanges, as well as on futures exchanges. Futures trading of equity indices has enhanced customer opportunity with none of the ill consequences predicted by the SEC or securities exchanges. In fact, their business has directly benefitted. One-year ago the Chicago Mercantile Exchange, with the Chicago Board of Trade and NYMEX, undertook to craft amendments to the Commodity Exchange Act that would enhance competition and customer opportunity. We continue to believe that the joint exchange proposal is the best formation for regulatory relief. However, we are well aware that the legislative and industry consensus in favor of a good plan, trumps our theoretically better plan. We are prepared to join the consensus and to give up our plan in favor of the CFTC staff proposal, if we can assure Shad-Johnson relief and fix some of the minor flaws in the CFTC plan. Our goal was and remains equivalent regulatory treatment for functionally equivalent execution facilities, clearing houses and intermediaries. If we can get to that goal by the path of the CFTC's proposal, then let us proceed with reasonable haste. Thank you very much for the opportunity to give testimony today. [The prepared statement of Mr. McNulty can be found in the appendix on page 51.] The Chairman. Thank you very much, Mr. McNulty. Mr. Donovan, did you want to add anything? Mr. Donovan. David Brennan presented our testimony. What I would like to do, though, is thank you for having this hearing today, because this is a process that we have been engaged in for a number of years. The clock is ticking, and we have a short year. We know the members of Congress are going to want to get out as early as possible this year, and quite honestly, I am afraid if we do not complete the process this year, that Congress will grow weary of this issue. So I harken to Senator Lugar's admonition at the last hearing, that we had better resolve this and work closely with all segments of the financial services sector to move this along. I do think that there are some things that we have to have from this legislation. Namely, a codification of what the CFTC has put forward, because having lived with the CFTC for the past 20- years and a number of chairmen, commissioners and staff, it is very important for us to put something in place that also provides legal certainty for the futures industry so that we can deal with the future. The Chairman. Well, thank you. Let me just pick up on your remarks, Mr. Donovan. Right now, the CEA is being rewritten, we have not come forward with a proposal. We have not even passed a proposal out of the Committee. At the same time, the CFTC is proposing new regulations. Meanwhile every day you have all sorts of new types of competition. You are looking at reorganizing yourselves to better address the future competition and the competition that you have out there now. You are being hurt by the lack of legal uncertainty in that you do not know what the new CEA is going to look like. You do not know what the new regulations are going to look like. How is this uncertainty impacting the Chicago Board of Trade's plans for reorganizing itself? Mr. Donovan. I think, first of all, we are moving ahead at full speed because we really believe that we have to restructure the exchange. Chairman Brennan has taken on the initiative, and he has done a tremendous job of moving it along under very difficult circumstances. It is difficult to change a membership organization when you are having success. But we realize that the future is moving at Internet speed and we have to make plans for our restructuring as though Congress will address that legislatively and will give us the regulatory framework and flexibility to do what we propose in our plan. If you saw today's issue of ``Crain's''. The Chairman. I read it, yes. Mr. Donovan. There is a piece in there from Chairman Brennan where he talks about the blueprint that we have. Well, we are moving very quickly to separate two companies. Each of them will have different needs, and each of these companies will have to find a regulatory framework with which to function and one that, once a law is passed, will not be so rigid that the day after the bill is signed that new technology will not dictate that it be changed, because Congress is not going to come back to this again in the near future. So it is our hope that we will have enough flexibility and have a performance standard, rather than a design standard, that we can look to for guidance as the goals that we have to achieve after this legislation is passed. The Chairman. When do you hope to accomplish your proposed reorganization? Would you want to address that? Mr. Brennan. Mr. Chairman, for my purposes I wish it was yesterday. But, we are waiting for about two more pieces of the plan before we can go to a membership vote. As soon as I can get those, I am planning on scheduling a special Board meeting, and the vote will be 30-days after that special Board meeting. Right now, I am waiting to hear from an independent allocation committee which is made up of our five individual directors. Their job is to determine the allocation of stock, because we have five different classes of membership. That is pretty much dictated by law. The Chairman. Ultimately you would have two separate companies, one which would be the pit based exchanges, and the other which would be the electronic exchange. Mr. Brennan. That is correct. The Chairman. Now, just looking at these new regulations, and maybe I am premature in asking this, but would you be trying to become an exempt multilateral transaction facility for the electronic exchange and remain a recognized future exchange for your pit based? Do you have any ideas on this? Mr. Brennan. We have not gotten into that kind of detail yet, but I think we are going to analyze our business by product and we expect to be trading the same products in both places. To the extent that we can reach the flexibility we need with both, we will approach it on a product basis I would expect. The Chairman. But these proposed changes, once they occur, could have a huge impact on your reorganization, could they not? Mr. Brennan. Yes. The Chairman. Yes. Mr. McNulty, how would these proposed changes affect the Mercantile Exchange's proposed reorganization? Mr. McNulty. Well, Mr. Chairman, having advised some airlines and utilities and banks even in their recent deregulation and changes of technology, one of the things that we found is that you need to be a speedy decision maker and you need to be able to make the right kinds of investment. So the Chicago Mercantile Exchange has filed an S-4 with the SEC in order to demutualize the exchange. And what we hope to gain by that, of course, is the ability to work more flexibly with the capital structure and also the ability to have a corporate governance that is streamlined and allows us to make those speedy decisions. This change in regulation will cause us to make some legal steps, undoubtedly. So we would imagine, for example, that the recognized futures exchange and the derivatives transaction facility would be essentially in the parent firm, following demutualization. And then we could imagine that the exempt multilateral transaction facility would be a subsidiary of the parent firm. The Chairman. As Mr. Paul pointed out, they would envision that the exempt multilateral transaction facility would have to be a separate corporation, a separate legal entity. Mr. Wilmouth, how do the proposed regulations change or expand the role of the NFA as a self-regulating body for the industry? Mr. Wilmouth. It is rather difficult to tell at this stage of the game exactly what role we are going to be taking by intermediaries and the exchanges. We made a basic decision 2- years ago to put ourselves forward as an outsourcing facility for self-regulatory functions that have to be performed by the industry. Over the past 2-years I have made proposals to both Chicago Board of Trade and the Chicago Mercantile Exchange to outsource their self-regulatory responsibilities to us. At the present time they have decided to maintain that in house, but as they come forward and become electronic exchanges, then we certainly are going to revisit that proposition. The other thing that we have done, we are, as I said in my prepared testimony, talked to six different electronic, seven different electronic exchanges recently who are just coming to the forefront with all different types of new products and wanting to become futures exchanges. We are discussing with them each of the possibility of outsourcing their self- regulatory functions to us. So we think this is a broad step forward for us. We think it has great opportunities for us in the future and we are gearing ourselves toward that line. The Chairman. Would the Board of Trade and Mercantile Exchange, care to comment on what you might do in terms of taking advantage of the option of having self-regulatory functions that would obviate the need for greater CFTC supervision. I do not mean to be putting you on the spot. How does all this strike you? To be a DTF you would have to have a self-regulatory body. I would imagine your internal self-regulation would fit the bill or you could outsource it. How do you see whether it will be internal or whether you will contract it out to the NFA? How do you see the self-regulatory function being changed by the CFTC's proposed regulations? Mr. Donovan. Well, I think that looking to a restructured Chicago Board of Trade, our new ECBOT, so to speak, our electronic company would be looking to find its way into the least regulated areas and require less regulation. Just by virtue of the electronic trading, you have more information electronically and the markets may require a lesser level of regulation. As far as the CBOT, the open outcry portion of that, we feel that right now our self-regulatory front line function is far and away the best anyway. We think that the CFTC strictly should be an oversight agency, one that provides the flexibility for us to use our self-the regulatory structure as a marketing tool, for people to want to come and trade at the Chicago Board of Trade. I have a great deal of respect for Bob Wilmouth and NFA. I served on the Board from the very beginning, but I really feel that the regulation that an exchange provides is a front line regulation and serves as a marketing tool, something that you can do better than anyone else, that people feel comfortable trading in your exchange. Mr. McNulty. I can only echo Mr. Donovan's comments. We have spent years building a highly disciplined self-regulatory body in the CME, and we think that is one of the reasons people come to work on our exchange. The Chairman. OK. Let me shift gears just a little bit and ask the Chicago Board of Trade a question specifically. Although the basis for eligibility as a DTF applies to all commodities, the report states that domestic agricultural commodities may constitute a unique category because the current futures markets tend to be the primary, if not the only, centralized source of price basing for those commodities. In your submitted testimony, you recommend that trading in physical commodities, including agricultural futures, qualify for DTF treatment. Would you please comment further on the reasons for your recommendations here? Mr. Brennan. I will begin. I think rather simply, Mr. Chairman, we believe markets are markets. And to the extent that you can provide liquid markets, the less regulatory burdens you have, the more market players you will have, and the more people that will come and provide liquidity. Any time you have any kind of barriers to entry or any kind of restrictions, it may keep participants away. That ultimately affects the end users. So very simply, we believe that markets are markets and if you have the right regulatory structure, a concern about, whether it be cornering or those issues, I think that those are handled through the regulatory requirements. The Chairman. Let me ask Mr. McNulty about clearing facilities. The report recommends the expansion of clearing facilities in the United States. Do you support this recommendation? Mr. McNulty. Well, I think that clearing facilities, in the case of the CME, would be one of the major assets of the exchange. And we could foresee a time when not only do we have further cooperation than we already have with many of the global clearing houses, but we also could foresee a time where we use this as a new source of revenue, where with many of the new exchanges that are opening up, we could provide them with back office services, clearing services, settlement, even dispute resolution as part of a revenue stream for the exchange. The Chairman. Mr. Wilmouth, let us return to the best practices issue. In your testimony, you recommended that the core principles should be supplemented with best practices guidelines developed through the industry self-regulatory process. Would you want to comment further on this recommendation. Specifically, would you imagine some of the best practices would be written up in the regulations that the CFTC promulgates pursuant to whatever changes we make in the statute itself, or would you imagine that the CFTC would just have papers on file that people could ask for their best practices, manuals? How would you envision that would work? Mr. Wilmouth. Let me, first of all, say that I look best practices as kind of like a safe harbor, and this is a constantly changing thing. So I am not certain that I would want to codify it specifically by the CFTC, because they would be constantly changing. Let me give you an example of what we are doing right now, if I may. With the Futures Industry Association, funded by the CFTC, we have initiated a best practices study focusing on order entry and transmission procedures in the futures industry. What we did is we formed, and this is part of the self-regulatory process from gathering all the ideas of the best minds in the industry, we have formed four separate committees to take a look at the best practices in that specific area. We formed an operations committee, a technology committee, a compliance committee and a legal committee, made up of industry practitioners. Together with some outside consultants, we are visiting with all of the exchanges, a significant number of the FCMs. We are even sending some of our consultants abroad to talk to some of the exchanges over there. We hope to come out with a best practices in that specific area, through the cooperation of the entire industry. I would envision that same practice applying across the board to all the best practices that we would envision coming out of the CFTC regulatory reform measure. We think that makes good sense because it draws on the talent, the wealth of talent that exists in the industry. The Chairman. So as these best practices guidelines are developed, and if there is a market participant who is complying with those best practices, you would see that as a safe harbor. If they have been following these types of practices, they would presumably be safe from getting in trouble. Mr. Wilmouth. They would be a safe harbor, that is right. And I do not think that we want those specified specifically, because they are going to change over a period of time. They will constantly be changing. The Chairman. So we would just maybe refer to a best practices policy which itself could be ever changing. Finally, I have a question for all the panelists. You all agree that we should codify these regulatory changes? Is there an agreement on that. With respect to intermediaries, the report recommends relaxed standards as to risk, disclosure, registration, financial requirements and the treatment of customer segregated funds. What do you think of these recommendations? Mr. Donovan. We are supportive of the recommendations. We are supportive of a bill that will allow the flexibility to allow this industry to address the technology, the globalization and innovation of our competitors. And if we are unable to do that when this legislation is passed, the business will not be in the United States. The Chairman. OK. Mr. McNulty. I would like to echo Mr. Donovan's comments, and I can tell you, having been in the OTC markets for 25- years, it would normally take us 24-hours to turn around a contract, whether the request came from Hong Kong, Latin America, Europe, we could turn around and launch a contract in Switzerland within 24-hours. We are not close to that yet in the United States, and I think this legislation would lead us to that point. And I think it would also loosen some of the restrictions on the intermediaries which would also allow this market to grow at a faster rate than it has in the past 10- years. The Chairman. You really like the idea of being able to come out with a new contract without getting prior approval; that is very important to you. Let me just sum up here. Do you think that this proposal gives you the type of regulatory relief that you need in the 21st Century, leaving aside the issue of the Shad-Johnson. Which I am going to try and address Shad-Johnson at an upcoming hearing and will certainly be something that we will continue to talk about and be working on. Mr. Donovan. It is a step in the right direction. It will definitely depend on how rigid the rules are applied to core principles. If they take away the flexibility that you need, it will miss its purpose. The Chairman. The devil is going to be in the details here, how we actually put this in the law. Mr. Donovan. Right. The Chairman. But you agree with the principles, and you think it gives you pretty good flexibility and will help you compete, is that correct? Mr. Donovan. Yes. The Chairman. That is good. I am very happy to hear that. I want to thank you all for testifying today. We will later take up the issue of futures on individual stocks and Shad-Johnson. If you read the CEA, and I have it right here, I am struck first by the many pages that deal with this complicated Shad- Johnson agreement. It is one of the first things that is addressed in the CEA. I think we are going to have to work on that. To be fair, we will have to have other hearings and receive input from people who might have a different opinion than yours. We will do that at the time. I remain committed toward making sure that our Chicago markets, not only survive, but succeed and flourish in the 21st Century, and I look forward to working with you all toward that end. Thank you all very much. I would now like to take about a 5-minute break before we bring in the final panel of market participants. [Recess.] Could we bring this hearing back to order. On our third panel of market participants and intermediaries we have several distinguished panelists. Mr. Barry Lind, who is from Lind-Waldock & Company, has one of the largest retail customer bases, as I understand it, in the country; Mr. Jan R. Waye, Senior Vice President of Cargill Investor Services; Mr. George Crapple, President of the Managed Funds Association; and also Mr. David Downey, Executive Vice President of Interactive Brokers LLC. Mr. Peter Lee, who is the Managing Director of Merrill Lynch Futures, has had a family emergency and was supposed to be here today, but could not be here due to that emergency. I am going to ask unanimous consent that his testimony be included in the record. Since there is nobody else here to object, I will give that consent. [The prepared statement of Mr. Lee can be found in the appendix on page 82.] We will begin with Mr. Lind, the Chairman of Lind-Waldock & Company. Would you summarize what your company does. And what its role in the market is. As I mentioned, you have a large customer base. Could you first describe the manner in which you participate in the market. If you could stick to the topic of how these new regulations would affect your company in the futures market, and stick to that main issue, we would appreciate it. Thank you. STATEMENT OF BARRY J. LIND, CHAIRMAN, LIND-WALDOCK & CO., LLC, CHICAGO, ILLINOIS Mr. Lind. Thank you, Mr. Chairman, and thank you for the opportunity to be here. Lind-Waldock is best known for having the largest retail customer base in the industry. We do a lot of institutional business and commercial business, but our primary focus here is on the retail. We are members of almost all the major exchanges in the U.S. We do a lot of our business on-line. Over half our orders come in on-line, as the industry is changing. The Chairman. From retail customers? Mr. Lind. From retail customers. We are probably as well electronically committed and situated as any firm in the industry. And today I would like to address you in regard to the retail aspect of things, because I knew there would be a lot of other people covering the other aspects. First, let me say that I am very impressed and very happy that the CFTC and Chairman Rainer are looking to modernize and rationalize the regulatory framework of the futures market. Even though this is a work in progress, I would like to commend him for his good work in harmonizing the interests of the industry and the market participants. And I think that the work that he has done has assured us that everybody has gotten a fair hearing. He is certainly very qualified and he is a knowledgeable listener. And that is what has resulted in I think this overall position that we have today of re- engineering the regulation which I agree with. In general, I agree with the approach. The regulation needs to have flexibility that is based on the type of market that is being regulated, the kind of instruments and the sophistication of the participants. This allows some markets to operate with less regulation, an outcome that I think is a good one. However, there seems to be a consensus that less regulated markets are appropriate for institutional and for qualified investors. There is more hesitation to allow individual investors the advantages that may exist in less regulated areas. My own position is that individual investors should be allowed access to less regulated markets in order to have the advantages of increased competition that a less regulated market will bring. I believe that with the appropriate framework individuals can enjoy this access with substantially the same protections as the current regulatory environment has. One of my fundamental convictions is that my customer, in addition to regulatory protection, should be able to have the benefit of the best price available, even if it occurs outside a market that is the most protective of the customer. Any regulatory scheme that has the effect of keeping my customers from less regulated markets will be a costly victory for my customers. They will have all the benefits of protection from fraud and market manipulation but they will be limited to markets where largest liquidity providers may have vanished and it is from this perspective that I offer my comments. The bedrock of customer protection in current regulations is the requirement that customers' funds be segregated. And I commend the CFTC for keeping this requirement as an important part of the customer protections in any market where an individual investor is permitted to conduct transactions. I fully endorse the report's additional recommendation that non- institutional traders be allowed to access a derivatives transaction facility only through a registered futures broker that is a clearing member of at least one recognized futures exchange, and has a minimum net capital of $20 million. The benefit of this is twofold. It provides discipline for the carrying firm by requiring that they have capital at risk, and it offers the benefit of regular periodic inspections by an external monitor. And let me say this about the level of capital requirement. I think that this will tend to exclude less responsible parties who may be looking to make a quick buck in these less regulated markets. 20-million will suffice to keep most of these people, if not all of them, out. I am pleased that the report calls for changing the net capital rules to base them on risk. I have been asking for this for years and years. The current capital rule is an old, old banking rule and makes no sense in derivative markets. Right now, as an example, if I have a customer with $100,000 in cash and no position, I have to put up $7,000 in capital. If, however, he has 100,000-bushels-of-beans on with no money, and therefore, I have substantial risk. Today I have no capital charge for him. So a risk based capital rule would be a move in the direction of rationality. Most observers, including myself, expect the deregulated environment resulting in increased competition. Even though competition may tighten market spreads in other markets, I think it will take liquidity away from the recognized futures exchanges. If this result occurs, the ability to enter into a transaction in one arena and to offset it in another would benefit all parties, except possibly the market maker. In my written testimony I have termed this the universal transfer mechanism, if you care to look at that. In a multiple market maker market, I didn't think I would get through that, there will be multiple platforms on which trades can be made. In this kind of environment the challenge is to provide a level of transparency to the price discovery process. We believe in the not too distant future all trades will be conducted on electronic trading platform, where our customers will receive the best bid and offer from the recognized futures exchanges and the counter parties with whom we are dealing with. In this environment our customers will simply point and click on the best market available. However, we are not there yet. In the interim we propose that brokers who allow retail customers to deal in less regulated markets be obligated to display multiple bids, offers and last sales. These would come from the market makers with whom the retail customer's broker is dealing, along with appropriate recognized futures exchanges. The customer would then simply choose what he believes to be the best priced market. These multiple prices should be recorded along with the customer's transaction. The one thing that the customer's futures broker cannot totally control is the price. But if the customer can see all the prices that we have available we have put him in the best position that he can possibly be in. I endorse the report's provision for streamlining the registration of FCM's introducing brokers. I agree that the mandatory disclosures for non-institutional customers should be streamlined and make use of a single signature format including the freedom to accept electronic signatures. All commission requirements including documentation and record keeping should be flexible enough to embrace changes in technology without requiring amendment. In these matters the adoption of core principles that state the goal of the regulation, rather than prescribe exactly how the goal should be met, will go a long way in achieving flexibility in dealing with technical innovation and make us a lot more competitive. I favor broadening the range of instruments in which segregated funds can be invested, and removing barriers respecting the secured amount requirements for the funds of customers trading non-U.S. markets. I am very encouraged by this report. It is a document that recognizes the dual objectives of regulation, fair markets and suitable customer protection. It reflects careful thought and sensitivity to the needs, both of the industry and the market participants. It moves away from the traditional inflexible regulatory models. It breaks new ground with its philosophy of core principles and offers a shining example of both the process that should be involved in producing regulations and the results that can be achieved by following this process. This is a working document that provides a framework to be fleshed out. Along with everyone affected by this regulation, I am waiting to see if the final version fulfills the promise of its beginnings. However, this report does make an excellent beginning. Thank you. [The prepared statement of Mr. Lind can be found in the appendix on page 95.] The Chairman. Thank you very much, Mr. Lind. May we now hear from Mr. Waye from Cargill Investor Services. Thank you for being here. STATEMENT OF JAY R. WAYE, SENIOR VICE PRESIDENT, CARGILL INVESTOR SERVICES, INC., CHICAGO, ILLINOIS Mr. Waye. Thank you, Mr. Chairman. Good morning. Cargill Investor Services is A global futures commission merchant operating in all major futures markets around the world. Our client base can be broadly categorized between fund clients of which we are going to hear more of later, large commodity institutions, And large financial institutions. Representing those clients and speaking on behalf of, in addition to Mr. Lind, from the FCM community, I would say we broadly support the recommendations put forward in the staff recommendation to the Commission. We believe this is a step in the right direction, to move from a rules based environment to one guided by broad principles with specific recommendations for best practices. I would, however, like to make four comments and just briefly summarize on my written remarks which were supplied earlier. First, and before going into the specific recommendations, one of the goals of the report was to provide and continue to provide legal certainty for over the counter derivative contracts. The report said that is imperative and we agree. But we would take it a step further on behalf of our clients and say that we not only need certainty for OTC financial contracts. We also need legal certainty for OTC commodity contracts. And by commodity contracts I am including everything, whether we are talking about corn or crude oil or cotton or electricity. We have seen significant volatility in commodity prices in these contracts, often more so than we have seen in financial markets in the last several years. Let me explain why this is important. We believe commercial parties should be able to enter into over the counter contracts on commodities without one of the parties later on saying: ``No, I am going to walk away from that contract, because I entered into an illegal off exchange futures transaction which was an invalid contract to begin with. We were not allowed to do it.'' We believe that legal certainty is essential to prohibit that from happening. We have seen the volatility that can occur in the electricity markets. We have seen the volatility that can occur in agricultural markets. Commercial participants simply need the right to enter into bilateral transactions off exchange and get the same legal certainty that exists in financial over the counter transactions. There has been a lot of innovation that has brought to bear in financial OTC markets. There has been a significant benefit to consumers in terms of risk management. We believe all those same arguments that have been made for financial OTC certainty, equally apply to commodity OTC certainty. The Chairman. Could I stop you for a moment, right now? To what extent are you able to enter into a private contract right now with some institutional customer who wants to have a tailor made contract that will pay his or her institution on the basis of what happens to the price of an agricultural commodity such as corn? Can you do that now? Mr. Waye. You can do it, Mr. Chairman, but you run the risk without the legal certainty of the CFTC or the SEC or some other agency bringing an enforcement action against you later on, that, that was really an off exchange futures contract, even though it was bilaterally negotiated. The Chairman. How much of that are you doing right now? How much business are you doing that involves private OTC type contracts dealing with underlying agricultural commodity? Mr. Waye. Including both agriculture and energy, and this is a rapidly expanding area. Electricity OTC contracts, we saw the problems a couple of years ago, when electricity prices spiked to record highs during the summer. And then we also saw a record number of defaults. A few years ago we saw a case in Brent crude oil that's called the Transinor case, where one of the parties argued they could walk away from the transaction because it was an off exchange futures contract. So there is a need to eliminate the uncertainty, to encourage the innovation rather than to have this cloud hanging over commodity markets. The Chairman. It is good you bring up this point, because we only hear of this legal uncertainty problem in the context of financial over the counter derivatives. That is an area that is growing rapidly and most of that is really interest rates swaps. Mr. Waye. Yes, absolutely. And the final comment I would make is, whether we like it or not, people that get involved in commodity markets, tend to be more litigious than institutions trading in financial markets. They tend to walk away from contracts more frequently. The volatility sometimes is much greater. So I guarantee you that going forward we will continue to see these kind of actions pop up. I would like to go to my second point, and that is one already covered somewhat earlier by the comments you made yourself on the DTF, the derivatives transaction facility, and how do we determine what commodity contracts can be traded on a DTF. But we talked about products with inexhaustible supply, and Mr. Chairman, you pointed out that with Treasury securities that is already a present problem, number one. Number two, one of the few examples of price manipulation did take place with Treasury securities futures on Treasury bond futures. We support the staff report that certain markets do need to be held to higher level transparency and regulation, and we think that is the case, because they perform an important price discovery function. So our comment here is not so much to disagree with the staff report, but just to recommend an alternative definition that contracts were be excluded from the DTF be those contracts that there is no real price discovery function taking place. I think a lot of financial market participants today would say the price discovery for Treasury bonds probably does not take place anymore in the Chicago Board of Trade, but probably does for corn. So where the market has a true price discovery function taking place, that market needs to be held to a higher degree of oversight and regulation and concern because it is in the public interest. Not because it is in any particular members' interests or participant here this morning, but it is in the public interest. We are trying to discover a true price. Participants in those markets and markets themselves need to be held to a higher degree of regulation. Third, you said not to go here, but I have to, because I made a comment on stock index products. I will not repeat what was said earlier on Shad-Johnson. But I would say as a global futures commission merchant that our clients outside the U.S. do have access to a much broader range of equity based products that trade on financial futures exchanges than they do in the U.S. The Chairman. Do you trade those stock futures? Mr. Waye. On behalf of clients. The Chairman. What countries do you do that in? Would you know off the top of your head? Mr. Waye. Absolutely. In fact, I will just combine this with my last point to save time, because in a lot of these countries we have seen the equities markets and the futures markets merged into one. In the cases of Singapore, Sydney, Frankfort and Paris, we have recently seen a merging, a coming together of the equities exchanges and the futures exchanges under a common platform, a common clearing house and a common regulator. So our clients in those markets are clients of our firm, Cargill Investor Services, are able to trade stock index products, a wide variety of stock index products or stock index derivatives that trade on the futures exchange because in those countries it is all one exchange. It is moving towards one platform and it is one clearing house. The Chairman. Do you have American customers who are using Cargill to trade futures on individual stocks in foreign countries? Do you have that at this point? Mr. Waye. Yes, but only if those contracts have been approved by the SEC. If the contracts have not yet been approved by the SEC, it would be illegal for us to offer them to U.S. domiciled clients. The Chairman. OK. Mr. Waye. But non-U.S. domiciled clients can have access to those contracts. I appreciate it is a murky area, but just coming from a customer side, our non-U.S. clients have access to a much broader array of stock in equity based futures contracts than those same customers in the U.S. Finally, a note on competition. I am glad to see, and the comment was made earlier in the past panel, about the number of new exchanges that are being proposed in the U.S. Our only concern here is that the CFTC be prompt and fair in evaluating these new exchanges and approving them for operation, if they deem so appropriate. I note they did this a couple of weeks ago with a new exchange in Texas which had been under review I believe for 2- or 3-years. There are six or seven new exchanges in the pipeline. And we believe that the role of the CFTC is to encourage competition between exchanges, just as we have significant competition between FCMs and competition exists in other areas of the market, and we are pleased to see the CFTC take steps and acknowledge that these new markets are going to be developed, just as we have seen new markets expand significantly both in equities and in fixed income securities. Mr. Chairman, that pretty much summarizes the comments that I made in our written submission, and I would be very happy to answer any further questions or be of any further assistance. Thank you. [The prepared statement of Mr. Waye can be found in the appendix on page 74.] The Chairman. Thank you very much, Mr. Waye, for your testimony. And now Mr. Crapple, President of the Managed Funds Association, we appreciate your being here. If you could tell us a little bit at the start what the Managed Funds Association is and does, we would appreciate that. STATEMENT OF GEORGE E. CRAPPLE, CHAIRMAN, MANAGED FUNDS ASSOCIATION, NEW YORK, NEW YORK Mr. Crapple. Certainly. A small correction, I am appearing as Chairman of the Managed Funds Association. Our President Jack Gaine overcame great transportation obstacles to get here, and he is also here. But I have the seat at the table. MFA is a national trade association representing more than 700 participants in the hedge fund and managed funds industry. I should say I am also the co-Chairman and co-Chief executive of Millburn Ridgefield which has managed money in the currency and futures markets since 1971, and also sponsors funds of funds and equity hedge funds. MFA appreciates the opportunity to testify before the Subcommittee concerning the CFTC's New Regulatory Framework Report and issues relating to the reauthorization of the CFTC. Our association commends the CFTC for its commitment to reinventing the regulatory program in fundamental ways, an approach designed to attract seemingly intractable regulatory issues that have been with us for many years, as well as issues that may be critical in permitting our markets to remain global leaders in the 21st Century. Members of the MFA in the aggregate manage the vast majority of the over $40 billion invested in managed futures and a significant portion of the nearly $400 billion invested in hedge funds. Our members are active participants in all derivative markets, on and off exchanges, foreign and domestic. Accordingly, a regulatory framework that promotes competition and innovation which results in liquid, efficient markets is of enormous significance to us. We believe the CFTC's report and the previously issued President's Working Group report on over the counter derivatives identify a number of important issues deserving priority and attention. We believe in general that the CFTC's overall purpose and its suggested approach are highly constructive. The report significantly advances the debate over the optimal regulatory structure in the U.S. futures markets and we applaud the development. I would like to first speak briefly on the new regulatory framework report. The highly competitive markets in which MFA's members and other market participants operate require prompt and creative responses to new market conditions, new technologies, new products and new trading and clearing mechanisms. The CFTC is to be commended for developing approach to exchange regulation that is designed to expand the ability of U.S. futures exchanges to meet these challenges through a regulatory framework that affords the maximum latitude, subject only to constraints reasonably designed to assure basic customer and market protections. As we understand it, the report contemplates a regulatory approach under which futures exchanges and the over the counter derivatives trading facilities would operate on an even playing field, one in which appropriate circumstances would be subject to minimal regulatory burdens. We support this concept of a new highly flexible, largely unregulated marketplace. Now, I think I could echo really some of the comments that Barry Lind made. We are concerned about the role of our constituents in the new less or non-regulated marketplaces. Commodity pool operators and commodity trading advisors and qualified registered professionals acting for pools, hedge funds, and individual accounts should be able to access all futures markets, just as today they have access to swaps, over the counter derivatives and foreign futures and options, markets that are not subject to the highest level of regulation. For CTAs, CPOs and their clients, special conditions or risks in these newly developed markets should be addressed as they are generally today in the case of foreign futures markets by the use of a standardize risk disclosure statement. As is the case with foreign futures, this risk disclosure statement should be simple and distinct, clearly highlighting the special risks associated with the particular kind of market, thereby permitting the customer to make an informed choice whether to assume these risks. The approach would facilitate the broadest access for CTA advised futures customers in commodity funds to the greatest possible array of innovative U.S. derivative markets, resulting in the deepest, most liquid and hence, efficient derivative market, a goal that we all share. This approach is far superior to limiting eligibility to access a particular market, to defined group of customers, such as limiting access to only the institutional clients of a CTA. This would create significant problems. As the CFTC knows from its recent efforts, the use of this approach to implement a post trade, order allocation procedure rendered the rule unworkable. The reporting and record keeping nightmare is great. In the current case, for example, if the CTA had 50 clients in a program and only 30 of them qualified for access to the larger more efficient market, the CTA would be forced to trade the 30 accounts in one market and the other 20 accounts in another. As a result, most importantly, the CTA's performance results for the 30 accounts could differ substantially from those with the 20 accounts. Most likely, better results would be gotten for the 30 supposedly large customers. The fragmentation of liquidity would also adversely affect the efficiency of both markets. So in summary on this point, MFA strongly suggests that CTAs, CPOs and all of their clients and investors have access to all futures and derivative markets. I would next like to very briefly address the issue of regulatory relief for commodity pool operators and commodity trading advisors which is not part of the new regulatory framework report, but is contemplated to be forthcoming. The CFTC is operating with the MFA, that they will be reviewing the regulatory framework for CPOs and CTAs with the same objectives, enhancing efficiency and competitiveness, which have guided its review of exchange regulation. The CFTC staff in cooperation with the MFA is developing draft core principles for CPOs and CTAs, designed to supplement the report's recommendations concerning other aspects of regulation. We strongly support this effort and have so far assisted and stand ready to assist the CFTC and the MFA in any way they consider appropriate. There are many inefficiencies to be remedied, including for example, putting public and private offerings of pool interests on a level playing field with public and private offerings of securities and for example, public offerings of mutual funds. We are under a much more restrictive offering regime for which there is no apparent public interest necessity. Lastly, I would like to mention legal certainty of OTC derivatives. The CFTC report is not principally designed to address the issue but the report builds upon and is consistent with the President's Working Group recommendations for enhanced legal certainty for OTC derivatives, in particular by reinforcing and augmenting the Part 35 swaps exemption, and by providing new exemptions for innovative trading and clearing structures for OTC derivatives. MFA strongly supports the objective of enhancing legal certainty for OTC derivatives including the President's Working Group recommendations for legislation to exceed OTC financial derivatives from the CEA, as well as the report's recommendation for actions by the CFTC to enhance legal certainty. I would say having listened to Mr. Waye's remarks, that we would certainly endorse additional legal certainty for OTC commodity contracts as well. We believe that in defining the statutory exclusion for OTC derivatives and other measures to enhance the legal status of swaps, the existing criteria defined in eligible swaps participants should not be further restricted. In fact, they should be expanded to include all clients of CTAs and all commodity pools. The President's Working Group suggestion that consideration be given to increasing financial threshold for natural persons engaging in swaps to $25 million in discretionary investments, in our view, is not warranted by experience or public policy. MFA opposes the creation of additional restrictions upon access to swaps and other derivatives transactions. In fact, the real limitation on participation to these markets is finding a swaps or derivative dealer who has confidence in accepting the business of a particular customer. And we think this is the real check on preventing unqualified people from participating in these markets. In conclusion, MFA fully supports the efforts of this Subcommittee and of the CFTC under Chairman Rainer to make U.S. futures regulation as innovative as the industry overseas. We look forward to providing our full assistance and cooperation. Once again, thank you for the opportunity to present MFA's views on this important topic. [The prepared statement of Mr. Crapple can be found in the appendix on page 77.] The Chairman. Thank you very much, Mr. Crapple. We appreciate that. Mr. Downey from Interactive Brokers, LLC, thank you for being here. I would appreciate if you could describe for the panel a little bit about what your company does, and then go on to describe your views on the proposed new regulations. STATEMENT OF DAVID G. DOWNEY, EXECUTIVE VICE PRESIDENT, INTERACTIVE BROKERS LLC, CHICAGO, ILLINOIS Mr. Downey. Mr. Chairman, thank you very much for inviting me to participate. It is an honor and a privilege. Interactive Brokers is an organization that provides electronic access to the world's markets, to a variety of customers ranging from large broker/dealer and FCM trading desks down through some of Mr. Crapple's constituents of professional fund managers to individual investors trading out of their kitchens via the use of the Internet. Our platform provides all of these participants with the exact same level of access into the marketplace at the exact same price levels. So they all participate on a level playing field. We use a network that is connected to over 30 exchanges around the world. We allow our customers to connect to all 30 of them. Retail, that is our small customers who deserve the highest level of protection, we only allow them into the electronic marketplaces where they are protected. They are not allowed into the open outcry markets because of the inefficiencies that occur. The Chairman. Is that by your own choice or is that CFTC regulations? Mr. Downey. No. I have the technology to bring them into the open outcry using my own people. But I have come to the conclusion recently, within the last 4-months, that there is nothing I can do to control the risk present in these customers entering the open outcry. And we are going to develop only from what we believe will eventually succeed. No one has been able to put forth an argument that the open outcry will ever overcome the inefficiencies and cost structures associated with it. They cannot compete on a cheaper, faster basis with electronic markets. With that said, Mr. Chairman, I have to join everybody here. I think this is a tremendous start with what the CFTC has put out, and it is based on leadership. We are at a moment where we need absolutely to show, and that includes from Congress. Very briefly, on the document itself, I have two main topics. One is I do not believe that any customer should be denied access to any facility as long as they are intermediated and protected. I think that if you start splitting them up where you have large players creating prices that are somehow reflected in the retail trading arena, the retail should have access to both markets. I think that can be achieved through the intermediaries' role. In the absence of that price transparency, if they are trading like products on different platforms for different people, all prices should be known to all market participants, whether they are allowed to trade there or not, as long as they have a correlated market elsewhere. They can be influenced by prices being established. The second issue besides the pricing is that it was very clear about the codes of conduct for the RFE, the DTF and the intermediary. On the first two, the issue of audit trails and making sure that there are time stamps that are very clearly spelled out, protecting the customer's access to the markets on a who knows what when basis, because that is market manipulation. But there is no such call on the intermediary's code of conduct, and that is exactly where they need it the most. There are three pieces to the interaction between customers and the market. There is a collection piece, ruled by the member firms. There is a distribution piece, ruled by the member firms. And an execution piece, ruled by the exchanges today. The danger of time stamping the orders and frontrunning and market manipulation are just as prevalent upstream as they are at the matching edges. So if I could make that statement, that the codes of conduct for intermediaries simply include high resolution audit trails, at least as high as the exchanges themselves, to make the audit trails meaningful. With that said, I generally agree with the document. I believe it is a tremendous start for us, and details need to be worked out. But the details that need to be worked out are going to be influenced exactly from the leadership from Congress on two very important issues. The first is competition. Competition is going to be technology based. The exchanges are rushing towards ownership and they are going to be self- regulated, and it raises serious questions, are they going to be partisan in deciding whether a certain technology will or will not succeed. This is no longer an abstraction. We have some exchanges on the securities side who have been faced with issues, should we allow customers to access our markets with the given technology, and they have taken affirmative steps not to allow customers access, and to cripple the technology. That simply has to be protected against. My concerns with the current framework, with the framework that is being proposed is that the exchange can stop a piece of technology being given to a customer and I need to know who do I plead to. The Chairman. Can you give some examples of what you have in mind there? Mr. Downey. Sure. On the options exchanges, the SEC has come out and said that the member firms have a duty to provide best execution; that is, deliver their customer orders to the highest bid or the lowest offer. The broker/dealers have provided this technology that allows a customer in a kitchen in Iowa from observing the prices on all competing exchanges and pointing and clicking and sending an order to the appropriate exchange. Last Wednesday the CBOE effectively terminated the customer's rights to do the arbitrage if there was a market dislocation between two exchanges or three exchanges. The customer did not have the right to take advantage of that, given the available technology and they stopped automatic execution on that exchange with the blessing of the SEC, a complete contradiction to Congress' bias toward giving technology and the SEC's own statement on broker/dealer's best execution responsibility. We have had the experience that while the regulators, acting on the intent of Congress, have pushed technology and competition. When push comes to shove, the exchanges step up to the plate and beg for mercy and the regulators simply back down. The NASD, for instance, Mr. Chairman, had a recent proposal on order handling. They received 71 industry comment letters, 59 of them negative in some regard to its new proposal. The SEC let it stand without comment, no changes. That has to be a Congressional issue. We demand the regulators, you are to act in the fall on technology, innovation and competition, and you have to make it very clear as to the burden of denying technology which will foster competition. That is the first part, leadership. The second issue is on the clearing house. Competition in the marketplace in the futures, when I hear that people are going to create exchanges, I think that is a great idea. Where are they going to clear it? Where are they going to clear this stuff? If they do not have a facility to clear, that they have a matching engine means nothing to me as a participant. In the futures market today there is no national clearing mechanism. There is no way for an individual with a matching engine idea to come up and step up and find a place to clear it. They have to go back. Interesting, Mr. McNulty pointed out that he intends to make his clearing operation a revenue stream. That means he is going to use it as a corporate asset, to keep competitors out and raise the prices. If you really want competitive markets in the futures, by the way, where is the competition between products and the futures market? There is none. Where is it in the securities market? Every exchange. Options market? Every exchange. Futures market? They are all based on each other's exchanges. And that is because of clearing. Clearing in the futures market was instituted by Congress in the 1920's as a result of a default of the Chicago Board of Trade in the 1900's, early 1900's. Market participants were unable at that time to come to an agreement on clearing and Congress had to step in. In my mind they had a flaw in it. They stepped in and said if you want to be a contract market, you got to have a clearing house. But they did not describe how open that clearing house had to be. They left it to the markets to describe it. The Chicago Board of Trade has a separate entity. The Chicago Mercantile Exchange has a division. But they are both exclusive to anyone else, and you cannot get in. When the member firms say we want to compete, they really want to compete on the clearing house. They want people to allow them to clear. And only Congress is going to allow that to happen. CFTC cannot push it. This document is not going to help. We need leadership from Congress. We want competition, and in order to get competition you need clearing. Clearing structures should be open to all, along the lines of a national clearing and settlement mechanisms established in the securities market by the Securities and Exchange Act amendments of 1975. Without that, we would not have the SEC on the securities side or the OCC on the options side that allows for competition like the international securities exchange, the all electronic options exchange which has driven the options business to incredible competition, lowering and narrowing of bids and spreads, benefiting the member, benefiting the customer base. That is what competition is all about, and it is about clearing. Mr. Chairman those two issues, a real vision on how we are going to let technology thrive and the establishment of a national clearing mechanism for futures is something that we need leadership from Congress on. Thank you. [The prepared statement of Mr. Downey can be found in the appendix on page 87.] The Chairman. Thank you very much for that testimony, Mr. Downey. Would any of the other panelists wish to comment on Mr. Downey's proposal for a national clearing house? Mr. Lind? Mr. Lind. I do not know how you would get that to work. I can say this, that certainly you could not force the Board of Trade clearing corp. or the Chicago Mercantile Exchange to take on the clearing of another exchange. First off, at the Mercantile Exchange, they have a good to the last drop rule. So any funds that we have up there are one thing, but if there was a big default they could just keep coming after us on a prescribed rotation until all the money was gone. No one is going to guarantee a little cattle exchange or some major exchange that may not know what they are doing. So how you can take that from the level, and certainty you could not force the Chicago Mercantile Exchange to do that. And how you can take that on a national realm where you put everybody there, I do not see how the integrity of that would be able to be set up so that people would be comfortable. Because if you are going to have DTFs and other exchanges that are coming about, there would be a lot of reassurance that would be needed to get people to be willing to guarantee that or put money into that. The Chairman. Does anybody else wish to comment? Mr. Waye? Mr. Waye. It is difficult to perceive, with all the changes that are going to be coming up, with electronic markets and the new deregulatory framework, how the clearing house issue is going to unfold. But I think as a clearing firm, we would be willing to put our capital at risk, if we are satisfied with the organization, with the rules and the regulations, and if that means new clearing houses where there are solid financial parties and solid rules and regulations. We would be prepared to put our capital at risk to enable our clients to participate on new markets. So I cannot guarantee exactly how it is going to unfold, whether existing clearing houses will start to clear a broader array of underlying physical products, for example. Or we may get futures cleared more broadly among a variety of clearing houses. The CFTC staff would allow the non-U.S. clearing house, such as the London clearing house, to establish a facility or partnership in the U.S. to clear potentially some of the exempt MTEF trades. And I am sorry staff is not here today, to just ask the question. I believe that is the case. So I think we will see more competition for clearing. I think we will see member firms like ourselves be willing to clear new exchanges, if we are confident of the financial strength of those exchanges. So I agree with Mr. Downey, clearing is really a very, very core critical issue and it is difficult to predict exactly how it is going to unfold, but I think we will see significant change coming up in the next year or two. The Chairman. Mr. Crapple? Mr. Crapple. I think it would be highly desirable and it is necessary for effective competition by new exchanges that there be a clearing mechanism available. I do not really think that a major, a new exchange is going to have much of a chance getting started unless it has got the backing of major securities and futures firms that are clearing members of other exchanges. So I see it more as a voluntary rather than mandated approach. But there is no doubt that if it came about through one means or another, that it would be a great enhancement to competition. The Chairman. Mr. Downey, I want to ask you a question about access to exempt multilateral transaction facilities, exempt MTEFs. Would you support access to an exempt MTEF by retail customers as long as they are represented by intermediaries? Mr. Downey. Yes. I think that the people that you are discussing would be exempt and are going to be people who are professionals who are basically trading a lot of individuals' money. Those individuals are going to have access to it, but they are trusting some person to actually pull the trigger on their behalf. I think I would like to say this. The definition of a sophisticated customer is something that is very difficult to pin down. I know some very sophisticated customers with $100,000 in capital and I know some very unsophisticated customers with 10-million in capital, and I think one would be allowed to trade and the other one would not. I think that it really comes down to do you understand the risks involved here? Do you understand this trade might have some defaulters to it? And also again, in trading it comes down to one thing in my mind. That is the price. Does everybody know what the price is? Does everybody know what the pressure is going to be? And if you do not allow individuals to trade in these facilities, as long as they are trading a product that does have a correlation to a market that is trading downstream, prices have to be disseminated in a very timely manner and that means no delay. As soon as they know about the price, they disseminate it so everybody else can trade on the knowledge that there is a big transaction that took place and it is going to affect everybody's pricing. The Chairman. What do the other panelists think about that issue, whether there should be access to an exempt MTEF by retail customers as long as they are represented by intermediaries? Mr. Crapple. I will take a stab at that. I think Mr. Lind would probably go a step farther than I feel the need to go, because in his case he is an FCM who would be an intermediary, and in the case of the Managed Funds Association, our clients, our constituents are the CTAs and CPOs. So in the case of a customer of a CTA, an individual, regardless of his means, has signed documentation granting discretionary trading authority to a registered category under the CFTC. So the individual is no longer making his own trading decisions. He has delegated that, and as long as the person that it has been delegated to has been invented by the CFTC and the MFA, we see no good argument for foreclosing that ultimate customer from any category of the new market frameworks. Now, I think Mr. Lind referred to a concept of FCMs with $20 million in capital. At least in a case like that, if an FCM is forwarding orders to any level of exchange and something has gone wrong, you have got a pocket to go to. The customer is not without recourse. Anyone with capital could actually be an FCM. And it is possible for any fly-by-night organization. You would not, I do not think, want to see a blanket rule that any customer of any FCM could go to any market necessarily. But I have great sympathy for the concept of limiting it to FCMs that achieve the material capital. The Chairman. Mr. Lind? Mr. Lind. It comes down to two basic situations. One situation, the more exotic situation might be as an example, something that was offered to me a year ago, which I should have taken. You, as a customer of mine, on an exempt market, maybe the product that is going to be offered is something like this. You can get a return of 1-percent or a return of what the S&P index does over the course of 2-years. So you put up $100,000 and the worst that you are going to get back is $102,000 or if the S&P index goes up 20-percent a year, you get back $140,000. They should be able to deal in that type of product, and they should be able to deal in that type of product through me. So that is the more exotic type. But the basic situation that we have is right now a lot of transactions, not anywhere near as many percentage-wise as used to be. The market has grown and volume is still good at the futures exchanges, but when we get these off exchange products, if the exchange market, for example, right now is two, three, an off exchange you get the inside market is now two and a half, three, but if the liquidity goes off exchange, like I would suspect a lot of it is going to happen, then the market might be something more like one, four on the exchange. So I want my customer to be able to get at least the two, three, if not the two and a half, three market. I certainly do not want him to have to pay four or sell at one, because then, no matter how much you protect him, then he has been hurt by this. So wherever the market is, that is what I would like to get for my customer. The danger that you have in that is if you have some people, because it does not take much to become an introducing broker, and my fear is that he will go down to this off exchange operation down the street with his buddy and instead of having a market of two, three, he will have a market of even to 40 or even to 60. And we have seen that in the past. And that is why I propose the protection, that the firm has got to be a clearing member, has got to have enough money at risk so that he is not going to do something wrong. No member of an exchange that is any kind of substantial member at all is going to mess around like that. So I think that the protections are there. And if the protections are there, then I think that we certainly have to be able to give the best price to the customer, wherever it exists, whether it exists at the exchange, or at an exchange or any of the other categories that have been provided. The Chairman. Thank you. You do not have anything to add, Mr. Waye? Mr. Waye. I would just go back and support Mr. Crapple's comment, that I believe individual investors who are having their funds managed by a third party, and that third party is registered with the CFTC and the MFA, that third party then should have the ability to transact in the exempt MTEF market on behalf of its clients, whether those clients are retail or institutional or commercial. So I would support Mr. Crapple's comments in that regard. The Chairman. So the retail customers get into that MTEF that way. Mr. Waye. Yes. The Chairman. Mr. Lind, in your opening statement you talked a lot about access to markets. You did not use the word, but I think you were really talking about the bifurcation of the market between retail and institutional customers and you were concerned that retail customers could be denied access to the market with the greatest liquidity. Do others of you share that concern under this proposed regulatory scheme? Business could really migrate from the RFEs. Liquidity could migrate from the RFEs to the less regulated DTFs and exempt MTEFs. If the retail customers do not have a way of getting in those markets, they are really going to be locked out of the most liquid markets. That is a real problem, is it not? Mr. Lind. That is my problem. Mr. Crapple. I think that is a good point. I think inevitably there will be some tendency in that direction. An analogy that was made by someone used to be if you could trade the same contracts, certain grain contracts at the Chicago Board of Trade or if you were a small fry, at the Mid-American Commodity Exchange and you had to set the positions limits, so actually the big traders used them all. And they would send orders to the Mid-American Commodity Exchange, and they have a bank of people that the changer phones and they would just immediately lay this off on the big liquid Board of Trade markets. The problem with that is the toll charge on it. It was more expensive. I think that we probably would be faced with something, you would get more customer protection in one sense, but there would be some cost. The Chairman. Mr. Downey? Mr. Downey. Technology today, I think I have demonstrated it to you in the past, the small retail customers know exactly what they are getting, as long as they can see the price and watch the price move and they can see the buy and sell fluctuations by themselves and they can make an informed decision. I do not see the growth of the market being dominated by the institutions. I see the growth of this market being dominated by individual investors who have taken their own decisions into their own hands. And to deny them access to the liquidity of a marketplace simply because they are deemed unsophisticated, I think that is unfair. If they can be delivered, using the technology of a member to protect them and to make sure that they have all requisite information that they need for protection, they deserve to be able to participate. The Chairman. The problem here is that, in an attempt to help protect the retail investor, we could in fact deny them the best prices and thereby hurt them. Far from protecting them, we could be hurting them. We have got to be very careful here. To summarize, am I correct in saying that you feel that if the retail customers would have access to the exempt MTEFs through other intermediaries, but not directly, they would be protected? Mr. Downey. I do. The Chairman. OK. They would still have access to those most liquid markets, is that correct? Mr. Downey. You must remember that the only reason why it is not clearing houses is because of contract market status. These would not be contract market status, these entities, these MTEFs, so they would not need a clearing house. Retail customers should not be exposed to non-clearing house cleared products. I am trying, again, to lobby you to create a clearing house. The Chairman. Right, right. I hear you. I hear you Mr. Lind. Wait a minute. Mr. Chairman, may I comment on that? The Chairman. Yes. Mr. Lind. The opposite party in this type of transaction, I am acting as the intermediary for my customer, and maybe the opposite party is Goldman Sachs. Now, in my proposal, all my customers' funds have to be segregated to begin with. But the responsibility of making that trade good on one side is Goldman Sachs. Now, if Goldman Sachs defaults, my customers' monies are still protected because it is all segregated funds. Now, if we do not have an arrangement, where we settle every day and he defaults to me, then my in my opinion that obligation is mine. The customer gave me the order. I deal with Goldman Sachs, Goldman Sachs goes out of business, I have to make my customer good. I may have his money in segregated funds, but I may not have the profit that he had on a position, I have to make that good myself. But the customer will be totally protected in that regard, whether there is a clearing house with a DTF or not. The Chairman. What do you think about the suggestion for the relaxed standards as to the segregated funds? Does anybody want to comment any more on that? Mr. Waye. Mr. Chairman, I think the recommendations by staff to allow a somewhat greater degree of flexibility in how segregated funds are invested and managed by the FCM, as Mr. Lind said, we would support that. The Chairman. What are you allowed to invest them in now? Mr. Waye. U.S. Treasury securities. The Chairman. And that is pretty much it? What would the proposal be that you can invest them in? Mr. Waye. I have not seen it exactly. But I have heard CFTC staff say you might be able to invest them in similar securities to what a clearing house accepts today. Or I am not quite sure if their thought is to lower it like double A or single A or A-1 plus P-1 commercial paper. I am not sure. Just that they would broaden it beyond treasuries only, which is the current requirement. The Chairman. I think they had in mind municipal bonds and the like. I should not comment on that. I will leave that to the CFTC. What do you think about the other suggestions for relaxed standards as to risk disclosure, registration, financial requirements and the like? What do you all think of these recommendations for the intermediaries? Mr. Downey. I personally do not find them to be a burden at all. They are deliverable. I know a lot of it is the paper, they would create paper and deliver it and get signed signatures. I think the CFTC has already moved forward on electronic signatures which opens up the door for electronic delivery. I do not provide any of my customers these risk disclosure statements in a paper format. They capture them electronically. They read them. They take a test on them. And they acknowledge that they have gotten them. I do not find them to be a burden. Technology can solve that problem, and I consider it a good policy to understand that our customer understands the risks involved in the business he is about to undertake. Mr. Lind. First, let me say that the risk disclosure statement for the retail customer today, I am guessing now but I would have to say it is probably over 20-years old. And times have changed. The sophistication of people today, even people who have never traded before, is so much higher than it was back then, that I think that risk disclosure today, I think there should be a risk disclosure. I think it should be for today's times. I do not think that most of my customers read it. Certainly I do not give them a test. What do you do if someone fails the test? Mr. Downey. Let them take it again. Mr. Lind. Right. They would check off that they have received it, but I doubt that very many people read it. Now, I think that a more appropriate message about the risks of trading could be enclosed in a short enough form that the people probably would read it. But right now, the whole thing is pretty burdensome, and it is really out of date, but we can live with that. And I think it should be there. Also, going back to the segregated funds, part of the reason why the relaxation of segregated funds would be, because our competition overseas has a whole relaxed aspect to that. They can invest in many other things. Some of the customers here would like to direct the firm that they are trading with to take the funds and invest it in something else where they are going to get a better return rather than on treasuries. I, myself, for the retail customer believe the funds should stay segregated but only for the retail customer, and that those funds should be invested only in treasuries the way they are today. The Chairman. Well, thank you very much. I am going to adjourn this Committee meeting now. I appreciate very much the substantial contribution all of you have made, through your prepared remarks and through your testimony today. Rest assured, I will take this input back to Washington, as we rewrite the Commodities Exchange Act this year. Let us hope that we get it done by September, which we have set as an absolute deadline. Thank you all very much for your help today. Thank you. 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