Commodity Exchange Act: Issues Related to the Regulation of Electronic
Trading Systems (Letter Report, 05/05/2000, GAO/GGD-00-99).

Pursuant to a congressional request, GAO reviewed issues related to the
regulation of electronic trading systems, focusing on: (1) how
technology is being used in the exchange-traded futures market, and what
concerns this use raises under the Commodity Exchange Act (CEA); (2) how
technology is being used in the over-the-counter (OTC) derivatives
market, and what concerns this use raises under the CEA; and (3) what
alternatives have been suggested for addressing the concerns raised
under the CEA by the use of technology in the exchange-traded futures
and OTC derivatives markets.

GAO noted that: (1) automated order routing systems (AORS) have been
used for over 10 years to route orders from futures commission merchants
(FCM) to and within futures exchanges; (2) AORS can now transmit orders
from the customer's computer to the FCM's computer, and then to the
exchange for execution; (3) to the extent that AORS provide for enhanced
trade monitoring and control, more precise trading records, and more
direct market access, their use can benefit the exchange-traded futures
market and its participants and can reduce some regulatory concerns; (4)
nonetheless, according to some futures market participants, the use of
AORS without adequate controls can also raise regulatory concerns about
the adequacy of system capacity and security as well as opportunities to
engage in unauthorized trading; (5) electronic trade-matching systems
are being used in place of or in addition to open outcry to execute
orders; (6) similar to AORS, electronic trade-matching systems can offer
many benefits and reduce some regulatory concerns; (7) electronic
trading systems for OTC derivatives more directly link buyers to sellers
that previously interacted through telephones and faxes; (8) to the
extent that these systems enhance trader monitoring and control and
interface with risk management software, they can reduce both
firm-specific and systemic risk; (9) to the extent that these systems
link multiple participants and transmit contract execution details
electronically, they can improve market transparency and reduce the time
and cost of trade execution and reporting; (10) nonetheless, without
adequate controls, these systems can raise concerns about inadequate
system security and unauthorized customer trading; (11) general
agreement exists among regulators and market participants that the
approach to regulation needs to be revised to better accommodate
electronic trading systems for exchange-traded futures and OTC
derivatives; and (12) market participants have suggested three
approaches for accomplishing this objective: (a) drafting a separate
section of the CEA to deal with electronic trading; (b) developing core
principles to which all electronic trading systems must adhere; and (c)
developing a flexible regulatory structure under which electronic
systems are regulated based on the extent to which they raise specific
public policy concerns under the CEA.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-00-99
     TITLE:  Commodity Exchange Act: Issues Related to the Regulation
	     of Electronic Trading Systems
      DATE:  05/05/2000
   SUBJECT:  Commodity futures
	     Derivative securities
	     Computer networks
	     Securities regulation
	     Risk management
	     Electronic data interchange
	     Internal controls

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GAO/GGD-00-99

United States General Accounting Office
GAO

Report to Congressional Requesters

May 2000

GAO/GGD-00-99

COMMODITY EXCHANGE ACT
Issues Related to the Regulation of Electronic

Trading Systems

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B-284243

Page 21GAO/GGD-00-99 Regulation of Electronic Trad
ing Systems
     B-284243

     May 5, 2000

The Honorable Richard G. Lugar
Chairman
Committee on Agriculture, Nutrition
 and Forestry
United States Senate

The Honorable Thomas W. Ewing
Chairman
Subcommittee on Risk Management,
 Research, and Specialty Crops
Committee on Agriculture
House of Representatives

As part of your deliberations on the Commodity
Futures Trading Commission's (CFTC)
reauthorization, you expressed an interest in
exploring concerns related to the application of
technology to derivatives1 trading. The
application of technology has resulted in the
development and use of electronic systems that are
changing the way derivatives are traded. While
these systems have benefited derivatives markets
and their participants, they have also raised
regulatory concerns. In various forums during 1999
and 2000, including congressional hearings,
concerns were raised about the appropriate
regulation of electronic trading systems for
exchange-traded futures2 and over-the-counter
(OTC) derivatives.3 To assist you in your
deliberations related to these concerns, we agreed
to answer the following questions:

ï¿½    How is technology being used in the exchange-
 traded futures market, and what concerns does this
 use raise under the Commodity Exchange Act (CEA)?
ï¿½    How is technology being used in the OTC
derivatives market, and what concerns does this
use raise under the CEA?
ï¿½    What alternatives have been suggested for
 addressing the concerns raised under the CEA by
the use of technology in the exchange-traded
 futures and OTC derivatives markets?
 
Results in Brief
The application of technology is changing the way
that exchange-traded futures are traded. Automated
order routing systems (AORS) have been used for
over 10 years to route orders from futures
commission merchants (FCM)4 to and within futures
exchanges. However, FCMs are extending the use of
AORS to customers, enabling them to use their
computers instead of telephones to place orders.
AORS can now transmit orders from the customer's
computer to the FCM's computer, and then to the
exchange for execution. To the extent that AORS
provide for enhanced trade monitoring and control,
more precise trading records, and more direct
market access, their use can benefit the exchange-
traded futures market and its participants and can
reduce some regulatory concerns. Nonetheless,
according to some futures market participants, the
use of AORS without adequate controls can also
raise regulatory concerns about, among other
things, the adequacy of system capacity and
security as well as opportunities to engage in
unauthorized trading. The National Futures
Association (NFA),5 a self-regulatory organization
(SRO),6 along with the Futures Industry Institute
(FII),7 is developing best practices for order
routing systems that will, according to NFA
officials, help address these concerns.

Introduced in the United States in the early
1990s, electronic trade-matching systems are being
used in place of or in addition to open outcry-a
method of public auction that occurs on an
exchange floor-to execute orders.  Similar to
AORS, electronic trade-matching systems can offer
many benefits and reduce some regulatory concerns.
Futures market participants have also said that
the use of these systems without adequate controls
can raise regulatory concerns. CFTC officials told
us that they review electronic trade matching
systems for compliance with international
standards as part of their exchange-designation
process. These standards generally address futures
market participants' concerns.

Operating in the United States since at least
1994, electronic trading systems for OTC
derivatives more directly link buyers and sellers
that previously interacted through telephones and
faxes. To the extent that these systems enhance
trader monitoring and control and interface with
risk management software, they can reduce both
firm-specific and systemic risk.8 Moreover, to the
extent that these systems link multiple
participants and transmit contract execution
details electronically, they can improve market
transparency9 and reduce the time and cost of
trade execution and reporting. Nonetheless,
without adequate controls, these systems can raise
concerns about inadequate system security and
unauthorized customer trading. In addition,
uncertainty exists over whether the use of
electronic trading systems for OTC derivatives may
cause transactions that are otherwise excluded or
exempted from the CEA to fall under its
provisions. According to CFTC and market
participants, this uncertainty could call into
question the legal enforceability of
electronically traded OTC derivatives and inhibit
the development and use of electronic trading
systems. For example, the potential for an
electronic trading system for OTC derivatives to
be classified as a board of trade or a
multilateral transaction execution facility (MTEF)10
could prevent OTC derivatives traded through the
system from qualifying for an exclusion or
exemption from the CEA.

General agreement exists among regulators and
market participants that the current approach to
regulation needs to be revised to better
accommodate electronic trading systems for
exchange-traded futures and OTC derivatives.
Market participants have suggested three
approaches for accomplishing this objective:
drafting a separate section of the CEA to deal
with electronic trading, developing core
principles to which all electronic trading systems
must adhere, and developing a flexible regulatory
structure under which electronic systems are
regulated based on the extent to which they raise
specific public policy concerns under the CEA. In
addition, a November 1999 report11 of the
President's Working Group on Financial Markets
(Working Group)12 included several recommendations
designed, in part, to enhance legal certainty
concerning the use of electronic trading systems
for OTC derivatives that do not involve
nonfinancial commodities with finite supplies. The
Working Group acknowledged that its
recommendations, if implemented, would not only
blur distinctions between exchange-traded futures
and OTC derivatives but also create differences in
the level of regulation between OTC derivatives
that are electronically traded and cleared and
exchange-traded products with similar
characteristics. Recognizing that some exchange-
traded futures would have characteristics similar
to the excluded OTC derivatives, the Working Group
has supported CFTC efforts to provide appropriate
regulatory relief for the exchange-traded futures
market. CFTC has proposed actions and taken others
that, in aggregate, could provide significant
regulatory relief to this market. In addition,
House and Senate committees are considering
actions that would address issues related to
electronic trading systems in the OTC derivatives
and/or exchange-traded futures markets.

Continued progress in addressing the regulatory
concerns raised by electronic systems could be
critical to the ability of the U.S. exchange-
traded futures and OTC derivatives markets to
remain innovative and globally competitive.  Such
progress requires that the federal financial
market regulators remain aware of how rapidly
changing technology is affecting the derivatives
markets. In particular, regulators need to know
whether existing regulations are impeding the
development of electronic trading systems in the
United States, and whether additional regulations
or different regulatory approaches are needed to
protect the U.S. markets and their users.
Recognizing the difficulty of ensuring that
regulations appropriately address market risks in
stable periods, and the additional challenges that
are likely to be presented by ongoing and rapid
advances in technology, we are recommending that
the Working Group monitor and report to Congress,
as appropriate, on regulatory concerns related to
the application of technology in the derivatives
markets. We are also making a separate but similar
recommendation to CFTC.  The federal financial
regulators and derivatives industry officials that
reviewed a draft of this report generally agreed
with our conclusions and recommendations.

Background
Since the mid-1980s, the exchange-traded futures
and OTC derivatives markets have experienced
substantial growth. Exchange-traded futures and
OTC derivatives have similar characteristics and
economic functions but traditionally have differed
in some ways. Futures are regulated by CFTC under
the CEA, which provides for specific exclusions
and exemptions from its provisions. In comparison,
OTC derivatives-including options13 and
swaps14-generally are not subject to direct federal
regulation. General agreement exists that any
regulation of the derivatives markets should serve
to protect market integrity, financial integrity,
and customers.

The Derivatives Markets Have Experienced
Significant Growth
The U.S. exchange-traded futures market has
experienced significant growth over the last
decade. Between December 1989 and September 1998,
the annual trading volume on U.S. futures
exchanges increased approximately 93 percent, from
323 to 625 million contracts. Notwithstanding this
decade of growth, from September 1998 to September
1999, the annual trading volume decreased by
approximately 2 percent, from 625 to 614 million
contracts.

Worldwide, the notional amount outstanding of
exchange-traded futures and options has also
grown, but not at the same pace as has the OTC
derivatives market. The June 1999 total estimated
notional amount15 outstanding of exchange-traded
financial futures and options worldwide was $15.1
trillion, an increase of approximately 6 percent
from June 1998 and an increase of approximately
583 percent from December 1989. In comparison, the
June 1999 estimated total notional amount of the
OTC derivatives market worldwide was $81.5
trillion, an increase of approximately 17 percent
from June 1998 and an increase of approximately
4,075 percent from December 1989.16

Similarities and Differences Exist Between
Exchange-Traded Futures and OTC Derivatives
Exchange-traded futures and OTC derivatives have
similar characteristics and can serve similar
economic functions but traditionally have differed
in some ways. The market values of both types of
contracts are determined, in part, by the value of
an underlying asset, reference rate, or index. The
economic uses of both contracts include providing
users a means of hedging (i.e., shifting the risk
of price changes to those more willing or able to
assume this risk) and speculating (i.e., investing
with the intent of profiting from price changes).
In some cases, both contract types can also serve
a price discovery function.17 However, this
function is more typically associated with
exchange-traded futures, and according to the
Working Group, prices established in OTC
derivatives transactions do not serve a
significant price discovery function.

Exchange-traded futures and OTC derivatives differ
in the ways they are transacted and cleared. As
discussed below, all futures must be traded on a
CFTC-designated exchange, unless otherwise
excluded or exempted from the CEA. As such,
futures have traditionally been traded in central
locations on the floors of organized exchanges,
with clearinghouses assuming responsibility for
daily clearance18 and settlement19 of all trades.
Clearinghouses manage credit risk,20 in part, by
substituting themselves as the buyer to every
seller and the seller to every buyer. They also
guarantee daily settlement, thereby eliminating
the need for the original counterparties to
monitor each other's creditworthiness. In
contrast, OTC derivatives contracts traditionally
are privately negotiated between counterparties,
also called principals. These negotiations have
typically occurred outside of centralized trading
facilities. Because OTC derivatives are entered
into on a principal-to-principal basis and are not
typically settled through a clearinghouse, each
counterparty is exposed to credit risk, which is
addressed through the negotiation of contract
terms.

Finally, exchange-traded and OTC derivatives
typically differ in their degree of
standardization. Exchange-traded futures generally
have standardized terms, except for price,21 which
the market determines. In contrast, the terms of
OTC derivatives contracts-such as price, maturity,
and quantity-generally are negotiated to meet the
specific economic needs of the counterparties.
However, according to the Working Group, as OTC
markets have developed, the extent to which market
participants engage in large numbers of
transactions with similar terms has increased. For
example, while the opportunity to negotiate the
terms of an OTC contract may exist, this
opportunity may not be used to a great extent for
certain types of instruments, such as "plain
vanilla," or relatively standardized and
uncomplicated interest rate swaps.

Futures Are Generally Regulated Under the CEA
Congress created CFTC as an independent agency by
amending the CEA in 1974 and gave CFTC exclusive
jurisdiction over all futures and commodity
options, except options on securities and options
on foreign currencies traded on a national
securities exchange.22 The CEA establishes a
regulatory structure that was historically
designed to ensure that all futures on regulated
commodities are traded on self-regulated exchanges
and through regulated intermediaries. The act does
not define the term futures contract but broadly
defines commodity to include virtually anything.
Although the CEA generally requires futures to be
traded on an exchange, it excludes certain
transactions from CFTC regulation under the
Treasury Amendment.23 As amended in 1992, the CEA
also provides CFTC with the authority to exempt
certain transactions from all but one of its
provisions.

The Treasury Amendment
In 1974, Congress adopted the Treasury Amendment
to exclude from CFTC regulation certain
transactions in, among other things, foreign
currency and government securities, unless
conducted on a board of trade. As part of the
legislative history accompanying the 1974
amendments to the CEA, Congress noted that the
interbank market, also called the interdealer
market,24 was more properly supervised by bank
regulators and, thus, regulation by CFTC under the
CEA was unnecessary. That is, unlike some
participants in the exchange-traded futures
markets who might need the protection provided by
the CEA, foreign exchange market participants were
sophisticated and informed institutions not
requiring such protection.

CFTC Exemptive Authority
To address the legal risk faced by many OTC
derivatives, Congress gave CFTC broad authority
under the Futures Trading Practices Act of 199225
to exempt any contract from all but one CEA
provision.26 Congress required that the exemption
must be consistent with the public interest, and
the contract must be entered into solely between
appropriate persons, as defined in the act.27 Under
its exemptive authority, CFTC can change the
conditions of an exemption or eliminate the
exemption. In providing CFTC exemptive authority,
Congress responded to industry concerns that
because of their similarities to exchange-traded
futures, swaps and other OTC derivatives faced the
possibility of falling within the judicially
crafted definition of a futures contract. This
possibility posed a legal risk for many OTC
derivatives because of the CEA requirement that
futures be traded on an exchange to be legal and,
thus, enforceable.28

In January 1993, CFTC exempted a broad group of
swaps from virtually all CEA provisions, including
the exchange-trading requirement.29 CFTC retained
the CEA's antimanipulation and antifraud
provisions, but these are applicable only to the
extent that swaps are determined to be futures. In
granting the swaps exemption, CFTC was not
required to, nor did it, determine that the OTC
derivatives covered by its exemptions were
futures.

CFTC established four conditions that swaps are
required to meet to qualify for an exemption.
First, they must be entered into solely by
eligible swap participants.30 Second, they may not
be part of a fungible class of agreements that are
standardized as to their material economic terms.
Third, the creditworthiness of the parties to the
swap must be a material consideration in entering
into and determining the terms of a swap
agreement. Under this third condition, exempted
swaps could not be cleared through clearinghouses
similar to those used to clear exchange-traded
futures. However, CFTC noted in issuing the swaps
exemption that it would consider the terms and
conditions of an exemption for a swaps
clearinghouse in the context of a specific
proposal.31 Fourth, the swap may not be entered
into and traded on or through an MTEF. According
to CFTC, these four conditions were intended to
reflect the way that swaps transactions occurred
when the exemption was granted and to describe the
conditions under which such transactions would not
raise significant regulatory concerns under the
CEA.

OTC Derivatives Generally Are Not Subject to
Direct Federal Regulation
In contrast to exchange-traded futures, OTC
derivatives generally are not subject to direct
regulation by a federal financial market
regulator.32 They may be indirectly regulated, but
only to the extent that their users or dealers33
are regulated. Most U.S. OTC derivatives dealers
are banks or affiliates of broker-dealers34 or
FCMs. U.S. banks are overseen by federal bank
regulators and subject to supervision and
regulation that includes minimum capital,
reporting, and examination requirements.
Affiliates of broker-dealers and FCMs are
generally unregulated, although SEC and CFTC have
limited authority to obtain information about the
activities of such affiliates. In addition, these
affiliates may be subject to an industry SRO.
Recognizing the limits of these approaches to
oversight, SEC has instituted an alternative
regulatory scheme for OTC derivatives dealers that
conduct limited securities activities.35 However,
participation in this scheme is voluntary and has
been very limited. According to the Working Group,
a small number of OTC derivatives dealers are not
affiliated with entities subject to direct or
indirect banking, securities, or futures
regulation. Such dealers include insurance,
finance, and energy companies.

OTC derivatives have generally been viewed by the
federal financial market regulators as presenting
limited regulatory concerns. For example, OTC
financial derivatives have been viewed as
presenting limited market integrity concerns
because they are considered to be less susceptible
to price manipulation and are not viewed as
serving a significant price discovery function.
They have also been considered less susceptible to
price manipulation because the vast majority are
settled in cash, based on a rate or price
determined by a separate, highly liquid market
with a very large or virtually unlimited
deliverable supply. Finally, they have been
generally viewed as presenting limited customer
protection concerns because participation is
limited to eligible participants acting for their
own accounts.

Regulation Serves to Protect Market Integrity,
Financial Integrity, and Market Participants
General agreement exists that the public policy
goals of federal financial market regulation are
to protect market integrity, financial integrity,
and customers. Protecting market integrity
requires that controls be in place to prevent
price manipulation and to provide for accurate
price discovery. The prevention of price
manipulation and the provision of accurate price
discovery are two primary goals of the CEA.
Protecting financial integrity requires that
controls be in place to address both credit and
systemic risks. CFTC regulations focus on, among
other things, ensuring the financial integrity of
futures exchanges, clearinghouses, and FCMs, in
part, to protect the financial system from
systemic risk. Protecting customers requires
controls to ensure that customers are treated
appropriately by intermediaries and that their
orders are fairly executed. The need for customer
protection is implicit throughout the CEA.

Scope and Methodology
To address our three objectives, we interviewed
officials of CFTC; the Securities and Exchange
Commission (SEC); the Office of the Comptroller of
the Currency (OCC); and the Federal Reserve Board;
two futures exchanges that are SROs (the Chicago
Board of Trade (CBT) and the Chicago Mercantile
Exchange (CME)); two additional futures exchanges
(the Cantor Financial Futures Exchange (CFFE) and
FutureCom); a third SRO (NFA); four electronic
trading systems (Altra Energy Technologies;
Derivatives Net, Inc.; E-Foreign Exchange.com; and
Interactive Brokers); and three industry
associations (the Foreign Exchange Committee,
Futures Industry Association (FIA), and
International Swaps and Derivatives Association).
In addition, we reviewed the November 1999 Working
Group report, Federal Register notices, comment
letters on CFTC concept releases and rule
proposals, transcripts of congressional hearings
and CFTC roundtable discussions, as well as
journal articles and studies by industry experts.
We also attended Senate and House hearings, a CFTC
roundtable discussion, two futures industry
conferences, and congressional briefings by market
participants in which electronic trading systems
for derivatives were discussed.

In addition, to learn how technology is being used
in the exchange-traded futures and OTC derivatives
markets, we reviewed documentation of the
electronic trade-matching systems of four futures
exchanges (the New York Mercantile Exchange's
(NYMEX) Access, CFFE, CME's Globex, and CBT's
Project A) and observed demonstrations of the
electronic trading systems operated by three
companies (Derivatives Net, Inc.; E-Pit; and
Interactive Brokers). We also interviewed two
users of the Interactive Brokers electronic
trading system.

We requested comments on a draft of this report
from the heads, or their designees, of CFTC, SEC,
the Federal Reserve Board, the Department of the
Treasury, and OCC. We also requested comments from
CBT, CME, FIA, the International Swaps and
Derivatives Association, and NFA. In discussions
held in April 2000, the Director of the Office of
Legislative and Intergovernmental Affairs, CFTC;
the Chief Counsel of the Division of Market
Regulation, SEC; an Associate Director of the
Division of Research and Statistics, Federal
Reserve Board; the Director of the Office of
Federal Finance Policy Analysis, Department of the
Treasury; and the Deputy Comptroller, Risk
Evaluation, Bank Supervision Policy, OCC, provided
us with oral comments. Similarly, in discussions
held in April 2000, officials of CBT, FIA, and NFA
provided us with oral comments. We did not receive
comments from CME and the International Swaps and
Derivatives Association. The technical comments
that we received were incorporated in the report
as appropriate. The substantive comments that we
received are discussed near the end of this
report. We did our work in Chicago, IL; New York,
NY; and Washington, D.C., between October 1999 and
April 2000 in accordance with generally accepted
government auditing standards.

Technology Can Automate Futures Trading and
Further Some Regulatory Objectives
The application of technology to the exchange-
traded futures market has led to the development
of electronic systems that automate some manual
processes. We have categorized these systems as
AORS and electronic trade-matching systems.36 The
use of both types of systems can further
regulatory objectives associated with the futures
market as well as raise some regulatory concerns.

Use of AORS Can Further Regulatory Objectives
Although AORS have been used for over 10 years to
route orders from FCMs to and within futures
exchanges, FCMs have extended the use of AORS to
customers, enabling them to use their computers
instead of telephones to place orders. Although a
very limited number of such AORS are in use, the
number is expected to increase significantly in
the near future. When linked to customers, AORS
can replace predominantly manual processes for
communicating a customer order to an FCM. Once a
customer order is received by an FCM's computer,
it can then be directed to the exchange for
execution. With proper controls, AORS used to
transmit customer orders can further regulatory
objectives by enhancing customer protection,
market integrity, and financial integrity, as well
as provide other benefits to futures market
participants. However, without proper controls,
such AORS can raise customer protection and other
regulatory concerns related to inadequate system
capacity and security and increased opportunities
for unauthorized trading. NFA and FII are
developing best practices for order routing
systems that will, according to NFA officials,
address concerns related to AORS use.

AORS Change the Way Orders Are Transmitted
Futures market customers have traditionally
contacted an FCM by telephone to place an order.
The FCM would then time-stamp the order, prepare
an order ticket, and communicate the order to a
firm's desk on the exchange floor, either
electronically or by telephone. Once the order was
received on the exchange floor, a floor order
ticket would be prepared and either hand delivered
or communicated through the use of hand signals to
a floor broker37 who would then execute the trade.
Larger customers typically would communicate their
orders directly to a firm's desk on the exchange
floor. CFTC regulations require that floor order
tickets contain a record of the time an order is
received on the exchange floor and reported from
the floor as executed.

     Although AORS have been used for over 10
years to route orders from FCMs to futures
exchanges, as well as within exchanges themselves,
AORS have recently begun to be used by FCMs to
allow customers to route futures orders from their
computer systems to an FCM's computer system via
dedicated telephone lines or the Internet. The
FCM's system then electronically routes the
customer's order to a firm's desk on an exchange
floor or an electronic trade-matching system
(discussed separately below) for execution. Such
AORS can communicate trade execution information,
such as price, quantity, and time of execution,
back to customers.

     Depending on the specific AORS and other
systems with which it interfaces, the extent of
human involvement in handling and executing a
customer order can vary. For example, with some
systems, the order may be transmitted through the
FCM's computer system to a firm's desk on an
exchange floor and then communicated via hand
signals or through electronic means to a floor
broker for execution. In other systems, the order
flows through the FCM's computer system directly
to a floor broker or an electronic trade-matching
system for immediate execution. In addition, these
systems vary in the quantity and quality of
information they provide to customers based on
several factors, including a customer's
relationship with the FCM, technology
restrictions, and cost constraints. For example,
while some systems may provide customers with real-
time bid and offer quotations, others may not
provide current price quotations. These systems
also differ with regard to the markets that can be
accessed through them. For example, while some
systems provide customers with access to only U.S.
futures exchanges, others provide access to both
U.S. and foreign exchanges.

     Although a very limited number of FCMs
provide their customers with access to AORS, the
number is expected to increase significantly in
the near future. In October 1999, one industry
expert stated that within 1 year most FCMs would
offer AORS to their customers. In addition,
preliminary results of a 1999 survey of U.S. FCMs
indicate that over 60 percent of the technology
plans of FCMs included provisions for developing
or enhancing order routing and management systems.38

Use of AORS Can Further Regulatory Objectives and
Provide Other Benefits
With proper controls, the use of AORS can further
regulatory objectives by changing how
intermediaries route customer orders, providing
for more accurate recording of details related to
customer orders, and improving monitoring and
control of customer activities. In addition, they
can provide other benefits to futures market
participants.

AORS use can enhance customer protection by
reducing or eliminating opportunities for FCMs to
mishandle customer orders. As such, AORS use can
reduce regulatory concerns about fraud in
connection with the mishandling of such orders.39
As discussed below, when an AORS is connected to
an electronic trade-matching system, customer
protection can be further improved. In addition,
AORS use can benefit market participants by
providing for faster order delivery and reduced
transaction costs.

AORS use can also enhance customer protection and
market integrity in both open-outcry and
electronic trading environments by allowing for
the creation of automated trade order records that
detail precisely when, where, and by whom an order
was placed as well as any subsequent changes to
that order. Such automated records can enhance
market integrity by providing greater assurance
that transactions are accurately recorded and
error free. According to FIA officials, the use of
AORS has significantly benefited FCMs by reducing
trade processing errors caused by human error. In
addition, their use can deter and/or facilitate
detection of trading abuses. That is, by recording
the details of a customer order, as well as any
changes made to that order, AORS use can make it
more difficult for intermediaries to abuse
customer orders and make it easier to detect such
abuses.

In addition, AORS use can help protect the
financial integrity of FCMs, thereby reducing
systemic risk, and can enhance customer protection
by providing improved monitoring and control of
customer activities. Because AORS can record
customer trades automatically, FCMs can build into
AORS the capacity to monitor customer open
positions as trades occur, or in real time. When a
customer's total market exposure on open positions
reaches or exceeds a predetermined level, the AORS
can alert the FCM. One AORS we reviewed allowed
the FCM to halt a customer's trading activity in
such a situation and inform the customer that
continuing to trade would require additional
margin,40 referred to as a margin call. FIA
officials told us that only one FCM currently
operates an AORS with this capability, but that
other FCMs are working to develop it.41 AORS can
also provide automated trading filters that
prevent customers from entering orders for certain
types of instruments or placing orders beyond a
certain amount. Enhanced monitoring and control of
customer activities can also benefit FCMs and
reduce systemic risk. That is, because FCMs are
ultimately financially responsible for trades they
execute on behalf of their customers, they can
benefit from, and systemic risk can be reduced by,
a system that prevents customers from entering
into transactions that they may not be able to
honor and that could, thus, jeopardize the
financial position of the FCM. In addition,
alerting customers more quickly of their losses
can enhance customer protection by providing them
with a more timely opportunity to consider the
potential financial impact of continued trading.

Without Controls, the Use of AORS Could Raise
Customer Protection and Other Concerns
Without proper controls, the use AORS could raise
customer protection and other concerns under the
CEA. One futures market participant said that AORS
use could increase risks to customers if systems
do not have the capacity to handle large trading
volume. System failure due to lack of capacity
could result in customers not knowing whether
their orders were executed, thus preventing them
from taking further action that could decrease
losses or increase profits. Some market
participants also expressed concern that an AORS
with inadequate security could increase the risk
of unauthorized access to that system. CFTC and
NFA officials said that the primary risks
associated with AORS use are unauthorized access
and trading beyond customer credit limits.
According to the 1999 survey of FCMs, concerns
about system capacity and security have limited
FCM use of electronic systems. However, FIA
officials stated that AORS use currently does not
raise significant concerns, and that issues
related to AORS security and capacity are more
appropriately addressed by FCMs and exchanges than
by regulatory efforts. The officials also said
that market competition will be sufficient to
motivate FCMs and exchanges to provide adequate
security and capacity because customers will not
continue to use AORS that experience problems in
these areas.

In March 1999, CFTC proposed rules regarding
access to automated boards of trade.42 The proposed
rules included minimum standards for, among other
things, system security, controls over customer
activities, and recordkeeping. According to CFTC,
the comment letters responding to these proposed
rules indicated that futures market participants
have overwhelmingly negative views on the need for
minimum standards for AORS. For example, FIA
commented that the association has serious
reservations about CFTC prescribing minimum
standards for AORS, and that a better approach
would be for CFTC to articulate its regulatory
objectives for AORS and allow AORS operators
flexibility in achieving those objectives. CME
commented that the proposed rules are unnecessary
because existing internal control requirements for
FCMs are sufficient. NYMEX commented that specific
requirements for AORS would limit the ability of
AORS operators to respond to changing technology
and market conditions. In contrast to these views,
Interactive Brokers, the operator of an AORS,
expressed agreement with CFTC's view that
mandating specific, minimum controls for AORS is
appropriate because such controls can enhance
customer confidence, thereby increasing market
participation and, ultimately, market liquidity.
According to CFTC, the proposed rules were
withdrawn in June 199943 in response to the
negative comments from futures market
participants.

NFA and FII Are Developing Best Practices for AORS
     According to CFTC officials, no specific
regulatory regime exists for AORS. However, NFA
and FII, in consultation with exchange and
industry representatives, are developing best
practices for AORS as part of a study related to
order routing. The study is being funded primarily
by $1 million provided by CFTC and is to be
completed by September 1, 2000.44 NFA officials
told us that the NFA and FII approach is to
develop general principles, in the form of best
practices, to which AORS should adhere and to give
system operators flexibility in following those
principles. The principles would address, among
other things, AORS security and capacity, and
controls over customer trading activity. NFA
officials noted that they are already conducting
reviews of AORS, as part of their oversight of NFA-
member FCMs, using the principles being developed
as part of the study.

Use of Electronic Trade-Matching Systems for
Exchange-Traded Futures Can Further Regulatory
Objectives
Introduced in the United States in the early
1990s, electronic trade-matching systems for
exchange-traded futures can replace predominantly
manual processes for executing trades. Although
representing a small percentage of U.S. futures
trading volume, the use of electronic trade-
matching systems is growing. Use of these systems
can further regulatory objectives and provide
other benefits to futures market participants.
Although their use can raise regulatory concerns
if the systems are not properly designed, CFTC
officials told us that they review electronic
matching systems for compliance with minimum
standards developed by the International
Organization of Securities Commissions (IOSCO),45
which generally address these concerns.
Nonetheless, the development of fully electronic
futures exchanges may present additional
regulatory challenges.

Electronic Systems Change the Way Exchange-Traded
Futures Are Executed
Execution of transactions on futures exchanges has
traditionally taken place by open outcry. As
described above, a floor broker standing in a
central location, called a trading pit, would
receive an order communicated by hand signals, a
floor order ticket, or an AORS to either buy or
sell a certain quantity of futures contracts. The
floor broker would then, orally and using hand
signals, present the order to other traders, who
would communicate their response to the order.
When the order was filled, the buyer and seller
would manually record, among other things, the
price and quantity of the contracts traded. The
trade details would typically be communicated back
to the FCM and its customer, and from the FCM to
the clearinghouse. The clearinghouse would then
clear and settle the trade, substituting itself as
counterparty. Clearinghouses may clear trades
continuously and settle trades one or more times a
day.

Electronic trade-matching systems were introduced
in the United States in the early 1990s as
adjuncts to open-outcry trading. These systems can
replace open-outcry trading by automatically
matching bids and offers, thereby eliminating the
need for a physical trading floor. With electronic
trade-matching, orders are electronically routed
to the trade-matching system, where a trade-
matching algorithm is used to match bids and
offers submitted for execution. However, within
the systems we reviewed, some variation exists in
how trade-matching systems operate. For example,
on one system, bids and offers are matched and
executed automatically, while on another system,
bids and offers that match are not executed unless
actively accepted by a participant. Bids and
offers entered into these systems are displayed
anonymously to the market-that is, participants do
not know who made a particular bid or offer. In
addition, while the trade-matching systems we
reviewed match trades based on timing and price,
at least one system gives participants making bids
or offers that improve prices-that is, bids that
are higher than the current best bid or offers
that are lower than the current best offer-certain
priority rights in responding to subsequent
counterbids or offers. Another system also gives
similar priority rights to bids or offers that are
of sufficient volume to match all current best
bids or offers. For the systems that we reviewed,
once trades are executed, the trade-matching
systems automatically send the trade details to
the counterparties and, in most cases, to the
clearinghouse.

Use of Electronic Trade-Matching Systems Has
Generally Increased
Use of electronic trade-matching systems for
exchange-traded futures has generally increased.
CBT, CME, and NYMEX principally rely on open-
outcry systems to trade futures; however, each
exchange operates an electronic trade-matching
system. CME's automated trade-matching system,
Globex, has been in operation since 1992; NYMEX's
Access system has been in operation since 1993;
and CBT's Project A has been in operation since
1994. At CME and NYMEX, electronic trading volume
in 1999 was 16.1 and 2.4 million contracts,
representing increases of nearly 81 and 30
percent, respectively, over the prior year. In
addition, the CME's E-mini Standard & Poor's 500
stock index futures contract, which is
electronically traded, was the third-highest
volume futures contract at the exchange in 1999.
Although electronic trading volume at CBT
decreased by approximately 10 percent between 1998
and 1999, its 1999 volume of 11.2 million
contracts was still approximately 88 percent
greater than in 1997. Electronic trading volume at
CBT, CME, and NYMEX represented approximately 4,
8, and 2 percent of total exchange trading volume,
respectively, in 1999.

Use of trade-matching systems for exchange-traded
futures in Europe is also increasing, as major
European exchanges have been moving from open-
outcry trading to fully electronic trade-matching
systems. For example, in 1998, a French futures
and options exchange, the Marche a Terme
International de France, moved from a
predominately open-outcry trading system to a
fully electronic trading system. Also in 1998, the
London International Financial Futures and Options
Exchange began trading products on its electronic
trade-matching system, and plans call for all
financial contracts to be traded on this system by
May 2000. Additionally, in 1999, Eurex, a fully
electronic exchange created by the 1998 merger of
the Deutsche Terminborse and Swiss Options and
Financial Futures Exchange,46 became the world's
largest futures exchange in terms of trading
volume, with an annual trading volume of 378.8
million contracts.

Finally, U.S. futures exchanges are increasingly
seeking electronic linkages with foreign exchanges
that will provide participants at each exchange
with access to the other exchanges' products. For
example, in October 1999, Eurex and CBT signed an
agreement to create a joint venture company to
operate a single electronic trading platform to
allow access to both exchanges through a single
computer screen. Similarly, CME formed the Globex
Alliance in February 1999 to develop a common
electronic trading system to connect the trade-
matching systems of its members.47 In addition,
U.S. customers can access some foreign futures
exchanges through computer terminals placed in the
United States by those exchanges.

Use of Electronic Trade-Matching Systems Can
Further Regulatory Objectives and Provide Other
Benefits
Several characteristics of well-designed
electronic trade-matching systems for exchange-
traded futures can enhance the regulatory
objectives of market integrity, financial
integrity, and customer protection, as well as
provide other benefits to futures market
participants. These characteristics include
consistent, anonymous, low-error trade matching;
automated trade execution and allocation, with
faster clearing; precise audit trails that enhance
trade monitoring capabilities; and lower costs.

Electronic trade-matching systems can enhance
regulatory objectives because, according to CFTC
and market participants, they can provide
consistent, anonymous, low-error trade matching.
First, trade-matching engines with fixed,
transparent trade-matching algorithms can ensure
that trades are matched or filled in a fair and
consistent manner, thereby enhancing market
integrity and customer protection. Second,
electronic trade-matching systems can eliminate
out-trades.48 Eliminating out-trades can reduce the
potential for financial loss associated with price
movements between the time of the original trade
and resolution of the out-trade or from
unfavorable trade resolution, such as the
cancellation of a profitable trade.

Properly designed electronic trade-matching
systems can also enhance customer protection by
minimizing the role of brokers in handling and
allocating customer trades. As mentioned above,
customer protection can be enhanced by an
electronic trade-matching system that receives
orders from an AORS because such a linkage can
limit or eliminate the opportunity for brokers to
mishandle customer orders. For example, little or
no opportunity would exist for frontrunning or
trading ahead49 of a customer's order because an
FCM might not see a customer's order before it was
transmitted to the trade-matching system, and the
system, not a broker, would execute the trade. In
addition, little or no opportunity would exist for
bucketing50 a customer's order because the trade-
matching system, not a broker, would match the
order. Also, if customer account identification
numbers are required at the time of order entry,
electronic trade-matching systems can prevent
inappropriate trade allocation, such as allocating
only profitable trades to certain accounts,
although additional time may be required to enter
account information. Also, according to CFTC and
market participants, by automatically sending
trade details to the clearinghouse once a trade is
executed, trades matched by electronic systems can
be cleared faster than by traditional systems in
which trade details are manually recorded and
later communicated to the clearinghouse. Faster
trade clearing can benefit all market participants
by allowing them to more quickly update their
market positions and more readily identify
positions that might increase financial risk.

According to CFTC and market participants,
electronic trade-matching systems, as in the case
of AORS, can provide precise audit trails that
enhance trade monitoring capabilities. By
electronically recording trading activities, these
systems can make it faster and easier for CFTC and
SROs to review and analyze trading activities. As
mentioned above, to the extent that FCMs can use
AORS to halt trading, these capabilities can
reduce systemic risk and enhance customer
protection by facilitating the early detection of
trading activities that could put an FCM at
financial risk, as well as deterring and/or
detecting trading abuses that disadvantage
customers.

According to some futures market participants,
electronic trade-matching systems can also lower
trading costs. First, they said that because trade
matching occurs electronically, these systems can
eliminate the costs associated with maintaining a
physical trading facility. According to these
market participants, although facilities to house
computer systems must be maintained, these costs
are less than those of maintaining a trading
floor. However, CBT officials disagreed based on
the exchange's experience offering both open-
outcry and electronic markets. They told us that
the costs to provide an electronic trading system
include the initial cost to develop or otherwise
acquire the system software (which may include
recurring license fees), hardware costs,
facilities to house the computer systems, ongoing
maintenance, costs for periodic system upgrades,
help desk support, and network costs. They said
that, as a result, the costs for electronic
systems are not necessarily lower, but rather
appear in different ways.

Second, some futures market participants said that
because trade matching is automated, these systems
can eliminate the costs associated with using a
floor broker to execute trades on behalf of a
customer. However, according to CBT officials,
these savings may be offset by other fees FCMs
charge for their role in the execution process. In
addition, they said that in exchange for immediate
execution on an automated system, a customer gives
up a price edge and loses the benefit of a floor
broker's skill in obtaining an average fill price
between the prevailing bid/ask spread.

According to a market observer, lower costs
associated with the development of electronic
trade-matching systems should foster competition
by increasing the number of futures exchanges.
However, according to FIA officials, the lack of
either a single clearinghouse for all exchange-
traded futures or coordinated clearing among
futures exchanges will impede competition, even
with increased use of electronic trade-matching
systems.

Without Adequate Controls, Use of Electronic Trade-
Matching Systems Could Raise Concerns
Some market participants have expressed concerns
that, without adequate controls, the use of
electronic trading systems for exchange-traded
futures could raise or increase the risks
associated with (1) preferential trade-matching
and (2) offsetting or noncompetitive matching of
the buy and sell orders of two customers, called
cross-trading.  Concerns were also expressed about
insufficient system capacity, inadequate system
security, and unauthorized customer trading. These
are similar to the concerns expressed about AORS
and are not repeated here. CFTC officials told us
that their review of electronic trade-matching
systems includes the application of minimum
standards that were developed by IOSCO. These
standards generally address the concerns expressed
by market participants.

Ensuring that electronic trade-matching systems
provide fair trade execution to all participants
has been an industry and regulatory concern.
According to CFTC officials, in reviewing trade-
matching systems that seek designation as a CFTC-
approved contract market,51 CFTC analyzes the trade-
matching system to ensure that trades will be
executed fairly. Nonetheless, an AORS official
objected to the CFFE trade-matching engine,
approved by CFTC, which gives preference to higher
volume traders whose bids improve prices or bring
liquidity to the market. The official said that
such a preference allows noncompetitive execution
of trades, thereby reducing market integrity. CFTC
officials told us that the same trading matching
engine was used successfully in the cash Treasury
market, and that the engine's preferences were
designed to increase market liquidity,52 which
enhances market integrity. An SEC official said
that CFFE's trade-matching system simply rewards
those who are first to provide the best price to
the market. That is, those who bring a new price
to the market are actually communicating
information to others in the market, and should be
rewarded for it. In addition, a futures exchange
official stated that as long as any preferences
are disclosed to users of a trade-matching system,
the preferences themselves are irrelevant. That
is, if potential users object to the preferences,
they will not use the system.

A CFTC official said that some concern exists that
the use of AORS in conjunction with electronic
trade-matching engines could allow for improper
cross-trading in thinly traded markets. That is,
one person could simultaneously enter matching buy
and sell orders on the same terminal, virtually
guaranteeing the trade would be matched
noncompetitively, thereby violating CFTC
regulations. However, the CFTC official also said
that this problem could be mitigated by requiring
a minimum time gap between such orders placed at
the same terminal, thereby ensuring that all bids
and offers would be exposed to the market for a
minimum period of time. However, requiring a time
gap would subject orders to price risk as prices
could move against customers during the required
time gap. Similarly, FIA officials stated that
impermissible cross-trading could be detected by
the audit trails provided by well-designed
systems.

CFTC officials told us that they review electronic
matching systems for compliance with minimum
standards developed by IOSCO as part of their
exchange-designation process.  These standards
generally address the concerns expressed above.
For example, the standards state that systems
should be reviewed to identify vulnerabilities,
such as the risk of unauthorized access and system
failure. In addition, the standards state that the
system should be designed to operate in a manner
that is equitable to all market participants and
that any differences in treatment among classes of
participants should be identified. CFTC officials
also told us that IOSCO is considering whether to
update these standards.53

Use of Fully Electronic Futures Exchanges May
Present Additional Challenges
     The development and use of fully electronic
futures exchanges that are not affiliated with an
existing futures exchange and that are organized
as for-profit organizations may present additional
regulatory challenges under the CEA. While one
such exchange, FutureCom,54 was approved by CFTC on
March 13, 2000, as an Internet-based contract
market in cash-settled live cattle futures, and
another such exchange, BrokerTec,55 is currently
under development, concern exists that current
regulations are either inappropriate or
inapplicable for regulating electronic systems and
impose obstacles to setting them up. Accordingly,
some market participants suggested that CFTC could
do more to clarify the requirements that a system
must meet to receive CFTC approval as an exchange.
As discussed below, CFTC expects to address these
concerns as part of its revised approach to
futures market regulation.

A former CFTC chairman said that his review of the
CEA revealed 122 requirements-of which 55 percent
did not apply to electronic trading systems likely
to be developed in the near future. For example,
he believes that regulations applicable to FCMs,
floor brokers, and other intermediaries, such as
registration requirements and antifraud
provisions, would be irrelevant in systems where
customers bypass such intermediaries, route orders
directly to a trade-matching system, and deal with
each other on a principal-to-principal basis.
Confusion over whether and how to meet such
requirements could impede the development of new
electronic trading systems. However, officials of
one futures exchange disagreed, noting that even
if market users could bypass FCMs for trade
execution, the FCMs would continue to provide
clearing services and related account opening,
margin collection, and credit monitoring
functions.  These officials further expressed the
view that the intermediation role of FCMs could
increase as they expand their customer bases,
especially in the retail area, by offering
customers Internet access and other AORS access to
markets.

The former CFTC chairman also stated that unlike
existing exchanges, for-profit exchanges in the
future would not necessarily be membership
organizations and, thus, might not have the
resources to operate a clearinghouse or to
establish an independent self-regulatory program.
Some market participants agreed with the former
CFTC chairman and expressed concern that because
the current regulatory structure does not
contemplate a clearing organization that is
separate from an exchange, it may be difficult for
new electronic trading systems to establish a
clearing function. Officials of one futures
exchange disagreed with this interpretation of
current regulatory requirements and noted that
many exchanges use separately owned and governed
clearing organizations to clear and settle
transactions on their markets.56 Although FutureCom
is a fully electronic, for-profit futures
exchange, it did not raise these concerns because
it will operate a clearinghouse that is funded by
its members and affiliated with the exchange.

Officials of one futures exchange disagreed with
the former CFTC chairman that for-profit exchanges
would have inadequate financial resources to
support self-regulatory programs. They said that
the for-profit structure could provide new
opportunities to raise funds through the capital
markets. They further noted that an exchange,
under any structure, will be motivated by
competitive forces to devote appropriate resources
to compliance programs since the fairness and
efficiency of its markets is one basis on which it
competes to attract participants. NFA officials
said that as exchanges move to a for-profit
structure, they could contract with NFA to provide
self-regulatory services.

A CFTC official said that a move toward for-profit
exchanges would not necessarily change the
agency's regulatory goals, only the methods for
accomplishing those goals. That is, all futures
exchanges, regardless of their ownership
structure, would be required to meet the same self-
regulatory requirements. He said that self-
regulatory services that are contracted out would
be reviewed in basically the same way as those
that are provided through a traditional futures
exchange. CFTC has already approved two
arrangements where the operator of an electronic
trade-matching system does not provide its own
self-regulatory services. Specifically, the New
York Cotton Exchange provides all of CFFE's self-
regulatory services, and NFA is to perform
financial and recordkeeping surveillance over
FutureCom members that are registered with CFTC.

Technology Can Automate OTC Derivatives Trading
and Reduce Systemic Risk
Electronic trading systems for OTC derivatives
bring together buyers and sellers that previously
interacted through telephones and faxes. These
systems can reduce systemic risk and provide other
benefits to market participants. However,
uncertainty over whether electronically traded OTC
derivatives fall under the CEA may create
uncertainty about the enforceability of such
derivatives and, in turn, inhibit the use of
electronic trading systems for OTC derivatives.

Electronic Trading Systems for OTC Derivatives
Replace Telephones and Faxes
OTC derivatives dealers, which are primarily banks
and affiliates of broker-dealers or FCMs, have
traditionally conducted their transactions through
direct telephone contacts with counterparties,
supplemented by using faxes and/or the services of
an intermediary, called a voice broker. To search
for a counterparty to an OTC derivatives
transaction, a dealer would contact a voice broker
by telephone and provide the details of the
transaction. The voice broker would communicate
the transaction details to other market
participants by telephone or fax. Another dealer
wishing to accept the offer would contact the
voice broker, who would then contact the dealer
making the offer. At this point, the voice broker
would disclose the identity of the dealers to each
other so that each could determine, based on the
credit rating of and/or credit limits established
for the other, whether they would be willing to
enter into the transaction. If the dealers reached
agreement, the voice broker would send the details
of the transaction to each dealer. The dealers
would then complete all further administrative
tasks through direct communication with each
other.

Operating in the United States since at least
1994, electronic trading systems for OTC
derivatives can facilitate direct communications
among potential counterparties and, in doing so,
can eliminate the need for a voice broker's
traditional services. That is, the systems that we
reviewed allow OTC derivatives dealers to post
their own bids and offers and electronically view,
negotiate, and accept the bids and offers of other
participants (bids and offers are not matched
automatically, as in some electronic trade-
matching systems for exchange-traded derivatives).
When transactions are agreed to, the systems send
the details of the completed transactions to the
participants involved. In addition, bids and
offers posted on the system are anonymous until
either a transaction is agreed to or agreement is
reached to negotiate the terms of the transaction.
Systems currently in operation allow for
transactions in several types of instruments. For
example, Derivatives Net, Inc., allows for
transactions in interest rate swaps, and Altra
Energy Technologies allows for transactions in
natural gas swaps. While trading volume on the
Derivatives Net, Inc., is limited because it began
operation in August 1999, operators of the Altra
Energy Technologies system, which began operation
in 1994, indicated that volume has been
increasing.

Technology Automates OTC Derivatives Trading and
Can Reduce Systemic Risk
To the extent that electronic trading systems for
OTC derivatives can provide for enhanced trader
monitoring and control and an interface with risk
management software, they can reduce firm-specific
financial risk and systemic risk. In addition, to
the extent that these systems link together
multiple participants and transmit contract
execution detail electronically, they can increase
market liquidity, improve price transparency, and
make trading faster and cheaper. As with other
electronic trading systems, a lack of adequate
capacity and security could raise concerns.

According to market participants, electronic
trading systems for OTC derivatives can reduce
systemic risk by enhancing the ability of trading
managers to monitor and control the activities of
their traders. For example, one system enables
trading managers to quickly view all transactions
being proposed and executed by their traders.
Moreover, the system enables trading managers to
electronically restrict with whom their traders
may transact and the types of transactions they
may enter. That is, the system enables users to
program in minimum credit requirements for their
counterparties and to automate the credit
screening process. These monitoring and control
capabilities can reduce systemic risk by helping
deter and/or detect the accumulation of market
positions by traders that could place the firm
and, therefore, counterparties at unacceptable
financial risk.

Electronic trading systems for OTC derivatives can
also help reduce systemic risk by providing
participants with real-time data on the risk
exposure of their overall market positions. For
example, one system operator offers customers risk
management software that can be linked to its
trading system and used to update a customer's
market position following an executed transaction.
Such a system can help reduce systemic risk by
allowing participants to monitor their overall
risk exposure from OTC derivatives transactions in
real time.

According to OCC officials, electronic trading
systems for OTC derivatives can help increase
market liquidity. The officials said that as it
currently operates, the OTC derivatives market is
fragmented, with transactions done on a principal-
to-principal basis and dealers making markets. As
a result, the use of electronic trading systems
that provide for multilateral execution of OTC
derivatives would create a more centralized and
consolidated market, making it more liquid.

In addition, according to market participants,
electronic trading systems for OTC derivatives can
improve price transparency and make trading faster
and cheaper. These systems can improve price
transparency by providing simultaneous access to
multiple bids and offers, which can provide better
assurance of receiving the best available price.
In addition, allowing participants to
simultaneously view bids and offers can also make
trading faster by instantly providing information
that was previously obtainable only through
multiple telephone calls or through voice brokers.
To the extent that such systems reduce the use of
intermediaries, they can also reduce associated
costs.

Finally, market participants said that electronic
trading systems for OTC derivatives can make
trading more efficient for participants by
electronically capturing and transmitting contract
execution information to them. This capacity can
reduce errors that may occur when information is
communicated via telephone or fax and, as a
result, eliminate the risk of loss associated with
the time required to correct such errors.

Legal Uncertainty May Inhibit the Use of
Electronic Trading Systems for OTC Derivatives
Although electronic trading systems have the
potential to enhance market performance and
protections, uncertainty exists over whether their
use may cause OTC derivatives that are otherwise
excluded or exempted from the CEA to fall under
its provisions. According to the Working Group,
uncertainty exists over whether CFTC might change
the conditions of the swaps exemption in such a
way that otherwise excluded or exempted
transactions traded on electronic systems would
fall under the CEA. Under the CEA, all futures
contracts must be traded on a CFTC-designated
exchange, unless otherwise excluded or exempted
from this requirement. If a derivatives
transaction fails to meet the conditions of an
exclusion or exemption and was not conducted on a
CFTC-designated exchange, it could be deemed an
illegal and, therefore, unenforceable futures
contract. Consequently, users of electronic
trading systems for OTC derivatives face the risk
that transactions traded on these systems may not
be legally enforceable to the extent that such
transactions are determined to be futures. This
legal uncertainty can inhibit the development and
use of such systems.

Uncertainty Exists Over Whether Electronically
Traded OTC Derivatives Fall Under the CEA
Some market participants expressed concern that
even though CFTC has not directly regulated most
OTC derivatives, some OTC transactions may fall
under the CEA because they are transacted on an
electronic trading system. Uncertainty regarding
their coverage under the CEA is based primarily on
four concerns. First, concern exists that an
electronic trading system for OTC derivatives
could be classified as a board of trade under the
CEA. Such a classification would prevent
transactions on the system from qualifying for
exclusion under the Treasury Amendment because the
amendment excludes from the CEA certain foreign
currency and government securities transactions
unless traded on a board of trade. Concern arises
because the CEA broadly defines a board of trade
to mean any exchange or association of persons who
are engaged in the business of buying or selling
any commodity, a definition which, according to
the Working Group, could be interpreted to include
electronic trading systems for OTC derivatives.

Second, concern exists among some market
participants that an electronic trading system for
OTC derivatives could be classified as an MTEF,
preventing OTC derivatives traded through the
system from qualifying for the swaps exemption.
Under the swaps exemption, certain OTC derivatives
transactions are exempt from the CEA provided
that, among other things, they are not entered
into and traded on or through an MTEF. Concern
arises because the applicability of CFTC's
definition of an MTEF to electronic trading
systems for OTC derivatives is not clear. For
example, although an electronic system used only
to communicate information may not be an MTEF, a
system used to execute transactions may be. Some
market participants have said that using an
electronic trading system to enter into an OTC
derivatives agreement instead of using a telephone
changes only the mode of communication and should
not alter the regulatory status of that agreement.
However, futures exchange officials have said that
electronic systems that allow for automatic
execution of agreements operate in a manner
similar to CFTC-regulated exchanges and should
thus be regulated in a similar manner. The CFTC
Chairman has said that the definition of an MTEF
for exemptive purposes needs to be addressed.

Third, concern exists among some market
participants that while electronic trading systems
may facilitate the use of clearinghouses in OTC
markets, which can reduce systemic risk, the use
of a clearinghouse by an OTC trading system could
prevent it from meeting another condition of the
swaps exemption. That is, the swaps exemption does
not extend to transactions that are subject to a
clearing system. However, as previously discussed,
CFTC has said that it would consider the terms and
conditions of an exemption for a swaps
clearinghouse in the context of a specific
proposal and has done so.

Fourth, concern exists among some market
participants that CFTC might change the conditions
of the swaps exemption in such a way that
otherwise exempted OTC transactions traded on
electronic systems would fall under the CEA. This
concern exists because CFTC is authorized to
change the conditions of the swaps exemption. In
1998, two actions by CFTC raised concerns that
CFTC might modify the swaps exemption to impose
new regulations on the OTC derivatives market. In
the first action, CFTC stated in a February 26,
1998, comment letter addressing SEC's proposal for
an alternative regulatory scheme for derivatives
dealers affiliated with broker-dealers57 that the
proposal could conflict with the CEA to the extent
that certain OTC derivatives fall under the CEA
and are subject to CFTC's exclusive jurisdiction.
Some OTC derivatives market participants expressed
concern that CFTC's letter suggested that some
swap agreements might be viewed as futures and
thus subject to regulation. In the second action,
CFTC issued a concept release on May 12, 1998,
requesting comment on whether the swaps and hybrid
exemptions continued to be appropriate in light of
market changes.58 CFTC indicated that it was
receptive to broadening its exemptions or imposing
additional safeguards, if warranted. On November
23, 1999, CFTC withdrew the release.59

Uncertainty May Inhibit the Use of Electronic
Trading Systems
Uncertainty over whether use of electronic trading
systems for OTC derivatives may cause transactions
conducted on such systems to violate one or more
conditions of the swaps exemption means users of
such systems face the risk that CFTC or a court
could find them to be illegal and, thus,
unenforceable futures. According to the Working
Group report, uncertainty over the enforceability
of derivatives contracts, if not addressed, could
discourage innovation and growth in the U.S. OTC
derivatives market and damage U.S. leadership in
this market by driving the business off-shore. The
Working Group report also states that uncertainty
involving OTC derivatives has hampered efforts to
utilize electronic trading systems and clearing
facilities in the OTC market and thus prevented
the enhancement of market efficiency and
transparency and the reduction of systemic risk.

Approaches to Revising the Regulatory Structure
Have Been Suggested
General agreement exists among industry officials
that the current approach to regulation needs to
be revised to better accommodate electronic
trading systems for exchange-traded futures and
OTC derivatives. At least three approaches have
been suggested for revising the regulatory
structure for exchange-traded futures to more
effectively accommodate electronic trading
systems. Also, the Working Group has made several
recommendations designed to enhance legal
certainty concerning the use of electronic trading
systems in the OTC derivatives market. However, it
has recognized that the recommendations, if
implemented, would eliminate significant criteria
used to differentiate between exchange-traded
futures that are regulated and those OTC
derivatives that are not directly regulated, if
regulated at all. The Working Group has explained
its rationale for recommending exclusions for
electronic trading systems for OTC derivatives
from the CEA and has supported CFTC efforts to
provide appropriate relief for the exchange-traded
futures market. CFTC has proposed actions and
taken others that, in aggregate, could provide
significant regulatory relief to this market. In
addition, House and Senate committees are
considering actions that would address issues
related to electronic trading systems in the OTC
derivatives and/or exchange-traded futures
markets.

Three Approaches Have Been Suggested for Revising
the Regulatory Structure for Exchange-Traded
Futures
     Various market participants have suggested at
least three approaches for revising the current
regulatory structure for exchange-traded futures
to accommodate electronic trading systems. These
approaches are drafting a separate section of the
CEA to address electronic trading, developing core
principles and guidelines to which all electronic
systems must adhere, and developing a flexible
regulatory structure where electronic systems are
only regulated to the extent that they raise
public policy concerns. These approaches are not
mutually exclusive, and a successful approach may
contain elements of each.

Drafting a Separate Section of the CEA
     Some market participants have suggested
drafting a separate section of the CEA to address
electronic trading systems for exchange-traded
futures. In support of this suggestion, a former
CFTC chairman commented that the CEA currently
focuses on open-outcry trading and the
relationship between customers and intermediaries,
two features of the market that may be less
significant to the extent that electronic trading
systems for exchange-traded futures are introduced
and used. In addition, as noted earlier, some
futures market participants have also observed
that the development of fully electronic futures
exchanges that are not affiliated with an existing
futures exchange and are organized as for-profit
organizations may present regulatory challenges
under the CEA. As such, they have said that
revising the CEA to accommodate both electronic
and open-outcry trading together would be more
difficult than drafting a separate section
dedicated to electronic trading systems.

     One potential challenge under this approach
would be determining whether a system or exchange
would be covered under a new electronic trading
section, the current CEA, or some combination of
both. For example, the major futures exchanges use
both open-outcry and electronic trading systems to
trade futures. In some cases, trading on these
systems is linked because the same contracts are
traded simultaneously on both systems. In
addition, both systems use the same clearing
facilities and utilize elements of the same order
routing system. Given that the open-outcry and
electronic trading systems are not wholly
separate, it might be difficult to determine which
sections of the CEA would apply to the shared
portions of the systems. In addition, futures
exchange officials stated that drafting a separate
CEA section to address electronic trading systems
for exchange-traded futures could subject such
systems to less regulation than open-outcry
exchanges, putting open-outcry exchanges at a
competitive disadvantage. These futures exchange
officials also disagreed with the assumption that
the relationship between customers and
intermediaries will be less significant features
of electronic futures exchanges in the near
future.

Developing Core Principles and Guidelines
Some market participants have suggested developing
core principles and guidelines to which all
exchanges and trading systems would be required to
adhere. Under this approach, exchanges and system
operators would be allowed to determine the best
means for complying with such principles and
guidelines. These market participants have said
that current regulations can inhibit the use of
technology because they are very specific and in
many cases require CFTC approval of new systems,
contracts, and rules. They have also said that
core principles and guidelines could accommodate
the development of any new technology better than
specific regulations. According to a United
Kingdom regulatory official, this approach has
been adopted in the United Kingdom, and it will
facilitate the international coordination that
will be increasingly needed as electronic systems
effectively eliminate national borders.

One potential challenge under this approach would
be developing principles and guidelines that are
sufficiently flexible and, at the same time,
specific enough to provide a framework that
supports appropriate enforcement action. That is,
the less specific a guideline, the more difficult
it can be to determine compliance and, thus,
whether and what enforcement action might be
necessary. As discussed below, the regulatory
framework proposed by a CFTC staff task force
would replace prescriptive rules with flexible
regulatory principles.

Establishing a Flexible Regulatory Structure
Some market participants have suggested
establishing a flexible regulatory structure under
which various types of electronic systems would be
regulated based on the extent to which they raise
specific regulatory concerns. That is, types of
systems that raise greater regulatory concerns
would be subject to greater regulation. Such an
approach could subject systems to only the minimum
amount of regulation necessary to ensure that
regulatory objectives are met. One potential
challenge to this approach would be developing
criteria that distinguish between types of systems
based on the risks they present. The regulatory
framework developed by a CFTC staff task force
(discussed further below) proposes some criteria
for making such distinctions. In addition,
monitoring individual systems to the extent
necessary to determine if changes in the system or
its operation might warrant a change in regulation
could be difficult for regulators, because a new
determination would be required every time a
change was made to the system. Periodic
certification of a system's adequacy by a third
party could provide a means for addressing this
concern.

The Working Group Recommendations Address Legal
Uncertainty but Eliminate Criteria for
Differentiating Exchange and OTC Derivatives
At the request of the Senate and House Agriculture
Committees, the Working Group completed a study of
the OTC derivatives market and, as discussed
above, issued a report in November 1999 that
recommended, among other things, changes to the
CEA to clarify the scope of the Treasury Amendment
and to exclude OTC derivatives not involving
nonfinancial commodities with finite supplies.
According to the Working Group, these
recommendations, if implemented, would enhance
legal certainty for Treasury Amendment products
and other OTC derivatives, including those traded
through certain electronic trading systems. In
addition, the recommendations would eliminate, in
effect, most of the criteria traditionally used to
differentiate exchange-traded futures from OTC
derivatives for regulatory purposes.

Clarifying the Scope of the Treasury Amendment
To enhance legal certainty for Treasury Amendment
products, including those products traded through
electronic systems, the Working Group has
recommended clarifying the amendment's scope by
replacing the term "board of trade" with the term
"organized exchange." An organized exchange would
be defined as an exchange that is open to retail
or agency transactions60 and that serves a self-
regulatory function with respect to its members or
participants (or enters into arrangements with
another entity to serve such a function on its
behalf). This change would enhance legal certainty
for OTC derivatives covered by the Treasury
Amendment, including those traded through certain
electronic trading systems. For example, an
electronic trading system for Treasury Amendment
products that allowed for the execution of
transactions through agents would be excluded from
the CEA, provided it did not serve (or arrange for
another entity to serve) a self-regulatory
function.

According to Treasury officials, the Working Group
recommendation serves to protect retail customers
transacting in Treasury Amendment products without
unnecessarily disturbing the OTC foreign currency
derivatives market. These officials said that OTC
derivatives transactions in government securities
that involve retail customers would be excluded
from the CEA. However, they said that such
transactions would be covered under the Government
Securities Act and other provisions of the federal
securities laws, which include antifraud and
antimanipulation provisions. Similarly, the
Treasury officials said that OTC derivatives
transactions in foreign currency would be subject
to the CEA, if they are entered between retail
customers and entities (or affiliates thereof)
that are not regulated by SEC or a federal banking
regulator. According to the Treasury officials,
all other OTC foreign currency transactions would
be excluded from the CEA as long as they are not
subject to a self-regulatory regime. These
officials said that the OTC foreign currency
market has operated successfully without any
regulation, thus presenting no reason to regulate
it. According to SEC and Treasury officials, the
rationale for regulating a SRO is to ensure that
it effectively performs its self-regulatory
function and does not use its authority to the
detriment of market participants. Officials of one
futures exchange emphasized that SROs will
continue to perform their self-regulatory
functions responsibly in the absence of government
oversight, citing the incentive that exchanges
have to protect their reputations. They said that
regulators should provide incentives to encourage
OTC market evolution toward self-regulation-the
benefits of which are well established. In
addition, they said that it is illogical to
regulate systems that have proven self-regulatory
functions but not to regulate those lacking such
functions, because doing so could create an
undesirable incentive for exchanges to discontinue
their self-regulatory functions.

Removing Three of the Four Conditions of the Swaps
Exemption
As discussed above, CFTC exempted most swaps from
the CEA without determining whether they were
futures. CFTC specified four conditions that swaps
had to meet to qualify for an exemption. According
to CFTC, these conditions were intended to reflect
the way that swaps transactions occurred when the
exemption was granted and to distinguish exempted
swaps from exchange-traded futures for
regulatory-not legal-purposes. If implemented, the
Working Group recommendations would, in effect,
remove three of these four conditions under
specified circumstances. Accordingly, they would
remove most of the traditional distinctions
between exchange-traded futures and OTC
derivatives not involving nonfinancial commodities
with finite supplies. As a result, the
recommendations raise questions about the
rationale for the regulatory differences between
exchange-traded futures and such OTC
derivatives-recognizing that each market may raise
similar regulatory concerns and, thus, warrant
comparable regulation.

First, the Working Group has recommended removing
from the swaps exemption the requirement that
swaps not involving nonfinancial commodities with
finite supplies not be standardized as to their
material economic terms. If implemented, this
recommendation would remove one of the criteria
traditionally used to differentiate between
exchange-traded futures and OTC derivatives,
namely that exchange-traded futures traditionally
have had standardized terms, except for price,
while OTC derivatives traditionally have had
negotiated, nonstandardized terms. The Working
Group made this recommendation because the current
requirement creates legal uncertainty, insofar as
the material economic terms of many swap
agreements are similar. According to the Working
Group report, eliminating this requirement is also
necessary to allow for the development of clearing
systems for OTC derivatives, which have the
potential to lessen systemic risk.

Second, the Working Group has recommended that
clearing of swaps be permitted, subject to
appropriate regulatory oversight of the clearing
function. Furthermore, the Working Group reported
that this exclusion should not prohibit excluded
swaps from being fungible or require that the
creditworthiness of the swaps counterparties be a
material consideration, insofar as transactions
are subject to regulated clearing. This
recommendation would remove another of the
traditional criteria differentiating exchange-
traded futures and OTC derivatives-namely that
exchange-traded futures are cleared and settled
through clearing organizations, and OTC
derivatives are entered into on a principal-to-
principal basis where each counterparty is exposed
to credit risk. The Working Group made this
recommendation because clearing systems can lessen
systemic risk and, therefore, should be
encouraged.

Third, the Working Group has recommended excluding
from the CEA electronic trading systems, including
MTEFs, used to enter or trade swaps not involving
nonfinancial commodities with finite supplies,
provided that participants in the system act
solely for their own accounts. The Working Group
made this recommendation to encourage innovation,
competition, efficiency, liquidity, and
transparency in the OTC derivatives market.
Because the recommended change would be in the
form of a statutory exclusion, it would eliminate
CFTC's ability to modify the exclusion in the
future, thereby addressing concerns about such
potential action. If implemented, the
recommendation would remove another of the
criteria traditionally used to differentiate
futures and OTC derivatives. That is, it would
remove the criteria that futures are traded
through the interaction of multiple buyers and
sellers on an organized exchange. In contrast, OTC
derivatives traditionally have been privately
negotiated between two parties outside an
organized exchange. In addition, the Working Group
recommended that Congress establish that clearing
systems are not, and do not by themselves imply
the presence of, MTEFs, and that an electronic
trading system that is excluded from the CEA does
not become subject to the CEA because transactions
entered through the trading system are also
cleared.

The Working Group recommendations, if implemented,
would remove most of the traditional distinctions
between exchange-traded futures and OTC
derivatives not involving nonfinancial commodities
with finite supplies. Nonetheless, some
distinctions would remain. Specifically,
electronic trading systems for exchange-traded
futures might allow for participation by retail
customers and transactions on those systems might
serve a price discovery function. In contrast,
electronic trading systems for OTC derivatives
that qualify for an exclusion from the CEA
generally could not allow participation by retail
customers, and transactions on those systems would
be presumed not to serve a price discovery
function. According to Treasury officials, the
Working Group viewed the OTC derivatives it
recommended for exclusion from the CEA as not
serving a significant price discovery function
and, thus, not warranting regulation. Table 1
summarizes the effects of the Working Group
recommendations on the swaps exemption and the
traditional distinctions between exchange-traded
futures and OTC derivatives not involving
nonfinancial commodities with finite supplies.

Table 1:  Effects of the Working Group
Recommendations on the Conditions of the Swaps
Exemption and the Distinction Between Exchange-
Traded Futures and OTC Derivatives Not Involving
Nonfinancial Commodities With Finite Supplies
Current swaps exemptive   Recommended revision     Effect on distinctions
condition                                          between exchange-traded
                                                  futures and OTC
                                                  derivatives not involving
                                                  nonfinancial commodities
                                                  with finite supplies
The swap agreement must   Consider raising minimum No change.
be entered into by        discretionary investment
eligible swap             capital for natural
participants.             persons to $25 million.
The swap agreement may    Remove requirement that  OTC swaps could be part
not be part of a fungible swap agreements cannot   of a fungible class of
class of agreements that  be fungible insofar as   agreements, provided they
are standardized as to    transactions are subject are subject to regulated
their material economic   to regulated clearing.   clearing, and
terms.                    Remove requirement that  standardized as to their
                          swap agreements cannot   material economic terms.
                          be standardized.         Traditionally, exchange-
                                                  traded derivatives have
                                                  been fungible and
                                                  standardized, while OTC
                                                  swaps have been unique,
                                                  negotiated instruments.
The creditworthiness of   Remove requirement that  OTC swaps could be
the parties to the swap   creditworthiness be a    cleared by a
agreement must be a       material consideration   clearinghouse, provided
material consideration in insofar as transactions  the clearinghouse is
entering into and         are subject to regulated regulated. Traditionally,
determining the terms of  clearing.                exchange-traded
a swap agreement.                                  derivatives have used
                                                  clearinghouses, while
                                                  parties to OTC swaps
                                                  transactions have faced
                                                  counterparty credit risk.
The swap agreement may    Amend the CEA to exclude OTC swaps could be traded
not be entered into and   any form of electronic   through the interaction
traded on or through an   trading system, provided and execution of multiple
MTEF.                     it allows only eligible  bids and offers.
                          swap participants to act Traditionally, exchange-
                          solely for their own     traded derivatives have
                          accounts, even if        been traded through the
                          multiple bids and offers interaction of multiple
                          are open to all          buyers and sellers, while
                          participants. Establish  OTC swaps have been
                          that a clearing system   privately negotiated.
                          is not, and does not by
                          itself imply the
                          presence of, an MTEF.
Source: GAO analysis of the swaps exemption and
Working Group recommendations.

The Working Group Has Explained Its Rationale for
CEA Exclusions and Supports Relief for Futures
Exchanges
In its November 1999 report, the Working Group
explained its rationale for recommending an
exclusion from the CEA for electronic systems for
OTC derivatives that meet certain conditions. In
doing so, the Working Group attempted to draw
distinctions between the OTC and exchange-traded
derivatives markets for regulatory purposes. These
distinctions were based on the sophistication of
system participants, including the existence of
retail customers and an agency function; the
susceptibility of contracts to manipulation; and
the existence of a price discovery function.
However, some futures exchange officials have
expressed concerns about the rationale for some of
these distinctions. The Working Group acknowledged
that its recommendations, if implemented, would
blur the distinctions between exchange-traded
futures and OTC derivatives not involving
nonfinancial commodities with finite supplies. The
Working Group has supported CFTC efforts to
provide "appropriate regulatory relief" to the
exchange-traded futures markets.

Concerns Have Been Raised About Drawing
Distinctions Based on the Sophistication of
Participants
The Working Group has recommended that OTC
electronic trading systems that limit
participation to eligible swaps participants
trading for their own accounts be excluded by
statute from the CEA. That is, no retail customers
and no agency function would be permitted in
excluded systems. Futures industry officials have
expressed concern about the rationale and
potential effect of this recommendation. First,
officials from one futures exchange disagreed that
mostly institutional markets-that is, markets with
few retail participants, such as the futures
market-should be subject to the CEA while
exclusively institutional markets-that is, markets
with no retail participants-would not be subject
to the CEA. They said that 95 percent or more of
the trades in its markets are for parties who
would be considered institutional participants and
who would qualify as eligible swaps participants
under the Working Group's exclusion. They added
that the remaining 5 percent can only access the
futures market through a regulated intermediary,
which is responsible for ensuring that the
customer understands the risks of trading and
complies with financial integrity requirements.
Officials of two futures exchanges have agreed
with the Working Group that the relationship
between a customer and an intermediary should be
subject to some level of regulation. They have
asserted, however, that this relationship can be
regulated separately from trade execution and,
therefore, the presence of retail customers does
not provide a sufficient basis for regulating an
execution facility.

Second, officials of one futures exchange have
said that users of certain electronic systems for
OTC derivatives are also performing an agency
function. For example, they said that when a bank
executes a swap agreement with a customer, then
attempts to offset that agreement by executing a
swap agreement with another customer or dealer,
the bank is effectively acting as an agent for the
original customer. However, OCC and Federal
Reserve officials said that in such a situation, a
bank is not executing the transaction on behalf of
the customer-that is, acting as an agent for the
customer. Rather, the bank is negotiating the
contract with the customer on a principal-to-
principal basis, and the customer, as a principal,
is responsible for protecting its own interests.

Third, a futures exchange official said that an
exclusion that limits participation in a trading
system to eligible swaps participants trading for
their own accounts would encourage the creation of
exclusively institutional markets to the
disadvantage of retail customers. That is, while
the exclusion would not prevent institutional
participants from transacting in retail markets,
it would prevent retail customers from transacting
in institutional markets. According to the futures
exchange official, the latter would be larger and,
therefore, more liquid than the comparable markets
available to retail customers. As a result, they
would offer better prices. The Chairman of the
Federal Reserve testified that the effect of
creating two markets with different prices could
be mitigated to the extent that traders employ
arbitrage strategies to take advantage of price
imbalances between the markets.

Concerns Have Been Raised About Drawing
Distinctions Based on the Susceptibility of
Contracts to Manipulation
The Working Group has also reported that most OTC
derivatives are not susceptible to manipulation
because the vast majority are settled in cash,
based on a rate or price determined by a separate,
highly liquid market with a very large or
virtually unlimited deliverable supply. The
Working Group contrasted the OTC market with the
exchange-traded futures market for nonfinancial
commodities that are in limited supply and, as a
result, are more susceptible to price distortions
and manipulation. A futures exchange official
agreed with the Working Group that less regulation
is necessary for contracts that are less
susceptible to manipulation, but they have also
said that this principle should be applied equally
to all types of publicly traded derivatives. That
is, if a publicly traded derivative is not
susceptible to manipulation, it should be subject
to less regulation, regardless of where it is
traded or whether it is a financial or
nonfinancial derivative. In addition, an OTC
derivatives market official said that certain
energy-based swaps should receive the same
regulatory treatment as financial derivatives
based on their large supply and lack of
susceptibility to manipulation. The CFTC Chairman
has said that establishing criteria for use in
determining whether contracts are readily
susceptible to manipulation is a difficult issue
that needs to be further addressed.

Concerns Have Been Raised About Drawing
Distinctions Based on a Price Discovery Function
The Working Group has also noted that prices
established in OTC derivatives transactions do not
currently serve a significant price discovery
function, unlike exchange-traded derivatives for
many nonfinancial commodities. In addition, the
Working Group noted that if OTC derivatives
transactions executed on an electronic trading
system come to serve a significant price discovery
function, a limited regulatory regime may become
necessary to enhance market transparency and
efficiency. Finally, the Working Group also noted
that its members would continue to monitor and
consider the desirability of regulatory or
legislative action to address issues that may
arise in the future. Officials of a futures
exchange said they objected to basing an exclusion
from the CEA on whether a price discovery function
exists because of the difficulty in determining
when price discovery occurs, either for exchange-
traded or OTC derivatives.

In addition, we have expressed concerns in
previous reports61 about the potential risks
associated with regulatory gaps in the OTC
derivatives market and the reliance on voluntary
industry measures to fill these gaps. Except for
its recommendations related to clearing systems,
the Working Group recommendations, if implemented,
would generally continue this reliance, unless
electronic trading systems for OTC derivatives
came to serve a significant price discovery
function. Specifically, our ongoing concern has
been that the lack of SEC and CFTC authority to
supervise unregistered affiliates of broker-
dealers and FCMs that function as dealers in the
OTC derivatives markets creates a regulatory gap
that impedes SEC's and CFTC's ability to identify
and mitigate problems that may threaten markets or
the entire financial system. This lack of
authority, or regulatory gap, has become more
significant as the percentage of assets held
outside regulated broker-dealers and FCMs has
grown.

In a 1998 report on hedge funds,62 the Working
Group recognized the existence of this regulatory
gap and recommended that Congress provide SEC and
CFTC with expanded authority to obtain and verify
information from unregistered affiliates of broker-
dealers and FCMs. However, as we reported earlier,
this recommendation may not go far enough in
enabling SEC and CFTC to identify and respond more
quickly to the next potential systemic crisis. The
Working Group recommendation would still leave
important providers of credit and leverage in the
financial system without firmwide risk management
oversight by financial regulators. Without
additional authority to regulate the affiliates,
SEC and CFTC do not have the authority needed to
identify and address potential weaknesses in
securities and futures firms' risk management
practices that might lead to another systemic
crisis. Such authority could be similar to that
already available to the Federal Reserve over bank
holding companies.

The Working Group Supports CFTC Efforts to Provide
Regulatory Relief to Futures Exchanges
The Working Group acknowledged that its
recommendations, if implemented, would blur the
distinctions between exchange-traded futures and
OTC derivatives not involving nonfinancial
commodities with finite supplies. Moreover, it
stated that the recommended exclusions would
create differences in the level of regulation
between electronically traded and cleared OTC
derivatives and exchange-traded products with
similar characteristics. Nonetheless, the Working
Group stated that its recommended exclusions are
consistent with the public policy goals of
protecting retail customers from unfair practices,
protecting price discovery, and guarding against
manipulation. In that regard, it noted that to the
extent that exchange-traded futures markets are
accessible to retail customers, serve a price
discovery function, or are susceptible to
manipulation, regulation of these markets may be
warranted. Conversely, to the extent that these
factors are less relevant to certain futures
markets, regulatory adjustments may be necessary.

Recognizing that exchange-traded futures should
not be subject to regulations that do not have a
public policy justification, the Working Group has
supported CFTC efforts to provide appropriate
regulatory relief to the U.S. exchange-traded
futures market. First, the Working Group has
recommended that exchanges that have been
designated as regulated contract markets by CFTC
be permitted to establish electronic trading
systems for qualified swaps that would not be
regulated. Such electronic trading systems would
be limited to eligible participants trading for
their own accounts.  Second, the Working Group has
recommended that Congress explicitly authorize
CFTC to use its exemptive authority to provide
regulatory relief for exchange-traded financial
futures. As a result of this second
recommendation, the Senate and House Agriculture
Committees, in a November 1999 letter, encouraged
CFTC to use its exemptive authority to lessen the
regulatory burdens on the U.S. futures market.

CFTC Has Undertaken Actions to Provide Regulatory
Relief to the Exchange-Traded Futures Market
In response to the November 1999 letter, a CFTC
staff task force has proposed to the Commission a
regulatory framework designed to move CFTC from a
direct regulator to an oversight regulator. The
proposed framework would establish three types of
trading facilities and make no distinction between
electronic and open-outcry systems. According to
the task force, each type of facility would be
subject to a different level of CFTC oversight
based on the nature of the commodities traded on
the system as well as the sophistication of the
participants allowed to trade on the system.
Facility operators could choose to operate as any
one or a combination of the three types of
facilities. In addition, the framework would
permit clearinghouses to be separate from an
exchange or trading facility. The proposed
framework would also replace prescriptive rules
with flexible core principles, including rules for
intermediaries and clearinghouses. According to
the task force report, in addition to providing
facility operators with greater flexibility, the
proposed framework would provide OTC trading
facilities with greater certainty that their
contracts would be legally enforceable. The
framework would, among other things, clarify that
certain otherwise excluded or exempted OTC
derivative transactions could be cleared and that
certain transactions entered into in reliance on
the swaps exemption would not become illegal due
to a violation of that same exemption. CFTC
anticipates using the proposed framework as the
basis for a notice-and-comment rulemaking to be
issued in the near future. In addition, the agency
plans to hold at least one public hearing to
discuss issues related to the proposed framework.

CFTC has undertaken other actions designed to
provide regulatory relief to U.S. futures
exchanges. First, in November 1999, CFTC proposed
a revision to its contract market rule filing and
review procedures that would allow exchanges to
place new rules and rule amendments into effect 1
business day after submission to and receipt by
CFTC, subject to certain conditions.63 Second, in a
November 1999 companion release, CFTC revised the
required procedures for listing new types of
contracts to allow exchanges to list such
contracts for trading without first receiving CFTC
approval.64

Congressional Action Is Being Considered
House and Senate committees are considering
actions that would address issues related to
electronic trading systems in the OTC derivatives
and/or exchange-traded futures markets. On April
6, 2000, Representative Leach, Chairman of the
House Committee on Banking and Financial Services,
introduced a bill that would implement the Working
Group's recommendations, including those related
to electronic trading of OTC derivatives. On April
11, 2000, Representative Leach held a hearing to
address legislative issues stemming from the
Working Group recommendations.  In addition,
Senator Lugar, Chairman of the Senate Agriculture
Committee, and Representative Ewing, Chairman of
the Subcommittee on Risk Management, Research, and
Specialty Crops, House Agriculture Committee, are
separately developing legislation that would
implement the Working Group's recommendations, as
well as elements of the CFTC staff task force's
proposed regulatory framework.

Conclusions
Although technology is being used in the
derivatives markets to increase efficiency,
thereby making trading faster and cheaper, its use
can also further regulatory objectives.
Specifically, the use of technology has the
potential to (1) enhance market integrity; (2)
promote financial integrity by, among other
things, reducing systemic risk; and (3) improve
customer protection. Despite these potential
benefits, the use of technology in the derivatives
markets can raise concerns that may warrant a
shift in the current regulatory focus. For
example, the development of AORS that allow
customers to enter orders directly from their
computers has raised concerns among some futures
market participants about the need for best
practices that address, among other things, the
adequacy of system security and controls over
customer trading. In addition, the use of
technology in the exchange-traded and OTC
derivatives markets has raised concerns about the
potential for the current regulatory structure to
hinder the continued development and use of
electronic trading systems and, in turn, the
ability of the U.S. markets to remain globally
competitive.

U.S. regulators and policymakers have recognized
these concerns about the use of technology in the
derivatives markets and are attempting to address
them. To address concerns related to AORS, NFA
officials told us that NFA and FII are developing
best practices for order routing that will cover
AORS. Also, actions have been taken to address
concerns about the potential for the current
regulatory structure to hinder the use of
technology in the derivatives markets. In November
1999, the Working Group made several
recommendations designed, in part, to reduce legal
uncertainty concerning the use of electronic
trading systems for OTC derivatives that do not
involve nonfinancial commodities with finite
supplies. Additionally, in February 2000, a CFTC
staff task force proposed to the Commission a
regulatory structure designed to provide futures
exchanges with greater flexibility in meeting
regulatory requirements and to enhance legal
certainty for electronically traded OTC
derivatives. Finally, congressional committees are
considering actions that would implement the
Working Group's recommendations and/or elements of
the CFTC staff task force proposal.

Although the Working Group recommendations, if
implemented, would remove legal impediments facing
electronically traded OTC derivatives not
involving nonfinancial commodities with finite
supplies, they present some challenges. First, by
potentially removing most of the traditional
distinctions between such OTC derivatives and
exchange-traded futures, these recommendations
raise a question about the rationale for the
regulatory differences between these products when
traded on electronic trading systems. Second, the
recommendation to exclude such electronically
traded OTC derivatives from regulation as long as
they do not serve a significant price discovery
function raises a question about how and by whom
this determination would be made. Third, the
Working Group recommendations, with one exception,
would continue the reliance on voluntary industry
measures to fill the regulatory gap involving
unregistered affiliates of broker-dealers and FCMs
that function as dealers in the OTC derivatives
market. As discussed in other reports, we are
concerned about the potential risks that this
regulatory gap presents to the markets and the
financial system and continue to believe it should
be closed.

While recognizing that some actions are being
taken to address the regulatory concerns raised by
the development and use of electronic systems in
the exchange-traded and OTC derivatives markets,
we believe that continued progress in these and
related areas could be critical to ensuring that
the U.S. derivatives futures markets remain
innovative and globally competitive. Such progress
requires that the federal financial market
regulators remain aware of how rapidly changing
technology is affecting the derivatives markets.
In particular, regulators need to know whether
existing regulations are impeding the development
and use of electronic trading systems and whether
additional regulations or different regulatory
approaches are needed to protect the markets and
their users.

Recommendations
Recognizing the difficulty of ensuring that
regulations appropriately address market risks in
stable periods and the additional challenges that
are likely to be presented by ongoing and rapid
advances in technology:

ï¿½    We recommend that the Secretary of the
 Treasury; the Chairman, CFTC; the Chairman, Board
 of Governors of the Federal Reserve System; and
 the Chairman, SEC, as members of the President's
 Working Group on Financial Markets, monitor and
 report to Congress, as appropriate, on regulatory
 concerns related to the application of technology
 in the derivatives markets. Such efforts should
 address (1) the implementation status and market
 impact of the Working Group's 1999 recommendations
 related to electronic trading in the OTC
 derivatives and exchange-traded futures markets,
 (2) the need to impose a regulatory regime on OTC
 derivatives that are electronically traded to
 enhance market transparency and efficiency, and
 (3) the desirability of regulatory or legislative
 action to address concerns associated with
 electronic trading.
 
ï¿½    Similarly, we recommend that the Chairman,
CFTC, monitor and report to Congress, as
appropriate, on (1) the status of NFA and FII
efforts to develop best practices for order
routing that address AORS and the adequacy of
industry efforts to implement these practices and
(2) the status and market impact of efforts to
implement the regulatory framework proposed by the
CFTC task force in its February 2000 report.
Agency and Industry Comments and Our Evaluation
     With the exception of our recommendation to
the Chairman, CFTC, related to AORS, the federal
financial regulators, CBT, FIA, and NFA generally
agreed with the conclusions and recommendations in
our draft report. Regarding a draft recommendation
that the Chairman, CFTC, monitor and report to
Congress, as appropriate, on the implementation
status and market impact of efforts to develop
minimum standards for AORS, CFTC commented that,
based on industry feedback, the agency no longer
plans to issue such standards. We revised the
report to reflect this information. As discussed
above, CFTC has provided NFA and FII with $1
million to develop best practices for order
routing systems, including AORS. Our revised
recommendation to CFTC focuses on our concern that
NFA and FII efforts to develop best practices
adequately address AORS and that the futures
industry takes appropriate steps to implement the
best practices. Regarding a draft recommendation
to the Secretary of the Treasury, as Chairman of
the President's Working Group on Financial
Markets, officials from the Federal Reserve and
Treasury stated that it would be more appropriate
to address the recommendation to each of the
members of the Working Group. We revised our
recommendation accordingly.

     Technical comments provided by CFTC, the
Federal Reserve Board, OCC, SEC, Treasury, CBT,
FIA, and NFA were incorporated into this report,
as appropriate.

     We are sending a copy of this report to
Representative Larry Combest, Chairman, House
Committee on Agriculture; Senator Tom Harkin,
Ranking Minority Member, Senate Committee on
Agriculture, Nutrition and Forestry;
Representative Charles Stenholm, Ranking Minority
Member, House Committee on Agriculture;
Representative Gary A. Condit, Ranking Minority
Member, Subcommittee on Risk Management, Research,
and Specialty Crops, House Committee on
Agriculture; the Honorable Lawrence H. Summers,
Secretary of the Treasury; the Honorable Alan
Greenspan, Chairman of the Board of Governors of
the Federal Reserve; the Honorable William J.
Rainer, Chairman, CFTC; the Honorable Arthur
Levitt, Chairman, SEC; and other interested
parties. We will also make copies available to
others upon request.

     If you or your staff have any questions
regarding this report, please call me at (202) 512-
8678 or Cecile O. Trop at (312) 220-7600. Key
contributors to this report are acknowledged in
appendix I.

Thomas J. McCool
Director, Financial Institutions
  and Market Issues

_______________________________
1 Derivatives are contracts that have a market
value determined, in part, by the value of an
underlying asset, reference rate, or index (called
the underlying). Underlyings include stocks,
bonds, agricultural and physical commodities,
interest rates, foreign currency rates, and stock
indexes.
2 Exchange-traded futures are derivatives
contracts that are transacted on organized
exchanges and that obligate the holder to buy or
sell a specific amount or value of an underlying
asset, reference rate, or index at a specified
price on a specified date. These contracts may be
satisfied by (1) delivery or cash settlement if
held to expiration or (2) offset prior to
expiration.
3 OTC derivatives traditionally have had
negotiable terms, including price, maturity, and
quantity, and have been transacted outside of an
organized exchange.
4 An FCM is an individual, corporation,
association, partnership, or trust that solicits
or accepts orders to buy or sell futures contracts
and accepts payment from those whose orders are
accepted.
5 NFA is responsible, under CFTC oversight, for
qualifying commodity futures professionals and for
regulating the sales practices, business conduct,
and financial condition of firms that are not
members of exchanges.
6 SROs play an extensive role in the regulation of
the U.S. securities and futures industries. They
include all of the U.S. securities and futures
exchanges, the National Association of Securities
Dealers, NFA, and the Municipal Securities
Rulemaking Board. In addition, state agencies also
oversee banking, securities, and insurance
activities.
7 FII is a non-profit educational foundation
established by the board of directors of the
Futures Industry Association, the national trade
association of the futures industry.
8 Systemic risk is the risk that a disruption-at a
firm, in a market, or from another source-will
cause difficulties at other firms, in other
markets, or in the financial system as a whole.
9 Market transparency is the availability of
information about a market, such as bid, offer,
and execution prices and amounts.
10 Although CFTC has not defined MTEF by rule, CFTC
has defined an MTEF in the preamble to the final
rule on the Exemption of Certain Swap Agreements
as a physical or electronic facility in which all
market makers and other participants have the
ability to execute transactions and bind both
parties by accepting offers that are made by one
member and open to all members of the facility. In
this release, CFTC also said that a computer-based
system for swap agreements is beyond the scope of
the rules regarding the exemption of certain swaps
but may be the proper subject of CFTC's authority
at a later time. Exemption for Certain Swap
Agreements, 58 Fed. Reg. 5587, 5591 (1993)
(codified at 17 CFR Part 35).
11 See Over-the-Counter Derivatives Markets and the
Commodity Exchange Act, the President's Working
Group on Financial Markets (November 1999).
12 The Working Group was created following the
October 1987 stock market crash to address issues
concerning the competitiveness, integrity, and
efficiency of the financial markets. The Secretary
of the Treasury chairs the Working Group, and the
other members are the chairmen of CFTC, the
Federal Reserve System, and the Securities and
Exchange Commission.
13 Option contracts (American style) give the
purchaser the right, but not the obligation, to
buy (call option) or sell (put option) a specified
quantity of a commodity or financial asset at a
specified price (the exercise or strike price) on
or before a specified future date. Options can be
transacted on an organized exchange or OTC.
14 Swaps traditionally are privately negotiated
contracts that typically require counterparties to
make periodic payments to each other for a
specified period. The calculation of these
payments is based on an agreed-upon notional
amount that is not typically exchanged.
15 The notional amount is the amount upon which
payments between parties to certain types of
derivatives contracts are based. When this amount
is not exchanged, it is not a measure of the
amount of risk in a transaction.
16 These data were reported by the Bank for
International Settlements, which was established
in 1930 to, in part, provide a forum for
cooperative efforts by the central banks of major
industrial countries.
17 Price discovery is the process of determining a
price level based on supply and demand factors.
18 Clearance is the process of capturing trade
data, comparing buyer and seller versions of the
data, and guaranteeing that the trade will settle
once the data are matched.
19 Settlement is the process of determining the
daily closing price for each contract and marking
all open positions to that price-that is,
collecting losses from clearing members carrying
losing positions and making payments to clearing
members carrying gaining positions.
20 Credit risk is the risk of loss resulting from a
counterparty's failure to meet its financial
obligation.
21 For example, the futures markets have developed
products, such as flexible options, in which terms
other than price can be negotiated.
22 CEA section 2(a)(1)(B), which codified the Shad-
Johnson Jurisdictional Accord, excludes these
options from CFTC's jurisdiction. The accord,
reached between the Chairmen of the Securities and
Exchange Commission and CFTC in 1981, resolved a
dispute concerning jurisdiction over exchange-
traded securities-based derivatives. Under the
accord, the Securities and Exchange Commission was
given jurisdiction over options on securities and
options on foreign currencies traded on a national
securities exchange. We reviewed issues related to
the Shad-Johnson Jurisdictional Accord in a
separate report. See CFTC and SEC: Issues Related
to the Shad-Johnson Jurisdictional Accord (GAO/GGD-
00-89, Apr. 6, 2000).
23 The CEA also provides an exclusion for forward
contracts to facilitate the movement of
commodities through the merchandizing chain.
Forward contracts are privately negotiated, cash
transactions in which commercial buyers and
sellers agree upon the delivery of a specified
quantity and quality of goods at a specified
future date. A price may be agreed upon in advance
or determined at the time of delivery. CFTC has
distinguished forwards from futures on the basis
of whether the contract serves primarily as a
vehicle for deferred delivery or for risk
shifting. Delivery is typically expected under a
forward contract.
24 The interbank market is an informal network of
banks and dealers that serves the needs of
international business to hedge risk stemming from
foreign exchange rate movements. It includes not
only banks but also other financial institutions
and industrial corporations.
25 Pub. L. No. 102-546.
26 The Futures Trading Practices Act of 1992 did
not authorize CFTC to exempt swaps and other OTC
derivatives from CEA section 2(a)(1)(B)-the Shad-
Johnson Jurisdictional Accord.
27 Appropriate persons, as defined in the Futures
Trading Practices Act (7 USC  6(c)(3)), include
banks, savings associations, certain employee
benefit plans, insurance companies, investment
companies, commodity pools, broker-dealers, FCMs,
and government entities. A corporation or
partnership may be an appropriate person if it has
a net worth exceeding $1 million or total assets
exceeding $5 million. CFTC may determine that the
inclusion of other persons is appropriate based on
financial or other qualifications or on the
applicability of appropriate regulatory
protections.
28 In 1989, to reduce the legal risk facing swaps,
CFTC issued a swaps policy statement that
clarified the conditions under which it would not
regulate certain swaps as futures. In part, CFTC
predicated its policy statement on the rationale
that swaps lacked certain elements that
facilitated futures trading on exchanges, such as
standardized terms and a clearinghouse.
29 Swap Exemption, 17 C.F.R. 35.2.
30 Eligible swap participants include banks,
securities firms, FCMs, insurance companies,
commercial firms with a net worth exceeding $1
million, and individuals with total assets
exceeding $10 million. 17 C.F.R.  35.1(b)(2)
(1999).
31 In March 1999, CFTC approved a petition by the
London Clearing House to exempt certain swaps
submitted for clearing through its clearinghouse,
called SwapClear, from most CEA provisions and
CFTC regulations.
32Although OTC derivatives generally are not
subject to direct regulation by a federal
financial market regulator, CFTC has authority to
regulate certain commodity options that are traded
off-exchange, and SEC has authority to regulate
OTC options on securities.
33 Dealers stand ready to act as buyers, sellers,
or counterparties for end-users and other dealers.
34 Broker-dealers are agents that handle public
orders to buy and sell securities. They also act
as principals that buy and sell securities for
their own accounts.
35 See various sections of 17 C.F.R. part 240.
36 Although other forms of technology are being
used on futures exchanges, such as handheld
trading devices that can replace written floor
order tickets and sophisticated computer programs
that serve as surveillance tools to deter and
detect trade practice abuses, we have focused on
AORS and electronic trade-matching systems because
they have had and are expected to continue having
a more significant role in changing the way
futures are traded.
37 A floor broker executes trades on the floor of a
futures exchange for customers and may also
execute trades for personal or employer accounts.
38 TowerGroup conducted the survey, which was
sponsored by FIA. As of April 6, 1999, FCMs
representing over 50 percent of total U.S. futures
customers' equity had responded to the survey.
39 For example, an SEC official told us that
concern exists in the securities market that
electronic trading systems can be programmed to
frontrun customer orders and that this concern is
relevant to futures market AORS. To frontrun is to
take a futures or options position based on
nonpublic information regarding an impending
transaction by another person in the same or a
related market.
40 Margin is cash or collateral deposited by
customers as a performance bond with their FCMs
for the purpose of protecting the FCMs and,
ultimately, clearinghouses against loss on
exchange-traded futures contracts.
41 An FIA official also said that this capability
would be most relevant to FCMs with retail
customers. FCMs would be unwilling to halt
institutional customers' trading without assessing
their exposures across markets-a capability that
is currently not available.
42 Access to Automated Boards of Trade, 64 Fed.
Reg. 14159 (1999).
43 Access to Automated Boards of Trade, 64 Fed.
Reg. 32829 (1999).
44 The $1 million in funding is part of a $7
million settlement with Refco, Inc., of an
administrative proceeding brought by CFTC alleging
that Refco violated provisions of the CEA and CFTC
regulations related to the handling of customer
orders.
45 See Principles for the Oversight of Screen-Based
Trading Systems for Derivatives Products, IOSCO
(June 1990). IOSCO includes securities
administrators from over 60 countries and
facilitates efforts to coordinate international
securities regulation.
46 The Deutsche Terminborse and Swiss Options and
Financial Futures Exchange were both fully
electronic exchanges before the merger.
47 In addition to CME, the Globex Alliance includes
the Montreal Exchange (Canada), Paris Bourse
SBFSA, Singapore International Monetary Exchange,
and Bolsa de Mercadorias & Futuros (Brazil).
48 An out-trade is a trade that cannot be cleared
by a clearinghouse because the trade data
submitted by the buyer and seller differ in some
respect. For example, the price and/or quantity
may not agree. In such a case, the discrepancy
must be resolved before the trade can be cleared.
49 Trading ahead occurs when brokers buy (or sell)
for their personal accounts or an account in which
they have an interest, while having in hand any
executable customer order to buy (or sell) in the
same contract month at the market or at the same
price.
50 Bucketing involves directly or indirectly taking
the opposite side of a customer's order into a
broker's own account or into an account in which a
broker has an interest, without open and
competitive execution of the order on an exchange.
51 Contract markets are boards of trade or
exchanges designated by CFTC, under the CEA, to
trade specified futures or options.
52 Liquidity is the extent to which market
participants can buy and sell contracts in a
timely manner without changing the market price.
53 According to CBT officials, a number of
exchanges around the world have already completed
surveys about their electronic trading systems in
connection with this project.
54 The FutureCom exchange is operated by FutureCom,
a limited partnership and an affiliate of the
Texas Beef Group.
55 The BrokerTec system is to be operated through
subsidiaries of BrokerTec Global, LLC, a
consortium of securities dealers that includes ABN
Amro, Banco Santander, Barclays Capital, Credit
Suisse First Boston, Deutsche Bank Securities,
Dresdner Bank, Goldman Sachs, Lehman Brothers,
Merrill Lynch, Morgan Stanley Dean Witter, Salomon
Smith Barney, and Warburg Dillon Read.
56 As discussed below, the regulatory framework
proposed by a CFTC staff task force would clarify
that clearinghouses could be separate from an
exchange or trading facility.
57 OTC Derivatives Dealers, 63 Fed. Reg. 59362
(1998).
58 Over-the-Counter Derivatives, 63 Fed. Reg. 26114
(1998).
59 Concept Release Concerning Over-the-Counter
Derivatives, 64 Fed. Reg. 65669 (1999).
60 An agency transaction occurs when an
intermediary executes a transaction on behalf of a
customer.
61 See Securities Firms: Assessing the Need to
Regulate Additional Financial Activities (GAO/GGD-
92-70, Apr. 21, 1992); Financial Derivatives:
Actions Needed to Protect the Financial System
(GAO/GGD-94-133, May 18, 1994); Financial
Derivatives: Actions Taken or Proposed Since May
1994 (GAO/GGD/AIMD-97-8, Nov. 1, 1996); Risk-Based
Capital: Regulatory and Industry Approaches to
Capital and Risk (GAO/GGD-98-153, July 20, 1998);
and Long-Term Capital Management: Regulators Need
to Focus Greater Attention on Systemic Risk
(GAO/GGD-00-3, Oct. 29, 1999).
62 Hedge Funds, Leverage, and the Lessons of Long-
Term Capital Management, Report of the President's
Working Group on Financial Markets, April 28,
1998.
63 Proposed Revision of the Commission's Procedure
for the Review of Contract Market Rules, 64 Fed.
Reg. 66428 (1999). In March 2000, CFTC stated that
this proposed revision would be addressed as part
of the proposed regulatory framework discussed
above.
64 Revised Procedures for Listing New Contracts, 64
Fed. Reg. 66373-01 (1999).

Appendix I
GAO Contacts and Staff Acknowledgments
Page 46GAO/GGD-00-99 Regulation of Electronic Trad
ing Systems
GAO Contacts
     Thomas J. McCool, (202) 512-8678

Cecile O. Trop, (312) 220-7600

Acknowledgments
     In addition to the persons named above,
Richard J. Hillman, Patrick A. Ward, Richard S.
Tsuhara, Angela Pun, and Sindy R. Udell made key
contributions to this report.

*** End of Document ***