Division of Economic Analysis
One of the Commission's principal responsibilities is to assure that futures markets operate competitively, are free of manipulation or congestion and serve the risk-shifting and price-discovery needs of the U.S. and world economies. Division of Economic Analysis (DEA) programs -- market analysis, market surveillance, and market research -- are designed to accomplish these objectives.
The staff of the market analysis section review applications to trade futures or option contracts and all subsequent rule changes on the terms and conditions of contracts that have economic significance. Improperly designed contracts can increase the chance of cash, futures, or option market disruptions and undermine the usefulness and efficiency of a market. To avoid these consequences, the market analysis staff considers whether the terms and conditions of a proposed contract or subsequent rule amendments to the contract conform to commercial practice and provide for adequate deliverable supplies. In the case of cash settlement contracts, the staff evaluates the cash settlement procedure to assure that it will be based on a reliable price series reflecting the underlying cash market. The market analysis staff considers a contract's potential commercial usefulness for hedging and price basing and other public interest considerations.
During FY 1997, the staff completed economic reviews of 24 applications for new futures contracts and 27 applications for new option contracts. The staff also completed reviews of 118 rule amendment packages for existing futures and option contracts. The total of 51 new contracts approved in FY 1997 was the second highest total for a single fiscal year. In addition, market analysis staff, along with staff from the surveillance and research sections, prepared analyses relating to the Commission's consideration of the adequacy of the delivery specifications and proposed delivery specifications for CBT's corn and soybean futures contracts.
During the fiscal year, the staff implemented the Commission's new fast-track procedures for processing contract market designation applications and exchange rule changes. These procedures further streamline the Commission's review procedures. Under these procedures, the Commission may approve certain cash-settled and nonagricultural contracts in ten days following receipt and other contracts in 45 days. Implementation of the fast-track procedures along with other changes to the Commission's internal review procedures have resulted in a reduction in the average period during which new contracts and exchange rule changes are pending with the Commission.
New Futures and Option Contracts
- Currency Contracts. During FY 1997, the Commission approved currency futures and options based on the Indonesia rupiah, Malaysian ringgit, Singapore dollar, Thai baht, New Zealand dollar and South African rand on the NYCE, and contracts based on the New Zealand dollar and South African rand on the CME. These contracts are the first futures and option contracts approved for these currencies and are designed to facilitate the specialized hedging needs of import/export firms and institutional investors having trade payments and receipts in these currencies. In the normal course of conducting international trade, such firms may face significant risk exposure due to currency fluctuations. In addition, the Commission approved several other currency futures and option contracts, including the NYCE Australian dollar futures and option contracts and its pound sterling/Japanese yen, pound sterling/Swiss franc and Deutsche mark/Spanish peseta cross rate futures and option contracts.
- Inflation-Indexed Debt Instruments. The Commission approved the CBOT inflation-indexed U.S. Treasury bond, long-term Treasury note and medium-term Treasury note futures and option contracts, the first contracts approved for inflation-indexed debt securities. The CBOT designed these contracts to meet the hedging needs of institutions exposed to risk arising from holding the inflation-indexed instruments recently issued by the Treasury. The contracts reflect the real, rather than the nominal, rate of return for instruments having long-, medium-, and short-term debt maturities.
- Contracts Traded Under a Link Arrangement Between a U.S. and Foreign Exchange. The CBOT proposed, and the Commission approved, trading Italian government bond futures and option and the CBOT U.K. gilt option via a link with the LIFFE. These linked contracts allow U.S. firms and individuals readily to establish positions in the LIFFE contracts during U.S. business hours.
- Foreign Interest Rates. The CME proposed, and the Commission approved, a 28-day Mexican interbank interest rate future and option and a 90-day Mexican Treasury bill future and option. The CME designed these contracts as hedging vehicles for Mexican and U.S. banks and institutions that invest in Mexican debt instruments or otherwise have exposure to short-term Mexican interest rates. U.S. firms' exposure to Mexican interest rate movements may grow as trade between the U.S. and Mexico increases, especially following the implementation of the North American Free Trade Agreement.
- Domestic and Foreign Stock Indexes. Futures and option contracts based on domestic stock indexes approved by the Commission this fiscal year include the CME E-mini S&P 500 and the CBOT Dow Jones Industrial Average index futures and option contracts. The Commission also approved contracts based on a foreign index -- the CME Dow Jones Taiwan stock index futures and option contracts. These contracts provide institutional portfolio managers with additional means of hedging risks associated with equity portfolios containing U.S. and Taiwan stocks.
- Livestock and Dairy Products The Commission approved the CME boneless beef futures contract and the boneless beef and boneless beef trimmings option contracts. In addition, the Commission approved the CSCE basic formula price milk futures and option contracts. These contracts provide additional risk-shifting vehicles for livestock and dairy firms, producers, resellers, and grocery store chains.
During FY 1997 the staff completed the economic reviews of 110 rule amendment packages for existing futures contracts and eight rule amendment packages for existing option contracts. Significant rule changes approved this year include:
- Proposals to modify the circuit breaker provisions of all domestic stock index futures and option contracts so that the price limit and trading halt provisions of those contracts remain coordinated with those of the equity markets, consistent with the recommendations for circuit breakers of the President's Working Group on Financial Markets.
- Major revisions to the CME U.S. Treasury bill futures contract to provide for cash settlement, based on the U.S. Treasury auction, in lieu of physical delivery.
- Major revisions to the CME pork bellies futures contract to provide for cash settlement, based on the prices compiled by the USDA, in lieu of physical delivery.
- Major revisions to the CME Brady bond futures contracts to provide for physical delivery of the underlying bonds rather than cash settlement as originally specified.
- Major revisions to the CME boneless beef trimmings futures contract regarding the delivery points, quality standards, contract size, and other terms and conditions, as well as a proposal to reactivate trading in that dormant contract.
- Amendments to the CME live cattle futures contract with respect to the quality standards and price differentials, the weight ranges of deliverable cattle, speculative limits and, other revisions.
- Revisions to the delivery procedures for the CBOT U.K. gilt and German government bond contracts to accommodate trading of those contracts through the CBOT's link with the LIFFE.
- Changes to the MGE shrimp futures contracts regarding delivery points, quality standards, and price differentials for nonpar delivery.
- Revisions to the NYMEX New York Harbor unleaded gasoline futures contract to revise the product quality standards regarding the delivery of reformulated gasoline in connection with the implementation of rules to meet Environmental Protection Agency requirements.
- Amendments submitted by the NYMEX to the crude oil futures contract regarding deliverable foreign crudes and the associated premiums and discounts for delivery of those crudes.
Review of Delivery Point Specifications for Corn and Soybean Futures Contracts
During FY 1997, the staff of the Division conducted economic analyses of the delivery point specifications for corn and soybean futures contracts. On December 19, 1996, the Commission notified the CBOT that the delivery point specifications of its corn and soybean futures contracts no longer meet the requirements under section 5a(a)(10) of the Commodity Exchange Act. Section 5a(a)(10) requires that exchanges permit the delivery of commodities underlying futures ''. . . at such point or points and at such . . . locational price differentials as will tend to prevent or diminish price manipulation, market congestion, or the abnormal movement of such commodity in interstate commerce.'' The Commission notified the CBOT that it had until March 4, 1997, (75 days) to adopt and submit contract amendments to correct the deficiency.
On April 16, 1997, CBOT submitted a response to the section 5a(a)(10) notification by proposing substantive amendments to exchange rules. The proposals would eliminate Toledo and St. Louis as delivery points for the futures contracts, provide for delivery at par at Illinois River barge-loading locations situated between Pekin, Illinois, and Chicago, and replace warehouse receipts with shipping certificates as the contracts' delivery instrument. The Commission received nearly 700 comments on the proposals in response to a request for public comment published in the Federal Register .
Following a review of the Federal Register comments and the staff's analysis, the CFTC, on September 15, 1997, issued a proposed order to the CBOT to change and supplement the proposed rules submitted in response to the section 5a(a)(10) notice. The proposed order would: retain Toledo and St. Louis as delivery points for the soybean futures contract; establish locational price differentials for all delivery points which reflect cash market relationships for the corn and soybean futures contracts; modify the CBT's proposed contingency plan concerning delivery during periods of river traffic obstruction and eliminate a proposed minimum $40 million net worth eligibility requirement for issuers of corn and soybean shipping certificates. The Commission scheduled a public meeting for October 15, 1997, to allow the CBOT formally to respond to the Commission's proposed order.
The Commission conducts a market surveillance program in order to maintain free and competitive futures and option markets. The presence of manipulation and other abusive practices could undermine the capacity of these markets to perform the economic functions of price discovery and risk management. The market surveillance program protects these functions by monitoring daily large positions, futures and cash price relationships and fundamental supply and demand conditions.
The market surveillance staff works closely with the exchanges and other government agencies to deal with any potential market threats that may develop. The staff apprises the Commissioners and senior CFTC staff of potential problems and significant market developments at weekly surveillance briefings so that the Commission may take prompt regulatory action when warranted.
Deliverable stocks on CBOT grain contracts were very low throughout the 1996/97 crop year in the wake of the closure of all but two warehouses in Chicago and tight supplies nationally. Strong feed and processor demand in the eastern U.S. also kept Toledo stocks low. Soybean futures expiring at the end of the crop year experienced historically large price premiums relative to the new crop futures.
Surveillance staff also provided extensive support to the Commission in its action to require the CBOT to revise its delivery specifications for its corn and soybean futures contracts and to evaluate and consider changes to its wheat contract. After the exchange submitted proposed changes to its corn and soybean contracts, surveillance staff helped analyze the proposal, particularly with respect to the impact on deliverable supply.
In the wake of the June 1996 Sumitomo Corporation scandal, the copper market was extremely volatile both in the U.S. and abroad. The long-term price backwardation (with the price of near months exceeding the price of later months) on both the LME and the Comex continued. The market surveillance staff closely monitored every Comex copper expiration, in conjunction with the exchange, as open interest remained high until late in the spot month. U.S. industrial demand for copper was strong, Comex stocks were low, and the movement of copper from Comex warehouses to an LME warehouse in California exacerbated the tightness.
Coffee prices soared to 20-year highs in 1997 due to extremely low U.S. and international inventories and widespread crop reduction. After starting 1997 at about $1.20 per pound, the nearby coffee futures price peaked at $3.18 per pound on May 29. Very low stocks of exchange-certificated coffee, large price increases and extraordinarily high premiums for nearby coffee over coffee for later delivery in both cash and futures markets reflected the extreme tightness of supply. Surveillance staff carefully monitored each coffee futures expiration.
The price of palladium, a precious metal with important industrial applications, became extremely volatile and rose sharply during May and June. Russia, the world's major producer, did not ship any palladium during the first half of 1997, leading to an international scarcity of supply and sharply higher prices.
During the expiration months in these and other commodities, the Commission and exchange staff frequently contacted large traders to verify and assess traders' capacity to make or take delivery of the commodity and to issue warnings, when appropriate, concerning the orderly liquidation of their positions. This surveillance effort successfully achieved an orderly expiration of these futures contracts.
Financial Futures Markets
Surveillance staff devoted a substantial amount of time and effort to monitoring events, large trader positions, and margin levels in financial cash and futures markets during FY 1997. Financial markets experienced several periods of episodic volatility as stock index levels incurred several large increases and declines and attained successive record highs. Interest rates, particularly long-term rates, fell to 18-month lows. The primary impetus was a combination of relatively moderate economic growth, low inflation, subdued wage pressures, an appreciating dollar, the expectation of improving corporate earnings, profit margins, rates of return on capital, and an unchanged Federal Reserve monetary policy. Surveillance staff monitored these markets and shared information with other financial regulators.
The surveillance staff published final rules amending large trader reporting requirements. The new rules require brokerage firms to report daily option large trader positions to the Commission along with daily futures positions. Prior to this rule, the exchanges were responsible for providing option large trader data to the Commission. Once implemented, exchanges will no longer be required to report option large trader positions. Exchanges may receive both futures and option large trader data for their markets from the Commission rather than from member firms. This alternative could reduce costs both for the exchanges and the brokerage firms.
The market research staff conducts research on major policy issues facing the Commission, assesses the economic impact of CFTC regulatory changes on the futures markets and other sectors of the economy, participates in the development of Commission rulemakings, provides expert economic support and advice to other Commission divisions, and conducts special market studies and evaluations.
Division staff supported the Commission's evaluation of whether the ban on agricultural trade options should be lifted. The staff prepared a detailed study of policy alternatives relating to this issue and prepared a Federal Register notice to solicit public comment. Division staff also helped the Commission conduct public meetings to seek further public comment on whether to lift the ban and, if so, under what conditions.
During FY 1997, the research staff provided analytic support to several Commission enforcement efforts involving the alleged sale of illegal off-exchange futures and options. In addition, the staff provided critical analysis for use in a Commission investigation of possible manipulation. Market research staff provided economic analysis and input relating to the use of communications media for fraud and other violations of the Commodity Exchange Act.
The market research staff continued to provide economic input into the analysis of commodity exchange and Commission regulatory initiatives and the formulation of Commission regulatory policy. Market research staff actively participated in the economic analysis and formulation of policies concerning newly developed derivative instruments to the extent that such instruments raised questions of regulatory jurisdiction. In this regard, staff undertook analyses of swaps, OTC options and instruments that combine the characteristics of securities and derivatives (i.e., hybrid instruments). The staff continues to undertake market microstructure analyses in connection with the Commission's review of exchange audit trail efforts and dual trading issues.
During FY 1997, market research staff examined economic issues relating to exchange-proposed amendments to various futures and option contracts and newly proposed futures contracts. In this connection, market research staff conducted research on the operation of the National Cheese Exchange and on grain delivery movements in the Midwest.
Market research staff educated potential futures market participants and regulators during FY 1997. In addition, staff, on the basis of the mandate contained in the Federal Agricultural Improvement and Reform Act of 1996, participated in the USDA's current risk management education effort.