INVESTMENT OUTLOOK : ASSESSING THE MAJOR MARKETS : Abuses in the Trading Pits Draw Attention of Regulators
This year’s commodity trading scandal was a thunderclap that will echo through Chicago’s futures pits for years, affecting the industry and outside investors alike.
Forty-seven traders and one clerk were indicted in August after a three-year FBI investigation. Thirteen members of the group have so far pleaded guilty, as Congress, regulators and the exchanges continue to debate reforms.
The team of FBI agents that went undercover for three years on the trading floors of the Chicago Mercantile Exchange and the Chicago Board of Trade found traders exploiting the pits’ venerable “open outcry” system to cheat customers. Under the system, the crowds of traders in the small amphitheaters, called pits, shout and use hand gestures to call out the prices that they want, and then record the trades on slips of paper.
While this informal system helps keep the markets active, it can allow traders to manipulate or ignore records of trades to their advantage.
In a practice called “front running,” a trader who receives a large order from a customer can trade ahead of the order, anticipating that the order will increase or decrease prices to his advantage.
Traders can also juggle orders so that they leave less profitable or money-losing trades to customers; and working with other traders, they can create false transactions to generate tax losses for themselves.
The investigation brought critics’ calls for a tamper-proof record-keeping system and curbs on “dual trading,” the system that allows traders to buy and sell contracts for themselves and customers at the same time.
While the industry insists that cheating is rare, the indictments have brought strong pressure for reform on the exchanges and their regulators, who are often accused of lax oversight.
The Commodity Futures Trading Commission, the industry’s chief federal regulator, is studying the idea of curbing dual trading. The CFTC in August also proposed a package of reforms that would increase surveillance in the pits and require cards that carry information to identify the trader and the order of the trade.
Separately, the Chicago Mercantile Exchange and the Chicago Board of Trade say they are investing $5 million to develop a hand-held electronic record-keeping device that would make it more difficult for traders to falsify records. Instead of writing down each sale or purchase on cards, traders would punch them into the equipment, which would in turn pass the information back to a central computer.
