THE FED STUDY ON FUTURES AND OPTIONS

Published in the National Journal,
December 21, 1985.

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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.

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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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