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Board of Trade v. Securities and Exchange Commission

decided: August 17, 1989.


Petitions for Review of Orders of the Securities and Exchange Commission.

Coffey and Easterbrook, Circuit Judges, and Fairchild, Senior Circuit Judge.

Author: Easterbrook

EASTERBROOK, Circuit Judge

Futures and options are competing financial instruments often used for hedging. The Chicago Board of Trade and the Chicago Mercantile Exchange trade futures on United States Treasury securities and options on futures on these securities. RMJ Options Trading Corporation, Delta Government Options Corporation, and Security Pacific National Trust Company (SPNTCO) trade options on Treasury bills, bonds, and notes. The futures markets contend that the RMJ-Delta-SPNTCO "System" is really an "exchange" that must register under § 6 of the Securities Exchange Act of 1934, 15 U.S.C. § 78f. The Securities and Exchange Commission is allowing the System to operate without registration under § 6: RMJ is a registered broker, Delta is a registered clearing agency, and the System secured a no-action letter from the Commission's staff. The futures markets ask us to set aside the no-action letter and the order registering Delta as a clearing agency.


Section 3(a)(1) of the ' 34 Act, 15 U.S.C. § 78c(a)(1), defines an "exchange" as

any organization, association, or group of persons . . . which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood. . . .

Section 5 of the Act, 15 U.S.C. § 78e, makes it unlawful for a broker or dealer to transact business on an "exchange" unless it has been registered under § 6 or is "exempted from such registration . . . because, in the opinion of the Commission, by reason of the limited volume of transactions effected on such exchange, it is not practicable and not necessary or appropriate in the public interest or for the protection of investors to require such registration." Section 5(2), 15 U.S.C. § 78e(2). The futures markets maintain that the System is an "exchange" that must register under § 6 because it "provides a market place" for securities and carries out "the functions commonly performed by a stock exchange". RMJ and its fellow participants deny this characterization, so we start by describing the System and the instruments traded there.

A call option is a promise to sell a security in the future at a price fixed today. The seller agrees to deliver the security for a set price (the "strike price") during a limited time. The buyer pays a sum (the "premium") for the privilege. The strike price exceeds the current market price of the security. Sellers are betting that the price will not exceed the strike price during the duration of the option; buyers are betting that it will. A put option works the other way 'round. The seller of the put option promises to pay a fixed price if the security is tendered during the life of the option. Both put and call options allocate the risk of price movements and allow each side of the transaction to hedge its position in the underlying security. Although the mechanics of futures transactions differ from those of options transactions, futures may serve the same economic functions, and both have the important byproduct of improving the liquidity of markets.

Sellers of call options and buyers of put options are called "shorts" because they do not (necessarily) own the securities -- although they have to do so if the other side exercises the call option, or may choose to do so if they want to exercise a put option. The party on the other side is called the "long" because it will own the security if it exercises the call or must honor the put. Longs on call options, and shorts on put options, face a risk in addition to the prospect that the price will not change enough to make exercise worthwhile: if the price does move, and the option is exercised, the other party may not deliver (for a call option) or pay (for a put option). Clearing houses stand between the parties, guaranteeing obligations so that each party shucks the risk of the other's non-performance. Once parties agree on the terms of an option, the clearing house "issues" the option and acquires the delivery or payment obligation on the other side. Each party deals exclusively with the clearing house, which matches transactions and requires margin and guarantees to minimize its own risk.

Clearing houses at least potentially offer another benefit: anonymity. Neither the buyer nor the seller need know who is on the other side of the transaction. Parties may seek anonymity because their identities (coupled with information about the size of their positions) may enable others to infer information that they want to keep confidential. "Blind brokers" specialize in matching buyers and sellers of securities without identifying them to each other. Options, which are executory contracts on one side, cannot be sold in anonymity without a clearing house. The long on a call option needs assurance that the short will deliver, the short on a put option assurance that the long will pay; an anonymous promisor is not a satisfactory trading partner. Clearing houses can be "in the know" while the traders are in the dark, producing anonymous trades with assured performance.

Securities issued by the United States government ("government securities") are traded over the counter only, by broker-dealers acting as principals. Many brokers specialize in these instruments, and some are "blind brokers". Until RMJ, Delta, and SPNTCO created their System, however, there was little trading in options on government securities, and anonymity was impossible. "The System" itself, as the parties describe it, is a combination of computer hardware and software that matches offers and keeps track of the obligations of the longs and shorts until the options expire or the positions are closed by offsetting transactions. Subscribers can consult terminals linked to the System's computer to discover bid and asked prices on options. They may call RMJ Options, the System's sole broker, to make bids (which RMJ will post on the System) or accept offers they have seen posted. RMJ enters the information into the System. Delta, the clearing house, reads the information from the System and formally "issues" the option to the buyer while "purchasing" an offsetting option from the seller. Such a trade is thus anonymous and fully guaranteed, while Delta's books are in balance at all times. Trades need not be anonymous, however. Any participant in the System may trade directly with another and notify RMJ, which enters the transaction into the System. Delta then acts as administrator and guarantor.

Delta protects its own position against participants' defaults by ensuring that each subscriber is creditworthy. No one may join the System without satisfying Delta's standards. Delta also sets margin requirements, as well as trading and position limits, to protect itself against the risk that participants will hold unbalanced portfolios taxing their resources (increasing the likelihood of default). SPNTCO acts as clearing bank for the System, and Delta does not issue or purchase options until SPNTCO has "accepted" the trade, verifying that the long and short have complied with Delta's rules on margin and position limits. SPNTCO holds the customers' (and Delta's) money and securities, paying traders and delivering securities according to the terms of the options.

After rearranging the structure of the System to satisfy federal banking regulators, RMJ, Delta, and SPNTCO needed the SEC's approval. Firms may register as brokers without much ado. The registration of a "clearing agency" under § 17A(b) of the Act, 15 U.S.C. § 78q-1(b), is more complicated. Those who seek to act as clearing agencies must satisfy nine statutory criteria, many of them calling for an exercise of discretion by the SEC. And the System faced opposition from the futures markets, which did not savor competition and sought to persuade the Commission that the System must register as an exchange. Registration as an exchange would be fatal to the System's current organization. The System is proprietary: it is organized for profit, with RMJ Options as its sole broker; only persons admitted to the System may trade. Section 6 of the '34 Act treats "exchanges" as organizations created and run by broker-members. Section 6(b)(3) provides that the rules of the exchange must "assure a fair representation of its members in the selection of its directors . . . and provide that one or more directors shall be representative of issuers and investors and not associated with a member of the exchange", and § 6(b)(5) says that the exchange's rules can't tolerate "unfair discrimination between . . . brokers". There is more, but from the System's perspective this is enough. Section 6 requires registered "exchanges" to conform to the model of the New York Stock Exchange or the Chicago Mercantile Exchange, and the System's creators wanted to strike off on a new path. So while Delta sought registration as a clearing agency under § 17A, RMJ asked the Commission to say that the System did not need to register under § 6.

The SEC obliged on both fronts. Richard G. Ketchum, Director of the Commission's Division of Market Regulation, wrote a letter explaining that the Division would not ask the Commission to take action against the System under § 6, at least not so long as the System operated in line with undertakings counsel had made. Although the letter did not offer a definition of "exchange", Ketchum singled out three attributes for particular attention (footnote omitted):

Specifically, the staff may determine that the requirements of exchange registration should be imposed upon the System should it find that, at some point in the future:

(1) there develops a continuous, two-sided market in options that: (a) expire at the same monthly intervals; (b) have identical premiums or strike prices; or (c) are written on underlying securities having the same maturity date or yield;

(2) the operator of the System, or any entity operating on its behalf, elects to standardize terms, such as strike price and expiration month, that are currently ...

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