TESTIMONY OF LEO MELAMED

Senate CEA Re-authorization Hearing
September 23, 1999

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Testimony of Leo Melamed
Chairman Emeritus and Senior Policy Advisor
Chicago Mercantile Exchange
before the Committee on Agriculture, Nutrition and Forestry Hearing regarding CEA Re-authorization
UNIITED STATES SENATE
SEPTEMBER 23, 1999

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Chairman Lugar, members of the Committee, I am Leo Melamed, Chairman Emeritus and Senior Policy Advisor to the Chicago Mercantile Exchange ("CME"). I was chairman of the CME over the span of many years, and in 1972, presided over the birth of exchange traded financial futures. These broad based financial inventions in Chicago proved to be the primordial soup which, a decade or so later, financial engineers were able to apply to computer technology and unleash today's universe of financial derivatives. Proudly, the 1990 Nobel Laureate in Economics, Merton Miller, proclaimed the invention of financial futures as "the most significant financial innovation of the last twenty years." And Alan Greenspan very recently stated that these instruments of trade, both on and off exchanges, enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it.....a process that has undoubtedly improved national productively growth and standards of living.

Mr. Chairman, I am also chairman and CEO of Sakura Dellsher, an international futures commission merchant, and recently, served as chairman of the Subcommittee on Regulatory Parity for U.S. Exchanges of the CFTC's Global Markets Advisory Committee. Our subcommittee produced near unanimous recommendations to permit U.S. exchanges to compete with foreign exchanges that establish trading networks in the U.S. without complying with the Commodity Exchange Act ("CEA"). A copy of our Report is appended. Finally, I am the author of one and one-half science fiction books. Unfortunately, it is this last qualification that is most helpful in explaining the current status of our efforts to reform the CEA and the Shad/Johnson Accord.

One year ago, the Chicago Mercantile Exchange, with the Chicago Board of Trade, undertook to craft Amendments to the Commodity Exchange Act that would allow every segment of the U.S. derivatives industry a fair chance to thrive in the Twenty First Century. We proposed five principles and a long list of detailed proposals. With much work we were able to find a way to rationalize the CEA to restore internal consistency in concert with sound public policy. Within our framework, each segment of the industry, other than security exchanges-more about them later, got exactly what it had been publicly seeking. Our proposal went farther than the OTC request for codification of the swaps exemption. We proposed that swaps could be cleared without losing their exemption. We were diligently following advice of congressional leaders that we needed to gain sufficient support from the derivatives industry to insure passage of much needed reform legislation.

Earlier this year, Senator Lugar and Representative Combest sponsored a two day symposium attended by all segments of the futures industry - exchange and over-the-counter. Senator Fitzgerald and Representative Ewing attended both sessions. I presented the five principles of the exchanges' plan to reform the CEA. I stressed the need to eliminate the artificial constraints of Shad/Johnson and provide legal certainty to the OTC market. Initially, the exchanges' principles were widely accepted and the details were intensely discussed for the purpose of fine-tuning. Our goal seemed attainable.

Lately, there has been a major loss of momentum in the process. During the course of two roundtables organized by Chairman Ewing on the House side, we have come to understand the resistance to our proposal. You see, we classified exchanges that would be subject to CFTC jurisdiction in a fair and logical fashion. We then proposed a level of regulation that would permit such exchanges to operate in a true business like fashion with sufficient oversight to protect any important national public policy concerns. The rest of the industry initially accepted the approach because it only seemed to apply to the traditional futures exchanges.

But technology has changed everything. The traditional futures exchange was a brick and mortar edifice with shouting traders, milling clerks and flashing quote boards. We haven't had a new exchange like that since 1986. Modern exchanges are incorporeal. The only reminder of the past is the flashing quotes and now those are on our computer screens, not wallboards on the floor surrounding a trading pit.

It is now within the grasp of most financial institutions to acquire and operate trade execution systems that duplicate the trading function of exchanges. As a result, everybody seems poised to create an exchange or join and expand the operation of an existing exchange. There is a major story almost every day announcing a new alliance to operate an exchange or a quasi exchange. Foreign exchanges want to take a large share of the U.S. execution business.

The same people who applauded the proposed level of regulation for the existing derivative exchanges are aghast that they would be subject to CFTC jurisdiction and regulation if they create their own electronic exchanges. Thus we have been treated to a bizarre spectacle as every segment of the derivatives industry tries to explain why its proposed or projected exchange is not really an exchange and should not be treated like the CME, CBT or NYMEX.

Blackbird, the derivatives trading platform operated by Derivatives Net, Inc., is the most visible of this recent trend. Blackbird appears to be a multilateral transaction execution facility for swaps and other financial instruments. Each member's bids and offers are live and available to every other participant that passes the automatic credit screen. The contracts traded are highly standardized. No legislation or regulation seems to exempt Blackbird from registration; yet it has apparently gone live. Reports are that it offers trading facilities for swaps, Forward Rate Agreements and other futures-like derivatives. Its members include many of the same major dealers that use traditional exchange markets. A schematic comparison of futures exchanges and Blackbird is attached. The essential difference between the two is that futures exchanges are subject to regulation and oversight and acknowledge important public responsibilities while Blackbird operates with no constraint.

The Committee's invitation to testify raised three questions respecting the impact of technology on the derivatives industry, whether all electronic trading activity should be regulated under the CEA, and whether electronic trading should be regulated differently than open outcry trading. I have described the impact of technology, changes in market structure and the efforts of new market entrants to avoid federal regulation. My answer to the question of "which electronic trading activity should be regulated" is more direct. All electronic systems that distribute live bids and offers to multiple parties should be treated equally. There is no justification for regulating agency systems, like designated contract markets, and excluding principal-to-principal systems, like Blackbird. In fact, ultimate customers in agency systems have a much greater degree of protection under a wide range of federal and state laws.

The Committee also asked whether open outcry and electronic systems should be subject to different regulatory systems. If Congress adopts our principle of converting the CFTC into a true oversight agency, no distinction between electronic and open outcry trading is necessary.

As noted new exchange entrants have scrambled to avoid a consistent, logical definition of exchanges that would subject them to CFTC jurisdiction. Those efforts have been matched by the efforts of SEC regulated exchanges to avoid a long overdue reformation of the Shad/Johnson accord. The option exchanges are intent upon denying their customers the freedom to trade a single futures contract on a narrow index or an individual equity. Under current law, public customers who want to trade a future on an equity need to go over-the-counter or to do a synthetic future through the facilities of an option exchange. A synthetic future requires two transactions at twice the commission and four times the cost of a simple future to achieve an identical result.

Seventeen years ago, Shad-Johnson attempted to provide a temporary resolution to a jurisdictional conflict between the SEC and the CFTC. It is rank science fiction to apply it as a permanent barrier to innovation and growth as has been the case.  Stock index futures, the most successful of which was launched at the CME in 1982, have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements. The options markets and the swaps dealers offer customers risk management tools and investment alternatives involving both sector indexes and single stock derivatives. Ironically, futures exchanges, which pioneered and advanced this innovation have been frozen out.

The reasons advanced against reform of Shad-Johnson disguise competitive and/or political concerns. Today, Shad-Johnson is being used as a weapon against competition. The SEC, through statutory misinterpretation and, what the U.S. Court of Appeals for the Seventh District, recently has found to be at best "arbitrary and capricious," and at worst "suspect," application of its powers, has denied futures exchanges the right to trade futures on stock indexes that reflect price movements in substantial market sectors. The SEC has taken the position that futures could not be traded on the Dow Jones Utilities and Transportation Averages because they did not "reflect" the utilities and transportation sectors, respectively. The aforementioned court decision has overturned and vacated that SEC decision, finding: "The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves . . . . The Securities and Exchange Commission, which regulates stock markets, has sided with its clients." Slip Op. at 4.

The Shad-Johnson ban on single stock futures was understood by Congress to be temporary. The court of appeals found that the ban "was a political compromise; no one has suggested an economic rationale for the distinction." Slip Op. at 4. In the absence of such a rationale, Congress should lift the single stock futures ban and allow the marketplace to decide whether these instruments would be useful new risk management tools. Many exchanges around the world trade single stock futures; no reason exists to deny U.S. markets the opportunity to offer this product as well.

Finally, we need to deal with the groups that want to expand the exemption created by the Treasury Amendment. That provision was engrafted on the CEA to prevent the CFTC from taking jurisdiction over private transactions in foreign currencies and U.S. Treasury Securities that were negotiated between sophisticated banks and their customers. The Treasury Amendment preserved jurisdiction over any transactions in those commodities that were executed on a board of trade like the CME or the CBT. That reservation of jurisdiction is the basis for the CFTC's jurisdiction over both exchanges.

The exchange's proposal to reform the CEA expanded the basic principle of the Treasury Amendment and applied it to all products traded by means of privately negotiated transactions. In effect, our proposal created a bigger and better Treasury Amendment by giving the exact same exemption to all products. We were stunned when this offer of reform was met with cries of consternation. The lawyers for certain associations, dealers and banks discovered that their clients had hoped to rely upon the Treasury Amendment as an exemption to permit them to operate electronic exchanges for trading derivatives involving Treasury Securities and currencies.

Such an interpretation for the Treasury Amendment is again science fiction. Nothing in the Treasury Amendment says it exempts derivative exchanges in Treasury Amendment products. Thus, we have been met with loud demands that the Treasury Amendment be preserved followed by soto voce explanations that "preservation" in this case means amending the Treasury Amendment to permit banks and broker dealers to operate derivative exchanges outside the CFTC's jurisdiction

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Exhibit I

Lugar diagram 1

Lugar diagram 2

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