Commodity Exchanges and Regulation: From Ancient Trading to Modern Rules
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
Rules Exist for a Reason
Chapter 3, by Jerry W. Markham, is about commodity exchanges and how they are regulated. This is not the most exciting topic at first glance, but once you see why these rules exist, it starts to make sense. Every major regulation traces back to some fraud, manipulation, or market blowup that hurt real people.
The chapter covers a lot of ground: the history of exchanges, the CFTC, anti-fraud protections, margin requirements, and the Dodd-Frank reforms. Let me break it down.
From the Civil War to the CFTC
Modern futures exchanges in the United States go back to just before the Civil War. The Chicago Board of Trade, founded in 1848, became the center for futures trading. During the Civil War, the Union government actually banned gold futures trading because speculation was undermining the value of Greenback dollars. That ban lasted exactly two weeks. It did not work.
After the war, two problems kept popping up. First, people manipulated commodity prices through futures trading. Second, “bucket shops” appeared. These were basically gambling dens where people bet on commodity price movements. The bucket shop operators often ran off with customer money when bets went bad.
Congress tried for decades to pass legislation. Nothing passed until 1921, and that first law was struck down as unconstitutional. In 1922, the Grain Futures Act was enacted under the Commerce Clause, requiring futures exchanges to register as “contract markets.” It also banned price manipulation, but only for a few agricultural commodities.
The Commodity Exchange Act of 1936 (CEA) expanded regulation. Brokers had to be regulated. Customer funds had to be held in separate accounts. Sales fraud was prohibited. But it still only covered a narrow list of agricultural products.
It was not until 1974 that Congress created the Commodity Futures Trading Commission (CFTC) and gave it jurisdiction over all commodity futures and options, not just the ones listed in the old law. This was a big deal because by then, futures trading had expanded well beyond agriculture into financial products like Treasury securities and stock indexes.
The CFTC-SEC Turf War
Creating the CFTC kicked off a long-running battle with the Securities and Exchange Commission (SEC). The CFTC had exclusive jurisdiction over all futures, including those on financial products. The SEC thought it should regulate derivatives on securities.
After losing some court battles, the SEC and CFTC reached the Shad-Johnson Accord in 1982, splitting jurisdiction. The SEC got options on individual stocks and securities. The CFTC kept futures on stock indexes. They shared jurisdiction over some instruments. This compromise was messy, and further amendments have been needed over the years to keep up with market innovation.
How the CFTC Is Organized
The CFTC is a five-member federal agency. Members are appointed by the president for five-year terms, and no more than three can be from the same political party. It is headquartered in Washington, DC, with offices in New York, Chicago, and Kansas City.
The CFTC has several important divisions:
- Division of Enforcement: Investigates violations and brings civil cases. Can subpoena documents and testimony. Can seek injunctions and freeze assets.
- Division of Market Oversight: Oversees exchanges, detects abusive trading, and monitors for price manipulation.
- Division of Clearing and Risk: Oversees clearinghouses and large traders to prevent defaults that could create systemic risk.
- Division of Swap Dealer and Intermediary Oversight: Manages compliance for swaps trading, including capital and margin requirements.
There is also a Whistleblower Office that pays people who report violations leading to successful enforcement actions.
Exchanges and Clearinghouses
Futures exchanges must register with the CFTC as “designated contract markets” (DCMs). They are required to act as self-regulatory organizations, meaning they police their own members.
The clearinghouse is a critical piece. It stands between the buyer and seller of every futures contract. If you buy a contract, the clearinghouse becomes your seller. If you sell, it becomes your buyer. This removes the risk of the other party defaulting. The Financial Stability Oversight Council has designated major clearinghouses as systemically important financial institutions. They are that essential.
To protect against defaults, clearinghouses require margin from both buyers and sellers. Initial margin is a deposit posted when a trade is made, usually a small percentage of the contract value. Variation margin covers daily gains and losses through the mark-to-market process. If your position loses money, you get a margin call and have to add more funds.
Futures Commission Merchants
Your broker in the futures world is called a futures commission merchant (FCM). FCMs must register with the CFTC, maintain minimum capital requirements, and hold customer funds in segregated accounts.
There is no SIPC or FDIC insurance for commodity accounts. If your FCM goes bankrupt, you rely on the segregation of funds to protect your money. Recent years have seen some large FCM failures with shortfalls in customer accounts. Not all of those funds were recovered. That is a sobering thought.
FCMs are required to give customers a written risk disclosure before they trade. It tells you that you can lose more than your initial deposit, that futures are highly leveraged, and that your funds are not government-insured. You have to sign it before you can trade.
Anti-Fraud and Anti-Manipulation
The CEA prohibits fraud in commodity futures trading. This covers misrepresenting risks, making unrealistic profit predictions, unauthorized trading, and “churning” (excessive trading to generate commissions).
Interestingly, the CEA does not prohibit insider trading the way securities law does. There is actually a provision saying that anti-fraud rules do not require disclosing nonpublic information about a commodity. However, trading on stolen information is still prohibited, and CFTC employees and members of Congress cannot trade on nonpublic information.
Manipulation is harder to prove. The CFTC has to show four things: an artificial price existed, the accused had the ability to cause it, they actually did cause it, and they intended to. In 40 years, the CFTC has won only one fully adjudicated manipulation case, though they have obtained many settlements.
The most common forms of manipulation historically were “corners” and “squeezes.” A corner is when someone buys up all available supply of a commodity to dictate prices. A squeeze is similar but involves controlling a substantial (but not all) portion of supply.
The Dodd-Frank Revolution
The 2007-2008 financial crisis exposed major problems in the unregulated swaps market. AIG nearly collapsed due to credit default swaps, requiring $182 billion in government assistance. That disaster led to the Dodd-Frank Act in 2010.
Dodd-Frank brought swaps under regulation for the first time. New categories of regulated entities were created: swap dealers, major swap participants, and swap data repositories. Most swaps now have to be cleared through a central counterparty.
Dodd-Frank also tackled some specific trading abuses. It banned spoofing (placing orders you intend to cancel before execution), though this is tricky to enforce because over 90 percent of orders on electronic platforms are canceled before execution anyway.
The act also split swap jurisdiction among the CFTC, SEC, and bank regulators. The CFTC handles commodity-based swaps. The SEC handles security-based swaps. They share jurisdiction on mixed swaps.
The NFA: Another Layer of Regulation
The National Futures Association (NFA) is a self-regulatory organization for the industry. Membership is mandatory for commodity professionals. In 2016, over 4,000 firms and 57,000 individuals were registered.
The NFA handles registration, conducts examinations, and can bring disciplinary actions. It can fine members up to $250,000 per violation, suspend or expel members, and more.
My Take
This chapter is long and detailed, but the history is important. Every rule in commodity regulation exists because someone got hurt. Bucket shops stole customer money. Manipulators cornered markets. FCMs went bankrupt with customer funds missing. Unregulated swaps nearly took down the global financial system.
The regulatory framework is far from perfect. The CFTC-SEC turf war creates gaps and overlaps. Proving manipulation is nearly impossible. And as markets evolve with high-frequency trading and new financial products, the rules struggle to keep up. But the system is much better than no regulation at all.