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Computer Chips Could Become a New Commodity on Futures Markets

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<i> Times Staff Writer</i>

Early last year, when prices for computer memory chips were climbing as quickly as a squirrel up a tree, Jeff Bittner saw a good chance to make a fast buck.

Bittner bought 5,000 of the tiny semiconductors for $3.50 each on a Wednesday, sold them two days later for $5 each, and pocketed a tidy $7,500 profit.

Still, he regrets that he didn’t hold on until the following Monday, when the price climbed another dollar. “That’s how fast the price was moving,” exclaimed Bittner, president of a small Laguna Hills microchip distributor.

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Before long, Bittner may be joined by a legion of new speculators in computer chips. Both the Pacific Stock Exchange and the Twin Cities Board of Trade in Minneapolis have proposed trading futures contracts on dynamic random access memory chips beginning in early 1990. DRAMs are the most common type of chip used to store information in personal computers and an array of other electronics products.

If the proposals are approved, the memory chips will become the first high-tech product ever traded on a futures market, which normally handles the likes of pork bellies, corn and crude oil.

Applying to CFTC

Supporters of DRAM futures trading say it would help ease price fluctuations, benefiting chip makers and users. But the proposal has sparked a debate within the semiconductor industry, with skeptics arguing that the contracts won’t catch on because chips are different from traditional commodities and can’t be traded the same way.

Undaunted, Pacific Stock Exchange officials say they will apply to the Commodity Futures Trading Commission in Washington in the next few weeks for approval to launch a futures contract for 256-kilobyte and 1-megabit DRAMs. The Twin Cities board, a new exchange, also is seeking CFTC approval to begin trading chip futures and options.

“We looked at the semiconductor industry and said ‘this is a product that needs a futures market,’ ” said Jeffrey R. LeMunyon, vice president of operations for the Minneapolis board.

Skeptics, however, say there are important differences between microchips and other commodities that make them poorly suited for futures trading. DRAMs, they say, are not an interchangeable commodity like wheat or potatoes. They are subject to rapid technological change and are finding their way into a growing number of products. Increasingly, they vary according to manufacturer, speed, design, density and packaging, critics say.

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“This is something I’d expect to come out of Las Vegas, not the stock exchange,” said Charles M. Clough, president of El Segundo-based Wyle Laboratories, the West Coast’s largest semiconductor distributor. “I think the exchange would do better to stick to things that have a true commodity flavor.”

Proponents of the DRAM futures idea argue that the memory-chip business has the key characteristics of any commodity market. Futures trading will help reduce volatility in the market and ease the financial risk for chip makers and users.

“Because of the history of price fluctuations in DRAMs, the industry needs some kind of instrument to enable them to hedge their risks in price fluctuations,” said Roy Berces, a Pacific Stock Exchange spokesman. “A futures contract is an age-old device for doing just that.”

Price Protection

A futures contract is an agreement that allows a buyer to purchase a commodity at a fixed price at a future date. Producers and buyers of the commodities use the futures market to protect themselves against sharp price fluctuations. Speculators, who almost never take possession of the actual commodity, use the market to assume the risks of rising or falling prices in exchange for a chance to profit on those changes.

A semiconductor maker, for example, might use the futures market to lock in a price for a batch of chips that it knows it won’t be able to sell to its regular customers until six months from now. A computer maker, worried that a possible rise in chip prices could make its products more expensive to build in six months, could buy a futures contract to protect itself against a sudden price fluctuation. Speculators, in principle, would make the market more fluid by stepping in as additional buyers or sellers, depending on which way they think the market will go.

The Pacific Stock Exchange has declined to release details of its proposal until it is submitted to the CFTC. The exchange has said it will set up a trading floor in San Francisco because of that city’s proximity to Silicon Valley as well as its ties to Pacific Rim nations and investors there.

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The 551-member exchange, which currently operates equity trading floors in San Francisco and Los Angeles and an options trading floor in San Francisco, began drafting plans for a DRAM futures exchange in early 1988, in the midst of a severe shortage of memory chips. The shortage hurt many computer firms that had to scramble to get enough DRAMs to keep their production lines going.

Pacific Stock Exchange officials said futures contracts would have eased the effects of last year’s chip shortage by enabling computer makers to purchase DRAM contracts with locked-in prices. A futures market also would have addressed the reverse situation in 1985 and 1986, when semiconductor companies suffered badly from a glut of memory chips and falling prices, officials said.

Problems for Apple

“There is a large structural inefficiency that exists in the semiconductor industry,” said Bill Tai, vice president of marketing for Memory Clearinghouse Co. in San Francisco, a business formed last year to help the Pacific Exchange develop the DRAM futures proposal.

The presence of an active “gray market” in DRAMs is evidence of the need for a different type of distribution system in the semiconductor industry, Tai said. The gray market is a collection of hundreds of electronics distributors and brokers that buy and sell chips that are obtained from computer makers and other sources.

“The gray market now serves as an inventory buffer to absorb the swings in supply and demand,” Tai said. But the price of DRAMs bought and sold in the gray market is not organized in any fashion, and buyers and sellers have no way of knowing if they are getting the best price possible.

Ann Schwetje, a semiconductor analyst at Smith Barney, Harris Upham & Co., agreed that the futures exchange seems like a good idea. She notes that Apple Computer ran into big problems last year when it overbought 1-megabit DRAM chips, fearing a short supply.

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“Apple took on a big inventory of chips and when the price fell, they had to make their computers with higher-priced DRAMS, while their competitors bought less costly chips,” Schwetje said.

Apple and several other computer makers, including AST Research of Irvine and Sun Microsystems of Mountain View, Calif., blamed the DRAM problem as a major reason for a big drop in earnings earlier this year.

A big question for the San Francisco and Minneapolis exchanges is whether they can win the support of chip producers and their large customers, particularly the personal computer makers. “It is critically important to have their involvement,” said Philip McBride Johnson, a former CFTC chairman and New York attorney who is advising the Pacific Stock Exchange. “Futures contracts don’t succeed unless they become commonplace tools in the industry.”

Although the exchange said it has had extensive discussions with the electronics industry, several chip manufacturers and PC makers said they knew too little about the proposal to comment. And a few said they would not support the proposal.

Officials from Texas Instruments, Hitachi America and Hewlett-Packard have gone on record saying they would not participate in the futures market. They say that chip makers and their customers can better deal with the problem of market volatility by themselves.

Confident It Can Work

“We really don’t view DRAMs as a true commodity,” said Stan Victor, a spokesman for Texas Instruments, one of three U.S. producers of memory chips. “Rather than using a financial instrument, we are addressing the volatility of the memory market through a combination of efforts” with customers.

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The Texas chip maker has worked out deals with some of its largest customers in which they are making advance payments for DRAMs. Texas Instruments is using those funds to build additional manufacturing facilities and boost its future production capacity. The customers, in turn, are being guaranteed a future supply of DRAMs in case of a shortage.

Another question for the exchanges is whether they can spark enough interest among speculators.

“Futures markets require hedgers,” said Johnson, the former CFTC chairman. “The market works sort of like Lloyds of London. Some people buy insurance and bet that the ship won’t sink, while others buy it betting that it will.”

Johnson, a partner in the New York law firm Skadden, Arps, Slate, Meagher & Flom, has practiced commodities law for 25 years and said he is confident a futures market for computer chips can work.

“There are so many different products now being traded in the futures market that nothing surprises me anymore,” Johnson said. “People once wondered whether you could trade perishable items such as cattle or eggs, and they’re doing fine.” Meanwhile, speculators say they will be watching the DRAMs futures proposal, which would formalize a money-making idea that some savvy investors already have seized upon.

During last year’s DRAM shortage, “people who knew nothing about chips were trying to buy orders up to 1 million,” said Bittner, the Laguna Hills distributor. “These were people like stockbrokers and accountants who wanted to buy DRAMs and hold them until the price went up.”

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