```

[Senate Hearing 106-907]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 106-907

          CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK''

=======================================================================

                                HEARING

                               before the

                       COMMITTEE ON AGRICULTURE,
                        NUTRITION, AND FORESTRY
                          UNITED STATES SENATE
      SUBCOMMITTEE ON RESEARCH, NUTRITION AND GENERAL LEGISLATION

                       ONE HUNDRED SIXTH CONGRESS

                             SECOND SESSION

                                   ON

          CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK''

                               __________

                             MARCH 20, 2000

                               __________

                       Printed for the use of the
           Committee on Agriculture, Nutrition, and Forestry

                   U.S. GOVERNMENT PRINTING OFFICE
69-315                     WASHINGTON : 2001

_______________________________________________________________________
            For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 
                                 20402
?

           COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

                  RICHARD G. LUGAR, Indiana, Chairman

JESSE HELMS, North Carolina          TOM HARKIN, Iowa
THAD COCHRAN, Mississippi            PATRICK J. LEAHY, Vermont
MITCH McCONNELL, Kentucky            KENT CONRAD, North Dakota
PAUL COVERDELL, Georgia              THOMAS A. DASCHLE, South Dakota
PAT ROBERTS, Kansas                  MAX BAUCUS, Montana
PETER G. FITZGERALD, Illinois        J. ROBERT KERREY, Nebraska
CHARLES E. GRASSLEY, Iowa            TIM JOHNSON, South Dakota
LARRY E. CRAIG, Idaho                BLANCHE L. LINCOLN, Arkansas
RICK SANTORUM, Pennsylvania

                       Keith Luse, Staff Director

                    David L. Johnson, Chief Counsel

                      Robert E. Sturm, Chief Clerk

            Mark Halverson, Staff Director for the Minority

                                  (ii)

  
                            C O N T E N T S

                              ----------                              
                                                                   Page

Hearing:

Monday, March 20, 2000, CFTC Report Entitled ``A New Regulatory 
  Framework''....................................................     1

Appendix:
Monday, March 20, 2000...........................................    41
Document(s) submitted for the record:
Monday, March 20, 2000...........................................   103

                              ----------                              

                         Monday, March 20, 2000
                    STATEMENTS PRESENTED BY SENATORS

Fitzgerald, Hon. Peter G., a U.S. Senator from Illinois, 
  Chairman, Subcommittee on Research, Nutrition and General 
  Legislation, Committee on Agriculture, Nutrition and Forestry..     1
                              ----------                              

                               WITNESSES
                                PANEL I

Paul, Robert C., General Counsel, Commodity Futures Trading 
  Commission, Washington, DC.....................................     2

                                PANEL II

Brennan, David P., Chairman, Chicago Board of Trade, Chicago, 
  Illinois, accompanied by Thomas Donovan, President and Chief 
  Executive Officer, Chicago Board of Trade, Chicago, Illinois...    14
Crapple, George, President, Managed Funds Association, New York, 
  New York.......................................................    29
Downey, David, Executive Vice President, Interactive Brokers LLC, 
  Chicago, Illinois..............................................    32
Lind, Barry, Chairman, Lind-Waldock & Company, Chicago, Illinois.    23
McNulty, James J, President and Chief Executive Officer, Chicago 
  Mecantile Exchange, Chicago, Illinois..........................    15
Wilmouth, Robert K., President, National Futures Association, 
  Chicago, Illinois..............................................    11
Waye, Jan R., Senior Vice President, Cargill Investor Services, 
  Inc., Chicago, Illinois........................................    26
                              ----------                              

                                APPENDIX

Prepared Statements:
    Fitzgerald Hon. Peter G......................................    42
    Brennan, David P.............................................    60
    Crapple, George..............................................    77
    Downey, David................................................    87
    Lee, Peter...................................................    82
    Lind, Barry..................................................    95
    Paul, Robert C...............................................    46
    McNulty, James J.............................................    51
    Waye, Jan R..................................................    74
    Wilmouth, Robert K...........................................    67
Document(s) submitted for the record:
    CFTC (report) A New Regulatory Framework, submitted by Jan R. 
      Waye.......................................................   104

 
          CFTC REPORT ENTITLED ``A NEW REGULATORY FRAMEWORK''

                              ----------                              

                         MONDAY, MARCH 20, 2000

                                       U.S. Senate,
          Subcommittee on Research, Nutrition, and General 
  Legislation, of the Committee on Agriculture, Nutrition, 
                                              and Forestry,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 10:05 a.m., in 
room 2525, Dirksen Federal Building, 219 South Dearborn Street, 
Chicago, Illinois, Hon. Peter G. Fitzgerald, Chairman of the 
Subcommittee,) presiding.
    Present or submitting a statement: Senator Fitzgerald.

OPENING STATEMENT OF HON. PETER G. FITZGERALD, A. U.S. SENATOR 
 FROM ILLINOIS, CHAIRMAN, SUBCOMMITTEE ON RESEARCH, NUTRITION, 
   AND GENERAL LEGISLATION, OF THE COMMITTEE ON AGRICULTURE, 
                     NUTRITION AND FORESTRY

    The Chairman. This hearing will come to order. This is a 
hearing on the Subcommittee on Research, Nutrition and General 
Legislation of the U.S. Senate Committee on Agriculture, 
Nutrition and Forestry.
    The purpose of the hearing is to examine proposed 
regulations that may be coming forth from the Commodity Futures 
Trading Commission. CFTC has suggested that it is willing to 
grant broad regulatory relief to futures exchanges and create a 
new regulatory--framework.
    I've asked each panelist, instead of reading the prepared 
remarks, to instead summarize their remarks as best they can. 
I'm going to set a good example by sparing you the reading of 
my opening statement which I am now going to ask myself for 
permission to submit for the record.
    And with that, Mr. Paul, welcome to Chicago and please, why 
don't you begin.
    [The prepared statement of Senator Fitzgerald can be found 
in the appendix on page 42.]

STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES 
   TRADING COMMISSION, WASHINGTON, DC., ACCOMPANIED BY PAUL 
            ARCHITZEL, DIVISION OF ECONOMIC ANALYSIS

    Mr. Paul. Thank you Mr. Chairman. I'm pleased to be here to 
testify before you on behalf of Chairman Rainer and appreciate 
the opportunity to discuss recent efforts at regulatory reform.
    I also want to introduce you to my left, Paul Architzel 
from our Division of Economic Analysis who headed up the task 
force that prepared this regulatory framework that we are 
discussing today.
    I will try to summarize my written remarks as briefly as 
possible but I am sure, Mr. Chairman, that you can feel free to 
interrupt me as I go through this with any questions you may 
have and I'll leave time at the end to answer any questions you 
might have.
    Chairman Rainer has identified three public policy goals on 
which the CFTC should focus in regulating derivatives markets: 
first, creating a comfortable climate for competition in all 
sectors of the industry; second, removing any regulatory 
barriers that hamper these markets from fully exploiting 
innovations in technology; and third, decreasing the level of 
systemic risk in domestic and international derivatives 
trading. To achieve these goals it is imperative to modernize 
the way we regulate futures markets.
    Accordingly, a staff task force of the Commission has 
developed a new regulatory framework that would change the 
regulatory structure for derivatives. The proposed framework is 
intended to promote innovation, maintain U.S. competitiveness, 
reduce systemic risk, and protect derivatives customers.
    The new frame work is a work in progress; it is a staff 
document on which there has been no Commission action to date. 
The CFTC intends to hold at least one public hearing on this 
proposal to get as much input as possible from the markets and 
participants. We want to find solutions that serve the public 
interest. But we also recognize that time is not our ally. In 
spite of the difficulty of developing answers to questions of 
regulatory architecture, we must work together to expeditiously 
reach conclusions suitable for these markets and the public 
interest.
    Technology offers us tangible benefits that are either 
immediate or imminent, including faster and better execution; 
significantly lower transaction costs; cross-market clearing, 
netting and offsetting systems; and increased liquidity. The 
U.S. futures industry must embrace technology without 
reservation to build stronger markets if it expects to remain 
competitive.
    Flexibility is the hallmark of the new framework. The 
staff's proposal recommends that the Commission replace the 
current one-size-fits-all regulation for futures markets with a 
structure that would instead apply broad, flexible ``core 
principles,'' which are tailored to match the degree and manner 
of regulation to a variety of market structures and 
participants. Under this proposal, multilateral trade execution 
facilities will operate in one of three categories, taking into 
account the nature of the underlying commodities and the 
sophistication of the customers. While the framework invites 
changes, it does not impose it on established futures 
exchanges. Existing exchanges operating as contract markets may 
reorganize under the terms of the framework, but they are not 
compelled to do so.
    The framework offers the following three basic categories 
of exchanges or trading facilities correlating to a spectrum of 
regulation: recognized futures exchanges, recognized derivative 
transaction facilities and exempt multilateral trading 
facilities. And I want to compliment the Chairman on getting 
those rather accurately in his introduction.
    The category recognized futures exchange [RFE], or an RFE, 
would include multilateral transaction execution facilities 
that permit access to any type of customer, institutional or 
retail, and that trade any type of contract, including those 
that are based on commodities that have finite deliverable 
supplies or cash markets with limited liquidity. Because these 
markets trade markets that may have a greater susceptibility to 
price manipulation and because the presence of non-
institutional traders participating here raise deeper concerns 
for customer protection, RFEs would be subject to a higher 
level of Commission oversight than market in either of the 
other two categories.
    Nonetheless, the proposed RFE offers significant regulatory 
relief compared to the current requirements applicable to 
designated contract markets. Detailed prescriptive rules would 
be replaced with 15 broad ``core principles.'' These include 
principles relating to market surveillance, position reporting, 
transparency, fair trading and customer protection. Any board 
of trade, facility, or entity that is currently required to be 
designated as a contract market would be eligible to qualify as 
an RFE.
    The second category, the derivatives transaction facility 
[DTF], would be subject to a lesser degree of Commission 
oversight. A facility would be eligible to become a DTF if: (i) 
the contracts traded on the facility are for commodities that 
have nearly inexhaustible supplies or for which there is no 
underlying cash markets (e.g., weather derivatives); (ii) the 
Commission determines on a case-by-case basis that the contract 
would be appropriate for this level of regulation; or (iii) the 
facility limits access to commercial traders only.
    A DTF would be required to adhere to only seven core 
principles, including those relating to market oversight, 
transparency, and recordkeeping. Because a DTF either would be 
limited to commodities that are not susceptible to manipulation 
or would limit access to institutional or commercial 
participants, a DTF would not be required to adhere to certain 
other core principles applicable to an RFE such as those 
relating to position monitoring, customer protection or dispute 
resolution.
    Finally, the third category, the exempt multilateral 
transaction execution facility [MTEF], or exempt MTEF, would 
operate on an unregulated basis. This would be a self-
effectuating exemption for transactions among institutional 
traders in commodities that are unlikely to be susceptible to 
manipulation.
    These markets would be exempt from all requirements of the 
Commodity Exchange Act and Commission regulations, except for 
anti-fraud and anti-manipulation. Moreover, if a designated 
contract market elects to trade an eligible contract that 
serves as a sort of price discovery on an exempt MTEF, the MTEF 
would be required to continue to provide pricing information to 
the public. Exempt MTEFs would not, however, be permitted to 
hold themselves out to the public as being regulated by the 
Commission.
    That is a brief overview of the staff's regulatory 
proposal, and I would be happy to answer any questions. Thank 
you again for the opportunity to testify before you today.
    [The prepared statement of Mr. Paul can be found in the 
appendix on page 46.]
    The Chairman. Mr. Paul, thank you, and I think you gave a 
very good, concise explanation of the three different 
categories that would be available.
    Let me ask you the threshold question. I believe in the 
CFTC's report to Congress about these proposals that you 
suggested that you have the ability to implement it through 
your own regulatory powers without any help from Congress. Does 
the CFTC believe that this proposal should or should not be 
codified by Congress?
    Mr. Paul. Well, although we believe that we have proper 
statutory authority under Section 4(c) to adopt these 
regulations without legislation, we do see a benefit in working 
with your Subcommittee and Chairman Lugar's Parent Committee in 
codifying some of the structure. We think that it would perhaps 
enhance the ability to get meaningful legislation adopted that 
would greater legal certainty to the markets.
    The Chairman. If Congress decides to, as we rewrite the 
CEA, codifying the core principles and having three different 
layers?
    Mr. Paul. I am not sure that we would go as far as 
codifying, suggesting that you codify the core principles, only 
because that might detract from the kind of flexibility that we 
hope to achieve through this regulatory framework. But I think 
what we had discussed internally, and I think already 
discussing with Congressional staff, is codifying the 
categories and maybe some of the over-arching concepts without 
necessarily delving into the kind of detail that you would find 
at the 15 core principles for the RFE, or the seven core 
principles for the DTF.
    The Chairman. This proposal would really not depend on what 
type of physical exchange you are, whether you are a pit based 
exchange or an electronic exchange. It would go beyond those 
areas and an electronic exchange could try to qualify 
theoretically to be a recognized futures exchange, I suppose. 
In addition a pit based exchange could at least try to be a 
recognized derivatives transaction facility. And possibly, if 
they are just institutional traders trading commodities with 
inexhaustible supplies and no underlying cash market, a 
traditional pit based exchange could try to become an exempt 
multilateral transaction facility.
    Mr. Paul. I could not have said it any better myself. That 
is the beauty of this proposal. I think the staff, working with 
Mr. Architzel, had their different approaches including those 
that might be based on what the medium is, but we think that 
kind of flexibility that we put into this proposal is of 
greater benefit to the markets. We let the markets choose which 
medium it would like to trade in, and by gearing the 
regulation, calibrating it according to what products and who 
the participants are, we think we can achieve regulatory goals 
without unduly hampering the innovation on the technology side.
    The Chairman. Now, both of the main futures exchanges in 
Chicago, the Chicago Board of Trade and the Chicago Mercantile 
Exchange, are now considering proposals to reorganize 
themselves internally. The Chicago Board of Trade is 
considering creating two separate companies, one that would be 
an on-line company and the other that would be the traditional 
pit based exchange.
    Would a change in these regulations affect the way those 
exchanges might want to be organized? If they decided that they 
wanted to have an RFE, a DTF and an exempt MTEF, would they 
have to have three separate subsidiaries? How would this work? 
Would each have to have a separate legal identity?
    Mr. Paul. The framework currently would call for separate 
entities for different type of structures, but we are 
discussing that, because our interest is making sure that the 
participants know exactly what level of regulation that they 
are engaging in. So therefore, I think the original inclination 
was to have separate entities. But I think that we are 
considering whether or not we want to provide the kind of 
flexibility that may be able to allow a single entity to offer 
different types of markets, as long as it is clear to the 
participants, to the customers, which entity they are trading 
and therefore, what level of protection that they might be 
protected by.
    Mr. Architzel. Just to clarify. Recognized markets can be 
traded under the same legal entity. It is only the exempt MTEF 
that is required to be traded through a separate legal entity, 
because that level is not regulated. So the exchanges would 
have the ability to operate both the RFE and the DTF under the 
same legal entity.
    The Chairman. OK. So that one legal entity could have the 
RFE and the DTF, but if you wanted to have the exempt MTEF you 
would have to have a separate subsidiary or a separate company.
    Mr. Architzel. Exactly.
    The Chairman. OK. That clarifies. That is important.
    Now, to be a recognized derivatives transaction facility, a 
recognized DTF, you say that there would be two main 
requirements: First, only commodities with, nearly 
inexhaustible deliverable supplies, no underlying cash market, 
or contracts that the CFTC allows on an individual case-by-case 
basis could be traded. Secondly, commercial traders would be 
allowed to trade. What do you mean by commercial traders?
    Mr. Paul. I'll try to clarify that. That is either/or, Mr. 
Chairman.
    The Chairman. OK. That is right. So in other words, retail 
customers and that would not be a problem. If they are dealing 
with commodities, such as Euro dollars or foreign currencies, 
commodities a nearly inexhaustible deliverable supply?
    Mr. Architzel. That is correct. Retail customers are 
permitted with special enhanced protection. This DTF is 
intended to be a market mainly for institutional customers. But 
if the market qualifies as a DTF on the basis of the nature of 
the commodity, then it is possible for retail customers to 
access the market if certain conditions are met. Those 
conditions are that the customers trade through a registered 
FCM, that the FCM be a clearing member of at least one RFE and 
that the FCM meet a higher minimum net capital standard.
    The second group of markets that can be a DTF are markets 
which are open only to commercial traders. This type of DTEF, 
which is essentially B-2-B, is only commercial traders is open 
for any commodity. So these are two very distinct types of 
markets.
    The Chairman. OK. So you could envision an agricultural 
commodity being traded in a DTF provided that only 
institutional participants are involved?
    Mr. Architzel. At this point we have not limited the types 
of commodities that can trade on a DTEF, although the staff 
report recommends that the Commission seek comment on whether 
agricultural commodities in particular should be qualified to 
belong in this category. So that is something that we recommend 
that the Commission seek comment on. Agricultural commodities 
have somewhat different characteristics and in the past were 
sometimes treated differently under the regulations. But 
certainly any physical commodity could belong in the DTF 
category and qualify for it, if the market were restricted to 
commercial traders.
    The Chairman. Now, let me just talk about commodities with 
a nearly inexhaustible deliverable supply. Do you fit United 
States Treasury Bonds in that category?
    Mr. Architzel. That is a ``moving target'' right now.
    The Chairman. Because the supply is going down. I mean it 
is 3.5 trillion outstanding right now, but it is scheduled to 
go down to zero by 2015.
    Mr. Architzel. I think that is something that needs to be 
addressed further. We should have guidelines saying what 
commodities fit into this category. And as markets change, as 
commodities change, we could review and revise the guidelines.
    The Chairman. Now, on the exempt multilateral transaction 
facilities, would I be correct to surmise that no retail 
customers could, under any circumstances, be allowed in that?
    Mr. Architzel. That's correct.
    The Chairman. That would be totally institutional. Right 
now the current sections of the CEA that provide the principle 
regulatory framework for the CFTC are Section 5 and 6 of the 
CEA.
    How would the new regulatory framework impact those 
sections?
    Mr. Architzel. The core principles summarize and digest 
most of the provisions in Section 5 and 5a, and would serve as 
a replacement by and large for those individual sections of the 
Act. In other words, sections 5 and 5a of the Act, talk about 
the manipulability of commodities, and there is a core 
principle that relates to that. So the core principle would 
serve as an alternative to that provision of the Act.
    The Chairman. The report recommends, as you have talked 
about, that the current CFTC regulatory framework be replaced 
with the derived four principles that are intended to encompass 
all technology and business organizations. However, the report 
does not address in detail how these principles are to be 
implemented or provide guidelines for industry participants to 
follow.
    Who will determine how industry participants will apply 
these principles and how they will be accomplished?
    Mr. Architzel. The report envisions that the core 
principles will be accompanied by statements of acceptable 
practices or best practices, and those would be interpretive 
statements by the Commission, giving guidance to the industry 
on compliance with the core principles. We also envision that 
the interpretive statements would be written in cooperation 
with the industry and envision that the National Futures 
Association will be providing input to us on those as well.
    I think it is important to note, though, because those 
would be acceptable practices, they would not be exclusive of 
other ways that facilities could come to us and demonstrate 
that they are in compliance with the core principles. That is 
what we are trying to achieve from this framework, as opposed 
to giving the specific prescription as to how they should 
achieve these goals, but leave it open to them. But we give 
them the convenience of knowing if they do things in a certain 
way that creates a safe harbor.
    The Chairman. OK. According to your report, non-
institutional customers require greater market protection than 
institutional or commercial customers. Non-institutional 
customers may be permitted access on both an RFE, a recognized 
futures exchange, and DTF facility, recognized derivatives 
transaction facility, although the core principles for an RFE 
contain provisions for customer protection and dispute 
resolution for non-institutional customers. The DTF core 
principles do not contain such provisions.
    Could you explain the absence of the customer protection 
and dispute resolution provisions in the DTF core principles?
    Mr. Paul. Well, I will start and Paul can supplement it. We 
feel that we can achieve customer protection for the non-
institutional customers trading on DTF by regulating the 
intermediary. And this is frankly a concept that we learned by 
soliciting comments from the industry. And we think that as 
long as we have an intermediary that is a registrant of the 
CFTC, and therefore, is obligated to follow the CFTC rules with 
respect to risk disclosure, segregation of assets, making sure 
that they get the information they need on the markets, that we 
can protect the customer at that level as opposed to doing it 
at the exchange level.
    Mr. Architzel. I think the additional thing to note is that 
although there is not the dispute resolution provision, there 
would be the availability of the CTFC reparation procedures 
which is like a small claims court for customers who feel they 
have been injured by a violation of the Act or regulations. And 
those would remain available to retail customers, because they 
would be trading through registrants.
    The Chairman. You have a lot in your report about the 
segregation of customer funds. If I read it correctly, 
institutional customers would be able to opt out of requiring 
that their funds be segregated; was that how you set this up?
    Mr. Architzel. That is only if the DTF has rules providing 
for that. And in doing so, in providing those rules, they would 
also have to provide for financial disclosure and other types 
of disclosures to market participants on what the effects would 
be by having the opt out allowance.
    The Chairman. If those funds are not segregated and there 
is a problem, it really gets hard to trace, does it not? How do 
you determine whose money was taken, misappropriated or 
misapplied?
    Mr. Paul. Well, I guess we believe that, that is a risk 
that we would allow certain customers to take as long as they 
are fully informed of what the risks are. And that is also why 
we are not recommending that, that be permitted at the 
recognized futures exchange level. And just parenthetically, 
when the task force originally put together this proposal, they 
had another category between the RFE and DTF known as a 
recognized institutional futures exchange, which would be 
somewhere in between the regulatory framework on the spectrum 
of regulation, and that would be created so that institutional 
customers could opt out of seg. We found that there was not a 
real appetite for that in the market. So we thought we would 
simplify it with just the three big markets we have now.
    The Chairman. You figured that the big boys who are 
participating in the markets can take care of themselves. That 
they would probably demand their funds be segregated or have 
those kind of protections that they could handle, is that 
correct? Whereas, a retail customer might not think of that 
issue, is that correct?
    Mr. Architzel. This issue has come up over the years. There 
are foreign exchanges that operate without segregation of 
customer funds, and generally that is available for larger 
customers as an option. Over the years our exchanges have said 
that they would be able to compete more effectively with 
foreign markets if they were able to make adjustments to. So 
that is something that we are comfortable with for large 
institutional customers only, provided that appropriate 
disclosures are made at the market level.
    Mr. Paul. One of the reasons, just to finish this thought, 
one of the reasons why there did not seem to be a keen appetite 
for the RFE is because the proposal also recommends that we 
broaden the permissible investment of segregated funds. And 
that is really why not only customers, but also the 
intermediaries were reluctant to extend segregated funds any 
further than they had to because they would get low return on 
those funds that were segregated, to the extent that we have 
made it a little broader possibilities as to what they could 
invest it in and provide better return, the need to opt out of 
seg is not as acute.
    The Chairman. OK. Now, the first page of the report 
recommends that the Commission propose a quote, ``new 
regulatory framework to apply to multilateral execution 
facilities that trade derivatives.''
    How does the CFTC define, quote, ``transaction execution 
facility,'' and what is the CFTC's position on the meaning of 
multilateral? What is the CFTC's position on the meaning of 
this term in the context of the current swaps exemption?
    Mr. Paul. Well, that is actually one of the thorniest 
concepts that we are wrestling with right now, Mr. Chairman. 
And we are engaged in ongoing discussions both internally and 
with various representatives of the industry, to come up with a 
definition that we will include in our proposed rule making, 
that will better define what a multilateral transaction 
execution facility is.
    Beyond that, I think at this point it is such an inchoate 
issue that I think that we probably cannot give you much 
further guidance at this time.
    The Chairman. So that is a work in progress?
    Mr. Paul. That is where the rubber meets the road on the 
current proposal.
    The Chairman. OK. We are going to have to come up with all 
the details to actually get these regulations or statutory 
things enacted.
    The report states that the registration process should be 
``streamlined,'' quote, unquote, for futures commission 
merchants and introducing brokers; however, it does not state 
in any detail how this is to be done.
    Would you explain what the report means by streamlining the 
registration process?
    Mr. Architzel. The streamlining envisioned there is 
accepting various types of accounting reports at various stages 
during the year, rather than requiring a certified audit at the 
time of actual filing for registration. That is the nature of 
streamlining envisioned.
    The Chairman. OK. The report provides for an exempt 
multilateral transaction facility in which a facility could 
choose to operate a market exempt from commission regulations 
except for the anti-fraud and anti-manipulation provisions. 
This facility would only be available to institutional traders 
who trade commodities with inexhaustible deliverable supplies, 
or supplies that are otherwise sufficiently large to render a 
contract traded unlikely to be susceptible of manipulation.
    Doe not this exemption operate to deny retail customers 
access to the most liquid markets?
    Mr. Paul. Well, Mr. Chairman, the retail customer currently 
does not have access to all markets. We do not think that we 
are denying access by virtue of our proposal. In fact, we 
actually think that we are providing them with access to 
certain markets they might not currently have through some of 
the flexibility we have built into the DTF category.
    So to the extent that retail customers currently trade in 
designated contract markets, they will be able to continue to 
do so through the recognized futures exchanges. We think they 
will probably get access to broader markets through the DTF 
category, but the exempt MTEF category is really designed to 
provide a regulatory framework that the over the counter market 
that currently exists completely outside of our regulation to 
operate under.
    The Chairman. They do not have access to that now; namely, 
the over the counter market involving private contracts. I 
notice that you suggest that you suspect that many over the 
counter type markets now might want to become DTFs so that they 
could have that imprimatur of CFTC regulation. Would you 
explain your thinking on that a little bit more? Do you see 
some positive advantages in saying that you are regulated. Do 
you believe people might have more faith in the integrity of 
the markets if they know that you have that regulatory check?
    Mr. Paul. Absolutely. And we believe that there is interest 
amongst certain types of markets and certain market 
participants to trade in a regulatory environment. All 
regulation is not bad. Many market participants seek the U.S. 
markets because of its high regulatory integrity, because of 
the sense that the markets and the participants are being 
looked after. So for those types of markets we certainly don't 
want to deny them a home if they are looking for some place 
that they can provide greater comfort to their participants and 
for their products.
    Mr. Architzel. It is also noteworthy that the recognition 
that the Commission bestows on markets, either the RFE or the 
recognized DTF, corresponds to those minimum regulatory 
standards that other regulators internationally subscribe to, 
so that recognition as a DTF carries with it an acknowledgement 
that, that market meets the minimum international standards. It 
may therefore make it easier for a market which intends to do 
business globally to get approved by regulators in foreign 
countries as well.
    The Chairman. I see. What would you say are minimum 
standards internationally, though? What basis is there for 
saying there are minimum standards internationally?
    Mr. Architzel. The staff spent a lot of time looking at 
guidance put out by various organizations of international 
regulators such as IOSCO, which is an international securities 
regulatory body. Over the years we have cooperated with those 
groups to harmonize our rules and regulations. So at this point 
there is a great deal of guidance put out by these 
international groups that most international regulators 
subscribe to. And our core principles correspond with that 
guidance very closely.
    The Chairman. Finally, I want to ask you a couple other 
questions. This is a little bit off the main subject of our 
hearing, which is your proposed new regulations. Many of the 
Chicago participants are interested in allowing futures on 
individual stocks. I know that, that will probably be the 
subject of several other separate hearings. But I was 
interested in how the margins are now set on stock index 
futures. Reading the CEA, it looks like it is really up to the 
Federal Reserve, but if the Federal Reserve declines to set up 
margin requirement, the CFTC steps in and sets a margin 
requirement.
    What is the margin requirement now on stock index futures 
and who has set that?
    Mr. Architzel. The exchanges in the first instance set the 
margin requirements, and report to us for approval of those. 
They are currently set at levels which cover very high 
confidence numbers above 99-percent for market movements on a 
daily basis in the market.
    The Chairman. What is the margin requirement? Do you know?
    Mr. Architzel. I would have to provide that data for you 
for the record in a written statement.
    The Chairman. OK.
    Mr. Paul. And one of the things that we have discussed with 
the SEC in our negotiations on Shad-Johnson is coming up with 
some sort of harmonized margin requirement for single stock 
futures regardless of where they trade. And we have discussed 
various approaches. The SEC has its own opinion on the subject. 
I do not want to speak on their behalf, but it seems like I 
think we are moving toward meeting in the middle on margin 
requirements that may begin to equity options as being really 
the closest parallel, but preferably something that is based 
on----
    The Chairman. Are those margin requirements about 50-
percent?
    Mr. Paul. Fifty-percent, Mr. Chairman, is for the actual 
stock. The equity options, and similar to what the futures 
exchanges do on index contracts is it is risk based and the 
span margining system that the Chicago Mercantile Exchange has 
developed which is probably the best at trying to calibrate, or 
at least take into account, the volatility of the instrument. 
And we think that is probably the approach that we should agree 
on with the SEC on a consistent margin framework for single 
stock futures, and whether that is done under the auspices of 
the Fed or done through an memorandum of understanding between 
the SEC and the CFTC and through the review process of the 
exchange margins. Those are the kinds of issues that we are 
trying to hammer out right now.
    The Chairman. OK. My final question is how long did it take 
you to come up with this new proposal? I saw you had a task 
force that put this together. How long have they been working 
on this?
    Mr. Architzel. We started in October.
    The Chairman. And you got it done that rapidly?
    Mr. Architzel. Yes.
    The Chairman. That is very good work. I want to compliment 
the CFTC on their proposals here. They seem to me, at least at 
first blush, to make a lot of sense. I have heard a lot of 
positive comment. I look forward to hearing in more detail what 
some of the others have to say today. But I want to compliment 
Chairman Rainer on moving the CFTC in this direction, and with 
the speed with which you acted. I think you have a pretty solid 
framework for us to work on. So thank you all very much.
    Mr. Paul. Thank you, Mr. Chairman.
    The Chairman. Now, we can move to the second panel. On the 
second panel we have James J. McNulty, President and Chief 
Executive Officer, Chicago Mercantile Exchange; Mr. David P. 
Brennan, Chairman, Chicago Board of Trade; Mr. Thomas R. 
Donovan, President and Chief Executive Officer, Chicago Board 
of Trade; and Mr. Robert K. Wilmouth, President of the National 
Futures Association.
    And again, if I could ask each of you to summarize your 
thoughts rather than reading the prepared remarks, I would 
appreciate that. We will submit your prepared remarks for the 
record. Also, I notice some of you, in your prepared remarks, 
had a lot about the possibility of futures on individual 
stocks. That is a little bit beyond the scope of today's 
hearing. While that is a great topic, I would probably hear 
from Bill Brodsky over at the CBOT real quick if we get too far 
down that road. So I want to keep it pretty much on target, on 
the proposed new regulations that the CFTC has come up with.
    I would also like to hear from the two exchanges on how 
these new proposals might affect your own plans for 
reorganization, both of which you both have underway already. 
If these regulations came into effect, would you want to 
rethink in any way your proposals for reorganizing, so that you 
could take advantage of these separate possible regulatory 
schemes.
    I do not know if we have a volunteer to go first. Would Mr. 
Wilmouth like to go first? Thank you for coming here.

STATEMENT OF ROBERT K. WILMOUTH, PRESIDENT AND CHIEF EXECUTIVE 
             OFFICER, NATIONAL FUTURES ASSOCIATION

    Mr. Wilmouth. Thank you very much, Mr. Chairman. I 
appreciate the opportunity to present the views of the National 
Futures Association on the CFTC's proposed new regulatory 
framework which we think is one of the most important 
developments in the futures industry since the creation of the 
Commission itself. And I will confine my remarks specifically 
to the CFTC's proposed new regulatory framework.
    We all know that we are facing great competition, both from 
off shore markets and over the counter markets, and the 
regulation of the industry must be overhauled and streamlined 
if regulated markets are going to remain competitive and be 
attractive. In short, we have to find new ways to reduce 
regulatory burdens without reducing regulatory protections.
    One way to achieve that goal is to maximize the use of 
self-regulation, while returning the Commission to its intended 
role of overseer of the self-regulatory process rather than as 
a micro manager. The Commission's proposed framework is 
dramatic and it is a bold step.
    The focus on core principles for both exchanges and 
intermediaries is exactly the right approach. The Commission 
should tell those that it regulates what they have to do, not 
how to do it. The answer to the how question changes with every 
new development in technology. That is why the role of self-
regulation will be even greater in the markets of tomorrow.
    Technology is really tearing down the barrier of entry 
faster than any government policy ever could. From 1977 to 1999 
there were no new futures exchanges formed. In the last 6-
months, at least six different enterprises have stated their 
interest in creating new electronic futures exchanges. All of 
them are dedicated to using effective self-regulation to insure 
the integrity of the marketplace, and the public's confidence 
in those markets. But none of these new exchanges that are in 
the formation stages are really shackled by the past. Every one 
of them is looking for more efficient ways to perform their 
self-regulatory functions, and every one of them has contacted 
NFA to discuss outsourcing that function to us.
    My point is simply not that NFA is going to play an even 
greater role in the years ahead, but that the flourishing 
number of exchanges and the corresponding changes to the entire 
industry, including its self-regulatory functions need action 
now, today. Time is of the essence. And we would urge both the 
Commission and Congress, Mr. Chairman, to move ahead as 
aggressively as possible.
    We certainly recognize that difficult work lies ahead. The 
comments of Paul Architzel and Robert Paul earlier indicate 
that. The proposed framework is just that, it is simply a 
framework. It does not address the details which will have to 
be resolved to move the proposal from the paper world to the 
real world. Some of these details should be readily solvable, 
but those core principles need to be supplemented with 
interpretive guidelines on which the entire industry can rely.
    But we suggest first of all how that guidance should not be 
provided. If we revert to having regulators in Washington 
dictating to the industry how the core principles have to be 
followed, we will end up right back where we are now. In 
addition, NFA is currently involved with the Futures Industry 
Institute on a best practices study on order transmission and 
entry, a study directed by the Commission and funded by a 
portion of the fine that they imposed in a CFTC enforcement 
action. We are convinced that a best practices approach is an 
excellent way to supplement the Commission's proposed core 
principles and provide the guidance that we think is necessary 
to the industry.
    Two basic points. When we talk about best practices, we 
have to consider the basic question of best practices from 
whose perspective. Best practices in our mind have to be 
considered from the perspective of the customer. We spent a 
good deal of time in our current study talking to end users and 
customers and what they want from best practices is very clear. 
They want procedures that insure fair treatment and quick 
execution at the best price.
    Second point. By definition, best practices have to be 
developed through direct and active involvement through the 
industry. The Commission should specify that the core 
principles will be supplemented with best practices guidance, 
developed through the industry's self-regulatory process, which 
includes NFA and of course, the exchanges.
    Another detail which can be resolved quickly involves the 
registration process, and you asked a question about that 
earlier. The Commission's proposal, as you stated, states that 
the registration process should be streamlined but does not 
necessarily address how in any great detail. Over the past 
several years, NFA has made a number of proposals to simplify 
the registration process, and we have recently updated those 
suggestions and submitted them to the Commission's staff.
    If a firm or an individual has gone through a screening 
process in the securities industry, conducting another 
background check for registration in the futures industry is 
clearly a wasted effort. And we agreed with the Commission's 
proposal, in effect, to passport those firms and individuals 
into registration. Those passported firms would still, however, 
be registered and subject to the same core principles as other 
firms. And there needs to be some mechanism to monitor their 
compliance with those principles, even if those firms are 
dealing with institutional customers.
    The answer again is self-regulation subject to Commission 
oversight. The Commission's proposal would not require those 
passported firms to be members of a futures industry SRO. We 
believe that this is an oversight which needs to be corrected.
    One of the major questions unanswered also in the current 
proposal, and you asked this question, is exactly what the 
Commission means by the term institutional customer. There are 
at least to my knowledge six different definitions of 
sophisticated customer in the Commission's rules. NFA proposed 
a uniform definition of sophisticated customer several years 
ago that was modeled very closely on the Commission's 
definition of eligible swaps participant. That definition has 
served very well for many, many years and should be the basis 
for the definition of institutional customer in this context. 
We would recommend that the threshold test for that term be no 
higher than those currently in place.
    Another key under the proposal will be the types of 
commodities which are not readily susceptible to manipulation, 
and should therefore be subject to less regulation. The answer 
must be a practical one, dictated by the realities of the 
marketplace, rather than theories of the classroom. The end 
users of the markets for petroleum products, for example, may 
very well have the best perspective on this issue and their 
views should be accorded great weight by the Commission.
    And finally, Mr. Chairman, let me reiterate our 
enthusiastic support for the Commission's overall approach, but 
let me also note that this exercise of the Commission's 
exemptive authority does not obviate the need for legislative 
action. We urge the Commission to move as quickly as possible 
to resolve the remaining issues and to enact its proposal. And 
we also urge Congress to support that effort and adopt 
legislation to codify, as you suggested, the Commission's 
approach. Thank you very much.
    [The prepared statement of Mr. Wilmouth can be found in the 
appendix on page 67.]
    The Chairman. Thank you, Mr. Wilmouth. Mr. Brennan. Thank 
you.

   STATEMENT OF DAVID P. BRENNAN, CHAIRMAN, CHICAGO BOARD OF 
   TRADE, ACCOMPANIED BY THOMAS DONOVAN, PRESIDENT AND CHIEF 
  EXECUTIVE OFFICER, CHICAGO BOARD OF TRADE, CHICAGO, ILLINOIS

    Mr. Brennan. Good morning, Mr. Chairman. I am David 
Brennan, Chairman of the Chicago Board of Trade. With me today 
is Tom Donovan, our CEO and President. We want to thank you for 
holding this hearing in the City of Chicago, the derivatives 
capital of the world. Our theme today is that we want Chicago 
to retain the title as the derivatives capital of the world. To 
do that, we have to change our way of doing business. And we 
are. But we also need to change the way Washington looks at our 
business. To do that we need to modernize the Commodity 
Exchange Act and tear down the existing barriers to 
competition.
    Mr. Chairman you have been a true leader on these important 
issues in Congress, and we thank you for your insights and your 
intellect and your leadership. In quite a short time you have 
proven that you are knowledgeable about our issues and 
committed to our mutual goals of fair competition and even-
handed government oversight. We thank you for your efforts.
    Another new leader in our industry also deserves praise. 
CFTC Chairman Bill Rainer is fully committed to rationalizing 
regulation of exchanges and the industry as a whole. He has 
brought market experience and creativity to the Agency. We 
applaud the Chairman's efforts and look forward to working with 
him on the finishing touches to his new regulatory blueprint.
    We have submitted a written statement that describes in 
detail our reaction to the CFTC's New Regulatory Framework. In 
summary, the Chicago Board of Trade endorses the CFTC's new 
regulatory approach. We believe the CFTC's proposal will add up 
to better markets, better competition and better service for 
the thousands that use our markets.
    Restructuring Federal regulation and restructuring our 
business go hand in hand. The CFTC's plan responds to the same 
market forces--technology, globalization, innovation, and 
competition-- which have also caused the exchanges to 
restructure.
    The Board of Trade is no exception. Our plan would take our 
existing pit trading and electronic trading business lines and 
restructure them into two independent for-profit companies.
    Both will try to attract business by providing liquid 
trading markets. Both will innovate and invest in technology to 
provide customers the best service. Both will make every effort 
to provide customers with a market that they can trust, and 
both markets will compete.
    Our plan is designed to give each company and each trading 
platform a fair chance to succeed. No business could really ask 
for more than that.
    Federal regulation is part of that ``fair chance.'' We 
believe in open markets and fair competition. To us, similar 
products, traded in similar circumstances should have similar 
government oversight. That means privately negotiated 
transactions may be excluded, but all public execution 
facilities should be treated the same. That is our ``golden 
rule'' of fair competition.
    Today that rule is not being met. After almost 80-years, 
the Commodity Exchange Act has become unworkable. Over-the-
counter derivatives, especially in the area of equity swaps, 
are plagued by legal uncertainty. Exchange markets suffer from 
extreme regulatory arbitrage, which the CFTC's proposal tries 
to remedy. For single stock futures, it is even worse. We are 
barred from competing at all under a law that we were told 18-
years-ago would be ``temporary,'' until a regulatory impasse 
could be resolved.
    Mr. Chairman, reform of the Commodity Exchange Act must 
cover each of these three areas. All we have ever asked for is 
a fair chance to compete. This year's CFTC Reauthorization 
offers us a real opportunity to reach that goal. With your 
leadership, we are more encouraged than ever before that we 
might finally get a fair chance to compete. Again, thank you 
for the opportunity to be here, and we appreciate your efforts. 
Thank you.
    [The prepared statement of Mr. Brennan can be found in the 
appendix on page 60.]
    The Chairman. Thank you very much, Mr. Brennan. Mr. 
McNulty, would you like to proceed?

 STATEMENT OF JAMES J. MCNULTY, PRESIDENT AND CHIEF EXECUTIVE 
    OFFICER, CHICAGO MERCANTILE EXCHANGE, CHICAGO, ILLINOIS

    Mr. McNulty. Yes. Thank you, Mr. Chairman, and committee 
members, ladies and gentlemen. I am James J. McNulty. I am the 
President and Chief Executive Officer of the Chicago Mercantile 
Exchange, and I have held this post since February 7th of the 
year 2000.
    The Chairman. This is a baptism by fire, your first 
Congressional hearing. You will have many more over the years.
    Mr. McNulty. Thank you. Obviously I come to this hearing 
short of experience in the history of the exchange; however, I 
have had 25-years of experience in the full range of financial 
markets. I have traded and supervised trading in all financial 
futures and options and I am sensitive to the needs and 
expectations of the over the counter markets, having trading in 
the bank, investment bank market for the past 25-years.
    I also appreciate the impact of technology on the future of 
the financial services industry and I hope that this testimony 
reflects that sensitivity.
    The CME is exceptionally encouraged by the CFTC staff task 
force report, A New Regulatory Framework. The Commission has 
been both responsible and responsive to the concerns of all 
elements in the financial services industry. We are pleased by 
the tone of the proposal, which is consistent with the 
progressive regulatory philosophy that depends on oversight and 
competition among markets, rather than prescriptive regulation 
and protected market spaces.
    The CFTC staff under Chairman Rainer has demonstrated a 
deepening understanding of the complex technological and 
competitive issues facing our markets, and the commitment to 
providing much needed regulatory relief. I will discuss our 
view of the details of the report and suggestions for 
implementing it below.
    The task force recommends that the Commission convert its 
proposal into proposed rule making, subject to a 60-day-
comment-period and public hearings to provide a full public 
airing of the important public policy issues. If those 
recommendations are followed, final rules implementing the 
proposal are likely to be adopted sooner than 6-months. Senator 
Lugar has indicated that the Commission's recommendations may 
provide a basis for drafting amendments to the CEA. We agree 
that the time is right to act and that legislation, based on 
the principles of the report, is better than rule making.
    We are less sanguine about reform of the Shad-Johnson 
Accord. Eighteen-years ago the Shad-Johnson Accord divided 
jurisdiction between the SEC and the CFTC and included a 
temporary ban on most equity futures contracts. That temporary 
ban lasted 18-years, during which the single stock futures have 
thrived in the OTC market in the form of equity swaps and on 
options exchanges in the form of synthetic futures. Recently 
the President's working group and Congressional leaders have 
called for an end to the ban.
    Of course, we are pleased that the agencies have agreed 
that this is appropriate and that U.S. exchanges would be 
permitted to compete in world markets and to offer U.S. 
customers the opportunity to manage their risk by means of 
equity futures contracts. We are also pleased that they have 
found a way to accommodate their jurisdictional and regulatory 
concerns on several important issues. But it is too late in the 
game to be satisfied with signs of progress. We share Senator 
Lugar's disappointment that the agencies were unable to resolve 
all of the jurisdictional concerns within the time frame 
requested.
    Our goal is freedom to give our customers what they want 
and need. Remember, we created tremendously useful products, 
equity indices, for example, in the face of overwhelming 
opposition. The SEC and its client exchanges opposed futures on 
indices with all of the same arguments that they now raise 
against futures on individual securities. Nonetheless, equity 
indices are among the most popular contracts on securities 
exchanges, as well as on futures exchanges.
    Futures trading of equity indices has enhanced customer 
opportunity with none of the ill consequences predicted by the 
SEC or securities exchanges. In fact, their business has 
directly benefitted.
    One-year ago the Chicago Mercantile Exchange, with the 
Chicago Board of Trade and NYMEX, undertook to craft amendments 
to the Commodity Exchange Act that would enhance competition 
and customer opportunity. We continue to believe that the joint 
exchange proposal is the best formation for regulatory relief. 
However, we are well aware that the legislative and industry 
consensus in favor of a good plan, trumps our theoretically 
better plan. We are prepared to join the consensus and to give 
up our plan in favor of the CFTC staff proposal, if we can 
assure Shad-Johnson relief and fix some of the minor flaws in 
the CFTC plan.
    Our goal was and remains equivalent regulatory treatment 
for functionally equivalent execution facilities, clearing 
houses and intermediaries. If we can get to that goal by the 
path of the CFTC's proposal, then let us proceed with 
reasonable haste. Thank you very much for the opportunity to 
give testimony today.
    [The prepared statement of Mr. McNulty can be found in the 
appendix on page 51.]
    The Chairman. Thank you very much, Mr. McNulty. Mr. 
Donovan, did you want to add anything?
    Mr. Donovan. David Brennan presented our testimony. What I 
would like to do, though, is thank you for having this hearing 
today, because this is a process that we have been engaged in 
for a number of years. The clock is ticking, and we have a 
short year. We know the members of Congress are going to want 
to get out as early as possible this year, and quite honestly, 
I am afraid if we do not complete the process this year, that 
Congress will grow weary of this issue. So I harken to Senator 
Lugar's admonition at the last hearing, that we had better 
resolve this and work closely with all segments of the 
financial services sector to move this along. I do think that 
there are some things that we have to have from this 
legislation. Namely, a codification of what the CFTC has put 
forward, because having lived with the CFTC for the past 20-
years and a number of chairmen, commissioners and staff, it is 
very important for us to put something in place that also 
provides legal certainty for the futures industry so that we 
can deal with the future.
    The Chairman. Well, thank you. Let me just pick up on your 
remarks, Mr. Donovan. Right now, the CEA is being rewritten, we 
have not come forward with a proposal. We have not even passed 
a proposal out of the Committee. At the same time, the CFTC is 
proposing new regulations. Meanwhile every day you have all 
sorts of new types of competition. You are looking at 
reorganizing yourselves to better address the future 
competition and the competition that you have out there now. 
You are being hurt by the lack of legal uncertainty in that you 
do not know what the new CEA is going to look like. You do not 
know what the new regulations are going to look like.
    How is this uncertainty impacting the Chicago Board of 
Trade's plans for reorganizing itself?
    Mr. Donovan. I think, first of all, we are moving ahead at 
full speed because we really believe that we have to 
restructure the exchange. Chairman Brennan has taken on the 
initiative, and he has done a tremendous job of moving it along 
under very difficult circumstances. It is difficult to change a 
membership organization when you are having success. But we 
realize that the future is moving at Internet speed and we have 
to make plans for our restructuring as though Congress will 
address that legislatively and will give us the regulatory 
framework and flexibility to do what we propose in our plan.
    If you saw today's issue of ``Crain's''.
    The Chairman. I read it, yes.
    Mr. Donovan. There is a piece in there from Chairman 
Brennan where he talks about the blueprint that we have. Well, 
we are moving very quickly to separate two companies. Each of 
them will have different needs, and each of these companies 
will have to find a regulatory framework with which to function 
and one that, once a law is passed, will not be so rigid that 
the day after the bill is signed that new technology will not 
dictate that it be changed, because Congress is not going to 
come back to this again in the near future. So it is our hope 
that we will have enough flexibility and have a performance 
standard, rather than a design standard, that we can look to 
for guidance as the goals that we have to achieve after this 
legislation is passed.
    The Chairman. When do you hope to accomplish your proposed 
reorganization? Would you want to address that?
    Mr. Brennan. Mr. Chairman, for my purposes I wish it was 
yesterday. But, we are waiting for about two more pieces of the 
plan before we can go to a membership vote. As soon as I can 
get those, I am planning on scheduling a special Board meeting, 
and the vote will be 30-days after that special Board meeting. 
Right now, I am waiting to hear from an independent allocation 
committee which is made up of our five individual directors. 
Their job is to determine the allocation of stock, because we 
have five different classes of membership. That is pretty much 
dictated by law.
    The Chairman. Ultimately you would have two separate 
companies, one which would be the pit based exchanges, and the 
other which would be the electronic exchange.
    Mr. Brennan. That is correct.
    The Chairman. Now, just looking at these new regulations, 
and maybe I am premature in asking this, but would you be 
trying to become an exempt multilateral transaction facility 
for the electronic exchange and remain a recognized future 
exchange for your pit based? Do you have any ideas on this?
    Mr. Brennan. We have not gotten into that kind of detail 
yet, but I think we are going to analyze our business by 
product and we expect to be trading the same products in both 
places. To the extent that we can reach the flexibility we need 
with both, we will approach it on a product basis I would 
expect.
    The Chairman. But these proposed changes, once they occur, 
could have a huge impact on your reorganization, could they 
not?
    Mr. Brennan. Yes.
    The Chairman. Yes. Mr. McNulty, how would these proposed 
changes affect the Mercantile Exchange's proposed 
reorganization?
    Mr. McNulty. Well, Mr. Chairman, having advised some 
airlines and utilities and banks even in their recent 
deregulation and changes of technology, one of the things that 
we found is that you need to be a speedy decision maker and you 
need to be able to make the right kinds of investment. So the 
Chicago Mercantile Exchange has filed an S-4 with the SEC in 
order to demutualize the exchange. And what we hope to gain by 
that, of course, is the ability to work more flexibly with the 
capital structure and also the ability to have a corporate 
governance that is streamlined and allows us to make those 
speedy decisions.
    This change in regulation will cause us to make some legal 
steps, undoubtedly. So we would imagine, for example, that the 
recognized futures exchange and the derivatives transaction 
facility would be essentially in the parent firm, following 
demutualization. And then we could imagine that the exempt 
multilateral transaction facility would be a subsidiary of the 
parent firm.
    The Chairman. As Mr. Paul pointed out, they would envision 
that the exempt multilateral transaction facility would have to 
be a separate corporation, a separate legal entity.
    Mr. Wilmouth, how do the proposed regulations change or 
expand the role of the NFA as a self-regulating body for the 
industry?
    Mr. Wilmouth. It is rather difficult to tell at this stage 
of the game exactly what role we are going to be taking by 
intermediaries and the exchanges. We made a basic decision 2-
years ago to put ourselves forward as an outsourcing facility 
for self-regulatory functions that have to be performed by the 
industry. Over the past 2-years I have made proposals to both 
Chicago Board of Trade and the Chicago Mercantile Exchange to 
outsource their self-regulatory responsibilities to us. At the 
present time they have decided to maintain that in house, but 
as they come forward and become electronic exchanges, then we 
certainly are going to revisit that proposition.
    The other thing that we have done, we are, as I said in my 
prepared testimony, talked to six different electronic, seven 
different electronic exchanges recently who are just coming to 
the forefront with all different types of new products and 
wanting to become futures exchanges. We are discussing with 
them each of the possibility of outsourcing their self-
regulatory functions to us. So we think this is a broad step 
forward for us. We think it has great opportunities for us in 
the future and we are gearing ourselves toward that line.
    The Chairman. Would the Board of Trade and Mercantile 
Exchange, care to comment on what you might do in terms of 
taking advantage of the option of having self-regulatory 
functions that would obviate the need for greater CFTC 
supervision. I do not mean to be putting you on the spot. How 
does all this strike you?
    To be a DTF you would have to have a self-regulatory body. 
I would imagine your internal self-regulation would fit the 
bill or you could outsource it. How do you see whether it will 
be internal or whether you will contract it out to the NFA? How 
do you see the self-regulatory function being changed by the 
CFTC's proposed regulations?
    Mr. Donovan. Well, I think that looking to a restructured 
Chicago Board of Trade, our new ECBOT, so to speak, our 
electronic company would be looking to find its way into the 
least regulated areas and require less regulation. Just by 
virtue of the electronic trading, you have more information 
electronically and the markets may require a lesser level of 
regulation. As far as the CBOT, the open outcry portion of 
that, we feel that right now our self-regulatory front line 
function is far and away the best anyway. We think that the 
CFTC strictly should be an oversight agency, one that provides 
the flexibility for us to use our self-the regulatory structure 
as a marketing tool, for people to want to come and trade at 
the Chicago Board of Trade.
    I have a great deal of respect for Bob Wilmouth and NFA. I 
served on the Board from the very beginning, but I really feel 
that the regulation that an exchange provides is a front line 
regulation and serves as a marketing tool, something that you 
can do better than anyone else, that people feel comfortable 
trading in your exchange.
    Mr. McNulty. I can only echo Mr. Donovan's comments. We 
have spent years building a highly disciplined self-regulatory 
body in the CME, and we think that is one of the reasons people 
come to work on our exchange.
    The Chairman. OK. Let me shift gears just a little bit and 
ask the Chicago Board of Trade a question specifically. 
Although the basis for eligibility as a DTF applies to all 
commodities, the report states that domestic agricultural 
commodities may constitute a unique category because the 
current futures markets tend to be the primary, if not the 
only, centralized source of price basing for those commodities.
    In your submitted testimony, you recommend that trading in 
physical commodities, including agricultural futures, qualify 
for DTF treatment. Would you please comment further on the 
reasons for your recommendations here?
    Mr. Brennan. I will begin. I think rather simply, Mr. 
Chairman, we believe markets are markets. And to the extent 
that you can provide liquid markets, the less regulatory 
burdens you have, the more market players you will have, and 
the more people that will come and provide liquidity. Any time 
you have any kind of barriers to entry or any kind of 
restrictions, it may keep participants away. That ultimately 
affects the end users. So very simply, we believe that markets 
are markets and if you have the right regulatory structure, a 
concern about, whether it be cornering or those issues, I think 
that those are handled through the regulatory requirements.
    The Chairman. Let me ask Mr. McNulty about clearing 
facilities. The report recommends the expansion of clearing 
facilities in the United States. Do you support this 
recommendation?
    Mr. McNulty. Well, I think that clearing facilities, in the 
case of the CME, would be one of the major assets of the 
exchange. And we could foresee a time when not only do we have 
further cooperation than we already have with many of the 
global clearing houses, but we also could foresee a time where 
we use this as a new source of revenue, where with many of the 
new exchanges that are opening up, we could provide them with 
back office services, clearing services, settlement, even 
dispute resolution as part of a revenue stream for the 
exchange.
    The Chairman. Mr. Wilmouth, let us return to the best 
practices issue. In your testimony, you recommended that the 
core principles should be supplemented with best practices 
guidelines developed through the industry self-regulatory 
process. Would you want to comment further on this 
recommendation. Specifically, would you imagine some of the 
best practices would be written up in the regulations that the 
CFTC promulgates pursuant to whatever changes we make in the 
statute itself, or would you imagine that the CFTC would just 
have papers on file that people could ask for their best 
practices, manuals? How would you envision that would work?
    Mr. Wilmouth. Let me, first of all, say that I look best 
practices as kind of like a safe harbor, and this is a 
constantly changing thing. So I am not certain that I would 
want to codify it specifically by the CFTC, because they would 
be constantly changing. Let me give you an example of what we 
are doing right now, if I may.
    With the Futures Industry Association, funded by the CFTC, 
we have initiated a best practices study focusing on order 
entry and transmission procedures in the futures industry. What 
we did is we formed, and this is part of the self-regulatory 
process from gathering all the ideas of the best minds in the 
industry, we have formed four separate committees to take a 
look at the best practices in that specific area. We formed an 
operations committee, a technology committee, a compliance 
committee and a legal committee, made up of industry 
practitioners. Together with some outside consultants, we are 
visiting with all of the exchanges, a significant number of the 
FCMs. We are even sending some of our consultants abroad to 
talk to some of the exchanges over there. We hope to come out 
with a best practices in that specific area, through the 
cooperation of the entire industry.
    I would envision that same practice applying across the 
board to all the best practices that we would envision coming 
out of the CFTC regulatory reform measure. We think that makes 
good sense because it draws on the talent, the wealth of talent 
that exists in the industry.
    The Chairman. So as these best practices guidelines are 
developed, and if there is a market participant who is 
complying with those best practices, you would see that as a 
safe harbor. If they have been following these types of 
practices, they would presumably be safe from getting in 
trouble.
    Mr. Wilmouth. They would be a safe harbor, that is right. 
And I do not think that we want those specified specifically, 
because they are going to change over a period of time. They 
will constantly be changing.
    The Chairman. So we would just maybe refer to a best 
practices policy which itself could be ever changing.
    Finally, I have a question for all the panelists. You all 
agree that we should codify these regulatory changes? Is there 
an agreement on that.
    With respect to intermediaries, the report recommends 
relaxed standards as to risk, disclosure, registration, 
financial requirements and the treatment of customer segregated 
funds. What do you think of these recommendations?
    Mr. Donovan. We are supportive of the recommendations. We 
are supportive of a bill that will allow the flexibility to 
allow this industry to address the technology, the 
globalization and innovation of our competitors. And if we are 
unable to do that when this legislation is passed, the business 
will not be in the United States.
    The Chairman. OK.
    Mr. McNulty. I would like to echo Mr. Donovan's comments, 
and I can tell you, having been in the OTC markets for 25-
years, it would normally take us 24-hours to turn around a 
contract, whether the request came from Hong Kong, Latin 
America, Europe, we could turn around and launch a contract in 
Switzerland within 24-hours. We are not close to that yet in 
the United States, and I think this legislation would lead us 
to that point. And I think it would also loosen some of the 
restrictions on the intermediaries which would also allow this 
market to grow at a faster rate than it has in the past 10-
years.
    The Chairman. You really like the idea of being able to 
come out with a new contract without getting prior approval; 
that is very important to you.
    Let me just sum up here. Do you think that this proposal 
gives you the type of regulatory relief that you need in the 
21st Century, leaving aside the issue of the Shad-Johnson. 
Which I am going to try and address Shad-Johnson at an upcoming 
hearing and will certainly be something that we will continue 
to talk about and be working on.
    Mr. Donovan. It is a step in the right direction. It will 
definitely depend on how rigid the rules are applied to core 
principles. If they take away the flexibility that you need, it 
will miss its purpose.
    The Chairman. The devil is going to be in the details here, 
how we actually put this in the law.
    Mr. Donovan. Right.
    The Chairman. But you agree with the principles, and you 
think it gives you pretty good flexibility and will help you 
compete, is that correct?
    Mr. Donovan. Yes.
    The Chairman. That is good. I am very happy to hear that. I 
want to thank you all for testifying today. We will later take 
up the issue of futures on individual stocks and Shad-Johnson. 
If you read the CEA, and I have it right here, I am struck 
first by the many pages that deal with this complicated Shad-
Johnson agreement. It is one of the first things that is 
addressed in the CEA. I think we are going to have to work on 
that. To be fair, we will have to have other hearings and 
receive input from people who might have a different opinion 
than yours. We will do that at the time.
    I remain committed toward making sure that our Chicago 
markets, not only survive, but succeed and flourish in the 21st 
Century, and I look forward to working with you all toward that 
end. Thank you all very much.
    I would now like to take about a 5-minute break before we 
bring in the final panel of market participants.
    [Recess.]
    Could we bring this hearing back to order.
    On our third panel of market participants and 
intermediaries we have several distinguished panelists. Mr. 
Barry Lind, who is from Lind-Waldock & Company, has one of the 
largest retail customer bases, as I understand it, in the 
country; Mr. Jan R. Waye, Senior Vice President of Cargill 
Investor Services; Mr. George Crapple, President of the Managed 
Funds Association; and also Mr. David Downey, Executive Vice 
President of Interactive Brokers LLC.
    Mr. Peter Lee, who is the Managing Director of Merrill 
Lynch Futures, has had a family emergency and was supposed to 
be here today, but could not be here due to that emergency. I 
am going to ask unanimous consent that his testimony be 
included in the record. Since there is nobody else here to 
object, I will give that consent.
    [The prepared statement of Mr. Lee can be found in the 
appendix on page 82.]
    We will begin with Mr. Lind, the Chairman of Lind-Waldock & 
Company. Would you summarize what your company does. And what 
its role in the market is. As I mentioned, you have a large 
customer base. Could you first describe the manner in which you 
participate in the market. If you could stick to the topic of 
how these new regulations would affect your company in the 
futures market, and stick to that main issue, we would 
appreciate it. Thank you.

STATEMENT OF BARRY J. LIND, CHAIRMAN, LIND-WALDOCK & CO., LLC, 
                       CHICAGO, ILLINOIS

    Mr. Lind. Thank you, Mr. Chairman, and thank you for the 
opportunity to be here. Lind-Waldock is best known for having 
the largest retail customer base in the industry. We do a lot 
of institutional business and commercial business, but our 
primary focus here is on the retail. We are members of almost 
all the major exchanges in the U.S. We do a lot of our business 
on-line. Over half our orders come in on-line, as the industry 
is changing.
    The Chairman. From retail customers?
    Mr. Lind. From retail customers. We are probably as well 
electronically committed and situated as any firm in the 
industry. And today I would like to address you in regard to 
the retail aspect of things, because I knew there would be a 
lot of other people covering the other aspects.
    First, let me say that I am very impressed and very happy 
that the CFTC and Chairman Rainer are looking to modernize and 
rationalize the regulatory framework of the futures market. 
Even though this is a work in progress, I would like to commend 
him for his good work in harmonizing the interests of the 
industry and the market participants. And I think that the work 
that he has done has assured us that everybody has gotten a 
fair hearing. He is certainly very qualified and he is a 
knowledgeable listener. And that is what has resulted in I 
think this overall position that we have today of re-
engineering the regulation which I agree with.
    In general, I agree with the approach. The regulation needs 
to have flexibility that is based on the type of market that is 
being regulated, the kind of instruments and the sophistication 
of the participants. This allows some markets to operate with 
less regulation, an outcome that I think is a good one. 
However, there seems to be a consensus that less regulated 
markets are appropriate for institutional and for qualified 
investors. There is more hesitation to allow individual 
investors the advantages that may exist in less regulated 
areas.
    My own position is that individual investors should be 
allowed access to less regulated markets in order to have the 
advantages of increased competition that a less regulated 
market will bring. I believe that with the appropriate 
framework individuals can enjoy this access with substantially 
the same protections as the current regulatory environment has.
    One of my fundamental convictions is that my customer, in 
addition to regulatory protection, should be able to have the 
benefit of the best price available, even if it occurs outside 
a market that is the most protective of the customer. Any 
regulatory scheme that has the effect of keeping my customers 
from less regulated markets will be a costly victory for my 
customers. They will have all the benefits of protection from 
fraud and market manipulation but they will be limited to 
markets where largest liquidity providers may have vanished and 
it is from this perspective that I offer my comments.
    The bedrock of customer protection in current regulations 
is the requirement that customers' funds be segregated. And I 
commend the CFTC for keeping this requirement as an important 
part of the customer protections in any market where an 
individual investor is permitted to conduct transactions. I 
fully endorse the report's additional recommendation that non-
institutional traders be allowed to access a derivatives 
transaction facility only through a registered futures broker 
that is a clearing member of at least one recognized futures 
exchange, and has a minimum net capital of $20 million.
    The benefit of this is twofold. It provides discipline for 
the carrying firm by requiring that they have capital at risk, 
and it offers the benefit of regular periodic inspections by an 
external monitor. And let me say this about the level of 
capital requirement. I think that this will tend to exclude 
less responsible parties who may be looking to make a quick 
buck in these less regulated markets. 20-million will suffice 
to keep most of these people, if not all of them, out.
    I am pleased that the report calls for changing the net 
capital rules to base them on risk. I have been asking for this 
for years and years. The current capital rule is an old, old 
banking rule and makes no sense in derivative markets. Right 
now, as an example, if I have a customer with $100,000 in cash 
and no position, I have to put up $7,000 in capital. If, 
however, he has 100,000-bushels-of-beans on with no money, and 
therefore, I have substantial risk. Today I have no capital 
charge for him. So a risk based capital rule would be a move in 
the direction of rationality.
    Most observers, including myself, expect the deregulated 
environment resulting in increased competition. Even though 
competition may tighten market spreads in other markets, I 
think it will take liquidity away from the recognized futures 
exchanges. If this result occurs, the ability to enter into a 
transaction in one arena and to offset it in another would 
benefit all parties, except possibly the market maker. In my 
written testimony I have termed this the universal transfer 
mechanism, if you care to look at that.
    In a multiple market maker market, I didn't think I would 
get through that, there will be multiple platforms on which 
trades can be made. In this kind of environment the challenge 
is to provide a level of transparency to the price discovery 
process. We believe in the not too distant future all trades 
will be conducted on electronic trading platform, where our 
customers will receive the best bid and offer from the 
recognized futures exchanges and the counter parties with whom 
we are dealing with. In this environment our customers will 
simply point and click on the best market available. However, 
we are not there yet.
    In the interim we propose that brokers who allow retail 
customers to deal in less regulated markets be obligated to 
display multiple bids, offers and last sales. These would come 
from the market makers with whom the retail customer's broker 
is dealing, along with appropriate recognized futures 
exchanges. The customer would then simply choose what he 
believes to be the best priced market. These multiple prices 
should be recorded along with the customer's transaction.
    The one thing that the customer's futures broker cannot 
totally control is the price. But if the customer can see all 
the prices that we have available we have put him in the best 
position that he can possibly be in.
    I endorse the report's provision for streamlining the 
registration of FCM's introducing brokers. I agree that the 
mandatory disclosures for non-institutional customers should be 
streamlined and make use of a single signature format including 
the freedom to accept electronic signatures. All commission 
requirements including documentation and record keeping should 
be flexible enough to embrace changes in technology without 
requiring amendment. In these matters the adoption of core 
principles that state the goal of the regulation, rather than 
prescribe exactly how the goal should be met, will go a long 
way in achieving flexibility in dealing with technical 
innovation and make us a lot more competitive.
    I favor broadening the range of instruments in which 
segregated funds can be invested, and removing barriers 
respecting the secured amount requirements for the funds of 
customers trading non-U.S. markets. I am very encouraged by 
this report. It is a document that recognizes the dual 
objectives of regulation, fair markets and suitable customer 
protection. It reflects careful thought and sensitivity to the 
needs, both of the industry and the market participants. It 
moves away from the traditional inflexible regulatory models. 
It breaks new ground with its philosophy of core principles and 
offers a shining example of both the process that should be 
involved in producing regulations and the results that can be 
achieved by following this process.
    This is a working document that provides a framework to be 
fleshed out. Along with everyone affected by this regulation, I 
am waiting to see if the final version fulfills the promise of 
its beginnings. However, this report does make an excellent 
beginning. Thank you.
    [The prepared statement of Mr. Lind can be found in the 
appendix on page 95.]
    The Chairman. Thank you very much, Mr. Lind. May we now 
hear from Mr. Waye from Cargill Investor Services. Thank you 
for being here.

   STATEMENT OF JAY R. WAYE, SENIOR VICE PRESIDENT, CARGILL 
           INVESTOR SERVICES, INC., CHICAGO, ILLINOIS

    Mr. Waye. Thank you, Mr. Chairman. Good morning. Cargill 
Investor Services is A global futures commission merchant 
operating in all major futures markets around the world. Our 
client base can be broadly categorized between fund clients of 
which we are going to hear more of later, large commodity 
institutions, And large financial institutions. Representing 
those clients and speaking on behalf of, in addition to Mr. 
Lind, from the FCM community, I would say we broadly support 
the recommendations put forward in the staff recommendation to 
the Commission. We believe this is a step in the right 
direction, to move from a rules based environment to one guided 
by broad principles with specific recommendations for best 
practices.
    I would, however, like to make four comments and just 
briefly summarize on my written remarks which were supplied 
earlier. First, and before going into the specific 
recommendations, one of the goals of the report was to provide 
and continue to provide legal certainty for over the counter 
derivative contracts. The report said that is imperative and we 
agree. But we would take it a step further on behalf of our 
clients and say that we not only need certainty for OTC 
financial contracts. We also need legal certainty for OTC 
commodity contracts. And by commodity contracts I am including 
everything, whether we are talking about corn or crude oil or 
cotton or electricity. We have seen significant volatility in 
commodity prices in these contracts, often more so than we have 
seen in financial markets in the last several years.
    Let me explain why this is important. We believe commercial 
parties should be able to enter into over the counter contracts 
on commodities without one of the parties later on saying: 
``No, I am going to walk away from that contract, because I 
entered into an illegal off exchange futures transaction which 
was an invalid contract to begin with. We were not allowed to 
do it.'' We believe that legal certainty is essential to 
prohibit that from happening. We have seen the volatility that 
can occur in the electricity markets. We have seen the 
volatility that can occur in agricultural markets. Commercial 
participants simply need the right to enter into bilateral 
transactions off exchange and get the same legal certainty that 
exists in financial over the counter transactions.
    There has been a lot of innovation that has brought to bear 
in financial OTC markets. There has been a significant benefit 
to consumers in terms of risk management. We believe all those 
same arguments that have been made for financial OTC certainty, 
equally apply to commodity OTC certainty.
    The Chairman. Could I stop you for a moment, right now? To 
what extent are you able to enter into a private contract right 
now with some institutional customer who wants to have a tailor 
made contract that will pay his or her institution on the basis 
of what happens to the price of an agricultural commodity such 
as corn? Can you do that now?
    Mr. Waye. You can do it, Mr. Chairman, but you run the risk 
without the legal certainty of the CFTC or the SEC or some 
other agency bringing an enforcement action against you later 
on, that, that was really an off exchange futures contract, 
even though it was bilaterally negotiated.
    The Chairman. How much of that are you doing right now? How 
much business are you doing that involves private OTC type 
contracts dealing with underlying agricultural commodity?
    Mr. Waye. Including both agriculture and energy, and this 
is a rapidly expanding area. Electricity OTC contracts, we saw 
the problems a couple of years ago, when electricity prices 
spiked to record highs during the summer. And then we also saw 
a record number of defaults. A few years ago we saw a case in 
Brent crude oil that's called the Transinor case, where one of 
the parties argued they could walk away from the transaction 
because it was an off exchange futures contract. So there is a 
need to eliminate the uncertainty, to encourage the innovation 
rather than to have this cloud hanging over commodity markets.
    The Chairman. It is good you bring up this point, because 
we only hear of this legal uncertainty problem in the context 
of financial over the counter derivatives. That is an area that 
is growing rapidly and most of that is really interest rates 
swaps.
    Mr. Waye. Yes, absolutely. And the final comment I would 
make is, whether we like it or not, people that get involved in 
commodity markets, tend to be more litigious than institutions 
trading in financial markets. They tend to walk away from 
contracts more frequently. The volatility sometimes is much 
greater. So I guarantee you that going forward we will continue 
to see these kind of actions pop up.
    I would like to go to my second point, and that is one 
already covered somewhat earlier by the comments you made 
yourself on the DTF, the derivatives transaction facility, and 
how do we determine what commodity contracts can be traded on a 
DTF. But we talked about products with inexhaustible supply, 
and Mr. Chairman, you pointed out that with Treasury securities 
that is already a present problem, number one. Number two, one 
of the few examples of price manipulation did take place with 
Treasury securities futures on Treasury bond futures. We 
support the staff report that certain markets do need to be 
held to higher level transparency and regulation, and we think 
that is the case, because they perform an important price 
discovery function. So our comment here is not so much to 
disagree with the staff report, but just to recommend an 
alternative definition that contracts were be excluded from the 
DTF be those contracts that there is no real price discovery 
function taking place.
    I think a lot of financial market participants today would 
say the price discovery for Treasury bonds probably does not 
take place anymore in the Chicago Board of Trade, but probably 
does for corn. So where the market has a true price discovery 
function taking place, that market needs to be held to a higher 
degree of oversight and regulation and concern because it is in 
the public interest. Not because it is in any particular 
members' interests or participant here this morning, but it is 
in the public interest. We are trying to discover a true price. 
Participants in those markets and markets themselves need to be 
held to a higher degree of regulation.
    Third, you said not to go here, but I have to, because I 
made a comment on stock index products. I will not repeat what 
was said earlier on Shad-Johnson. But I would say as a global 
futures commission merchant that our clients outside the U.S. 
do have access to a much broader range of equity based products 
that trade on financial futures exchanges than they do in the 
U.S.
    The Chairman. Do you trade those stock futures?
    Mr. Waye. On behalf of clients.
    The Chairman. What countries do you do that in? Would you 
know off the top of your head?
    Mr. Waye. Absolutely. In fact, I will just combine this 
with my last point to save time, because in a lot of these 
countries we have seen the equities markets and the futures 
markets merged into one. In the cases of Singapore, Sydney, 
Frankfort and Paris, we have recently seen a merging, a coming 
together of the equities exchanges and the futures exchanges 
under a common platform, a common clearing house and a common 
regulator. So our clients in those markets are clients of our 
firm, Cargill Investor Services, are able to trade stock index 
products, a wide variety of stock index products or stock index 
derivatives that trade on the futures exchange because in those 
countries it is all one exchange. It is moving towards one 
platform and it is one clearing house.
    The Chairman. Do you have American customers who are using 
Cargill to trade futures on individual stocks in foreign 
countries? Do you have that at this point?
    Mr. Waye. Yes, but only if those contracts have been 
approved by the SEC. If the contracts have not yet been 
approved by the SEC, it would be illegal for us to offer them 
to U.S. domiciled clients.
    The Chairman. OK.
    Mr. Waye. But non-U.S. domiciled clients can have access to 
those contracts. I appreciate it is a murky area, but just 
coming from a customer side, our non-U.S. clients have access 
to a much broader array of stock in equity based futures 
contracts than those same customers in the U.S.
    Finally, a note on competition. I am glad to see, and the 
comment was made earlier in the past panel, about the number of 
new exchanges that are being proposed in the U.S. Our only 
concern here is that the CFTC be prompt and fair in evaluating 
these new exchanges and approving them for operation, if they 
deem so appropriate. I note they did this a couple of weeks ago 
with a new exchange in Texas which had been under review I 
believe for 2- or 3-years. There are six or seven new exchanges 
in the pipeline. And we believe that the role of the CFTC is to 
encourage competition between exchanges, just as we have 
significant competition between FCMs and competition exists in 
other areas of the market, and we are pleased to see the CFTC 
take steps and acknowledge that these new markets are going to 
be developed, just as we have seen new markets expand 
significantly both in equities and in fixed income securities.
    Mr. Chairman, that pretty much summarizes the comments that 
I made in our written submission, and I would be very happy to 
answer any further questions or be of any further assistance. 
Thank you.
    [The prepared statement of Mr. Waye can be found in the 
appendix on page 74.]
    The Chairman. Thank you very much, Mr. Waye, for your 
testimony. And now Mr. Crapple, President of the Managed Funds 
Association, we appreciate your being here. If you could tell 
us a little bit at the start what the Managed Funds Association 
is and does, we would appreciate that.

    STATEMENT OF GEORGE E. CRAPPLE, CHAIRMAN, MANAGED FUNDS 
                ASSOCIATION, NEW YORK, NEW YORK

    Mr. Crapple. Certainly. A small correction, I am appearing 
as Chairman of the Managed Funds Association. Our President 
Jack Gaine overcame great transportation obstacles to get here, 
and he is also here. But I have the seat at the table.
    MFA is a national trade association representing more than 
700 participants in the hedge fund and managed funds industry. 
I should say I am also the co-Chairman and co-Chief executive 
of Millburn Ridgefield which has managed money in the currency 
and futures markets since 1971, and also sponsors funds of 
funds and equity hedge funds.
    MFA appreciates the opportunity to testify before the 
Subcommittee concerning the CFTC's New Regulatory Framework 
Report and issues relating to the reauthorization of the CFTC. 
Our association commends the CFTC for its commitment to 
reinventing the regulatory program in fundamental ways, an 
approach designed to attract seemingly intractable regulatory 
issues that have been with us for many years, as well as issues 
that may be critical in permitting our markets to remain global 
leaders in the 21st Century.
    Members of the MFA in the aggregate manage the vast 
majority of the over $40 billion invested in managed futures 
and a significant portion of the nearly $400 billion invested 
in hedge funds. Our members are active participants in all 
derivative markets, on and off exchanges, foreign and domestic. 
Accordingly, a regulatory framework that promotes competition 
and innovation which results in liquid, efficient markets is of 
enormous significance to us. We believe the CFTC's report and 
the previously issued President's Working Group report on over 
the counter derivatives identify a number of important issues 
deserving priority and attention.
    We believe in general that the CFTC's overall purpose and 
its suggested approach are highly constructive. The report 
significantly advances the debate over the optimal regulatory 
structure in the U.S. futures markets and we applaud the 
development. I would like to first speak briefly on the new 
regulatory framework report.
    The highly competitive markets in which MFA's members and 
other market participants operate require prompt and creative 
responses to new market conditions, new technologies, new 
products and new trading and clearing mechanisms. The CFTC is 
to be commended for developing approach to exchange regulation 
that is designed to expand the ability of U.S. futures 
exchanges to meet these challenges through a regulatory 
framework that affords the maximum latitude, subject only to 
constraints reasonably designed to assure basic customer and 
market protections.
    As we understand it, the report contemplates a regulatory 
approach under which futures exchanges and the over the counter 
derivatives trading facilities would operate on an even playing 
field, one in which appropriate circumstances would be subject 
to minimal regulatory burdens. We support this concept of a new 
highly flexible, largely unregulated marketplace. Now, I think 
I could echo really some of the comments that Barry Lind made. 
We are concerned about the role of our constituents in the new 
less or non-regulated marketplaces.
    Commodity pool operators and commodity trading advisors and 
qualified registered professionals acting for pools, hedge 
funds, and individual accounts should be able to access all 
futures markets, just as today they have access to swaps, over 
the counter derivatives and foreign futures and options, 
markets that are not subject to the highest level of 
regulation. For CTAs, CPOs and their clients, special 
conditions or risks in these newly developed markets should be 
addressed as they are generally today in the case of foreign 
futures markets by the use of a standardize risk disclosure 
statement.
    As is the case with foreign futures, this risk disclosure 
statement should be simple and distinct, clearly highlighting 
the special risks associated with the particular kind of 
market, thereby permitting the customer to make an informed 
choice whether to assume these risks. The approach would 
facilitate the broadest access for CTA advised futures 
customers in commodity funds to the greatest possible array of 
innovative U.S. derivative markets, resulting in the deepest, 
most liquid and hence, efficient derivative market, a goal that 
we all share.
    This approach is far superior to limiting eligibility to 
access a particular market, to defined group of customers, such 
as limiting access to only the institutional clients of a CTA. 
This would create significant problems. As the CFTC knows from 
its recent efforts, the use of this approach to implement a 
post trade, order allocation procedure rendered the rule 
unworkable. The reporting and record keeping nightmare is 
great. In the current case, for example, if the CTA had 50 
clients in a program and only 30 of them qualified for access 
to the larger more efficient market, the CTA would be forced to 
trade the 30 accounts in one market and the other 20 accounts 
in another. As a result, most importantly, the CTA's 
performance results for the 30 accounts could differ 
substantially from those with the 20 accounts. Most likely, 
better results would be gotten for the 30 supposedly large 
customers. The fragmentation of liquidity would also adversely 
affect the efficiency of both markets.
    So in summary on this point, MFA strongly suggests that 
CTAs, CPOs and all of their clients and investors have access 
to all futures and derivative markets. I would next like to 
very briefly address the issue of regulatory relief for 
commodity pool operators and commodity trading advisors which 
is not part of the new regulatory framework report, but is 
contemplated to be forthcoming.
    The CFTC is operating with the MFA, that they will be 
reviewing the regulatory framework for CPOs and CTAs with the 
same objectives, enhancing efficiency and competitiveness, 
which have guided its review of exchange regulation. The CFTC 
staff in cooperation with the MFA is developing draft core 
principles for CPOs and CTAs, designed to supplement the 
report's recommendations concerning other aspects of 
regulation. We strongly support this effort and have so far 
assisted and stand ready to assist the CFTC and the MFA in any 
way they consider appropriate. There are many inefficiencies to 
be remedied, including for example, putting public and private 
offerings of pool interests on a level playing field with 
public and private offerings of securities and for example, 
public offerings of mutual funds. We are under a much more 
restrictive offering regime for which there is no apparent 
public interest necessity.
    Lastly, I would like to mention legal certainty of OTC 
derivatives. The CFTC report is not principally designed to 
address the issue but the report builds upon and is consistent 
with the President's Working Group recommendations for enhanced 
legal certainty for OTC derivatives, in particular by 
reinforcing and augmenting the Part 35 swaps exemption, and by 
providing new exemptions for innovative trading and clearing 
structures for OTC derivatives.
    MFA strongly supports the objective of enhancing legal 
certainty for OTC derivatives including the President's Working 
Group recommendations for legislation to exceed OTC financial 
derivatives from the CEA, as well as the report's 
recommendation for actions by the CFTC to enhance legal 
certainty. I would say having listened to Mr. Waye's remarks, 
that we would certainly endorse additional legal certainty for 
OTC commodity contracts as well.
    We believe that in defining the statutory exclusion for OTC 
derivatives and other measures to enhance the legal status of 
swaps, the existing criteria defined in eligible swaps 
participants should not be further restricted. In fact, they 
should be expanded to include all clients of CTAs and all 
commodity pools. The President's Working Group suggestion that 
consideration be given to increasing financial threshold for 
natural persons engaging in swaps to $25 million in 
discretionary investments, in our view, is not warranted by 
experience or public policy. MFA opposes the creation of 
additional restrictions upon access to swaps and other 
derivatives transactions. In fact, the real limitation on 
participation to these markets is finding a swaps or derivative 
dealer who has confidence in accepting the business of a 
particular customer. And we think this is the real check on 
preventing unqualified people from participating in these 
markets.
    In conclusion, MFA fully supports the efforts of this 
Subcommittee and of the CFTC under Chairman Rainer to make U.S. 
futures regulation as innovative as the industry overseas. We 
look forward to providing our full assistance and cooperation. 
Once again, thank you for the opportunity to present MFA's 
views on this important topic.
    [The prepared statement of Mr. Crapple can be found in the 
appendix on page 77.]
    The Chairman. Thank you very much, Mr. Crapple. We 
appreciate that. Mr. Downey from Interactive Brokers, LLC, 
thank you for being here. I would appreciate if you could 
describe for the panel a little bit about what your company 
does, and then go on to describe your views on the proposed new 
regulations.

    STATEMENT OF DAVID G. DOWNEY, EXECUTIVE VICE PRESIDENT, 
           INTERACTIVE BROKERS LLC, CHICAGO, ILLINOIS

    Mr. Downey. Mr. Chairman, thank you very much for inviting 
me to participate. It is an honor and a privilege.
    Interactive Brokers is an organization that provides 
electronic access to the world's markets, to a variety of 
customers ranging from large broker/dealer and FCM trading 
desks down through some of Mr. Crapple's constituents of 
professional fund managers to individual investors trading out 
of their kitchens via the use of the Internet. Our platform 
provides all of these participants with the exact same level of 
access into the marketplace at the exact same price levels. So 
they all participate on a level playing field.
    We use a network that is connected to over 30 exchanges 
around the world. We allow our customers to connect to all 30 
of them. Retail, that is our small customers who deserve the 
highest level of protection, we only allow them into the 
electronic marketplaces where they are protected. They are not 
allowed into the open outcry markets because of the 
inefficiencies that occur.
    The Chairman. Is that by your own choice or is that CFTC 
regulations?
    Mr. Downey. No. I have the technology to bring them into 
the open outcry using my own people. But I have come to the 
conclusion recently, within the last 4-months, that there is 
nothing I can do to control the risk present in these customers 
entering the open outcry. And we are going to develop only from 
what we believe will eventually succeed. No one has been able 
to put forth an argument that the open outcry will ever 
overcome the inefficiencies and cost structures associated with 
it. They cannot compete on a cheaper, faster basis with 
electronic markets.
    With that said, Mr. Chairman, I have to join everybody 
here. I think this is a tremendous start with what the CFTC has 
put out, and it is based on leadership. We are at a moment 
where we need absolutely to show, and that includes from 
Congress. Very briefly, on the document itself, I have two main 
topics. One is I do not believe that any customer should be 
denied access to any facility as long as they are intermediated 
and protected. I think that if you start splitting them up 
where you have large players creating prices that are somehow 
reflected in the retail trading arena, the retail should have 
access to both markets. I think that can be achieved through 
the intermediaries' role.
    In the absence of that price transparency, if they are 
trading like products on different platforms for different 
people, all prices should be known to all market participants, 
whether they are allowed to trade there or not, as long as they 
have a correlated market elsewhere. They can be influenced by 
prices being established.
    The second issue besides the pricing is that it was very 
clear about the codes of conduct for the RFE, the DTF and the 
intermediary. On the first two, the issue of audit trails and 
making sure that there are time stamps that are very clearly 
spelled out, protecting the customer's access to the markets on 
a who knows what when basis, because that is market 
manipulation. But there is no such call on the intermediary's 
code of conduct, and that is exactly where they need it the 
most. There are three pieces to the interaction between 
customers and the market.
    There is a collection piece, ruled by the member firms. 
There is a distribution piece, ruled by the member firms. And 
an execution piece, ruled by the exchanges today. The danger of 
time stamping the orders and frontrunning and market 
manipulation are just as prevalent upstream as they are at the 
matching edges. So if I could make that statement, that the 
codes of conduct for intermediaries simply include high 
resolution audit trails, at least as high as the exchanges 
themselves, to make the audit trails meaningful.
    With that said, I generally agree with the document. I 
believe it is a tremendous start for us, and details need to be 
worked out. But the details that need to be worked out are 
going to be influenced exactly from the leadership from 
Congress on two very important issues. The first is 
competition.
    Competition is going to be technology based. The exchanges 
are rushing towards ownership and they are going to be self-
regulated, and it raises serious questions, are they going to 
be partisan in deciding whether a certain technology will or 
will not succeed. This is no longer an abstraction. We have 
some exchanges on the securities side who have been faced with 
issues, should we allow customers to access our markets with 
the given technology, and they have taken affirmative steps not 
to allow customers access, and to cripple the technology. That 
simply has to be protected against.
    My concerns with the current framework, with the framework 
that is being proposed is that the exchange can stop a piece of 
technology being given to a customer and I need to know who do 
I plead to.
    The Chairman. Can you give some examples of what you have 
in mind there?
    Mr. Downey. Sure. On the options exchanges, the SEC has 
come out and said that the member firms have a duty to provide 
best execution; that is, deliver their customer orders to the 
highest bid or the lowest offer. The broker/dealers have 
provided this technology that allows a customer in a kitchen in 
Iowa from observing the prices on all competing exchanges and 
pointing and clicking and sending an order to the appropriate 
exchange. Last Wednesday the CBOE effectively terminated the 
customer's rights to do the arbitrage if there was a market 
dislocation between two exchanges or three exchanges. The 
customer did not have the right to take advantage of that, 
given the available technology and they stopped automatic 
execution on that exchange with the blessing of the SEC, a 
complete contradiction to Congress' bias toward giving 
technology and the SEC's own statement on broker/dealer's best 
execution responsibility.
    We have had the experience that while the regulators, 
acting on the intent of Congress, have pushed technology and 
competition. When push comes to shove, the exchanges step up to 
the plate and beg for mercy and the regulators simply back 
down. The NASD, for instance, Mr. Chairman, had a recent 
proposal on order handling. They received 71 industry comment 
letters, 59 of them negative in some regard to its new 
proposal. The SEC let it stand without comment, no changes. 
That has to be a Congressional issue.
    We demand the regulators, you are to act in the fall on 
technology, innovation and competition, and you have to make it 
very clear as to the burden of denying technology which will 
foster competition. That is the first part, leadership.
    The second issue is on the clearing house. Competition in 
the marketplace in the futures, when I hear that people are 
going to create exchanges, I think that is a great idea. Where 
are they going to clear it? Where are they going to clear this 
stuff? If they do not have a facility to clear, that they have 
a matching engine means nothing to me as a participant.
    In the futures market today there is no national clearing 
mechanism. There is no way for an individual with a matching 
engine idea to come up and step up and find a place to clear 
it. They have to go back. Interesting, Mr. McNulty pointed out 
that he intends to make his clearing operation a revenue 
stream. That means he is going to use it as a corporate asset, 
to keep competitors out and raise the prices. If you really 
want competitive markets in the futures, by the way, where is 
the competition between products and the futures market? There 
is none. Where is it in the securities market? Every exchange. 
Options market? Every exchange. Futures market? They are all 
based on each other's exchanges. And that is because of 
clearing.
    Clearing in the futures market was instituted by Congress 
in the 1920's as a result of a default of the Chicago Board of 
Trade in the 1900's, early 1900's. Market participants were 
unable at that time to come to an agreement on clearing and 
Congress had to step in. In my mind they had a flaw in it. They 
stepped in and said if you want to be a contract market, you 
got to have a clearing house. But they did not describe how 
open that clearing house had to be. They left it to the markets 
to describe it. The Chicago Board of Trade has a separate 
entity. The Chicago Mercantile Exchange has a division. But 
they are both exclusive to anyone else, and you cannot get in. 
When the member firms say we want to compete, they really want 
to compete on the clearing house. They want people to allow 
them to clear. And only Congress is going to allow that to 
happen. CFTC cannot push it. This document is not going to 
help.
    We need leadership from Congress. We want competition, and 
in order to get competition you need clearing. Clearing 
structures should be open to all, along the lines of a national 
clearing and settlement mechanisms established in the 
securities market by the Securities and Exchange Act amendments 
of 1975. Without that, we would not have the SEC on the 
securities side or the OCC on the options side that allows for 
competition like the international securities exchange, the all 
electronic options exchange which has driven the options 
business to incredible competition, lowering and narrowing of 
bids and spreads, benefiting the member, benefiting the 
customer base. That is what competition is all about, and it is 
about clearing.
    Mr. Chairman those two issues, a real vision on how we are 
going to let technology thrive and the establishment of a 
national clearing mechanism for futures is something that we 
need leadership from Congress on. Thank you.
    [The prepared statement of Mr. Downey can be found in the 
appendix on page 87.]
    The Chairman. Thank you very much for that testimony, Mr. 
Downey.
    Would any of the other panelists wish to comment on Mr. 
Downey's proposal for a national clearing house? Mr. Lind?
    Mr. Lind. I do not know how you would get that to work. I 
can say this, that certainly you could not force the Board of 
Trade clearing corp. or the Chicago Mercantile Exchange to take 
on the clearing of another exchange. First off, at the 
Mercantile Exchange, they have a good to the last drop rule. So 
any funds that we have up there are one thing, but if there was 
a big default they could just keep coming after us on a 
prescribed rotation until all the money was gone. No one is 
going to guarantee a little cattle exchange or some major 
exchange that may not know what they are doing. So how you can 
take that from the level, and certainty you could not force the 
Chicago Mercantile Exchange to do that. And how you can take 
that on a national realm where you put everybody there, I do 
not see how the integrity of that would be able to be set up so 
that people would be comfortable. Because if you are going to 
have DTFs and other exchanges that are coming about, there 
would be a lot of reassurance that would be needed to get 
people to be willing to guarantee that or put money into that.
    The Chairman. Does anybody else wish to comment? Mr. Waye?
    Mr. Waye. It is difficult to perceive, with all the changes 
that are going to be coming up, with electronic markets and the 
new deregulatory framework, how the clearing house issue is 
going to unfold. But I think as a clearing firm, we would be 
willing to put our capital at risk, if we are satisfied with 
the organization, with the rules and the regulations, and if 
that means new clearing houses where there are solid financial 
parties and solid rules and regulations. We would be prepared 
to put our capital at risk to enable our clients to participate 
on new markets. So I cannot guarantee exactly how it is going 
to unfold, whether existing clearing houses will start to clear 
a broader array of underlying physical products, for example. 
Or we may get futures cleared more broadly among a variety of 
clearing houses.
    The CFTC staff would allow the non-U.S. clearing house, 
such as the London clearing house, to establish a facility or 
partnership in the U.S. to clear potentially some of the exempt 
MTEF trades. And I am sorry staff is not here today, to just 
ask the question. I believe that is the case. So I think we 
will see more competition for clearing. I think we will see 
member firms like ourselves be willing to clear new exchanges, 
if we are confident of the financial strength of those 
exchanges. So I agree with Mr. Downey, clearing is really a 
very, very core critical issue and it is difficult to predict 
exactly how it is going to unfold, but I think we will see 
significant change coming up in the next year or two.
    The Chairman. Mr. Crapple?
    Mr. Crapple. I think it would be highly desirable and it is 
necessary for effective competition by new exchanges that there 
be a clearing mechanism available. I do not really think that a 
major, a new exchange is going to have much of a chance getting 
started unless it has got the backing of major securities and 
futures firms that are clearing members of other exchanges. So 
I see it more as a voluntary rather than mandated approach. But 
there is no doubt that if it came about through one means or 
another, that it would be a great enhancement to competition.
    The Chairman. Mr. Downey, I want to ask you a question 
about access to exempt multilateral transaction facilities, 
exempt MTEFs. Would you support access to an exempt MTEF by 
retail customers as long as they are represented by 
intermediaries?
    Mr. Downey. Yes. I think that the people that you are 
discussing would be exempt and are going to be people who are 
professionals who are basically trading a lot of individuals' 
money. Those individuals are going to have access to it, but 
they are trusting some person to actually pull the trigger on 
their behalf. I think I would like to say this. The definition 
of a sophisticated customer is something that is very difficult 
to pin down. I know some very sophisticated customers with 
$100,000 in capital and I know some very unsophisticated 
customers with 10-million in capital, and I think one would be 
allowed to trade and the other one would not. I think that it 
really comes down to do you understand the risks involved here? 
Do you understand this trade might have some defaulters to it?
    And also again, in trading it comes down to one thing in my 
mind. That is the price. Does everybody know what the price is? 
Does everybody know what the pressure is going to be? And if 
you do not allow individuals to trade in these facilities, as 
long as they are trading a product that does have a correlation 
to a market that is trading downstream, prices have to be 
disseminated in a very timely manner and that means no delay. 
As soon as they know about the price, they disseminate it so 
everybody else can trade on the knowledge that there is a big 
transaction that took place and it is going to affect 
everybody's pricing.
    The Chairman. What do the other panelists think about that 
issue, whether there should be access to an exempt MTEF by 
retail customers as long as they are represented by 
intermediaries?
    Mr. Crapple. I will take a stab at that. I think Mr. Lind 
would probably go a step farther than I feel the need to go, 
because in his case he is an FCM who would be an intermediary, 
and in the case of the Managed Funds Association, our clients, 
our constituents are the CTAs and CPOs. So in the case of a 
customer of a CTA, an individual, regardless of his means, has 
signed documentation granting discretionary trading authority 
to a registered category under the CFTC. So the individual is 
no longer making his own trading decisions. He has delegated 
that, and as long as the person that it has been delegated to 
has been invented by the CFTC and the MFA, we see no good 
argument for foreclosing that ultimate customer from any 
category of the new market frameworks.
    Now, I think Mr. Lind referred to a concept of FCMs with 
$20 million in capital. At least in a case like that, if an FCM 
is forwarding orders to any level of exchange and something has 
gone wrong, you have got a pocket to go to. The customer is not 
without recourse. Anyone with capital could actually be an FCM. 
And it is possible for any fly-by-night organization. You would 
not, I do not think, want to see a blanket rule that any 
customer of any FCM could go to any market necessarily. But I 
have great sympathy for the concept of limiting it to FCMs that 
achieve the material capital.
    The Chairman. Mr. Lind?
    Mr. Lind. It comes down to two basic situations. One 
situation, the more exotic situation might be as an example, 
something that was offered to me a year ago, which I should 
have taken. You, as a customer of mine, on an exempt market, 
maybe the product that is going to be offered is something like 
this. You can get a return of 1-percent or a return of what the 
S&P index does over the course of 2-years. So you put up 
$100,000 and the worst that you are going to get back is 
$102,000 or if the S&P index goes up 20-percent a year, you get 
back $140,000. They should be able to deal in that type of 
product, and they should be able to deal in that type of 
product through me. So that is the more exotic type.
    But the basic situation that we have is right now a lot of 
transactions, not anywhere near as many percentage-wise as used 
to be. The market has grown and volume is still good at the 
futures exchanges, but when we get these off exchange products, 
if the exchange market, for example, right now is two, three, 
an off exchange you get the inside market is now two and a 
half, three, but if the liquidity goes off exchange, like I 
would suspect a lot of it is going to happen, then the market 
might be something more like one, four on the exchange.
    So I want my customer to be able to get at least the two, 
three, if not the two and a half, three market. I certainly do 
not want him to have to pay four or sell at one, because then, 
no matter how much you protect him, then he has been hurt by 
this. So wherever the market is, that is what I would like to 
get for my customer.
    The danger that you have in that is if you have some 
people, because it does not take much to become an introducing 
broker, and my fear is that he will go down to this off 
exchange operation down the street with his buddy and instead 
of having a market of two, three, he will have a market of even 
to 40 or even to 60. And we have seen that in the past. And 
that is why I propose the protection, that the firm has got to 
be a clearing member, has got to have enough money at risk so 
that he is not going to do something wrong. No member of an 
exchange that is any kind of substantial member at all is going 
to mess around like that. So I think that the protections are 
there. And if the protections are there, then I think that we 
certainly have to be able to give the best price to the 
customer, wherever it exists, whether it exists at the 
exchange, or at an exchange or any of the other categories that 
have been provided.
    The Chairman. Thank you. You do not have anything to add, 
Mr. Waye?
    Mr. Waye. I would just go back and support Mr. Crapple's 
comment, that I believe individual investors who are having 
their funds managed by a third party, and that third party is 
registered with the CFTC and the MFA, that third party then 
should have the ability to transact in the exempt MTEF market 
on behalf of its clients, whether those clients are retail or 
institutional or commercial. So I would support Mr. Crapple's 
comments in that regard.
    The Chairman. So the retail customers get into that MTEF 
that way.
    Mr. Waye. Yes.
    The Chairman. Mr. Lind, in your opening statement you 
talked a lot about access to markets. You did not use the word, 
but I think you were really talking about the bifurcation of 
the market between retail and institutional customers and you 
were concerned that retail customers could be denied access to 
the market with the greatest liquidity. Do others of you share 
that concern under this proposed regulatory scheme? Business 
could really migrate from the RFEs. Liquidity could migrate 
from the RFEs to the less regulated DTFs and exempt MTEFs. If 
the retail customers do not have a way of getting in those 
markets, they are really going to be locked out of the most 
liquid markets. That is a real problem, is it not?
    Mr. Lind. That is my problem.
    Mr. Crapple. I think that is a good point. I think 
inevitably there will be some tendency in that direction. An 
analogy that was made by someone used to be if you could trade 
the same contracts, certain grain contracts at the Chicago 
Board of Trade or if you were a small fry, at the Mid-American 
Commodity Exchange and you had to set the positions limits, so 
actually the big traders used them all. And they would send 
orders to the Mid-American Commodity Exchange, and they have a 
bank of people that the changer phones and they would just 
immediately lay this off on the big liquid Board of Trade 
markets. The problem with that is the toll charge on it. It was 
more expensive. I think that we probably would be faced with 
something, you would get more customer protection in one sense, 
but there would be some cost.
    The Chairman. Mr. Downey?
    Mr. Downey. Technology today, I think I have demonstrated 
it to you in the past, the small retail customers know exactly 
what they are getting, as long as they can see the price and 
watch the price move and they can see the buy and sell 
fluctuations by themselves and they can make an informed 
decision. I do not see the growth of the market being dominated 
by the institutions. I see the growth of this market being 
dominated by individual investors who have taken their own 
decisions into their own hands. And to deny them access to the 
liquidity of a marketplace simply because they are deemed 
unsophisticated, I think that is unfair. If they can be 
delivered, using the technology of a member to protect them and 
to make sure that they have all requisite information that they 
need for protection, they deserve to be able to participate.
    The Chairman. The problem here is that, in an attempt to 
help protect the retail investor, we could in fact deny them 
the best prices and thereby hurt them. Far from protecting 
them, we could be hurting them. We have got to be very careful 
here.
    To summarize, am I correct in saying that you feel that if 
the retail customers would have access to the exempt MTEFs 
through other intermediaries, but not directly, they would be 
protected?
    Mr. Downey. I do.
    The Chairman. OK. They would still have access to those 
most liquid markets, is that correct?
    Mr. Downey. You must remember that the only reason why it 
is not clearing houses is because of contract market status. 
These would not be contract market status, these entities, 
these MTEFs, so they would not need a clearing house. Retail 
customers should not be exposed to non-clearing house cleared 
products. I am trying, again, to lobby you to create a clearing 
house.
    The Chairman. Right, right. I hear you. I hear you
    Mr. Lind. Wait a minute. Mr. Chairman, may I comment on 
that?
    The Chairman. Yes.
    Mr. Lind. The opposite party in this type of transaction, I 
am acting as the intermediary for my customer, and maybe the 
opposite party is Goldman Sachs. Now, in my proposal, all my 
customers' funds have to be segregated to begin with. But the 
responsibility of making that trade good on one side is Goldman 
Sachs. Now, if Goldman Sachs defaults, my customers' monies are 
still protected because it is all segregated funds.
    Now, if we do not have an arrangement, where we settle 
every day and he defaults to me, then my in my opinion that 
obligation is mine. The customer gave me the order. I deal with 
Goldman Sachs, Goldman Sachs goes out of business, I have to 
make my customer good. I may have his money in segregated 
funds, but I may not have the profit that he had on a position, 
I have to make that good myself. But the customer will be 
totally protected in that regard, whether there is a clearing 
house with a DTF or not.
    The Chairman. What do you think about the suggestion for 
the relaxed standards as to the segregated funds? Does anybody 
want to comment any more on that?
    Mr. Waye. Mr. Chairman, I think the recommendations by 
staff to allow a somewhat greater degree of flexibility in how 
segregated funds are invested and managed by the FCM, as Mr. 
Lind said, we would support that.
    The Chairman. What are you allowed to invest them in now?
    Mr. Waye. U.S. Treasury securities.
    The Chairman. And that is pretty much it? What would the 
proposal be that you can invest them in?
    Mr. Waye. I have not seen it exactly. But I have heard CFTC 
staff say you might be able to invest them in similar 
securities to what a clearing house accepts today. Or I am not 
quite sure if their thought is to lower it like double A or 
single A or A-1 plus P-1 commercial paper. I am not sure. Just 
that they would broaden it beyond treasuries only, which is the 
current requirement.
    The Chairman. I think they had in mind municipal bonds and 
the like. I should not comment on that. I will leave that to 
the CFTC.
    What do you think about the other suggestions for relaxed 
standards as to risk disclosure, registration, financial 
requirements and the like? What do you all think of these 
recommendations for the intermediaries?
    Mr. Downey. I personally do not find them to be a burden at 
all. They are deliverable. I know a lot of it is the paper, 
they would create paper and deliver it and get signed 
signatures. I think the CFTC has already moved forward on 
electronic signatures which opens up the door for electronic 
delivery. I do not provide any of my customers these risk 
disclosure statements in a paper format. They capture them 
electronically. They read them. They take a test on them. And 
they acknowledge that they have gotten them. I do not find them 
to be a burden. Technology can solve that problem, and I 
consider it a good policy to understand that our customer 
understands the risks involved in the business he is about to 
undertake.
    Mr. Lind. First, let me say that the risk disclosure 
statement for the retail customer today, I am guessing now but 
I would have to say it is probably over 20-years old. And times 
have changed. The sophistication of people today, even people 
who have never traded before, is so much higher than it was 
back then, that I think that risk disclosure today, I think 
there should be a risk disclosure. I think it should be for 
today's times. I do not think that most of my customers read 
it. Certainly I do not give them a test. What do you do if 
someone fails the test?
    Mr. Downey. Let them take it again.
    Mr. Lind. Right. They would check off that they have 
received it, but I doubt that very many people read it. Now, I 
think that a more appropriate message about the risks of 
trading could be enclosed in a short enough form that the 
people probably would read it. But right now, the whole thing 
is pretty burdensome, and it is really out of date, but we can 
live with that. And I think it should be there.
    Also, going back to the segregated funds, part of the 
reason why the relaxation of segregated funds would be, because 
our competition overseas has a whole relaxed aspect to that. 
They can invest in many other things. Some of the customers 
here would like to direct the firm that they are trading with 
to take the funds and invest it in something else where they 
are going to get a better return rather than on treasuries. I, 
myself, for the retail customer believe the funds should stay 
segregated but only for the retail customer, and that those 
funds should be invested only in treasuries the way they are 
today.
    The Chairman. Well, thank you very much. I am going to 
adjourn this Committee meeting now. I appreciate very much the 
substantial contribution all of you have made, through your 
prepared remarks and through your testimony today. Rest 
assured, I will take this input back to Washington, as we 
rewrite the Commodities Exchange Act this year. Let us hope 
that we get it done by September, which we have set as an 
absolute deadline. Thank you all very much for your help today. 
Thank you.
    [Whereupon, at 12:30 p.m., the hearing was adjourned.]
      
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                            A P P E N D I X

                             March 20, 2000

      
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                   DOCUMENTS SUBMITTED FOR THE RECORD

                             March 20, 2000

      
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