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THE
FED STUDY ON FUTURES AND OPTIONS
Published
in the National Journal,
December 21, 1985.
Building
the image of futures markets is a full-time endeavor. It is
a mission that went hand-in-hand with our unceasing efforts
to create new contracts, to expand market applications, to
educate institutional users, and with the overall labors to
raise the recognition of our markets.
Consider
then the value of the priceless endowment in the form of a
favorable official report about futures markets written by
four of America's prestigious federal agencies: the Board of
Governors of the Federal Reserve System, the U.S. Treasury
Department, the Securities and Exchange Commission, and the
Commodity Futures Trading Commission.
The
study, A Study of the Effects on the Economy of Trading
in Futures [and] Options, was undertaken at the behest
of the U.S. Congress and took more than two years to conclude.
(We were told it weighed 4 pounds, 4 ounces.) Such a study
deserved all the recognition we could engender.
From
time immemorial, predicting the future has been a hazardous occupation.
Good news was universally welcome, but its failure to materialize—or
its counterpart—was shabbily treated. To behead the messenger
of bad tidings was not an uncommon reward. Little wonder then
that futures and options have since their inception been an area
shrouded in mystery, frequently maligned, and more often than
not a convenient scapegoat for unpleasant business phenomena.
Never mind that there has been little empirical evidence to support
many of the fears concerning these markets. Never mind that
their protagonists have always responded to antagonistic taunts
with seemingly reasonable answers. Never mind that internal
market studies have always supported favorable conclusions.
Self-serving evidence or rationale is by itself far too feeble
a defense to overcome the power of beliefs founded in ignorance.
Consider
then the significance of a study about futures and options at
the behest of none other than the U.S. Congress. Consider then
the significance of such a study conducted by none other than
four federal agencies of impeccable credentials and incomparable
qualifications. Consider then the value of such a study on the
future life of these markets. Would it not, once and for all,
shed meaningful light on this dim corner of business activity?
Would it not at long last provide credible answers to age old
concerns and nagging doubts? Clearly, this should be its goal.
Such
was the mandate of the Futures Trading Act of 1982 when
it directed the Board of Governors of the Federal Reserve System
(Fed), the Commodity Futures Trading Commission (CFTC), the Securities
and Exchange Commission (SEC), with assistance of the U.S. Treasury
to address the serious concerns surrounding futures and options
and determine their impact on the U.S. and its business community
(see Box 1). Moreover, in order to ensure the integrity and
quality of the result, the Fed was made primary agent for the
study and required to include an analysis of the work product
by the other contributors.
The
report, A Study of the Effects on the Economy of Trading
in Futures [and] Options, which took greater than two years
to complete, deserves special recognition and public attention.
It is remarkable in two respects. The first is its scope, which
covers almost every conceivable public policy question ever raised
about futures and options in foreign currencies, interest rates,
and stock indexes. The second is its general conclusion that
financial futures and option markets seem to be serving a useful
social function.
What
is especially surprising about the report is the amazing distance
the Fed has covered over the past few years. Just seven years
ago, the Fed joined with the Treasury in calling for a moratorium
on the approval of new futures contracts on Treasury notes and
stock indexes. The CFTC obliged them, and the moratorium lasted
until the Fed and Treasury could complete a joint study that
was rather parochial in its regulatory interest. When the Fed/Treasury
study was released in the Spring of 1979, the CFTC was given
a grudging approval to go ahead with its work. But the report
then conveyed a high degree of concern that trading in financial
futures—and Treasury bill, note, and bond futures in particular—could
prove harmful to their related cash markets. The Treasury, for
example, expressed grave concerns about possible corners and
squeezes, because, to prevent the ill effects of a corner or
squeeze, the Treasury might have to issue more debt of a particular
type and maturity than had been planned as part of its normal
debt management policy. The Treasury naturally was loath to
lose any freedom in conducting its operations.
The
present study, although it contains enough "on-the-one-hand-on-the-
other-hand" language to make us all wish that economists had
only one hand, has none of the former grudging tone of acceptance. The
change in tone is all the more remarkable because the authors
of the current report were key players in the preparation of
the 1979 study. The difference, then, cannot be shrugged off
as little more than a change in political philosophy accompanying
a change in administration. Rather, the men and women of the
Fed have, from their own perspective, grown up with our markets.
They have become far better acquainted with these markets: how
they work, who uses them and the tools they represent. They
have thus become much more comfortable with what originally appeared
to be an enigmatic activity of dubious value.
To
fully appreciate the significance of the report's findings, one
must first understand the exhaustive nature of the study and
the thoroughness by which the Fed examined every aspect of our
markets. After conferring with the other agencies, the Fed brought
together industry and academic experts to discuss the questions
and to get advice on charting a course of study. The course
adopted included: Interviews by the CFTC and SEC staff with more
than 100 financial institutions and commercial firms who participate
in financial futures and options markets; A broad survey of "public" participants,
conducted by Market Facts; A poll of the views of outside experts
on various issues raised by the Congress; An extensive survey
of about 50 years worth of academic articles written on the subject
of futures and options; and, The preparation of several original
special papers on selected facets of the questions raised by
Congress. The scope of the study was all inclusive, covering
virtually every issue ever raised about these markets and examining
each from every aspect, to wit: The basic economics of futures
and options; the development and growth of the markets; the trading
conducted and strategies utilized by institutional, commercial
and professional participants; public and non-commercial participation;
the effects of these markets on the U.S. economy; market imperfections,
unfair trading practices, financial integrity, sales practices
and regulations pertaining thereto; legal restrictions on the
use of these markets; surveys of market traders; and findings
and conclusions.
The
result was a massive document which, together with the Fed's
separate report on securities and futures margin, represented
a most comprehensive and weighty report. Basically, the study
found that financial futures and options do serve a useful economic
purpose by providing a more efficient way to manage risk; that—if
anything—the liquidity of related cash markets such as those
for U.S. Treasury securities and common stocks have been improved
by the presence of futures and options; and that there appear
to be no significant regulatory problems concerning either manipulation
or customer protection (see Box 2). Consider some of the specific
conclusions.
Economic
efficiencies: From interviews with institutional
investors, the authors learned that general price risks could
be handled far less expensively by buying or selling futures
or options than by trading directly in the cash market.
In their own words, "...it would appear that futures and
options make possible greater output per unit of productive
resources, just as in the case of any cost saving technological
innovation." [IV-12]. This means that money managers—including
pension fund managers, stock and bond mutual funds, and banks—can
produce higher rates of return with our markets for any given
level of risk. Or, if greater stress is laid on avoiding
risk, the same rate of return can be earned but at a lower
level of risk. Either way, pensioners, investors, and bank
depositors can be better served.
Capital
accumulation and allocation: The study repudiates
the age-old misconception that positions taken in futures
or options markets divert investable funds from the rest
of the economy and proves that nothing could be further from
the truth. Unfortunately, the tenacity of this myth is substantial,
making it difficult to eradicate.
Market
liquidity: The study notes that "...it appears
that financial futures and options markets have, if anything,
generally increased cash market liquidity, perhaps most particularly,
liquidity in markets for Treasury securities" [VI-35].
From the Fed's standpoint, this means that their "...ability
to conduct open market operations in an orderly manner across
a range of maturities in government securities appears to
have been enhanced by the new futures and options contracts."
It also means that "...the Treasury's ability to conduct
debt management operations in similarly enhanced."
The
study indicates that the public benefits as a result of financial
futures. The improved liquidity in the Treasury securities market
means interest rates paid by the taxpayer on debt incurred by
the Federal government is lower than it would be without financial
futures markets. And, from interviews with investment banking
firms, it is clear the ability to hedge corporate bond underwriting
results in a lower all-in cost of funds for the private sector
as well.
Cash
market price stability: The study finds that "Most
formal empirical studies of the impact of futures and options
markets on cash market prices and direct studies on the behavior
of cash market prices suggest that it is stabilizing, or
at least do not establish that it is destabilizing." Even
so, the Fed is unwilling to conclude altogether that futures
and options are unambiguously good for their related cash
markets. The study concludes, instead, that "...the role
of speculation as a vehicle that generally stabilizes market
prices is still in question" [VI-28].
Margins:
In a companion piece on Federal margin regulation, the Fed has
reviewed exhaustively both the theory and evidence on margins
and finds the case for Federal intervention to be extremely weak.
Chairman Volcker, in his cover letter to Congress, went so far
as to suggest that "...Congress give serious consideration to
adopting a new approach toward margin regulation. One such approach
might be to repeal existing regulation, effectively turning over
responsibility for setting margins to the members of the various
securities exchanges and other institutions that make margin
loans. ...Past experience suggests that such entities, independently
or through self-regulatory organizations, generally have maintained
margins adequate to protect themselves against loss..." [Volcker
to Helms, January 11, 1985]
Although
this alternative was not the Chairman's first choice, it was
the first choice of Donald Regan, who was then Secretary of the
Treasury and whose reading of the study led him to believe that
the Federal government could get out of the business of regulating
margins altogether.
While
the study is to be lauded in most respects, it is noteworthy
to record two areas where it is deficient:
Difference
between futures and forwards: The
study should have done more to distinguish between futures,
which are standardized contracts traded on commodities exchanges
that guarantee both sides of the trade, and forwards,
which are customized off-exchange arrangements with no guarantor
standing in between. While the distinction may seem a bit
obscure, the difference is fundamental.
With
few exceptions, most financial catastrophes involving trading
for future delivery have occurred in the forward market, not in
the futures market. The problems faced by government securities
dealers over the past few years have stemmed from the repo market,
an off-exchange market. And banks such as Franklin National in
the U.S., Herstat Bank in Germany, or Fuji Bank in Tokyo have
gotten into trouble from the forward—not the futures—market.
The reason for the difference is largely one of accountability.
In futures, all gains and losses are settled in cash at the end
of every business day: if trades are profitable, money comes
in; if trades are losses, money is paid out. With futures, bank
traders cannot hide losing positions or unrealized losses from
management. Therefore, from the standpoint of control, futures
are far superior to forwards. Bank regulators such as the Fed
should appreciate this distinction.
The
regulators' report card: As to be expected,
the various agencies involved in this study have given themselves
high marks. However, I believe they graded themselves a
bit too highly in that there are many areas in which both
the securities and futures markets are regulated too heavily.
And with the sole exception of a brief ray of hope in Chairman
Volcker's letter of transmittal for the Federal margin study,
I find no suggestion in the collected reports that the agencies
plan to undo any of the unnecessary regulations they have
devised (usually in response to problems more imagined than
real).
In
conclusion, now that the facts are in, now that the mandate by
Congress has been satisfied, how should we view the result and
what can we say about the achievement? Will it provide futures
and options with an environment within which to prosper, or will
it do little in responding to concerns that historically have
inhibited their potential? The answers are important and generally
positive.
Frankly,
for those who are certain our markets are the work of the devil,
the Fed report will be discarded as so much rubbish. The results
of this study—or any other study—will make little difference
to confirmed unbelievers, detractors or the unenlightened. These
nay-sayers are not easily persuaded by the facts nor do they
often bother to examine the evidence. Thus, for the most part,
this large body of negative thinking will remain intact, believing
as it always has and continuing its attack on our markets unabated.
On
the other hand, for those who are charged with the responsibility
of legislating or regulating our markets, the Fed study has monumental
significance. It offers generally positive answers to virtually
every concern posed about futures and options and provides a
rationale for their favorable treatment. Indeed, the report
gives reason not to impede their continued growth and provides
impetus to foster an environment wherein they can expand and
continue to serve the business sectors for whom they are intended.
Finally,
for those of us whose daily lives are intertwined with futures
and options, the Fed study represents a signal milestone. It
provides us with concrete and impeccable evidence that much of
what we have maintained for years is true: Our financial markets
serve a useful and important economic function. Moreover, they
do not undermine existing cash market structures, nor impede
formation of capital. On the contrary, our markets tend to enhance
cash market liquidity as well as provide an important means by
which inherent economic risks can be shifted to those who are
more willing to assume it. The net result is a strengthening
of the economic fabric of this nation.
Box
1
WHAT
CONGRESS WANTED TO KNOW
(Questions
asked of the Fed)
1.
What economic purposes are served by futures and options markets?
2.
What effects do futures and options markets have on the formation
of real capital in the economy and the liquidity of credit markets?
3.
Are the public policy tools in place to regulate trading activities
in futures and options markets adequate to prevent manipulation
of and to guard against other harmful economic effects in these
markets, their underlying cash markets and related financial
markets?
4.
Are there adequate investor protections afforded participants
in these markets?
Source: A
Study of the Effects on the Economy of Trading in Futures Options,
p. I-l.
Box
2
WHAT
THE FED DETERMINED
(General
conclusions reached by the Joint Study)
1.
The new financial futures and options markets serve a useful
economic purpose, primarily by providing a means by which risks
inherent in economic activity (such as market, interest rate,
and exchange rate risks) can be shifted from firms and individuals
less willing to bear them to those more willing to do so. This
desirable risk transfer function appears likely to spread to
additional commercial and financial firms and increase in magnitude
as experience is gained with these new markets and legal impediments
to their use are modified.
2.
Financial futures and options markets appear to have no measurable
negative implications for the formation of capital. The new
markets for financial futures and options appear to have enhanced
liquidity in some of the underlying cash markets on which they
are based and do not appear to have reduced the liquidity of
any of these markets.
3.
Financial futures and options contracts differ in important characteristics.
Nonetheless, they have many common elements: both serve similar
economic functions, markets for both are closely interrelated
with the underlying cash markets on which they are based, participants
in both appear to have similar characteristics, and both have
similar potential for causing harm if they function improperly.
Thus, there is need for close harmonization of federal regulation
of these markets.
4.
Trading in the functionally similar instruments under the jurisdiction
of the SEC or CFTC does not appear to have resulted in significant
harm to public customers or to these derivative or related cash
markets. Some aberrations have resulted from arbitrage trading
in index options and the securities composing the indexes. The
potential for such disruptive trading in the index markets requires
continued monitoring by the SEC and CFTC.
5.
With respect to the issues examined in this study, the agencies
believe no additional legislation is needed at this time to establish
an appropriate regulatory framework. The SEC and CFTC currently
have similar regulations and supervisory procedures in place
in some areas requiring government oversight, and both agencies
are committed to working cooperatively to establish a compatible
framework of regulation capable of dealing effectively with all
activities requiring such supervision and regulation.
Source: A
Study of the Effects on the Economy of Trading in Futures Options,
pp. I-2, I-3.
Reprinted
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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