H.R. 131131 AND THE BIRTH OF THE CFTC

Testimony of Leo Melamed,
before the United States Senate Committee on Agriculture, Nutrition and Forestry,
May 14, 1974.

H.R. 13113 is just another number identifying one of the interminable pieces of U.S. House of Representatives legislation. However, this was no ordinary legislative effort. For U.S. futures markets, it was a momentous occasion for it represented the end of an era and the beginning of a new one—this Bill created the Commodity Futures Trading Commission (CFTC).

Many within our industry opposed the idea of a federal agency to regulate futures markets. They cited all of the expected reasons in opposition: federal regulations will suffocate the markets; the federal government will create unnecessary red tape; the growth of federal bureaucracy should be curtailed; federal bureaucracy will impose burdensome costs on our industry; futures markets cannot be equated with securities markets; futures markets expertise can only be found within the markets, etc. Much of what they said is true.

There were, however, compelling reasons for the creation of such an agency and I, generally speaking, fell into this camp. First of all, in my opinion it was inevitable. Futures markets were growing rapidly, expanding their scope and becoming prominent; it was naive to believe that our markets would be exempt from federal authority, when all other similar market endeavors were federally regulated. In other words, it was to be something akin to a shot-gun wedding. Thus I felt that, if a federal regulatory agency was unavoidable, it is best that our industry accept this fate and partake in its creation.

Aside from the foregoing, I was cognizant that a federal agency could also prove beneficial to the growth of our markets. Our plans relating to new financial instrument futures were ambitious and could be greatly assisted with a federal stamp of approval. Indeed, some innovations—such as a market in Treasury bills, or a system of cash-settlement—would be impossible to implement unless the federal government embraced them. Moreover, a federal agency could aid the image of futures markets and lend us a measure of credibility.

Most of the real work—the endless discussions, the education, the lobbying, and the negotiations—preceded the actual hearings. This was our last opportunity to prevail in some highly significant areas that were proposed in a manner contrary to best interest of futures markets, e.g., economic justification, margin control and injunctive powers. And it was the final opportunity to record in the permanent record our views on this new federal authority as well as a few words of caution.

My testimony also had a most interesting sidelight. I reminded the members of this Senate Committee of the success of American agriculture compared with nations that were governed by a centrally-planned economic order and where there were no futures markets. I admonished the Senators to remember the benefits of futures markets and that there was no Moscow Commodity Exchange, no Peking Duck Exchange, and no Havana Cigar Exchange.

Those words gave Mr. Martin Cohen—the CME's advertising executive who was in the audience—an idea for a new advertising campaign. It led to his award-winning advertising theme (and popular CME posters): "How come there's no Moscow Commodity Exchange?" "How come there's no Peking Duck Exchange?" "How come there's no Havana Cigar Exchange?"

Mr. Chairman, I deem it a privilege to come before this Committee, and am honored to have an opportunity to speak before you in representation of the Chicago Mercantile Exchange. The position of our Exchange is not in opposition to the creation of a new federal Commodity Commission; nor do we oppose many of the provisions that are under current consideration in the proposed legislation.  Indeed, many of the provisions contained in the House Bill, H.R. 13113 were the result of suggestions that we ourselves initiated.  Nevertheless, we are strongly opposed to several specific provisions within this legislation and fear that their enactment would be highly injurious to futures markets operation.  For the same or similar reasons, we also oppose some of the legislative concepts presently before the Senate. To underscore our point of view, I would like to explain the areas in which we feel legislation should be avoided, and convince you that our goal—as yours—is in the best interests of the public.

Mr. Chairman, there are no commodity exchanges in Moscow; there is no Peking Duck Exchange in China; there is no Havana Cigar Exchange. The farmers of those countries have no need for a mechanism that offers risk transference, price projection, or price protection.  In those countries, the governments establish the prices at which farmers can sell their products. Consequently, the farmers' primary risk is entirely removed.  Alas, by removing the risk, that system also removes the incentive.  The sorry history of such systems is that they have been abysmal failures.

In contrast, our nation and its agriculture during the last 100 years proved to be the only one in the world that could continue to produce more food products than we could consume—and of a higher quality and at a lower cost than anyone else. Mr. Chairman, there are many reasons for this remarkable fact.  But, the central and primary reason is that we have, for the most part, maintained a free enterprise system.  This is the pivotal difference between us and them.  This is the secret of our success and their failure.

Commodity futures markets, Mr. Chairman, are part and parcel of this successful system as it relates to agriculture. U.S. futures markets have been in existence for more than 100 years and are integrally intertwined with our agriculture and agribusiness complex.  It has been proven time and time again that these futures markets provide some of the most useful and irreplaceable tools for the producer and the consumer; that the degree of economic benefit from such markets is, in fact, greater than most would realize; and that without these tools and services, our agricultural markets would be severely impaired and far less efficient.

It is our very real concern that in any attempt to better the use of commodity futures markets we not endanger the very function of such markets.  It is our very real concern that, in an attempt to change them for the better, we not inadvertently affect the fundamental operation of this complex mechanism.  For if the end result of any new legislation is to impede these contract markets, we impair the free market system as a whole.

Indeed, it is most unfortunate that legislation relating to futures was prompted in large measure by our recent food price spiral.  Speculation at our exchanges was erroneously viewed by some as a possible cause of the nation's rising prices.  This type of reasoning ignored the fundamental economic and political factors that were underlying the problem, many of which had been festering for over a decade.  It is a reasoning that is analogous to that practiced by ancient monarchs who beheaded the messenger of bad tidings.

To act as a messenger is, in fact, one of the primary functions of futures markets.  Futures markets, by their very definition, act to provide us with a glimpse of what is coming.  If these markets had failed to predict the reality of higher prices, they would not have functioned properly.  As a matter of fact, they did not fail, and moreover, they responded to the emergency far better than might have been anticipated. Those who blamed these markets last year for predicting higher food prices, it would seem, should praise these same markets today for predicting lower prices.

But we accept neither the blame nor the praise.  In each case, the markets were acting as a mechanism to transfer risk from the producer to the speculator. In each case, the markets were acting much as a giant computer projecting prices into the future. The markets may not always be correct in their computations, but they represent a moment-to-moment analysis of all involved in the marketplace. A barometer such as this cannot be blamed or given credit for the weather conditions that exist or will occur.

Nor should our markets be castigated because they utilize and are utilized by speculators.  Speculators do not affect the eventual outcome of actual supply and demand.  But speculators are the essential ingredient that make these markets function.  They are willing to shoulder the risk that the farmer undertakes when he first plants his crop or buys his heifers—a risk the farmer wants to shed. It is the risk that Russian, Chinese, and Cuban farmers do not have. Therefore, they need no mechanism for price insurance. That is right, no speculators, no exchanges, and no successful agricultural system.

Therein lies the rub.  Should any legislation endanger the liquidity of these markets, should it create the ability of political or arbitrary forces to disrupt their operation, should it place upon markets such requirements that impede their normal processes, should it stifle innovation,it would be a step toward dismantling the free enterprise portion of our nation's agriculture and a giant step toward eventual production quotas.  We know where that road leads.

As a matter of fact, our nation has just experienced the horror of price by administrative edict and its inevitable partner—administrative supply allocation.  It was just yesterday, it seems, that our Exchange together with other free market institutions and economic experts pleaded that we not adopt a policy of price controls.  But, we were then but a frail voice in the storm over inflation.  The clamor for immediate relief was too great for Congress and the President to withstand.  So our Government embraced price controls and, as a result, our nation suffered all of the dire consequences attendant to that remedy.

Have we learned any lesson?  Are we now ready to accept the proven fact that, especially in agriculture, there is no solution to higher prices other than higher production or lower demand?  That higher production cannot be legislated?  That lower demand cannot be ordained? That any material government interference with profit incentive is counter-productive. That any government interference with our free enterprise system, which has its own checks and balances, must inevitably lead to disaster. Have we learned this lesson, or are we doomed to make this mistake again and again?

Mr. Chairman, legislation that gives a federal administrative agency power to demand economic justification before a new instrument of trade will be approved or power with which to unduly interfere with the function of our futures markets, will be the same step backwards.  It will create the ability to inhibit innovation and influence price by administrative action rather than the desired influences of free economic forces. Take, for instance, the issue of margin control.  We are vehemently and unequivocally opposed to any legislation that would transfer this authority from the exchanges themselves.  Margin is a misnomer with respect to commodities.  There is a fundamental difference, both from a conceptual and operational standpoint between margin on securities and margin on commodity futures contracts.  Unfortunately, this fact is sometimes not understood.

Securities market margin is a direct measure of the creation of bank credit.  It determines the proportion between the amount paid for securities and the amount borrowed for their purchase.  There is no such relation in futures markets. In futures markets, margin acts as a surety or security deposit.  It is conceptually designed to protect the financial solvency and integrity of the brokerage firm. Our record in this regard is remarkably good, particularly in comparison to the record of securities brokerage firms even though those exchanges have been supervised by the SEC since 1934.

On the other hand, the function of margin in commodity markets is geared toward protecting the monetary variance between daily fluctuations.  The margin required is not measured by the value of the product or contract, but is determined by the volatility of the market and the possible change in daily price movement.  It is earnest money to guarantee the sanctity of our contracts.

Everyone who has carefully studied futures markets should reach the same conclusion as did the Nathan Report of December 1967.  This report was the result of a study on this subject made at the behest of the USDA.  It concluded that margin on commodity futures markets cannot be utilized for any purpose other than the one presently used without impairing the actual operation of the market itself.  That its function is to act as a security deposit and cannot relate to payment on credit towards purchase of the product.  And, furthermore, that no agency is better equipped or situated to regulate this area than the exchanges themselves.

Were this power transferred to another agency or utilized for any other purpose, one could easily see how such power could be applied to create artificial causes for price movement.  Mr. Chairman, we would again be on the threshold of price control.

Similarly, legislation that delegates uninhibited injunctive power over these markets to an agency or commission creates the possibility of affecting price by the threat of administrative action.  Any such legislation must clearly delineate, without ambiguity, the conditions, causes and purposes for which such injunctive power is to be utilized.  Otherwise, such legislation will prove to be a much greater detriment to our markets than are the ills they attempt to correct.

Mr. Chairman, it is our fundamental belief that the best and most successful manner of regulation is self-regulation.  We submit that any legislation that fails to take this principle into account will fail in its primary objectives. We believe that the exchanges not only have the necessary and intimate knowledge of the market operation but also have ready access to the personnel and expertise vital for correct administrative action in matters relating to the intricacies of these markets.  It would indeed be a disservice to our nation if the new legislation failed to tap and properly utilize these resources.

We urge that the new legislation, particularly in sensitive areas affecting price, liquidity and margin provide a means for the contract markets to first do it right, and for the new agency to intercede only when and if the exchanges have neglected this responsibility.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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