REPUTATION AND COMPETITION:
POWERFUL ENGINES

Published in Futures & Derivatives Law Report,
April 1997.

Occasionally the government pauses to appraise what it hath wrought—usually after exposure and embarrassment: $300 toilet seats and hammers spur DOD procurement reforms; caverns of butter beget USDA milk marketing reform; drug and violence ridden high-rises refocus HUD's urban renewal efforts; mandatory airbag requirements that kill infants forces a review of government's big brother policies.

How refreshing if no crisis and no taxpayers' waste prompts government reform. In February,(1) Chairman Greenspan put himself ahead of the curve. He stated that "the need for U.S. government regulation of derivatives instruments and markets should be carefully re-examined." I rush to agree.

In re-examining the need for regulation, the chairman of the Fed suggested that public policy objectives of regulation should be clearly specified, and regulations enacted should be evaluated to determine if they support the stated purposes and remain necessary.

What prompted the chairman's call for regulatory reassessment was recognition that "changes in technology have permitted the development in recent years of increasingly diverse financial instruments and intensely competitive market structures."(2) He looked at the multi-trillion dollar-a-day market in derivatives and saw participants like McDonald's, Morgan, Motorola, Mitsubishi, Merck, Mobil, municipalities, and mortgage associations. He saw international risk management initiatives undertaken by entities such as Bordens, Bristol-Myers Squibb, Bank of America, British Air, and Briggs and Stratton. He saw pension funds—from the Arizona State Retirement System to Zurn Industries—using derivatives. The alphabet of participants is overwhelmingly institutional.

Chairman Greenspan understands that each one of these institutions has the ability to choose the type and forum for the financial transaction that fits its needs, and the means to evaluate the transactional and counterparty-credit risks involved. The Fed chairman recognizes that the global marketplace has become mature and sophisticated and has developed its own set of checks and balances in place of government regulation. He has concluded that reputation and competition are powerful motivating forces for sustained proper behavior. And the Fed chairman made it "abundantly clear" that institutional traders in the OTC (over-the-counter) derivatives markets of swaps and options do not require government protection or regulation: "Private market regulation appears to be achieving public policy objectives quite effectively and efficiently."(3)

Alan Greenspan's views about the institutional users of off-exchange derivatives markets is equally true about the on-exchange institutional users; they are the same participants. If anything, exchanges possess additional inherent safeguards—central clearing coupled with daily mark-to-the-market—that offer time-tested, difficult to duplicate, protective mechanisms for all participants. If anything, on-exchange trading poses less risk for the institutional trader. If anything, on-exchange institutional users should be treated no differently than they are in the OTC market.

The CFTC—our federal regulator—disagrees. The CFTC contends that if institutional users of exchange-traded instruments were exempted from the stricture of federal regulations, the exchange marketplace would lose its protective mechanisms, become open to manipulation, and forfeit its ability for price discovery. It further contends that, as a result, exchange markets would become open to a Sumitomo or Barings debacle, that risk disclosure statements benefiting the general public would disappear, and that protective mechanisms such as circuit breakers would become uncoordinated. The CFTC even goes so far as to suggest that a centralized marketplace is fraught with more financial risk than the de-centralized OTC market and therefore requires additional regulation.

Those contentions do not hold up. As Alan Greenspan indicated, the magnitude of the underlying markets coupled with the sophistication of the participants make manipulation of the financial derivatives markets nearly impossible. Three decades ago, futures markets were an agricultural trading club where, unfortunately, one did observe manipulations of the markets at the expense of the individual investor. But modern futures markets long ago left behind their historical agricultural base to become arenas for mammoth financial transactions. Their retail customers have given way to a highly sophisticated institutional clientele. Each day, the Chicago Mercantile Exchange trades futures contracts with notional values in excess of $476 billion in Eurodollars, $12 billion in Deutsche marks, Japanese yen, and other currencies, and $39 billion in the S&P 500 index. The Chicago Board of Trade, LIFFE in London, the MATIF in Paris, and other exchanges in every major money center, offer similar deep markets. Indeed, the derivatives markets, both on- and off-exchange, are overwhelmingly resilient, sophisticated, and institutional. The likelihood of manipulative activity in such markets is minimal.

To argue that a de-centralized market is somehow more secure or more fair than a centralized marketplace defies historical fact and logic. To suggest that credit established by an exchange clearing entity is less secure because the parties are "unable to determine the identity or assess the creditworthiness of their counterparties,"(4) ignores the fact that the parties are instead looking at the creditworthiness of the exchange clearing entity. The clearing entity assesses the creditworthiness of its clearing member firms which, in turn, guarantee their customers' transactions. Thus, in exchange trading, the counter-party risks of OTC trade are spread among all clearing member firms in a rational and secured fashion and in accordance with an established formula. Further, the centralization of matching and processing empowers efficient multilateral netting of risk which fosters a reduction of systemic risk. It is therefore universally accepted that the existence of an exchange clearing entity results in a safer and more secure trading environment than is the case without this mechanism in the decentralized OTC market.

Nor do the facts support the other CFTC contentions. It is weak to point to the FBI Sting of 1989, as has the CFTC, in order to prove pervasive fraud on the Chicago exchange floors. Out of nearly 3000 Merc members, less than one percent were found to have committed any wrongdoing, hardly an alarming statistic. More to the point, Sumitomo, Barings, Daiwa, Metallgesellschaft, and similar recent debacles ensued during the CFTC watch. Was our federal regulator able to prevent them from occurring? Of course not. Did a federal regulator catch the manipulative activity in the cash bond market by Salomon Brothers a few years ago before it occurred? It did not. When internal controls are lacking or violated, the federal government is all too often unable to do anything about it until after the fact. Certainly federal regulations do act to discourage misdeeds, but prudent internal controls and good business practices by force of competition and self-preservation are far stronger deterrents to fraud.

In any event, the exchanges are not seeking to remove the CFTC's ubiquitous anti-fraud control. Nor do the exchanges wish to diminish the CFTC's authority over exchange futures trading by the general public or retail investors. The protection of federal regulations would, in such instances, remain undiminished. The National Futures Association (NFA) will also continue to fulfill its trade practices and auditing functions. Perhaps the role of the NFA can even be expanded. Nor do the exchanges intend to do away with the basic tenets of futures trade: price-discovery, record-keeping, trade reporting, self-policing, statistical dissemination, segregation of funds, or daily mark-to-market procedures. These hallmarks of futures markets make U.S. exchanges viable and competitive, and would remain intact for institutional users as well as the general public.

It is also specious to suggest that without CFTC action on behalf of the CME, market innovations such as circuit breakers could become disconnected from their SEC counterpart. One should remember that this innovation was not fostered by the CFTC in the first place. Rather, circuit breakers are the result of private-sector initiatives flowing from cooperation between the futures and securities exchanges after the 1987 stock market crash. Indeed, most futures-related innovations of the last two decades were private-sector-driven inspirations that often required agonizing time-periods for CFTC acceptance. Why, for instance, should a new instrument or idea at an exchange await bureaucratic federal approval, or need to prove so-called "economic justification?" In the final analysis, it is difficult to find even one new instrument that the CFTC ever turned down, yet it easy to illustrate how the long approval process irreparably injured an exchange's competitive edge. I have consistently argued that "pioneerism needs no economic justification," the marketplace will itself make a value determination soon enough. Or why, for instance, are the predominant number of futures market funds (the equivalent to mutual funds) formed offshore? The U.S. regulatory morass is the answer. Should we tolerate regulations that drive legitimate American business to foreign shores?

Because U.S. futures exchanges have served as an engine of innovation, they often spurred the OTC market to be more creative. As a consequence, the U.S. financial service sector is number one in the world. It is ironic for the CFTC to suddenly claim, as it has, that the stunning success of American futures exchanges is the consequence of government regulation. While government regulation has played a constructive role, a much better case can be made that our markets succeeded despite the harsh American regulatory environment.

Clearly, government regulations are, by far, not the only problem facing the futures industry. Over- the-counter and foreign competition will continue to challenge our exchanges whatever the regulatory environment, as will the continuing onslaught of technology. If U.S. exchanges continue to be impeded by a status-quo mentality and are unwilling to adopt changes, innovations, and efficiencies, particularly those made necessary by technological advancements, then they surely will lose the competitive battles they are facing, no matter what government does.

Nevertheless, at this juncture in our history, as a first necessary step to remain competitive—with OTC as well as foreign markets—futures exchanges must be unshackled from strict regulatory chains. Institutional users of these markets, to a large degree, should be allowed to be regulated by competition and reputation—the most powerful incentive and sanction system yet devised. Let us not wait until there is a national crisis—when U.S. futures exchanges have been crushed by foreign competition—before we act to do the right thing. Let us follow the Fed chairman's advice.

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     (1) Remarks by Alan Greenspan, Chairman, Federal Reserve Board of Governors, Federal Reserve Bank of Atlanta Financial Markets Conference, February 21, 1997.

     (2) Ibid.

     (3) Ibid.

     (4) Letter, CFTC Chair Brooksley Born to Honorable Richard G. Lugar, December 26, 1996.

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