Executive Says Freedom Helps--but Hurts When Lawbreakers Abound : Critics See Loose Trading Rules as Key Problem

The Chicago futures markets, the site of the FBI’s massive fraud investigation, are a noisy, bruising world, where only the quick-witted endure, and fortunes can be made or lost within hours.

The Chicago Board of Trade and Chicago Mercantile Exchange, like their 10 sister commodity exchanges, boast that the freedom they give traders makes them “the last bastion of unfettered capitalism.” But some critics maintain that the Chicago markets’ loose rules leave them vulnerable to lawbreakers.

“It’s freedom that keeps the markets ticking, but freedom hurts us, too, when there are unscrupulous people around,” said an executive of a big futures trading company in Chicago.

The traders who swarm the small amphitheaters called the “pits” are not actually buying or selling any product today, but rather are promising to do so at a specified future date at a specified price.

The futures markets sprang up in the era of Andrew Jackson as a means for farmers to reduce the risk that prices for their crops and livestock would collapse before they got them to market.

They would strike deals to sell hundreds of bushels of corn at a certain price after the harvest--ensuring them a good price. As this deal-making caught on, Chicago city slickers saw they could get rich if they could correctly guess which way prices were moving, even though they didn’t have any inventory of the grain or livestock.

For example, these traders might strike a deal to sell 100,000 bushels of corn at $2.50 a bushel on, say, Sept. 1. If the price for a Sept. 1 corn contract rose to $2.60 a bushel the next day, the trader could sell his contract immediately, and walk away with a $10,000 profit.

Of course, if the price fell to $2.40, he would be out $10,000 just as quickly.

(And it isn’t just the thickheaded who can lose their shirts. Leo Melamed, chairman of the Chicago Mercantile Exchange’s executive committee, went bankrupt in the pits as a youth, before making back his losses and amassing a fortune.)

Guessing Price Trends

The lure of such money attracted dozens of these so-called commodity futures traders, who set up permanent shop in huge bustling halls in Chicago, buying and selling contracts for corn and wheat, soybeans and beef, pork bellies (bacon) and other commodities. They learned that they could make money by guessing the trend of prices, whether it was up or down.

While some critics damned them as speculators, the traders argued that they provided an essential economic service. They allowed farmers to shift the risk of fluctuating prices to traders, who were willing to bear it because of the possible profits.

And it wasn’t just farmers they were serving, but anyone who owned a large quantity of a commodity and wanted to reduce their risk--or “hedge”--against a price decline.

Detroit auto makers, for example, trade millions of dollars in copper futures contracts to hedge their huge risk in that metal, which they use to build each auto.

In the last decade, the futures markets have boomed as the agricultural commodities have been joined by more exotic “financial futures,” such as contracts on the prices of Treasury bills and bonds, currencies and stock-index futures. Also booming recently has been trading in contracts for oil, which have been swapped in rapidly growing numbers since 1984.

Traders in these contracts don’t actually deliver these investments at the specified dates. Rather, they square their winnings or losses in cash.

Even so, making these bets allows investors to reduce their risk that prices will go against them.

“You can trade futures contracts on anything, as long as it has a day-to-day use, worldwide interest and fluctuating prices,” said Neil McGarity, a spokesman for the Futures Industry Assn.

Overall, the volume of contracts has been growing at 20% a year in the 1980s, at both the Chicago Board of Trade and the Chicago Mercantile Exchange, commonly called the Merc.

This boom has meant that in recent years, as some other parts of Chicago’s business world have withered, the futures business has picked up some of the slack. There are now 100,000 people directly employed by the futures exchanges, and hundreds of others whose jobs indirectly depend on them, according to Merc officials.

For generations, young Chicagoans, often from working-class backgrounds, have headed to the pits to earn their living.

They take jobs as “traders,” who trade for their own behalf, or “brokers,” who carry out trades for others. An exchange member can perform both functions.

But making a fortune there is not easy work.

Unlike the New York Stock Exchange, where a “specialist” directs the trading of each stock, at the pits each participant is free to make his own deals by continuously calling out their buying or selling price. This “open outcry” system ensures a constant din in the pits, since there may be hundreds of traders and brokers looking for buyers or sellers at any given moment. Traders often seal their deals by means of hand gestures, to make sure they understand someone they may not hear well.

The pits are bruising places, for traders are always jockeying for the clearest view of the rest of the pit. Traders are routinely elbowed, jabbed, tossed onto the floor. Sometimes, though rarely, an excited trader throws a punch at someone who has gotten in his way.

Grueling Pace Takes Its Toll

The routine of the trading life is so punishing that traders usually leave the most active pits after their 30s.

The traders rave about the joys of this system, which allows someone with a stake of a few thousand dollars to try to make a fortune. But there are critics, too, who insist that the relatively loose rules of the pits opens the door to the kind of allegedly crooked trading practices that the FBI has focused on.

One industry executive, asking that he remain unidentified, says he believes that trading floor abuses can creep in for two reasons.

In the chaos of trading, it is harder to keep track of whether a broker is getting his clients the best price for a contract. At any moment, there may be a wide range of prices called out, he said.

Second, he said, players in the pits can be brokers and traders at the same time. This means that if, for example, they are holding a large order for a contract that is likely to drive the contract’s price up or down, they may slip in their own order ahead of the client’s, he said.

“We know there is a potential for this kind of stuff,” he said. “All we can do is tell our people to watch out for it.”

Others in the industry say the growing number of traders in the pits, and their quicker turnover, means traders don’t know all those they see in the pits, as traders did in the old days. The Merc has 2,724 members now, for example, compared to 1,275 a decade ago.

Critics say another weakness in the system is that traders keep track of their transactions by marking slips of paper that can be lost, falsified or destroyed.

Sees Special Problems

Dennis Klejna, enforcement director of the Commodity Futures Trading Commission, the industry’s chief regulator, acknowledged that the trading system creates special enforcement problems.

“It’s no secret that it’s not always easy to detect what’s going on out in that very active situation,” said Klejna, who declined to discuss the reported FBI investigation.

Allegations of trading-floor abuses crop up regularly. In 1987, to counter allegations that some brokers failed to give customers the best price for a contract, the Merc reserved the top step of its S&P; 500 stock-index futures trading pit for members who executed orders for others but did not trade for their own accounts.

Last November, Board of Trade commodities trader Thompson B. Sanders was sentenced to six years in jail for masterminding a scheme in which a confederate wore a wig and a false ID badge in the market’s Treasury bond pit. Sanders and five others used the disguises to duck out on unprofitable trades; they made $300,000 in profitable ones.

And Thursday, the Merc announced it had imposed a fine of $750,000--its largest ever--on a husband-and-wife trading team who had “prearranged” trades. The Merc did not provide further details of the infractions by the couple, Barry and Carlem Haigh, who were also expelled from the exchange.