Regulation and Futures Markets

Question 1

Futures markets

Answer 1

Futures markets work as they are centralised and standardise. Both require a clear organisation and set of rules.

Question 2

Regulation

Answer 2

Is vital to efficiency and is at two levels;

• Basic rules of operation (day to day)
• Broader economic rules e.g. self governance of markets

Regulation to ensure social welfare is maximised

Question 3

Speculation

Answer 3

Exists to ensure market confidence, consumer protection limitation of crime and public awareness and social welfare is maximised rules must be clear and effective.

Question 4

Who regulates and How?

Answer 4

At the market level, the Clearing House determines the rules and regulations relating to contracts and brokers

All Clearing Houses are then subject to speciific regulatory control:

• US commodities and Futures Trading Commission (CFTC)
• UK Financial Services Authority (SIB)

Question 5

CFTC Roles

Answer 5

1) Financial Surveillance
2) Market surveillance
3) Trade pattern monitoring
4) Economic research
5) Review trading filings and clearing organisation rules and contracts
6) Share information externally
7) Investigate violations
8) file and prosecute cases
9) Take remedial/punitive actions

Question 6

Dodd-Frank Wall street Reform and Consumer Protection Act (2010)

Answer 6

Designed in response to the financial crisis in world markets its main aim was:

Promote financial stability of the united states by improving accountability and transparency in the financial system.

Question 7

Principles of Financial Services and Markets Act (2000): Principles

Answer 7

1) Competition
2) Innovation
3) Proportionality
4) Efficiency
5) Role of management
6) International competitiveness

Question 8

Economic Rational for Regulation

Answer 8

Market are optimal so to regulate requires market failure to exist. How does it apply to FMs:

Monopoly

• Natural monopoly is not ideal as lowest cost does not equal price e.g. utilities
• Man made monopoly (e.g. groups acting together) can manipulate markets

Question 9

Market failures

Answer 9

Monopolies
Public Goods
Externalities
Information Failures

Question 10

Public Goods

Answer 10

Non excludable and not produced by competitive markets (free riding)
State provision otherwise but no real grounds in FMs unless…
Could argue about global public goods effects of financial stability of which FMs are a part

Question 11

Externalities

Answer 11

MSC does not equal MSB

Property rights need to clearly enforced to ensure no gap arises or minimise disputes

Question 12

Information Failures

Answer 12

Need information for optimality. Markets might not trade information as we expect because:

i) Public good nature (Collective action)
ii) Paternalistic Approach (regulate quality)

Question 13

Cost o fIntervention

Answer 13

Not costless to intervene need to weigh up costs and benefits and where failure small, not worth intervening.

Costs: bureaucracy, changing resource allocation

Question 14

Manipulation explained:

Answer 14

The elimination of effective price competition in a market for cash commodities and/or futures contracts through the domination of supply or demand and the exercise of the domination to intentionally produce artificially high or low prices

Key: Artificiality, dominance and intention

Aim: To generate profits

Question 15

Manipulation

Answer 15

• May arise out of monopoly control, so small group gains while others loose.
• Prices do not reflect S and D but are biased estimates of Sp
• Pricing efficiency declines (misallocation) as volatility increases around maturity
• Relative prices changed thus distorting hedging ability (Pirrong 1994)

Question 16

Why are FMs susceptible to Manipulation

Answer 16

Specific delivery date and deliver points (buy all contracts)

Specific commodity (no substitutes)

Trade volume is often greater than the underlying supply thus it is possible to create market power by trading in both markets i.e. short hedgers don’t get enough supply o trade.

Question 17

Long Manipulation can occur

Answer 17

1. Cost of additional unit of commodity to deliver increases a number of deliveries increases.
2. Single trader owns enough futures positions and/or enough of deliverable supply that he can demand short deliverer meet commitments

Evidence of Squeezes:

• Temporary and large increase in prices at delivery market absolutely and relatively to other markets
• Large plunge in prices afterwards.

Question 18

Regulating Manipulation

Answer 18

Preventative or Punitive Approaches

• Position Limits - Limited number of contracts can be held but this cuts risk transfer
• Entry requirements
• Emergency intervention

Question 19

Pirrong (1994)

Answer 19

He argues that most regulatory tools are ineffective as they are preventative

Compare on the basis of four criteria:

1) If offence is easily detected
2) If perpetrator is wealthy
3) If perpetrator knew what they were doing
4) If administrative costs of prosecution are low

Pirrong suggests 1-3 will mean trader internalises costs thus wont commit crime so number of cases small hence costs low thus harm based measures better.

Question 20

Regulation Effects

Answer 20

Pashigan (1986) - explained the effects of regulation on seat prices on Chicago markets; increased regulation forced prices down

Bae, Kwon and Park (2009) - volatility spill over from index futures trading stocks onto non-index stock volatility. Created a regulation index to capture three periods in Korean stocks market.

Volatility spillover varies with regulatory envionment.

Question 21

Great Western Food Distribution v. Brannan (1953)

Answer 21

Company had 40% of spot and 60-75% of futures market respectively. In essence they cornered the market (GUILTY)

Question 22

Cargill Inc. v. Harin (1971)

Answer 22

Looked at trading patterns and it was believed there was insider trading based on USDA information. (GUILTY)

Question 23

Hunts Silver corner

Answer 23

Short hedgers being squeezed as no silver available to offset position and drove up prices
Due to squeeze, didn’t want to sell futures so Fp increased
Suggest a squeeze of 5-7 months (very long) (GUILTY)

Question 24

Sumitomo Copper (1996)

Answer 24

Manipulated London copper contract

• Squeezes rolled over and over
• Went long in physical and futures
• Piled up copper in exchange warehouses pushing up spot prices
• Prices high in 1993 despite high stocks, strong production and low demand. (GUILTY-ish)

Question 25

Dairy Farmers of America (2008)

Answer 25

Kansas city based Dairy Farmers of America attempted to manipulat the milk futures market.

Bought block cheddar cheese which sets milk futures price
Speculative futures position exceeded limits set by the CME
Fined $12 million (GUILTY)

Question 26

Further Issues

Answer 26

• Non standard trading (over the counter deals/junk bonds)
• Screen-based trading (More difficult to regulate)
• Linking across markets (whose rules apply)
• Large scale trading (Pension funds and blocks create problems)