© 1999 Managed Account Reports LLC. Reproduced from MAR December 1999 with permission. For further information please visit http://www.marhedge.com.

MAR

REGULATORY

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.

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Printed in MAR Update, December 1999.

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