CBOE supports shift at SEC from rules-based approach

Both CFTC Chairman Gensler and SEC Chairman Schapiro recently have expressed support for a harmonization effort. The Reform Proposal clearly outlines that, as a result of the differing missions of the SEC and CFTC, as well as the separate statutes under which they operate, futures and comparable securities products are not regulated in a consistent manner. These inconsistencies have led to conflicts between the agencies over new products, clearing and portfolio margining. The two agencies also have different approaches to margin levels, default, malfeasance, bankruptcy, insolvency, insider trading and other investor protection issues. These disparities have created competitive inequalities between the securities and futures markets and have resulted in unintended but, nonetheless, negative consequences for investors and for our ability to compete in a global marketplace. The remainder of this testimony highlights specific differences in the approaches of the two agencies

and offers suggested ways in which the SEC and CFTC might harmonize

regulation to reduce the negative impact of these inherent disparities.

Differing Approaches to Regulation

The operating principles guiding the SEC and CFTC are fundamentally different.

Since the passage of the Commodity Futures Modernization Act of 2000, the

CFTC has operated under a “principles-based” regulatory approach for the

exchanges and clearing organizations under its jurisdiction. The CEA sets forth

separate sets of “core principles” for exchanges and clearing organizations. While

all futures exchanges and clearing organizations must adhere to the core principles

applicable to them, they are given considerable discretion in determining how they

will do so. This more flexible principles-based approach is used extensively by

European regulators. In contrast, securities exchanges and clearing organizations

are subject to a “rules-based” regulatory approach under the SEC whereby they

and their members are required to comply with a number of specific and

prescriptive regulations. While the SEC and CFTC should discuss the pros and

cons of each approach, we support the Administration’s proposal that the SEC give

serious consideration to shifting closer to a principles-based approach for

exchanges and clearing organizations under its jurisdiction.

Oversight of Self-Regulatory Organizations (“SROs”)

A prime example of the different regulatory approaches of the CFTC and SEC is

how each oversees the SROs under their respective jurisdictions. The CFTC’s

risk-based approach to oversight of SROs sets regulatory objectives for regulated

entities and focuses its attention on areas posing the most risk. Under this

approach, SROs are free to establish or change their own rules with the

requirement only that they certify with the CFTC that the proposed rule change is

in compliance with the CEA. Upon receipt of a self-certification, the CFTC can

decide whether or not to conduct a full review of the proposal. This structure

enables SROs to implement business decisions promptly, yet permits the CFTC to

concentrate on proposals that present significant regulatory issues.

In contrast, the SEC’s mechanical rules-based approach dictates very specific

market rules and maintains a prosecutorial orientation on failures to comply with

detailed rules. As a result, the SEC employs an outdated structure where SROs

must submit all proposed rule changes to the SEC, with the majority automatically

being subject to an extensive SEC review. The differences in the review process

significantly disadvantage securities SROs in three ways. First, it often causes

substantial delays for securities SROs in introducing new products. While futures

SROs can start a new product very quickly through a self-certification process,

many new securities products have to undergo an extensive SEC review process

that can take months or, in some cases, more than a year. Second, securities SROs

are similarly delayed by the rule change review process in making changes to their

operations. Third, securities SROs can be subject to arbitrary standards imposed

during the SEC review process.

This disparity between the two approaches poses severe domestic and international

competitive disadvantages to securities SROs and inhibits innovation in the

securities markets. The best way to harmonize the two approaches is for the SEC

to adopt a process for handling SRO rule changes that resembles the CFTC

certification process.

New Products

CBOE is known throughout the world for product innovation and has engineered

virtually every major options innovation since launching the options industry in

1973. It is not surprising, therefore, that the most vexing aspect of split jurisdiction

for CBOE is the delays that result in bringing new products to market. Legal

uncertainties frequently arise when a novel aspect of a proposed new securities

derivative product causes the CFTC to claim that the product has elements of a

futures contract, or a novel aspect of a new futures product causes the SEC to

claim it is a security. This can result in an interminable delay in bringing a new

product to market while the two agencies try to decide who has jurisdiction over

the instrument -- or worse -- when it takes a multiyear court process to resolve the

issue.

Product delays have occurred repeatedly over the past 20 years. For example, in

the recent past, CBOE had two new product proposals -- one involving an option

on an exchange traded fund (ETF) that holds investments involving gold and one

involving an option on a credit default product -- both placed on hold for an

extremely long period of time (3½ years in the case of Gold ETFs and 7 months for

the credit default product) because the two agencies could not agree on

jurisdiction. In contrast, Eurex (Europe’s largest derivatives exchange) was able to

introduce a credit default product in Europe within weeks of announcing its

intention to do so, and well before the U.S. exchanges had approval to introduce

their credit default products in the U.S. due to the disagreement between the two

agencies.

Currently, there is no real mechanism in place to resolve jurisdictional disputes.

This has led to long delays in the decision-making process, which hinders

competitiveness to the detriment of investors and our markets. This is not intended

to imply that either agency is not putting forth a good-faith effort toward the

resolution of such impasses. Each is earnestly applying its respective statute when

analyzing a particular jurisdictional issue. The impasses that frequently arise are

the natural result of differing and, sometimes, conflicting philosophies of the

securities laws and commodities laws. However, no matter how well intentioned

the agencies are, a neutral arbiter is needed to resolve disputes in a timely manner.

We believe that a process needs to be implemented whereby a quick and decisive

resolution to jurisdictional disputes can be obtained. One approach would be to

use the Treasury Department as a tiebreaker in jurisdictional disputes. Treasury is

well versed in the issues typically presented in jurisdictional disputes and is well

suited to resolve them. Another possible approach would be to use the President’s

Working Group on Financial Markets or, if the Reform Proposal is adopted, the

Financial Services Oversight Council (“FSOC”) for resolution of jurisdictional

disputes. Regardless of whether Treasury or the FSOC is used, we believe that an

SRO should be able to petition the tiebreaker directly if one of its new product

proposals is caught in a jurisdictional disagreement between the two agencies.

Prompt resolution of jurisdictional disputes is vital to quickly bringing new

products to market, to implementing new market mechanisms, and to the ability of

the U.S. capital markets to compete in a global marketplace.

Legal uncertainties caused by duplicative regulation also impede the clearing of

new products. The Options Clearing Corporation (“OCC”), the clearing agency for

the seven U.S. options markets and the world’s largest derivatives clearing house,

clears exchange-traded derivative products and is registered with both the SEC and

the CFTC. OCC clears securities options, which are under the jurisdiction of the

SEC, security futures, which are jointly regulated by the SEC and CFTC, and

futures, which are under the jurisdiction of the CFTC. OCC is the only U.S.

clearing organization able to clear all of these products within a single clearing

organization, which provides for greater operational efficiency and, thus, reduces

systemic risk in the clearing and settlement process. However, because of its dual

registration, OCC is subject to the jurisdiction of the CFTC, as well as that of the

SEC, every time it introduces a new securities option product.

The CFTC operates under a self-certification process by which OCC could certify

that a particular new product does not fall within the jurisdiction of the CEA.

However, in cases where there is ambiguity as to where the jurisdictional line lies,

OCC has been compelled to seek prior approval from both agencies in order to

avoid the risk of litigation after trading has begun. Forcing OCC to operate under

this cumbersome process inhibits the benefits of common clearing by a third-party

guarantor, which were so dramatically highlighted by the recent crisis. By contrast,

futures exchanges and their captive clearing houses have no concomitant need to

pre clear their new products with the SEC.

An interim step to address this problem would be to use Treasury in the tiebreaker

role described. Rather than ask for prior approval from both agencies to clear a

new product, OCC could rely on Treasury’s disposition of a SEC–CFTC

disagreement on a new product. For example, if Treasury determines that a new

derivative product to be cleared by OCC should be regulated as a securities

product, then OCC would not need to ask for prior approval from the CFTC to

clear it.

Market Structure

The securities markets are subject to a comprehensive series of market structure

statutory provisions, rules, and interpretations. For example, Section 11A under

the Securities Exchange Act of 1934 provides a panoply of market structure

objectives and requirements. To effectuate these provisions, the SEC has issued

rules and interpretations regarding market transparency, best execution, trade

throughs, and intermarket competition. The commodities laws do not contain

similar provisions. As a result, the futures exchanges operate without the same

degree of government involvement in market structure or related issues. Not

surprisingly, the nature of intermarket competition is very different in the securities

markets than in the futures markets. The CFTC and SEC should discuss whether it

makes sense for the securities and futures markets to have such different treatment

with respect to market structure issues.

Margins

The problems resulting from divided jurisdiction go beyond our pressing concerns

about legal uncertainty for new products. U.S. financial firms are subject to

duplicative and disjointed oversight from separate agencies when trading virtually

equivalent products, such as stock index options and stock index futures. Key

investor protection and market soundness provisions, such as margin levels, are

handled very differently by the two agencies for similar products.

The different approaches to the setting of margin levels between the SEC and

CFTC have a significant impact on competition between the securities and futures

markets. Futures markets set margin levels without real CFTC involvement. In

contrast, initial stock margin levels are set by the Federal Reserve and the SEC,

and equity options margin levels, while proposed by the exchanges, must be

approved by the SEC. One consequence of these different approaches is that

futures margin levels have been consistently much lower than margin levels

required in the securities markets (except for security futures, which are jointly

regulated by the SEC and CFTC). For example, stock index futures margin levels

often have been 5 percent or less of the contract value. Yet, for stock index

options, purchasers must pay the full purchase price while sellers must post margin

equal to the premium received plus 15-20 percent of the index value. Other areas

where treatment of margin for futures products is more lenient compared to

equivalent securities products include differences in the type of collateral posted

for margin and the instruments permitted to act as margin offsets.

The differences in margin levels found in the options markets and in the stock

index futures markets have a direct and palpable effect on competition between the

two marketplaces. Lower margin levels provide futures with a cost advantage over

options that is not justified by differences in the risks between the two products.

The result is that equivalent products do not compete on a level playing field solely

because they are subject to separate margin oversight. To resolve this, all equity

derivatives margin should be subject to the same standards and process of

oversight.

Another area of margins regulations we would like to see addressed involves

portfolio margining. In 2007, the availability of portfolio margining was greatly

enhanced for securities customers, including those who trade security futures,

through expansion of an existing portfolio margin pilot program approved by the

SEC. This expanded pilot includes equity options, security futures and individual

stocks as instruments eligible for portfolio margining. The pilot enhances U.S.

competitiveness by bringing the benefits of risk-based margining employed in the

futures markets, and in most non-U.S. securities markets, to U.S. securities

customers. The exchange rules adopting this pilot also authorized the inclusion of

related futures positions in securities customer portfolio margining accounts.

The ability to margin all related instruments in one account would allow customers

to fully realize the risk management potential of these instruments in a way that is

both operationally and economically efficient. However, legal impediments that

prevent putting futures positions in a securities customer portfolio margining

account significantly undercuts the ability of customers to fully realize the capital

efficiencies of portfolio margining. For more than four years, the SEC and CFTC

have been unable to agree on how to permit futures to be included in a securities

portfolio margin account. Because the two agencies continue to disagree on the

most appropriate approach, the ability of many customers to employ portfolio

margining between futures and securities has been stymied. Unless this deadlock

is broken, portfolio margining will not reach its full potential in the United States,

even though it is used in many jurisdictions abroad. As a first step in resolving this

disparity, Congress would need to amend the Securities Investor Protection Act

(SIPA) to allow broad-based index futures to be treated as securities when included

in an SEC-regulated portfolio margining account. The CFTC would then need to

provide an exemption from the segregation requirements of the CEA for futures

positions held in a securities portfolio margining account. Another step would be

for the CFTC to permit a portfolio margin account to be established using the “one

pot” clearing method utilized in the securities markets.

Customer Protection and Market Integrity

There are several areas where the securities laws are more vigorous than the

futures laws in promoting customer protection and market integrity. First, the

securities laws contain strong prohibitions against corporate insiders trading on the

basis of material, non-public information. The CEA does not prohibit insider

trading even on securities-based futures, other than on single stock futures. The

lack of an insider trading prohibition for CFTC products potentially enables a

miscreant to use such instruments to engage in transactions using inside

information when otherwise prohibited from doing so using securities. This

disparity will take on increasing importance with the growth of credit-related

instruments. Second, the securities laws and SRO rules impose suitability

requirements on broker-dealers making recommendations to customers, including

heightened suitability standards for options transactions. The CFTC does not

impose a suitability requirement, nor do the futures exchanges or the National

Futures Association (“NFA”), except for single stock futures. There is no

legitimate policy reason to apply disparate insider trading and suitability rules on

securities-based futures as opposed to securities themselves. The prudent

resolution to resolve this disparity would be to strengthen futures laws along the

lines of the provisions that apply to securities options.

Bankruptcy and Insolvency

The securities and futures laws also differ on the procedures for broker insolvency.

The securities laws generally require brokers to join the Securities Investor

Protection Corporation (“SIPC”), which assesses its members fees to create a fund

to be used in case of broker insolvency. The fund reimburses customer losses up

to a certain limit. In addition, the SEC’s customer protection rules require brokers

(a) to have physical possession or control of all “fully-paid securities” and “excess

margin securities” carried for customer accounts and (b) to maintain a “Special

Reserve Bank Account” for the exclusive benefit of customers in which the broker

must maintain an amount of funds calculated pursuant to a formula specified in

SEC rules.

The CEA does not provide for SIPC-type insurance protection for futures

customers. The CEA does require strict segregation of customer funds from the

funds of the futures commission merchant (“FCM”) holding the account. The

customer funds must be held in a separate bank account that is clearly designated

as belonging to customers. This ensures (1) that the FCM does not commingle

customer funds with its own funds and (2) that, in the event of an FCM

bankruptcy, customer funds would be identified as such and would not be available

to other creditors of the FCM.

This disparity poses conflicting insolvency treatments for an entity that is both a

broker-dealer and a FCM. It also complicates efforts to address default or

malfeasance by a large market participant, as evidenced by the different approach

the two agencies took two years ago with respect to the problems surrounding the

failure of Sentinel Management Group, Inc. In harmonizing the futures and

securities laws, attention should be given to whether the bankruptcy structures

should continue to be so dramatically different for securities and futures accounts.

If the two separate structures are kept in place, then attention should be given to

how best to reconcile the differences when a dual broker-dealer/FCM becomes

insolvent.

Conclusion

CBOE believes that the joint CFTC–SEC harmonization project provides a unique

and timely opportunity to bring needed changes to the U.S. regulatory landscape in

order to promote investor protection and the competitiveness of U.S. financial

markets.

CBOE, WFE, and I, personally, stand ready to work with the two agencies and

their staff as they consider these important issues. Thank you again for the

opportunity to testify at this important hearing. I would be happy to answer any

questions you may have.