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FOR RELEASE ON’ DELIVERY
THURSDAY, NOVEMBER 1 , 1979
1 2 :3 0 P.M. EST




THE FUTURE OF FUTURES.
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Commodities and Financial Futures Conference
sponsored by the
Federal Bar Association and Commerce Clearing House
Washington, D.C.
Thursday, November 1, 1979

THE FUTURE OF FUTURES

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Commodities and Financial Futures Conference
sponsored by the
Federal Bar Association and Commerce Clearing House
Washington, D.C.
Thursday, November 1, 1979

The financial futures markets, since their inception in the
mid-1970's, have had a tremendous vogue.
have been a huge success.

In terms of volume, they

The number of contracts outstanding on the

four organized exchanges on which financial instruments futures are dealt in
is on the order of 200,000.

The average daily volume of contracts traded so

far this year is about 20,000, compared to about 7,000 for the same
period last year.

The peak volume occurred in September when over

600,000 financial futures contracts were traded during the month.

Achievements of the Financial Futures Markets
These impressive results are a monument to the power of financial
innovation.

Forward markets in financial assets have always existed and

continue to exist.

But organized futures markets, with their homogeneous

contracts, reduced credit risk, and low transactions costs have made
attractive and accessible to many what previously was of interest only to
a few.




-2-

Simultaneously with, and in fact somewhat ahead of, the develop­
ment of the financial futures markets, there has proceeded the development
of options markets for common stocks.

These have had a similar growth

experience, to the point where the exchange traded options volume in 1978
on all exchanges combined had come to equal approximately three-fourths
of the volume of the New York Stock Exchange.

Many of the considerations

applicable to financial futures are applicable also to the options markets.
It is somewhat surprising, nevertheless, that a phenomenon so
large and dramatic as the growth of the futures and options markets
should have produced so relatively few obvious and visible consequences.
The activity in these markets seems to be mostly turnover, with very few
net results of any sort.

To someone like myself who is more at home in the

foreign exchange market, it is not particularly alarming to observe such
phenomena as heavy trading among financial institutions with only a very
moderate residual of customer transactions, such as is characteristic of
foreign exchange markets.

In the New York foreign exchange market, the

share of customer transactions, according to a survey by the Federal Reserve
Bank of New York some time ago, stood at about 5 percent of total transactions,
the other 95 representing interbank trading.

On the other hand, in the forward

market for foreign exchange, which is an important part of total foreign
exchange trading, they deliver what they sell.
To underline how strongly some people feel about delivery, let me
mention an instance from the Congress.

It seems that two administrative

assistants were talking about their respective Congressmen.
being particularly complimentary.
his old mother for a nickel."

The first AA said, "Your man would sell

"So would yours," the second AA replied.

'■Yes," said the first AA, "but mine would deliver."



They were not

-3-

I t i s t r u e , o f c o u r s e , t h a t the many u s e f u l f u n c t io n s t h a t the
f i n a n c i a l f u t u r e s m arkets can perform do not n e c e s s a r i l y depend on ta k in g
or making d e l i v e r y o f the u n d erlyin g a s s e t s .

A p o s i t i o n can be hedged, r i s k

t r a n s f e r r e d , the b e n e f i t s o f l e s s r i s k y and, t h e r e f o r e , presumably cheaper
and more p l e n t i f u l c r e d i t r e a l i z e d through c o n t r a c t s th a t arc c lo s e d out
p r i o r to the d e l i v e r y d a t e .

The f i n a n c i a l f u t u r e s m arkets perform a kind

o f unbundling j o b , such as has been thought d e s i r a b l e in many a r e a s o f the
economy.

They allo w the a c t i v i t y o f g e n e r a tin g a s s e t s such as mortgages

to be s e p a ra te d from the ta k in g o f the f i n a n c i a l r i s k in h e r e n t in i n t e r e s t
ra te flu ctu a tio n s.

They perm it the same to l e n d e r s , such as b an k s, who a r e

e x p e r t a t a n a ly z in g d e f a u l t r i s k but may n o t want to be exposed to i n t e r e s t
rate r is k .
In fo rm a tio n on e x p e c t a t io n s about fu tu r e developments becomes more
w idely a v a i l a b l e as s p e c u la t o r s and hedgers e x p re s s t h e i r views oC the futurethrough the p r i c e s they bid and o f f e r .

The f r u i t s o f p o s s i b l y v e ry c o s t l y

r e s e a r c h i n t o the b u s in e s s and f i n a n c i a l o u tlo o k a re thus made a v a i l a b l e to
the p u b lic through the p r i c e s o f f i n a n c i a l f u t u r e s .

Some Q u estion s
These are v a lu a b le s e r v i c e s .

The tr o u b le i s

th a t the t h e o r i e s

th a t t e l l us about t h e i r a v a i l a b i l i t y in p r i n c i p l e cannot t e l l us v e ry much
about how im portant th ese s e r v i c e s are q u a n t i t a t i v e l y .

I n q u i r i e s i n t o the

views o f market p r a c t i t i o n e r s , as c o n t r a s t e d w ith economic t h e o r i s t s , provide
a p i c t u r e o f c o n f l i c t i n g o p in io n s about the m e r its o f the f u t u r e s m arkets
th a t a r e f ir m ly held but w ith probably l i t t l e b a s i s in f a c t u a l e v id e n c e .
The F e d e r a l R ese rv e and T rea su ry surveyed a number o f market p a r t i c i p a n t s




-4as part of the study of these agencies into the futures market and
discovered one set of opinions that was favorable to the futures markets
and another set that was unfavorable.
markets —

generally the majority —

Those who thought well of the
claimed that the markets provide

important social benefits by enabling hedging and improving the general
liquidity of markets.
underlying securities.
banks.

They saw no adverse impact on the price of the
Activity in futures was thought to be useful for

Potential problems could be monitored and controlled.

Moreover,

usefulness of the markets was expected to improve over time as more
potential hedgers became aware of these possibilities.
The other side seemed to believe more or less the opposite on
each of these issues.
tion, not hedging.

Most of the activity, it was said, was pure specula­

Financial futures markets were mainly the preserve of

wealthy investors and speculators creating unnecessary risks.

There was a

serious danger of adverse effects on the underlying securities, such as
increasing their price volatility and affecting the level of their price
thereby complicating Treasury debt management and Federal Reserve open
market policy.

The markets also created risks for participating banks.

There seems to be available only a moderate amount of information
to resolve these disagreements.
is

We know that the great majority of contracts

closed out prior to their delivery dates.

We also know that up until

now the number of banks participating is a small fraction of the total
banking community.

In addition, the market participants interviewed in the

Treasury-Federal Reserve study seemed to believe that in the early stages
the futures markets were primarily speculative.




Nevertheless, all this

-5does not prove, though it might suggest that the bulk of the activity
reflects speculation rather than hedging.
Evidence of impact on the price of the underlying securities
is scanty, in large part due to the short lives, thus far, of the
financial futures markets.

In the commodity markets, the preponderance

of the evidence seems to suggest that futures trading has brought about
some beneficial smoothing of seasonal fluctuations.

Some observers of

the financial futures markets have suggested that there may be some very
temporary impacts of futures trading on the price of the underlying
securities, especially at the time when contracts mature.

Some market

participants believe that the possibility of a squeeze on the price of
particular Treasury securities exists because the deliverable supply may
not be fully adequate.

Information from Futures Trading
The value of information supplied about the future as a result
of financial futures trading may be questioned on the grounds that the
prices in Treasury futures markets tend to differ from forward prices
implicit in the yield structure of spot markets.

If the futures market

says that the Treasury bill rate eight or nine months hence will be
10 percent, and the yield curve says that it will be 11-1/2 percent, who
is right?

Moreover, given such frequently occurring differences, why is

it that arbitrage is insufficient to eliminate them?

Transactions costs,

minor risk factors, timing difference in the data, or the difficulty of
shorting Treasury bills may be responsible.

But in any event, the informa­

tion generated by these competing markets seems to suffer from some fuzziness.




-6-

And, granted that there is value in the information provided by
the prices resulting from massive trading, one might still ask whether this
is an efficient way of supplying information?

People who bet on horses are

said to believe that their activity encourages racing and thereby improves
the breed of horses.

People who bet on future prices of securities are

presumed to render a valuable service by generating information.

One is

bound to wonder whether both parties are not trying to do things the hard way.
There must be cheaper ways of producing better horses and better information.

The Viewpoint of the Regulator
Whichever way the balance of truth may point, one thing is
certain:

The futures markets present a challenge to those charged with

regulating these markets.

They pose fundamentally some of the basic

questions that all regulators must confront.

Is it appropriate, in a

democracy, to interfere with the free play of market forces even if it
could be shown that there is no immediate and obvious social benefit to be
observed from the play of these forces?

All regulation comes at a cost in

terms of freedom of markets and self-determination of human beings.

In our

present environment, given the prevailing mania to regulate everything
and anything, the marginal cost of regulation in these terms is particularly
high.

Do any potential injuries that futures trading might inflict justify

this added cost?
Even if it can be shown that regulation would help to prevent
some demonstrable abuses, these may well pertain to a small minority of
cases.




One might ask whether it is justifiable to limit the freedom and

7

the opportunity for profit of the many in order to protect the few against
the consequences of their folly.

This question is being answered in the

affirmative in much of our contemporary regulation, particularly in the
consumer area.

I suspect that protection for the few is being bought at

an excessive cost to the many.
Looking at the enormous regulatory burden that today falls upon
the banks, there certainly is a heavy cost involved in imposing still
another regulation on more than 14,000 banks who will have to read and study
complicated material until they discover that it pertains to only a small
fraction of their number who today are participating in futures markets.
The mere presence of this additional regulatory burden may become an obstacle
to the entry of more banks into the futures markets.
It is not obvious that it makes sense to try to control, via regula­
tion, a risk in the very limited area of financial futures that is totally
pervasive in banking.

No bank engages in pcrfect maturity matching.

Every

bank, in a sense, is a comprehensive futures contract, with a long position
that typically has a longer maturity then the short position.

If wc do not

prevent a bank from buying bonds and mortgages and financing them with demand
deposits or 90-day CDs, it is doubtful to me that we should single out the
special risks of financial futures for special regulation.
If, however, we accept that some kind of regulation is needed,
should it not at least reflect economic reality to the extent possible
instead of artificial legal and accounting principles?

For instance, does

it make sense to allow a bank to engage in futures transactions in order




-8-

to ’’hedge" some particular asset or liability, even if that does not
reflect the bank's overall risk exposure to interest rate changes?
A bank may be in a reasonably well-hedged position if both its
assets and liabilities are tied to floating interest rates.

Would it make

sense, under such circumstances, for the bank to hedge separately any
particular asset or liability, thereby in effect unhedging its overall
position?

This is one of the questions that the Federal regulatory

agencies today seem to be facing.
Likewise, would it be appropriate to impose position limits on
banks, perhaps in relation to their capital, when the degree of their
exposure to risk in futures markets may differ widely, for identical
dollar amounts, with the maturity of the futures contract?

A bank can

be safer with a large volume of very short-term futures, particularly if
they fit well into its overall balance-sheet exposure, than with a small
volume of longer term futures not well adapted to the interest rate risks
it faces.
If, as a reluctant regulator, I contemplate questions like these
that today confront the Federal regulatory agencies, I arrive at the
conclusion that less may be more.

Rather than try to write tight rules

that will keep many of the banks out of the futures markets and may disorient
some of those who enter, it may be preferable to first limit regulation to a
requirement that banks establish sensible rules and sound internal controls,
and then to monitor the existence of and adherence to these rules and controls
through bank examination.

Such rules will already be adhered to in well run

operations and impose discipline rather than restrictions where needed.




-9-

As a regulator, the Federal Reserve today, together with the
Treasury, also is required to consider and advise the Commodities Futures
Trading Commission (CFTC) on the type of futures contracts that are to
be authorized.

It has been the particular virtue of our exchanges trading

financial futures to provide a framework in which futures trading can take
place with minimum credit risk and minimum cost while also limiting the
exposure of the trading parties through margin requirements and marking to
market.

There remain certain risks affecting the issuer of the underlying

securities, in particular the U.S. Treasury.

However remote, in theory,

the danger of a corner or squeeze may appear, under the particular circum­
stances of ownership of Treasury securities that prevail today, it cannot
be discounted altogether.

A good share of many Treasury issues today is

owned by the Federal Reserve and by foreign monetary authorities, neither
of which would be likely to be available to arbitrage special situations.
Under these conditions, it is not impossible for a well-financed operator
to establish a dominant position in a particular issue.

Whether or not

such an operator could establish a corner or at least exert a squeeze
depends largely on the interest elasticity of the market, namely, the
alertness and institutional freedom of action of owners of that issue and
adjacent issues.

I believe that it is wise to establish precautions against

such a contingency, along the lines taken by the Treasury and the Federal
Reserve in their advice to the CFTC.

Spreading of similar contracts over

different months on different exchanges, delivery of securities from a basket
rather than restricting delivery to a single security, uniform reporting of
positions in new contracts to the CFTC and making sure that exchanges have
equally effective rules for dealing with emergencies seem reasonable
precautions.



10-

The ingenuity of the writers of futures contracts is not, of
course, exhausted in the devising of Treasury and GNMA securities contracts.
I find an intellectually fascinating innovation the concept of a futures
contract denominated in terms of some common stock index.

Such a contract,

to be sure, gets away altogether from the concept of a deliverable security.
But it fits in with the principles of capital asset valuation and would
permit a type of hedging against systemic or industry risk that would offer
very interesting opportunities to equity investors.

The feasibility of

such a contract must remain in doubt until the details have been worked
out, but I hope that efforts along those lines will continue.

Misdirection of Risk Taking?
I began my remarks by commenting on the large volume of trans­
actions in futures and options markets by all market participants today.
Where such large values are at stake, usually a number of clear facts
emerge.

This has not been the case in futures markets.

about their effects, good, bad or indifferent.

We know little

The simple conclusion from

this might seem to be that if we cannot make up our minds about the nature
and consequences of what we see, that there must be less here than meets the eye.
I believe that this usually plausible conclusion does not follow
in the present case.

There is, I suspect, a consequence flowing from high

activity in futures markets and in stock market options that we have not
sufficiently evaluated.

It has to do with the effect of such trading on the

demand for securities, the underlying as well as others.

I am not speaking

here of volatility or minor price variations when contracts mature.




Rather,

-11-

it is the absorption of speculative and risk-taking activity into what
is essentially a betting operation that concerns me.
Demand for futures and options is not demand for the underlying
securities.

The willingness to take risks that is absorbed in futures and

options markets is withdrawn from the equities markets, among other areas.
The supply of such willingness to take risks is not unlimited.

Even though

the volume of money absorbed by the futures and options markets is small,
that is not a proper measure of their effect on the demand for equities.
Someone who buys futures or options obviously is a potential investor in
equities.

In the futures and options markets, one can get a much bigger

bang for a buck than by buying into the dull old stock market.
know what the bettor then does with the rest of his savings.

1 do not
From the SEC

study we do know that only 5 percent of investors questioned in one particular
survey said that they were following a strategy of combined options and
fixed income securities.

Thus, the option buyer apparently does not put

his surplus funds into bonds.

But given the high risk he runs in his

futures and options, he is unlikely to put the rest into stocks.
he buys real estate, or life insurance.

Perhaps

Perhaps he leaves protection of

his old age to his pension fund and social security and foregoes significant
saving activity in the hope of making a killing on futures and options.

It

is in this substitution of betting on securities instead of investing in them
that the main economic effect of this trading must be sought, to the possibly
great damage of our economy which badly needs equity investment.
I do not see a remedy for this absorption of risk-taking capacity
into what is essentially a betting activity coming from any regulation or
restriction placed on that activity.




That, I believe, would be a futile

-12-

attempt.

Rather, what is needed is to make equity investment itself

more attractive.

If we could find a good way of eliminating the double

taxation of dividends, and if we could limit the taxation of "capital
gains" to the taxation of real gains rather than of the capital itself,
as inevitably happens after a period of severe inflation, equity invest­
ment would again become attractive.
with futures and options.
would be the beneficiary.




It might even then be able to compete

Our economy, more than individual investors,