THE CHICAGO COMMODITIES SCANDAL : How Futures Scandal May Affect Markets

The indictments on Wednesday of 46 traders and brokers at the nation’s two largest futures exchanges raises important questions about the nature of trading on those markets and their future.

Here are some answers to some basic questions:

Question: What is at stake?

Answer: Some experts say the scandal calls into question the basic integrity of the futures markets. The indictments show that their freewheeling nature make them ripe for fraudulent activity.

Prosecutors and regulators said Wednesday that they hope the indictments and resulting increased surveillance will instill new confidence that investors will be treated fairly. If not, some investors may bypass the markets and trade directly with each other or use other alternatives.

However, this is not the first time futures traders have been cited for abuses. Similar instances in the past led to increased public attention but not necessarily to any dramatic reforms or loss of confidence in the markets.

Q: How does this affect me?

A: Very few individual investors engage directly in futures trading because of its high risk and volatility. Many don’t even understand futures contracts, which allow the holder to buy or sell a certain quantity of a commodity or financial instrument at a certain date and price.

But you are indirectly affected by the futures markets every day. Farmers use the futures markets to protect themselves from losses should prices decline by the time the crops are harvested. Banks and other financial institutions also use the markets to reduce the risk of losses from changes in interest rates.

Q: How does this compare to other financial scandals, such as the recent Wall Street insider trading cases?

A: There are a number of similarities. The direct victims of insider trading in stocks include small shareholders as well as big institutions, just as in the commodities probe. Some of the offenses documented in the indictments also involve practices similar to insider trading. One such practice is called “front running.” That occurs when a trader has advance knowledge of a customer order that will move the market but trades for his own account first.

However, unlike the insider stock trading cases, each offense so far alleged in the futures probe has been by itself rather small, in many cases involving only a few hundred or few thousand dollars. But added up, the frauds resulted in the systematic cheating of customers possibly totaling millions of dollars.

Q: What are the alleged abuses?

A: The abuses generally involve instances where unscrupulous brokers and traders collaborated to make profits at the expense of customers or to shift losses to those investors. In other instances, brokers suffering losses as a result of mistaken orders would pass on those losses to customers. There also are instances where traders collaborated to hide taxable income.

Q: How pervasive are the abuses?

A: The bulk of traders and brokers are honest. But many large sophisticated institutions that invest in commodities have long recognized that abuses will occur as long as the markets are so volatile and open to manipulation. The exchanges estimate that 1% of trades are not completed as well as they would like.

Q: What can investors do to avoid such abuses?

A: Investors can be more vigilant in checking to see that they got the best prices possible. Investors also can place so-called limit orders, which specify the price at which the trade should be made. “Market orders,” which request only that trades be made at the best possible price when they hit the trading floor, are the ones most susceptible to abuse.