Special Supplement: The
Merton Miller Group:
Derivatives Doyens Dissect New Commodity Futures Law
Rob
Senator Richard Lugar (R-Indiana),
Chairman of the Senate Agriculture, Nutrition and Forestry Committee, and second
ranking Republican on the Foreign Relations and Intelligence Committees.
Philip
McBride Johnson,
head of the exchange-traded derivatives practice at Skadden, Arps,
Slate, Meagher & Flom. From 1981-83 he served as chairman of the
Commodity Futures Trading Commission, where he negotiated the "Shad-Johnson
Jurisdictional Accord," a blueprint for the regulation of financial
derivatives, with his counterpart at the Securities and Exchange Commission.
Leo
Melamed,
chairman and ceo of Melamed & Associates, and chairman
emeritus and senior policy advisor of the Chicago Mercantile Exchange.
As chairman of the CME, Melamed introduced foreign currency futures in 1972,
creating the first futures market for financial instruments. He also introduced
GLOBEX, the world's first electronic after-hours futures trading system, in
1987.
Richard
Sandor,
chairman of Environmental Financial Products, a firm
specializing in environmental derivatives. He also served as second vice
chairman of the Chicago Board of Trade and, as chief economist
at the CBOT in the early 1970s, was the principal architect of the interest-rate
futures market.
Robert
Wilmouth is
president and ceo of the National Futures Association, the
industry-wide self regulatory organization for the futures market, and former
chairman of LaSalle National Corp./ LaSalle National Bank.
Prior to joining the NFA in 1982, he served for five years as president and CEO
of the Chicago Board of Trade.
The Merton Miller
Group, (MMG)
which is composed of four founding fathers of the derivatives markets, met
recently in Reston, Va., to continue their dialogue on the dramatic forces that
are changing the futures industry. Senator Richard Lugar (R-Indiana),
chairman of the Senate Agriculture Committee, participated in the event, filling
a chair left vacant by the late Nobel Laureate Merton Miller, which is
now reserved for guest participants in his honor.
On
this occasion, the MMG's colloquy ranged over questions pertaining to U.S.
foreign policy...
* Is the time now at
hand--or even overdue--for a crisis management study of U.S. financial markets
in the context of the globalization of markets and multifarious non-military
threats to the U.S. Can the financial markets fashion hedging tools against
these unknowns?
--"The crisis
situations that are the most perilous that I can think of are ones in which
somehow terrorism comes to the continental United States, not an ICBM attack or
something more dramatic like a foreign invasion, but rather, given what I call
asymmetric warfare, i.e., smaller countries or sects of people, religious groups
or political groups, with a mission that we may not be able even to define or
know until the attack occurs."-- Sen. Richard Lugar.
...The
implications of the Commodity Futures Modernization Act, enacted on December 15
2000...
* The new law has reduced
the power of the CFTC. It relegates the CFTC to the role of "overseer"
of the regulated markets with far less day-to-day involvement than before.
Perhaps more important, it has allowed (for the first time) unregulated
"off-exchange" futures activity among sophisticated institutions.
--"You now
have a vast change in the landscape regarding ease of entry, with three-tiered
markets. Now people are going to be able to construct an exchange in 30 or 60
days and take on the existing and established exchanges."--Richard
Sandor.
...And
a prognosis for single stock and narrow-based stock index futures.
* These were barred for the
last 20 years by the Shad-Johnson Accord. Now they will be permitted but under
co-regulation by the CFTC and the SEC. The Group thrashes out whether these new
instruments are expected to be popular; how well they will be able to compete
with the well-entrenched securities option markets (e.g., the CBOE); and whether
traders are likely to show any bias between using the securities or futures
markets.
--"There is a
large community of day traders that will use single-stock futures. For them it
will be easier. If we can connect in, plug into that community, we're going to
get retail trade of that kind."--Leo Melamed.
Institutional Investor:
Senator, what was the rationale for and philosophical underpinnings of the
Commodity Futures Modernization Act of 2000.
Senator Richard Lugar:
The Community Futures Trading Commission's (CFTC) issuance of the concept
release on over-the-counter derivatives early in 1998 was perceived by many in
the industry as foreshadowing possible regulations of these instruments as
futures. That cost of regulatory action, given the importance of the OTC
markets, significantly modified the long-time legal understanding and in essence
the cry for legal certainty really took on an acute focus. That led not just to
USDA, but now the Treasury, the Federal Reserve Board, the Securities
and Exchange Commission (SEC)--all who opposed the concept release--to
request the Congress enact a moratorium on the CFTC's ability to do this. As a
result of this, Congress passed a six-month moratorium--legislation introduced
in our committee was generally accepted without a great deal of debate on the
CFTC's abilities. In fairness to the Chairman Brooksley Born at the time,
she acted, as we all did, after Long Term Capital Management hearings and
a feeling that the retail consumer or user really had to be protected.
In addition to trying to
tackle the legal certainty for over-the-counter derivatives, we were trying to
get into regulatory modernization. Non-agricultural futures are approximately
85% [of the market] and rising. In February of the year 2000, the CFTC issued a
proposal that would provide regulatory reform to the futures exchanges and their
customers and proceeded to act upon that. We saw a significant opportunity for
regulatory reform. Then of course we tackled the Shad-Johnson accord, regarding
the single stock futures, and on September 14 of 2000 the SEC and the CFTC
reached an agreement on the proper regulatory treatment of those instruments.
That was a very, very important coming together because throughout 1999 and 2000
there were no indications that that would happen.
Legal certainty came to the
over-the-counter transactions under a section of the bill that excludes
transactions in financial commodities if the transaction is one between eligible
contract participants--and these are institutions or higher-net-worth
persons--and is not executed on a trading facility. The key to these exclusions
is that no retail is allowed and these transactions occur in financial
commodities, which are more difficult to manipulate. The bank product exclusion
occurred largely through advocacy of Senator Phil Gramm of Texas.
Senator Gramm was interested
in excluding traditional bank products, such as loans and certificates of
deposit, from the Commodity Exchange Act. The agriculture people generally
accepted that, and for new banking products to develop after the date of the
enactment, the law creates a mechanism known as "jump ball" for
determining which agency, bank regulator or CFTC, governs the transaction.
We also got into hybrid
instruments. This section sets out a test to determine whether an instrument is
predominately a futures contract and governed by the Commodity Exchange Act or
predominately a security instrument, thus excluded from the Commodity Exchange
Act. In light of all the innovations that may occur, clauses such as this may
have an importance and I suspect that they will. Then we have exempted
commodities--institutional transactions in certain commodities such as energy
and metals may not need the full protection of the CEA or the CFTC, and that was
recognized in the law. But because they are more likely to be manipulated in
financial transactions, for example, they cannot be fully excluded from the Act.
As a result, the section provides an exemption from the CEA for institutional
transactions in energy and metals, as long as the participants agree to be
subject to the CFTC anti-fraud and manipulation authorities.
Finally, contract
enforcement between eligible counterparties. This is a very important clause.
This section provides a safe harbor for participants so their transactions will
not be voidable in a court of law based solely on the failure of the transaction
to comply with the terms or conditions of an exclusion or an exemption. In other
words, a mere technicality will not allow parties to walk away from their
obligations. Exchange designated as contract makers represent the highest tier
of regulation. It's intended for transactions subject to manipulation or that
serve the retail public. Agricultural users, for example, fall under this
designation and deliberately so. Agricultural interests said we have a lot of
retail users, and we want to make certain we have the same kind of regulatory
certainty we had before. The bill sets up what are derivatives transaction
execution facility (DTEFs). A board of trade may elect to operate as a DTEF if
it meets the requirements, namely the commodity is not susceptible to
manipulation and, two, the transactions are between large institutions with no
retail and at least a registered FCM that has capital of $20 million.
Finally, there's a third
group, the exempt boards of trade. Under this, futures contracts are trading on
an exempt board that is exempt from CEA. The participants once again are large
institutions and the commodity underlying is not subject to manipulation. This
is a long-time argument. Our advocacy is that's the way it ought to be. For
those who want more regulation there will be a degree of anxiety about all of
this as to what the large players will do to each other or to the public. But
nevertheless, given the extraordinary growth of the numbers of options, and by
these added in the number of choices, creations, and all the various ways it's
occurring around the earth, this seemed to be a sensible, common sense way.
Finally, we provided in the
Act for further derivatives clearing organizations. Under the old CEA, clearing
facilities and boards are regulated as one entity, since most of these
organizations were together under one organized structure. Our law now breaks
these into entities in two separately regulated facilities, allowing the
derivatives clearing organizations to clear a futures transaction, as well as
over-the-counter swap transactions. Prior to this change, the legal uncertainty
surrounding the swap transactions prevented these from being cleared on futures
clearing houses.
Here they'd be labeled as
futures, and that's back into the legal uncertainty problem. Our law fixes this
dilemma by allowing further clearing facilities as well as banks to clear OTC
derivatives, and thus reduces systemic risk by spreading the counterparty credit
risk throughout the system.
II:
What are some of the implications of the legislation?
Richard Sandor:
In particular regard to the single stock futures the pluses are it opens up a
whole new asset class, and a whole new potential set of users. The difficult
part is the implementation. We have two regulators, some of whom are going to be
concerned about their own turf--who's going to be the primary regulator? How do
you reconcile requirements that all be offset in the securities environment by
the Options Clearing Corporation [OCC]? and how does that compare to the
products traded on the futures market? What are the implications and the
execution difficulties?
To move on, you now have a
vast change in the landscape regarding ease of entry with three-tiered markets.
Now people are going to be able to construct an exchange in 30 or 60 days and
take on the existing and established exchanges.
So, the good news is that
the act is going to increase competition among exchanges. It's a very positive
step. You now have the ability, coupled with electronic capability, to launch a
thousand new products.
Leo Melamed:
The act does things for which we don't know all the consequences. Take for
instance the fact that for the very first time the CFTC is not going to be a
day-to-day regulator. It will instead be sort of an oversight agency. Now,
that's something we fought for a very, very long time. They finally have agreed
that sophisticated users in products that don't lend themselves to manipulation
don't need a regulator. That's a welcome step and certainly will produce
consequences that are quite different, because since the CFTC won't have
exclusive jurisdiction, it allows the SEC, for one, to pretend to have
jurisdiction or to want to have jurisdiction, and under the Act does have
confirmed jurisdiction, at least in the area of single stock futures.
What is an exchange now?
That's going to be called into question. And there are going to be, as Rich
said, many more exchanges. Who's going to regulate them, if anybody, is now
going to be an issue of contention.
The new environment coupled
with the new law will encourage, I think, a movement towards direct access to
the market, be it through the Internet or other ways. For instance, if the
credit function is the only thing that a futures commission merchant (FCM) has
left to do, a bank could act as an FCM by just providing the credit. This bank
is not a member of the market. The bank is not an FCM. The bank is certainly
only a conduit for the marketplace, and what we suddenly have is
disintermediation. If you disintermediate, the question becomes where does the National
Futures Association (NFA) come in? How does the NFA get to regulate A)
exchanges that aren't real exchanges in terms of the old established definition,
and B) if there is no FCM that is a member of the NFA because this whole new
system doesn't require that.
Robert Wilmouth:
In a seminar I held about two years ago composed of some of the leading figures
in the futures industry, I began a strategic planning process to chart out how
NFA could best add value to this rapidly changing futures industry. We reached
four basic conclusions: Electronic trading would become predominant in the US
futures markets; The exchanges would become demutualized, for-profit entities;
Technology would lead to an increase in the number of new and emerging
exchanges; and these new exchanges and eventually for-profit established
exchanges would likely outsource their regulatory functions to NFA.
In the 18 years of NFA's
existence, we were the only registered futures association. Now, we're we're
running into some competition that I didn't think we would run into. The Act
says that there must be a registered futures association. We're the only one.
But in this arena I must tell you that I think the gentlemen across the way's
organization will be our competitors. One key for our future survivability is
based on demutualization of the exchanges and the fact that for-profit entities
will want to get the best bang for the buck and will outsource a number of their
services to us.
Philip McBride Johnson:
First is a disclaimer--
Sandor:
--Always the lawyer. You haven't even said one thing and you're already
disclaiming. This is remarkable counselor--
Johnson:
--I was just going to say that if I had any real predictive powers I'd be
conferencing in here from Bora Bora.
I've identified four things
that I think it will be interesting to follow. Remember that on December 20,
2000 it was a felony publishable by five years in prison and a $1 million fine
to trade futures off the exchange. On December 21, it was an acceptable practice
among 11 categories of major market participants. It will be interesting to see
to what extent the futures business does gravitate upstairs for
principal-to-principal transactions among the institutions, and what impact that
will have on the centralized exchanges. Should all the institutional interest
rate business go upstairs, should all the institutional or commercial energy
business go upstairs, the impact on the central exchanges could be rather
substantial. So, I'm going to be interested to see what happens there.
The second is 25 years or so
ago a judgement was made that there should be a single regulator for all the
futures business, and one of the justifications at the time was that the futures
markets served a dozen or score maybe of different industries, many of which
already have cash-market regulators. It'll be interesting to see whether there
will be other cash-market regulators who step forward now to seek a deal similar
to what the SEC has gotten--USDA for the farm products, for example, or DOE
for the energy complex, particularly in the climate we live in now in the energy
sector; or how about the 50 state insurance commissions for insurance-related
products?
The third is the electronic
trading and demutualization, a combination of the two, but most importantly
demutualization. The chemistry of this business, as I have always understood it,
has basically been this: The exchanges have been able to self-regulate because
they have half a dozen different hooks into their membership. Most of the
members make their living there. That's one consideration--you behave or else.
Another is the risk of forfeiting a valuable seat on the exchange. Once
demutualization takes place and ownership gets severed from market use and the
users of the market become much more like the telephone company customer, then
it's going to become increasingly difficult for the administrator of the trading
system to effectively impose any kind of discipline on the end user because
there is a very little in the system now to prevent the end users from simply
saying, "I quit!" Then things begin to get a little troublesome for
them. It's something that the NFA is going to face in due course, too, because
eventually somebody is going to get into trouble with you guys and there's not
going to be any hook either from the NFA or from the exchange where the
misconduct took place to prevent him from simply saying, "Sue me."
Detection I don't think is a problem. Response is going to be the problem.
Sandor:
I agree that effective response to misconduct raises a new set of questions. But
if you look at this as a student of economics, an exchange still is, if you were
to rationalize it, in effect the least cost regulatory solution, if nothing
else. It's a commitment by people to trade under certain common sense rules and
equitable standards. If in fact regulation is required, one would expect an
exchange to emerge as a market because it is a very cost effective way to
regulate.
Johnson:
But it's mutualization which I think has been the glue that has held the
self-regulatory programs together in the past. When I become a utility and you
become my customer, I may be able to detect your misconduct easier, but I'm
going to have a devil of a time dragging you before a group of people to answer
for this and then to pay a fine if I should assess it upon you. My own view is
that the enforcement of the Commodity Futures Modernization Act is likely to
become almost an exclusively CFTC process because it is the only remaining
authority with the power to compel compliance and to really carry out
punishment.
My last point has to do with
a macro issue. As we look at the changed terrain that we have today, we find
that the principal beneficiaries of the deregulatory mode tend to be our biggest
institutions, our banks, our commercial companies, our pension plans. To the
extent that there are exemptions and exclusions they run principally to those
sectors. Those are also in many respects the most important institutions in our
society in the sense that their collapse would be calamitous for all of us.
We're relying now on a great deal more self-responsibility at that level than I
think we had in the past. It is true that in some instances, like investment
companies and broker dealers, you do have the SEC, and they're pretty savvy
about these markets. But I wouldn't rely on the state insurance commission to be
able to know whether someone is hedging or Texas hedging or whether they were
overextending themselves. So there are many people who are now eligible to be
emancipated from the CFTC oversight that may not have another sophisticated
regulator out there to pick up the slack.
II:
What are some of the unknowns within the act?
Johnson:
You know where we're going to see a litmus test. We're going to see a litmus
test on the use of "core principles". Because I would be willing
almost to bet the farm that we're going to go to the staff, and the staff's
going to say here's the way we've always done it, but if you have some other
ideas we'll noodle it for six months. It doesn't take long to figure out what
the path of least resistance is under those circumstances. I'm not saying it's
going to happen that way, but that's the risk I have to face when I get in
there. If someone says, I want to create a clearing system based entirely on
insurance policies, I could probably get that through CFTC eventually but
there'll be six or eight letters exchanged. There will be examinations of the
insurance companies. There will be all this stuff. That's just one example.
Melamed: In
the beginning there is this consideration: Whether the Merc or other exchanges
should act as the sort of parent for these new startup exchanges, provide them
with clearing facilities, and things the NFA can't do.
Wilmouth:
I have no problem with you providing them with clearing facilities.
Melamed:
But clearly the exchange can be--and that's one of the big opportunities for the
Merc--the clearing organization of choice for all the new startups where they
don't have any or capability to be a clearing organization. We can draw income
from that, that's a great service that we can provide.
Johnson:
Leo are you proposing to provide the guarantee function or just the processing
function? Because I noticed that FutureCom signed up with the BOTCC [Board
of Trade Clearing Corp.], but only for processing.
Wilmouth:
Yeah, BOTCC is the lead processor. Yeah, not for guarantee, that's right.
Johnson:
Are you going to have trouble with the normal clearing members and taking this
on going forward?
Melamed:
We're not taking on the guarantee function.
Johnson:
Oh, you're not?
Melamed:
No. This whole thing is just being invented as we speak. If the new entity comes
to us and says we're in plastics. We're going to have this exchange. We'll
create the instruments for you. You list them as futures contracts. We'll do the
cash, you do the futures in those. That's a good deal. In that case the futures
product would be guaranteed by the clearing house because it would be the Merc
futures product. Do you understand the distinction? If it's their futures
product, then we're only providing the clearing mechanism for them, the
know-how, so to speak, we're not going to guarantee it. But if it's our product,
we are.
Johnson:
All I'm saying is the latter is a huge hurdle for these new markets because they
may have VCs that are willing to front for the first $5 million or something.
But when the CFTC comes back and says you can't open your doors unless you've
got $10 million in the bank, that's a tough thing. That's a very tough thing.
Sandor:
It will be and is a hurdle. But there are people out there that are looking to
create utilities to provide services to all these new exchanges. These VCs are
smart--they can assemble $100 million for a clearing corp and go to any
exchange. They can say "We've got 50 B2B enterprises, and we can form a
financial guarantee company."
Johnson:
As long as Leo is only going to process these, he's not going to get the
business, right?
Sandor:
He won't get the clearing business, but he doesn't want the clearing business.
He wants the processing business. What's going to happen in the future is that
there will be NewCo clearing. NewCo clearing will be a mutually funded VC-based
clearing corp, which is going to go to online and go to 10 other new small
startups. We're going to see an unbundling of the whole process. So, NewCo can
act as a financial guarantee firm. They can use clearing 21 software, and use
the NFA for regulatory services.
Melamed:
--And until they have failed they're going to be just great!
Wilmouth:
There's one other thing that we're looking at, too, and I am uncertain whether
or not NFA should undertake it: Exchanges, which are either exempt or which fall
outside of the Commission's jurisdiction, are not required to obtain prior CFTC
approval but want an independent body to review certain aspects of their
operations and certify that they meet certain established standards. They're
coming out and saying, "We're outside the CFTC jurisdiction but what we
want is for you to audit us, examine us, according to a predetermined set of
standards, and give us a certificate, a seal of good housekeeping
approval." I'm debating that approach right now.
II:
Why are you uncertain Robert?
Wilmouth:
Well, Section 22 of the Act says that we are in deep trouble for failure to
enforce our rules, but only if we act in bad faith. If this was not an exchange
under the CFTC, we would not necessarily have the bad faith protection. They
want to become members, associated or affiliated members. They want to get our
seal of approval is what they want, but they're not subject to CFTC
jurisdiction.
Johnson: I
appreciate that. But they can't get it on the come, they can't get it cheap.
Wilmouth:
Oh, they're going to pay every penny of the NFA's costs.
II:
What is the future of the Chicago exchanges in light of the new act?
Melamed : The
act only serves to underscore the fact that the world has changed, and so in
itself it's not only a vehicle of change but a recognition of change. It's the
recognition of change that is really the question. Did the exchanges in Chicago
sufficiently in time recognize the change that has occurred in the world and
what can they do about it to stay viable. To some degree the answer is no, they
did not see it coming in time. If they had, I dare say there wouldn't be the
success factor that Europe has enjoyed. For instance, the London Futures
Exchange, which is a direct competitor of Eurex, neglected to understand
that electronic trade would take their business away. The Eurex was a pure
electronic exchange and it said, "we can take our Bund market away from you
guys, even though you have the liquidity, even though you have all the
membership, even though you have the most successful contract of its kind in
Europe." And they did. They took it away because LIFFE ignored reality Now,
to some extent in a similar fashion the American exchanges have ignored that
reality, and some of us have been for the last 10 years been beating on the drum
and shouting of that danger.
Sandor:
I'm not sure if Frankfurt's takeback of the Bund contract was the outlier, but
once the threat of survival came, London just coalesced and responded. They
established a committee with the Bank of England and with the London
Clearing House. They recognized that if London is to remain the center of
the European financial it had to coalesce. What we did see is an instructive
model. I offer this only as a possible case. LIFFE ended up being a commodity
exchange, doing coffee, cocoa and sugar, and now it's all electronic. It ended
up with traded stock options, which is all electronic, and ended up with
increased revenues. The question is, will one of the Chicago exchanges respond
like that? Is it going to be one single solitary market on a uniformed platform?
Is LIFFE's survival a model for what will happen in the US? That's really
the question. But the facts are they did coalesce because they had the human
capital.
Melamed:
One of the most obvious answers is when we offered our membership the truth,
demutualize for survival. Give up your rights to control. In doing so, you get
no money. We give you no money. We give you nothing of tangible return. We ask
you to give up your right to control the exchange so that we could survive, but
it's only a hope. We can't even promise you that we will survive. We'll just do
out best. Ninety-eight percent of the exchange voted away the membership right
of control and gave it to the board of directors.
Sandor:
But I think the governance issue is the issue. I serve on a number of boards of
companies ranging from a big electric utility to some dotcoms. The board sizes
range from six to 10. We see this at the New York Stock Exchange, and major
corporations, such as, the General Electrics of the world. Jack Welch
runs GE with a minimum board size and limited committees. The culture of the
exchanges has got to get down to six or eight or 10 directors and three or four
executive committees controlling the direction of the exchange.
II:
What's the potential impact of the bill on the CFTC and the NFA?
Wilmouth: Bill Rainer
has left the CFTC and the people that are remaining are the old-time people
who've been around for a long period of time and whether they're up to
implementing this new regime remains to be seen. They can interpret, they can
slow down, they can digress, they can hold up, and that's what really worries
me. But theoretically, under the CFTC -- and that's why I think the senator is
saying that he's going to exercise his oversight responsibilities to make
certain these things occur. But their road should be purely as an oversight
agency, taking a look at what we're doing--the core principles--and we're going
to draft the core principles and the best practices for them.
Melamed:
I want to reiterate one thing. That is that the regs for the use of single stock
futures have to be written and that one of the writers of that is the SEC, and
that we can't force the SEC to write those regulations. Only Congress can do
that, so there is this big question mark. In order to institute the essence of
the Act still requires the oversight of Congress to make sure that the people in
the agencies do what they're supposed to do.
Senator Lugar: All right, let me just comment. The horror stories that
you've heard are all true. But then it goes back to my point, watching this for
24 years and the evolution of the staffs of various chairman. Some have been
better than others. This is a part of our political system. The president makes
appointments of five members. One of the critical points that I've voiced
throughout is we have five members. This has often not been a priority of
administrations. We've gone through periods of times with three members, quite
long periods, as a matter of fact. Without a full Commission, the Agriculture
Committee's oversight function becomes critical, by that I mean having hearings,
calling the chairman, the acting chairmen, whoever these people are, with some
frequency, and asking what is going on. For the moment we have two vacancies
including the chairman's position. I frankly don't know the disposition of the
Bush administration with regard to either of the two nominees or the chairman.
But however it comes out, the point that all these gentlemen made is absolutely
critical. The difficulty of writing of all of these regulations, with the SEC,
may require us to work again with Senator Gramm and the Banking Committee, and
we'll be back with whoever Arthur Levitt's successor is. In other words,
we passed a law but that didn't end the big arguments. It opened lots of
opportunities.
II:
Is there a consensus at this table on what would be the preferred role of the
CFTC going forward?
Johnson:
The immense value of moving the CFTC to an oversight role is that all of the
momentum in the regulatory psyche is in the opposite direction. The public has a
perception that the police department is doing a fine job if you arrest the guy
and put him in jail. They don't expect you to stop the crime. The public's
perception of a regulator is that there are not suppose to be crimes committed
on this watch. The natural tendency of the regulator is to say I've got to
squeeze this animal until it can't hardly breath because if it has movement,
independent of me, it may do something wrong. Over a period of time you see the
screw tightening further and further and further.
Senator Lugar: Ten
years ago things had reached a pass for approving new future contracts--people
who came with a new contract to the CFTC could not get an answer for weeks, for
months, for years. In our oversight in the Senate committee I remember we tried
to sort of whittle down the time frame. We said you have to arrive at a
decision, I think in 90 days as an idea. They said, "oh, that's impossible.
The public interest, and these are complex things, and fraud and abuse will
occur." But nevertheless there was an insistence on our part. So when we
had a new reauthorization that came along, about two before this one, why then
we wrote all that in. That didn't mean that there was certainty at the time that
it was approved, but we tried to get some certainty into the time frame, just to
get the discipline back into the Commission, as opposed to this over-regulatory
squeeze that Phil was talking about.
Melamed:
In the new act for the first time the industry has been put in a position that
it allows for registration of people to use futures who previously were excluded
from the use of futures--namely, the representatives of the securities markets.
The world of futures has a very small sales group by comparison. Our sales force
is very limited, and for that reason if you compare the growth of the options
market, for instance, as compared to futures during the same period of time, you
can understand the difference. They are a securities market with this huge sales
force capable of bringing to them business. For the first time, to the credit of
this Act-- and this one of the things we pushed for--it is now possible for the
NFA to become a limited securities association. Anyone who registers with them,
and you won't have to jump through hoops to become registered--will become a
futures sales person.
Wilmouth: What
we're going to do is we're using the single word passport. If you are registered
and you passed through the right tests in the securities industry, you're going
to be passported for the purposes of single-stock futures into NFA. Then we will
allow you to sell futures, single-stock futures, on the New York Stock
Exchange. So, rather than take our test and be registered with NFA, and
become a member of NFA, they will be passported into our registration
automatically.
II:
Where is the market, who is the market for single-stock futures?
Melamed:
Very difficult.
Wilmouth:
I don't think there is any.
Melamed: This
is a very hard question. I do believe there is an interest in retail.
Wilmouth:
Can you separate it into retail and institutional? Because I think that's
important. Can we discuss for just a moment what is the market, the retail
market, for single-stock futures, bearing in mind we have an options market
which makes it less expensive to do than the futures market?
Melamed:
No, no, no! Just the other way around, just the opposite, Bob. It takes two
contracts in options to do one contract in futures.
Wilmouth: Oh,
okay, I see what you mean. It's easier. It's less riskier, though?
Melamed:
No, it's just simply less commission and less premium. You have to do it twice
in options to create a synthetic future, short or long. So it is a substantially
cheaper for a retail customer to do a future to protect his or her exposure in
stocks. There is no doubt about that.
Wilmouth:
But doesn't he run a greater risk?
Melamed:
No, no.
Wilmouth:
But we're talking about a retail customer now. That's what bothers me. Run
through an example.
Sandor:
Let me run through--
Wilmouth:
--Thank you. That's what I want you to do--
Sandor:
--Let me run through or share with you at least the English experience with
single stock futures, which has the grandiose history of five days, but does
have two years of study. We found in the two years of study that it's far
cheaper. You have to bear in mind that with options, if you're going to create a
synthetic future, you have to do two things. You have to get long a put, short a
call or visa versa to create it. You've got two bid/ask spreads and two
commissions. So, you've got twice the bid ask spreads, so you've got big
transaction costs.
You do have interested
people in the U.S. who are day traders and who don't need settlements and don't
need to be involved in cash securities transactions. They are simply traders.
Those people might be better served by not having to go through the settlement
process of making and taking delivery on an exchange. One way or the other, the
whole clearing and settlement process with futures is attractive. To the extent
that the retail public does not want an asymmetric risk like a put or a call,
but wants a symmetric risk like a future, and doesn't want to pay a premium up
front and wants to take a position--to speculate--then single stock futures will
be used.
Wilmouth: I
see those opportunities. What I'm saying, tell me this, an individual guy on the
street, Joe Dokes is on the street. Joe Dokes believes the price of IBM
stock in the next three months is going to go to $175. Okay, and it's now
selling at $125. He's going to say to himself, I want to buy a single stock
future on IBM pretty much. What do you tell him? What's he going to do? What are
his options? That's just what I'm saying.
Melamed:
Here are his options. He's what, a salesman or is properly qualified--
Wilmouth:
--Yeah, yeah, now you're getting down to it.
Sandor:
A securities salesman has to say, look, you can buy a six-month call on IBM on
the CBOE. You can pay a premium up front. The advantage of that is a one-time
cost only, and you have limited risk. Alternatively, he could buy the stock
itself and earn the dividends or splits or anything that comes with stock
ownership, if a dividend date occurs while the stock is owned the owner is
involved in a cash flow situation. The third choice is to take a futures
position, which brings a different attitude, downside risk, but the ability to
quickly reverse himself. This is great flexibility he might not have with the
other choices, and he pays no premium.
Wilmouth:
See, that's the point. Which one is he going to take? This is Joe Dokes the
retail customer.
Sandor: That's
going to depend on the customer's utility function, Bob. Some people may say I
have a three-month viewpoint. Some don't want to mark to market. Some would like
this viewpoint and would like to pay some money up front and walk away and not
look at the position because that's what their financial advisor says. For that
person the option is right.
Melamed: There
is a large community of day traders that will use single-stock futures. For them
it will be easier. If we can connect in, plug in to that community, we're going
to get retail trade of that kind. It won't effect capital formation but it will
create a universe of users in the retail level.
The institutional user has
found--those same people that ran around years ago worrying what futures were
going to do to the New York Stock Exchange trading, today walk on the New York
Stock Exchange floor, look at monitors everywhere on that floor to see what are
the futures price saying.
Sandor:
Let me punctuate the point because I think it has some interest. One thing we've
learned in a week of trading at the LIFFE is that people are saying that all the
European stock markets might not need to be merged because single-stock futures
have a common settlement procedure. It's exactly the sort of unintended
consequence that Leo pointed out. All of us in futures will look back and say,
there's EURONEXT, there's Eurex, and now there's an electronic platform that has
the same common settling and clearing procedures for all stocks whether they're
Italian, French or otherwise. People are beginning to look back and recognize
we've just started to merge the European markets. Nobody thought of that before
now.
One of the things that
emerged are creative uses of Treasury bond futures that really helped the whole
US debt issuance market in the '70s and '80s. The hedging of new issues became
huge. Will the day come that the capital market would be so good that when a
corporation needs to raise capital, it's investment bankers can give it the
certainty of it three months in advance? They're not going to have to wait and
reprice the issue every day now. They'll be a certainty to capital raising. Now
when you raise money in capital markets, just before closing you have to wait to
price the issue and you hope that the Fed doesn't do anything.
Senator Lugar:
How likely is this to occur?
Sandor:
This is what happened in debt markets and I think it will be a very important
and socially positive.
Lugar:
That'd be remarkable.
Sandor:
Yeah, this would make a huge difference to the US. The ability for a corporation
to come to work with an exchange to work with an investment banker and say,
"I'm going to need $300 million in the second quarter of 2001." The
investment bank offers a guarantee that on May 1 the corporation will receive
$200 million at $18 a share in new capital, and you don't have to worry in the
meantime. The price would be certain, it's pre-hedged for you. Whatever happens,
you know that you're going to get funding on May 1 no matter what happens.You're
not going to have any of the uncertainty and even if the documentation is not
finalized, the banker can roll the hedge forward and the price will be good for
another 60 days or 90 days. Now instead of having to use a blunt hedging
instrument like an index of 500 stocks, they could use a surgical tool or a very
narrow-based index.
II:
What is the potential impact of US foreign policy on financial markets?
Senator Lugar:
The global financial system has changed markets tremendously simply because of
the ease and speed with which people can move capital around the world seeking
greater returns and safer investments. In the futures markets, people are
groping with future uncertainties. But what does this mean? In some instances,
it may mean that they are trying to hedge against the possibilities of disaster.
So, my hope is that somehow we can fashion, at least for our own national
security and in advance of whatever these potential situations are, a crisis
management study for our financial markets so the players in these markets know
what they're going to do in advance of the disaster's occurrence. I would say,
for example, a non-foreign policy crisis, such as the stock market crash of
1987, revealed to most that there were flaws in the crisis management of our
financial markets, and that there was certainly a sense of impending disaster
for many people in terms of their financial situations.
The crisis situations that
are the most perilous today are ones in which somehow terrorism comes to the
continental United States. This won't occur as an ICBM attack or a foreign
invasion, but rather with what I call asymmetric warfare, i.e., smaller
countries or sects of people, religious groups or political groups, with a
mission that we may not be able to define or understand until the attack
happens. Such an attack occurred at the hands of the Aum Shinri Kyo sect
in the Tokyo subway with the ostensible purpose of overthrowing the Japanese
government. We were not aware of this through our intelligence services. We were
told the details in the aftermath of the attack and tried to figure out who
these people were. So, we may not know why a specific American city is targeted
with weapons of mass destruction, more likely chemical or biological than
nuclear, until after it occurs.
This increased possibility
of asymmetric warfare requires us to think through the gyrations and
oscillations of the financial markets that are likely to occur when the initial
panic ensues in that community or others around the country. Now is the time to
be asking whether there are some of these terrorist groups out there and what
are we prepared to do about this threat? I think that, until we prepare for
these possibilities, we have considerable dangers in our financial markets.
A sophisticated group of
people thinking in terms of crisis management ought not to think just about the
rescue forces that would come to help--the local providers, hospitals, and
police force--but the rescue forces need to have a plan for dealing with the
financial component. That seems to me to be an extremely important possibility
of the Commodity Exchange Act legislation, which attempts to limit systemic risk
with its legal clarifications for swaps and its new clearing authorities for
over-the-counter derivatives. We acknowledge that these markets are now global
in nature and interconnected, but that there is risk involved with that.
Wilmouth:
We have to recognize one thing before we start to approach how we're going to
solve some of these problems that impact the financial world as a result of
terrorism or whatever it happens to be. [Other] countries have their own
sovereign rights. They have their own customs, their own ideas. They're not
about to let anything be imposed on them from the outside. So, your best
approach, it seems to me, is aiming to get together a group of interested
nations, or interested bodies, in a cooperative spirit, who are willing to set
standards and formal rules, core principles and best practices. That is being
achieved to a certain extent through IOSCO [The International Organization of
Securities Commissions]. They are addressing the Internet impact, so that
we're all, whether it's in Istanbul Seoul, Korea, London, England or Washington,
DC, looking at Internet standards and how we evaluate information and systems
that utilize the Internet. We're looking on a worldwide basis at suitability, so
that you know that the right customers are doing business in the right place to
meet their investment objectives. But to try and impose rigid rules and rigid
standards isn't going to work. We've tried it before. The SEC tried to impose
our accounting standards on the rest of the world and failed at it.
Sandor: The
foreign policy implications are clear. A direct terrorist assault on an exchange
could do an awful lot of damage. At the Chicago Board of Trade we designed a new
trading floor with large concrete pillars in front of it. A good part of the
design of the structure was simply dictated by protection needs. Certainly a
rogue attack on a financial institution, like the Chicago Board of Trade,
with billions of dollars going through the system, or the Chicago Mercantile
Exchange, has enormous implications. Another area we worried about–and I
worked with a company called @stake on this–is the potential impact of
hackers. Internet-based electronic trading provides multiple entry points. It
used to be that one could put a "gray wall" around clearing and one
would be protected. Now, we've created a worldwide electronic network where
hackers may have the potential to create havoc. If there are hackers who can
somehow have an entry point with a PC and a Java-based front end with access
from various gateways, there are a lot of issues to worry about. I think that's
going to become a big concern as we go forward. The need for security; it's an
issue at CBOT and CME. We need to be concerned about things besides plastiques.
We've got to worry about people who could be sitting at an entry point in a
communications network 8,000 miles away. If you can hack into the Pentagon, and
you can hack into the Fed, you can hack into an exchange.
Wilmouth:
The corollary of that is you also have to have a recovery plan in case of a
crisis or security breach that does happen. I think we've gone a long way
forward after the Barings crisis. The Barings crisis had an impact on many
different countries who learned that they are vulnerable to happenings going on
outside of their country. I thought the studies that we did afterward gave us
some insight into how to handle a similar problem, the key point being that
recovery plans are just as important as thwarting plans.
Melamed:
As a matter of fact we did learn from that and we provided all kinds of
standards and best practices that today are in place. Many countries have
adopted that standard, not all.
But I want to go back just
to show the range of this discussion between what the Senator's list of
potential dangers to the world--not war, but less than war and yet highly
disruptive and highly impactive on all that we do--and stop short of where Rich
went, in terms of the computer infallibility. That also has a great impact on
what we do because, let me just say that The Commodity Futures Modernization Act
is not going to solve Rich's problem. It wasn't intended to. I'm just suggesting
that it has to go somewhere else, and I hope that the government has the forums
and committees or intelligence to deal with this because this is a new
international problem that will not only affect the financial markets that we
represent, it'll affect everything. It could even launch missile sites if it
wanted to. So, I'm going to stop short of discussing those effects and hope that
they can be attended to. This is not the Senate Agriculture Committee's
purview or jurisdiction. If you thrust this on the Senator he will go home or
something because it is far beyond anything this Act could do. It is, of course,
a serious consideration. I'm not demeaning its import at all. I'm just
suggesting that it has to go somewhere else than here.
For our purposes, however,
the Senator's list to me spells the thrust of today's globalization world. Every
effect anywhere of significance is felt everywhere else because the world is so
interconnected. Clearly, any one of these things whether it's India, Pakistan,
Afghanistan, Iraq, Iran, Colombia, Russia, whatever that list included, any one
of those will impact our markets instantaneously.
I stand sometimes and watch
and marvel at our Euro dollar pit, for instance. Our Euro dollar is arguably the
largest of its kind in size and magnitude, and it only deals with the short-term
instrument, 90-day Euro dollar rates. And yet, or because of it, it is connected
to every part of the world. There isn't anybody in the business of finance that
doesn't have an outlet through that pit. Somewhere in the perimeter around the
traders is a phone or other connection that will include the ability for someone
from Iran or Israel or China or North Korea or Afghanistan or India to do
something in that pit as it relates to some event that may have happened to
cause them to decide that they've got to protect themselves against it. So, the
world is completely globalized, completely interrelated. Sure, you're going to
find some corner of the world that is so isolated from real civilization it
doesn't have a connection but those places aren't meaningful; Every meaningful
part of the world is connected.
So, what the Senator was
doing in this laundry list was pointing out what is clearly the most important
aspect of futures markets. We must have what Bob Wilmouth has been saying. We
must have the ability to react properly. We must have in place the rules and
standards, so that everybody knows them. A given emergency occurs, here is
what's going to happen next and here is how we will protect ourselves from the
other guy, or from some disaster in finance. To a great extent we have a hot
squawk box, so to speak, between all the exchanges that know each other and
there is a designated person that can at any given moment press the button and
talk to everybody concerned. Not at an international level yet, that's on a
domestic level.
Wilmouth: This
type of communication and coordination needs to occur internationally.
Melamed:
I think we do have to go internationally. One more step forward has to occur as
well. Bob Wilmouth mentioned correctly that every nation has this guarded
jealousy over their own sovereignty and doesn't want to be dictated to, and we
must accept that. That's reality. Nevertheless, the United States is the most
developed, most sophisticated thinking nation as it relates to these things. The
Barings incident was clear proof of that. The only country that had the rules
right was the United States. That includes Great Britain. That includes
certainly Japan. That includes Singapore. The United States has the right rules
as to what you do in an emergency of that sort. So, clearly, it is incumbent
upon the United States, in some diplomatic fashion--you can't dictate, they are
sovereign nations--but through some mechanism, whether it's IOSCO or another
thing created--I like the idea of the Internet that you spoke of yesterday,
because that is a modern mechanism for starting this discussion and getting to
the result of standardization. They should understand what the United States
has. They should adopt those rules that makes sense to them. Or they should
provide substitutes for them that also make sense.
Johnson:
I took yesterday's discussion as an opportunity as well, which is the
possibility of designing derivatives products around some of these
contingencies. You and I looked at each other and said cat bonds. I think
there's a possibility here.
Sandor:
We actually did some business in Y2K bonds–
Melamed:--An
overblown problem that never materialized, I'm afraid. My poor company sunk
millions for that.
Johnson:
But for derivatives and risk management tools created out of them, we would be
living under a system where you either are solvent or you're bankrupt and
there's nothing in between.
Sandor:
Phil, I think you're 100 percent right. I think there are enormous commercial
opportunities for that risk to be spread. I think it's the second leg of Leo's
and Bob's point. We're in the business of trying to mitigate and spread these
risks through financial products. And it's going on. It's another discussion why
the insurance derivatives went into the over-the-counter market and they seized
the opportunity and now flourish. But that market has significant implications
for the solution of the problems. We now have research efforts at the World
Bank to determine if derivatives in Central America can mitigate the various
kinds of weather risks in El Salvador. We are seeing research on the tragic
earthquake in India and trying to find a risk-spreading device to securitize
that. To some extent, while it's a stretch, the relief of this exemption of the
over-the-counter markets permits that kind of financial innovation. It permits
individuals at the major insurance companies, and at the World Bank, to be
looking at these solutions and not to be subject to CFTC regulations.
Johnson:
We have a disaster, right? We call in FEMA [The Federal Emergency Management
Agency]. The U.S. taxpayer basically absorbs on an aggregate basis the cost
of whatever the disaster happens to be, and here's an opportunity to privatize
it.
Melamed:
Yes, exactly.
Wilmouth:
One of the areas that we haven't touched on is the whole area of trying to find
a solution to the problem--where do we get an international body to play a
significant role in solving some of these financial crisis that may arise as a
result of terrorism or something like that? Someone might want to take a leaf
maybe out of the books of Norway, Sweden, Korea, Japan, Australia and the United
Kingdom. Take all of our regulators and lump them into one financial service
regulator including banking and insurance. That could simplify your problem.
Sandor:
As a member of the community, I would like to see the NFA take the lead as the
natural respondent to this international issue.
Melamed:
Had you been at the last strategy meeting that we held, you would have heard me
suggest to Bob that maybe the NFA should be changed, the name should be changed,
to the International Futures Association.
Wilmouth:
You're right. Listen, I've been a laborer in the international vineyard for
eight years, and it's tough. But there's one other thing that's coming up in
this area, talking about consolidation and international NFAs and stuff like
that, out of the many firms that we have been talking to eight of them had asked
us to take over the securities aspect of their regulation. Now, that requires
some changes in NFA's articles of incorporation and bylaws and all, but I'm
perfectly willing to look at that. Also, regarding the international aspects,
we've got several of these firms asking for additional things.
Melamed:
--A small problem may be the original charter. It was Senator Dole and
I…back in the Senate they were at that time thinking about charging 10 cents a
contract in order to pay for the regulation that was necessary. I said, let us
regulate it ourselves. He said, you don't have a way to regulate yourself. I
said uh, huh, let's create a regulatory agency. It was created, of course, as a
national thing. The NFA came into being. Bob did a great, an unbelievable great
job, and the NFA's probably, in terms of reputation and ability, is the best of
its kind in the world.
Wilmouth: That's
right. We have trained many other organizations on our business model, rules and
other regulatory practices. We have sent teams of people to Singapore and to
Hong Kong to train people.
Melamed: Exactly.
In India, as an advisor to India, I said I don't have anything to advise. Here's
the book. Do it this way and they [the NFA] did. I don't know to what extent but
they certainly used that as a basing mechanism. So, the NFA is a great model for
what we ought to be doing.
Johnson:
You're charging for all this, I trust.
Senator Lugar:
I would underline Phil's point in another way. A lot of firms often pay pretty
good fees to folks who retire from the State Department for so-called
political risk advice. As a corollary to getting the advice, there ought to be
some mechanism for acting upon it. This may very well come in the form of a
derivatives contract. People already buy risk insurance, such as those
individuals paying for policies to mitigate the risk of a hail or a wind storm.
But terrorism may come as often as a tornado, and it's predictable in a broad
sense that it will occur around the world periodically, if not monthly or Weekly
in some way. This is something that markets could help to offset, and in the
foreign policy arena, we ought to consider it.
II:
You gentlemen represent markets. Are you thinking in those terms, or this
concept good only for a weekend think-tank?
Sandor:
It's already happening. We're getting back to a topic that is something that you
mentioned at the outset, and is something that I worry about. I am concerned
about that in conjunction with global warming, sovereign risks and reforestation
efforts.
Melamed:
There are various degrees of our conversation on these things. Remember, our
main goal is not the security of the world. No exchange takes that on as its
primary goal. That is something I think that the Senator would be more worried
about than an individual exchange. Remember, our goal is to have a secure
exchange, to have the rules so that we survive as an institution. We've got to
have the right clearing organization, the right rules, and so no matter what
happens, no matter what the stresses are within limits of the imagination's
bounds, we want to have the right rules to protect ourselves and we want the
right contracts to provide the world with which it can make money.
Clearly, we aren't yet what
Bob suggested and hopefully we'll never get to be a utility, because if we're a
utility we're not going to make any money and we can't then exist. So, it's a
different world altogether. But if we stopped short being a utility, we want to
make money. We want to have the right rules to prevent us from disastrous
results during one of these kinds of upheavals. So our purpose is a little
different from securitizing the world. It's securitizing, in our case the
Chicago Mercantile Exchange.
Johnson:
By the way, this is a slight diversion but you know that the only stock index
derivatives that SEC refuses to allow to trade are those in the smaller
economies and emerging markets where they're most needed.
Melamed:
That is really bizarre. Where it's most needed, and that's true of this Act. In
fact, one of the points--it is a diversion but it's a correct diversion because
I want the Senator to understand, to hear this--and that is it's possible for
the Merc to be more successful immediately in narrow-based indices rather than
in individual stocks because it's an easier concept to launch and easier for
institutional trade, which then would create the liquidity that's necessary. So,
at the same time that we try to develop individual stock futures, we may go to
narrow-based indices, small stuff, that represents a little segment of the
capital markets, a little segment of the industry involved, maybe five, 10
stocks. Often those relate to foreign countries where they haven't got any
mechanism to hedge the risk. But we could create not an individual stock for
them but rather little individual, small-based indices. That's what this Act
presumed. Yet, in the area of foreign indices, the SEC is going to give us a
problem to do that. That's where exactly it's needed. We were thinking of doing
that, and that's one of the problems we have.
Johnson:
I have made that point so many times. It's as if policy has nothing to do with
this, it's all numbers. We don't like the numbers in it so.
Senator Lugar:
What's wrong with the numbers?
Johnson:
I don't know. What is the capitalization of the S&P 500 now? Trillions of
dollars. A lot of these economies like Taiwan or India or whatever their stock
markets might be $50, $70 billion, and the SEC takes one look at that and says,
the combination of the low capitalization plus the fact that you either got the
telecoms or the banks or somebody dominating even within that sector, means that
this is–
Melamed:
--Doesn't fit the formula, It doesn't fit the formula.
Sandor: On
that theory, the level of irrationality is such that you would have been
precluded from listing a Scandinavian telecom index 10 years ago and you would
have missed the two biggest stocks in Europe, Ericsson and Nokia,
because one would have said that's a non-starter.