Culture change is a top priority for the futures market

Corporate America desperately needs a serious ethical overhaul, and that includes the financial sector.  Leadership, from the board of directors and the CEO down through the layers of an organization, is essential to establishing and maintaining an ethical corporate culture.  Management must continuously stress the need for ethics through every available channel of communications -- speeches, articles, training, leadership conferences, compensation systems, recruitment and retention policies, and the like.  Corporate structure must reflect a commitment to ethical behavior.  The Board of Directors should have a committee charged with independently monitoring the ethical climate of the organization.  Employees should have a channel of communications separate from the chain of command and reporting directly to top management through which they can raise critical ethical issues without fear of reprisal.

CFTC Commissioner Bart Chilton presented a compelling keynote speech at the Hard Assets Investment Conference in Chicago on September 21 advocating several critical actions to improve the distressing ethical climate in the financial sector.  The full text of his remarks is available on the CFTC's website.  Essential points he recommends include:

• Aligning compensation systems to stress risk management over periods of time that reflect an emphasis on sustainable growth rather than immediate profit;

• Recruiting and hiring a workforce receptive to balancing risk and assuring that a drive for profits does not overwhelm other considerations; 

•  Providing sufficient funding to the CFTC through a user fees similar to those used to fund other financial regulators; and

•  Focusing regulations on 
• a corporate structure that emphasizes independence and diversity of viewpoints and skill sets among its directors;
• ownership rules that reduce the chance of conflicts of interest;
• internal and external business conduct standards that clearly demarcate acceptable practices;
• preventing conflicts of interest through limitations on proprietary trading by banks, with careful distinction between hedging risk and proprietary trading; and
• requiring registration of high frequency traders and insuring that they test their algorithms before using them for trading and include a "kill switch" to shut them down if they seriously malfunction.

Some of Commissioner Chilton's recommendations are already contained in draft or final rules, although implementation and operational experience will undoubtedly provide essential data to guide revision and further development.  In any case, his suggestions deserve serious consideration over what will be a long period of rehabilitating the reputation of the financial sector. 

Should the CFTC enforce the prohibition on wash trades against high frequency traders?

"Wash trades" -- trades that give the appearance of a sale and purchase of a futures contract, but do not expose the parties to market risk, or that leave the parties in the same position after the trade as before it -- have been illegal for many years.  Wash trades send false signals to the market, making it appear that there is more interest in a contract than there actually is.

Many high frequency trading programs commit wholesale wash trades, sometimes even accepting their own offers.  Whatever may be the benefits of HFT -- a topic of intense debate -- they come at the price of these wash trades.

Should the CFTC seek to enjoin or otherwise penalize wash trades committed by HFT programs?  Perhaps the enforcement process would enable the agency to evaluate HFT programs more rigorously and put the advocates of the programs to their proof.  Should programmers be required to cleanse HFT programs of features that induce wash trades?  The objections to wash trades seem to be the same whether they are executed in the old-fashioned, paper-based systems, or at lightning speed by computers.  And, in any case, the law articulated by Congress and the courts doesn't seem to support any distinction premised on the environment in which the trades are conducted or on alleged countervailing benefits to the market.

End of fiscal year crisis anticipated

Fiscal year 2012 will end on September 30.  It has become the custom for Congress to enter a holding pattern for about a quarter of a fiscal year, putting the government on life support with successive short-term continuing resolutions, which maintain spending at the levels of the expired fiscal year until a permanent appropriation is provided.  There is every reason to expect this pattern to continue this year, especially in light of the presidential election in November.

The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation.  The House Appropriations Committee has recommended about       $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation.  The Senate Appropriations Committee recommends the full $ 308 million requested by the President.

The Dodd-Frank Act radically expanded the CFTC's jurisdiction.  The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency.  And, of course, old-fashioned fraud and other market abuses continue unabated.  Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve.  Agency personnel levels are barely equal to those of 1995. 

Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country.  The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.

Mutual trust underpins the derivatives market

The Wall Street Journal recently reported on widespread breaches of contracts for cotton resulting from extreme volatility in the cotton market since 2010.  This has led, in turn, to losses on corresponding futures contracts used for hedging and to increasing distrust and litigation along the cotton supply chain.  The article points out that cotton generally changes hands seven times "from seed to sweater."

When the binding nature of contracts erodes, it not only unsettles the market for the commodity involved, but also reduces the value of related futures contracts for hedging risk and discovering prices.  Futures contracts are intended to reflect consensus concerning the likely fair market value of a commodity at some given time in the future.  To the extent that value is determined through arbitration and litigation, it does not reflect the price set by a willing buyer and seller not under compulsion and with reasonable knowledge of market factors.  Although exchanges and commodity associations have enforcement mechanisms available to them, such as barring defaulting parties from use of the market or association, these mechanisms will not, in themselves, restore order to the market because of its vast size and complexity.

The current situation with the cotton market underscores the limitations of any system of market supervision and regulation.  Only mutual trust and respect for contractual obligations can assure a functional market, regardless of how effectively markets are supervised and regulated.