CFTC Seeks Congressional Ban on Leverage Contracts
Federal commodities regulators said Monday that they will ask Congress to outlaw leverage contracts, the futures-like investments that have historically generated a disproportionate number of fraud complaints to government authorities.
The request, embodied in the Commodity Futures Trading Commission’s 1986 reauthorization proposal to Congress, represents at least the fifth time since 1975 that the CFTC has tried to ban leverage contracts or subject its promoters to strict regulation. The agency is now asking that leverage contracts be phased out through 1988, after which they would be considered illegal unless sold through a legitimate futures exchange. Senate and House committee hearings are expected to begin next month.
Twice before, Congress has refused to ban the investments, instead ordering the CFTC to issue regulations for their sale. Now, say CFTC officials and others in the commodity field, the agency may finally have enough congressional support to win a ban.
But that change in congressional sentiment comes as the leverage industry, long a shunned stepchild of the mainstream futures trade, is winning support from some major commodity players, including such large investment houses as Merrill Lynch & Co., Prudential-Bache Securities and Dean Witter Reynolds. All have publicly criticized other recent efforts to ban or tightly regulate leverage trading.
The reason is that, because of a legal quirk, leverage contracts are the only commodity instruments that may legally be traded off an exchange floor. Many commodity firms contend that more off-exchange trading must be permitted if the futures business is to survive as a competitive market. They fear that outlawing leverage will close the door to the kind of competition that over-the-counter stock trading and the “third market” have brought to the securities exchanges.
“Leverage does represent a factor forcing the exchanges to compete for business,” said Thomas Russo, a prominent New York commodities lawyer, “and that’s why the exchanges have been fighting to abolish leverage--for purely competitive reasons.”
Charges of Fraud
Unfortunately, as Russo acknowledged, the leverage trade is less than an immaculate base from which to mount a crusade for greater competition.
CFTC officials say that leverage contracts have generated customer charges of fraud against their sellers at a far greater rate than is warranted by their share of the commodities market. State anti-fraud authorities also say they spend a disproportionate amount of time fighting hard-sell “boiler room” telephone operations that purport to sell similar contracts to unwitting customers.
In a typical leverage transaction, a customer puts up a fraction of the market value of a quantity of gold or silver--$1,000, perhaps, to buy a contract for $4,000 in silver. The firm “lends” the customer the balance, much as a brokerage lends a stock buyer money for a margin purchase. The customer anticipates turning a profit from a subsequent rise in the price of silver but risks losing his entire investment if silver declines by only 20%.
Unwary investors are particularly exposed to losses when prices of the underlying commodities are especially volatile, for then short-term swings in the market can suddenly wipe out what customers thought would be long-term investments. As many leverage transactions are structured, a firm’s customers carry virtually all of the market risk of the instruments--but often are neither adequately informed of the risks nor protected from a firm’s financial malfeasance. The wild silver market of the early 1980s produced hundreds of complaints against leverage firms.
CFTC Regulations
Last year, under congressional prodding, the CFTC finally issued regulations holding leverage firms to strict minimum capital requirements and mandating that they institute the same rudimentary customer protection practices required of conventional futures merchants.
Only two firms have met the CFTC standards and are currently permitted by law to sell the contracts: Newport Beach-based Monex International Ltd., by far the larger, and International Precious Metals Corp. of Fort Lauderdale, Fla. A third firm, First Asset Corp. of Beverly Hills, formerly known as American Coin Exchange, has an application pending before the agency for permission to do leverage business.
