883 F.2d 525 (7th Cir. 1989), 89-1084, Board of Trade of City of Chicago v. S.E.C.

Docket Nº:89-1084, 89-1449.
Citation:883 F.2d 525
Party Name:BOARD OF TRADE OF the CITY OF CHICAGO, and Chicago Mercantile Exchange, Petitioners, v. SECURITIES AND EXCHANGE COMMISSION, Respondent, and Delta Government Options Corporation, RMJ Options Trading Corporation, and Security Pacific National Trust Company, Intervening Respondents.
Case Date:August 17, 1989
Court:United States Courts of Appeals, Court of Appeals for the Seventh Circuit

Page 525

883 F.2d 525 (7th Cir. 1989)

BOARD OF TRADE OF the CITY OF CHICAGO, and Chicago

Mercantile Exchange, Petitioners,

v.

SECURITIES AND EXCHANGE COMMISSION, Respondent,

and

Delta Government Options Corporation, RMJ Options Trading

Corporation, and Security Pacific National Trust

Company, Intervening Respondents.

Nos. 89-1084, 89-1449.

United States Court of Appeals, Seventh Circuit

August 17, 1989

Argued June 7, 1989.

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Garrett B. Johnson, Kirkland & Ellis, Chicago, Ill., Yosef J. Riemer, Robert Steigerwald, Susan C. Brown, Mark D. Young, Kirkland & Ellis, Washington, D.C., for Bd. of Trade of City of Chicago, petitoner.

Jerrold E. Salzman, Freeman, Freeman & Salzman, Chicago, Ill., for Chicago Mercantile Exchange, Petitioner.

Anne E. Chafer, Asst. Gen. Counsel (with her on the brief, Daniel L. Goelzer, Gen. Counsel, Paul Gonson, Solicitor, Joan A. McCarthy, Special Counsel, and Douglas E. Crow, Atty. Phillip D. Parker, Associate Gen. Counsel), S.E.C., Washington, D.C., for S.E.C., respondent.

Catherine A. Ludden, Gaston & Snow, New York City, Harold C. Hirshman, Stuart Altschuler, Sonnenschein, Carlin, Nath & Rosenthal, Chicago, Ill., for Delta Government Options Corp., intervenor.

Robert A. McTamaney, Carter, Ledyard & Milburn, New York City, for RMJ Options Trading Corp., intervenor.

Nancy A. Petranto, New York City, for Sec. Pacific Nat. Trust Co., intervenor.

Before COFFEY and EASTERBROOK, Circuit Judges, and FAIRCHILD, Senior Circuit Judge.

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 Sec. 6 of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78f. The Securities and Exchange Commission is allowing the System to operate without registration under Sec. 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.

I

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

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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. Sec. 78e, makes it unlawful for a broker or dealer to transact business on an "exchange" unless it has been registered under Sec. 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. Sec. 78e(2). The futures markets maintain that the System is an "exchange" that must register under Sec. 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-

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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 Sec. 17A(b) of the Act, 15 U.S.C. Sec. 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...

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