Phil Johnson speaks about the creation of the CFTC
When the Congress was creating the Commodity Futures Trading Commission in the early 1970s, I was active in trying to ensure that the new CFTC would be the sole regulator of the futures markets. Those exchanges were rapidly expanding into new industries beyond farm products; industries already subject to other regulators that might seek a role in their subjects' futures activity unless barred from doing so.
To succeed, the CFTC's exclusive jurisdiction would have to be set forth explicitly in the new legislation. And the term "commodity" would need to be expanded beyond the existing list of agricultural items to include all manner of assets, tangible and intangible - including financial instruments like securities.
With much help and support, the effort was successful and, for nearly a decade, the CFTC was master of its domain.
Not that there was no pushback. The Securities and Exchange Commission (SEC), in particular, felt aggrieved, ever threatening to sue the Chicago Board of Trade if it listed the first-ever interest-rate futures contract based on a debt security. The CBOT (and the CFTC) stood their ground and the SEC shifted to a new strategy for the repeal of the statute's jurisdictional provision (unsuccessfully at the time).
After I arrived at the CFTC in 1981, when applications by futures markets were seeking OK to list broad stock index contracts like the Dow Jones Industrial Averages and the S&P 500, the SEC expressed profound concern which led to an agreement between the two agencies (often referred to as the Shad-Johnson Accord and later enacted into law) under which the CFTC retained exclusive authority over these products on the condition that they must be settled in cash and not by delivery of the underlying stock bundles (incidentally, settling a long legal debate whether an instrument prohibiting delivery can properly be classified as a "futures contract").
But a cost was paid for the Accord. The CFTC agreed not to process any applications to trade futures contracts on single stocks or customized stock indices. (No such proposals were then pending and, indeed, no serious interest in those products would emerge for roughly 20 more years).
But it eventually happened and, in 2000, Congress enacted new legislation under which the CFTC and the SEC would co-regulate futures on individual equity futures and narrow-based equity indexes. I have no knowledge whether the CFTC agreed to this arrangement or simply lost the battle but this minor erosion of CFTC power would now put to the test.
It is interesting that no existing futures market elected to list these products on its main board. Instead, they formed new entities as trading venues.
Two such entities were formed and began operations within a year or two after the new law took effect. One lasted only a few years while the other continues operations today.
So, what have we learned from this experiment? The surviving exchange, despite best efforts, has not met early expectations. According to Futures Industry Association annual ranking of futures markets by trading volume, it does not appear in the top 40. CFTC reviews show that 90% or more of its reported volume consists of block trades and/or exchanges of futures for product negotiated privately between two parties and simply reported post-execution to the exchange for further processing (e.g., clearing). It also allows parties to design their own stock indexes, often tailored to unique portfolios of stocks not likely to appeal to a broad population of traders.
Why has this occurred? Without taking sides, here is what I am hearing:
1. With stock options and swaps both available and often more liquid, and with the buy side of option reducing potential loss to the premium paid, stock futures struggle to compete.
2. Initial margin requirements for these products are substantially higher than for most other futures contracts, discouraging speculative participation at a minimum,
3. The SEC imposes its transaction fee, an added cost.
4. There is concern that trading a co-regulated product will increase compliance expenses and risks.
5. The exchange does not (and has so stated) offer price discovery (where traders and merchants look for a reliable price indicator). Rather, they check the stock markets instead.
6. Despite the private origination of most trades (bypassing the exchange's matching facility), an exchange fee is payable on each trade.
All or none of this may be true. I do not advocate or adopt any of them. But the exchange, after well over a decade of hard and talented effort, has been pedaling uphill. There must be a reason why. Some of the "causes" mentioned above (like competition from other products) have nothing to do with the 2000 co-regulation decision but the question begs: what if the CFTC had retained exclusive jurisdiction and the pre-existing futures markets had listed these instruments under their own protocols?
Note: Modern Trader will discuss the current state of single stock futures in our next issue.