U.S. House of Representatives
Committee on Agriculture
Review of the Application of U.S. Futures Exchange LLC
for Designation as a Contract Market
Statement of John M. Damgard, President
Futures Industry Association
November 6, 2003
Mr. Chairman, members of the Committee. On behalf of the Futures Industry Association (FIA), I want to thank you for the opportunity to appear before you today to discuss the application of the U.S. Futures Exchange LLC for designation as a contract market. FIA is a principal spokesman for the commodity futures and options industry. FIA’s regular membership is comprised of approximately 40 of the largest futures commission merchants (FCMs) in the United States. Among its associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of its membership, FIA estimates that its members effect more than 90 percent of all customer transactions executed on United States contract markets.
When Congress amended the Commodity Exchange Act through the Commodity Futures Modernization Act of 2000, an underlying purpose, as expressed in the Act, was “to promote responsible innovation and fair competition among boards of trade, other markets and market participants.” The application of the U.S. Futures Exchange, an indirect subsidiary of Eurex, marks an important step in realizing the vigorous competition among markets that Congress anticipated in the CFMA.
Attached to my statement is a copy of the comment letter that FIA has filed with the Commission in support of the U.S. Futures Exchange application. I respectfully request that it be made a part of the record here. I will not repeat the points made in that letter. Instead, my comments today will focus on two issues with respect to which the Committee indicated particular interest: the process for designation as a contact market and the U.S. Futures Exchange self-regulatory program.
The Designation Process
The CFMA signaled a radical new approach to the regulation of the derivatives markets. Prior to enactment of the CFMA, the Commission’s prescriptive regulations had unnecessarily delayed the approval of new contracts and the introduction of innovative trading procedures. To replace these regulations, Congress set out a limited number of broad criteria that an applicant for designation would have to meet in order to be approved as an exchange and certain core principles with which the exchange would have to continue to comply in order to maintain its designation. Consistent with its goal of promoting responsible innovation, Congress further provided that the exchange “shall have reasonable discretion in establishing the manner in which it complies with the core principles.”
Significantly, Congress removed the requirement that an exchange identify the contracts that it intended to list for trading in connection with its application for designation as a contract market. As with existing exchanges, therefore, an exchange applicant is permitted to wait until it has been designated as a contract market and may then list its contracts by certifying to the Commission that the contract complies with the provisions of the Commodity Exchange Act. This provision of the law assures that new exchanges and existing exchanges are on a level playing field with respect to the listing of new contracts.
Congress also specifically removed the statutory requirement that effectively required the Commission to publish applications for designation for comment in the Federal Register. This change in the law promised to expedite the review and approval of new exchanges. More important, it confirmed that the Commission, as the expert agency responsible for the regulation of derivatives markets, is best suited to determine whether an applicant meets the statutory criteria and is able to comply with the core principles that Congress established.
As a result of these amendments to the Act, the Commission is under no obligation to request public comment from interested parties prior to determining whether an applicant meets the criteria specified in the Act. Congress has left the decision to seek comment—and the manner in which it seeks comment—to the Commission to determine in its sole discretion. In this regard, we note that, since the enactment of the CFMA, the Commission has designated four new contract markets: OneChicago; Nasdaq-Liffe Markets (NQLX); Island Futures Exchange; and CBOE Futures Exchange. In each instance, the Commission approved the applications without requesting comment from the public. Although the industry’s experience under the CFMA is obviously limited, we have seen nothing to date that would cause us to recommend a change in the Commission’s authority.
In providing a thirty-day period for public comment on the U.S. Futures Exchange application, the Commission presumably determined that its review could benefit from receiving the views of the industry, although it did not request comment on any specific aspect of the exchange application. As discussed above, that is the Commission’s decision to make in its sole discretion. Nonetheless, we caution that the Commission must take care not to adopt different procedures for certain applicants that may appear to be designed solely to prevent new entrants from establishing their business in a timely manner. Such actions would clearly be contrary to congressional intent in enacting the CFMA.
In this regard, it is important to remember that Eurex is not an unknown entity to the Commission. To the contrary, over a period of more than seven years, in connection with various requests for regulatory relief from U.S. requirements, the Commission has had several opportunities to review Eurex, its operations and the rules and regulations to which it is subject. Each time, it has found no reason not to grant Eurex the same relief that other foreign exchanges were granted.
For example, in 1999, the Commission staff adopted a no-action position, authorizing Eurex, among other foreign markets, to place terminals in its members’ offices in the U.S. for trading in certain Eurex contracts. Before adopting this position, the staff conducted a thorough review of Eurex including its operating and trading rules, its trading system, its settlement and clearing system and its compliance programs. In 2000 and again in 2002, the Commission staff adopted no-action positions authorizing the offer and sale of certain stock index futures contracts listed for trading on Eurex. More recently, the Commission, pursuant to its rule 30.10, granted an exemption from registration for firms authorized by Eurex that wish to solicit orders from U.S. customers trading on that exchange. In granting this latter exemption, the Commission specifically found that Eurex is subject to a regulatory scheme that is comparable to that to which U.S. exchanges are subject.
We also want to emphasize that the lack of a public comment period has not denied FIA the opportunity to express its views with respect to the organization, operation and rules of exchange applicants. Rather than dealing indirectly through the Commission, however, we now work directly with the relevant exchange or clearing organization, a change in procedure that has proved to be both more efficient and more productive. For example:
In connection with the applications of OneChicago LLC and NQLX, the Security Futures Committee, composed of representatives of FIA member firms and member firms of the Securities Industry Association, met often with the staffs of these exchanges and provided both oral and written comments. Our goal was twofold. First, we wanted to assure to the extent possible that the exchange rules were designed to facilitate the efficient execution of transactions in the security futures products that would be listed on each exchange. Second, we wanted to be certain that any operational issues our member firms identified were resolved prior to the initiation of trading.
Immediately following the announcement of the clearing link between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBT), FIA advised the leadership of both exchanges that we were ready to work with them to resolve the numerous questions that were certain to arise as the business and operations details of their arrangement were implemented. To this end, we formed an ad hoc committee under the leadership of Craig Smithson, Executive Director of UBS Warburg.
As with OneChicago and NQLX, representatives of FIA member firms have held a number of meetings with the staff of the U.S. Futures Exchange to discuss its rules and operational structure. In particular, we have recommended several changes to their trading procedures, which the exchange has agreed to consider.
Finally, we recently formed an ad hoc committee to work with the U.S. Futures Exchange and The Clearing Corporation to resolve operational issues as they develop their clearing link.
Self-Regulatory Program
As the Committee is aware, in connection with its application for designation, the U.S. Futures Exchange has contracted with the National Futures Association to perform on behalf of the exchange essentially all of the market surveillance and compliance programs that exchanges are required to implement. Although we have every confidence in NFA’s ability to perform these functions, the Commission ultimately will determine
whether NFA’s programs are properly designed to permit U.S. Futures Exchange to meet its statutory obligations through NFA. As a matter of policy, FIA supports the exchange’s decision to delegate these responsibilities to NFA. As a matter of law, the CFMA amendments to the Act specifically provide that a “a contract market . . . may comply with any applicable core principle through delegation of any relevant function to a registered futures association or other registered entity.” NFA, of course, is a registered futures association.
We note that the contract between the U.S. Futures Exchange and NFA is not unique. NFA currently performs self-regulatory functions for BrokerTec Futures Exchange and the Merchants Exchange. NFA also has a contract with Island Futures Exchange to perform services when that exchange begins trading. Similarly, OneChicago has contracted with CME to perform certain of its self-regulatory functions, while NQLX has a contract with the NASD.
The decision of a new exchange to contract with an established self-regulatory organization should be welcomed, not challenged. In a 2000 White Paper entitled “Reinventing Self Regulation”, which was recently updated and reissued, the Securities Industry Association identified certain guiding principles for securities self-regulatory organizations that are no less applicable to the futures industry. Specifically, SIA stated that any self-regulatory structure should:
Foster Investor Protection;
Preserve Fair Competition;
Eliminate Inefficiencies;
Encourage Expert Regulation;
Promote Reasonable and Fair Costs of Regulation;
Foster Due Process; and
Encourage Industry Participation and Self-Regulation.
We submit that the public and the industry can have greater assurance that these seven purposes will be achieved—and an exchange will be able to perform its statutory responsibilities more effectively—if it retains the services of an experienced self-regulatory organization rather than attempting to build its own. As an economic matter, requiring an exchange to maintain its own staff to perform these functions would likely create an insurmountable barrier to entry that would inhibit any entity from applying for designation.
Conclusion
We do not know if the U.S. Futures Exchange will succeed, assuming its application is approved. Capturing liquidity from existing exchanges is exceptionally difficult in the best of circumstances. Market participants have demonstrated a well-earned confidence in U.S. exchanges and convincing these participants to trade elsewhere will not be easy. Nor is there any certainty that contracts currently listed for trading on Eurex will be successful if listed for trading here.
However, we do know that competition invariably improves markets. In fact, in recent months we have seen reductions in fees and welcome changes in trading rules that we believe have been adopted in anticipation of the U.S. Futures Exchange application. These changes benefit both customers and intermediaries by reducing costs and facilitating the execution of certain transactions.
FIA wants to emphasize that our support for competition is not limited to foreign exchanges that may wish to list products currently traded on U.S. markets. We support competition across all markets and all products. In this regard, FIA has consistently pointed favorably to the experience in the equity options markets, where the ability to list fungible products on multiple markets that then are cleared through a common clearing organization has led to a dramatic increase in competition among all exchanges. Our members compete on a product-by-product basis daily. We see no reason why exchanges should not be subject to similar competitive pressures.
We also see no obstacles that would prevent the Chicago Mercantile Exchange and the Chicago Board of Trade, in particular, from taking the fight to the U.S. Futures Exchange. CME and CBT, in the aggregate, account for approximately 85 percent of all U.S. futures exchange volume. In achieving this position, they have demonstrated that they are both fierce and able competitors.
As I noted when I began my remarks, an underlying purpose of the CFMA is “to promote responsible innovation and fair competition.” Provided an applicant meets the criteria specified in the Act and the Commission’s regulations, an exchange should be designated as a contract market upon the same terms and conditions—and pursuant to the same procedures—to which all other applicants are subject.
It is worth remembering that, when foreign exchanges first applied to the Commission for authority to place their terminals in the U.S., many U.S. exchanges, including those represented here today, argued that the foreign exchanges should be required to come to the U.S., apply for designation as contract markets and compete with U.S. exchanges on a level playing field. Eurex has agreed to meet this challenge, establishing a subsidiary here to compete with other U.S. exchanges on the same terms and conditions—and subject to the same laws and regulations—to which all U.S. exchanges are subject. FIA would be greatly troubled if the world’s largest futures exchange, or other entrants that are willing and able to comply with U.S. laws and regulations, were unfairly denied this opportunity.
Thank you again for the opportunity to appear with before you today. I would be happy to answer any questions you may have about the process at the Commission or any other areas of interest to you.
