Re: Implementation of the Commodity Futures Modernization Act of 2000
June 19, 2003
Thank you, Chairman Moran, and members of the Subcommittee. I appreciate the opportunity you have given me to testify on behalf of Chicago Mercantile Exchange Inc. I have had the honor to serve as Chairman of CME since April of 2002. This has been a time of growth and change for our exchange as it continued its steady evolution from its origins in 1874 as an agricultural traders' club into one of the world's most innovative and high-tech financial exchanges. On Dec. 6, 2002, we completed our initial public offering and became the first publicly traded financial exchange in the United States - listing our stock on the New York Stock Exchange.
This has also been a very challenging political and economic period for our country and the world. In these uncertain economic times, we at Chicago Mercantile Exchange strive to fulfill the essential role of helping institutions, corporations and individuals around the globe efficiently manage their financial risk.
The CFMA: Successful landmark legislation:
In the judgment of CME, the Commodity Futures Modernization Act of 2000 (CFMA) represents successful landmark legislation that materially and beneficially reformed some of the nation's most important financial markets. Our futures markets are substantially stronger and more vibrant today as the direct result of Congress' enactment of the CFMA and, equally importantly, the CFTC's judicious and deliberate implementation of those reforms. Innovation has been encouraged and made less costly and more rewarding. The time between conception of a new product or trading system and its implementation has gone from years to days. Today, the vast majority of CME's investment in innovation is for improvement and testing rather than paperwork and bureaucratic review.
I want to highlight some of our many achievements under the CFMA regime and indicate some important initiatives now under way by CME.
- During 2003, our volume continues to grow. So far in 2003, CME's average daily volume has increased more than 12 percent over the same period in 2002. During June thus far, our average daily volume has exceeded 3 million contracts, a healthy 43 percent increase from the 2002 average daily volume.
- Our open interest last week reached an all-time record of more than 25 million contracts. Open interest is the number of futures and options contracts outstanding at the close of trading each day and is a widely recognized indicator of the level of customer interest in an exchange's products. We are proud to have the largest futures and options on futures open interest of any exchange in the world.
- CME solidified its position as the largest futures exchange in the United States and the second largest exchange in the world for the trading of futures and options on futures, based on trading volume.
- GLOBEX® volume has grown from hundreds of contracts per day to more than one million contracts per day, while the open outcry trading floor continues to serve its core customers who prefer that trading venue.
- GLOBEX continues to grow, representing approximately 44 percent of our total volume in the first quarter of this year.
- CME's E-miniTM S&P 500® futures contract reached a new record of 116 million contracts in 2002, an increase of 194 percent from the prior year. Our E-mini S&P remains the fastest-growing product in the history of CME.
The latest major development at CME is the recently signed definitive agreement with the Chicago Board of Trade to establish the CME/CBOT Common Clearing Link. Under this agreement, CME will provide clearing services for all CBOT products beginning on Jan. 2, 2004. We expect that the CFTC's regulatory review will be efficient and expeditious, free of the time-consuming processes that would have been standard prior to the CFMA. Naturally, we also expect the CFTC to grant all regulatory approvals in order to maintain our targeted roll-out date of Jan. 2, 2004.
This historic transaction between the two largest futures exchanges in the United States will give our clearing firms and customers significant operational, margin and capital efficiencies. We are delighted to unite with the CBOT to offer the customers of our exchanges exactly what they have told us they wanted. By clearing CME and CBOT products through our Clearing House, we can offer extended portfolio margining. In other words, we will recognize the positions held at both exchanges and reduce performance bonds as appropriate. This exemplifies our efforts to provide value to our customers and shareholders at the same time. This new clearing agreement also signals CME's ability to provide transaction processing services to third parties.
The Common Clearing Link agreement with the CBOT is one of the many important items on CME's agenda, which includes several other important initiatives of which the Subcommittee should be aware:
- CME is focused on expanding the range of execution choices we offer our customers, including increased electronic trading. Our foreign exchange complex enjoyed great success in 2002. Trading was up 8 percent from 2001, with GLOBEX trading increasing 115 percent in this product line. In response to customer demand, on Jan. 26 of this year, we launched our Eagle Project, which enables implied electronic calendar spread trading of Eurodollar futures on GLOBEX.
- As a result of the rationalization of product introduction permitted by the CFMA, CME is building on its heritage of innovation by adding new products and services to address current and emerging risk management needs. Innovation is a hallmark of this exchange, and our passion for innovation is as strong today as ever.
- In addition, we will continue to collaborate with our clearing member firms to ensure constructive dialogue and the pursuit of mutually beneficial industry growth opportunities. Specifically, we are focused on streamlining operations and increasing efficiencies to benefit our important FCM community that participates in our markets. To that end, we are diligently working on several fronts, including:
- Cost reductions;
- Straight-through processing and standardization;
- Further improvements on GLOBEX; and
- Collateral flexibility for our clearing member firms.
Rather than detracting from our ability as an effective self-regulator, CME's incentives and capability to maintain an effective program of self-regulation have been enhanced by its reorganization as a for-profit public company. The regulatory staff's independence and empowerment has been cemented by this new corporate structure and the reporting lines that have been implemented. CME is subject to the disclosure and reporting requirements imposed by the Securities Act of 1933 and by Securities and Exchange Commission regulations. CME's ownership base has been expanded to include institutional investors. Professional securities analysts who are unaffiliated with CME and/or its bankers follow every action of the company. Any failure to maintain and effectively implement prudential regulatory programs will cause these analysts and shareholders to adopt a negative view of our performance, and our stock price could decline. The scrutiny of these shareholders and analysts further ensures that we have sufficient inducement to maintain the effective regulatory programs that are so critical to our brand name and our success.
Single Stock Futures: CFMA's Unfulfilled Promise
The CFMA broke new and important ground in authorizing the trading of single stock futures. The discussions between the CFTC and the SEC with regard to the regulatory regime pertaining to single stock futures have taken a considerable amount of time, and we understand that the agencies believe they are coming to the end of that process. Undoubtedly, the depressed state of the equity markets has contributed to the modest initial trading of single stock futures, but we believe that with a resurgent stock market, interest in single stock futures will materially increase. Overall, we remain confident that the CFMA's authorization of single stock futures was wise public policy, and the removal of legal prohibitions on that product was a significant positive development.
Nonetheless, we want to bring to the Subcommittee's attention to what we consider to be a very important problem we have experienced in the initial efforts to bring single stock future products to market. If unaddressed, this problem threatens to undermine Congress' intent in the CFMA that exchanges not be burdened by duplicative regulation.
Our experience as a notice registered security exchange and our view of the regulatory burdens to which our joint venture, OneChicago, has been subjected, lead us to question whether the CFMA provisions respecting joint jurisdiction over exchanges that trade security futures products are being misapplied by the SEC. After a protracted effort to list a security futures product, CME withdrew its submission rather than subjecting itself to confusing and costly dual regulation.
This is not the venue in which to retell in detail this long story. In brief, Congress granted the CFTC and SEC jurisdiction over exchanges that list and trade security futures products, but clearly determined that an exchange's principal registration status should decide which agency should take the lead. In the case of CME and OneChicago, the CFTC is the primary regulator. The SEC has asserted authority that effectively puts it on a par with the CFTC and creates a system of active dual regulation contrary to the clear intent of Congress.
The SEC and CFTC negotiated an "abrogation" provision for use by the SEC based on a clearly expressed understanding that it was to be used only in dire circumstances after full review of exigencies by and a majority vote of the SEC Commissioners following consultation with the CFTC Commissioners. Congress mirrored this understanding in Section 19(b)(7)(C) of the '34 Act, which provides:
"the Commission, after consultation with the Commodity Futures Trading Commission, may summarily abrogate the proposed rule change and require that the proposed rule change be refiled in accordance with the provisions of paragraph (1), if it appears to the Commission that such proposed rule change unduly burdens competition or efficiency, conflicts with the securities laws, or is inconsistent with the public interest and the protection of investors." (emphasis supplied)
It was expected that there would be no abrogation without Commission-to-Commission negotiation. Nonetheless, on Aug. 20, 2001, without hearing, notice or prior publication, the SEC delegated complete authority to its staff to abrogate rule changes of security futures exchanges that were primarily regulated by the CFTC. The SEC's delegation order included an explicit finding in accordance with Section 553(b)(3)(A) of the Administrative Procedure Act, "that these amendments relate solely to agency organization, procedure, or practice, and do not relate to a substantive rule." Yet, SEC staff has determined that the delegation was not ministerial - it transferred the SEC's power and authority to the staff. The delegation of authority to abrogate includes a delegation of authority to the Director of Division of Market Regulation to make the prerequisite statutory findings. The delegation of authority to abrogate implicitly includes the delegation of power to the Director of Division of Market Regulation to conduct consultations with the Commodity Futures Trading Commission. This delegation appears contrary to the understanding under which Congress permitted the SEC to retain such abrogation authority over security futures rules.
SEC staff has consistently asserted authority to rewrite the terms and conditions of new security futures contracts and the trading rules for such products based on its power to abrogate such rules if the exchange did not accede to all of the SEC staff's comments and "suggestions." A new contract cannot be launched if the potential for abrogation is in place. The SEC staff has converted its delegated abrogation authority into the power to act as the primary regulator with respect to the content of all new contracts and trading rules relating to security futures. The SEC is also in the process of taking over the review and oversight role of the CFTC by asserting the right to audit all functions of an exchange that trades security futures products.
Despite Congressional intention to permit exchanges to self-certify new contracts, the consequences of opening trading in the face of an abrogation threat are so severe as to give SEC staff de facto power to reinstitute a "pre-CFMA" regime requiring prior SEC approval of all rules and rule amendments. The SEC staff used threats of abrogation to impose wording differences for rules that would have created meaningless inconsistencies between CME rules for broad- and narrow-based index products - such as those for Final Settlement Prices. Such inconsistencies are likely to create confusion during emergencies (e.g., in 1999 when Hurricane Andrew almost prevented the opening of the NYSE on triple witching day; in the immediate aftermath of 9/11/2001). The SEC staff threatens to abrogate new contract rules based on an economic model for speculative position limits for cash-settled futures that is untested, not public and that produces limits that are not rationally related to similar products' limits. The SEC staff frequently insists on non-substantive changes that create inconsistent wording within the over all rulebook and may cause confusion when rules that should have the same meaning and purpose are worded differently.
We cannot list and trade security futures products without recognition from the SEC and CFTC that the concept of "listing standard" does not include the terms and conditions of a contract and that the exemption from filing rules contained in CFMA Section 6(g)(4)(B) is operative. We also need assurance from the SEC and CFTC that the SEC will not duplicate the inspection and monitoring functions of the CFTC simply because a futures exchange lists a securities futures product as a Section 6(g) exchange.
Fixed Income Futures: CFMA's Orphan
While we applaud the many improvements made by the CFMA's rewrite of the Shad/Johnson Accord and other major parts of the CEA, there is one area in which it was a step backward, or at best a step sideways. That is the areas of index futures on non-equity securities. The rules distinguishing between broad-based and narrow-based security indexes apply to all securities, but were drafted without clear consideration of the significant differences in size and trading velocity between equities and fixed income securities. The U.S. fixed income securities are not typically traded on organized exchanges, and their trading volume is significantly smaller than stock volume. The CFMA does not distinguish between the two very different classes of securities, with the result that the same criteria are applied in determining which cash instruments can be the basis for futures contracts.
It is almost universally accepted that exchange-traded futures and options are complementary to cash products, and can lead to significant improvements in transparency and liquidity in those cash markets. Market regulators are concerned about the lack of liquidity and transparency in U.S. fixed income markets and have made some efforts to improve the situation, with mixed success. Therefore, it is tragic that the distinctions drawn for equity markets are a great deterrence to listing futures on indexes of corporate bonds, security-based swaps and other fixed income-related instruments.
We urge Congress, the CFTC and the SEC to use all available means to remedy this situation.
Recent Issues Involving Importation of Cattle:
Country of Origin Labeling (COOL) is part of the 2002 Farm Bill. It will require, among other things, all meat sold at retail (grocery stores) to carry a label showing the country (or countries) in which the animal was born, raised and processed. This labeling requirement becomes effective on Sept. 30, 2004, and retailers are subject to a $10,000 fine for each violation.
In response to these labeling requirements, retailers are holding their suppliers (meat packers & processors, among others) responsible for meeting these same recordkeeping and documentation requirements, and in turn the packers are holding their suppliers (livestock producers) responsible. While we are aware of the ongoing controversy among affected elements of the industry as to whether Congress should revisit COOL - perhaps delaying or modifying the provision or even repealing it - under the current circumstances, CME will need to bring our Live Cattle contract into compliance with COOL. However, proposed regulations will not be available until September 2003, and final regulations will not be available until sometime in early 2004 at the earliest, and possibly Sept. 30, 2004 (the date the law goes into effect) at the latest. The October 2004 Live Cattle contract - the first one for which deliveries would be subject to COOL - is scheduled to be listed on Sept. 2, 2003 - at least several months, and maybe a full year, before the final regulations become available. The long and uncertain "gap" between normal listing dates and final regulations means that if we chose to delay listing until there is certainty we would have few, or no, contract months listed for trading while we wait for the final regulations. Even in the best-case scenario - final regulations issued in January 2004 - there would be only four of the regular contract months listed for trading, versus the normal seven months. In addition to these timing issues, there are several contract design issues that will need to be resolved, but this will be difficult without the final regulations and some indication about how the market will differentiate between certified and uncertified cattle and between purely domestic and imported cattle. Significant issues respecting deliverable supply may result.
A further complication is the possibility that COOL could be revised, postponed or rescinded between the time final regulations are issued (and CME contracts are listed based on those regulations) and Sept. 30, 2004. This would cause the contract specifications to be totally out of sync with cash market practices, and likely require Emergency Action to correct the situation.
CME looks forward to working with the CFTC to come to the most efficient response to the several serious challenges raised by the COOL mandate. We will keep the Subcommittee informed on developments as we proceed.
New Concerns Not Addressed in the CFMA: Foreign Ownership or Control of a U.S. Exchange.
CME strongly supported the CFMA and its philosophy of expanding our opportunities to compete while simultaneously challenging us by permitting new market structures and easing barriers to entry of new competition. As much deliberation as Congress gave the CFMA over the several years preceding its enactment, no consideration was given to the question of foreign control of a U.S.-based derivatives exchange. CME welcomes fair competition from all sources but is concerned that the CFMA's lack of specific focus on foreign ownership may be taken as a signal that significant issues arising out of such control are irrelevant to the statutory standards for designation of a contract market.
For example, it is a legitimate concern that: 1) a foreign exchange that generates profits under a system that protects it from significant competition will use those profits to subsidize efforts to capture U.S. markets; 2) market entry would be by means of abusive practices such as payment for order flow; 3) foreign ownership could impair the effectiveness of the CFTC's emergency authority - especially where the emergency results from the governmental action in the jurisdiction of the foreign owner; and 4) restrictions on trading by an exchange's officers or directors are of limited utility when such persons are foreign nationals beyond the reach of U.S. jurisdiction. Neither the CEA nor existing CFTC regulations even require a foreign company with more than 10 percent ownership of a U.S. exchange to meet any qualification requirements.
This list is illustrative, but by no means exhaustive. Where the issue of who owns the exchange raises legitimate and perhaps novel public policy issues, ownership becomes a material element of the application. Those public policy issues should be given due consideration by the Commission under the aegis of its public interest authority.
Conclusion:
The enactment of the CFMA has brought a wide variety of constructive and beneficial reforms to the regulation of America's derivative markets. The nation and all the market participants, including CME, are better off as a result of the CFMA. The CFTC has administered the CFMA responsibly, but new challenges remain to be addressed if the full promise of the CFMA is to be realized. We look forward to continuing to work with the Congress and the CFTC in finding appropriate answers to these challenges
