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Emerging issues and policy options in the U.S. futures industry.

THE U.S. FUTURES industry experienced explosive growth in the 1980s as annual volume tripled to more than a quarter of a billion contracts. This surge was attributable primarily to increased trading of financial and currency futures contracts, as well as to the emergence of stock index futures. Another major factor stimulating industry growth was trading in options contracts on futures, which began in 1983. Options volume increased from nothing to more than 60 million contracts by the end of the decade. In spite of rapid expansion of the futures industry, major issues are now emerging that suggest the future might not be so bright.


Futures industry growth in the 1980s came largely in response to product innovation and the loosening of regulatory restraints early in the decade. For example, energy market and bank deregulation, combined with actions by the Commodity Futures Trading Commission (CFTC) legalizing futures options, led to new contracts in petroleum and financial products that brought volume into the industry at key points. In addition, technological innovation allowed computerized program trading, thereby increasing volume in stock index futures and options arbitrage. Indeed, from 1980 through the mid-1980s, whenever it appeared volume growth might diminish, new stimulus rejuvenated the industry.

By the end of the decade, however, futures market growth slowed. Trading volume that rose at double-digit rates through 1987 fell to only 5.6 percent growth in 1990. In 1991, volume actually dropped for the first time in modern history. Beyond the cyclical impact of the recession, five factors have emerged to inhibit long-run volume growth. These include: (1) reduced price volatility in the primary futures markets; (2) the "maturing" of most futures market contracts; (3) the growth of off-exchange trading; (4) mergers and acquisitions among firms that are major users of futures markets; and (5) the emergence of strong overseas competition from foreign futures and options exchanges.

The decline in long-run price volatility is reflected in the behavior of individual commodities as well as broad-based indexes. For example, the annual price volatility of gold and silver (measured as the ratio of the standard deviation to the mean) declined from double-digits in the early and mid-1980s to 5 and 8 percent, respectively, in 1990. Similarly, the price volatility of the Commodity Research Bureau Index fell by half during the 1980s. Declining price volatility generally reduces trading volume by limiting profit opportunities for speculators, as well as reducing the need for commercial firms to hedge because price risk is lower.

The second long-run factor restraining futures volume growth is the "maturation" of many futures market contracts. Futures contracts exhibit the same dynamic life cycle characteristics as other products: birth, growth, maturity, and death. Many new futures contracts introduced in the 1970s and early 1980s "matured" in the late 1980s. As a result, volume growth slowed naturally as market participants became familiar with the contracts, implemented the appropriate hedging or trading programs, and reached a steady-state or optimum levels of futures market participation.

The third factor negatively affecting futures volume is growth in "off-exchange" trading. Off-exchange activity is especially prevalent in currency markets but is also significant in precious metals, as well as for other commodities. Off-exchange markets are typically made by banks, trading companies and securities firms that either act as intermediaries by matching buyers with sellers, or make markets themselves by taking the trading position opposite the customer. These activities reduce futures market volume by moving transactions off the exchange floor.

The major attractions of off-exchange trading are that: (1) margin money is not required; and (2) products can be tailored specifically to customer needs with respect to volume (larger trades at one price), timing (off-hours), delivery location (or no delivery), and design flexibility (strike prices, expiration dates, and settlement mechanisms). The reasons more volume has not moved off the exchange is that off-exchange trading is typically principal-to-principal (and consequently more risky) and bid-ask spreads may be higher, making tailored off-exchange products more expensive than similar exchange-traded alternatives.

The fourth factor limiting futures market growth in recent years is heightened merger and acquisition activity. Vertical mergers or acquisitions reduce futures volume because commercial firms typically hedge only their net position or risk exposure. For example, the acquisition of a petroleum refiner by a crude oil producer would reduce the combined entity's need to hedge crude oil prices because the parent company's crude would be delivered directly to the refinery. Similarly, a livestock feeding company that acquired a grain merchandising firm would need to hedge corn prices less than each firm separately. And the same is true for horizontal mergers. For example, currency hedging by two international companies that merge would be less as a combined entity because risk positions would be offset internally.

The last long-run factor inhibiting U.S. futures growth is the emergence of strong competition from overseas futures exchanges. Notable examples include: (1) the London International Financial Futures Exchange, which established successful futures contracts in pounds, gilts, marks, and German government bonds; (2) the Paris Marche a Terme International de France, with contracts in French government bonds and options as well as the CAC 40 stock index; (3) the International Petroleum Exchange in London, which has emerged as the world's second viable energy exchange; (4) the London Metals Exchange (LME), which converted from principal-to-principal trading to a clearing-house organization following the tin crisis in 1985; and (5) the Osaka Securities Exchange, which trades Nikkei 225 Index futures and options.


Over the past two years Congress devoted significant effort to the reauthorization of the CFTC. The process was lengthy and drawn out as various political forces struggled to execute private agendas. At this time, the Senate and House of Representatives each has approved its own versions of the CFTC reauthorization legislation, and the final bill is being assembled by a joint conference committee. The two approved bills differ significantly, and it is unclear what shape the final version will take.

Major differences in the bills involve technical issues, such as dual trading, as well as jurisdictional issues. The Senate version gives general margin oversight authority for stock index futures to the Federal Reserve. It also specifies that the regulation of "hybrid" products (products with characteristics of both futures and securities) will be based on a "predominance" test. Products with terminal values that are 50 percent or more based on futures will be regulated by the CFTC, while the SEC will have jurisdiction over hybrid products that have a futures content of less than 50 percent. Previously, the CFTC had regulatory authority over any product that had elements of futurity.

Both reauthorization bills restrict dual trading activity and toughen requirements on audit trails. But the House bill also gives the CFTC authority to control margins on stock index futures during periods of high stock market volatility. The House bill has no provisions for dealing with hybrid products or stock index futures.

The passage of the Senate bill was delayed due in large part to a "turf battle" between the SEC and CFTC concerning regulation of stock index futures and hybrid products. The SEC, supported by the securities and options industry, sought transfer of jurisdictional powers over these products to the SEC. The CFTC, supported primarily by the Chicago and New York futures exchanges, sought to maintain jurisdictional control of stock index futures.


The CFTC's oversight role is an accepted public mandate and Congress will continue to desire some regulation of futures markets. For this reason, it is critical to define the appropriate regulatory role of the agency. The general industry view is that regulation should not impede market efficiency and innovation, nor should it put U.S. exchanges at disadvantages versus foreign exchanges.

In this context, of major concern is CFTC regulatory inefficiency that has been institutionalized to the detriment of the futures industry. Three examples are illustrative: (1) the prohibition on trading futures contracts for individual stocks; (2) the CFTC regulation that requires a minimum $75 billion capitalization for stock indexes used as a basis for trading futures or options; and (3) CFTC approval of trading foreign futures contracts with U.S. delivery, without subjecting foreign exchanges to the same regulatory requirements as U.S. exchanges.

The trading of futures contracts on individual stocks was prohibited in 1982 with the settlement of an interagency dispute between the CFTC and SEC concerning the regulation of stock index futures. The agreement specified that the SEC was to regulate options on securities, foreign currency, and stock indexes, while the CFTC was to regulate futures and futures options for these products. Futures and futures options for individual stocks were not permitted "until further consideration by the two agencies." However, neither agency subsequently reconsidered this regulation.

The prohibition on futures trading for individual securities does not make sense, because it is possible to duplicate the features of stock futures by using options contracts. Options on individual securities are legal, of course, and millions of contracts trade annually on major U.S. exchanges, as well as over-the-counter. Using these markets, a futures trade on an individual stock can be synthetically replicated. For example, to sell IBM forward, simply sell a call option and buy a put option on IBM at the same expiration date and strike price. To buy IBM for future delivery, buy the call option and sell the put. Thus, stock futures exist de facto, even though they are not directly traded.

This problem is a classic example of redundancy. Complete markets theory states that trading of redundant contracts will not exist in a market economy -- only the more efficient contracts will survive. In the case of futures on individual stocks, regulators arbitrarily legalized a redundant futures contract -- through options -- while prohibiting its more natural form. This arbitrary legalization sidesteps the market test for survival. As a result, options on equities are used to replicate futures by default.

It is obvious that executing two transactions (buying and selling a put and a call) to duplicate what can be done with one transaction (buying or selling a single futures contract) is less efficient. In addition, options contracts are more difficult for market participants to understand and price efficiently, nor do options markets provide for futures price discovery. For these reasons, the prohibition of futures trading on stocks is imprudent.

A second example of regulatory inefficiency -- the prohibition on trading futures for all but the largest stock indexes -- was implemented in 1984 when the SEC and CFTC published guidelines for futures on nondiversified stock indexes. The guidelines require an index: (1) to include a minimum of twenty-five stocks; (2) to start with an initial capitalization of $75 billion; and (3) limit one stock to a maximum of 25 percent of the index and three stocks to no more than 45 percent. The $75 billion capitalization requirement is huge and prohibits indexes on all but the broadest market sectors, including the largest companies.

As in the case of stock futures, the prohibition arbitrarily eliminates one type of contract while permitting redundant ones. For example, options on narrow stock indexes are permitted to trade and synthetic futures can be constructed from these option contracts. The Philadelphia Stock Exchange trades options in the Gold/Silver Index -- an index consisting of only seven stocks and a capitalization of only about $9 billion. Similarly, although meeting the regulators' capitalization test, the American Stock Exchange's Oil Index and Philadelphia's Utility Index consist of only sixteen and twenty stocks, respectively. The regulations are inconsistent. Options are allowed on some indexes but not others, while the corresponding futures contracts are prohibited under the same regulatory scheme.

The third example of regulatory inefficiency does not involve redundancy but simply cost-adding regulation and discrimination against U.S. exchanges in favor of foreign exchanges. Under existing regulation, the CFTC requires daily mark-to-market of futures contracts traded in the U.S. Industry participants with futures positions pay (or receive) variation margin deposit in cash daily as contract values change. An initial margin deposit is also required. But the CFTC allows U.S. firms to execute transactions on foreign exchanges not subject to the same regulations as U.S. exchanges. One notable example is the LME in the U.K.

The LME operates under British regulatory laws but has CFTC approval to market its contracts in the U.S. But LME does not require the posting of margin money, initial or variation. Consequently, firms in the U.S. can buy or sell metals in London at significantly lower cost. This provides a huge financial incentive to trade in London. Annual savings in opportunity cost can reach $1 million for larger companies that trade actively.

In 1991, the CFTC permitted LME to open warehouses in the United States for delivery of metals as settlement on futures contracts. This allows U.S. firms to buy and sell metals futures contracts through London while taking or making delivery in the U.S. at significantly lower cost than trading the same contract on an U.S. exchange. Consequently, by imposing significantly higher costs on U.S. futures trading, the CFTC has assured that most metals futures business is done overseas.


The short-term futures industry outlook is dominated by the U.S. emergence from recession. Increased economic activity will stimulate futures trading and volume will return to a positive growth path. Growth is likely to remain low by historical standards, however, given the prospective absence of favorable volume-stimulating exogenous developments and volatility that occurred in the 1980s.

Besides the lack of exogenous stimulus, a major reason for slower growth is simply industry maturity. The likely response will be mature-product marketing strategies, such as accelerated new product introduction, greater product differentiation, and strategic partnerships or mergers. In addition, more competition between exchanges will occur.

In many ways, the implementation of these strategies is already apparent. Several more eclectic, or exotic, and tailored new products have been introduced. For example, The Chicago Board of Trade (CBT) introduced interest rate swaps in 1991, and plans to introduce futures on health and automobile insurance, as well as pollution allowances. Similarly, heightened contract competition is evidenced by the recent CBT and Chicago Mercantile Exchange's (CME) battle to establish a Japanese stock index contract, as well as by CBT's "capture" of the two- and five-year Treasury note futures market from the N.Y. Cotton Exchange. And the CBT has developed an off-hours electronic trading system as a mechanism to compete both with off-exchange trading, as well as with overseas exchanges.

Strategic partnerships are also already forming as exchanges position themselves for the 1990s. For example, COMEX, IPE, and SIMEX plan to trade a sour crude oil contract sequentially through a twenty-four-hour trading day; and COMEX, EOE, SOFFIX, and the American Stock Exchange are marketing the Eurotop 100 stock index. Other major factors that will influence futures volume in the 1990s include the growth of managed funds by commodity pool operators and increased sales of hybrid securities to retail investors.

In summary, product improvements and enhanced marketing, as well as emergence from the recession, should put the U.S. futures industry back on a positive volume growth path for the 1990s. Growth will slow from the 1980s, however, unless there is a regulatory reform or significant stochastic shocks that increase market volatility. The allowance of futures trading in individual stocks and more narrow indexes, combined with a leveling of the "playing field" for U.S. exchanges, could spark the industry to double digit growth, but this is a best-case scenario.


It seems obvious that resolving several regulatory and policy issues could improve the performance of the futures industry. These include: (1) ending the political imbroglio accompanying CFTC reauthorizations; (2) terminating the ongoing jurisdictional power struggle between the CFTC and SEC; (3) reducing CFTC regulation, particularly the prohibition of futures on stocks and certain stock indexes; and (4) a leveling of the playing field for U.S. contracts versus foreign futures contracts.

With respect to reauthorization, clearly "sunset" legislation is useful, but the Congressional approach of letting political vested interests dominate the reauthorization process often produces middle-of-the-road compromise instead of improvement. Importantly, when the process is drawn out over two years it creates uncertainty in the industry and delays decisionmaking in much the same way discussion of tax law change creates uncertainty and postpones investment.

Regarding SEC and CFTC disputes, simply relying on the agencies to resolve differences themselves is inappropriate. Clearly Congress needs to delineate agency bounds in situations that result in regulatory paralysis, as in the case of the prohibition of stock futures trading. One approach might be to charter an independent commission to review the functional structure of both the CFTC and SEC, as well as their relationship with the Federal Reserve and other entities. The possibility of combining agencies and eliminating functions should be considered.

Regarding CFTC regulation of stock and index futures, and leveling the playing field, solutions are obvious: futures contracts on individual stock and index futures should be legalized and the CFTC should require foreign futures contracts (purchased in the U.S. for delivery or settlement in the U.S.) to meet the same regulatory requirements imposed on U.S. contracts.


In summary, a number of challenges face the U.S. futures industry. A strong economic recovery should reverse the 1991 decline in volume, assuming normal price volatility. Positive but slower industry growth throughout the 1990s is likely in conjunction with economic expansion and industry efforts to introduce new products, form strategic alliances, and compete more directly with foreign exchanges and off-exchange trading. Stronger volume growth is possible if regulatory inefficiencies are reduced. A resolution of CFTC/SEC jurisdictional disputes, as well as the removal of ill-conceived trading prohibitions must be addressed. And importantly, a level playing field versus foreign exchanges is critical if the U.S. futures industry is to continue to prosper.

R. McFall Lamm, Jr., is Vice President and Chief Economist, Commodity Exchange Inc., New York, NY.


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Arrow, K.J. and G. Debreu, "Existence of an Equilibrium for a Competitive Economy," Econometrica (1954), pp. 265-90.

Arrow, K.J. "The Role of Securities in the Optimal Allocation of Risk Bearing," The Review of Economic Studies (1964), pp. 91-96.

Board of Governors of the Federal Reserve System, CFTC, and SEC. A Study of the Effects on the Economy of Trading in Futures and Options, Report submitted to Congress, Washington, D.C., December 1984.

Flood, M. "An Introduction to Complete Markets." Federal Reserve Bank of St. Louis Review, March/April 1991, p. 32-57.

Futures Industry Institute, Futures and Options Fact Book, Washington, D.C., 1991.

Gramm, W. "Economic, Regulatory, and Legislative Challenges: SWAPs and the CFTC," speech to the International Swap Dealers Association, New York, July 24, 1991.

Hudson, M. "Derivatives," Euromoney supplement on derivatives, July 1991, pp. 43-46.

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Author:Lamm, R. McFall, Jr.
Publication:Business Economics
Date:Oct 1, 1992
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