Reforms to Alter Way U.S. Trades in Futures

The FBI’s investigation of widespread trading abuses in the Chicago futures markets will accelerate the push for reforms in how those markets operate and are supervised, futures industry experts say.

Some developments, such as increased computerized trading and surveillance, are already in the works and could over time lead to major structural changes--even a reduction in the age-old use of the “open outcry” trading system of hand signals and shouts that lies at the heart of some alleged abuses.

The Chicago Mercantile Exchange last week formed a panel of industry officials and others to review trading procedures and recommend changes.

“There is no question that they (the exchanges) are going to make some major moves,” says Dennis W. Draper, a USC finance professor who also serves as a consultant to the Chicago Board of Trade, which, along with the Chicago Mercantile Exchange, is at the center of the FBI probe.

But the outlook for other major reforms is mixed, particularly since some changes--such as disallowing brokers to trade for themselves and changing the role of the Commodity Futures Trading Commission--are likely to meet with considerable resistance.

And many experts say it is still too early to tell what other changes will result until more details of the investigation are known. Making too many changes may create new problems, they caution.

“It is not unreasonable to predict that if this investigation results in large-scale indictments or significant cases, it could be the beginning of the end of the open outcry system,” said Stephen J. Senderowitz, a Chicago attorney and former federal prosecutor who now represents some traders and brokers who have been subpoenaed in the FBI investigation. “But that is a big ‘if’ because we don’t know the significance of these cases.”

“You have to look at precisely what the problems are and then gear the regulatory response to those problems,” says Thomas A. Russo, a New York attorney at the firm of Cadwalader Wickersham & Taft and former director of the division of trading and markets at the CFTC. “You have to be a surgeon, not a butcher, and deal with those problems without taking Draconian steps that could also hurt the market.”

Abuses Being Addressed

Much of the current reform effort centers on providing a better “audit trail” of records to track trading patterns and reducing opportunities for brokers to put their own interests ahead of their customers’.

The FBI investigation is expected to expose such abuses as “front running,” in which a broker knows that a customer order is coming but trades ahead of it for his own account to profit at the customer’s expense. The probe is also expected to expose brokers marking up the price of trades to make extra profits off customers.

Such abuses, which for some time have been known to occur, are already being addressed in some ways by the exchanges.

The Chicago Merc--generally regarded as more willing to introduce modern technology than its cross-town rival, the Board of Trade--is preparing to launch this fall a system called Globex. This computerized order system, which is expected to be approved shortly by the CFTC, would operate during hours that the Merc’s trading floor is closed. That will allow the Merc to offer 24-hour trading, making it more competitive and attractive to the growing number of foreign investors in the U.S. futures markets.

Globex will create an automatic audit trail for the exchanges and regulators to detect possible abuses. More important, it could be the system that eventually phases out the open outcry system--although that still may be years away.

“Ultimately you will have computerized trading, not necessarily in the next 10 years; it may take longer. But it is a more efficient way to do business,” attorney Russo says.

The New York Mercantile Exchange, known for its oil futures, has agreed to be part of the Globex system, and the Commodity Exchange Inc. in New York, which trades gold and other metals futures, is said to be studying a similar linkup.

But the Chicago Board of Trade appears to be much less interested in replacing the open outcry system, a freewheeling yet efficient system that traditionalists say sets the Chicago markets apart as the last bastion of true free enterprise.

“You’re going to find that the open outcry system is going to die a very hard death,” USC’s Draper contends.

Skeptics add that increased automation could create its own set of problems. Due to the limitations of computer screens, traders using Globex won’t be able to see as many buy and sell orders as they can in the recessed areas called pits where the open outcry system works, says Merton Miller, a finance professor at the University of Chicago’s graduate school of business. Without the same level of competing orders, brokers and traders may not get the best prices, as they can in an open pit, with the increased costs possibly offsetting any gains in reduced cheating, Miller says.

‘No Perfect System’

Also, a computer system always is vulnerable to computer crime and other electronic abuse.

“There is no one perfect system,” Miller says. “Every solution involves some compromises and trade-offs. The pit is cheaper to operate, but a computer screen is more easily monitored.”

“Somebody is going to work out a scam to take advantage of Globex,” says Robert Tamarkin, a futures market historian in Chicago and author of “The New Gatsbys,” a book about commodity trading. “There are too many good computer minds in the world today. The Globex system seems very vulnerable.”

But Globex is not the only change in the works. The Merc next month also plans to introduce on a pilot basis its Trade Order Processing System, or TOPS. The system will allow customer orders to be entered into a computer that will transmit them directly to brokers in the pits, automatically time-stamping the orders and thus providing a better audit trail.

Under current procedures, customer orders are time-stamped manually by clerks who then “run” them to the pits, where a broker manually time-stamps them again when he executes the order. The Chicago Board of Trade is working on a similar program.

Such a system, if its bugs are worked out and it becomes widely used, would augment one already in place at the Merc called Computerized Trade Reconstruction. That is an electronic system, initiated in mid-1987, that allows the exchange to match trading records and other data so as to “place” the time that trades took place to the nearest minute. Brokers on the floor--in the heat of frenetic trading--currently are required only to record their trades within half-hour time brackets. The Chicago Board of Trade has a similar system.

Another suggestion to improve surveillance is for the exchanges to place additional supervisory personnel in the pits, possibly under cover. Currently only one such person is typically stationed in each pit.

Brokerages also could be required to report, in account statements to customers, the exact time at which orders were executed. Customers can then check that information against the records at the exchanges.

But even with the improved audit trails and surveillance that these systems will create, they will by no means eliminate abuses. Unscrupulous traders can still collude to cheat customers outside the computer systems.

“There is not an awful lot more that can be done within the existing structure,” Miller says. “There is just a limit as to how much policing you can do.”

However, some possible reforms would reduce the incentive for abuses. The most often suggested change involves ending or curbing the ability of brokers to simultaneously trade for clients and for their own private accounts. Such “dual trading” gives unscrupulous operators the opportunity to engage in front running and other abuses at the expense of clients.

Exchange rules make it illegal for a broker to put his own trades ahead of clients’. And the Merc recently implemented a rule allowing only brokers who trade for clients, and not for themselves, to use the top step of the pit where futures are traded on the Standard & Poor’s 500-stock index. Those on the top step are in a better position to see and be seen by other traders.

Another often suggested reform involves the implementation of “sunshine trading” rules that would allow brokers and traders to announce their customer orders before trading begins. That could make front running easier to detect. Current CFTC rules bar traders and brokers from discussing trades outside of the pits.

‘Have to Do Something’

Author Tamarkin thinks that sunshine trading and the curbing of dual trading are good bets to be enacted because the exchanges must do something to appease large institutional investors--particularly the Japanese--who are increasingly using the futures markets and may be upset about the latest revelations of alleged abuses.

“If they get nervous about using these markets, especially the Japanese, they’re going to turn away from them and use off-exchange instruments,” Tamarkin says. “Consequently, the exchanges have to do something dramatic.”

But exchanges and brokers are likely to fight any major cutbacks in dual trading. They contend that allowing brokers to place orders for themselves in effect increases trading volume and competition in the markets. Without that, customers may not get orders filled as quickly and at the best prices. That could offset any savings from reduced abuses, exchanges argue.

“In (some) pits where there is a considerably smaller number of traders, you need dual trading for liquidity,” argues Merc spokesman Andrew Yemma. “You have to weigh the potential for abuse versus providing the liquidity that customers desire.”

Undoubtedly the biggest reform question involves the fate of the CFTC, the federal agency that is the principal regulator of the futures industry. The CFTC’s operating authority is up for renewal this year, and heads of both Senate and House agriculture committees--which have oversight responsibilities for the agency--have expressed serious concerns about the agency’s ability to supervise the markets.

Agency critics, including some securities industry officials and regulators, say the CFTC is too lax and cozy with the futures industry. They are clamoring for regulation of futures to come under the jurisdiction of the Securities and Exchange Commission.

But such a change appears to be a long shot. Futures industry officials and the agriculture committees are likely to fight any changes, contending that futures markets are structurally different from securities markets and thus need to be regulated differently. Alternatively, Congress could decide to give the CFTC more money and staff, with a directive to get tougher, or could direct the agency to better coordinate regulatory activities with the SEC.

REFORMING THE PITS

ABUSE

Brokers putting trades for themselves ahead of clients’ trades. Also trading in advance of clients’ trades to take advantage of the probable change in price resulting from the client’s trade, a practice called “front running.”

POSSIBLE REFORMS

Elimination or curbing of “dual trading,” which allows brokers to trade for their own accounts as well as for clients. Institution of “sunshine trading,” which requires brokers and traders to announce their unfilled orders before trading begins.

ABUSE

Brokers, possibly in collusion, fictitiously mark up prices at which trades were executed, charging customers for the excess and pocketing the difference.

POSSIBLE REFORMS

Computerized trading systems can create better audit trails to trace and detect abuse. The exchanges also can boost surveillance with more personnel on the floor.

POSSIBLE REFORMS

Brokerages also could be required to report, in account statements to customers, the exact time at which orders were executed. Customers can then check that information against the records at the exchanges.

ABUSE

Brokers misrepresent trades or create fictitious trades in an attempt to recoup losses from erroneous trades.

POSSIBLE REFORMS

Computerized trading systems, besides creating a better audit trail, also could reduce the possibility for trading errors resulting from miscommunication between brokers or traders in the pits. Los Angeles Times