The country's derivatives exchanges have complained about onerous regulation by the Commodity Futures Trading Commission ever since it was established. But suddenly, the exchanges' call for regulatory relief seems to be falling on fertile soil in Congress, thanks to recent legislation proposed by Sen. Richard Lugar (R-Ind.) and others that has enjoyed a broad swath of bipartisan support. The critical proposal in the bill is the "professional market exemption," a feature that would allow professional investors to trade without certain regulatory protection.

All this raises larger questions. Should exchanges be deregulated? Does the existing level of regulation warrant drastic action? What value do the current rules have? How much deregulation is too much? And what would the derivatives landscape be like under the new regulatory framework?

The participants' responses covered the ideological spectrum. Some believed the proposed legislation would finally level the playing field and allow the American exchanges to compete with the largely deregulated foreign and over-the-counter markets. Others believed that the legislation would serve the interests of American investors poorly, pointing to well-known derivatives debacles as ominous examples of the need for continued regulatory vigilance. All of the respondents displayed the kind of passion that has characterized the debate on this increasingly contentious issue.

Jack Sandner
Chairman, Chicago Mercantile Exchange

The Commodity Exchange Act (CEA) regulating the nation's futures exchanges had its most recent thorough revision in 1974, when the Commodity Futures Trading Commission was established and the CEA was broadened to apply to financial futures such as those that had been introduced on the Chicago Mercantile Exchange two years earlier. Periodic renewal of the CFTC's mandate and of the CEA has resulted in some fine-tuning since that time, and the 1992 revisions exempted swaps markets from CFTC regulation while requiring all futures to be traded on regulated exchanges.

In the 23 years since the CFTC was established, the most significant development in the financial world is the globalization of financial markets. Today, futures exchanges have sprung up worldwide, all designed to trade the kind of financial futures that the Merc invented, and many closely replicating the exact financial products traded on U.S. exchanges. In country after country, regulation of these futures markets is designed to nurture and enhance business, giving the exchanges every possible advantage in the face of fierce global competition.

At the same time in the United States, the growth of unregulated, over-the-counter (OTC) derivatives has grown by more than 500 percent since 1991, outstripping the growth of trading on regulated futures exchanges. Institutions, from banks, investment firms and insurance companies to mutual funds and pension funds, utilize these customized products to manage financial risk and allocate assets. Trading on futures exchanges, while offering significant advantages-such as price transparency, precise audit trail information, streamlined back-office interfacing and virtual elimination of counterparty risk-has become nonetheless a more cumbersome vehicle as regulations proliferate, particularly given the attendant extra costs.

This OTC derivatives market, with its broad exemptions granted by the CFTC under revisions of the CEA enacted in 1992, exemplifies in some ways the "professional market exemption" that the U.S. exchanges are requesting. This OTC market already thrives without CFTC oversight, and the exchanges simply seek parity with the OTC markets. It is clear, however, that the CFTC does not view its role to be an advocate for the business of U.S. futures industry interests in the economy. Instead, the commission views its role as the insurer of some ideally perfect regulatory scheme. With "professional" and institutional users already moving away from regulated futures, as evidenced perhaps most clearly at the CME in eroding currency trading volume where OTC markets now account for 80 percent of the dollar volume, the jury is coming in with a verdict that regulation must keep pace with financial innovation or doom itself to extinction.

The so-called professional market provisions envisioned in the current legislation would include the same regulatory authorities extended to the OTC market in 1992. The market would be for professional, sophisticated traders and the CFTC would continue to have antifraud, antimanipulation and emergency power authorities. In addition, the hallmark safeguards of exchange trading-price discovery, price transparency, segregation of funds, audit trail, clearing-would all pertain to a new market.

U.S. futures exchanges need the flexibility to respond to and anticipate market demand quickly, without the many months of delay that the current environment necessitates. It is ironic that the sophisticated institutions that are our major customers-and that leave futures and options positions open on the Merc overnight and longer in order to manage financial risk-must be subjected to additional risk because certain products and tools are needed to allocate assets appropriately and manage the uncertainties inherent in myriad complicated transactions and investment strategies. Futures exchanges, furthermore, have the highest possible self-interest in maintaining the integrity of their markets and preserving the public's trust in the institution and the industry.

If U.S. exchanges cannot offer these institutions the products they need and demand, they will continue to move their businesses to jurisdictions where they will receive the treatment they need and deserve. The Commodity Exchange Act revisions now before Congress go a long way toward updating futures industry regulation in a positive way. Their enactment can help revitalize an American industry poised to offer the market innovations to take us into the 21st century.

Donald Horowitz
Senior vice president and general counsel, Sakura, Dellsher Inc. and editor, Futures & Derivatives Law Report

Recently I participated on a panel at the Financial Executives Institute Treasurers Conference in New York. The event's topic concerned derivatives accounting and disclosure, so the 75 or so attendees at our two sessions were bona fide end-users. Before I began the second session, I took a poll of the audience to see how many of these end-users used exchange-traded derivatives in their financial programs. My quick survey revealed that perhaps 10 people, representing firms throughout the United States and Canada, used exchange-traded instruments. After the session I approached several participants and asked them why they chose the OTC market over the exchanges. The most common answer was that the OTC market offered more certainty and customization than the regulated exchange markets.

This response was not surprising. A front-page article in the Chicago Tribune bemoaned this situation by pointing out that "Chicago's global market share has been cut nearly in half since 1987 (from 60 percent to 31 percent), reflecting in part a higher regulatory burden." The Economist echoed this observation in an article which noted that the growth rate at LIFFE, which was only set up in 1982, was much faster than the 130-year-old CBOT.

Will the passage of the Commodity Exchange Amendment Act of 1997 reverse this situation and return the Chicago exchanges to global dominance? Not by itself. Many factors are contributing to Chicago's declining share of the expanding derivatives business, and burdensome regulation is only one. However, it will make a difference.

Congress and the CFTC clearly need to examine the present state of futures and derivatives regulation. If the exchanges are correct in their estimate that 90 percent of the trading volume is by "professionals," then, as Federal Reserve Board chairman Alan Greenspan noted in his Coral Gables, Fla., speech, government must "enunciate clearly" the public policy objectives for the regulation of derivatives. These so-called "professionals" use OTC derivatives as an integral part of managing their firms' financial business. They are subject only to the remedies imposed by contract law, which have apparently been sufficient since the number and size of derivatives-related defaults are statistically insignificant. Accordingly, it is not clear exactly what public policy purpose government regulation is serving.

Finally, while Congress and the industry are debating the wholesale deregulation of the futures markets, we all must pay attention to CFTC chairperson Brooksley Born's repeated observation that "exchange trading in the United States has thrived under our current regulatory system." Moreover, she has also observed that this system has "assured market participants around the world that our markets are fair, safe and transparent." While it would be in no one's best interest to back away from that objective, the U.S. markets need to be unshackled from the constraints of the present regulatory structure.

Howard Kramer
Senior associate director, division of market regulation, U.S. Securities and Exchange Commission

Every few years, the futures exchanges complain about some new threat to their existence that can only be cured by deregulation. This time the supposed threat is the relatively unregulated OTC derivatives market. The exchanges claim they need to establish an unregulated professional market to compete with the OTC market.

The professional market regulatory exemption ignores fundamental differences between exchange and OTC derivatives markets. Most important, futures exchanges are organized public marketplaces. Exchanges centralize market activity by bringing together buyers and sellers, thereby promoting liquidity for market participants. Exchanges also provide centralized environments that facilitate price discovery. In contrast, the OTC derivatives marketplace involves privately negotiated contracts between institutional customers, warranting a different framework for, and level of, regulation.

The professional market exemption in the proposed legislation would create a two-tiered market, for which 90 percent of all trading occurs in a separate, unregulated environment that would seriously impair market liquidity for small business and retail participants in the nonprofessional market, making it difficult for them to buy and sell at fair prices. The resulting smaller exchange market would have full CFTC regulatory protections, but would lose the economic benefits of being an active, deep and liquid market.

At the same time, the professional market exchange would not be subject to audit trail, books and records, and other regulatory requirements that are essential in uncovering, and thereby deterring, fraud and manipulation and ensuring sound operations. Problems of the magnitude seen in recent trading scandals involving professional traders such as Barings and Sumitomo show too clearly the limitations of relying only on exchange self-oversight. Such events also demonstrate that institutional participants in exchange markets can pose potential systemic problems. Moreover, an unregulated professional exchange could profoundly affect clearinghouse integrity in the event that a firm cannot honor its trades. Problems at the professional market or clearinghouse could easily spill over to the broader financial markets.

Programs such as the professional market pilot program adopted by the CFTC in 1995 offer a more appropriate way of developing a suitable model for the operation of professional exchange markets. Indeed, appropriate levels of regulation can help markets grow by assuring market participants that markets are sound, fair and transparent. The U.S. derivatives exchanges have prospered because of a reasoned mix of innovation, liquidity and regulation. If the balance among these elements needs some readjusting, then let it be done in a thoughtful and careful manner, not with a meat cleaver. The continued vigor and safety of our financial markets are too important to be imperiled by an excess of deregulatory zeal.

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the commission or of the author's colleagues on the commission's staff.

Alger "Duke" Chapman
Former chairman and CEO, Chicago Board Options Exchange

This past February, as chairman of the Chicago Board Options Exchange and on behalf of nine other securities self-regulatory organizations, I appeared before the Senate Committee on Agriculture, Nutrition and Forestry to express our concern over proposed exemptions from the Shad-Johnson Accord. Specifically, our concerns are confined to two legislation provisions in Section 257, the bill proposed by Sen. Lugar-one being a proposed exemption from the Shad-Johnson Accord for all OTC transactions between so-called appropriate persons that is contained in Section 5 of the bill, and the other a proposal by the futures exchanges that an exemption from Shad-Johnson be included as part of the proposed professional markets exemption contained in Section 6 of the bill. If these exemptions were enacted, all transactions in securities futures and securities hybrids that are effected between appropriate persons either over the counter or in a professional market-which as a practical matter accounts for an overwhelming proportion of all transactions in such instruments-would be statutorily exempt from regulation by the CFTC.

We did not take a position on any other of the bill's provisions, nor is it my intention to take a pro or con stand on the larger issues posed here regarding broad-based deregulation of exchanges. Our specific objections to the Lugar bill were based neither on an affinity, nor an aversion, to regulation. We don't advocate regulation for regulation's sake, but would argue instead for a thoughtful process to accompany its determination on a case-by-case basis. If Congress and the CFTC decide in favor of the professional market exemption, for instance, we wouldn't object, but we would argue against exempting securities-based products without input from the securities regulators, self-regulatory organizations and Congressional committees in the belief that, for securities, the futures and securities markets are a single integrated market and that a substantial portion of the futures markets should not go unrelated without full knowledge of the impact of that deregulation in the securities markets.

A brief history of the Schad-Johnson Accord provides some perspective to this position. Shad-Johnson prescribes how options and futures on securities and securities indices are to be regulated. The accord was enacted in 1982 upon joint agreement of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) following rigorous examination and thorough consideration by the four Congressional committees overseeing both agencies. Changes to this important law should be subject to the same deliberate process undertaken in its development.

We know that there is a strong relationship between trading in derivatives and related case markets. We know that there is, at best, incomplete information on the extent or nature of trading in these markets. We also know that a market in which regulators have no legal ability to require trading reports, to impose "circuit breakers," position limits, trading halts or margin requirements if they should prove necessary, to obtain the information required to monitor the markets, or to mandate fair competition among participants, is a market that could present great potential dangers for the nation's regulated securities markets. Actions that would preclude regulators from addressing systemic risk should not be taken unless it can be concluded that such action would be safe and in the public interest, and would have no adverse effect on the proper functioning of and competitive balance in securities.

Thomas Donovan
President and CEO, Chicago Board of Trade

The Chicago Board of Trade and other U.S. futures exchanges seek nothing more than a regulatory approach that allows us the freedom to compete and the ability to innovate. Without it, our markets will disappear.

Today, U.S. futures exchanges face competition from two sources-less regulated foreign exchanges and virtually unregulated OTC derivatives markets. Both enjoy a tremendous, but unfair, regulatory cost edge over U.S. exchanges. By contrast, our regulatory cost disadvantage has shunted the growth of our markets and even caused some to shrink.

Consider the facts: In the past five years, the OTC swaps market growth has been better than 50 percent, almost 10 times the growth rate of the CBOT's most popular contract, Treasury bond futures. Trading volume in our financial products has fallen two years in a row and total trading volume at the Chicago Mercantile Exchange has declined in the past two years in part because of the loss of its currency contracts to the OTC markets.

The foreign futures exchange story is the same. A decade ago, no foreign futures exchange traded any of the top-10 futures of options contracts. Now seven of the top 10 contracts are outside the United States.

As we have testified before Congress this year, our regulatory structure needs to be changed. Federal regulation is choking our markets. Exchange markets are entitled to, but have thus far been denied, the same treatment as the OTC markets and foreign exchanges as a matter of fair competition.

Despite the unfounded doomsday predictions of some, self-regulation does not mean no regulation. Nobody has more at stake in the integrity of our markets than we do. Our professional markets would continue to offer customers many well-known safeguards already found in exchange markets, including open and competitive trading, transparent pricing, daily mark-to-market of positions, and unsurpassed financial integrity through clearing systems that eliminate counterparty risk.

Each of these safeguards was invented by exchanges, not the federal government, because the integrity of our markets is paramount to our success. Yet with all these safeguards in exchange markets, there are some who favor more regulation of exchanges. Nobody has yet explained to our satisfaction why the safer market should have more federal regulation.

The Chicago Board of Trade is not afraid of competition. We welcome it. We just want the freedom to compete on a level playing field.

John V. Rainbolt
Chairman, International Issues Subcommittee of the American Bar Association's Committee on Futures and Derivatives Regulation

I have some concerns that the professional market exemption may not live up to its original billing and may even hurt the U.S. exchanges, which support the proposal. Having drafted some of the current law and later serving on the CFTC, my views may be looked at as biased. They are, however, derived from 18 years in private practice observing interaction between exchanges and the CFTC on several domestic and international fronts.

U.S. futures exchanges are subject to federal oversight, but the system gives back benefits, some intangible. Ironically, the professional market exemption eliminates many of these, perhaps inadvertently. If the professional market exemption is actually a serious effort to change the law to benefit the U.S. futures industry, assuming the CFTC is correct in its description of the impact of the amendment, the following guidelines will help get it pointed in the correct direction.

Don't give tough competitors a gift. Volume and seat prices have soared at U.S. futures exchanges under CFTC regulation. The principal foreign competition has come from LIFFE, MATIF, SIMEX and DTB, exchanges largely modeled on the Chicago and New York markets. Currently, U.S. customer business on overseas markets must meet CFTC requirements, known as Part 30 rules, themselves based on rules that govern handling of orders and funds in CFTC markets. When the pro market exemption eliminates the rules for 90 percent of the United States marketplace, it also demolishes the foundation for Part 30 requirements controlling U.S. customer orders going to foreign exchanges. This not only sets the stage for a race to the bottom with global implications from a regulatory standpoint-eliminating customer standards in the U.S. market risks the leadership role the CFTC now plays in setting a level playing field among global markets. Removing all constraints from foreign competitors who now follow U.S. guidelines seems totally counterproductive.

Try to keep the good stuff you already have. When Congress created the CFTC, it barred individual states from making and enforcing their own rules to control the sale of futures products. CFTC exclusive jurisdiction over futures also ended claims from other federal regulators. If the professional market exemption becomes law, should Congress also return U.S. exchanges and firms to state "Blue Sky" jurisdiction and a constant preoccupation with putting out fires in state legislatures and state security commissions? Here, exchanges should be trying to keep things as they are.

Avoid the British experience. As the professional market legislation also proposes, U.K. regulators concentrated on the politically correct goal of protecting small punters, leaving professionals to their own devices. Knowing the relevant history, a U.S. politician worth his or her salt should wonder if the Conservative government's approach to market oversight has something to do with the number of Tory resumes on the street, and if a vote to duplicate U.K. market regulation communicates this disease, brought on by a rapid succession of Barings, Morgan Grenfell and Sumitomo problems, to name a few. British regulation, now recovering and making adjustments, failed not only to protect the public from the industry, but the industry from itself. Not a good idea in the United States.

Avoid unnecessary journeys. Ask if this trip is really necessary. The CFTC, acting on its own, could exempt professional markets from many changes that the pro market exemption provision would authorize, perhaps eliminating the need to amend the statute. Exchanges and firms probably believe it is to their tactical advantage to push a legislative fix. As matters progress, however, at some point the exchanges and the CFTC may decide that "can we talk?" is not a bad idea. It isn't.

Gay Evans
Chairperson, International Swaps and Derivatives Association and senior managing director, Bankers Trust International

ISDA's primary members are among the principal users of the futures exchanges. Therefore, to the extent that excessive regulatory burdens impact the exchanges' ability to offer cost-effective, innovative products, ISDA members are less able to use those products efficiently in connection with managing the risks of their own businesses, and less able to offer competitively priced, privately negotiated transactions for customers to manage their business risks.

While there are significant differences between exchange-traded products and privately negotiated products, we do support efforts to formulate a statutory exemption that would allow exchanges to offer products in a less-regulated environment. This would permit exchanges more flexibility to provide financial products that in turn can create opportunities for privately negotiated transactions.