In September, various derivatives industry luminaries testified before the Senate Agriculture, Nutrition and Forestry Committee on the ways electronic trading has affected the markets, and what the appropriate level of regulation is under the Commodity Exchange Act. The testimony gave committee leaders, as well as new Commodity Futures Trading Commission chairman William Rainer, plenty to think about before CEA reauthorization hearings heat up in 2000.

Committee chairman Richard Lugar (R-Ind.) kicked off the festivities by arguing that “in some ways, electronic exchanges may deserve a lighter regulatory structure than traditional exchanges due to their ability to match trades in a neutral manner and maintain audit trails that can pinpoint trades to the second. However, technology also has the potential to open these markets to anyone with a home computer and a phone line. In recognizing this trend, Congress needs to be assured that adequate oversight exists to protect less sophisticated retail customers from Internet fraud and abuse.”

Chicago Board of Trade chairman David Brennan argued for a newfangled regulatory approach. Operators of an execution facility or a clearinghouse should be subject to clear performance standards designed to prevent manipulation or fraud and to preserve financial integrity, he said, but no specific statutory or regulatory prescriptions should be enacted telling the execution facility or clearinghouse how to achieve those objectives. He proposed that, “If the government believes that the self-regulatory organization is not satisfying the statutory performance standard, it may initiate proceedings based upon fact, not suspicion, ultimately to make the necessary changes or suspend or revoke the self-regulatory organization’s right to do business. The government would retain its current powers to take action in true market emergencies, to take enforcement actions itself against any fraud or manipulation and to maintain financial integrity of firms and markets.”

“Electronic exchanges may deserve a lighter regulatory structure because of their ability to match trades in a neutral manner and maintain audit trails.” —Sen. Richard Lugar

Brennan then defined “publicly offered derivatives” as those in which one party makes an offer to multiple counterparties and one of those counterparties is able to accept the offer by clicking a button on a computer or shouting out “I accept” without any further negotiation. Thus, the various over-the-counter “execution facilities” that have popped up in the last year trade what the CBOT calls publicly traded derivatives. “Exchanges, like the CBOT, were the first execution facilities years ago; now there are a variety of execution facilities in existence…” he said. “The use of an execution facility for a transaction should trigger coverage under the [Commodity Exchange Act].”

Later, Shawn Dorsch, president of DNI Holding, which runs the Blackbird system, took the opposite tack. He argued that Blackbird isn’t an exchange or a clearinghouse, but simply an electronic version of a voice broker. Through Blackbird, he argued, a dealer can circulate to other Blackbird participants the vital facts reflecting its own proposed transaction, or it can review other dealers’ invitations to negotiate. The system helps a dealer find a transaction that matches the dealer’s needs and gives the dealer a means of communication to negotiate and agree on the basic economic and other terms of the transaction. “Use of Blackbird,” he said, “will promote competition, improve transparency, record-keeping and risk control, and reduce costs. Blackbird will bring substantial private and public benefit, without changing any meaningful feature of custom-tailored swaps activities as they currently operate, and without creating any need for novel regulation.”

With such lines being drawn in the sand, former CFTC chairman Phillip McBride Johnson recommended that, instead of scrapping current rules under the CEA, the Senate should draft a new “chapter” of the CEA to take effect when the U.S. markets complete their inevitable changeover to screen-based, publicly owned electronic trading systems.

The content of the new provisions, he said, should focus on the fairness and reliability of the trading system itself; monitoring of the market against intentional disruptions; managing credit risks; and whether to impose regulatory requirements on end-users.

With the onslaught of electronic trading systems likely to continue for some time, the Senate Ag Committee clearly has its work cut out.

Melamed Says Reform Shad-Johnson Now Leo Melamed, chairman emeritus and senior policy adviser at the Chicago Mercantile Exchange, offered his views on the Shad-Johnson Accord in testimony before the Senate Agriculture, Nutrition and Forestry Committee on September 23. The following is excerpted from that testimony. I am the author of one and one-half science fiction books. Unfortunately, it is this…qualification that is most helpful in explaining the current status of our efforts to reform the Commodity Exchange Act and the Shad-Johnson Accord. New exchange entrants have scrambled to avoid a consistent, logical definition of exchanges that would subject them to CFTC jurisdiction. Those efforts have been matched by the efforts of SEC-regulated exchanges to avoid a long-overdue reformation of the Shad-Johnson Accord. The options exchanges are intent on denying their customers the freedom to trade a single futures contract on a narrow index or an individual equity. Under current law, public customers who want to trade a future on an equity need to go over-the-counter or do a synthetic future through the facilities of an option exchange. A synthetic future requires two transactions at twice the commission and four times the cost of a simple future to achieve an identical result. Seventeen years ago, Shad-Johnson attempted to provide a temporary resolution to a jurisdictional conflict between the SEC and the CFTC. It is rank science fiction to apply it as a permanent barrier to innovation and growth, as has been the case. Stock index futures, the most successful of which was launched at the CME in 1982, have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements. The options markets and swaps dealers offer customers risk management tools and investment alternatives involving both sector indexes and single-stock derivatives. Ironically, futures exchanges, which pioneered and advanced this innovation, have been frozen out. The reasons advanced against reform of Shad-Johnson disguise competitive and/or political concerns. Today, Shad-Johnson is being used as a weapon against competition. The SEC, through statutory misinterpretation—and what the U.S. Court of Appeals for the Seventh District recently has found to be at best an “arbitrary and capricious” and at worst a “suspect” application of its powers—has denied futures exchanges the right to trade futures on stock indexes that reflect price movements in substantial market sectors. The SEC has taken the position that futures could not be traded on the Dow Jones Utilities and Transportation Averages because they did not “reflect” the utilities and transportation sectors, respectively. The aforementioned court decision has overturned and vacated that SEC decision, finding: “The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves…The Securities and Exchange Commission, which regulates stock markets, has sided with its clients.” The Shad-Johnson ban on single-stock futures was understood by Congress to be temporary. The Court of Appeals found that the ban “was a political compromise; no one has suggested an economic rationale for the distinction.” In the absence of such a rationale, Congress should lift the single-stock futures ban and allow the marketplace to decide whether these instruments would be useful new risk management tools. Many exchanges around the world trade single-stock futures; no reason exists to deny U.S. markets the opportunity to offer this product as well. Finally, we need to deal with the groups that want to expand the exemption created by the Treasury Amendment. That provision was engrafted on the CEA to prevent the CFTC from taking jurisdiction over private transactions in foreign currencies and U.S. Treasury Securities that were negotiated between sophisticated banks and their customers. The Treasury Amendment preserved jurisdiction over any transactions in those commodities that were executed on a board of trade like the CME or the CBOT. That reservation of jurisdiction is the basis for the CFTC’s jurisdiction over both exchanges. The exchanges’ proposal to reform the CEA expanded the basic principle of the Treasury Amendment and applied it to all products traded by means of privately negotiated transactions. In effect, our proposal created a bigger and better Treasury Amendment by giving the exact same exemption to all products. We were stunned when this offer of reform was met with cries of consternation. The lawyers for certain associations, dealers and banks discovered that their clients had hoped to rely upon the Treasury Amendment as an exemption to permit them to operate electronic exchanges for trading derivatives involving Treasury securities and currencies. Such an interpretation of the Treasury Amendment is again science fiction. Nothing in the Treasury Amendment says it exempts derivatives exchanges in Treasury Amendment products. For the complete text of Melamed’s testimony, see www.senate.gov/~agriculture/mel99923.htm.

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