Futures Pits Too Important Not to Reform

So undercover FBI agents, wearing hidden recording devices on the floors of Chicago’s commodity exchanges, are said to have evidence of traders making money improperly at the expense of investors.

That wouldn’t surprise anybody who knows the lore of the raucous, old-fashioned commodity markets. Commodity speculation is a game where tradition cheerfully accepts that 90% of the players lose money and where an old joke of the business goes: “What’s the quickest way to make a small fortune in commodities? Start with a large one!”

Yet, the fact is, not many people are hurt directly. Commodity futures attract relatively few individual investors, and commodity investors of any kind, corporate or individual, number only in the hundreds of thousands, compared to the 30 million Americans who invest in stocks and bonds. More people know calculus than know the commodity markets.

But the markets are important nonetheless, which is why you’re likely to see a major federal investigation, followed by reform and tighter regulation from Washington. Like so much else, the 150-year old commodity markets of Chicago are now an integral part of global finance.

They are where banks and nations hedge their risks on hundreds of billions in currency trading, where banks hedge interest rates and investment managers hedge stocks and bonds--not to mention where farmers and grain merchants since the 1840s have hedged against price movements in corn, cattle and soybeans. “The markets are a risk management facility for the American economy,” Clayton K. Yeutter, the newly appointed secretary of agriculture and a former head of the Chicago Mercantile Exchange, once said grandly.

Bets Settled in Cash

For example, if a bank wants to offset its risk on interest rates, it can do so on the Chicago Mercantile Exchange or Chicago Board of Trade by purchasing or selling futures contracts on Treasury bills or bonds. The Treasury bill contract represents a promise to deliver $1 million worth of T-bills at a future time and at a specific interest rate. The June, 1989, contract traded the other day, for instance, at an effective interest rate of 8.2%.

That means the buyer--say, a bank hedging its interest rate risk on a loan portfolio--has locked in a rate of 8.2% in June. The seller, perhaps another bank, hopes that interest rates decline in the interim, so it can buy T-bills on the open market at a lower price to satisfy its obligation to the buyer and make a profit on the difference.

But keep in mind that this is not the stock market, and people aren’t buying and holding T-bills or corn or wheat. They are betting on the movements of prices or interest rates, and so they generally settle their bets in cash.

It is of necessity a fast-moving market, needing lots of betting to keep price movements from jumping around wildly. That is why speculators are welcomed--such as the floor traders and brokers, called “locals” in Chicago, among whom the FBI reportedly worked undercover.

Also, such a market needs a way to buy and sell contracts at a small fraction, or margin, of the face value. Farmers can’t put up a crop’s full value to hedge their risk on a crop; banks can’t put up millions to hedge millions.

As a result, cash deposits on big contracts are marginal. The T-bill contract on the Merc can be bought for an $800 deposit (but you have to keep $50,000 in cash on deposit with the exchange to qualify as a player).

So an $800 cash bet swings $1 million worth of T-bills, with each 1% movement in the T-bill interest rate representing $10,000. And on an average day, more than $2 billion worth of T-bill contracts will be traded by floor brokers shouting and waving at each other across a pit.

The abuses in such a market are age-old and recognized by veteran players. If a trader sees a big order coming from a major bank, say, it is a simple matter to step in front of the order, buy for himself and profit as the big order affects the price.

Veteran commodity investors say there is often a disturbing gap between the price at which an order is entered and the price they get.

Those are the kind of abuses FBI agents are said to have seen and heard, and why reform is coming to the colorful world of fast-talking floor traders.

There are others reasons, too. The traders and their methods are an anachronism in a day when computers can efficiently bring together buyers in Tokyo and sellers in Milan. The expertise that traders alone supplied is now available on a digital network.

So after the inevitable investigation, more automation is sure to come. And the markets will be more tightly regulated by Washington. Regulation of commodity markets may curb but won’t end abuses--56 years of securities regulation hasn’t stopped Wall Street from scheming.

But it’s a matter of protecting the franchise. The United States has the world’s most liquid and proficient capital markets. That’s an asset worth policing and a reputation worth preserving. Reform is coming to the Chicago markets so the world will know that the U.S.A. casino runs a clean game.