Special Supplement: The Merton Miller Group: Derivatives Doyens Dissect New Commodity Futures Law

The Merton Miller Group, (MMG) which is composed of four founding fathers of the derivatives markets, met recently in Reston, Va., to continue their dialogue on the dramatic forces that are changing the futures industry. Senator Richard Lugar (R-Indiana), chairman of the Senate Agriculture Committee, participated in the event, filling a chair left vacant by the late Nobel Laureate Merton Miller, which is now reserved for guest participants in his honor.

On this occasion, the MMG's colloquy ranged over questions pertaining to U.S. foreign policy...

* Is the time now at hand--or even overdue--for a crisis management study of U.S. financial markets in the context of the globalization of markets and multifarious non-military threats to the U.S. Can the financial markets fashion hedging tools against these unknowns?

--"The crisis situations that are the most perilous that I can think of are ones in which somehow terrorism comes to the continental United States, not an ICBM attack or something more dramatic like a foreign invasion, but rather, given what I call asymmetric warfare, i.e., smaller countries or sects of people, religious groups or political groups, with a mission that we may not be able even to define or know until the attack occurs."-- Sen. Richard Lugar.

...The implications of the Commodity Futures Modernization Act, enacted on December 15 2000...

* The new law has reduced the power of the CFTC. It relegates the CFTC to the role of "overseer" of the regulated markets with far less day-to-day involvement than before. Perhaps more important, it has allowed (for the first time) unregulated "off-exchange" futures activity among sophisticated institutions.

--"You now have a vast change in the landscape regarding ease of entry, with three-tiered markets. Now people are going to be able to construct an exchange in 30 or 60 days and take on the existing and established exchanges."--Richard Sandor.

...And a prognosis for single stock and narrow-based stock index futures.

* These were barred for the last 20 years by the Shad-Johnson Accord. Now they will be permitted but under co-regulation by the CFTC and the SEC. The Group thrashes out whether these new instruments are expected to be popular; how well they will be able to compete with the well-entrenched securities option markets (e.g., the CBOE); and whether traders are likely to show any bias between using the securities or futures markets.

--"There is a large community of day traders that will use single-stock futures. For them it will be easier. If we can connect in, plug into that community, we're going to get retail trade of that kind."--Leo Melamed.

 

Institutional Investor: Senator, what was the rationale for and philosophical underpinnings of the Commodity Futures Modernization Act of 2000.

Senator Richard Lugar: The Community Futures Trading Commission's (CFTC) issuance of the concept release on over-the-counter derivatives early in 1998 was perceived by many in the industry as foreshadowing possible regulations of these instruments as futures. That cost of regulatory action, given the importance of the OTC markets, significantly modified the long-time legal understanding and in essence the cry for legal certainty really took on an acute focus. That led not just to USDA, but now the Treasury, the Federal Reserve Board, the Securities and Exchange Commission (SEC)--all who opposed the concept release--to request the Congress enact a moratorium on the CFTC's ability to do this. As a result of this, Congress passed a six-month moratorium--legislation introduced in our committee was generally accepted without a great deal of debate on the CFTC's abilities. In fairness to the Chairman Brooksley Born at the time, she acted, as we all did, after Long Term Capital Management hearings and a feeling that the retail consumer or user really had to be protected.

In addition to trying to tackle the legal certainty for over-the-counter derivatives, we were trying to get into regulatory modernization. Non-agricultural futures are approximately 85% [of the market] and rising. In February of the year 2000, the CFTC issued a proposal that would provide regulatory reform to the futures exchanges and their customers and proceeded to act upon that. We saw a significant opportunity for regulatory reform. Then of course we tackled the Shad-Johnson accord, regarding the single stock futures, and on September 14 of 2000 the SEC and the CFTC reached an agreement on the proper regulatory treatment of those instruments. That was a very, very important coming together because throughout 1999 and 2000 there were no indications that that would happen.

Legal certainty came to the over-the-counter transactions under a section of the bill that excludes transactions in financial commodities if the transaction is one between eligible contract participants--and these are institutions or higher-net-worth persons--and is not executed on a trading facility. The key to these exclusions is that no retail is allowed and these transactions occur in financial commodities, which are more difficult to manipulate. The bank product exclusion occurred largely through advocacy of Senator Phil Gramm of Texas.

Senator Gramm was interested in excluding traditional bank products, such as loans and certificates of deposit, from the Commodity Exchange Act. The agriculture people generally accepted that, and for new banking products to develop after the date of the enactment, the law creates a mechanism known as "jump ball" for determining which agency, bank regulator or CFTC, governs the transaction.

We also got into hybrid instruments. This section sets out a test to determine whether an instrument is predominately a futures contract and governed by the Commodity Exchange Act or predominately a security instrument, thus excluded from the Commodity Exchange Act. In light of all the innovations that may occur, clauses such as this may have an importance and I suspect that they will. Then we have exempted commodities--institutional transactions in certain commodities such as energy and metals may not need the full protection of the CEA or the CFTC, and that was recognized in the law. But because they are more likely to be manipulated in financial transactions, for example, they cannot be fully excluded from the Act. As a result, the section provides an exemption from the CEA for institutional transactions in energy and metals, as long as the participants agree to be subject to the CFTC anti-fraud and manipulation authorities.

Finally, contract enforcement between eligible counterparties. This is a very important clause. This section provides a safe harbor for participants so their transactions will not be voidable in a court of law based solely on the failure of the transaction to comply with the terms or conditions of an exclusion or an exemption. In other words, a mere technicality will not allow parties to walk away from their obligations. Exchange designated as contract makers represent the highest tier of regulation. It's intended for transactions subject to manipulation or that serve the retail public. Agricultural users, for example, fall under this designation and deliberately so. Agricultural interests said we have a lot of retail users, and we want to make certain we have the same kind of regulatory certainty we had before. The bill sets up what are derivatives transaction execution facility (DTEFs). A board of trade may elect to operate as a DTEF if it meets the requirements, namely the commodity is not susceptible to manipulation and, two, the transactions are between large institutions with no retail and at least a registered FCM that has capital of $20 million.

Finally, there's a third group, the exempt boards of trade. Under this, futures contracts are trading on an exempt board that is exempt from CEA. The participants once again are large institutions and the commodity underlying is not subject to manipulation. This is a long-time argument. Our advocacy is that's the way it ought to be. For those who want more regulation there will be a degree of anxiety about all of this as to what the large players will do to each other or to the public. But nevertheless, given the extraordinary growth of the numbers of options, and by these added in the number of choices, creations, and all the various ways it's occurring around the earth, this seemed to be a sensible, common sense way.

Finally, we provided in the Act for further derivatives clearing organizations. Under the old CEA, clearing facilities and boards are regulated as one entity, since most of these organizations were together under one organized structure. Our law now breaks these into entities in two separately regulated facilities, allowing the derivatives clearing organizations to clear a futures transaction, as well as over-the-counter swap transactions. Prior to this change, the legal uncertainty surrounding the swap transactions prevented these from being cleared on futures clearing houses.

Here they'd be labeled as futures, and that's back into the legal uncertainty problem. Our law fixes this dilemma by allowing further clearing facilities as well as banks to clear OTC derivatives, and thus reduces systemic risk by spreading the counterparty credit risk throughout the system.

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II: What are some of the implications of the legislation?

Richard Sandor: In particular regard to the single stock futures the pluses are it opens up a whole new asset class, and a whole new potential set of users. The difficult part is the implementation. We have two regulators, some of whom are going to be concerned about their own turf--who's going to be the primary regulator? How do you reconcile requirements that all be offset in the securities environment by the Options Clearing Corporation [OCC]? and how does that compare to the products traded on the futures market? What are the implications and the execution difficulties?

To move on, you now have a vast change in the landscape regarding ease of entry with three-tiered markets. Now people are going to be able to construct an exchange in 30 or 60 days and take on the existing and established exchanges.

So, the good news is that the act is going to increase competition among exchanges. It's a very positive step. You now have the ability, coupled with electronic capability, to launch a thousand new products.

Leo Melamed: The act does things for which we don't know all the consequences. Take for instance the fact that for the very first time the CFTC is not going to be a day-to-day regulator. It will instead be sort of an oversight agency. Now, that's something we fought for a very, very long time. They finally have agreed that sophisticated users in products that don't lend themselves to manipulation don't need a regulator. That's a welcome step and certainly will produce consequences that are quite different, because since the CFTC won't have exclusive jurisdiction, it allows the SEC, for one, to pretend to have jurisdiction or to want to have jurisdiction, and under the Act does have confirmed jurisdiction, at least in the area of single stock futures.

What is an exchange now? That's going to be called into question. And there are going to be, as Rich said, many more exchanges. Who's going to regulate them, if anybody, is now going to be an issue of contention.

The new environment coupled with the new law will encourage, I think, a movement towards direct access to the market, be it through the Internet or other ways. For instance, if the credit function is the only thing that a futures commission merchant (FCM) has left to do, a bank could act as an FCM by just providing the credit. This bank is not a member of the market. The bank is not an FCM. The bank is certainly only a conduit for the marketplace, and what we suddenly have is disintermediation. If you disintermediate, the question becomes where does the National Futures Association (NFA) come in? How does the NFA get to regulate A) exchanges that aren't real exchanges in terms of the old established definition, and B) if there is no FCM that is a member of the NFA because this whole new system doesn't require that.

Robert Wilmouth: In a seminar I held about two years ago composed of some of the leading figures in the futures industry, I began a strategic planning process to chart out how NFA could best add value to this rapidly changing futures industry. We reached four basic conclusions: Electronic trading would become predominant in the US futures markets; The exchanges would become demutualized, for-profit entities; Technology would lead to an increase in the number of new and emerging exchanges; and these new exchanges and eventually for-profit established exchanges would likely outsource their regulatory functions to NFA.

In the 18 years of NFA's existence, we were the only registered futures association. Now, we're we're running into some competition that I didn't think we would run into. The Act says that there must be a registered futures association. We're the only one. But in this arena I must tell you that I think the gentlemen across the way's organization will be our competitors. One key for our future survivability is based on demutualization of the exchanges and the fact that for-profit entities will want to get the best bang for the buck and will outsource a number of their services to us.

Philip McBride Johnson: First is a disclaimer--

Sandor: --Always the lawyer. You haven't even said one thing and you're already disclaiming. This is remarkable counselor--

Johnson: --I was just going to say that if I had any real predictive powers I'd be conferencing in here from Bora Bora.

I've identified four things that I think it will be interesting to follow. Remember that on December 20, 2000 it was a felony publishable by five years in prison and a $1 million fine to trade futures off the exchange. On December 21, it was an acceptable practice among 11 categories of major market participants. It will be interesting to see to what extent the futures business does gravitate upstairs for principal-to-principal transactions among the institutions, and what impact that will have on the centralized exchanges. Should all the institutional interest rate business go upstairs, should all the institutional or commercial energy business go upstairs, the impact on the central exchanges could be rather substantial. So, I'm going to be interested to see what happens there.

The second is 25 years or so ago a judgement was made that there should be a single regulator for all the futures business, and one of the justifications at the time was that the futures markets served a dozen or score maybe of different industries, many of which already have cash-market regulators. It'll be interesting to see whether there will be other cash-market regulators who step forward now to seek a deal similar to what the SEC has gotten--USDA for the farm products, for example, or DOE for the energy complex, particularly in the climate we live in now in the energy sector; or how about the 50 state insurance commissions for insurance-related products?

The third is the electronic trading and demutualization, a combination of the two, but most importantly demutualization. The chemistry of this business, as I have always understood it, has basically been this: The exchanges have been able to self-regulate because they have half a dozen different hooks into their membership. Most of the members make their living there. That's one consideration--you behave or else. Another is the risk of forfeiting a valuable seat on the exchange. Once demutualization takes place and ownership gets severed from market use and the users of the market become much more like the telephone company customer, then it's going to become increasingly difficult for the administrator of the trading system to effectively impose any kind of discipline on the end user because there is a very little in the system now to prevent the end users from simply saying, "I quit!" Then things begin to get a little troublesome for them. It's something that the NFA is going to face in due course, too, because eventually somebody is going to get into trouble with you guys and there's not going to be any hook either from the NFA or from the exchange where the misconduct took place to prevent him from simply saying, "Sue me." Detection I don't think is a problem. Response is going to be the problem.

Sandor: I agree that effective response to misconduct raises a new set of questions. But if you look at this as a student of economics, an exchange still is, if you were to rationalize it, in effect the least cost regulatory solution, if nothing else. It's a commitment by people to trade under certain common sense rules and equitable standards. If in fact regulation is required, one would expect an exchange to emerge as a market because it is a very cost effective way to regulate.

Johnson: But it's mutualization which I think has been the glue that has held the self-regulatory programs together in the past. When I become a utility and you become my customer, I may be able to detect your misconduct easier, but I'm going to have a devil of a time dragging you before a group of people to answer for this and then to pay a fine if I should assess it upon you. My own view is that the enforcement of the Commodity Futures Modernization Act is likely to become almost an exclusively CFTC process because it is the only remaining authority with the power to compel compliance and to really carry out punishment.

My last point has to do with a macro issue. As we look at the changed terrain that we have today, we find that the principal beneficiaries of the deregulatory mode tend to be our biggest institutions, our banks, our commercial companies, our pension plans. To the extent that there are exemptions and exclusions they run principally to those sectors. Those are also in many respects the most important institutions in our society in the sense that their collapse would be calamitous for all of us. We're relying now on a great deal more self-responsibility at that level than I think we had in the past. It is true that in some instances, like investment companies and broker dealers, you do have the SEC, and they're pretty savvy about these markets. But I wouldn't rely on the state insurance commission to be able to know whether someone is hedging or Texas hedging or whether they were overextending themselves. So there are many people who are now eligible to be emancipated from the CFTC oversight that may not have another sophisticated regulator out there to pick up the slack.

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II: What are some of the unknowns within the act?

Johnson: You know where we're going to see a litmus test. We're going to see a litmus test on the use of "core principles". Because I would be willing almost to bet the farm that we're going to go to the staff, and the staff's going to say here's the way we've always done it, but if you have some other ideas we'll noodle it for six months. It doesn't take long to figure out what the path of least resistance is under those circumstances. I'm not saying it's going to happen that way, but that's the risk I have to face when I get in there. If someone says, I want to create a clearing system based entirely on insurance policies, I could probably get that through CFTC eventually but there'll be six or eight letters exchanged. There will be examinations of the insurance companies. There will be all this stuff. That's just one example.

Melamed: In the beginning there is this consideration: Whether the Merc or other exchanges should act as the sort of parent for these new startup exchanges, provide them with clearing facilities, and things the NFA can't do.

Wilmouth: I have no problem with you providing them with clearing facilities.

Melamed: But clearly the exchange can be--and that's one of the big opportunities for the Merc--the clearing organization of choice for all the new startups where they don't have any or capability to be a clearing organization. We can draw income from that, that's a great service that we can provide.

Johnson: Leo are you proposing to provide the guarantee function or just the processing function? Because I noticed that FutureCom signed up with the BOTCC [Board of Trade Clearing Corp.], but only for processing.

Wilmouth: Yeah, BOTCC is the lead processor. Yeah, not for guarantee, that's right.

Johnson: Are you going to have trouble with the normal clearing members and taking this on going forward?

Melamed: We're not taking on the guarantee function.

Johnson: Oh, you're not?

Melamed: No. This whole thing is just being invented as we speak. If the new entity comes to us and says we're in plastics. We're going to have this exchange. We'll create the instruments for you. You list them as futures contracts. We'll do the cash, you do the futures in those. That's a good deal. In that case the futures product would be guaranteed by the clearing house because it would be the Merc futures product. Do you understand the distinction? If it's their futures product, then we're only providing the clearing mechanism for them, the know-how, so to speak, we're not going to guarantee it. But if it's our product, we are.

Johnson: All I'm saying is the latter is a huge hurdle for these new markets because they may have VCs that are willing to front for the first $5 million or something. But when the CFTC comes back and says you can't open your doors unless you've got $10 million in the bank, that's a tough thing. That's a very tough thing.

Sandor: It will be and is a hurdle. But there are people out there that are looking to create utilities to provide services to all these new exchanges. These VCs are smart--they can assemble $100 million for a clearing corp and go to any exchange. They can say "We've got 50 B2B enterprises, and we can form a financial guarantee company."

Johnson: As long as Leo is only going to process these, he's not going to get the business, right?

Sandor: He won't get the clearing business, but he doesn't want the clearing business. He wants the processing business. What's going to happen in the future is that there will be NewCo clearing. NewCo clearing will be a mutually funded VC-based clearing corp, which is going to go to online and go to 10 other new small startups. We're going to see an unbundling of the whole process. So, NewCo can act as a financial guarantee firm. They can use clearing 21 software, and use the NFA for regulatory services.

Melamed: --And until they have failed they're going to be just great!

Wilmouth: There's one other thing that we're looking at, too, and I am uncertain whether or not NFA should undertake it: Exchanges, which are either exempt or which fall outside of the Commission's jurisdiction, are not required to obtain prior CFTC approval but want an independent body to review certain aspects of their operations and certify that they meet certain established standards. They're coming out and saying, "We're outside the CFTC jurisdiction but what we want is for you to audit us, examine us, according to a predetermined set of standards, and give us a certificate, a seal of good housekeeping approval." I'm debating that approach right now.

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II: Why are you uncertain Robert?

Wilmouth: Well, Section 22 of the Act says that we are in deep trouble for failure to enforce our rules, but only if we act in bad faith. If this was not an exchange under the CFTC, we would not necessarily have the bad faith protection. They want to become members, associated or affiliated members. They want to get our seal of approval is what they want, but they're not subject to CFTC jurisdiction.

Johnson: I appreciate that. But they can't get it on the come, they can't get it cheap.

Wilmouth: Oh, they're going to pay every penny of the NFA's costs.

II: What is the future of the Chicago exchanges in light of the new act?

Melamed : The act only serves to underscore the fact that the world has changed, and so in itself it's not only a vehicle of change but a recognition of change. It's the recognition of change that is really the question. Did the exchanges in Chicago sufficiently in time recognize the change that has occurred in the world and what can they do about it to stay viable. To some degree the answer is no, they did not see it coming in time. If they had, I dare say there wouldn't be the success factor that Europe has enjoyed. For instance, the London Futures Exchange, which is a direct competitor of Eurex, neglected to understand that electronic trade would take their business away. The Eurex was a pure electronic exchange and it said, "we can take our Bund market away from you guys, even though you have the liquidity, even though you have all the membership, even though you have the most successful contract of its kind in Europe." And they did. They took it away because LIFFE ignored reality Now, to some extent in a similar fashion the American exchanges have ignored that reality, and some of us have been for the last 10 years been beating on the drum and shouting of that danger.

Sandor: I'm not sure if Frankfurt's takeback of the Bund contract was the outlier, but once the threat of survival came, London just coalesced and responded. They established a committee with the Bank of England and with the London Clearing House. They recognized that if London is to remain the center of the European financial it had to coalesce. What we did see is an instructive model. I offer this only as a possible case. LIFFE ended up being a commodity exchange, doing coffee, cocoa and sugar, and now it's all electronic. It ended up with traded stock options, which is all electronic, and ended up with increased revenues. The question is, will one of the Chicago exchanges respond like that? Is it going to be one single solitary market on a uniformed platform? Is LIFFE's survival a model for what will happen in the US? That's really the question. But the facts are they did coalesce because they had the human capital.

Melamed: One of the most obvious answers is when we offered our membership the truth, demutualize for survival. Give up your rights to control. In doing so, you get no money. We give you no money. We give you nothing of tangible return. We ask you to give up your right to control the exchange so that we could survive, but it's only a hope. We can't even promise you that we will survive. We'll just do out best. Ninety-eight percent of the exchange voted away the membership right of control and gave it to the board of directors.

Sandor: But I think the governance issue is the issue. I serve on a number of boards of companies ranging from a big electric utility to some dotcoms. The board sizes range from six to 10. We see this at the New York Stock Exchange, and major corporations, such as, the General Electrics of the world. Jack Welch runs GE with a minimum board size and limited committees. The culture of the exchanges has got to get down to six or eight or 10 directors and three or four executive committees controlling the direction of the exchange.

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II: What's the potential impact of the bill on the CFTC and the NFA?

Wilmouth: Bill Rainer has left the CFTC and the people that are remaining are the old-time people who've been around for a long period of time and whether they're up to implementing this new regime remains to be seen. They can interpret, they can slow down, they can digress, they can hold up, and that's what really worries me. But theoretically, under the CFTC -- and that's why I think the senator is saying that he's going to exercise his oversight responsibilities to make certain these things occur. But their road should be purely as an oversight agency, taking a look at what we're doing--the core principles--and we're going to draft the core principles and the best practices for them.

Melamed: I want to reiterate one thing. That is that the regs for the use of single stock futures have to be written and that one of the writers of that is the SEC, and that we can't force the SEC to write those regulations. Only Congress can do that, so there is this big question mark. In order to institute the essence of the Act still requires the oversight of Congress to make sure that the people in the agencies do what they're supposed to do.

Senator Lugar: All right, let me just comment. The horror stories that you've heard are all true. But then it goes back to my point, watching this for 24 years and the evolution of the staffs of various chairman. Some have been better than others. This is a part of our political system. The president makes appointments of five members. One of the critical points that I've voiced throughout is we have five members. This has often not been a priority of administrations. We've gone through periods of times with three members, quite long periods, as a matter of fact. Without a full Commission, the Agriculture Committee's oversight function becomes critical, by that I mean having hearings, calling the chairman, the acting chairmen, whoever these people are, with some frequency, and asking what is going on. For the moment we have two vacancies including the chairman's position. I frankly don't know the disposition of the Bush administration with regard to either of the two nominees or the chairman. But however it comes out, the point that all these gentlemen made is absolutely critical. The difficulty of writing of all of these regulations, with the SEC, may require us to work again with Senator Gramm and the Banking Committee, and we'll be back with whoever Arthur Levitt's successor is. In other words, we passed a law but that didn't end the big arguments. It opened lots of opportunities.

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II: Is there a consensus at this table on what would be the preferred role of the CFTC going forward?

Johnson: The immense value of moving the CFTC to an oversight role is that all of the momentum in the regulatory psyche is in the opposite direction. The public has a perception that the police department is doing a fine job if you arrest the guy and put him in jail. They don't expect you to stop the crime. The public's perception of a regulator is that there are not suppose to be crimes committed on this watch. The natural tendency of the regulator is to say I've got to squeeze this animal until it can't hardly breath because if it has movement, independent of me, it may do something wrong. Over a period of time you see the screw tightening further and further and further.

Senator Lugar: Ten years ago things had reached a pass for approving new future contracts--people who came with a new contract to the CFTC could not get an answer for weeks, for months, for years. In our oversight in the Senate committee I remember we tried to sort of whittle down the time frame. We said you have to arrive at a decision, I think in 90 days as an idea. They said, "oh, that's impossible. The public interest, and these are complex things, and fraud and abuse will occur." But nevertheless there was an insistence on our part. So when we had a new reauthorization that came along, about two before this one, why then we wrote all that in. That didn't mean that there was certainty at the time that it was approved, but we tried to get some certainty into the time frame, just to get the discipline back into the Commission, as opposed to this over-regulatory squeeze that Phil was talking about.

Melamed: In the new act for the first time the industry has been put in a position that it allows for registration of people to use futures who previously were excluded from the use of futures--namely, the representatives of the securities markets. The world of futures has a very small sales group by comparison. Our sales force is very limited, and for that reason if you compare the growth of the options market, for instance, as compared to futures during the same period of time, you can understand the difference. They are a securities market with this huge sales force capable of bringing to them business. For the first time, to the credit of this Act-- and this one of the things we pushed for--it is now possible for the NFA to become a limited securities association. Anyone who registers with them, and you won't have to jump through hoops to become registered--will become a futures sales person.

Wilmouth: What we're going to do is we're using the single word passport. If you are registered and you passed through the right tests in the securities industry, you're going to be passported for the purposes of single-stock futures into NFA. Then we will allow you to sell futures, single-stock futures, on the New York Stock Exchange. So, rather than take our test and be registered with NFA, and become a member of NFA, they will be passported into our registration automatically.

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II: Where is the market, who is the market for single-stock futures?

Melamed: Very difficult.

Wilmouth: I don't think there is any.

Melamed: This is a very hard question. I do believe there is an interest in retail.

Wilmouth: Can you separate it into retail and institutional? Because I think that's important. Can we discuss for just a moment what is the market, the retail market, for single-stock futures, bearing in mind we have an options market which makes it less expensive to do than the futures market?

Melamed: No, no, no! Just the other way around, just the opposite, Bob. It takes two contracts in options to do one contract in futures.

Wilmouth: Oh, okay, I see what you mean. It's easier. It's less riskier, though?

Melamed: No, it's just simply less commission and less premium. You have to do it twice in options to create a synthetic future, short or long. So it is a substantially cheaper for a retail customer to do a future to protect his or her exposure in stocks. There is no doubt about that.

Wilmouth: But doesn't he run a greater risk?

Melamed: No, no.

Wilmouth: But we're talking about a retail customer now. That's what bothers me. Run through an example.

Sandor: Let me run through--

Wilmouth: --Thank you. That's what I want you to do--

Sandor: --Let me run through or share with you at least the English experience with single stock futures, which has the grandiose history of five days, but does have two years of study. We found in the two years of study that it's far cheaper. You have to bear in mind that with options, if you're going to create a synthetic future, you have to do two things. You have to get long a put, short a call or visa versa to create it. You've got two bid/ask spreads and two commissions. So, you've got twice the bid ask spreads, so you've got big transaction costs.

You do have interested people in the U.S. who are day traders and who don't need settlements and don't need to be involved in cash securities transactions. They are simply traders. Those people might be better served by not having to go through the settlement process of making and taking delivery on an exchange. One way or the other, the whole clearing and settlement process with futures is attractive. To the extent that the retail public does not want an asymmetric risk like a put or a call, but wants a symmetric risk like a future, and doesn't want to pay a premium up front and wants to take a position--to speculate--then single stock futures will be used.

Wilmouth: I see those opportunities. What I'm saying, tell me this, an individual guy on the street, Joe Dokes is on the street. Joe Dokes believes the price of IBM stock in the next three months is going to go to $175. Okay, and it's now selling at $125. He's going to say to himself, I want to buy a single stock future on IBM pretty much. What do you tell him? What's he going to do? What are his options? That's just what I'm saying.

Melamed: Here are his options. He's what, a salesman or is properly qualified--

Wilmouth: --Yeah, yeah, now you're getting down to it.

Sandor: A securities salesman has to say, look, you can buy a six-month call on IBM on the CBOE. You can pay a premium up front. The advantage of that is a one-time cost only, and you have limited risk. Alternatively, he could buy the stock itself and earn the dividends or splits or anything that comes with stock ownership, if a dividend date occurs while the stock is owned the owner is involved in a cash flow situation. The third choice is to take a futures position, which brings a different attitude, downside risk, but the ability to quickly reverse himself. This is great flexibility he might not have with the other choices, and he pays no premium.

Wilmouth: See, that's the point. Which one is he going to take? This is Joe Dokes the retail customer.

Sandor: That's going to depend on the customer's utility function, Bob. Some people may say I have a three-month viewpoint. Some don't want to mark to market. Some would like this viewpoint and would like to pay some money up front and walk away and not look at the position because that's what their financial advisor says. For that person the option is right.

Melamed: There is a large community of day traders that will use single-stock futures. For them it will be easier. If we can connect in, plug in to that community, we're going to get retail trade of that kind. It won't effect capital formation but it will create a universe of users in the retail level.

The institutional user has found--those same people that ran around years ago worrying what futures were going to do to the New York Stock Exchange trading, today walk on the New York Stock Exchange floor, look at monitors everywhere on that floor to see what are the futures price saying.

Sandor: Let me punctuate the point because I think it has some interest. One thing we've learned in a week of trading at the LIFFE is that people are saying that all the European stock markets might not need to be merged because single-stock futures have a common settlement procedure. It's exactly the sort of unintended consequence that Leo pointed out. All of us in futures will look back and say, there's EURONEXT, there's Eurex, and now there's an electronic platform that has the same common settling and clearing procedures for all stocks whether they're Italian, French or otherwise. People are beginning to look back and recognize we've just started to merge the European markets. Nobody thought of that before now.

One of the things that emerged are creative uses of Treasury bond futures that really helped the whole US debt issuance market in the '70s and '80s. The hedging of new issues became huge. Will the day come that the capital market would be so good that when a corporation needs to raise capital, it's investment bankers can give it the certainty of it three months in advance? They're not going to have to wait and reprice the issue every day now. They'll be a certainty to capital raising. Now when you raise money in capital markets, just before closing you have to wait to price the issue and you hope that the Fed doesn't do anything.

Senator Lugar: How likely is this to occur?

Sandor: This is what happened in debt markets and I think it will be a very important and socially positive.

Lugar: That'd be remarkable.

Sandor: Yeah, this would make a huge difference to the US. The ability for a corporation to come to work with an exchange to work with an investment banker and say, "I'm going to need $300 million in the second quarter of 2001." The investment bank offers a guarantee that on May 1 the corporation will receive $200 million at $18 a share in new capital, and you don't have to worry in the meantime. The price would be certain, it's pre-hedged for you. Whatever happens, you know that you're going to get funding on May 1 no matter what happens.You're not going to have any of the uncertainty and even if the documentation is not finalized, the banker can roll the hedge forward and the price will be good for another 60 days or 90 days. Now instead of having to use a blunt hedging instrument like an index of 500 stocks, they could use a surgical tool or a very narrow-based index.

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II: What is the potential impact of US foreign policy on financial markets?

Senator Lugar: The global financial system has changed markets tremendously simply because of the ease and speed with which people can move capital around the world seeking greater returns and safer investments. In the futures markets, people are groping with future uncertainties. But what does this mean? In some instances, it may mean that they are trying to hedge against the possibilities of disaster. So, my hope is that somehow we can fashion, at least for our own national security and in advance of whatever these potential situations are, a crisis management study for our financial markets so the players in these markets know what they're going to do in advance of the disaster's occurrence. I would say, for example, a non-foreign policy crisis, such as the stock market crash of 1987, revealed to most that there were flaws in the crisis management of our financial markets, and that there was certainly a sense of impending disaster for many people in terms of their financial situations.

The crisis situations that are the most perilous today are ones in which somehow terrorism comes to the continental United States. This won't occur as an ICBM attack or a foreign invasion, but rather with what I call asymmetric warfare, i.e., smaller countries or sects of people, religious groups or political groups, with a mission that we may not be able to define or understand until the attack happens. Such an attack occurred at the hands of the Aum Shinri Kyo sect in the Tokyo subway with the ostensible purpose of overthrowing the Japanese government. We were not aware of this through our intelligence services. We were told the details in the aftermath of the attack and tried to figure out who these people were. So, we may not know why a specific American city is targeted with weapons of mass destruction, more likely chemical or biological than nuclear, until after it occurs.

This increased possibility of asymmetric warfare requires us to think through the gyrations and oscillations of the financial markets that are likely to occur when the initial panic ensues in that community or others around the country. Now is the time to be asking whether there are some of these terrorist groups out there and what are we prepared to do about this threat? I think that, until we prepare for these possibilities, we have considerable dangers in our financial markets.

A sophisticated group of people thinking in terms of crisis management ought not to think just about the rescue forces that would come to help--the local providers, hospitals, and police force--but the rescue forces need to have a plan for dealing with the financial component. That seems to me to be an extremely important possibility of the Commodity Exchange Act legislation, which attempts to limit systemic risk with its legal clarifications for swaps and its new clearing authorities for over-the-counter derivatives. We acknowledge that these markets are now global in nature and interconnected, but that there is risk involved with that.

Wilmouth: We have to recognize one thing before we start to approach how we're going to solve some of these problems that impact the financial world as a result of terrorism or whatever it happens to be. [Other] countries have their own sovereign rights. They have their own customs, their own ideas. They're not about to let anything be imposed on them from the outside. So, your best approach, it seems to me, is aiming to get together a group of interested nations, or interested bodies, in a cooperative spirit, who are willing to set standards and formal rules, core principles and best practices. That is being achieved to a certain extent through IOSCO [The International Organization of Securities Commissions]. They are addressing the Internet impact, so that we're all, whether it's in Istanbul Seoul, Korea, London, England or Washington, DC, looking at Internet standards and how we evaluate information and systems that utilize the Internet. We're looking on a worldwide basis at suitability, so that you know that the right customers are doing business in the right place to meet their investment objectives. But to try and impose rigid rules and rigid standards isn't going to work. We've tried it before. The SEC tried to impose our accounting standards on the rest of the world and failed at it.

Sandor: The foreign policy implications are clear. A direct terrorist assault on an exchange could do an awful lot of damage. At the Chicago Board of Trade we designed a new trading floor with large concrete pillars in front of it. A good part of the design of the structure was simply dictated by protection needs. Certainly a rogue attack on a financial institution, like the Chicago Board of Trade, with billions of dollars going through the system, or the Chicago Mercantile Exchange, has enormous implications. Another area we worried about–and I worked with a company called @stake on this–is the potential impact of hackers. Internet-based electronic trading provides multiple entry points. It used to be that one could put a "gray wall" around clearing and one would be protected. Now, we've created a worldwide electronic network where hackers may have the potential to create havoc. If there are hackers who can somehow have an entry point with a PC and a Java-based front end with access from various gateways, there are a lot of issues to worry about. I think that's going to become a big concern as we go forward. The need for security; it's an issue at CBOT and CME. We need to be concerned about things besides plastiques. We've got to worry about people who could be sitting at an entry point in a communications network 8,000 miles away. If you can hack into the Pentagon, and you can hack into the Fed, you can hack into an exchange.

Wilmouth: The corollary of that is you also have to have a recovery plan in case of a crisis or security breach that does happen. I think we've gone a long way forward after the Barings crisis. The Barings crisis had an impact on many different countries who learned that they are vulnerable to happenings going on outside of their country. I thought the studies that we did afterward gave us some insight into how to handle a similar problem, the key point being that recovery plans are just as important as thwarting plans.

Melamed: As a matter of fact we did learn from that and we provided all kinds of standards and best practices that today are in place. Many countries have adopted that standard, not all.

But I want to go back just to show the range of this discussion between what the Senator's list of potential dangers to the world--not war, but less than war and yet highly disruptive and highly impactive on all that we do--and stop short of where Rich went, in terms of the computer infallibility. That also has a great impact on what we do because, let me just say that The Commodity Futures Modernization Act is not going to solve Rich's problem. It wasn't intended to. I'm just suggesting that it has to go somewhere else, and I hope that the government has the forums and committees or intelligence to deal with this because this is a new international problem that will not only affect the financial markets that we represent, it'll affect everything. It could even launch missile sites if it wanted to. So, I'm going to stop short of discussing those effects and hope that they can be attended to. This is not the Senate Agriculture Committee's purview or jurisdiction. If you thrust this on the Senator he will go home or something because it is far beyond anything this Act could do. It is, of course, a serious consideration. I'm not demeaning its import at all. I'm just suggesting that it has to go somewhere else than here.

For our purposes, however, the Senator's list to me spells the thrust of today's globalization world. Every effect anywhere of significance is felt everywhere else because the world is so interconnected. Clearly, any one of these things whether it's India, Pakistan, Afghanistan, Iraq, Iran, Colombia, Russia, whatever that list included, any one of those will impact our markets instantaneously.

I stand sometimes and watch and marvel at our Euro dollar pit, for instance. Our Euro dollar is arguably the largest of its kind in size and magnitude, and it only deals with the short-term instrument, 90-day Euro dollar rates. And yet, or because of it, it is connected to every part of the world. There isn't anybody in the business of finance that doesn't have an outlet through that pit. Somewhere in the perimeter around the traders is a phone or other connection that will include the ability for someone from Iran or Israel or China or North Korea or Afghanistan or India to do something in that pit as it relates to some event that may have happened to cause them to decide that they've got to protect themselves against it. So, the world is completely globalized, completely interrelated. Sure, you're going to find some corner of the world that is so isolated from real civilization it doesn't have a connection but those places aren't meaningful; Every meaningful part of the world is connected.

So, what the Senator was doing in this laundry list was pointing out what is clearly the most important aspect of futures markets. We must have what Bob Wilmouth has been saying. We must have the ability to react properly. We must have in place the rules and standards, so that everybody knows them. A given emergency occurs, here is what's going to happen next and here is how we will protect ourselves from the other guy, or from some disaster in finance. To a great extent we have a hot squawk box, so to speak, between all the exchanges that know each other and there is a designated person that can at any given moment press the button and talk to everybody concerned. Not at an international level yet, that's on a domestic level.

Wilmouth: This type of communication and coordination needs to occur internationally.

Melamed: I think we do have to go internationally. One more step forward has to occur as well. Bob Wilmouth mentioned correctly that every nation has this guarded jealousy over their own sovereignty and doesn't want to be dictated to, and we must accept that. That's reality. Nevertheless, the United States is the most developed, most sophisticated thinking nation as it relates to these things. The Barings incident was clear proof of that. The only country that had the rules right was the United States. That includes Great Britain. That includes certainly Japan. That includes Singapore. The United States has the right rules as to what you do in an emergency of that sort. So, clearly, it is incumbent upon the United States, in some diplomatic fashion--you can't dictate, they are sovereign nations--but through some mechanism, whether it's IOSCO or another thing created--I like the idea of the Internet that you spoke of yesterday, because that is a modern mechanism for starting this discussion and getting to the result of standardization. They should understand what the United States has. They should adopt those rules that makes sense to them. Or they should provide substitutes for them that also make sense.

Johnson: I took yesterday's discussion as an opportunity as well, which is the possibility of designing derivatives products around some of these contingencies. You and I looked at each other and said cat bonds. I think there's a possibility here.

Sandor: We actually did some business in Y2K bonds–

Melamed:--An overblown problem that never materialized, I'm afraid. My poor company sunk millions for that.

Johnson: But for derivatives and risk management tools created out of them, we would be living under a system where you either are solvent or you're bankrupt and there's nothing in between.

Sandor: Phil, I think you're 100 percent right. I think there are enormous commercial opportunities for that risk to be spread. I think it's the second leg of Leo's and Bob's point. We're in the business of trying to mitigate and spread these risks through financial products. And it's going on. It's another discussion why the insurance derivatives went into the over-the-counter market and they seized the opportunity and now flourish. But that market has significant implications for the solution of the problems. We now have research efforts at the World Bank to determine if derivatives in Central America can mitigate the various kinds of weather risks in El Salvador. We are seeing research on the tragic earthquake in India and trying to find a risk-spreading device to securitize that. To some extent, while it's a stretch, the relief of this exemption of the over-the-counter markets permits that kind of financial innovation. It permits individuals at the major insurance companies, and at the World Bank, to be looking at these solutions and not to be subject to CFTC regulations.

Johnson: We have a disaster, right? We call in FEMA [The Federal Emergency Management Agency]. The U.S. taxpayer basically absorbs on an aggregate basis the cost of whatever the disaster happens to be, and here's an opportunity to privatize it.

Melamed: Yes, exactly.

Wilmouth: One of the areas that we haven't touched on is the whole area of trying to find a solution to the problem--where do we get an international body to play a significant role in solving some of these financial crisis that may arise as a result of terrorism or something like that? Someone might want to take a leaf maybe out of the books of Norway, Sweden, Korea, Japan, Australia and the United Kingdom. Take all of our regulators and lump them into one financial service regulator including banking and insurance. That could simplify your problem.

Sandor: As a member of the community, I would like to see the NFA take the lead as the natural respondent to this international issue.

Melamed: Had you been at the last strategy meeting that we held, you would have heard me suggest to Bob that maybe the NFA should be changed, the name should be changed, to the International Futures Association.

Wilmouth: You're right. Listen, I've been a laborer in the international vineyard for eight years, and it's tough. But there's one other thing that's coming up in this area, talking about consolidation and international NFAs and stuff like that, out of the many firms that we have been talking to eight of them had asked us to take over the securities aspect of their regulation. Now, that requires some changes in NFA's articles of incorporation and bylaws and all, but I'm perfectly willing to look at that. Also, regarding the international aspects, we've got several of these firms asking for additional things.

Melamed: --A small problem may be the original charter. It was Senator Dole and I...back in the Senate they were at that time thinking about charging 10 cents a contract in order to pay for the regulation that was necessary. I said, let us regulate it ourselves. He said, you don't have a way to regulate yourself. I said uh, huh, let's create a regulatory agency. It was created, of course, as a national thing. The NFA came into being. Bob did a great, an unbelievable great job, and the NFA's probably, in terms of reputation and ability, is the best of its kind in the world.

Wilmouth: That's right. We have trained many other organizations on our business model, rules and other regulatory practices. We have sent teams of people to Singapore and to Hong Kong to train people.

Melamed: Exactly. In India, as an advisor to India, I said I don't have anything to advise. Here's the book. Do it this way and they [the NFA] did. I don't know to what extent but they certainly used that as a basing mechanism. So, the NFA is a great model for what we ought to be doing.

Johnson: You're charging for all this, I trust.

Senator Lugar: I would underline Phil's point in another way. A lot of firms often pay pretty good fees to folks who retire from the State Department for so-called political risk advice. As a corollary to getting the advice, there ought to be some mechanism for acting upon it. This may very well come in the form of a derivatives contract. People already buy risk insurance, such as those individuals paying for policies to mitigate the risk of a hail or a wind storm. But terrorism may come as often as a tornado, and it's predictable in a broad sense that it will occur around the world periodically, if not monthly or Weekly in some way. This is something that markets could help to offset, and in the foreign policy arena, we ought to consider it.

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II: You gentlemen represent markets. Are you thinking in those terms, or this concept good only for a weekend think-tank?

Sandor: It's already happening. We're getting back to a topic that is something that you mentioned at the outset, and is something that I worry about. I am concerned about that in conjunction with global warming, sovereign risks and reforestation efforts.

Melamed: There are various degrees of our conversation on these things. Remember, our main goal is not the security of the world. No exchange takes that on as its primary goal. That is something I think that the Senator would be more worried about than an individual exchange. Remember, our goal is to have a secure exchange, to have the rules so that we survive as an institution. We've got to have the right clearing organization, the right rules, and so no matter what happens, no matter what the stresses are within limits of the imagination's bounds, we want to have the right rules to protect ourselves and we want the right contracts to provide the world with which it can make money.

Clearly, we aren't yet what Bob suggested and hopefully we'll never get to be a utility, because if we're a utility we're not going to make any money and we can't then exist. So, it's a different world altogether. But if we stopped short being a utility, we want to make money. We want to have the right rules to prevent us from disastrous results during one of these kinds of upheavals. So our purpose is a little different from securitizing the world. It's securitizing, in our case the Chicago Mercantile Exchange.

Johnson: By the way, this is a slight diversion but you know that the only stock index derivatives that SEC refuses to allow to trade are those in the smaller economies and emerging markets where they're most needed.

Melamed: That is really bizarre. Where it's most needed, and that's true of this Act. In fact, one of the points--it is a diversion but it's a correct diversion because I want the Senator to understand, to hear this--and that is it's possible for the Merc to be more successful immediately in narrow-based indices rather than in individual stocks because it's an easier concept to launch and easier for institutional trade, which then would create the liquidity that's necessary. So, at the same time that we try to develop individual stock futures, we may go to narrow-based indices, small stuff, that represents a little segment of the capital markets, a little segment of the industry involved, maybe five, 10 stocks. Often those relate to foreign countries where they haven't got any mechanism to hedge the risk. But we could create not an individual stock for them but rather little individual, small-based indices. That's what this Act presumed. Yet, in the area of foreign indices, the SEC is going to give us a problem to do that. That's where exactly it's needed. We were thinking of doing that, and that's one of the problems we have.

Johnson: I have made that point so many times. It's as if policy has nothing to do with this, it's all numbers. We don't like the numbers in it so.

Senator Lugar: What's wrong with the numbers?

Johnson: I don't know. What is the capitalization of the S&P 500 now? Trillions of dollars. A lot of these economies like Taiwan or India or whatever their stock markets might be $50, $70 billion, and the SEC takes one look at that and says, the combination of the low capitalization plus the fact that you either got the telecoms or the banks or somebody dominating even within that sector, means that this is–

Melamed: --Doesn't fit the formula, It doesn't fit the formula.

Sandor: On that theory, the level of irrationality is such that you would have been precluded from listing a Scandinavian telecom index 10 years ago and you would have missed the two biggest stocks in Europe, Ericsson and Nokia, because one would have said that's a non-starter.

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