One of the Commission's principal responsibilities is to assure that futures markets operate competitively, 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 - focus on these objectives.
The market analysis section reviews 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 manipulation and undermine the usefulness and efficiency of a market. To avoid these consequences, the market analysis staff consider whether the terms and conditions of a proposed contract or subsequent rule amendments to a contract conform to commercial practice and provide for adequate deliverable supplies. In the case of cash settlement contracts, staff evaluate 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 review a contract's potential commercial usefulness for hedging and price basing, as well as other public interest considerations.
During FY 1998, the staff completed economic reviews of 27 applications for new futures contracts, 31 applications for new option contracts, and 141rule amendment proposals for existing futures and option contracts. Highlights of the new contracts and rule amendments follow.
Review of Delivery Point Specifications for Corn and Soybean Futures Contracts
During FY 1998, the Division completed its economic analyses of the delivery point specifications for corn and soybean futures contracts. On December 19, 1996, the Commission notified the Chicago Board of Trade (CBT) that the delivery point specifications of its corn and soybean futures contracts no longer met the requirements of 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."
On April 16, 1997, the CBT responded to notification by proposing substantive amendments to exchange rules. The Commission received nearly 700 comments on the proposals in response to their publication in the Federal Register .
Following a review of the Federal Register comments and the staff's analysis, the Commission, on November 7, 1997, issued an Order under section 5a(a)(10) to change and supplement the delivery specification of the CBT corn and soybean futures contracts. Following the Commission's Order, the CBT drafted revisions to the corn and soybean futures contracts, applying for new designations in these contracts. The revised contracts contained delivery specifications different from those in the Commission's Order. After notice of these draft proposed revisions was published in the Federal Register, the CBT on March 20, 1998, submitted proposed new contract terms for corn and soybean futures beginning with contract months in the year 2000.
On May 7, 1998, the Commission granted the applications for contract market designation. The Commission permitted the CBT: (1) to add the southern Illinois River as a delivery location for soybeans and to delete the Toledo, Ohio, switching district as a delivery location for soybeans; (2) to modify the premiums for delivery of soybeans and corn at non-par locations; (3) to modify a required contingency plan to include a conforming of locational adjustments; and (4) to add a minimum net worth eligibility requirement for issuers of shipping certificates of $5 million. In approving the contracts, the Commission found that the proposal met the legally required level of deliverable supplies for the contracts and otherwise met the requirements of the Act. However, the Commission directed the CBT to report annually for five years on the experience with deliveries and expiration performance in the revised contracts and on the extent to which particular locational price differentials may discourage or encourage deliveries to be made from each delivery location.
Agricultural Trade Options
On April 16, 1998, the Commission adopted final interim rules to permit the offer and sale of off-exchange agricultural trade options. Although the Commission considered lifting the ban on agricultural trade options several times over the past 15 years, there have been deep divisions within the agricultural community on this issue. Opponents of lifting the ban have expressed concerns over possible fraudulent activity and have suggested that such contracts might result in confusion in the producer community. Others supported the availability of trade options to the agricultural sector to augment exchange-traded options on futures contracts.
In adopting the final interim rules, the Commission stated its intent to reexamine the rules during and at the conclusion of the three-year pilot program. The interim rules permit only those entities which handle the commodity in normal cash market channels to solicit to offer to buy or sell or to buy or sell such options. Vendors of such options are required to become registered as agricultural trade option merchants, to report to the Commission on their transactions, to provide their customers with disclosure statements, and to safeguard their customers' premiums. The interim rules substantially streamlined requirements contained in the proposed rules, particularly the proposed registration reporting and customer fund segregation requirements. The Commission exempted individuals or entities which meet a substantial financial requirement. The Commission also removed the prohibition on the offer or sale of exchange-traded options on physicals on these commodities.
FY 1998 was the first full year of operation of the Commission's new fast-track review procedures which streamlined the contract market designation process. Of the 58 contracts approved, 38 were submitted by the exchanges for processing under the new procedures. Nineteen were approved under 10-day fast-track provisions, and 19 were approved under 45-day fast-track provisions.
New Futures and Option Contracts
Coal. The Commission approved the New York Mercantile Exchange (NYMEX) Central Appalachian coal futures and option contracts, the first contracts approved for this commodity. These contracts can be used by firms in the coal industry to hedge price risks associated with spot and forward market transactions in the evolving coal cash market. Recent deregulation of the electricity market, of which coal is a major component, has increased price volatility and uncertainty in the coal market for electric utilities, producers, and other commercial participants. The coal spot market has been growing as longer term contracts are being phased out, resulting in a need for an effective hedging and pricing tool.
Middle East Sour Crude Oil. The Commission approved the NYMEX Middle East sour crude oil futures contract which is cash-settled based on published prices for Dubai and Oman sour crude oils. This contract will provide additional pricing and hedging opportunities for participants in the Middle East and Asian sour crude markets.
Livestock, Dairy and Grain Products. Contracts approved this fiscal year include the Chicago Mercantile Exchange (CME) pork composite and physical-delivery frozen pork bellies futures and option contracts and the CME minibasic formula price milk option contract. These contracts provide additional risk-shifting vehicles for livestock and dairy firms, producers, merchants, processors and packers. In addition, the Commission approved a Minneapolis Grain Exchange (MGE) durum wheat option which provides a risk-shifting vehicle for producers and commercial firms in the grain business.
Regional Electricity Contracts. The 12 electricity contracts approved this fiscal year were the NYMEX Cinergy and Entergy electricity futures and options, the CBT ComEd and Tennessee Valley Authority electricity futures and option contracts, and the MGE Twin Cities on-peak and off-peak electricity futures and option contracts. These contracts provide electricity market participants with risk management tools to respond to the evolving electricity cash market in additional market regions of the Eastern U.S. Fuel sources used for generation, weather conditions, transmission costs, and limitations on the available transmission capability all contribute to regional differences in the electricity market. These contracts were designed to meet the special-ized hedging needs of firms in the electricity market created by industry deregulation.
Currencies. The CME Russian ruble futures and option contracts, the first contracts approved for this currency, are designed to facilitate the specialized hedging needs of import/export firms and institutional investors having trade payments and receipts in rubles. In addition, the Commission approved several currency cross-rate futures and option contracts involving the European currency unit and Canadian dollar, pound sterling, Japanese yen, Swiss franc, and Deutsche mark, as well as the CME European currency unit option contract.
U.S. and Foreign Interest Rates. The Commission approved the CME overnight Federal funds rate futures and option contracts and the four U.S. Treasury instrument contracts of the Cantor Fitzgerald Futures Exchange (CFFE), a new futures exchange that conducts trading in an electronic format. The Commission also approved the CME Euro Canada and Japanese govern- ment bond futures and options. These contracts are designed to provide a hedging vehicle for U.S. banks and institutions that invest in U.S., Canadian, or Japanese debt instruments or otherwise have exposure to fluctuations in interest rates.
Contracts Based on U.S. Bankruptcies and Equity Indexes. The Commission approved the CME quarterly bankruptcy index futures and option contracts, which provide creditors with a means of hedging risks associated with the effect of personal bankruptcies on loan portfolios. In addition, the Commission approved the NYFE's application for designation of a New York Stock Exchange small composite futures contract, which provides institutional portfolio managers with an additional means of hedging risks associated with U.S equity portfolios.
Catastrophe Insurance Options. The Commission approved the CBT's nine Property Casualty Service single event catastrophe insurance options, which base each option on a different state or region of the U.S. These contracts are designed to offer primary insurers, underwriters, and reinsurance companies a means of managing the risks associated with potentially poor underwriting results and unanticipated greater dollar values of claims for a particular group of policies involving a single catastrophic event such as a hurricane or earthquake.
During FY 1998, the staff completed the economic reviews of over 100 rule amendment packages for existing futures and option contracts. Significant rule changes approved this year include:
· Major revisions to the MGE durum wheat futures contract regarding the delivery point, delivery procedures, quality standards and contract size, along with a proposal to reactivate trading in this dormant contract.
· Revisions to the Coffee, Sugar and Cocoa Exchange nonfat dry milk futures contract to provide for cash settlement based on the prices compiled by the U.S. Department of Agriculture.
· Major revisions to the trading month listing cycle for the New York Commodities Ex-change's (NYCE) five-year U.S. Treasury note futures contract to reflect a change in the U.S. Treasury auctioning pattern.
· Major revisions to the MGE barley futures contract changing the delivery point from Tulare, California, to Portland, Oregon, along with other amendments related to the delivery procedures.
· Amendments to the CME, NYFE, and MidAmerica Commodities Exchange (MCE) currency contracts to accommodate the European Monetary Union and the introduction of the single European currency - the euro - which will replace the European Currency Unit as well as the currencies of several other countries in the European Monetary Union.
· Revisions to the NYMEX electricity contracts related to the contract size, delivery procedures, and price limit provisions.
· Several amendments submitted by the NYMEX to the light sweet crude oil futures contract regarding deliverable foreign crudes and the associated premiums and discounts for delivery of those crudes.
· Amendments to the NYMEX precious metals futures contracts regarding delivery points and facilities.
· Major revisions to the circuit breaker provisions of all domestic stock index contracts to increase the trigger levels for imposing trading halts. These changes were adopted along with comparable revisions to the circuit breaker provisions of the equity markets in accordance with the President's Working Group recommendations.
· Amendments to the CME currency cross rate contracts to provide for physical delivery rather than cash settlement of the currencies.
The CFTC market surveillance program is designed to protect the price discovery and hedging functions of futures and option markets by preventing price manipulation. Futures prices are disseminated internationally as part of the price discovery process for commodities and financial instruments. They also affect what Americans pay at the grocery store, at the service station, and for numerous other goods and services. Because futures and option prices are susceptible to manipulation and excessive volatility, and because producers and users of these commodities can be harmed by manipulated prices, preventative measures are necessary to ensure that market prices accurately reflect supply and demand conditions.
The goal of the market surveillance program is to maintain free and competitive futures and option markets to enable these markets to perform their essential pricing and risk-shifting functions. Surveillance economists routinely monitor large trader positions, futures and cash price relationships, and fundamental supply and demand conditions to detect any threats of manipulation. The market surveillance staff work closely with the exchanges and other government agencies to deal with any potential market threats that may develop. The staff apprise the Commissioners and senior staff of potential problems and significant developments at weekly surveillance meetings so the Commission is prepared to take prompt regulatory action when warranted.
During the volatile period of FY 1998, surveillance staff closely monitored financial futures and cash markets and kept the Commission advised of ongoing developments. Beginning in the fall of 1997, international equity and foreign exchange markets were buffeted by the Asian financial crisis. Japan's economy continued to stagnate, and many of the emerging Asian economies experienced massive capital outflows that led them to devalue their currencies in relation to the dollar. In this context, U.S. equity markets experienced the largest point decline in history on October 27, 1997, when the Dow Jones Industrial Average fell 554 points. U.S. stock index values resumed their climb after that date, establishing new record highs in June 1998. U.S. Treasury bond yields also achieved record lows as a result of low inflation and capital inflows into safe investments. Domestic and international financial markets were roiled once again in August 1998 when Russia devalued the ruble and defaulted on government debt. Substantial price volatility occurred in most financial futures markets in the fall of 1998.
The Commission intensified surveillance of grain markets all year as a result of historically low stocks in deliverable position. In the soybean market, serious concerns led to increased efforts regarding several soybean futures expirations.
Silver prices rose sharply from $4 to over $7 per ounce between July 1997 and February 1998. A steep decline in Commodity Exchange, Inc., (COMEX) silver stocks was accompanied by increasing tightness and an historic price backwardation (where the prices of contracts which expired in near months exceeded the prices of contracts which expired in later months) in both the COMEX and London silver markets. Higher spot prices in London drew COMEX silver stocks to London vaults, further reducing U.S. supplies. The most significant concern was the demand for silver by the holder of a sizeable position in London. The COMEX expirations and domestic and global prices and developments were closely monitored by the market surveillance staff in cooperation with the exchange and British regulatory authorities. Subsequently, prices fell and spreads loosened as the market was able to provide sufficient supplies.
The price of palladium, a precious metal with important industrial applications, began rising in January 1998, and reached an all-time record high of $419 per ounce on May 18, 1998. Russia, the largest global supplier of the metal, reportedly exported no palladium during the first five months of 1998, creating an international scarcity. Prices for the June future were extremely volatile as industrial demand remained high. The expiration of the June future required intense surveillance as supplies were scarce, stocks in exchange-licensed warehouses reached an historic low, and the largest long trader intended to stand for delivery. This surveillance effort successfully achieved an orderly expiration.
The market research staff conduct research on major policy issues facing the Commission, assess the economic impact of CFTC regulatory changes on the futures markets and other sectors of the economy, participate in the development of Commission rulemakings, provide expert economic support and advice to other Commission divisions, and conduct special market studies and evaluations.
During FY 1998, 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 testified in several cases requiring expert information on the economic functions and uses of futures contracts. 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 development of policies concerning new derivatives instruments. 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 continue to undertake market microstructure analyses in connection with the Commission's review of exchange audit trail efforts and dual trading issues.
During FY 1998, market research staff examined economic issues relating to exchange-proposed amendments to various futures and option contracts and newly proposed futures contracts. Staff conducted research on grain delivery movements in the Midwest to support the Commission's review of the CBT's corn and soybean delivery proposal. In addition, research staff studied the markets for repurchase agreements and forward rate agreements in connection with regulatory issues raised by the development of clearing facilities for swaps on such instruments.
Market research staff also provide educational information to potential futures market participants and regulators. During FY 1998, on the basis of the mandate contained in the Federal Agricultural Improvement and Reform Act of 1996, staff participated in the USDA's current risk management education effort.