Off-Exchange Futures Deals Trigger Battle : Bid to End Monopoly Could Open Door to Competition, Fraud
Soon after New Year’s, the Chicago commodities firm of Rosenthal & Co. announced plans for an innovative program for individual investors interested in buying into the Treasury-bond market. The firm gave its product the fanciful and benign-sounding name of BAMBI.
But to some federal regulators and some members of the Chicago Board of Trade--the only place where T-bond futures can legally be traded--BAMBI, an acronym for “before-and after-market bond interchange,” looked a lot like an effort to trade T-bond futures without resorting to the exchange floor.
To the exchange and the regulators, there is nothing benign about that.
It is known as “off-exchange” futures trading. Although off-exchange trading is theoretically illegal, many futures merchants are looking for ways to blur the technicalities that distinguish futures from other financial instruments, in an effort to cut their own costs and pick up some of the millions of dollars in trading business now monopolized by the exchanges.
Not surprisingly, the nation’s 10 commodity exchanges are prepared to fight for their exclusive rights with everything they have. Moreover, the Commodity Futures Trading Commission, the federal agency that oversees the entire business, is increasingly uneasy that off-exchange trading could impair its ability to keep fraudulent operators out of the commodity markets and their hands out of individual investors’ pockets.
Some Favor Competition
But major commodity firms hold it no secret that they think the futures exchanges would benefit from having some rivals.
“BAMBI opens up the competition of the marketplace,” said Leslie Rosenthal, managing partner of Rosenthal & Co. “We’re getting opposition from people who have had the market to themselves, who think it’s some club.”
But Rosenthal is careful to draw fine distinctions between its BAMBI program and the sale of futures off the exchange.
“This is not a future,” Rosenthal said, arguing that BAMBI is simply a way for individual investors to participate in the cash market in T-bonds, which is otherwise closed to all those without at least $1 million to invest. By allowing T-bond purchases in the hour before and the two hours after the Chicago T-Bond pit is open, BAMBI would allow investors to protect their stakes from adverse developments during those periods.
At the moment, the CFTC is “studying” just what BAMBI amounts to. “We’re trying to educate them,” Rosenthal said.
Simultaneously, the Chicago Board of Trade has referred the question to its business conduct committee, a panel that keeps an eye on the non-exchange behavior of such member firms as Rosenthal. “There’s a fair amount of mystery about what this program is,” Scott Early, the Chicago Board’s general counsel, said.
Aimed at Individuals
But Rosenthal acknowledged that his product is aimed not principally at institutional investors but at individuals “who are familiar with trading futures.” That might also raise concerns at the CFTC.
The issue of off-exchange trading is dividing the commodity industry like none other, for it pits the firms that trade futures and options against the exchanges on whose floors those trades take place.
A future is generally a contract for the delivery of a given commodity at a set point in the future at a given price. Most futures contracts do not result in actual delivery of the commodity but end in an offsetting transaction in which only cash changes hands. An option represents the right, but not the obligation, to buy the underlying commodity at a set price within a set period.
In questioning why every trade must be a floor transaction, the securities firms are challenging nearly 70 years of commodity market custom and federal regulation. The challenge goes to the very heart of the futures and options markets--the way participants make their profits, the way commodity prices are set on a global scale and the extent to which members of the public can be protected against fraud.
An illustration of how seriously the exchanges and firms take the matter is the intense interest shown in the CFTC’s recent proposal to ban the sale of leverage contracts, which are futures-like instruments sold by a handful of specialized firms.
Many Fraud Complaints
The leverage business, a minuscule corner of commodities trading, generates an abnormally large share of fraud complaints. Although the major futures firms would scarcely be caught dead associating themselves with leverage, most have been vocal in opposing the CFTC’s initiative, which they fear will seal off an important off-exchange beachhead. (The exchanges have been equally vocal in supporting the CFTC.)
Exchange officials contend that only the preservation of their exclusive franchise can ensure the integrity of commodity trading. Only that way can the markets’ deep liquidity--which ensures that every seller can find a buyer and vice versa--be maintained under the kind of regulation and oversight that protects investors.
To drain even a small portion of that trading off the floor and to the back offices of trading firms, the exchanges say, would permanently damage their procedure of setting prices by “open outcry”--the auction mechanism exemplified by those familiar scenes of hysterical commodity traders screaming themselves hoarse in the pits.
“There is a reason why large orders are done on the Comex,” said Terrence F. Martell, senior vice president of the Commodity Exchange in New York, where futures and options in precious metals are traded. “It’s because it is the most liquid market in the world, and if you start screwing with it by taking out small orders, you could kill the goose that lays the golden egg.”
Want to Customize
Futures merchants, which include such major investment houses as Merrill Lynch & Co., Shearson/Lehman Bros., and Paine Webber, respond that the standardized contracts traded on the exchanges do not always match the needs of sophisticated customers. The firms say they want only to customize hedging tools for their commercial clients to keep abreast of the fast-changing financial markets.
Perhaps the best argument against allowing more off-exchange trading is the history of earlier efforts to liberalize the rules. Generally, the outcome of these efforts has been a growth industry in fraud. In 1978, for example, Congress was moved to ban the sales of all commodity options because the investments, which were marketed by independent promoters without any connection to futures exchanges, were mostly crooked. Options have since returned to the market under a CFTC pilot program.
Then there is the record of leverage contracts, which are marketed legally by only two firms, including Monex International of Newport Beach, and illegally by scores of sleazy “bucket shops” to credulous investors.
Even “legitimate” leverage merchants are permitted to set their own prices for their futures-like contracts. This differs from conventional futures, whose prices are set by the market. The result is a mountain of fraud complaints to the CFTC from unhappy investors charging that they have been misled and robbed by unscrupulous salesmen, including some of those employed by Monex. After trying to regulate the leverage market for more than 10 years, the CFTC last month asked Congress to simply outlaw it.
Only Commercial Customers
Aware that the CFTC is preoccupied with protecting individual investors from sharp operators, futures merchants have taken pains to emphasize that the customers they want to serve with off-exchange contracts are exclusively commercial--that is, financial institutions with the sophistication to know the risks of the market and the know-how to ensure that they are dealing only with honest operators.
“There has to be a balance between the CFTC’s interest in preventing mass retail fraud, and an institutionally oriented effort to accomplish risk-management,” Michael Hogan, senior vice president of Shearson/Lehman Bros., said. “The major firms are not interested in retailing these things to a public customer, but in accommodating institutional customers.”
Some argue, nevertheless, that even professional investors need plenty of protection in the risky commodities markets.
“It’s not true that just because an institution has a lot of assets it’s necessarily sophisticated and can take care of itself,” said Mark Young, a Washington lawyer for the Chicago Board of Trade and other major exchanges. “If you need proof of that, just look at the government securities market,” where a largely unregulated trade in Treasury securities cost institutions as big as Chase Manhattan Bank millions of dollars in fraud-generated losses in the early 1980s.
The dispute over who has the right to market a commodity future or option comes as commodity trading--never a particularly placid marketplace--undergoes its most far-reaching change in history.
Institutions Involved
Once designed as a place for farmers and agricultural processors to protect themselves from seasonal swings in crop prices by shifting the risk to speculators willing to bet against them, the futures market now allows insurers, pension funds, banks and other financial institutions to hedge against the possibility that interest rates will change or stock prices will move against them.
Some of the new futures have proved so popular that their growth in trading volume consistently sets records. Sensitive to the steady erosion of traditional commodity trading, and their eyes opened to the vast potential in offering all kinds of industries new ways to mediate business risks, exchanges have even proposed futures that would allow businessmen to hedge against changes in consumer prices, office rents and automobile sales.
Some of these proposals are so novel that they invalidate the traditional distinctions between futures and “forward contracts,” which are exempt from CFTC regulation and are designed to allow commercial businesses to contract for the delivery of commodities at a future date. In the past, a key distinction was that a forward ultimately led to the actual delivery of a commodity, while a future resulted in a cash settlement between two investors.
For some of the new futures, however, the underlying commodity is cash itself, making the old definitions meaningless. Many futures merchants have taken advantage of the confusion to offer customers what they call forward contracts in the new commodities, while the exchanges complain that they are really selling illegal futures and the regulators try to sort out the difference. So far, CFTC officials are trying to limit sales of the new forwards to commercial clients, not members of the public.
Would Raise Concern
“If they start selling to people with no commercial interest in the market, we’d be very concerned,” Kenneth Raisler, general counsel to the CFTC, said.
The CFTC knows that as it tries to manage the explosive innovation of the commodities market it will inevitably step on some toes in a field traditionally very hostile to any regulation.
Late last year, for instance, the agency announced that it would interpret very narrowly the so-called “Treasury exemption,” a 1974 federal rule that allows financial institutions to trade foreign currencies and other financial instruments in the interbank market without the CFTC’s oversight.
“We disagreed that the Treasury amendment permits off-exchange futures in foreign currencies without limit,” Raisler said.
But the announcement raised howls at commodity firms, which thought that the amendment allowed anyone to trade foreign currency futures off the exchanges.
“The CFTC’s interpretation would have been very restrictive of international hedging,” complained Tone Grant, president of Refco & Co., a major Chicago firm with an extensive currency-trading business. “When you’re implementing rules and regulations, they have to be very precise, and I don’t think the market is precise enough yet for there to be such precise rules.” The agency’s proposal is being held up for additional industry comments, Raisler said.
It may well be that the pressure to innovate is so strong that something resembling off-exchange trading is inevitable. “Part of this is a false issue,” said Thomas C. Coleman, chief economist of the Chicago Board of Trade. “You’ll hear the exchanges saying they want everyone doing off-exchange trading to be shut down. That’s clearly overkill. But there’s perhaps a paranoia by futures merchants that the exchanges are trying to lock them into all kinds of restrictions.”
