technology and banking congressional hearing doc

'TECHNOLOGY AND BANKING THURSDAY, MARCH 25, 1999 USS, House oF Repasseytanves, ‘SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES "AND GOVERNMENT SPONSORED ENTERPRISES, COMMITTEE ON BANKING

TECHNOLOGY AND BANKING

GOVERNMENT SPONSORED

oF THE, COMMITTEE ON BANKING AND

FINANCIAL SERVICES U.S HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

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CONTENTS Hearing held on: ‘Mageh 25,1900 8

‘Corporation othe Volker, General Counce, Burew Beulechland, Eeankbrt GB 2 Rage, Hanke &, Viee President, Research and Strategie Analysis, Chicago Board of Frade có : Unger, Hon Leurs 8, Conmieeloner, ÙŠ' Eecuriies and Eieiange Commie Wali" Seven “ME, ”Sinir” PbS "Brags

APPENDIX

Propared statements: ‘Baker, Hon, Wehr H

Born, Hon, Brooksley

'TECHNOLOGY AND BANKING

THURSDAY, MARCH 25, 1999

USS, House oF Repasseytanves,

‘SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES "AND GOVERNMENT SPONSORED ENTERPRISES,

COMMITTEE ON BANKING AND FINANCIAL SERVICES, Washington, DC

‘The subcommittee met, purstiant to notice, at 10:10 a.m in room

2128, Rayburn House Office Bullding, Hon Richard H Baker, {chairman of the subcommittee), presiding Present: Chairman Baker; "Representatives, King, Lucas, Mansullo, Biggert, Kanjorski, C Maloney of New York, &: Maloney

of Connecticut, Mascara, and Jones

Chairman BAKER Good morning I would like to call this hearing

of the Capital Markets Subcommittee to order T know that other Members have indicated they will be attending within @ few moments Mr, Kanjorski, the Ranking Member, has Inade it known to me he will be here within the next few minutes, and I thought, as best we could try to keep on schedule, we would

fF ahead and begin with our testimony “The purpose of this hearing this morning really is to begin an in-

HÌ ae to the effects ọr potential effects livery of banking products and effect on capital markets The of technology on the {growth in Internet aceess by consumers to products has been really father phenomenal, Last year, for example, online trading ac counted for about 86 perceat of all customer transactions, up from Shout 15 pereent only in 1997 ‘Of those banks which are now accessible via internet, about 40 percent of commercial bank assets and 60 pereent of national bank 2scets are now accessible through internet means In tay own per sonal case, I'maintain an internet bank account, simply because of the novel nature of it, and because of the ease of convenience Trav- ling a great deal, you can set up the monthly automatic payment

of your aecounts 1d T'was fitst attracted to this by one of the early banks in Georgia, where you could actually pay up to 20 accounts a month for no service charge at all, which'T found phenomenal ‘The con sequence of this tecmnologieal development for the consumer is in- deed, I think, very, very appeal ‘Ruther, | have been told by those in the banking industry that activity engaging a teller within the bank lobby—-these are very non Hye may cm am mich ta $1.30, When 3a do an (TM transaction, that average cost will drop inio the mid-60, 65:

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STATEMENT OF HON BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION

Ms Born Thank you very much, Mr, Chairman, and Members

of the subcommittee T very inuch appreciate the opportunity to tes- tify concerning the changes that technological advances are bring- ing to the futures and derivatives markets and the ways in whiel the Commodity Futures Trading Commission is responding to them

Task that my written testimony be included in the record

chairman BAKER Without objection

Ms BorN Technological advancements are no doubt the single biggest source of change in the derivatives industry Many foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems As technological enhancements fuel the development of these systems, customers increasingly will gain ac-

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cess to these markets without having to trade through an nter- mediary, and the role of intermediaries may diminish ‘Technology is also contributing to changes in exchange govern- ance and organization New exchange ownership structures are emerging that are intended to improve exchanges" ability to engage

In Sete strategie planning and implementation, Membership ot nizations are being abandoned by some foreign exchanges in favor of public stack ownership, raising serious issues concerning whether ‘auch dematvallzed,profitoriented exchanges can ade: fuately continue to perform the self-regulatory role exchanges tra- ilonally have played Tia the face of these developments abroad, U.S futures exchanges confront the question of whether open-outery trading will remain a Viable alternative in the 2ist Century It remains true that the very liguld and efficient trading floors in Chicago and New York can stil exeeute more trades per minute than eurrently operating Slectronic futures trading systema, Moreover, US exchanges are employing new technologies to increase the efficiency and to Fedtce the coat of open-outery trading Some exchanges fre experimenting with the tise of automated order-rowting sys" and thelr members tems, wireless communication, and handheld trading units Ad- vanced computer software is being used to enhance exchanges Target surveillance activities US exchanges have also improved their existing electronic trad- ing agit und have suctonfly inegraed electronic and open outcry trading in some contracts, The Chicago Mercantile Exchange Pioncered this innovation when it offered concurrent eleeironie and Spencoutery trading of the “Eumin‘” version of its S&P 500 futures contract That development also opened the way for some firms to offer oniine trading ‘access to the Emin on Globex2, which is CME's electronic trading system The Chicago Board of ‘rade also how features ‘concurrent electronic and open-outery trading in any’ of its financial contracts ew, ily alcronie U.S exchanges ae lao ging launched In September 1998, the Cantor Financial Futures Exchange hecame the first fully electronic-based US, exchange, trading four futures contracts on’ U.S Treasury bonds end notes, When its recently adopted rule changes become effective, 1 will provide for direct lectronie agcess by members and certain other traders, Another aspiring U'S exchange, FutureCom, has not previously been des- ignated as a contract market in any contract, but has an applica tion currently pending before the Commission to become the frst internet-based Futures exchange in the world Using the internet to tranamit trade and financial information would facilitate direct ac- cess by the public and would result in the elimination of a signif ant role for intermediaries fhe Commission has spent considerable time and effort in ad dressing the dificult and rapidly evolving regulatory issues assoc ated with this technological innovation in the futures industry The Commission must adapt its regulatory framework to accommodate 4 variety of proposed alternative trading systems, induding inter: hetsbased exchanges, nonintermediated exchanges, and proprietary exchanges, At the same time, however, the Commission must en sure that it hes suficient regulatory tools to protect against frattd,

in opencoutery trading, automated trading raises other regulatory đEpuệt sịch syslem capacity and security, which are pot applica bie to the open-outery environment Similary, the need for Reness standards and customer protection measures, which underlies the Commission's current registration scheme for commodity profes: Sionals may become less significant with greater direct access and diminished discretion associated with automated trading T should caution that we have insufficient experience with electronic sys- tems accurately to identify all of the risks they pose at this time Technology today can efstivly provide exes tì cst personal computer to trading on exchanges around the world In Eponse to these developments, fast week the Commission issued Proposed rules regarding the placement in the U.S of trading ter- Iinals for foreign electronic exchanges The proposed roles vould provide an exemption from the contract market-designation re- Guirement and related requirements under the Commodity, Ex: change Act and the Commission's regulations to boards of trade es- fablished in a foreign country, whieh wish to make thelr products fceessibie from within the US, via automated trading systems, as ống aa such boards of trade are subject to generally comparable regulation in thelr home countries, Such exemption’ would avold uplicative and inconsistent regulation, encourage other countries fovallow access to the automated trading systems of U.S ex: changes, and stimulate global competition and open markets in the futures industry ‘Computerization has also facilitated the explosive growth in oC" derivatives market Some OTC derivatives market partic Pants are now interested in the development of automated trading

nd clearing systems that would closely resemble the regulated change-traded markets, The Commission has just Tuesday of this Wweekt granted a petition from the London Clearing House request" ing at exemption from the Commission's reguistions to permit clearing of swaps transactions forthe fret time The London Clear- ing House wishes fo establish “SwapClear,” a proposed facility for Glearing swap transactions that otherwise satisfy the terms” and onaitions for swap transactions under the Commission's regal tions, Swap clearing operations may provide substantial benefits to the OTC derivatives market, induding imposing controls on exces sive extensions of eredit, reducing counterparty credit risk, and in- creasing transparency ‘As the OTC derivatives market continues to grow and evolves to resemble traditional futures and options exchanges, new regulatory concerns about the market arise, and increased parity and treat- tment of the OTC and exchange markets is needed ‘The benefits of functional market oversight apply equally to exchange-traded and OTE derivatives, even though the nature of snd_ participation in

the OTC derivatives market warrant a different degree or kind of regulation from exchange-traded derivatives markets ere is no basis to claim that entity-based supervision of OTC derivatives dealers alone Ìs suffelent to oversee this market, While such supervision is very important to the safety and soundness of many of the large dealers, we cannot overlook the fact that many ricpants the OTC derivatives market including many hedge Rinds and other jeveraged institutions—are not subject to Government oversight or supervision Equally important, an entity based regulatory approgch doesnot provide oversight ofthe market generally, which may be particularly dangerous in a market that SS curreniiy as massive and opaque as the OTC derivatives market and that can be the souree of systemic financial risk Institutional fupervinors gute properly focue on the teas, market regulators jook at the forest Both are necessary This dual approach to regu- lation has been demonstrated to protect the publ

‘ore than 60 years “Phank you very tauch, and T would be happy to answer any que tions Members of the subcommittee may have ‘The prepared statement of Hon Brooksiey Born ean be found on page 67 in the appendix | Ghairman Batt Thank you very much, We certainly appreciate your testimony ‘Our next witness is the Commissioner of the Securities and Ex- change Commission, Laura Unger Weleome, Ms Unger

STATEMENT OF HON LAURA S, UNGER, COMMISSIONER, US ‘SECURITIES AND EXCHANGE COMMISSION

Ms, UNGER, Thank you, Mr Chairman, We eall our place the

‘Commission to0 So just so you know I do appreciate the oppor- tunity to testify before the subcommittee on behalf of the SEC to discuss the impact of technology on the capital markets, ‘As you indicated in your opening statement, technology has changed the world faster than many of us could have imagined, fand continues to change it at a pace that is both exciting and

@aunting More and more information is available to us every day Nowhere can the effect of technological change be seen any dearer than in the securities markets, These markets handle trading vol- lumes that were unimaginable a decade ago Investors have bene Rted from these changes, both in terms of choice and in terms of cost, Investors have access to the markels more than ever before, land they have this access more cheaply and more efficiently One of the most noteworthy results of the wide availability of new technology is the rise of online investing in the last five years

‘The internet is dramatically transforming how individual investors participate in the market Estimates for the humber of online ac- founta range anywhere from nearly four milion to over seven mil ion accounts, "The rise of internet trading is all the more astonishing when you consider that the first online brokers did not appear until 1996, Today, about 14 percent of all orders entered occur online through

ay oe of fhe hundred or a9 online brokers, Over 0 percent of the volume ia NASDAQ and NYSE stocks result Yrom trades entered over the internet,

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However, the internet's impact on trading by small investors is much more pronounced, Nearly 87 pereent of all individual inves- tors trades are entered online, up from 17 percent in 1997, The internet has brought significant benefits to Investors in terms of cost savings and access information ‘Online commissions have dropped 70 percent over the past two years, from an average of $52.89 a trade—they are not quite free Tết" bụt thy are $18,75 Retail investors are increasingly taking Rdvantage of these low transaction fees,

Tn a way, the internet le the wild card that makes it difficult to wediet what the securities markets will lok like five or ten years Rom now By some estimates, 21 million will have online accounts

by the year 2003, According to a study published in February 1999, the key economic factors that will have a large impact on the growth of electronic commerce will be ease and cost of access, con” Yenience, and the appeal of mass customization Despite changes In the way securities business is done, however, the fundamentals of the securities laws—competition, eficleey, and investor protection ‘continue to be the same, By’ and large, fechnology has made achieving these goals even easier It has also Falted ot expectation about what ie possible iin the wake of these trends, our challenge and the securities in- austry’s challenge, is to meet these expectations, The Commission Tecoghtizes these challenges and as a result { have begun to convene

2 series of roundtables to explore the impact of onfine trading on the markets and investors 1 will report to the Commission on my findings and we will work,

as regulators, to ensure that our scheme of securities regulation pul continue to, promote the deepest and most liguid markets in the world, a8 well as the safest for investors, 1 thought it would be helpful to briefly outline some of the issues the Commission is facing right now, whlch might provide some int sight into the future fe have observed at least three trends affecting the market re- sulting from online trading First, as you know, customers can col- lect, sort, and analyze vast amounts of data with the internet To

2 great extent, this ls leveling the playing field in terms of informa fiom access between retail and institutional investors, "The ability to Feoeive information almost instantaneously has fucled an insatiable demand for it from investors Research reports are quicidy becoming a commodity that online firms must offer in order to compete Investors also want access to Peal time quote information to monitor their market positions The Internet glves investors the ‘ability to customize the information they receive by"using “pul technology’ to set the parameters of er preferences

‘A stcond important trend is the convergence of discount and full service brokers, The popularity and affordability of online discount broker-dealers have ade them formidable competitors to th off

"A third trend is the rise of new market intermediaries, Nontradl tional intermediaries, such as financial portals and chat rooms are competing with market professionals for investors’ attention to be- come thelr deetination of choice” on the web

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8 Our next witness is the Senior Deputy Comptroller for Economic and Policy Analysis, at the Office of the Comptroller of the Cur- rency, Mr James Kamihachi

STATEMENT OF HON JAMES D KAMIHACHI, SENIOR DEPUTY

‘COMPTROLLER FOR ECONOMIC AND POLICY ANALYSIS, OF- FICE OF THE COMPTROLLER OF THE CURRENCY

Mr Kaci, Thank you, Mr, Chairman,

ME Chairman and Menbets of the subetramitiee, Tam pleased tovrepresent the OCC at this hearing on the impact of technological

hp op th financial etvices infty ahd capial markets

‘The polity implications of technology-driven changes in the finan: dal fates doterve carefal reviews commend you for holding tis timely hearing Tư the Senior Deputy Comptrolier for Economic and Policy Aualytis, One of iy respoosilites is to explore many emerging fell tschnalogy oliver? syste barks are developing in tae tion, Toveroge Salt with exportine in the models thay backs use to Teaste ana manage theif financial risks, ‘thoes financial eng

neers participate directly in the OCC’s exams of the most sophisti-

Tá Paliondl bane, Banks’ new uses of technology benefit consumers as banking be- comes more convenient and less coty 10 also holds the promise of Slowing banks to profitably serve more customers and of making Sur payinenta system much moro gia “Hy, bani are investing in new technology as never before Last yer, the banking industry spent nearly $19 billion on snfor Tratidn technology, outpacing both he insurance industr’s $17 il

on and the eecuities industry’ $12 bilion on information tech: bology apelng ‘Tie ts no Guestion that technological innovation is changing the nature of yanking businoas, Bet the sheer volume of eet Ing and emerging finanelal products and services makes aiicut tofgain lear turf important fg hewp ming that fow tecfnolopycariven products have Become ‘breakthrough’, products ike ret cards and Ais that fundamentally changed the way consumers Go transactions, The reason ls that breaktisough pro ticle depend on the convergence of many incremental innovations, which typically occur ever long period of time "The domme facing Goversent is to avotd stifing innovation that creates the foundation for breakthrough productos while mest tng ic responatilites to address market fellures, Tita, public pak icy affeting the pace and impact of technological advances oa 8 Tana services niast be very carefully drawn, ‘Wihere maeset tallures aries, Coverrment has & respousiiity to ach Ar bank supervisors, our job is f0 prevent undue risk-taking tevcagure a stable basking ayetern, Our duporricory responetultes include matataining the saiegy and soundnoes ofthe national ban Ing stem, protecing cmsumners) and avoiding nancial crn TA Eling car supertiion to acccuimadate the sophiotietea tock, moles banks uber we have increased cur spocaly tassing of ax

faminers in this area, We are also hiring Ph.b, economists, bringing hang the nanbor we wil have to Support exannston tess

fo for every three of the largest tational banks, And we have

9 issued guidance for banks and for examiners on risk management procedures for new technologies, For example, our broad guidance

fn technology risk management and on PC banking delineate the major risks that banks should think about We have also issued guidance tailored to particular technology products or concerns, in- cluding electronic stored-value cards, credit scoring models, and on criminal threats to the information system infrastructure of banks,

In conclusion, Mr Chairman, continuing technological innovs tions are crucial to the vitality of the banking industry Bank regu- ators must meet their responsibilities to see that innovations do not compromise the safety and soundness of the banking system, that consumers are adequately protected, and that criminal act ties are deterred But in so doing, we must avoid unnecessarily di torting or hindering advances that could lead to marked improve

‘ments in how the system meets the needs of our economy and of

‘our communities The OCC is working hard to ensure that we ut derstand new developments in financial markets, that we maintain the expertise needed to oversee new products and applications, and that we supervise effectively banks’ management of technology isk,

an pay bills, check balances, and transfer funds between accounts Increasingly, bills will be presented online, While stored-value cards have met with mixed success 20 far, it seems hard to bet against the day when iis eommonplace to download value from a

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‘Technology also underlies financial innovation and the growing use of risk management models, both of which suggest a future Where greater amounts of data and sophisticated analytics will be

‘used by banks of all sizes to design new products and control their exposures

‘Pechnology is also driving globalization, industry consolidation, and the blurring distinctions ‘among financial services providers Those trends talten together sugpest.a utare industry that may be increasingly bifureated, that is, a few large, complex institutions and a large number of small ones Tn many ways, these institutions may appear much as they do now What could vary considerably, however, is the degree to which they can extend thelr electronic reach far beyond their physical branches, ‘The trends underway pase challenges not only for man- agers of financial firms but also for policymakers and regulators rose job it at ensure tht the finaidal system continues to con: tribute to economic growth and well-being ‘The challenge is to allow the industry to evolve in response to market and technological developments While maintaining financial Stability and public confidence To ensure that the deposit insur- ance system Meeps pace with these changes, the FDIC faces chal- lenges in a number of key areas; resolving troubled institutions, su- pervision, and harnessing market forces to help its risk exposure T would like to finish by discussing the last of these As banks get larger and more complex, the case for supplementing super-

‘isory risk assessments with market judgments becomes more com pelliag One market approach that has received attention over the Years is to require banks to issue subordinated debt Under some proposals, deposit insurance premiums and corrective actions could

be imposed on banks that cannot roll over their subordinated debt

oF eotld be ted to the rates that the market charges Under these proposals, mandatory subordinated debt canbe viewed as a way to generate market signals of bank risk and to Provide ân additonal buRer between “fank ‘losses and deposit

‘To get a more direct measure of the risks it faces, the FDIC could ‘enter into rsk-sharing arrangements, with market partic pants Financial innovation has produced risksharing instruments Such as credit derivatives and insurance derivatives that may pro- vide models for this ‘There are at least two potential advantages to a market-guided approach to deposit insurance First, the pace of change in financial hnarkets may leave litle alternative to 2 market-guided approach,

‘To the extent that the evolution of financial markets outstrips the evolution of the regulatory framework, the potential grows for

‘ounterproductive gaps between market and regulatory approaches

fo asseseing 1 ‘Second, as we leamed from the resolution and liquidation efforts

of decide Ago, wel designed and well executed, publiprvate partnerships ean enbanee the FDIC's ability to perform key parts

of its mission, particularly when the tasks at hand are similar, if ol identical, task performed by the private sector Assessing

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‘The FDIC recognizes that the deposit insurance system must keep pace with the changes underway while maintaining the bed- rock of public confidence we currently enjoy We look forward to working wath others to mest this challenge nk you

(The prepared statement of Arthur Murton can be found on page

4100 in the appendix.) Chairman BAKER Thank you, Mr Murton

Ma Born, I note with great interest the potential establishment

of the first internet-based exchange and the consequences of that for the intermediaries Do you think that the role intermediaries now play is vital to consumer protections, for instance suitability, fas an example of concern, With the elimination of the inter: Iediary, what does that represent in the way of risk to the on:

‘Ms, BORN Well, the Commission is concerned about that, and that is part of the reason why the examination of FutureCor has taken some time Also, of course, we have not had all the informa: tion we need from the petitioner who is asking for contract designa tion tntil very recently Tt will create nonintermediated exchange, The Commission's regulatory scheme ‘has heavily relied on the fitness and ethics irsining and kmowledgeability” of futures-commission merchants, Who are our registrants, to protect against fraud and other abuses

in these markets Tam personally concerned We have not yet had presented to us

by the staff the FutureCom application, but | am sure that all the Commissioners will look very earefully dt that aspeet of it ‘Chairman BAKER, But given the huge success of the phenome- nally large day-trading market, looking past the next five years, do you really think the floor-based exchanges can remain a competi tive foro'n the marke given the power of this technology? "Ms, BORN I certainly’ think we are secing tremendous shift from foorrbased trading to more eloctroni-based trading That certainly ws happened abroad very quickly It is beginning to happen in this country over the last four or five years, I think the fact that you have electronic trading doesn't necessarily mean there is no role for

an intermedia “The proposed rules yre came out with on placement of foreign ter- minale in the United States, the terminals of foreign electronic ex changes in the United States, has an aspect to it that deals with

‘what the role of an intermediary should be for regular retail cus- tomers who are trading on their own PC's And it has a provision that is out for public comment now that would require that the transactions be controlled by the FCM in that there would be posi- tion limits or eredit limits that the FCM would be imposing, that the FCM would be responsible to make sure that the system was secure and ft for its purposes, and a few other limited™but still, Tehink, significant aspects of intermediary activity ‘Chairman BAKER, Thank you,

Ms, Unger, you indicated that some of the concerns for fraud that have existed in traditional markets now seem to be navigating thelr way through to the electronic market but that footprints are created that make detection of that "or ultimately finding the re:

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‘sponsible party—not necessarily easier, but it is a course that can bbe pursued Do you have concerns, though, that there will be the easual retail investor entering into transactions which they don't fully understand the risk they are taking and forgetting the fraud-

‘ulent or outright illegal conduct? ‘The relationship between the casual “I read a good article about, spepay X)seu Know, ST want part ofthe TPO,” whatever itis is the hot bution for that given week—and markets are being affected where historically you couldn't have the vast movement of re- Zourees in such short periods of time that I'm afraid you can have

"And that the day-trader phenomenon is having an effect on valu- ation of markets 1 am more concerned about that effect than I am fraudulent conduct in the overall e-trading environment,

‘Ms UNGER That's a loaded question, but I think I will start with separating the difference between online trading and day-trading

‘We at the Commission, and 1 think people in the industry, are be: ginning to really separate the two phenomena because they are Feally very different Online trading is someone at their PC, you or 1 oF your wife trading in their account And they are able to do it still through

‘an intermediary, still through a broker, but they are able to place their trades whenever they want, at night or during the day, and those trades ‘are executed in that account, ‘They are paying less

‘commission for that account at the discount broker

‘The full service firms ae just beginning to enter that market, byt now iris really dominated by the discount firms, "Then there is the phenomenon of day-trading, where you have a whole different arrangement really The individuals form limited li- ability companies They trade, they pool thelr money because there

is usually a cash requirement They are able to avoid the margin requirements that way Instead of a 50 percent margin require:

‘ment, there is no margin requirement because they are trading as

4 There are’ alot of sales advertising, perhaps misconceptions proprietary account as opposed to a retail account about the fact; or overzealous advertising, perhaps, that says, you know, “anyone ean come to this firm and we will make you money, lots of money Just sit in the room We will tell you when to trade

We will facilitate the capital that you need to make those trades And this is what you need to make money.” And sometimes they take a percentage of the commission

So that is very different from online trading, With respect to day- trading, I think we are more concerned at the Commission about day-trading than we are about traditional online trading

hey are very different issues that the Commission would look

at in the context of those two types of trading activities In the con- text of day-trading, you are right, we are not so sure that investors really understand the market well enough and the volatility that you mention, particularly in the area of internet-related stocks It is kind of ironic, but it is the internet that is driving this in many respects, but it is people trading on the internet and trading intra-day that are part of this day-trading phenomenon that really want to get their hands on internet stock and they want to be the next investors in Amazon.com or something like that

1

So, there is a lot of volatility in that particular sector of the econ- omy and in the market, and that is where they are focusing a Tot

of their money and attention in trying to make a quick profit off the intra-day swings in the prices

‘So we are concerned Chairman Levitt put out a letter January arora statement rather that warned investor of the fact that Tealy need to understand that if you put in an order for an IPO, for instance, and at the time you put in the order i's priced at $20,

St could gp ip to $100 before your order is filed unless you putin

a limit order Sp you need to be aware of things like that And there have been instances Teported in the press of that happening So lot of itis education, And we are inspecting the day-trading firms and coordi- hating with the SROs to see and make sure that they are operating Within the existing regulations ‘Chairman BAKER My concern is that we have an enormously powerful economy and a lot of folks are pulling money out of tradi- Honal savings accounts to pump into the kind of environment the

ge in what they think ie a train that has lef the station and {hey don't want to miss the last car And that with the cercainty, T will say, of some downturn

‘Tm not saying that is golng to happen this afternoon-

Ms, UNGER You are not saying a “rational exuberance.”

TLaughter.]

Chairman BAKER That is correct, Just someone wakes up and certain circumstances occur where we have in Wall Street parlance “correction.” I love that, term It means when you are losing your money it is a “correction.”

(aughter.]

And we see, say, a 20 percent adjustment to the current market

values, that I'am worried about the public reaction when you have Individuals who have, in fact, very much overextended themselves

on the belief that this is thelr ticket out of their current economic difficulty And some may be led to believe that they are insulated from loss, T don’t know on what basis individuals would make such a claim, but Tam really worried about the level of understanding of individ: vals putting, for their particular financial circumstance, great money at risk for whieh they don't have the resources to absorb the Toss when it ultimately does occur ‘Do you have any sense about—I know we have data indicating percentages of growth, and, you know, when you get down to 8.2 rade, you are really getting down to a level where lot of people are going to pay attention=-do we have any idea who the world of thie eorent ew Investiont poo! look like? Whereis the money coming from! Me UNGER We do, We believe it is sbout 9,000 individuals who are engaged in these day-trading activities And there are about a ftundred firms that are conducting the day-trading activities as well, We cant—we dont regulate investors, unfortunately, ai"

1

though some people think that we should, We regulate the brokers Sead ve ate doing i we are anh chesntrding nụn sper efforts, and as Tsaid, coordinating with the SROs, with the NASD, fo'ge into and inspect these hundred or so firms, make sure they arent violating the margin requirements, that there 1s adequate Superviston, that there isn’t a registration issue in terms of pool together people's money, that thelr advertising is aboveboard am fol fraudulent or misrepresenting the potential profits or whatever, and the suitability issue that was mentioned before, and that 1s

‘where we are focusing our attention, ‘But again, we were having a conversation in my office about this when setting up the next roundlables that we are doing Saying, You know, “Where were these people before? Were they day traders patting in the investment eemmunity betore? Wore they di ferent types of investors? What's the sort of personality profile?” 1 think they were used car salesmen,

Laughter

‘And, you know, we have seen students I have read articles about someone who used to Work at a taco stand You know, they get on the internet and they make a few correct predictions and then they establish ‘But, what we can-do is we cam look at the firms and make sure a following And ao it sort of snowballs, that they are operating within the regulations, and we can go out there and be proactive in terms of investor education "And the more we can say about investor education, the better

‘And we do have information at our web site, like Chairman Levitt’s statement is on our web site And we are trjing to go out there and bay as much as possible You know: “if you putin an order and you press the button and you don't get your confirmation back right Bway, that doesn’t mean that noone has gotten the order.” And then people end up entering multiple orders because they don’t un- derstand how it works, Or the phenomenon, you know, the TPO, Where it ends up, you think it's going to be 8i0 or $20 8 share and

TẢ So those types of 002A shave and you can’ afford that, | 7 things we are tying to heighten awareness about And Enow Chaltfnan Levitt has leo raised that at town meetings and that kind of thing ‘But ff you have any suggestions about how we can expand our scope of investor education, we would certainly be amenable ta hearing those, Chaifman BaKeR I think I will get back to you later

Me: UNGER ĐK

Chairman BAKEa Mr Kamihachi and Mr Murton as well, as to technology and banking tisk, do you sense that the explosion of technology and the access to internet-based accounts in-any way creates # higher concern of risk to the system or is it just the oppo she that because you are on the net thai you do have footprints that are created that you ean get in these institutions quickly or

is transparency of what they are doing a real concern? MP, RANIHACHI T think that is an important but very complex question Where you are talking about consumers’ access to thelt counts to do transactions oF to pay bills, that sort of thing, there are some fondamental differences between these retail aecounts and ‘wholesale accounts For wholesale accounts, there is limited

15

access tạ the system, but for retail accounts you have lo open ae- sss or they woulda be effective, And so they are mach mare vil erable to security breaksins And that is one kind of concern that wehave htnan Baxen, 1 really meant not only from that, end bt from a regulatory standard looking into that internet-based ac Count, There are banks that don't have a brick and mortar location Soes that internet-based financial institution really represent any Dew of different type of risk that a conventional institition woud ipso rm & feglators perspective” TP Kaniitacht, some respect, yes In some respects, no We only’ "have one national, bank that's been” authorised” 40” far, CompaBank, that operates on an internetonly basis One thing Sankers tell us ia that if you operate only on the internet, your eux tomer base can be diferent The evstomer who can't get a loan ficerto-face in thelr bometown tries over the interbet OF course, you have some people who are just seeking better rates, betier deals, You have to have much niore careful credit controls in am Internet situation Security controls and reliability can be a problem in any bank, but if youl are only doing business on the internet, there are par- ticular sues, What happens Sf your aystem goes down? How customer get access t9 ou? There needs to be some way in which

2 customer can eall you It's not very helpful If you send customer Service advice over the internet if you ean make your connection “The application of CRA fs an issue which the ageney fs thinking about How do you define the assessment area if you are in one lo: Eston bại doilg business nationwide? ‘Thats not unique to an Snternet bani, bt i isan inoue

‘Chairman Banta, Thank you

Mắt Mien,

Mr, MUNTOX I would agree with the points that Jim made, 1

‘would alao, perhaps, mention in terms of snfety and soundness that there may’ be some issues with deposit and funding volatility as people access thelr banks through the internet move, Tt may be hat they are more willing to move funds around in reaction to va fous things, And that may pose a challenge for banks and the man agement of liquidity Chairman BaKsi: On that point, I ean recall the days when it used to be “open an account and we vil give you a toaster” And Jos would see people moving font ane ban the next, but hey a to phyaleally drive up aiid do the transaction If you take the free sausage or free toaster concept and appiy ft to the internet, givờn the speed with which these modifeatons can be made, is fhore any concern that you could see some innovator in the market: place came in with his new offering and everybody runs t his foc Eon in 24chour period? Te that likely concern? Or is i some: thing to be worried about? ‘Mr, Mtopron, I think itis an issue that banks may have to face, aowing that the customers they are attracting online may be Wil: tng fo ove to other aces airman Baker There is no bank loyalty when you go to an internet ste?

16

Mr MURTON, Unless they are able to develop that loyalty

‘through some other means over the internet,

‘Chairman BAKER Thank you

Mr Maloney, Ihave gone way too long No questions?

Mr, MANZULLO Sorry I didn’t have the opportunity to listen to your testimony I will read it, and if I have any questions at that Boia, T hope you will be available for me to give you a call by tele- Thave read some of the testimony in today’s hearing, and I just want to state that based upon what I have seen so far, maybe T could give you some consolation for any further regulation,

"That may be good news to you I don’t see any smiles on your faces I see a smile over here, But based upon what I have seen

so far in this emerging area, I think as long as we are dealing with

‘companies that are responsible and reputable and make full disclo-

sures via this incredible system of internet that it would take a very dark day for me to say we need another layer of regulation

‘Chairman Baker Thank you, Mr Manzullo And thanks to each

of the witnesses for your testimony We would like to reserve the Tight for Members to advance questions after the hearing And we cortainly appreciate your wilingness to testify Thank you

T would like to invite our second panel of participants to come forward as well

‘Good morning and weleome I would like to weleome our second panel, And our first witness this morning to present testimony is the Vice Chairman of State Street Corporation, Mr Dale Carleton, Welcome, Mr Carleton

STATEMENT OF DALE L CARLETON, VICE CHAIRMAN,

‘STATE STREET CORPORATION

‘Mr CARLEToN Thank you Mr Chairman and Members of the subcommittee Thank you for the opportunity to appear before you,

My name is Dale Carleton I am vice Chairman of State Street Cor- poration, where I oversee the activities of our financial markets group Chairman Baxen 1f1 could ask, just pull the mike a litle closer,

we are having a little —

‘Mr CARLETON, Certainly, These activities include currency and come trading, securities lending, cash management, trade banking, asset liability management, and investment banking I will be speaking briefly today ‘and respectfully ask the Subcommitee's permission to submit a longer written statement for the record

‘Chairman Baxen,

out objection, for all the witnesses

Mr CARLETÔN, Thank you, | have been asked to describe how technology in the changing nature of financial intermediation in the United States has impacted and will continue to change tradi- {onal financial firms State Stret isan excellent case stody in this regan ‘We trace our roots in New England back over 200 years, yet we are today at the cutting edge of global financial change, providin informaton-driven Hmandial eervices to institutional Savestors

a

In my view, technology networks linking customers and counterparties will define the future of the global financial services industry And it will open great new opportunities for those firms, most of them American, that have embraced the concept and are spared to make the necessary investment in technology and iumman expertise to compete successfully

Finally, 1 will suggest some broad public policy parameters to protect ad encourage the further development of this dynamic in- justry ‘Sate Street Bank is one of the oldest banking institutions in the United States, with roots dating batk to 1792" Over the past evo centasies wo have evelved ftom & New England benfing metvution {Sia tray global haansel services compasy with 17,000 employees doing buses in 89 countries “Algeries of strategie decisions taken over the course of several detades have led us to focus on igh tach aseets servicing and in- Seatntent nisnagement for atioEenal investors: frst fa North erica and then expanding worldwide ‘Our transformation bogas In’ 1924, when the Massachusetts i- sani Serge Company aaked State Strat to handle cua, ge Srunting, ane recordheaying for an, innovative new product tho fhutual fonds th the late 600% and 1870s, State Street wes an carly leader in using technology to automate securities settlement

hd afekeoping prosescs ane b liminate physical betienecka aa fodated with niurual find transactions and administration Gur ently’ kuveetnent tn slocronte processing Porkholigy also placed ir in advantageous position when the 1074 Employee Re- Ñmement Income Security Act, or ERISA, created a regulatory framework for private pecsion and benefit plone, These new hands tgded to be managed dnd serviced ‘So Srate Street focused on developing technology to service the institutional investors who managed these vast tavestment, pools settling trades, and providing ecordkeeping for pension fand spon: Sots at thtr benetariee, "The passage of ERISA of subsequent legislation providing for the exeation of 401{K)s, and the step by step deregulation of the bank fig and securiies infustries over the fO70s ane 10805, have Ie dabd ted to the accumulation of vast pools of investment assets, Shs accumulation of pooled ivestnent assets as redeined Amer Pension assets have grown from less than $40 billion in 1975

to over $7 trillion taday” Mutual funds, today worth more than $5 Bilton, have exceeded commercial bank deposit, and with every

KH nh Eentage of our GDP rose, During the 1980's, continuous reinvestment in technology has al- rowed Slate Btrect fo cus even tare sharply on sericey the Hitutional investors who manage these vast hew investment pools Wile doing ‘sty we gradually withdrew from toany aress fall ervice banking, retail branches, ered cards, and the lke Hedy we ae soning to fcnvest In thnaogy that enables

us to deliver an intagrated array of financial iorsetion products tnd services to meet our customers increasingly sophisteaved it ostmnent nods

18

Our services to pension funds and mutual funds encompass in- vestment management, recordkeeping, portiolio accounting, and ad- Ininistration services Among the capabilities that we are building are integrated service delivery platforms dedicated to cash manage: ment, rik management and the trading of currencies, equity, and xed income, Snstruments to elp investors contol aks wile maximizing their returns ‘State Street provides custody accounting and recordkeeping for

$42 trillion in eustomer assets, And we manage some $486 billion worth of investments We are the langest custedian of pension as Sets in the United States We have over $1 trillion in pension a3

sets under custody globally ‘We are te largest provider of services to U.S mutual funds, and

we are expanding to service collective investment all over the World More than 90 percent of our revenue comes from servicing Ingtitutional investors and investment management ‘State Street has become an information company supported b technology In much of our business, we act as principal or tru Re hancial intermediary’ in a complex, interconnected chain of finan cial transactions between ‘securities depositories, broker-dealers, banks, stork exchanges, telecommunications and uilities provider nereasingly our efforts in technology are driven by the need to allow customers to process electronically on an end-to-end basis State Street and companies like us play an essential role in the

‘lobal, neer real-time transmission of nancial information through

ur institutional customers to tens of millions of individuals wi Inver in mutual finds o palpate tn defined benefit or defined contribution plans Tnvestors today want to know precisely where and how their as- sets are being deployed globally at all times So we have built multicurrency’ systems that deliver information to our investors around the clock, tall stages of the investment cycle, from Pretrade intimation tending and execution serieee to pos: Frade accounting, recordkeeping, and analysis Blectronie trading la a prerequisite for global financial institu tions, It makes entire markets more efficient to the ultimate bene- fit of individual investors U.S finance today is an enormous digital network, State Street is committed to making this network fune- ton continuously worldwide ‘Over the past five years, State Street has spent on average ap- roximately 20 percent ofits total annual operating expenses on in formation technology to meet this goal This evolution is only be- ginning Blectronieally-driven financial services are still 3t'a very Early stage of their development Online trading with the use of the internet as a platform for fi andi nations for nancial information hae enormous peten- tal for upside growth It remains unclear how electronically’ deliv- eed” fibancal services ram image beat,” aang, eounterparties, traditional banking, ‘and full service brokerages

‘This han global implications ‘All ove the world, inane fs becoming ovented toward securities = markets, Government control of industry is giving way to private ownership Closely-owned enterprises that for decades have de ended upon relationships with local commercial banks are increas

19 ingly going to global markets for finance capital Growth in cross- border investing is a key theme we follow at State Street

Tn the rapidly changing world of business today, companies need agile, swift-moving capital for startups, restructurings, mergers, fand acquisitions Capital markets are responding with cross-border alliances, securities listings on multiple exchanges, and around-the- Clock trading The vision of globally internetworked markets cannot come to pass without steady flows of dependable, accessible finan- cial information

‘An important technology challenge facing our industry today as

we look to this electronic future is achieving electronic connection with customers and counterparties to help facilitate global straight- through processing State Street plays a leadership role in the international initiatives focused on this goal

‘The only way the financial industry can accommodate the global boom in financial information is by achieving an end-to-end and seamless digital trail of data leading from investment research, to trades, to post-settlement and recordkeeping

‘We are actively working on this challenge to help our customers

to aggregate and manage the data flows of their customer bases by giving them more information In the quest to achieve this end-to- end information management and to be a trusted provider of finan- ial information to the markets, a corporate culture of risk manage-

‘ment and expertise is eritical

'By risk management, we mean traditional market and trans- action tisk as Well as information risk, Markets simply will not function unless all participants have faith in the quality and verac- ity of the information on which their decisions are based

The electronic delivery of financial services and information promises great things for the U.S and world capital markets For example, the development of automated trading systems, we be- lieve, could enable even more efficient securities trading’ than is sible today and more efficient allocation of capital for enabling Investors to execute trades that are inhibited today by existing structures,

“Another benefit could be to reduce intra-day volatility by allow- tng a greater numbers of intended trades to take place more rap-

y

‘and more efficenth

US nancial firms have a great opportunity to share their ex- pertise, practices, and solutions focused on electronic connections

‘with customers in many different markets Indeed the United Btates is a world leader in technology-driven financial services, a competitive advantage for our Nation that public policy should do everything to enhance ‘This involves support for free trade in financial services so that USS financial companies can gain access and compete freely around the world, I includes coherent regulation of emerging elec- tronic marketplaces so they can grow without being burdened by

‘acetate ed fape or taxation at an early stage of development Tt includes passage of financial modernization legislation that recognizes the blurring of boundaries between banking, insurance,

Để ga place. hú industries, whichis already taking place nthe mar

20 Public policies that encourage investment in financial technology, computing, information networks, and development, will pay real dividends for the Nation by helping U.S financial firms to compete and win in global markets

Further, Government can play a crucial role by providing regu- latory framework the drives full disclosure Investors need to make well-informed choices As finance grows steadily more complex, well structured regulation ensures that consumers and institutional in- yestors continue to have faith in the information that is the life- blood of healthy capital markets

“Thank you [The prepared statement of Dale L Carleton ean be found on page 158 in the appendix.)

Chairman Baker Thank you very much, Mr Carleton,

As you might well note, we have just had indication that votes have started on the floor it would be my intention to proceed with Our next witness, to allow you to conclude, and I will briefly recess the hearing to make what appears to be two votes, and come right back,

‘So I would like introduce our next witness, who I understand is, standing in this morning Mr Bill Lupien, the Chairman of OptiMark Technologies, has unfortunately notified us of illness— and is it Katovich?

Mr, KATOVICH Katovich,

Chairman BAKER, Katovich I apologize Mr Katovich, please welcome, we are certainly happy to have you here in your capacity with OptiMark Technologies

STATEMENT OF WILLIAM LUPIEN, CHAIRMAN AND FOUNDER,

‘OPTIMARK TECHNOLOGIES, INC

Mr KATovicH Thank you, Mr Chairman Good morning My name is John Katovich I'am the Senior Vice President and Gen- eral Counsel of OptiMark Technologies OptiMark is a developer of

‘advanced electronic trading systems headquartered in Jersey City, New Jersey Its patented trading system is currently in operation

on the Pacific Exchange and will be introduced as the central elec- tronic order-matching facility of the NASDAQ stock market in the third quarter of this year OptiMark is currently under contract to deliver its technology to securities markets in Canada and Japan

as wel "AS Mr Chairman has said, Mr Lupien, the Chairman and found-

er of OptiMark Technologies, was going to address you this morn- ing but was taken ill this morning and asked that I present the re- marks that he had prepared for this subcommittee

‘Mr Lupien has been active in the securities industry for over 35

‘years He was a specialist on the trading floor of the Pacifie Ex- change for 17 years He was instrumental in the design of the world’s first electronic trading system, called SCOREX, back in

1088, And as a director of the Pacific Exchange, he was actively in- volved in the design of the intermarket trading system, which is the system that links all of the Nation's securities exchanges elec-

‘tronieally

21

From 1989 to 1988, Mr, Lupien was President and Chairman of Instinct Corporation, which ts'the dominant lechrome trading net Wort in the word today We woul like to thapi Chsinnan Rakes ond the Members fhe subcommittee for inviting OptiMark to participate in todays dis: Stosions, Continued eeonomie expansion, capital formation, and the {pact of technology have lee te the most aynamic Iandstape thet dphestic and glee markets have ever experienced: Sting the Hane belance Between regulation and vree market economics i ct Teal wo the long-term prosperity and global dominance our capital

nạ ho lạng anh cm Today, we vil touch on that rate of change and the role we be- lieve tulaton can play (0 ensure enhented capital Yormation, fairness in use, andthe highest levels of investor protection ‘Technology i changing today’ capal markets at te Speed of light inerally and figuratively” As quickly as new lberepdc lines are laid, innovations in trading technology are changing the way’ Poyers and’ sellers come together, changing the role of financial Intermediaries, and improving the direct sctess that investors have eke guarket

“The Tnertet has made online trading a reality for millions of Americans, Five years ago ery fow peopl bad heard of te Inter fet nach less uged it eday, ab you have heard, i estimated TEs: epprontmately 80 percent of retail order flow Teaches the mar

et vir the terete in the same way that businesspeople, students, and eee Government employees use e-mail and the’ internet as comtersiones of their

dally lives, too are we witnessing a transformation in the access

{or dad enbcation in the capital mceets both at homme and abroad, ‘ihe speed at which US" broker-dealers are implementing, new online trading services aiso provides proot that direct connections fom the ueet straight through to setlement of a transaction will othe standard iy the very meer fare Before long, such “straight through processing” as we call t now today, wil povide trade sntzy, exteuton, settenegt and eating wwtith a matter of seconds, eaucng systemic credit risk and ent aneing market liquidity, The amount of information flowing to the User has also increased dramatically, and-new applications are Belng developed every day to help the investor dealt, integrate, and utilize termation to drive ther investment decisions, Ty chợt tong to market Hquicly ang information has actually reduced the barriers to competition, which the established ex- Changes and market centers had once enjoyed, We see this domesti- cally with the rising number of so-called “alternative trading sys temorand the elevonte inking of onenarginl repoal ex Changes into consolidated trading blocks, particularly in Hurope "he Buropean markets enjoy an agree rogulatry approach

to the use of wechnclogy and’ are alady making moves ward float alftncs to rae secre on tified teshloicl pi frm around the world, 24 hours a day Several foreign securities tachanges have demusialized in recent years, to the emptical ben: sft of thelr shareholders andl the capital markets ÁP nh have hears fis Tuesday the SEC approved the limited

US Speration fa’ Uiebaved ‘electronic teasing system called

22

‘Tradepoint, On Tuesday prior, as you heard, the CFTC proposed new rules that would allow foreign futures exchanges to place elec- tronic trading terminals in the United States

Tt is against this background that the U.S capital markets will compete for market share in the global economy If our regulatory principles and mandates are forward-thinking and progressive, we will help define the direction and nature for these global electronic markets If not, we will be outmaneuvered by overseas competition,

‘and we will be forced to compete on the grounds or restrictive and protectionist policy

‘There will always be tension, and we would argue a healthy ten- sion, between the objectives of innovation and regulation Regula- tion, based largely on statutory precedent is by definition retrospec- tive! Innovation, by contrast, is prospective, forward-looking This struetural epnfit has often served to impede innovation in the se

‘curities market,

‘We would suggest to this subcommittee that our regulators be encouraged to act with foresight, flexibility, and speed in achieving regulatory objectives, This will lead to higher levels of service, lower costs, and the ability to compete internationally

Innovation has been a defining characteristic of American suc- cess In the 1975 amendments to the Securities Exchange Act, Con- gress directed the SEC to take a more active role in the regulation

‘of now and innovative developments in the securities industry And during the past 25 years, the SEC has become a much more in- volved entity in every aspect of securities trading But this ap- proach, however well-intentioned it may be, has at times served to Festrie! innovation and market development,

‘Last December, however, the SEC issued new regulatory diree- tives addressing many of the issues surrounding electronic trading and the need to modernize our market infrastructures and promote innovation “Regulation ATS,” as it is known, provides for demutualized exchange governance, multi-tiered regulatory envi- ronments for electronic markets, and perhaps most significantly, it grants the exchanges the ability to develop and deploy pilot elee- tronic systems without first obtaining Commission approval

Regulation ATS is the most significant and positive piece of regu: latory structure promulgated in recent years But directives and rulemaking by Government agencies aloe may not be sufficient to engure the competitive success of our capital markets

Chairman BAKER Mr Katovich, Iam sorry to interrupt you I

am down to about three minutes So Tam going to have to run We will stand in recess for about ten minutes, and I will be back as soon as possible Thank you

[Recess.]

Chairman Baxer If T may, I would ask our hearing to reconvene

‘and our witnesses to proceed to the table, and apologize again, Mr Katovich, for having interrupted you midstream, but I certainly do appretaie your courtesy and would reengnze you to complete your

‘Mr KATOVICH, Thank you, Mr Chairman I will continue where Tleft off

23

1 was talking about directives and rulemaking that Government agencies currently provide And the point that Ï was going to make iSthat those alone may not be suffeient to ensure the competitive success of ur capital markets

‘We need to etisure that regulation and rulemaking address the rood of issuers, investors, aiid competitive market structure, not {he'parocial intrest and commercial concerns ofa prviogd few Established institutions in the securities industry have regularly and effectively used existing regulation to stifle innovation and

“Relevant and vlenceg of our” own company, OptiMlark ‘Technologies, ‘The jevant and compelling example is provided by the recent ex- compel eis provided by the recent OpuiMark trading system is an thnovative approach to maichin the interests of buyers and sellers utilizing supercomputers and ad vanced mathematical algorithms, ‘The OptiMark system was de Signed to integrate with existing market structures and is deployed

as a faclity ofits exchange partners ‘The SEC approved the Pacific Exchange's application to utilize the OptiMark trading system in an unprecedented 6/-page order, which the Commission delivered in just three months from the date

of filing This order clearly defined the Commission's strong sup port of market-structure innovation through the use of technology Bespite the SEC's strong support of the Pacific Exchange's and our intentions, the exchange became embroiled in a 1S-month debate fon how and, Indeed, whether the Nation's other securities markets ‘would allow this innovative technology to integrate with the na: onal market system "The cost of these delays that revolved around the competitive ex- change access issues alone exceeded $20 million And while OptiNfare had adequate reserves to weather those delays, other Innovators have neither the resources nor the stamina 0 endure

‘inlay quas-egulataryroadoeka in conclusion, our markets are undergoing an unprecedented "home pe- riod of transition brought about by advances in technology’ and communications, Today the U.S, financial markets may well be the envy of the worid And we believe this is in large measure due to the foresight of the framers of the 1934 Securities Act and the 1975, Amendments to that act 'As we move into an environment of global economic marketplaces featuring direct investor access, the natore and role of the Tegu- latory process is critical, We need to ensure that investors have the highest levels of protection, while facilitating innovation and im provement of market structures through the use of technology

While care must be taken to prevent abuse stemming from such in novation, it is equally important that we implement thoughtful reg-

‘lation so that our fear of abuse does hot hamper success Thank you, Me Chaleman nan, Nee

e prepared statement of William Lupien ean be found on page

159 in the appendix] Caairian’ BAKER, Thank you very much, ar I do appreciate ° = your remarks,

` Our next witness is a professor at Pennsylvania State University, Mr Ian Domowite, Welcome, Professor Domowitz

24 STATEMENT OF IAN DOMOWITZ, MARY JEAN AND FRANK P

‘SMEAL CHAIRED PROFESSOR GF FINANCE, SMEAL COLLEGE

OF BUSINESS ADMINISTRATION, PENNSYLVANIA STATE UNI- VERSITY

Mr, Donowrrz Thank you very much, Mr Chairman And thank

‘you for inviting me to speak here today Tam an academic who spe- Galizes in the study of trading markets, but I have also worked as a market practitioner in the senge of using, designing, and working

fn the building of electronic markets As with others, my testimony feals'with one of the most important developments in the trading Services industry today, the Impact of advances in computer a telecommunications technology on the cost of trading and the de- Velopment of market structure effects have been fundamental, something that you hinted at yourself, The cost of providing exchange trading services has de- Hlined significantly The means by which they can be delivered to investors has changed radically, and the natural industrial struc thre of the trading services industry has been transformed

‘All classes of market participants, exchanges, broker-dealers, in-

vestors and regulators are affected by these ‘developments ‘The

most important single shift in trade-execution services is the birth

of an industry, and the introduction of an element of true competi- Hon in tae ingutry, We are not accustomed to thinking about ex ange services as an industry, yet exchanges and other entities providing trade-execution seriiees are firms, regardless of their Precise governing structure These firms now offer different tech- Pologies for trading "Through these alternative technologies, transaction services are produced, Traders are consumers of trade services They choose the Technologies and associated transaction-services bundles, taking ex- plicit costs, implicit costs, and considerations of liquidity into ac- count "You may expect developments associated with any newly com- petitive industry ‘There will be a flurry of new entrants, such as the recent crop of socalled “ECN's"—exploiting market niches in the trading community These niches will not be limited to stocks

‘The analog of ECN's can be expected In the areas of futures trad ing, options trading, and the trading of fixed income securities Such entry is already underway in some areas, in a big way,

‘The first mover advantages of traditional exchanges are being eroded by lower costs of providing trade-execution services and ac- companying penetration’ pricing, Strategic investment in new trade-execution technology’ will abet successful entry into this in- dustry, improving traders’ ability to customize orders These en trants will continue to use technology to offer various means of submitting and executing orders without traditional human inter- vention ‘The economic paradigm for this industry should mostly parallel that of telecommunications Afterall, an exchange is simply a com- munications system, with trade execution attached to it As such,

‘you may expect mergers between trading services providers as well as joint venture arrangements, which might fall under the rubric

of what has sometimes been called "competition through coopera-

25

Supporting evidence for the statement is available already through developments in’ Buroge for example Merger activi Should not necessarily be viewed as anti-competitive, however Tt stimulates research and development, better trading’ technologies

‘with an associated lowering of costs to the trader and investor iin fact, there are factors that suggest a very competitive environ rent, without the need for regulatory intervention in the sense of regulating rates or market sifucture A competitive environment heed not require the existence of many firms offering the service 4s common economie theory might suggest, but it does require ease

of competitive entry, Such ease now is abetted by massive declines {n automated system development costs, the elimination of distance costs, and the expansion of securitized products ‘The effect of such competition on the pricing of trading services wal be ip elininate esting crows eubsidlation in the industry Tà terms of public policy, we have historically viewed such develop- mente as positive for consumers in areas other than trading ser Regulatory challenges will remain, however Technology will, for example, ereate a different environment in terms of globalization of trade activity, something that's been hinted at earlier today Policy makers now face the issue of permitting foreign exchanges direct access to the US marketplace, for example ‘Selfregulatory organizations will begin to oversee the activi

of trade-exeeution firms that operate ona for-profit basis as op- posed to membership organizations operating under a not-for-profit Umbrella, The laoue of conflict "This last point deserves some further elaboration The behavior of interests indeed can arise,

of exchanges is conditioned not only by the competitive environ- ment but also by the incentive structure deriving from thelr int hal governance arrangement The traditional mutual structure of fan exchange is a remnant of the preautomation era, when space limitations inherent to trading floors necessitated thé rationing of direct access to members, As members then became intermediaries for all nonmember order flow, exchange behavior came to be partly directed bythe iaerests of iembers and maineining intermed- ation profits ‘AS trading automation has facilitated virtually unlimited access,

ii local that new automated entrants have chosen not to be governed as intermediary cooperatives but rather as for-profit joint Stock companies selling execution services on a transaction basis

‘Outside the U.S, member-based exchanges are increasingly try: ing 10 replicate the incentive structures of such companies, by dematualizing or divorcing ownership from membership The his- torical record of such initiatives is short, but experience suggests that innovation such as foreign remote membership and direct in-

‘weston gouees are more ean Implemented when intermediaries are inority owners and that demutualization may therefore serve to improve the performance of the exchange as commercial enter-

26 lower costs At the minimum, to the extent that this lowering of costs is past on to the investor, I believe that the retail investor indeed will benefit

‘Again, thank you for your attention I will be happy to respond

to any questions you may have

[The prepared statement of Prof Ian Domowitz can be found on page 164 in the appendix.]

Thairman BAKER Thank you, Professor We certainly appreciate your participation here this morning ‘Our next witness is the President and CEO of Cantor Fitzgerald,

Mr, Howard Lutnick Welcome, Mr Lutniek,

STATEMENT OF HOWARD W LUTNICK, PRESIDENT & CEO,

‘CANTOR FITZGERALD

Mr, Lutwick, Thank you, Mr Chairman, Chairman Leach and Congressmen Manzullo and Lucas Cantor Fitzgerald operates an electronic trading system in the United States, and it is the most Successful trading system for the market of U.S Government secu- tities Once one understands that the U.S Government securities market trades twice as much, $50 billion a day at Cantor Fitzger- ald versus the NASDAQ stock market at $25 billion a day, one re- alizes that any comment that electronic trading systems cannot handle liquidity, are not a good place for liquidity to exist, will know for a fact in the United States that that is not true

‘So to start with, electronic trading systems can and do, do the work of all the people who yell and scream in pits The reason 1

am interested in talking today is about the future The future of marketplaces and of exchanges is one of the end of monopolies

‘Currently, the exchanges in America, each of them have their own particular monopoly ‘There is only one marketplace for U.S treasury futures There 1s one place for euro-dollar futures There

ig one place for cattle futures, one place for wheat futures, one place for soybeans, and so on, and so on That structure is going {to end, and electronic commerce is going to be the end of it

So, humber one, we have competition And as T think we all be- eve’ in this room, competition is fantastic, It will drive innovation, both from current market participants and the new market partici ants It is going to drive down costs, and, most importantly, it is going to drive access, wholesale information and access to the real

‘An example I like to use is that for some reason in the agrieul- tural futures business, farmers have become customers One would think that a farmer Who is a producer would be the ultimate in- sider T mean, they know their crop, they know their product better than anyone ‘else in the world Why is it that they have become

‘customers of members of exchanges?

In electronic environment, the information that the exchange cre- ates will be displayed on a computer screen That computer screen will be made available to each farmer so that those farmers will have the same information as everyone else has in the market And whether they succeed to the level that they hope to will be a matter

of their decisions, their information, and their choices And that empowerment, that enablement of what technology is all about is how T think the future will operate

27

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28

buy and sell when and if they choose, That should work for futures

‘That should work for stock options, ‘That should work for every ain-

le agricultural commodity in the United States ‘There should be

5 canh market electronically market electronically available, And that same information in available ‘There should be a futures everybody’s hands Tis an empowering event I¢s a strong event And it an inered- ibly poattive event And to any sesistance that you cam give to the marketplace 0 eompete would be well served, to encourage com- petition and end the monopolies that currently exist, and encour

ge competition, and encourage innovative ways of doing business, ‘Cantor Fitzgerald has a very successful business model up until now, but that business model may be attacked from who knows

‘where And someone else will come up with a really neat and exit- ing idea that we have not thought of, and either we will keep on Our toes and stay competitive or we will become a relic of the past

as well, And 1 think that 1s what is tremendously exciting about the future of marketplaces, ‘Any global or national commodity—electricity you will certainly see trade this way Your phone minutes certainly wil be traded this ‘way And don't let the issue of day-traders, people who take inordinate amount or risk change the model for al Americans The fact is, i'you harness information and distribute that information instantaneously to everybody who cares about that information, and give them realy, Teally inexpensive access, wow, you have madd America a fantastic place for farmers, for'thoee’ who trade

‘whether they are financial professionals, like State Street, or any- Ong who wats fo buy and sal a log Bond là lu vụ jverybody is on the same wholesale playing fleld, and the onl aufterenee 1s how much commission do Ì pay? Ir Ì em the institu tion, T pay a low commission because I trade a lot, and if 'm amall, I'pay @ slightly higher commission But we all know what it costs tug to get into the wholesale market And that is extraordinary, ‘Tappreciate the time you have had to let me speale Thank: yeu very much, Mr Chairman, ‘he prepared statement of Howard W Lutnick can be found on page 2a in the appendix airman Bakek, Thank you, Mr Lutnick We appreciate your comments very much ‘Gur last witness on this panel ig a senior fellow of The Brookings Institution, Me Steven Wallman Weleome, Mr Wallman

STATEMENT OF STEVEN MH WALLMAN, SENIOR FELLOW [NON-RESIDENT], THE BROOKINGS INSTITUTION

Mr, WALLMAN Thank you, Mr Chairman, Chairman Leach, and

‘Members of the subcommittee I would like to second a lot of what you heard on the first panel and also what has been heard today from the preceding commentators

‘The view I have starts with the proposition that technology has been a great advancement unequivocally with regard to the finan- cial services markets The issues that people present with regard

to the potential downside, day-trading and others, T think are in a real way very much swamped by benefits that technology has pro- vided in tertas of lower costs, better information available to more

29

people, more education, more investor protection, more efficiency in

Ehe'markets, more competition in the markets

And it has been truly extraordinary in terms of the overall level

of benefits that have been provided That, said, I think there are also some real challenges from technology's advances in the mar-

ke that has new impacts on regulation and the regulatory strc- tire T vould like to focus a little bit on those today T would like to first'mention that technology in a Teal way, obviously, challenges some of the core concepts on which regulation is based Some of the obvious ones are, for example, the issue of regulating in a world {that is in essence physically placed, a sovereign juriaditional issue

We here can make rules that affect the United States and: partic pants in the United States The internet on the other hand, of

Me is something that i global and i lows for acest any

‘where from anyplace it ls hard, ia many cases, to determine who is accessing a ste 0 reach any other place

It is hard, in many cases, to determine where the site is We are already confronting some really serious issues and questions as

‘what to do when you have 8 site hosted presumably somewhore utside of the United States that allows’ people in the United States to engage in trading of securities that are not registered in the United States ‘and’ we ca g with on of two routes We can either attempt 29 maintain a jurisdictional notion that says We are going to prectude That Kind of trading We will then shortly, I think see people sim- ply getting on the internet, avoiding broker-dealers in the United

‘States, and using foreign intermediaries in order to engage in the trading that they wish to engage in ‘Ar that point, US investors will lose the protections of the United States securities laws All with the point of trying to say that we are going to maintain those protections for U.S investors

by refusing to allow some of the foreign intermediaries to affor for- eign securities because they sre not fully registered here, But the emul ig tha we have ie all protection for O'S inventors because they will simply ‘circumvent ‘the ustal requirements for gol thedugh intertediarice in is countrys ‘Moreover, we will lowe market share Intermediaries in this coun- Tag “e try will lose trades that inereasingly will go abroad We have al- rendy seen that overwhelmingly in the institutional sector Insts Hons increasingly are placing money divectly abroad, not using ULB intermediaries, and it is clear that with the internet we cat start to see that very quickly with retail investors as well

T would also like to mention that one of the things that regu- lators rely on are basically gateway institutions, choke points—ex- changes, for example—that they can regulate, or broker-dealers that they can regulate, as you heard on the first panel, which have the indirect capabilities of then regulating hundreds of millions of investors and eter prtspants inthis county 4

‘can determine how an exchange will act as an exchange

if you can determine how five thousand or so broker-dealers vi dei as broker-dealers, you ean indirectly regulate a few hundred Tnillion Americans who otherwise invest in the equity markt

55.919 99-2

30 Again, what technology is doing, as we have just heard, starts to change some of the capability of being able to rely on those gate- way institutions in order to indirectly regulate large, wholesale in vestment activities As the internet and other forms of electronic communication continue to allow people to go directly to the other side of the tade-and what we will gee in the next phase of tech- nology are other things, such as smart-agent technology, XML tags, and things of that nature, which will, notwithstanding’ the best of intentions of some people to avoid disintermediation, allow for, in fact, intermediation you will start to see people no longer having

to Worry about gateway institutions at all And the regulatory le- verage that comes from being able to regulate gateway institutions and their indirect regulation of investors and others starts to dis- sipate In addition, reputational capital starts to diminish as you get more and more participants in the marketplace with lower barriers

to entry and lower costs Reputational capital invested by any one partc[pant becomes less Oné of the great leverages that regulators

we had has been, the ability to "if you wil, threaten action against partielpants in the marketplace Sine the marketplace has traditionally relied on trust and confidence of various participants, fyou can threaten that trust and confidence, you can have a great impact

Tr you start to have entities with lower barriers to entry and lower reputational costs are involved, that threat becomes less im-

TH rapidly, the idea of having regulatory change that moves ven that technology and information technology is regulation i at an in so eremenial, step-by-step pace i really one that becomes slightly ar- hale, If we ate going to avold having only incremental change on the regulatory side being the main drag on innovation, we need to think ebout 4 new way of regulating And that, I think, is gol lot inerenainly “regulating ta nandanh and to goa the kind

of thing you heard here earlier with regard to the ATS release

‘Also in 1995 and 1996, the SEC's issuance ofits electronic releases, for example, really allowed for the blossoming of information being provided over the internet to securities investors, and allowed for line trading realy to take off as it has “ust two other quick points, and then T would lke to outline one regulatory concept that I think is worthy of some consideration

‘There are within the ‘range of how regulators regulate and how laws are written very much of a sense of definitional concepts, One defined a bani, « securities firm, an insurance company, a futures commodity merchant And based on those definitions, you end up

31

with an entire regulatory scheme, and a whole series of regulatory Agencies overseeing those entities For a long time, we have had an easy matrix, which has been regulated entities in various industries engaging in sales of secur ties or banking products or futures or insurance that related spe- cially the kinds of entities that they were Banks sold banking products, securities firms sold securities, and so forth ‘What Increasingly is happening is that those kinds of definitional and product lines are breaking down, We are getting increasingly iivbrld products that could come to the fore that transcend either banking products or securities or insurance or futures, ‘They are the kinds of produets that promise to serve investors and financial Services consumers quite well ‘They are also the kinds of products that today’ are basically pre- cluded because of the regulatory scheme Tom coming into exist ence The idea of product definitions and product regulation—and Rinetional regulation as it has been thought of traditionally is real- ly product regulations something that T think we need to review

in the future it we are going to be in a position to allow trve inno vation “Just as an example, within a range of definitions, you can look atthe cient defaton, for example, ofan invertinent adviags Ine creasingly, there are computer programs that are available to peo ple that {8 essence do what an investinent adviser does They help Pick stocks, they help provide allocation, they add asset informa

on, and they help provide advice “The issue fs, if we are going to define things like that as invest- ment advisers, what đo we do with the regulatory structure? How Gs" regslae them? And are we really going be serving any public policy goal by attempting to suggest that a computer pro- Gram needs to be regulated as an investment adviser when % does SSinething similar towhat an investment adviser does? So we need to rethink in a real way that notion of regulating by product definitions, And T would suggest that people consider ai

ea, which T know will be considered politically not viable, but let

me throw it out for consideration purposes And itis just an ides But that is one of the luxuries that one has at the moment “And that is the notion that instead of thinking about things in

a product definition way, instead of thinking about securities ver~ Sus banking products versus insurance and futures, think about them all as financial services And to think about them as financial Services that can be provided to financial services consumers And iffon to think about why it Is that we care about regulating this

‘whole area in the first place And to recognize thet traditionally there have been four regulatory goals There has been consumer protection, insolvency concerns, systemic risk concerns, and market

con ea of sinking aout cach of hem a separately spied

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32

Bt you start to think about them as financial services, and then the question is, who are they sold to? And if they are sold to lange Institutions, you don't have to Worry about the consumer protection side of i a tc, they ae sold by a small entity andl there are Small amounts involved, systemie risk is not much of a concern, In Solvency may still be a concern Market regulation may still be a But the beauty of this approach is that overnight we create I erally tens of thousands of how competitors in the financial serv-

es econ generally We alow or Innovation on & broad sale Stead of people having to try to ft a hybrid product into one model

of securities or insurance of futures regulation They are now sim- ply capable of selling it as a financial services product ‘We allow innovation to go forward, and we allow technology basi- cally to push and press forward innovation ina way that allows people {0 provide whatever satisfies financial consumers needs a8 opposed to fitting in specific definitional characteristics Mhat said, there are a lot of issues that surround this proposal and a lot of others, T have outlined some of them in the longer wit- hess slatemen, Lei me Just conclude by saying that I think for Iong time our overall policymaking has to some degree been held hostage to its past in terms of the thinking, ‘The eurrent structure

that we've got was really imbued with a terrific amount of genius

and foresight, but it was imbued with that over half a century ago ‘tis thankfully a structure that in my view that has served our interests extraordinarily well, But the times have changed Tech: nology has been the main driver of changing that 1 think the Teast that we can do to ensure that the efforts of those who labored so hard in the past to bulld something which they viewed as a monument to the future and which has done ex: tradrdinarily ‘well for half a century, is not now viewed as an an- chor to the past, something that stops innovation and stops us from being able to compete on a global scale,

‘There is no other eountry in this world that has the kind of com- plete separation of various entitier=futures, banking, securities,

fd inatrance at do we And I think over time, Unless we eat change the paradigm, in part the way the United Kingdom has just done wath le Twin Bese proposal, breaking ut basteally thelr nancial services regulation info consumer protection and systemic Hsk-the Australians are starting to think about it, and others as wwell—t think we will unfortunately find that the regulatory struc- {re becomes a potential drag to innovation "And with that let me finish, Thank you,

{The prepared statement of Sloven Mil Wallman can be found

on page 244 in the appendix] fhairman Baise Thank you, Mr Wallman I apprectate your re- marks, and don't necessarily view the concepts of your testimony

as fringe, as some might consider it, Let me make'a few observa tions, and then question for the panel to respond to, Tagree that we appear as much the case on our financial mod- eraizaion tetuen infin 40 that we have been dsbaling now for a better part of a decade We are going from a rationed access sys- Tạm to the unlimited access system, whether we like or not, Or, in the case of securities, at least modified open-outery to electronic

38

base of transactions Now I don’t think it necessarily means a dis- placement of the intermediary's role, ironically because the elee- Tronic capacity will also deliver such inordinate quantities of infor

‘mation that the casual user Will throw up his arms and say, “What aol dor” Bo that rather than being an intermediary with maybe two or three items on his call sheet to promote, you will have the end user with thousands of sheets of paper trying to sort through them to Figure out what best ts thelr portfolio needs, but may ultimately execute the order directly, and relying on the intermediary more as

fn advise, and: perhaps soa greater extent, the seeurer of that transaction, So when the Pez machine shows up nonfunctional, he hhas some recourse ‘What troubles me is that, Mr Wallman, your last several com ments that the regulatory system in place did not in any way envi Sion, pethaps as late as 1995, no one could have envisioned what wwe see in 1000 And that withthe scope af operation that electronic Systems now make available to us, that you could well engage in iFansactions with someone that you do not realize behind the home eis located in Europe

fe become blind to the franchise value that used to be the hall-

‘mark of doing business It also means that the very small enter- rise can now engage in, perhaps, a very successful offering’ with, ferhaps, limited eapital and resgrees because the acquirer really Soesn't know how that firm stacks up because it has a wonderful, talking home page think this is ail ạ grand, a very exciting economic potential for our country, but 1 also, at the same time, worry that it opens us tạp to rather significant risk—I hate to use the Word systemie—but rather large and perhaps uncontrollable risk from a regulatory per~ spective Tlike’the idea of looking at end-purpose as, opposed to product type Nowhere is that more obvious than CFTC and the futures Mestion, And the idea that people trade not knowing whether their roduct is properly regulated or not and assume great lability for ong to may well be another reason for some of the offshore deve- opment we have seen, "First question—and maybe Mr Carleton maybe you would be an appropriate person Given the scope of State Street Bank's interest {mBorpiueeounériee, what do yu see in the current regulatory sy tom interference in innovation of new product that really is a disservice that results in unreasonable delay, higher cost, unreasonable {0 your ultimate customer, given the scope of what you do? Jou think we need a simpler standard of @ single sort on an intersational level? And my view—and maybe you ean respond to this as well, the American system, at least in this arena, seems to

be lagging a bit behind our international competitors 1s that a fair assessment?

Mr CARLETON Thank you, Mr Chairman, T believe so

Chairman BAKER, And pull that mike alittle loser to you

MP, CARLETON, I might start by putting in perspective where State Street is Our focus is fundamentally on institutional Invee- tors, So it is not the retail consumer It is not the day-trader as wwe have heard talked about earlier And our focus has been not sọ

34

much on creating products that have electronie delivery capabili- ties, but more on creating a process that permits our cients, our institutional investors, to increase levels of expected yields, reduce costs, and reduce File,

So the platforms and the products that we have developed using both the Internet and private proprietary networks are really de-

signed to do that I think where the regulatory issue comes in, and

itis probably less of an issue for us because we are not actively Involved in trading and underwriting equities, like some other f- nancial institutions, but it gets back to the whole financial mod- trnization work that as you say’ has been underway for at least ten Years, and whether or aot regulations in this country prohibit, it hot s0 much State Street, more broadly other financial instivations from doing what their competitors in the 88 other countries can al- ready do to some extent think the country is well ahead of many of our counterparts overseas in Asia and in Europe in terms of our ability to master:

‘mind and develop and implement electronic capabilities, And we are well ahead I think in terme of having a consumer base that un- derstands the value of that But I thinke we are behind in terms of our ability to deliver a broad spectrum of products and services without the necessary red tape that it sometimes takes to get Something up and running io interesting observation, though, ts Japan pot too tng ago asking a group of people about investment practices and typically

it is the postal system And if you ask a group of people? “how any are involved in mutual funds?", you might see one or two hhanda,‘and if you ask: “how many’ of your parents invest in mutal finds?, you will probably see no hands ‘Well, that ie a'markel that is untapped Now you tun around and look in this market here, most of the investors in my earlier comment about moving money out of banks and off deposits is going into the stock market, is going into mutual funds It isa very Cominen investment vehi here oT think we are well ahead in terms le understandin In the inestment proces, and T think we ean probably do ile Be

of catchcup in terms of the regulatory platform that permits Us to access and deliver a more broadly desired spectrum " Chairman Bakes Thank you Mr Lutniek, in light of your com- ment, would you care to give you perspective on current fegulatory structure in light of produit development or unneeded interference

in providing the ability to move forward with your business plan? How, what is your view? And T take it from your remarks, you feel obvious modifications are necessary, but tell me more ‘Mr LUTNICK Well, Cantor Filzgerald has a computer system that trades, oF creates a marketplace for U.S, Treasuries, So what

‘we thought-not very mavericie— "wouldn't it be nice to put the U's Treasury futures contract right next to the U.S Treasury cash bond, next t0 each other on the same system?” And to-do thaty we had fo sek additional regulatory oversight from the CPC, And we

‘And so, what you find fs that there is a real overlap of regulatory

oversight that one could easily say, and rightfully so, that financial

35

futures are very, very closely linked to the securities markets and

to treat them separately ts disointed But one would unfortunately also have to say that once one does one futures market, the US Treasury futures contract, there is Sirtually no difference between the U.S Treasury future and corn, wheat, and soybeans, and the agriculturals becatse a futures eon: tract has primary underiving characteristics that are all the same

So the fact is; there is that overlap “And so, | think the right answer is that as electronic market- places move forward, that the regulatory environment should seize tipon the opportunity that that gives a perfect aud tral, know exactly who bought it, who sold And try to ereate a famewor that encourages competition because that is just an absolute good Competition is a superb thing, and it fosters a level playing field “Chairman Baktn, So you are basically, as | am understanding it, saying that on a given home page with list of products, for the single home’ page you might have seven, eight regulators looking

at that page because of the diversity of the product offerings that Sou are frying to market through that service: Whereas, some other Tegulatory system, given particulary the nature of the similarity Between futures, might lend itself to more opportunity and com Sumer benefit if’ we had a simpler way of getting that product on that home page without those regulatory steps Ist? ‘ir Lurwick Te would be impossible for me to argue with that

evel as opposed to Federal regulation ‘there is a huge vested

rap th tạng that isnot about to wat ee that change "The thing that sort of seares me about it, and 1 would like the board to answer is, what are your experiences on, for instance, se- curities and multinational market kiing that may oceur? TP thạc {sa simple arbitrage instead of dealing with the New York Stock Exchange on a registered stock, why aut buy itin the London Bx change? ‘Then, one could make another purchase, say, on the Frankfurt Exchange, but even more than that, play the arbitrage hhumber of eurrency at that very moment in your trading How are

Sr gong fo protest againt Ut, or auld we? Two, what iv fog

to stop us fom setfing up multitransactions internationally to take a very small base product and run it up over a matter of 100

or 200 transactions that ean occur in a matier of fifteen or twenty

36

minutes, until a very large multiple effect when the trader does not have that wherewithal? Tis just like kiting checks, running it back and forth, but now you cạn do thất eleelronle tramafer so" quickly Who ts to attest to that? Is that occurring today? Mr LUTvICE, Well, [will start with the latter and then move for- ward: Cantor Fitzgerald's trading system has a limit, a credit limit, attached to it so that the eredit-providing intermediary, let's say

‘whether it was Schwab.com or Chase Bank, could literally author- Ite an account And say you ean only buy up to 10 or you ean only lose up to $5,000, And it is so robust and electronie ow that you tam literally email or beep the credit-risk manager associated with {hat particular account when they get to 80 percent or 90 percent, land those can be changed on the fly And that is a much higher {evel of eredit and audit oversight than you could get when people talle to each other on the phone ‘Mr Rassonskt T understand that, But I could plan on buying

a security that is listed on the New York Exchange and that has

2 differential on the London Exchange at the precise moment I Gosld mae the purchase on the Landon Bachange {can figure out the curreney difference at that point, take that credit, and make a buy-back om the New York Exchange ata much higher amount T can still have all the support for that system and go right back Ground the world in various exchanges where T could take maybe

$1000 in issue value and run it up to $1 million over a couple of hours using electron transactions it is all hiding the money in transactions in securities, and one, there is not any protector Two, it is an electronic product And, three, we do not even have national oF international conventions ‘0 deal with the responsibility and the protestions that are out there ‘Me LurNtcx Maybe | don't understand your question precisely, but at the institutional level, the fact thai two of the same prod: tats, two stocks in different markets are slightly out of whack, when one would be slightly higher than the other, the market, in Bitutional market participants live to make that,’a particular dif ferential, go away, And s0 they will sell the expensive and buy the Inexpensive ‘Mr KANJORSKI Before it goes away? What Ï am doing, though,

ig runing up my collateral Tam finding those moments when there ig imbalance, both in the security that I am trading with, any type of security, and with currency rates as they differentiate aound the world, Because T can do It at the speed of light, Ì can literally’ build So, my account moves from $1,000 in’ value to SIỗỗ đo, Sen thông relly han ot changed: Tei at rane actions that we have moved at the moment that no one ean deny that this last exchange i worth $100,000 if you take the eurrenc and the collateral involved because of the mathematics, It is worth

at that precise moment $100,000, but we are doing it with $1,000 tie aot any different than the old experience with kiting checks, You start-a check and keep running it through banks and you can rnin up a tremendous amount of potential collateral that really does hot exist ‘You have just made if But at that very moment, if you

ty to go through those transactions, in fact that collateral exists,

a7

‘until there is a collapse or until there is a signifieant change either

tp or đoạn and you are eaught at a disadvantage "phat is the only time you discern that there isa failure How are wwe going to prevent this from happening? Is it happening today? 1 Ñhow we have the arbilzageure out there, but do we have rmulkidegreed arbitrage occurring in the 80 countries of the world that are dealing with this?

‘Mr Lutwick: We deal in multiple of countries and multiples of products, and I'can’t recall an instance where a market participant Who wasnt worthy of eredit access to be able to do that, was grant- ced credit to these markets, And 1 think that was part of what my comments were, which is that It is the credit-guarantecing inter- Imediaries that stop that And they won' let someone who only has

$1,000 buy $100,000 worth ote luct because if they did, the cred-

itgranting intermediary would stand the risk of the loss, not the market at large it would be limited to the company that allowed a very economi- cally weak participant into the market, and you certainly couldn't

do that with U.S stocks ‘Mr KANJORSKI You are absolutely right on one transaction But,

if you do the arbitrage of the security and the currency, the last transaction made, according to the person looking at that credit, the account is good for that credit, ‘Mr, Lursiex We grant eredit on a gross basis So the fact is, you wouldn$ let someone with $1,000 buy a $1 million of anything, no Inatter how many times they did it because inevitably one side could fall over ‘Mr KANJonsi, You mean, an individual trader is not eapable of having multi accounts internationally to trade through? Is that what you are saying? ‘Mr LutNick Because there are different regulatory schemes in different markets, Tam sure anyone with the Mr KanJowsid” I'can understand going to Mr Wallman’s world

of the future, but the main point gets to be consumer protection Tam watching people today trading as day-Lraders on the markets

that have a net worth of $50,000 or $100,000 and they seem to be Without fear; whether they have gone to’ gambling or what, Tam fot certain

If greed is something that is coming out in our society, itis com- ing out in a very bad way I see national advertisements on tele- vision ‘on how to get present value for structured settlements, something that is horrendous, ‘The whole purpose of the court ap: proving a structured settlement isto protect a consumer that is de:

termined to use that for support I won't mention the court “judge”

that is advertising this, but any day that you can go on national television and say, “Call us up, and we will give you 4 discount rate and buy out your future on that settlement," this ts wrong

I Into of frightening” because they are dealing with the least sophisticated people, the least capable people, and the people in the test need, And, 1 see that is a calla cavion call, in our societ

at the market is not protecting the disadvantaged and the weal because they are not eriticizing it

Tt would seem to me that major people who are involved in the

trading market would say "this ls unconscionable Why do we not