By Robert Hunter

It’s no secret that the Chicago futures exchanges, since the 1970s, would have liked nothing more than to see their primordial enemy, the Commodity Futures Trading Commission, quietly legislated out of existence. Now, as the rocky tenure of CFTC chairperson Brooksley Born nears an end, the Chicago Board of Trade and the Chicago Mercantile Exchange are floating a proposal that comes remarkably close to doing just that.

Born’s relentless calls for increased regulation of the derivatives industry have won her few friends in American financial centers or in the Republican-controlled Congress. Indeed, most of the rumored candidates to replace her in the top spot are known to favor laissez-faire approaches, while one, CFTC commissioner Barbara Holum, has been an outspoken critic of Born’s regulatory hubris for years. Whoever replaces Born will have to deal with CFTC reauthorization in 2000, and a congressional backlash against Born’s zealousness could relegate the commission to footnote status in the annals of American economic regulation.

Such, anyway, is the hope of the CBOT and the Merc. At the International Swaps and Derivatives Association’s annual conference in March, the two exchanges circulated an early draft of a proposal to drastically curtail the CFTC’s powers when it is reauthorized in 2000.

The plan certainly scores points for ambitiousness. The biggest eye-opener: the CFTC’s fundamental role would change from regulator to supervisor. Under the proposal, the commission would no longer have the power to control and/or prescribe the terms of new futures contracts, but only to impose penalties if statutory violations occur. The exchanges, in other words, could list new contracts virtually at will.

Another show-stopper: the plan calls for the repeal of the 1982 Shad-Johnson Accord, which, among other things, doled out options regulation to the Securities and Exchange Commission and futures regulation to the CFTC. Under the accord, the SEC retains a veto power over stock and index futures contracts, and it has frequently exercised this right to nix what it perceived as too-narrow index futures contracts, such as the CBOT’s proposed contracts on the Dow Jones transportation and utility indices. The CBOT-Merc plan would open the door for futures exchanges to list futures contracts not only on narrow indices but on single stocks as well. This prospect, predictably, enrages U.S. stock and options exchanges, which argue that single-stock futures could seriously destabilize Wall Street by making market manipulation easier and allowing investors to play with lower margin requirements. The CBOT-Merc plan addresses these concerns in a novel way—it allows the SEC to act as a policeman against insider trading on futures exchanges.

The plan also calls for a drastic revision of the CFTC’s statutory powers. Under the proposal, the CFTC would be required to attempt to resolve any concerns it has with an exchange before initiating a formal hearing; exchanges would have the right to appeal any adverse CFTC actions to the U.S. Court of Appeals; and the CFTC would have exclusive jurisdiction over derivatives clearinghouses. The commission would retain its exclusive jurisdiction over “all derivative transactions” required to be conducted on derivatives exchanges—which in the proposal’s language includes only futures contracts.

In an astonishing about-face, particularly given the exchanges’ public posturing in recent years, the plan would explicitly prevent the CFTC from regulating over-the-counter derivatives transactions. The exchanges had argued that, since the CFTC had regulatory power over the transparent and commoditized exchange world, it should be allowed to oversee the massive—and murky—OTC market as well. The motive behind the turnabout: coalition-building. The proposal’s four-pronged revision of the Commodity Exchange Act is decidedly dealer-friendly and deceptively simple—publicly offered derivatives contracts would be traded on exchanges regulated by the CFTC, privately negotiated derivatives would be traded in an unregulated OTC market, systemic risk would be mitigated by requiring registration of all derivatives clearinghouses, and dealers would be allowed to pick their regulator from among a banking regulator, the SEC and the CFTC.

The proposal cozies up to dealers in another major way: expanded access to derivatives exchanges. Under the plan, broker-dealers and bank affiliates could solicit customer orders for exchange-listed futures, as long as all orders and funds flow through futures commission merchants. SEC rules would govern the broker-customer relationship for SEC-regulated broker-dealers, while federal banking rules would govern the relationship for bank affiliates.

An ambitious program indeed. And given the anti-regulatory sentiment fermenting in Washington these days, it’s likely that the plan will get serious attention next year among policy wonks.

In 1996, the Deutsche Terminborse—now Eurex—petitioned the Commodity Futures Trading Commission for special regulatory exemption to allow member firms to place Eurex terminals in their U.S. offices. The request was granted quickly, and it seemed as though the CFTC were amenable to opening up U.S. borders to foreign futures exchanges en masse.

But now, three years later, the foreign-terminal issue has yet to be resolved, Born has become a lame-duck commissioner and the CFTC’s March 16 proposal to address the issue may be her swan song, alienating every relevant party and even CFTC board members to an unprecedented degree. With Born’s tenure in its final days, no one knows for sure what the next twist in the saga will be.

“This is just an outrageous proposal that will inhibit the growth of global futures, and it can’t stand.” —John Damgard

The seeds of the problem lay in the Eurex exemption. Since then, several other foreign boards of trade have petitioned for similar regulatory relief, to no avail, and last year the CFTC decided to freeze new applications until it examined the situation more closely. In July 1998, the commission issued a concept release that sought public comment on the issue. Then on March 16 of this year, the commission proposed a radical new rule to establish an exemption procedure to allow foreign terminals in the United States.

Optimists hoped that a resolution to the issue was in hand, but, amazingly, the proposal managed to ruffle the feathers of every party involved—including the other CFTC commissioners. The proposal’s goals seem entirely reasonable at first glance. The commission stresses that it supports technological innovation and doesn’t want to make conditions “unduly burdensome” for U.S. customers. But it also argues that it “has an obligation to obtain and to review certain basic information, [including] a board of trade’s regulatory structure, its automated trading systems and the extent of its contacts and operations in the United States. Likewise, in an era where fully computerized exchanges are becoming common, the commission has an interest in ensuring that operators of these exchanges are not using developments in technology and global communications to evade U.S. regulatory requirements.”

The proposal seeks first to make sure that foreign boards of trade are subject to a bona fide regulatory system that is “generally comparable to that in the Untied States,” to protect U.S. customers from fly-by-night operations. The commission is also considering a provision requiring that “the automated order-matching/execution system of contract markets, linked exchanges or boards of trade…have the ability to provide pre-execution credit and trading or position-limit screening.” In addition, it is seeking to review the technological soundness and security of the trading systems used by foreign exchanges.

Perhaps the most controversial element of the plan is the commission’s refusal to require reciprocity from the home country of a foreign futures exchange for U.S. exchanges—an element that has U.S. exchanges hopping mad. “This is just an outrageous proposal that will inhibit the growth of global futures,” snarls John Damgard, president of the Futures Industry Association, “and it can’t stand.” The CFTC cites free-trade rules found in the North American Free Trade Agreement and the General Agreement on Trades and Services as the rationale for its decision. But U.S. exchanges argue that, without reciprocity, they could be forced to operate on an uneven playing field.

The plan’s ambitiousness has made overseas exchanges uneasy as well. “Every page [of the proposal] means ‘no’ to us,” says Brian Williamson, the chairman of Liffe. “We have faced procrastination and now complications. From our point of view, this is another injustice. This is protectionism.” Williamson says it’s clear that, if the proposal is passed, Liffe won’t be able to put its terminals on U.S. soil until next year.

Endgame

Born’s tenure may be coming to an end, but her grip on the reins of power is tightening. Shortly after the March 16 proposal was released, the CFTC announced that, following a 30-day public comment period, there would be a special roundtable discussion in Washington on April 20 in which industry leaders and CFTC commissioners could discuss the issue. On March 30, CFTC commissioner Barbara Holum sent a memo to Born and the other commissioners outlining a two-track approach. “Under the first track,” she wrote, “foreign boards of trade could seek authorization to place terminals in the United States on a case-by-case basis pursuant to the standards applied in the Eurex terminals no-action process. Under the second track, deliberation regarding the adoption of final guidelines could proceed independently, providing the public and regulated industry with adequate time to consider and debate the issues.”

Holum’s memo notes that her proposal “will permit an opportunity for access to the U.S. markets immediately while allowing time for an extended deliberation at the upcoming Commission roundtable discussion.” Apparently, Born had another conception of the roundtable. At the April 20 meeting, Born reiterated her proposal, while panel members, including U.S. exchange representatives, technology experts and traders, picked it apart. Then, at the end of the meeting, came a curious twist of events. After watching the proceedings silently, Holum stood up to present an entirely different proposal to level the playing field for U.S. and foreign exchanges. Born didn’t let her continue, and concluded the four-hour discussion without any closing remarks. “I’ve never heard of anyone managing a meeting like that,” Holum complained to reporters afterward. “I don’t even know what’s going to happen now.”

Holum says she plans to meet with the other two commissioners—the CFTC has four, including Born—to try to figure out a way to stymie the plan. “I really shouldn’t speak for the other members,” she said following the forum, “but I have a strong feeling that I’ll be backed.”

With Born’s days numbered, and with Holum reported to be a front-runner to replace her, the latest plan may indeed fall by the wayside. At least that’s what futures exchanges and traders around the world are hoping.

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