These differences appear to be so fundamental that there is a natural inclination to believe that a successful market or successful regulation of a market can only be achieved if the proper choice is made in each of these areas. In other words, the differences in organization and trading method appear to be so profound that some believe that a market or its regulators can only be successful if the best organization and trading method is used. Let us look at each of these issues more carefully.

Exchange Structure

This issue is of particular interest with respect to equity derivatives. There is widespread concern that the existence of a derivatives markets for which equities are the underlying product can lead to increased volatility in the equities market and that this volatility can be function of whether the derivatives exchange is a part of the equities exchange.

In this regard , it should be remembered that the fundamental reason for the existence of a derivatives market is price volatility in the underlying market. In a well-functioning derivatives market, price volatility will be the result of changes in the demand for, or supply of, the underlying product. If both markets are working properly, prices in the two markets will move together and the futures and cash prices will converge as the futures contract expires. Large changes in supply or demand conditions, therefore, should cause volatility in both markets - regardless of whether the derivatives exchange is part of the exchange on which the underlying instrument is traded. A poorly designed derivatives contract can cause volatility to be higher than it would otherwise be - regardless of structural considerations. The key, therefore, to preventing derivatives from increasing volatility lies primarily in ensuring proper contract design and in having adequate protections against manipulation rather than in separating - or combining - the derivatives and cash markets.

Clearing House Structure

There are two issues here. One is whether the clearing house should be a part of the exchange or a separate entity. This distinction itself is not very important. The critical issue is that the clearing house have the authority and commitment to impose and enforce prudential margining and collection standards for all market participants. Experience has shown that both types of structure can function very well. Moreover, it has not revealed that one type is more likely to function better than another.

The other structural issue concerns whether a separate clearing house for each exchange (regardless of whether the clearing house is part of the exchange) or a common clearing house for the derivatives and equity exchanges is more likely to be efficient and to promote financial integrity. There are advantages to both arrangements. A common clearing house reduces costs to its members, makes more information about financial risk readily available, and makes it easier for regulators to monitor the entire portfolio of a member. A possible advantage of separate clearing houses (or disadvantage of common clearing) is that the consequences of inadequate margining or other mistakes would have more widespread consequences. There may also be operational disadvantages to common clearing. Margining arrangements for equity and derivatives markets are different as are requirements for marking to market. There is no generally accepted view as to which arrangement is better at ensuring financial integrity, but there would seem to be little reason for regulators to require common clearing, although they certainly might permit it. The more critical issue is whether the appropriate rules for establishing financial integrity are in place and the proper procedures for monitoring and enforcing compliance with these rules are regularly carried out.

Trading Method

Most existing derivatives exchanges use the open outcry method in which a trade is executed only when the parties to the trade personally agree to its terms. A few use electronic or screen-based systems in which trades are executed by a computer based upon orders entered by the parties. This difference in trading methods raises the question of whether one system is superior with respect to achieving market and financial integrity and to providing fair treatment of customers. From a regulatory perspective, however, the difference between the two types of trading systems may not be as great as some believe.

All modern exchanges, whether screen-based or open outcry, rely on electronics to a large and growing extent. An open outcry system can use electronic technology for such purposes as transmitting orders, recording trades, constructing audit trails, and monitoring compliance. This means that today's open outcry exchanges are able to construct and maintain much more accurate records than was the case previously. As a result, both SROs and governmental regulators can be more effective in monitoring trading activity and in detecting and deterring rule violations.

The question of the type of trading system to use is fundamentally a business or economic issue rather than a regulatory issue. Both open outcry and electronic systems can achieve acceptable levels of integrity and fairness. Neither type of system is foolproof. No matter what type of trading method is used, problems can and will occur on occasion. Some people will violate the rules. Unforeseen circumstances will arise. When this happens SROs and other regulators must be prepared to discipline those who violate the rules and to modify systems and rules if necessary.

From a regulatory perspective, the most important issue is not the type of trading system. It is to ensure that the exchange has rules which are appropriate for the trading technology used and systems for monitoring and enforcing compliance with the rules. In today's world these systems will necessarily rely heavily upon electronic technology even though the trading system itself may well rely upon open outcry.