Commodity Clash

By Jerry Hagstrom

October 1, 1997

jhagstrom@njdc.com

Brooksley Born, chairperson of the Commodity Futures Trading Commission (CFTC), looked grim when she arrived at a Feb. 11 Senate Agriculture Committee hearing on deregulation of the nation's commodity exchanges. The pain on her face grew as she heard Senate Agriculture Committee Chairman Richard Lugar, R-Ind., and the two highest ranking Democrats on the committee, Senators Tom Harkin, D-Iowa, and Patrick Leahy, D-Vt., all cheerfully announce that they had agreed upon a plan to bring regulatory relief to an industry whose leaders said they were facing increased competition in the booming financial futures market from less-regulated foreign exchanges and over-the-counter firms.

With her fellow commissioners sitting stony-faced behind her, Born testified that the bill's industry-supported provisions creating unregulated professional markets--those made up of trading professionals with more than $10 million in assets--"would result in pervasive deregulation of the U.S. futures and options markets" and mean that recent trading scandals like the one in Singapore that brought down Britain's Barings bank could be replicated in the United States. Since Congress created the CFTC in 1975 to regulate both the agricultural and nonagricultural futures markets, Born noted, the United States has never had a commodity exchange scandal as big as the Barings failure.

Officials of the Chicago Board of Trade and the other 10 U.S. commodity exchanges countered that overregulation was endangering an industry with tremendous potential and thousands of jobs, particularly in the Chicago area. Privately they have portrayed Born as a lioness protecting the commission's regulatory powers and her 540-plus staff-including 41 economists, 164 lawyers and 86 investigators whose duties include daily surveillance of the exchanges.

But by April 15, when the House Agriculture subcommittee on risk management held its hearing on a proposal to deregulate agricultural as well as financial futures, the atmosphere had changed dramatically. The Federal Reserve Board, the Securities and Exchange Commission and the commodity exchanges' own customers all testified that they objected to the proposal and Born later claimed them as allies during press interviews. This summer, the battle took a comical turn, with the exchanges publicly disagreeing among themselves over a compromise bill.

Some scaled-down, face-saving compromise is still possible, but the battle was a reminder of a long-standing truth about the futures business and deregulation: Commodity trading is a vital and dynamic part of the capitalist system. But futures and options are so complicated and have such a history of fraud and abuse that customers have long sought regulatory protection to feel comfortable enough to use them. As Born noted in her Senate testimony, "The need for regulation of the futures markets has been recognized by Congress for over 70 years. The prices established by the futures markets directly or indirectly affect all Americans. They affect what we pay at the grocery store and at the service station, what we pay for our silverware, our copper plumbing, and our lumber."

A Long Evolution

Most of the trading and profits for commodity exchanges today come in financial futures, but the futures industry is firmly rooted in 19th century domestic agriculture.

Market participants discovered the exchanges efficiently performed two key functions: price discovery and risk shifting. By bringing together a large number of buyers and sellers, exchange trading floors became the best places to determine the value of commodities. In addition, the exchanges attracted speculators willing to analyze markets and assume risks neither farmers nor processors wanted to take. All the U.S. commodity exchanges adopted--and most still use--a trading system of "open outcry" in which traders at a single location, usually called a "pit" or a "ring" shout bids and offers and use their own sign language to be sure both parties agree on the specifics of what has been contracted.

Exchange officials insist to this day that open outcry is the most efficient system in the world for setting prices, but the speed of trading and the difficulty in keeping track of the exact process create the opportunity for illegal and unethical activity. What's more, the din and chaos on the trading floor create apprehension that such behavior may be occurring more frequently than it does.

From the early days, exchange participants have feared that the owner of a large amount of a commodity would "corner the market" by trading to raise prices and force sellers with contractual obligations to buy the product at a high price to fulfill their contracts, says Donald Heitman, a CFTC employee. Market participants also fear that traders will take advantage of market congestion-moments when trading is heavy to engage in insider trading and other shady deals, adds Heitman, who serves as CFTC's in-house historian.

With close to 50 percent of Americans living on farms in the early 1900s, commodity exchange activity was so important to the U.S. economy that abuses and fear of abuse led Congress to begin regulating exchanges. The first futures trading laws came two decades before Congress began regulating the securities markets in the 1930s. The 1914 Cotton Futures Act and 1922 Grain Futures Act were followed in 1936 by the Commodity Exchange Act, which set up the Commodity Exchange Authority as a division of the Agriculture Department (USDA). The authority was run by a commission consisting of the Secretaries of Agriculture and Commerce and the Attorney General.

At the turn of the century, other futures exchanges were created to handle "world commodities," such as cocoa, coffee, sugar, metals, silk and hides.

By the early 1970s the post-World War II Bretton Woods agreement, which set currency exchange rates, had broken down and international business executives wanted to spread the risk of currency value shifts. Business executives became interested in applying the principles of commodity futures markets to currency and other items with volatile prices. Political leaders also became concerned these new markets would need regulation. In addition, a scandal in gold futures gave rise to the need to protect the general public from fraud.

In 1974, Congress passed the Commodity Futures Trading Act, which replaced the Commodity Exchange Authority with a five-member commission including a chairperson, all appointed for staggered terms by the President and confirmed by the Senate. The act also gave the CFTC authority to approve an industry self-regulatory organization, the National Futures Association, to register professionals involved in commodity trading and educate them on ethical issues. Today there are 64,000 registered professionals. The 1974 law also transferred USDA's authority to regulate agricultural exchanges to the CFTC and gave the new agency authority to regulate "any item of goods or services traded on a futures basis." The act ordered the CFTC to approve or reject all new futures contracts and changes in trading floor rules; conduct daily surveillance of the exchanges to detect actual or potential manipulations, congestion or price distortion; investigate alleged violations of the Commodity Exchange Act and CFTC regulations; file complaints before the agency's administrative law judges; and refer criminal cases to the Justice Department for prosecution.

The act also gave the CFTC general authority to regulate so-called over-the-counter derivatives--customized trades made between firms and individuals rather than on the exchange floor. But the Treasury Department said the CFTC should not disrupt the long established interbank trade in foreign currency nor the dealer market in government securities. A provision known as the Treasury Amendment exempted over-the-counter trading in those transactions. Nevertheless, endless litigation has failed to define exactly what financial instruments and which financial institutions are exempt from CFTC regulation.

The 1974 law initially did not cover options, a newer form of financial instruments which provide the buyer the right, but not the obligation, to follow through on a futures contract. After London-based options began to be sold in the United States, often under unsavory conditions, the CFTC in 1981 authorized them to be traded through futures exchanges and devised a plan to regulate them.

The CFTC opened its doors in Washington, on April 21, 1975, and with field offices in New York, Chicago, Kansas City and Minneapolis--the cities where exchanges are located--and in Los Angeles, where CFTC enforcement officers specialize in investigating commodity marketing fraud.

A 20-year agency history published in 1995 shows the CFTC has intervened in some of the biggest fraud cases and historical events of the last two decades. The commission was the first federal agency established with a "sunset" provision requiring periodic congressional review of its performance and need for existence. When reauthorization came up in 1989, just after a lengthy FBI "sting" investigation in which agents posed as futures traders, a federal grand jury brought indictments against 45 traders and one clerk at the Chicago Board of Trade and the Chicago Mercantile Exchange. The sting operation and other scandals led to questions about whether the CFTC could handle the growth in the futures and options business. The Treasury Department proposed giving the Securities and Exchange Commission jurisdiction over stock index futures and oversight over margins for some futures contracts and there was pressure for increased regulation. The CFTC continued normal operations and, when reauthorization was completed in 1992, the law provided increased regulatory authority and bigger monetary penalties for both felony and civil violations and forced the exchanges to develop a better "audit trail" of trading floor transactions.

Growing Competition

To avoid a repeat of past battles over the CFTC's role, Congress passed a simple, five-year reauthorization in 1995, but agreed to consider separately the exchanges' complaint that overregulation was raising their business costs and making them less competitive. In June 1996, the exchanges jointly testified before the Senate Agriculture Committee arguing that CFTC rule-making should be governed by cost-benefit analysis, audit trail requirements should be simplified, the routine pre-approval process for new contracts should be eliminated, self-regulation should be emphasized, disqualification standards for floor brokers and traders should be changed, and regulation of the exchanges and over-the-counter activity should be equal.

Both the exchanges and the over-the-counter industry wanted to clarify the meaning of the Treasury Amendment. In 1989, for example, the CFTC had issued a policy statement that most swaps-extremely complicated financial transactions involving, for instance, the exchange of the income flow from a fixed income bond for the variable rate payment stream of another bond-were beyond the scope of the Commodity Exchange Act. But investment professionals say legal uncertainties remain.

The Senate Agriculture Committee convened Feb. 11 to consider a bill Lugar had drafted based on the exchanges' desire for less regulation. Chicago Board of Trade Chairman Patrick Arbor capitalized on the "Freedom to Farm" theme of the 1996 farm bill when he testified, saying, "What we are seeking today is 'freedom to compete' legislation. U.S. exchanges now face competition from two sources: over-the-counter derivatives and foreign futures exchanges. Both enjoy a tremendous, but unfair edge over U.S. exchanges."

Over the last five years, Arbor said, the over-the-counter swaps market had grown 500 percent while the Chicago Board of Trade's most popular contract, Treasury Bond futures, had grown only 54 percent. The over-the-counter market, he said, is now "about four times our size--$63.7 billion to $16.3 billion.

"What most professional market participants apparently want is regulatory freedom," he said. "They want to trade markets where they are not under the thumb of a government regulator who would require them to file regular and special reports, maintain specified books and records, meet position limits and fulfill ongoing government compliance and paperwork obligations."

Born's response was withering, an unusually strong reaction to a bipartisan bill. She noted that some of the biggest traders and trading houses have engaged in the most underhanded behavior. She also said the CFTC had found that U.S. trading activity had continued to grow even as the U.S. exchanges' proportion of world futures trading volume had decreased. The growth in foreign markets' share of world volume resulted, she said, from "contracts based on local underlying cash markets or on cash markets in the same time zone."

Born also opposed the bill's provision to allow the exchanges to develop totally unregulated markets in instruments covered under the Treasury Amendment because, she said, "centralized markets such as futures exchanges concentrate credit risks that are diffused on an over-the-counter market."

The only Senate Agriculture Committee member to express reservations about deregulation was Sen. Bob Kerrey, D-Neb. "The [agricultural] exemption makes me suspicious," he said, contending that users of agricultural futures and options are more sophisticated than the average investor. Retirees who are dependent on pension funds that could be involved in the futures and exchange markets are the futures' markets equivalent of farmers' using futures and options, Kerrey said.

In April, two months after the Senate hearing, the House subcommittee took up the bill. It was apparent that other agencies and the exchanges' customers had taken more time to study the issues. Born vigorously opposed the House bill's inclusion of agricultural futures in the deregulation plan. Richard Lindsey, director of the division of market regulation of the U.S. Securities and Exchange Commission, testified that the SEC opposed the professional market provision because it would "call into question the validity of the exchanges as price discovery mechanisms" and "undermine the SEC's ability to regulate trading and detect fraud in the various securities underlying the futures and options."

Other testimony revealed a split within the industry over the degree to which swaps should be exempt from regulation. The International Swaps and Derivatives Association Inc., testified that swaps should have a complete statutory exemption from CFTC regulation. But Ed Rosen, a lawyer representing a group of big league financial institutions including Morgan Stanley, Goldman Sachs, Citibank and Chase Manhattan Bank said his coalition supports codifying the exemptions but would not object to "expanding the scope" of regulation of "boiler rooms," a financial industries term for con artists who sell financial instruments to unwary individuals. In addition, several farm leaders testified they feared that, if the unregulated professional market were allowed to develop, speculators would lose interest in the agricultural futures market and it would lose liquidity.

In June, Lugar's staff proposed minimally reduced regulation of professional markets, but attempted to equalize the playing field between exchanges and over-the-counter markets by giving the CFTC authority to regulate off-exchange futures markets in government securities. The proposal did not extend to equity swaps, which compete with the Chicago Mercantile Exchange's stock-index futures. The Merc declined to support the bill. In late July, Lugar said he would no longer predict when or if the bill would move forward. The July-August issue of Derivatives Strategy, a publication that watches the futures industry, said "Chicago's exchanges had suffered a major, perhaps irreparable, political setback."

Analyzing the CFTC's roller-coaster year, Commissioner Joe Dial notes the commission has moved toward deregulation by shortening the time for approving contracts from 180 days to between 10 and 45 days. But, he says, "The exchanges have a difficult time realizing that their interest based on history occasionally has caused financial harm to the public interest. It is our responsibility to find the middle ground that allows the exchanges to carry out their self-interest while at the same time protecting the public interest."


By Jerry Hagstrom

October 1, 1997

http://www.govexec.com/magazine/1997/10/commodity-clash/5834/