Division of Economic Analysis
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 Surveillance, Market Analysis, and Market Research - focus on these objectives. DEA periodically examines the effectiveness of its programs and seeks to institute revisions that reduce the costs of compliance. During FY 1999, DEA proposed or implemented the following reforms.
Commission Guideline No. 1
On June 1, 1999, the Commission published final rules revising its Guideline on Economic and Public Interest Requirements for Contract Market Designation (Guideline No. 1). Guideline No. 1 details the information that an application for contract market designation should include in order to demonstrate that the contract market meets the economic requirements for designation. The revisions to Guideline No. 1 simplify the application for new contract approval and eliminate unnecessary paperwork burdens associated with the designation application itself.
The Commission organized Guideline No. 1 into several specific application forms, making use of a chart format for applications for designation of futures and option contracts to the extent possible. The Commission will now allow the use of third-party-generated materials in support of an application. In addition, the Commission clarified the review standards for several of the designation requirements. The Commission added a new appendix to Part 5 specifying the information that a foreign board of trade should submit to the Commission when seeking no-action relief to offer and to sell to persons located in the United States a futures contract or a futures contract on a foreign securities index traded on that foreign board of trade.
Approval Procedures for New Futures Contracts
In addition to the changes to Guideline No. 1, the Commission proposed a far-reaching and fundamental change to its approval procedures for new futures contracts offered on U.S. exchanges. This change responds to U.S. futures exchanges' concerns that their ability to list new contracts without delay is important to their continued competitiveness, particularly with foreign exchanges. Specifically, the Commission proposed a two-year pilot program to permit the listing of certain futures and option contracts on U.S. exchanges prior to CFTC review and approval. The Commission proposed the rule under the broad exemptive authority provided in section 4(c) of the Commodity Exchange Act. As proposed, U.S. exchanges would retain the choice to proceed under the current procedures for approval of new futures and option contracts, including fast-track review procedures. The proposed rule is pending further Commission consideration.
Contract Market Rule Review and Approval Procedures
On July 15, 1999, the Commission published proposed rules that would further streamline its procedures for reviewing exchange rules. The CFTC proposed to allow additional categories of exchange rule amendments to be approved automatically, upon adoption by the exchange, and to permit such amendments to be submitted to the Commission in a single, weekly, summary filing rather than in individual submissions. For certain other rules, the review time would be reduced to three days. The proposed rules also reorganize, in a clearer and more accessible format, the Commission's rules on expedited approval procedures for proposed rule amendments to contract terms and conditions.
Speculative Position Limit Rules
On May 5, 1999, the Commission published final rules increasing speculative position limits for various domestic agricultural products and streamlined certain associated rules. These rules limit the size of positions that speculators may hold in the U.S. futures markets and have been a key regulatory feature for over 60 years.
The revisions increase Commission speculative position limits only in the deferred trading months; the number of positions speculators are permitted to hold in the spot month remains unchanged. In addition, the revised rules simplify and reorganize various associated policies, exemptions, and rules by incorporating them in a single section of the Commission's rulebook. The rules also include a new provision on the aggregation of accounts by exempt commodity pools.
FY 1999 was the second full year of operation of the Commission's new fast-track review procedures, which streamlined the contract market designation process. Of the 73 contracts approved during FY 1999, 30 were submitted by the exchanges for processing under the new procedures. Twenty-one were approved under 10-day fast-track provisions and nine were approved under 45-day fast-track provisions.
Agricultural Trade Options
On August 31, 1999, the Commission published proposed changes to its rules on agricultural trade options. Agricultural trade options are off-exchange options on specified domestic agricultural commodities offered to producers, processors, or merchandisers in connection with their business. The Commission adopted the current rules permitting the offer and sale of agricultural trade options on April 16, 1998. These rules, among other things, require merchants offering these options to register with the Commission, require risk disclosure to customers, and place certain restrictions on the types of options permitted.
In February 1999, the Commission released two additional educational pamphlets on agricultural trade options entitled "How to Become an Agricultural Trade Option Merchant" and "Agricultural Trade Options - Information for Lenders and Extension Agents," prepared by division staff. These brochures are intended to complement a previously released Commission pamphlet entitled "Agricultural Trade Options - What Agricultural Producers Need to Know." These pamphlets provide an overview of agricultural trade options and the rules for trading them.
The Commission has received a number of comments from groups within the agricultural sector supporting reconsideration of various aspects of the rules as a means of increasing interest in the possible offer and sale of these instruments. After reviewing carefully its current rules, the Commission proposed several changes to permit greater flexibility in the types of options that can be offered, to streamline the reporting and disclosure requirements, and to bring the rules more into line with practices in the cash markets.
One notable change would permit cash settlement of agricultural trade options. The proposal would also streamline the registration requirements for agricultural trade option merchants and their sales agents in several respects, including removing the training requirement for sales agents. Proposed changes to the rules would revise the required disclosure statements and reduce overall reporting and recordkeeping requirements.
The Market Analysis staff 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 considers 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 members 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 reviews a contract's potential commercial usefulness for hedging and price basing, as well as other public interest considerations.
New Futures and Option Contracts
During FY 1999, the staff completed economic reviews of 38 applications for new futures contracts, 35 applications for new option contracts, and 135 rule amendment proposals for existing futures and option contracts. Highlights of the new contracts and rule amendments follow.
· Weather-Related Instruments. The Commission approved the Chicago Mercantile Exchange (CME) degree days index futures and option contracts, the first contracts based on weather data. These contracts are based on indexes of accumulated temperature variations, i.e., heating and cooling degree days, over a one-month period for 10 specified cities in the United States - Atlanta, Georgia; Chicago, Illinois; Cincinnati, Ohio; Dallas, Texas; Des Moines, Iowa; Las Vegas, Nevada; New York, New York; Philadelphia, Pennsylvania; Portland, Oregon; and Tucson, Arizona. These innovative contracts are designed to provide a risk management tool to help businesses protect their revenue during times of depressed demand or excessive costs due to unexpected or unfavorable weather conditions.
· U.S. and Foreign Interest Rates. The Commission approved several contracts based on U.S. and foreign interest rates, including the flexible coupon U.S. Treasury bond and Treasury note futures contracts of the Cantor Financial Futures Exchange (CFFE) and the CME three-month Eurodollar FRA (forward rate agreement) futures and option contracts. Contracts based on foreign interest rates approved this fiscal year were the CME Euroyen LIBOR (London Interbank Offered Rate) futures and option contracts. These contracts are designed to provide a hedging vehicle for U.S. banks and institutions that invest in U.S. or Japanese debt instruments or otherwise have exposure to fluctuations in interest rates.
· U.S. Equity Indexes. The Commission approved the CME REIT (real estate investment trust) index and Nasdaq 100 index futures and option contracts; the Kansas City Board of Trade Internet index (ISDEX) futures and option contracts; and the New York Futures Exchange Russell 1,000 large index future and Russell 1,000 index option contracts. These contracts provide institutional portfolio managers with additional means of hedging risks associated with U.S. equity portfolios.
· Currency and Currency Cross Rates. The Commission approved the MidAmerica Commodity Exchange euro future; the New York Cotton Exchange (NYCE) small euro future; the NYCE Australian dollar/Japanese yen cross rate, Australian dollar/New Zealand dollar cross rate, Swiss franc/Japanese yen cross rate, euro/Canadian dollar cross rate and euro/Norwegian krone cross rate futures and option contracts; and the CME E-Mini Japanese yen and E-Mini euro futures and option contracts. These contracts 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 face significant exposure in these currencies that can be offset with appropriately designed futures and option contracts.
· Dairy and Livestock Products. Several livestock and dairy contracts were approved by the Commission this fiscal year, including the Coffee, Sugar, and Cocoa Exchange large basic formula price (BFP) milk futures and option contracts; the CME cash-settled butter, dry whey, nonfat dry milk, and stocker cattle futures and option contracts; and the CME BFP midsize milk option contract. These contracts will provide additional risk-shifting vehicles for livestock and dairy firms, producers, merchants, processors, and packers.
· Regional Electricity Contracts. Contracts approved by the Commission this fiscal year include the New York Mercantile Exchange (NYMEX) and Chicago Board of Trade (CBOT) PJM (Pennsylvania-New Jersey-Maryland) electricity futures and option contracts. These contracts provide electricity market participants risk management tools to respond to the evolving electricity cash market in additional market regions of the eastern United States. Regional differences exist in the supply and demand for electricity, which result in pricing differences in the cash market. This is due to regional variations in fuel sources used for generation, weather conditions, and transmission costs, and, most importantly, limitations on the available transmission capability between regions. These contracts are designed to meet the special-ized hedging needs of firms in the electricity industry as a result of the ongoing deregulation of that industry.
· Aluminum. The Commission approved the Commodity Exchange, Inc., aluminum contracts, which can be used by firms in the aluminum industry to hedge price risks associated with spot and forward market transactions in the U.S. aluminum cash market.
During FY 1999, the staff completed economic reviews of 135 rule amendment packages for existing futures and option contracts. Sixty-three of the rule changes were submitted for review and approval under fast-track procedures. Of the 135 economic reviews processed this fiscal year, 90% were completed within 45 days (the fast-track review period), 79% were completed within 30 days, and 23% were completed within 10 days of submission.
Review of Delivery Specifications for Wheat Futures Contract. During FY 1999, DEA reviewed and the Commission approved amendments to the delivery specifications of the CBOT's wheat futures contract that were submitted by the CBOT in response to a request by the Commission. The Commission's request was based on concerns about the heightened potential for price manipulation due to the limited availability of deliverable supplies for the futures contract. The amendments reduce the level of spot-month speculative position limits applicable to the last five trading days of the March and May contract months and change the locational price differentials for deliveries at Toledo and St. Louis to make them more reflective of cash-market pricing relationships among the contract's delivery points.
In approving the amendments, the Commission advised the CBOT of its continuing concerns about the adequacy of deliverable supply of wheat during the months of March and May and recent developments concerning increased concentration of ownership or control of futures delivery facilities on the wheat futures contract. The CBOT was, therefore, directed to report annually to the Commission, for five years after contract expirations begin under the revised wheat contract terms, on the experience with deliveries and expiration performance and on the extent to which the contract's revised delivery terms may discourage or encourage deliveries to be made. In addition, the Commission directed the CBOT to monitor carefully the 1999 wheat, corn, and soybean expirations to assess the degree of increased concentration in the ownership and control of approved delivery facilities at the contract's delivery points, to determine whether it impacts adversely price convergence on the contracts, and to report its findings to the Commission in January 2000.
Other significant rule changes approved this year include:
· Changes to the delivery standards for the CBOT medium-term U.S. Treasury note futures contract to reflect a change in the U.S. Treasury pattern of auctioning five-year notes.
· Amendments to the CME Russian ruble futures contract relating to the cash-settlement calculation procedures, along with a proposal to reactivate trading in that contract.
· Changes to the CME random lengths lumber futures contract regarding the contract size and the quality standards relating to the specified deliverable species.
· Revisions to the CBOT oat futures contract to eliminate the 7.5-cent per bushel locational price discount for deliveries at Minneapolis/St. Paul so that deliveries would be at par with Chicago.
· Changes to the CBOT soybean oil futures contract to revise automatic annual adjustments to locational price differentials by raising to 20 cents from 10 cents per cwt the maximum allowable change per territory; provide that warehouse operators not on Class I railroads pay the switching/freight costs to the nearest such railroad; and limit each regular facility's delivery capacity to 30 times its daily load-out rate.
· A proposal to reactivate trading in the NYCE's dormant frozen concentrated orange juice #2 futures contract and make substantive modifications to the contract's terms. NYCE would change the quality standards by: adding a Brazil and Florida origin requirement; revising the brix, score, flavor, and defects standards; and adopting procedures for trading based on a price differential relative to the existing frozen concentrated orange juice contract up to the delivery month.
· 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.
· Revisions to the NYMEX's Palo Verde and COB (California-Oregon-Border) electricity contracts to halve the contract size and the rate of delivery, as well as changes to the monthly delivery unit amounts.
· Changes to the CBOT U.S. Treasury instrument futures contracts regarding the specified coupon for the notional bond upon which the contracts are priced.
· Amendments to the circuit breaker provisions of certain domestic stock index contracts to add another trigger level for imposing trading halts.
· Changes to the cash-settlement calculation procedures for the CME cheddar cheese, stocker cattle, and feeder cattle futures contracts to reflect changes to the manner in which the U.S. Department of Agriculture calculates the component values of those prices.
The Market Surveillance program is designed to maintain free and competitive futures and option markets by protecting the price discovery and risk transfer functions of those markets. Because attempted manipulation and other abusive practices could undermine the capacity of these markets to perform their economic functions, the Market Surveillance program takes preventative measures to ensure that market prices accurately reflect fundamental supply and demand conditions. Some of these measures include the routine daily monitoring of large trader positions, futures and cash prices, price relationships, and supply and demand factors in order to detect any threats of price manipulation.
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 is prepared to take prompt regulatory action when warranted.
During FY 1999, Market Surveillance staff monitored closely the financial futures and cash markets as the domestic equity indexes continued to rise at an extraordinary pace and experienced periods of considerable price volatility. Early in FY 1999, yields-to-maturity on U.S. Treasury instruments reached record lows, the yield curve flattened, and the U.S. dollar continued to appreciate. This rapid escalation of stock index values and volatility was accompanied by historically high price/earnings ratios and low dividend yields. The primary impetus behind this upsurge in equity values was a combination of relatively moderate economic growth, low inflation and interest rates, subdued wage pressures, an appreciating U.S. dollar, and the expectation of improving labor productivity and corporate earnings. With returns on money market and credit instruments at comparatively low levels, capital flows poured into the equity sector, particularly into technology stocks. Financial turmoil in Russia and Brazil, including the default on Russian debt obligations, contributed significantly to the volatility experienced in global financial markets during this period. Further losses were caused by a mass liquidation and subsequent evaporation of liquidity in global financial markets following the recapitalization of Long Term Capital Management LP. Later in FY 1999, the U.S. dollar weakened significantly relative to the Japanese yen and interest rates rose on speculation of higher inflation and a tightening of monetary policy by the Federal Reserve Board, an increasing trade deficit, and prospects for a global economic recovery, although equity prices remained at high levels. Staff conducted heightened surveillance and prepared special analyses of these events and circuit breaker mechanisms. Staff also shared information with other financial regulators.
Market Surveillance staff continued to support the Commission's investigation of possible manipulation of the copper market in relation to the activities of Sumitomo Corporation. On May 20, 1999, the Commission filed a complaint charging Global Minerals and Metals Corporation (Global) and two of its officers with manipulating and cornering the copper market. The complaint also named affiliates of Merrill Lynch Pierce Fenner and Smith with aiding and abetting Global in the copper manipulation. In June 1999, the Commission issued an order accepting an offer of settlement from Merrill (B&D) and Merrill International and dismissing the proceedings as to Merrill Lynch & Co., Inc.
Crude oil and petroleum product prices fell sharply to 12-year lows in the fall of 1998. Rising global oil supplies, particularly large oil stocks and high levels of production, outpaced international consumption in the wake of reduced Asian and global demand. NYMEX crude oil futures reached a low of $10.72 per barrel, down about forty percent from the prior year. Later in FY 1999, prices increased significantly on Organization of Petroleum Exporting Countries (OPEC) supply restrictions and prospects for a global economic recovery. Surveillance staff monitored the expiring energy futures expirations during this period for indications of price manipulation.
Market Surveillance staff intensified monitoring of live cattle futures expirations, several of which were characterized by a concentrated holding of long futures positions, a wide premium of the futures price over the cash price of deliverable cattle at the beginning of the delivery period, and subsequent heavy futures deliveries. Staff made numerous contacts with large traders in these futures contracts and with exchange surveillance staff. The basis narrowed to normal levels as the last trading date approached and as large traders liquidated their positions.
The Market Surveillance staff monitored closely the March 1999 cotton futures expiration. At the start of the notice period, the settlement price of the March future rose sharply and the spread between the March 1999 and May 1999 futures went from a discount to a premium. A major cotton merchant had a large long position and was taking deliveries to compensate for a severe shortage of good quality cotton from certain growing regions. The Market Surveillance staffs of both the Commission and the NYCE monitored this future closely and were in regular communication with the long trader and other market participants. The strong price of the March future and the tightening of the March-May spread encouraged traders with short positions to make an exceptionally large number of deliveries. The long trader stopped notices, but also transacted exchanges of futures contracts for physicals (EFPs) and sold or rolled over a significant portion of its position. The March 1999 cotton future expired in an orderly manner.
Large Trader Reporting
Completion of the integrated surveillance system, including the transition from mainframe to client-server technology, is scheduled for FY 2000. The Commission's Market Surveillance program relies heavily on an extensive automated large trader reporting system that allows economists to analyze the futures positions of all large traders on a daily basis. The new system incorporates the daily option large trader data that is necessary for effective surveillance. Most hardware, and much of the software, necessary for collection of this additional data is in place and staff have been collecting daily option large trader data using this system since October 1997. Migration from the mainframe to client-server will occur prior to January 2000. At that time, core programs for Market Surveillance will be in place. Additional programming resources will be required to add capabilities present in the mainframe system.
The new system has allowed the Commission to build software to facilitate electronic reporting by firms that formerly filed manual reports. Additionally, the Commission has relieved a burden on the exchanges by no longer requiring them to file option large trader data.
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.
During FY 1999, the Market 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.
The Market Research staff continued to provide economic input into the analysis of commodity exchange and Commission regulatory initiatives. Market Research staff participated actively in the development of policies concerning new derivatives instruments and trading mechanisms in futures markets. Staff also continued to undertake market microstructure analyses in connection with the Commission's review of exchange audit trail efforts and dual trading issues. Recently, staff began examining the market impact of the existing and alternative execution procedures such as exchanges for physicals and block trading. Market Research staff also applied the concepts of behavioral finance to study floor traders on futures exchanges.
During FY 1999, Market Research staff examined economic issues relating to exchange-proposed amendments to existing futures and option contracts and to applications for new futures contracts. Staff conducted research on delivery movement in the Midwest to support the Commission's review of the CBOT's wheat delivery proposal. The Market Research staff updated a 1994 study of the global competitiveness of U.S. futures markets. Staff members continue to conduct research on alternative derivative risk measurements and risk-based capital requirement procedures.