Status Report on Futures Issues
National Cattlemen's Association 1996 Annual Meeting, Marketing Committee, January 29, 1996
Exchange Audit Trails
The Futures Trading Practices Act of 1992 (FTPA) imposed new and stricter audit trail standards for futures exchanges. The exchanges were required, by October 1995, to capture audit trail times that are unalterable, continuous, independent, and automatic or similarly reliable -- and that would sequence all trades in a precise manner.
At the time the FTPA was being drafted, it was assumed that these standards would be met through new technology, such as the hand-held electronic trading card then being developed by the Chicago Board of Trade and the Chicago Mercantile Exchange. That system was known as AUDIT, short for "automated data input terminal." However, no one could be sure that this new technology would be achievable within the statutory time frame, so the law left the exchanges considerable "wiggle room." Thus, the audit trail enhancements must be implemented except to the extent the Commission determines that circumstances beyond the control of the exchange prevent compliance despite good faith efforts to achieve them.
Unfortunately, although the CBOT and the CME have devoted five years and spent some $20 million dollars on developing AUDIT, the system has encountered many developmental problems and has not lived up to expectations. Thus when the October 1995 deadline arrived, the exchanges had to rely on alternative methods to enhance their audit trail systems to meet the good faith standard.
Recently, the two Chicago exchanges disclosed their future audit trail plans. On January 22, the CBOT announced its intention to drop AUDIT as a means for executing customer trades. Instead, they will build a smaller electronic order entry system for their new trading floor. They will, however, continue development efforts on the AUDIT system for floor traders' personal trades (CTI Type 1 trades). They plan to use the existing AUDIT hardware for order transmission, rather than order execution, a change that will require new software. CBOT also will allow other, independently-developed hand-held electronic systems to be tested on the exchange floor.
The Chicago Mercantile Exchange has a four-pronged plan: (1) continue working on AUDIT for CTI Type 1 trades; (2) work with the Chicago Board Options Exchange on a pilot program using CBOE's hand-held order entry system; (3) explore off-the-shelf hand-held technology; and (4) consider allowing other hand-held systems to be used on the exchange floor.
Even though efforts to develop a hand-held electronic trading card have hit a snag, at least for the time being, it is important to note that the exchanges have made many significant improvements under the FTPA's good faith standard. The Commission tested the performance of the exchange systems and made various recommendations for additional improvements to address specific weaknesses of each system. Many of these recommendations were aimed at capturing additional timing and sequencing data, since data-intensive audit trail systems generally perform better.
The CBOT and the CME adopted most, but not all, of the Commission's recommendations. The Commission plans to conduct a further test some time in February to determine whether the enhancements the two Chicago exchanges did make are sufficient to demonstrate good faith compliance with the FTPA standards. Should the exchanges fail the follow-up audit trail test, the Commission has a wide range of potential responses open to it, including: (1) further jawboning; (2) requiring additional changes to exchange audit trail systems; (3) declining to approve new contract applications; (4) imposing dual trading restrictions; or even (5) bringing an enforcement action.
Agricultural Trade Options
After Congress lifted the statutory ban on agricultural commodity options in 1982, the Commission acted quickly to permit exchange-traded agricultural options. However, it left in place the pre-existing ban on off-exchange agricultural "trade options." In recent years, proposed changes in federal farm programs that would eliminate the government safety net -- combined with increasing global competition and other factors -- have created a need for more sophisticated risk management tools. However, as elevators, processors and producers seek to develop new types of forward contracts to meet today's competitive pressures, they find themselves pushing the edge of the envelope regarding the CFTC ban on off-exchange agricultural trade options. If an innovative contract should cross the line, to become, arguably, an illegal ag trade option, a party who stands to lose money on the deal could seize upon that legal uncertainty as an excuse for walking away from their obligations under the contract. The potential for market disruption is obvious.
Because I believe the Commission should not prohibit the private sector from reacting to market forces, I have worked for over a year to get the Commission to revisit the agricultural trade options issue. Those efforts finally led to a Roundtable Discussion on the Prohibition of Agricultural Trade Options, held in Washington on December 19, 1995. The Roundtable brought together a diverse group of commodity option and agricultural experts, regulators, academics, and market users to discuss all aspects of the ag trade option prohibition, including the potential costs versus benefits of lifting the prohibition. NCA was very ably represented at the Roundtable by Jon Ferguson. After thoroughly exploring the issues, the Roundtable participants expressed support for lifting the ban by a two-to- one margin.
The next step in the Commission's consideration of this issue will be for the staff of the Division of Economic Analysis to draft a release regarding lifting the ag trade options ban. After the Commission reviews, makes any appropriate changes, and approves this release, it would be published in the Federal Register for comment. The record developed from the release, along with other relevant information, such as the Roundtable proceedings, could then form the basis for a proposed rulemaking action to lift the agricultural trade options prohibition.
1993-95 Live Cattle Nearby Spreads
A question has been raised whether there has been a consistent weakening of the spot live cattle futures price relative to the next-deferred futures price as traders reduce their futures positions to the spot-month speculative position limit by the close of business on the first notice day (FND).
The enclosed graphs show the strengthening or weakening of the nearby spread for live cattle futures (the spot futures price minus the next-deferred futures price) for each expiration from February 1993 through October 1995. Each line represents a nearby spread (for example, the Oct '93 line represents the October '93-December '93 spread) for the 10 business days prior to FND. An upward move indicates that the spot price gained (i.e., strengthened) relative to the next deferred futures price. Conversely, a downward move indicates that the spot price declined (i.e., weakened) relative to the next deferred. Each graph shows the relative strength and weakness of the nearby spreads for a particular calendar year.
For 1993, four of the six nearby spreads had weakened by FND (i.e., the spot futures price had a net decline relative to the next-deferred futures price by the FND). The February 1993 nearby spread showed significant strength by the end of the 10- day period, i.e., the spot price gained on the next deferred by the end of the period, and the August spread ended slightly higher. Three of the six nearby spreads (February, October, and December) weakened on FND--the last day for speculative traders to reduce their positions to the spot-month limit.
For 1994, the February and April nearby spreads showed little strength or weakness during that 10-day period. The June and August nearby spreads strengthened and the October and December nearby spreads weakened by the end of the 10-day period. Three of the six spreads (April, June, and August) weakened on FND.
For 1995, the April and August nearby spreads had strengthened by FND, but not without considerable volatility. June and October nearby spreads ended a little weaker by FND, and the February spread was nearly unchanged. Three of the five spreads (February, April, and June) weakened on FND.
Overall, there does not seem to be a clear, consistent pattern of weakening nearby live cattle spreads during the 10 days prior to FND in 1993 through 1995. In roughly half of the cases--9 of the 17 expirations--the nearby spread weakened on FND. The October nearby spread was the only one that consistently weakened by the end of the 10-day period in each of the last three years. This result could be coincidental or it could be explained by the seasonally larger supply of market- ready cattle in the fall and the expectation that large deliveries are possible in October.