"Reaching the Right Balance: Options for Innovative Markets" Remarks By Arthur Levitt, Chairman United States Securities and Exchange Commission On the Occasion of the 25th Anniversary of the Chicago Board Options Exchange and Options Clearing Corporation Chicago, Illinois April 24, 1998 United States Securities and Exchange Commission 450 Fifth Street, N.W. Washington, DC 20549 Check against delivery It's a pleasure to join you today for this great occasion, celebrating the Silver Anniversary of the CBOE and the OCC. As we recognize your achievement over the past 25 years, we're also celebrating the leadership of the entire listed options industry in spurring one of the great developments in modern finance. I. We've all certainly come a long way since the CBOE opened up for business, 25 years ago, in a small and windowless room -- the converted smoking lounge at the Chicago Board of Trade. In 1973, the CBOE's founders played a role like the one the Wright Brothers did in 1903. The Wright Brothers started out with old technology -- after all, they were bicycle-builders from Dayton, Ohio -- but they took the theory of flight, and they pushed it further. They hardly could've predicted, during their brief flight at Kitty Hawk, that they were opening the way toward the future -- toward jet aircraft, transcontinental travel, and voyages to the moon. Like the Wright Brothers, the CBOE's founders took a theoretical, academic principle and put it into practice -- and now, the fortunes of millions of investors enjoy new opportunities for growth. Since those first days of trading in the spring of 1973, your volume has grown phenomenally. It's gone from just 911 contracts on your first day -- for call options only -- to about 700,000 daily contracts for puts and calls today. Today's celebration recognizes much more than your quarter-century of effort on behalf of investors. These events are also a celebration of what works -- especially when the financial community's spirit of innovation is left free to act with minimal interference. Your success has shown us that entrepreneurial drive is limitless -- and that the role of regulation should be limited. It's no secret that, when the options business started, most people at the SEC were skeptical. As you know, some were even hostile. Your innovations provoked a lot of honest debate, among people of good will, on both sides of the issue. The easy path would have been to stick with the status quo -- and not to change the old rules. But the SEC ultimately made the tough decision to embrace change. We made the right decision. Your innovative ideas about trading were a challenge to regulators. The SEC was confronted by new types of securities -- and methods of allocating risk -- that compelled it to alter its thinking. It wasn't easy to change. It seldom is -- in business, in government, or in any aspect of society.When the SEC was thinking through the question of options trading, the Commission was reminded of a truth that's simple in theory -- but hard to put into practice. Regulation must always be strong enough to serve the public's needs -- yet it must never become so tough that it chokes off innovation. A changing marketplace cannot be governed by restrictions that stifle its agility. The Commission eventually reached a balanced judgment when it considered the question of options in the 1970s. We did a careful study of the new options market, and we decided that the nay-sayers were wrong. We recognized that the vast potential of options could be unleashed -- if it was coupled with a sound, tailored regulatory approach. This is a wise approach to apply to all of our regulatory efforts as we move into the 21st century. II. Because the SEC in the early '70s ultimately had the wisdom to let the markets innovate, options have today become a viable choice for investors in managing risk and allocating capital. Last year, the number of options on all four major exchanges increased to nearly 280 million contracts -- up almost 40 percent in a single year. Each of the options markets has contributed to this growth: The CBOE is the contract volume leader and one of the chief innovators -- creating products such as LEAPs and Flex options. Amex took its in-house derivatives expertise and developed popular equity derivatives such as "Spiders," index warrants, and equity-linked notes. Philadelphia is the pioneer of listed currency option trading, and has been recognized for developing a number of successful sector index products. The Pacific has seen impressive growth in its equity options business, becoming a leading market for options overlying many important Silicon Valley companies. And the indispensable foundation for these exchanges is the Options Clearing Corporation. It's the largest and most trusted clearing organization in the world for financial derivatives. Of course, the success of the options markets has not always been a smooth ride. After the market break of 1987, many investors soured on options, and volume dropped considerably. At that pivotal moment, the options exchanges recognized that they needed to restore investors' confidence in their products in order to survive. Because, after all, in options as in all business, trust is more easily lost than won. So the U.S. options exchanges began collaborating through the Options Industry Council. Its educational campaign, focusing on teaching the responsible use of options strategies to retail investors, has helped strengthen investor confidence. While this effort has been a great success, we can all do a lot more to educate the public about sophisticated financial instruments. Working together, we have a collective responsibility to help investors understand the risks they might face, as well as the rewards they might enjoy. This is especially true because millions are novices, entering the marketplace for the first time. As leaders and participants on the exchanges, your role in maintaining the public perception of fairness and efficiency in our markets is critical. Education is critical, but confidence also comes from the belief that exchanges are governed and operated in the public interest. Designation as a self-regulatory organization carries huge responsibilities. I can think of no better way to ensure fulfillment of those responsibilities than to have at least 50 percent public representation on the board of each exchange. And that's why, today, I ask for your help in developing a more balanced board of directors. Reaching the right balance must be the hallmark of all our efforts -- both for market participants and for regulators. We must always remember that we have a duty to uphold the public interest. III. Looking to the future, responsible regulation requires flexibility. As your business modernizes, we're committed to modernizing our approach to regulation, too. We must pursue approaches that are adaptable to the continuing explosion of technological capacity -- and to the innovative development of new derivatives products. To help meet this challenge, the Commission -- just last Thursday -- considered a pair of deregulatory proposals that are designed to help you be more nimble. We believe these proposals can help you compete better -- with new trading systems, overseas exchanges, and the OTC derivatives market. The Commission is proposing to allow exchanges to operate low volume trading systems, and to trade most new products, without first receiving Commission approval. Under this approach, you would be able to experiment with new trading systems for up to two years. And more than 90 percent of all your new products would be able to go to market without delay. This would put more pressure on the SEC to conduct thorough inspections of the exchanges. But it would free you from the often time-consuming pre-review process. The proposals underscore our commitment to enhancing the competitiveness of our exchanges -- without sacrificing investor protection. I clearly remember, when I was chairing AMEX, the frustration we felt as we waited for the bureaucratic process to run its course before we began trading new products or started using new systems. Our approach is a major step forward in helping reduce such frustration among exchanges, traders, and investors. IV. An examination of listed-options regulation is, of course, important to those of you here. Yet it is only half the picture. The rapidly growing over-the-counter options market presents new benefits to investors -- and new challenges to regulators. Over the past several years, we've examined the derivatives market, and we've resisted any impulse to over-regulate: Our goal is to work with the industry, not against it, in order to maintain public confidence in the essential soundness of our system. That's why the Commission has proposed a new, limited regulatory structure for over-the-counter derivatives dealers. Many of you may know it by its nickname -- "Broker-Dealer Lite." As you know, U.S. securities firms have conducted much of their OTC derivatives business in either unregistered or overseas affiliates because our regulations make it too costly to operate out of a U.S.- registered broker-dealer. Our proposal would provide a new category of broker- dealer for those that act as counterparties in OTC derivatives transactions. This new entity would be subject to capital and margin treatment that is specifically tailored to a derivatives business. It would enable securities firms to more rationally pursue their business, and to better compete with banks and foreign firms. At the same time, it would improve our oversight of an important portion of securities firms' activities. My preliminary impression is that this is the best of both worlds. The proposal would allow American firms to compete more effectively in the global marketplace -- without sacrificing the protection of investors. Some observers have missed the point. They've suggested that the SEC is using this proposal as a way to reach beyond its jurisdiction. Clearly, this is not the case -- and it is not our intent. Our proposal merely seeks to give large securities firms the ability to voluntarily put their OTC derivatives in one U.S.-registered entity. Firms will only sign up for this if it makes business sense for them. Those who want to view the world the old-fashioned way -- through narrow jurisdictional classifications -- miss a key point: Major firms view their derivatives business as a whole, and they view it in global terms. If we want to work with the industry to build an effective system of oversight, we have to recognize and adapt to this reality. It's essential to maintaining that delicate equilibrium between free market forces and responsible regulation. V. As I said at the start of these remarks: It's always difficult to reach the right balance. Wise regulation can help create the background conditions that allow for our nation's prosperity. But we must never allow the guiding hand of regulation to become a deadening hand of bureaucracy. Driven by the spirit of entrepreneurship, and liberated from unnecessary regulatory burdens, our markets will continue to create wealth. That's the deeper lesson within the story of the CBOE -- a market that broke free of old ways of thinking, and offered investors new ways to put their capital to work. As I begin my second term at the Commission, I can think of no better place than Chicago for emphasizing the theme that I consider to be vital for the continuing success of all our markets: reaching a sensible balance between market creativity and regulatory diligence. The essential tools at our disposal are innovation, investor education, and a pragmatic approach to regulation. It's a pleasure and an honor for me to join you, to help celebrate your first 25 years of success. We'll all look forward to being back here again with you in another 25 years to celebrate your Golden Anniversary -- and to hail the success of the options markets, as the CBOE and OCC mark another milestone in your service to America's investors. # # #