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© 1999 Managed Account Reports LLC. Reproduced from MAR
December 1999 with permission. For further information please
visit http://www.marhedge.com.
The future of futures
Two big steps to a level playing field
By Desmond MacRae
After two decades of being the leading catalyst for
financial innovation, financial futures are in serious danger.
One reason is the astonishing growth of the swaps markets is pushing
them aside. Another is that electronic communications networks
that match buy and sell orders are cheaper than floor brokers.
Michael
Berry, a principal at Kottke Associates, a Chicago-based trading
advisor, makes a dire prediction. "US futures
exchanges will be out of business very soon unless they can solve
the problems they now face quickly," he says.
Two issues
"Two issues will determine the future of futures," says
Leo Melamed, chairman emeritus of The Chicago Mercantile Exchange,
who invented financial futures in 1972. One is the pressing need
for regulatory parity with the over-the-counter derivatives market.
The other is the need for futures exchanges to demutualize so they
can adapt to today's constantly changing markets.
"The primordial financial soup we created in the
1970s to which computers were later applied launched a complex
financial derivatives market that today has $80 trillion in outstanding
contracts," says Melamed. He notes that two-thirds of this, mostly
swaps, are done away from exchanges. Nevertheless, futures markets
are still an important pool of liquidity. "When things get
tough, professional dealers will turn to us to lay off any of the
excess as they did last fall."
Neither of the two President's Working Group reports
nor the General Accounting Office report released earlier this
year made recommendations to redress the present imbalance of regulation
between exchange-traded futures and over-the-counter markets.
These reports suggested the feasibility of a two-tiered
derivative universe, one being electronic exchange markets where
qualified principals can do swaps with one another virtually without
regulation. The other tier would be composed of individuals using
exchange traded futures markets.
Melamed
suggests that these tiers represent the reality of 1974 when
the CFTC had to worry about small traders in agricultural markets. "Now, about 90% of business on exchange traded futures
markets come from the same people who use OTC derivatives markets," says
Melamed.
A bill introduced by Representative Richard Baker
on November 19 makes these recommendations a legislative possibility.
The
Baker bill is good for markets in general. "This
noteworthy legislation defines the possibility of massive deregulation
of the OTC and exchange-traded swaps," says George Crapple,
co-chairman of Millburn Ridgefield Corp and chairman of the Managed
Funds Association. "If enacted, these proposals will be very beneficial
for large market participants."
But the bill does not follow the Working Group's
recommendation that the CFTC provide appropriate regulatory relief
for exchange traded derivatives. Legislative relief is not yet
in sight.
In
order to get approval to trade a new contract, US exchanges must
go through a regulatory pre-approval process. "Its
silly because in today's Internet-speed world, US futures exchanges
have competitors in Eurex and others that are adapting themselves
to changing market conditions very quickly," says Melamed.
"The sad thing about the two-tiered market is that
futures customers are essentially being denied the easy access
that equity markets provide so well to their customers," says Berry.
Why
sad? "Because futures exchanges have done a tremendous
job providing safe clearance and settlements, but terrible job
in providing access. The open-outcry floor brokerage method of
execution is out of date."
Demutualization
Whether any legislation will be passed in 2000 remains
to be seen. But regulatory parity is only one of two things futures
exchanges have to survive.
"We have to demutualize exchanges and incorporate
as for-profit entities to make decisions on the basis of what is
good for the market as a whole instead of responding to political
pressures from an inside membership, which is what some exchanges
are usually doing," says Melamed.
Berry
agrees. But even with demutualization, these two steps, Berry
predicts that of all of today's futures exchanges, only the Chicago
Mercantile Exchange may survive. "They have shown
they can innovate and adapt."
Meanwhile,
few nonfutures people understand the critical role futures play
in price discovery in modern finance. "Before
futures, there was virtually no reliable pricing information about
the giant foreign currency and bond markets," says Berry.
Even today, it is futures markets that provide proxy
data for the continuous stream of prices that modern financial
technology has come to depend on. It is hard to imagine a smoothly
functioning financial world without US futures exchanges, but their
future is anything but secure.
* * *
Printed in MAR Update, December 1999.
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