PIONEERISM NEEDS NO ECONOMIC JUSTIFICATION

Presented at the Annual Meeting of the American Bar Association,
Montreal, Canada,
August 13, 1975.

The Commodity Futures Trading Commission (CFTC) came into existence by Congressional Act, in 1974. The debate that preceded this legislation was heated and extensive. Because we believed that the CFTC was inevitable, we felt we could do more good for the futures industry by partaking in the process. Accordingly, we became an official advisor in the Congressional proceedings that created this federal agency. However, we never lost sight of the fact that—at best—it was to be a mixed blessing. Thus, while generally supportive of the CFTC Act, we labored to remove some of the more onerous provisions proposed. We were not always successful.

Of particular grave concern to me were the "economic justification" provisions that remained. I believed those provisions were inherently dangerous since they provided the Commission with a means—wittingly or unwittingly—to impede innovation. Innovation was to us the very soul of futures market existence. I like to believe that as a consequence of our influence and continued pressure in this respect, the provisions of Section 5 have never become the detrimental force they might have otherwise been.

Thus spoke Senator Herman Talmadge:

Futures trading has become a very important part of the nation's economy. During 1973, the total volume in futures contracts was over $500 billion. This is twice the volume of trading in all stock exchanges in the country. Currently, futures markets perform a vital function for agricultural producers, for manufActurers, for exporters, for consumers and for others.

With these words, the Chairman of the Senate Committee on Agriculture and Forestry introduced to the Senate the final version of the Commodity Futures Trading Commission (CFTC) Act of 1974 thereby creating this new federal agency. Although Senator Talmadge spoke those words in justification of the Act, the uninitiated may have wondered whether the Senator's words were used to justify the legislation or to condemn it.

If by 1973 futures trading had become so big and so important to the nation's economy without the Federal government, why was it necessary for the government to now come to its rescue. Weren't there unsuccessful or failing segments of our economy for the Senate to rescue? And if futures had become so important to the well-being of our economy without a major congressional Act, might not such an Act be detrimental to their further growth and service to the nation?

However, the Commodity Futures Trading Commission Act is now a fact of life and it will be of small purpose to debate its merit or necessity. What is of vital importance is that the Act be administered wisely in order to fulfill what we believe to be its primary purpose: the continued service of the futures industry to our nation's economy.

The Act is probably a better instrument than we had a right to expect. After all, its subject matter—futures markets—is highly complex and technical while the mechanism is arcane and highly sophisticated. Moreover, the legislators were not market experts or traders. It can be easily understood how errors or omissions could develop. Fortunately, few exist. The major aspects of futures were fully and comprehensively covered.

We are, for instance, especially gratified that the Act placed all contract markets under one roof. We are also pleased that the Act provided the CFTC with strong Federal authority in those areas that were in need of regulation. In sum total, therefore, we believe the Act can achieve its intended purposes, i.e., to promote the futures industry, insure fair practices and provide protection to the producer and consumer.

The Act can accomplish these goals because it has breadth and flexibility, ingredients critical to its successful implementation. Without breadth, the CFTC would be too limited in scope to function properly; without flexibility, industry rules would become too rigid for it to succeed. But it is not the words within the Act that will control. Ultimately, as is the case with most legislation, the final determinants of the Act's good or evil will be the Commissioners and staff who implement it.

Allow me, therefore, to address CFTC Commissioners and staff, present and future, and to focus on one aspect of the Act that is the most critical to the growth of our industry and its continued ability to serve our national interests. The subject is close to my heart. It concerns provisions in the Act which should have treated differently and thus needs careful interpretation. It will require much of the CFTC's wisdom and a good deal of its flexibility. It is my fervent hope that with these remarks I can leave a legacy of understanding, and provide an ounce of prevention in place of a pound of cure.

Section 5 of the Act deals with contract market designation. Its provisions contain requirements that a board of trade must meet before a given instrument can be approved for trade. As a result of historical application of this Section and the report of the Senate-House Conference Committee, the CFTC has accepted past interpretations of these requirements to mean that an exchange must demonstrate "economic justification" of a proposed contract prior to approval. In other words, there must be proof of economic purpose before any new futures contract can come into being.

The foregoing requirement—to which we vehemently object—is further complicated by the provision of paragraph (g) which requires "the board of trade to demonstrate that transactions for future delivery in the commodity for which designation as a contract market is sought will not be contrary to the public interest." In practice, economic justification and public interest, the two main requisites for designation under Section 5, will merge to act as one.

Futures exchanges have fought in vain against enactment of the foregoing requirements. We will continue to battle against their strict interpretation. Separately, these requirements are dangerous and onerous, and can act as serious impediments to expansion of our markets. In combination, they can become a market strait-jacket and the greatest barrier to innovation—the unique and quintessential characteristic of futures markets.

In 1632, Galileo Galilei published his Dialogue on the Two Principal Systems of the World. In non-scientific terminology, his work can be described as claiming that Copernicus was right; the earth did, in fact, revolve around the sun. Unfortunately, Galileo's discovery was deemed contrary to the public interest of the times and he was forced to recant. For the next 200 years, the sun continued to obediently revolve around the earth.

In 1957, after 250 million dollars on research, design and development, the Ford Motor Company brought into production the "hottest new automobile of the century"—a car that passed every economic justification test that could be devised. Thus, the Edsel was born and died ignominiously two years later. Today, the Edsel is in great demand, not as an automobile, but as a nostalgia relic.

History is replete with great discoveries, inventions, and ideas that failed to meet either the public interest or economic justification test of the day. Ideas that were consequently crushed or died aborning, often to be rediscovered and hailed years later. And no doubt there are many suppressed great ideas that remain dormant waiting to be rediscovered. History is equally replete with discoveries, inventions, and ideas that met the public interest and economic justification test of the day with flying colors, only to be subsequently discarded as evil or useless.

Futures market contracts are no different in this respect from other inventions and ideas. The demands of economic justification and public interest seem reasonable and logical enough on the surface. However, one can never be sure that the criteria used to predetermine the foregoing are the correct standards to apply. Just as beauty is often in the eye of the beholder, so is one man's poison another man's wine.

A predetermined test for economic justification has never by itself been a sure-fire ingredient to guarantee a successful futures contract. At the time the Chicago Mercantile Exchange's shrimp futures were instituted, the economic need for such a market was well established. However, the market never took off the ground and was delisted in less than two years. Examples of such contracts have occurred at every futures exchange in the country.

Would any Commissioners be foolish enough to guarantee an exchange the success of a new contract simply because it passed the justification and public interest tests? Futures markets require many ingredients to succeed—some tangible, some intangible. My belief is that there are thirteen components necessary to insure a successful contract—twelve of them we know, the last one we don't. But it is the thirteenth element which is the most critical and controlling.

The ultimate and only test for economic justification is the marketplace itself. If justification is indeed lacking, the market will surely fail. No foreordained set of standardized, pre-packaged rules or requirements can make that determination. We must have faith in the free market and the competitive arena of ideas and products. A better test has yet to be devised.

In a recent speech, the Chancellor of the University of Rochester, W. Allen Wallis succinctly stated that what concerns him most about government today is the "powerful movement away from limited government and individual freedom toward pervasive government and collective control of all activities ..." "It is a shift away," he regrets to say, "from trust in good faith, competence and responsibility toward reliance on detailed prescriptions by government and documentation by individuals of their actions, intentions and motives." Such a shift as it relates to our economy, the Chancellor sadly concludes, is resulting in a "dampening of enterprise innovation, initiative and industriousness."

We do not know the exact and detailed prescriptions for economic justification of a futures market. They are not the same for every commodity, nor are they always tangible, nor do they remain constant. Often, the actual economic uses of a futures market are determined, created, or become visible only after the market is in existence.

If futures contracts are forced to show compliance with and evidence of strict and stringent justification prescriptions, there will be few new markets. Strict and automatic justification regulations will, as Chancellor Wallis said, directly stifle any attempt at innovation, any thought of pioneering, any move towards change.

Not so many years ago, it was an accepted and inexorable truth that to be the product of a successful futures market, the commodity had to be storable. Every existing futures contract up to that time included this essential prerequisite. To suggest a futures market in a live commodity was unthinkable. Without question an economic justification test of that day would have applied the foregoing principal. Were this the case, the Chicago Mercantile Exchange would not have pioneered its live cattle futures concept. As a result, one of the most successful and most important futures markets in existence today would never have been instituted. Like with Galileo, the idea would have had to be rediscovered years later.

Even if the Commissioners of that day overlooked the issue of storable versus live, the CME revolutionary cattle concept would still have failed to meet the other more standard prescriptions of justification. The CME would have had to bring forth—as is required—sufficient numbers of respectable cattle raisers and feeders to testify that they could and would use such a market for hedging purposes. At the time, the cattle industry was generally opposed to our proposed new market. Their negative bias stemmed from normal resistance to a new concept that would alter entrenched and established modes of operation. Today, the CME's cattle futures contract can boast that up to 50% of its open interest is comprised of cattle hedgers positions—an extremely high percentage of hedge participation.

But the most striking example is the International Monetary Market (IMM). At the time the idea was conceived, it would have been impossible to pass present day criteria for economic justification. Indeed, at the time of application for currency futures, the world monetary order would still have been governed by the fixed parity regime of Bretton Woods. Clearly, no futures market could flourish under a fixed-pricing system. And, even later, under the Smithsonian Agreement, when currency rates were permitted to fluctuate 2.25% up or down from fixed parities, it is highly doubtful that our idea would have been approved. Since rates were not permitted to fluctuate significantly, hedging was not a necessity. Who needs a free market within a world system that has a prescribed limitation for price movement? More important, there were precious few bankers or economists that would have supported the necessity for our revolutionary idea. Futures markets were solely for agricultural products.

When we pioneered the IMM concept, we believed the fixed exchange rate system was doomed and that sooner or later the world would be forced to accept the idea of floating or flexible exchange rates. We believed that the principles of futures markets that served agriculture all these years could be successfully applied to finance. But we could not prove it at the time. Nor should we have had to. No body of regulators—no matter how well-meaning their purpose—should be allowed to prescribe necessary criteria before a new idea can be tested against the harsh reality of the marketplace.

Today, currency futures are an accepted concept. The IMM would pass any economic justification or public interest test. Today, most economists and bankers would subscribe to the market's necessity, but it might be too late—the IMM might already exist on another shore.

And what about so many other new concepts, new instruments, new ideas yet unborn? Will they be able to meet a foreordained system of economic justification? They shouldn't be required to. The CFTC will do this nation a great service if it remembers this fundamental principle of our free market economy.

At the risk of adding one more ism to the multitude that already exist, allow me to conclude that pioneerism, by definition, needs no economic justification.

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

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