When I was reviewing my remarks at home, one of my sons walked into the room and asked me what I was doing. I then asked him if he knew how many great speakers there are in the world today. He stopped to think about it for a second, and then said, "Dad, there is one less than you think." So I will heed the words of a wise man who once said, "Just remember, to be immortal does not mean your speech has to be eternal."
I am pleased to be following Jim Newsome, who has done an outstanding job as Chairman of the Commodity Futures Trading Commission. Under Jim's leadership and that of past CFTC Commissioners and members of Congress, the Commodity Futures Modernization Act of 2000 was passed. This legislation encourages our industry to seek market-driven business solutions, and it is incumbent upon institutions such as the Chicago Board of Trade to operate within the context of this legislation.
As a leader of a regulated exchange, I know my decisions do not always please everyone, and I am sure there are many here who have had similar experiences. When I face a tough decision, I think about Secretary of State Colin Powell's first lesson of leadership, which I would like to share with you. It reads as follows:
"Being responsible sometimes means pissing people off. Good leadership involves responsibility to the welfare of the group, which means that some people will get angry at your actions and decisions. It's inevitable, if you're honorable. Trying to get everyone to like you is a sign of mediocrity. You'll need to avoid the tough decisions, and you'll avoid confronting the people who need to be confronted."
Today I want to talk to you about the value propositions of the Chicago Board of Trade and share some of the tough decisions we have made on critical issues which ultimately enhance our core values of integrity, transparency, and innovation. Specifically, those involving our electronic trading platform, clearing provider and our fee structure.
The Chicago Board of Trade closed 2002 with its best year ever in terms of volume and the first four months of this year showed no signs of letting up with volume up over 33 percent from a year ago. Our hybrid business strategy of offering the best open auction and electronic trading platforms is working, as evidenced not only by our increased trading volume, but also by a stronger balance sheet and higher seat prices.
Joe Paterno, the football coach at Penn State, once said, "The will to win a competition is important, but the will to prepare is vital." At the Chicago Board of Trade we have always welcomed fair competition, but more importantly, we have always prepared for it. We have no magic formula, but our success to date is a function of our market model, liquidity providers, product portfolio, pricing strategy, and customer choice of access. This combination of factors enabled the CBOT® to secure a formidable competitive position; one that will allow for an aggressive posture against threats from other market models.
To date, the Chicago Board of Trade has defeated aggressive threats to our core interest rate products by new market entrants and other market models with trading practices that potentially threaten our core values of integrity, transparency, and innovation.
We will continue our pursuit of these values as a competitive advantage and do so in the wake of significant change and uncertainty.
Public confidence in Corporate America is as low as I have seen it in my entire career in this business, and the reasons are splashed across the headlines of the daily newspapers and hourly on networks such as CNBC. Conflicts of interest and greed have led to general distrust and lower consumer confidence. These themes continue to challenge the ability of our nation?s economy to recover from its current doldrums. Former Treasury Secretary Paul O'Neill perhaps captured the sentiment of the American public at the height of this market distrust when he said, "I think the people who have abused our trust, we ought to hang them from the very highest branches."
While bringing back the law of the Old West may sound good, realistically speaking we must focus our energies on restoring customer confidence in market regulation and business generally. We have been asked many times whether an Enron-type debacle could occur at the Chicago Board of Trade. Our response is no, due to the strict financial safeguards we have in place and our strict adherence to the Commodity Exchange Act. We have unsurpassed financial surveillance programs in place that continuously monitor the financial conditions of our member firms and their ability to comply with their obligations to their customers.
I recently saw an interview by Warren Buffett on CNBC where he was asked about his comments that derivatives were what he called "weapons of mass destruction." While Mr. Buffett reiterated his views on the perils of unregulated derivatives, he made clear the distinction with exchange-traded derivatives, noting that exchange-traded derivatives require the posting of performance bonds and other forms of collateral that protect them from exploding. More recently, we heard Federal Reserve Board Chairman Alan Greenspan say that the increased use of financial derivatives has been a boon to the United States. Further, these gentlemen have expressed confidence and support in the overall risk transfer and management process of the regulated futures industry, particularly as it pertains to transparency and pricing.
Integrity has been the watchword at the Chicago Board of Trade for 155 years. Our combination of open auction and electronic match platforms provides open communication and level playing fields with unprecedented speed and efficiency. In the interest of maintaining market integrity, we have made the necessary commitment and financial investments to improve our overall business model, including our decision to transition to LIFFE CONNECT® for our electronic platform, and the further development of our handheld technology for our open auction market.
Over the past year, our economy has been deluged with numerous reports of illicit trading practices, government investigations and conflicts of interest. Reporters and politicians alike ask the same question, how can we have a sustained recovery if there is investor mistrust?
Investigations into Enron and CMS Energy, among others, examined fraudulent power deals with wash trades designed to fool investors and others about the size of their businesses. According to news reports, Enron created a bogus trading room to show to potential customers. CMS Energy reportedly admitted that most of its volume in electricity trading in 2000 and 2001 resulted from sham trades without economic value. Such admissions cast substantial doubt on the reliability of opaque markets.
Opaque trading and conflicts of interest result in illegal activities at worst, and improperly functioning markets at best. Unlike major stock and commodities markets, these markets operate with little or no government or regulatory oversight and are difficult for customers and other market participants to monitor. The end result has seen increased investor wariness in both the regulated and unregulated markets, heightened interest in legislating a solution, and unprecedented change in U.S. financial markets generally.
At the Chicago Board of Trade, we continue to drive revisions to our business model and operating practices in order to insure that the needs of our customers and members are fulfilled in this period of change. In this regard, we continue to operate as an independent provider of risk management services; an enterprise driven by the need to achieve and maintain a liquid marketplace. An enterprise that has institutionalized the risk transfer process by providing an open and transparent market structure.
Integrity, transparency and innovation are the cornerstones of our business strategy. They are exhibited daily and provide value to our members, our liquidity providers, and our customers.
Integrity. One of the most critical issues for our markets is investor confidence and the avoidance or elimination of conflicts of interest. Simply put, the customer must always come first.
Market integrity excludes self-interested behavior, whether it comes from analysts hawking investment banking services or accountants influenced by consulting fees. We have seen and read stories of business executives manipulating the books and lying about the results in order to pump up stock prices. Investors and regulators have rightly focused on these practices, hopefully to stop them and to jail the wrongdoers.
But there are more subtle threats attacking the fairness of our markets. These threats occur when firms want to go beyond acting as an agent for a customer, and instead attempt to profit from the customer order in a way that the customer does not see.
"Internalization" is a benign sounding term that means that the customer's agent buys or sells the customer's order for himself and does so away from a centralized market. A related practice, "payment for order flow" means that the first broker can sell the customer order to another broker who trades against it.
These concerns about market integrity came through loud and clear in a letter by former SEC Chairman Harvey Pitt to the five security option exchanges. Mr. Pitt said, "I am seriously concerned that economic inducements to order flow providers and internalization by member firms create serious conflicts of interest that can compromise a broker's fiduciary obligation to achieve best execution of its customers' orders." Mr. Pitt went on to say that payment for order flow and internalization of order flow by firms "can discourage competition for orders among market makers" and "have the potential to encourage firms to consider their own economic interests over those of their customers."
At a time when investor confidence in the securities markets is at an all time low, bold action and tough decisions are needed to eliminate practices that work to the detriment of investors. Just as the SEC has taken a firm stand against the conflicts of interest affecting securities analysts, accountants and corporate executives for the protection of investors, it should also move to quickly address the conflicts of interest in internalization and payment for order flow.
Throughout its entire history, the Chicago Board of Trade has established and upheld the standard for insuring the highest principles under the Commodity Exchange Act; "the reduction of systematic risk, and the protection of customers and efficient operation of markets." Our self-regulatory practices and associated clearing guarantee have secured a level of customer confidence that is unparalleled in this industry.
This confidence has been earned over time, and was recently highlighted in a positive ruling for the exchange in the 1989 Ferruzzi soybean case justifying its emergency action to protect all users of the marketplace. Judge Wayne Andersen stated:
"Had the Commodity Futures Trading Commission and the Chicago Board of Trade stood by and done nothing--and that would have been the less difficult course and one compatible with their own belief in the integrity of free trade, and therefore, free markets, then damage, perhaps lasting damage, could have rippled through the entire agricultural world from the farmer through the elevator operators and processors, eventually to consumers." Judge Andersen went on to say, "The CFTC and the Chicago Board of Trade correctly exercised their legal power to protect the larger interests. They had a duty and fulfilled it."
Transparency and openness. Transparency means that trades are executed in an open manner for all to see. Each order has the privilege of market makers competing for that order. One of the most important financial surveillance tools we have is continual exposure of orders to competing market makers.
Our business model is predicated on high standards of transparency for all market users; thus ensuring constant exposure of all orders to competing market-makers on both our open auction and electronic platforms. Market openness, with no pre-arrangement of trading, no principal/agent conflicts, and no internalization of order flow, has been a critical value proposition at our exchange. It assures customers that competitive forces will be well informed of market prices so they trade at levels consistent with prevailing market conditions. Our hybrid strategy is working. The CBOT electronic trading platform serves market orders and top month financial trading very well. Complex transactions are best served in our open auction markets. Technology continues to develop, however, it is unable at this time, to provide sufficient capability to support all transaction types.
The Chicago Board of Trade is leading and doing so by preserving a market model that serves broader interests. To my way of thinking, fragmented markets are those that allow and support less than transparent market practices and lend themselves to potential pricing issues. Given the justifiable public outrage spawned by situations like Enron, we firmly believe that customers will continue to value transparency and CBOT's drive to preserve it.
Innovation. An industry-transforming event was the passage of the Commodity Futures Modernization Act. Its purpose was to give the U. S. futures exchanges a better chance to respond to competition from the over-the-counter market and international exchanges. The CFMA provided legislation for greater regulatory flexibility and the introduction of security futures products.
Under Jim Newsome's leadership, the tone of industry regulation has changed. Decisions are no longer made based solely on inflexible rules. Rather, the regulatory framework seeks to identify and encourage industry best practices and core principles. The approach allows U. S. exchanges to respond to ever-changing customer demand without unnecessary government intervention. The end result has been a collaboration between government and the marketplace for the benefit of the customers.
This legislation enables the CBOT to further develop innovative practices to meet user demand. We must build on our history of innovation and do so in an environment that is marked by unprecedented competition.
Let me quickly describe some clear-cut proactive examples of the level of innovation at the Chicago Board of Trade. We established an overnight open auction trading session in the 80s to meet the demand from our Asian markets and address the competitive threat from Tokyo. We were the first exchange to offer customer choice of access by offering our financial products side-by-side both in the trading pit and on the screen. We recently made a forward-looking decision to select LIFFE CONNECT® for our electronic trading platform due to its superior functionality and capabilities relative to other systems. Together with the Chicago Mercantile Exchange® and the Chicago Board Options Exchange we established OneChicago for the trading of single stock futures. And finally, our decision to work cooperatively with the Chicago Mercantile Exchange to create the CME/CBOT Common Clearing Link is the latest example of our desire and ability to come up with innovative solutions that will serve the needs of our customers.
We are constantly leveraging technology and partnerships to create more cost-efficient means by which users can trade our products. Furthermore, we re-engineered our pricing strategy to aid the liquidity providers on both trading platforms so as to ensure that all categories of market users receive the maximum value from our most important product: liquidity. Providing incentives for those who put their capital at risk, has resulted in tight and deep markets for the end user. This liquidity allows every market participant to assume or eliminate market exposure quickly and at a fair cost.
Further, we expend significant resources to develop, launch and market our new products to current and potential users in an increasingly competitive industry environment where all costs are internalized, yet designs may not be protected.
The Chicago Board of Trade's ability to capitalize on innovation, scale and product success has benefited market users who enjoy the most efficient markets at a low cost.
Now there are some who would like the regulated derivatives exchanges to structure their business models to operate as a utility and serve the narrow interests of a few. The development of a dealer driven market or utility, quite simply and directly, will neither promote nor maximize innovation. "Clearing choice," is a current label for this effort. In my mind, clearing choice would limit if not eliminate incentives provided for competitive innovation in the following areas: 1) products; 2) market structure; and 3) technology efficiencies.
Clearing choice would mean that no exchange would have sovereignty over how its markets would operate; each market would be linked with its competitors and subject to the lowest regulatory common denominator. Each market would be forced to share its major resources-- its innovation and market liquidity --with its competitors. It would be like asking each brokerage firm to share its best brokers, customer lists, underwriting arrangements, research departments and technology with each other.
Another objective of the choice clearing advocates is to promote competition for functionally similar products. Let me take a moment to point out several examples where such competition already exists within the futures industry.
The Chicago Board of Trade and the Chicago Mercantile Exchange each offer swap, agency and Eurodollar contracts. BrokerTec has cloned CBOT interest rate contracts. ICE and the Nymex list the same OTC energy contracts. The Merchant's Exchange in St. Louis and the Nymex offer the same energy futures contracts. OneChicago and NQLX provide the marketplace with identical stock futures contracts.
Innovation allows for competitive alternatives. If stifled costs will rise for market users. This increase will be reflected not necessarily in the transaction fees, but in the bid-ask spread, as the focus will shift from a competitive, open and transparent market to one that embraces practices that fragment liquidity. One only has to follow the payment-for-order-flow economic disaster presently undermining the stock options exchanges to understand how costs inevitably increase as fungibility forces marketplace users to think of ways to stabilize profit margins.
Ultimately, the lower margins discourage market makers, drain liquidity, and lead to wider bid/ask spreads. Increased costs and increased risks inevitably mean customers would have to pay more. Whether in the form of higher fees, commissions or margins, customers are likely to be disadvantaged under "clearing choice." And some customers may simply decide that the extra cost and extra risk is a good reason to manage risk elsewhere, through unregulated foreign markets, foreign controlled markets or through over-the-counter derivatives.
That would move more business into what some would call the "regulatory netherworld," the same place where some of Enron's transactions bedeviled its employees, shareholders and creditors.
CBOT time-tested values of transparency and market integrity, would be replaced with potential conflicts of interest and internalized order flow. That is, firms would end up engaging in transactions in a less than transparent manner with delayed reporting. The end result would be that customer orders would not be exposed to the open market and would not benefit from competitive pricing.
We have entered the latter stages of a crisis of confidence in our equity markets; we must weigh the goals of a few against the potential of a similar crisis in our nation?s futures markets.
To summarize, the Chicago Board of Trade endorses regulatory oversight based on guiding core principles. We support continued changes to governance rules that increase participation and competition in the futures industry. Quite simply, we support market solutions over government mandates.
The futures industry's record volume demonstrates that there is a growing recognition by participants that the current competitive centralized exchange environment provides the best combination of integrity, transparency, and global liquidity. We are opposed to re-regulation and prefer instead that the industry continue to allow flexibility in competitive exchange business models and to allow change to occur naturally in response to economic realities.
Keep in mind that we are only asking the futures industry to be true to itself, and to let our history of competitive innovation drive the market models going forward. The Chicago Board of Trade believes that the industry should follow the old adage, "the market and only the market will decide."
Carl Sandburg once defined Chicago in this manner:
"Hog Butcher for the World,
Tool maker, Stacker of Wheat,
Player with Railroads and the Nation?s Freight Handler;
Stormy, husky, brawling,
City of the Big Shoulders."
In remarks a year ago in Chicago, Leo Melamed gave new meaning to Sandburg?s verse when he described Chicago as the:
"Risk Capital for the World,
Innovator, Conceiver of Markets,
Player with Concepts and the Nation's Derivatives;
Stormy, husky, brawling,
City of the Big Shoulders."
Chicago will remain the Risk Capital for the world, the innovator and conceiver of markets, so long as we remember the value propositions upon which these markets were built: integrity, transparency, and innovation.
At the Chicago Board of Trade, we will face some difficult challenges and will make decisions that may not please everyone, but we will stay on course and focus on the key themes of access, products, liquidity and distribution. For us, focus equals success. We know what we successfully provide to our market users and what we choose not to provide. The future of the Chicago Board of Trade will continue to be guided by what we do best, and that value has been and continues to be recognized by our users. We will make decisions for the benefit of the marketplace as a whole, and in the name of integrity, transparency and innovation.
Thank you again for allowing me to be here with you today.
