Uncertain futures in evolving financial markets.

• Author: Krug, Anita K.
• Position: Abstract through II. Procedural Regulation, p. 1209-1236

ABSTRACT

Today's publicly offered investment funds, including mutual funds, have ever more diverse investment strategies, as they increasingly invest in financial instruments that, in earlier years, had been the province of only the most sophisticated investors. Although the new landscape of investment possibilities may substantially benefit retail investors, one financial instrument attracting increasing amounts of retail investors ' assets is acutely troublesome: the commodity futures contract. Futures originated as a means for farmers and other producers of agricultural commodities to ensure that their products could be sold at reasonable prices. Early on, the goals of futures regulation centered on one particular risk facing futures market participants--manipulative trading that destabilizes futures markets--with little emphasis on other risks, including risks to futures traders ' assets. Over the years, that goal has remained largely static.

As this Article argues, that is the problem. The many retail investors that now participate (indirectly) in the futures markets are at risk as a result of the inadequate regulation of futures commission merchants ("FCMs"), the brokerage firms that are essential for futures transactions. "Inadequate " regulation in this context, moreover, means inadequate procedural regulation--regulation aimed at protecting assets that a brokerage customer deposits with a broker for purposes of carrying out her trading activities. The weaknesses of the procedural regulation of FCMs are evident in rules governing both FCMs' operations and the liquidation of insolvent FCMs. And the deficiencies are more than theoretical, having become all-too-evident in the wake of two recent FCM bankruptcies. Proposing tailored policymaking solutions, this Article further contends that futures regulation can become substantially more effective--and do so in a cost-effective manner that need not excessively disrupt existing regulatory approaches. These proposals would not only help protect retail investors as they navigate new investment options; they would also help fortify the promising role that futures trading has begun to play in twenty-first century financial markets.

TABLE OF CONTENTS I. INTRODUCTION II. PROCEDURAL REGULATION A. Securities Brokers B. Futures Brokers III. UNCERTAIN CUSTOMER PROTECTION A. Operational Requirements 1. Regulatory Failures and Responses 2. Ongoing Deficiencies B. Bankruptcy Rules 1. Inapplicability 2. Invalidity 3. Irrelevance IV. THE FUTURE OF FCM REGULATION A. Regulatory Reform 1. Investment of Customer Assets 2. Bankruptcy Rules 3. Insurance B. The Significance of Reform V. CONCLUSION I. INTRODUCTION

Investment opportunities are all around us. There are thousands upon thousands of mutual funds and other publicly offered investment funds, (1) which, as the dominant investment repositories of retail investors' retirement capital and other assets, have come to play a crucial role in the securities markets. (2) Although one might wonder how any particular fund might distinguish itself from all others, at least one answer to that question has, in recent years, become apparent: Today's funds have ever more diverse investment strategies, as they increasingly invest in assets and financial instruments that in earlier eras had been the province of only the most sophisticated investors. (3) Indeed, funds focusing on, for example, international "small cap" stocks, so-called emerging economy stocks, and moderate-risk corporate bonds are now among the more staid investment programs, (4) particularly when one considers the recent emergence of funds focusing on, for example, real estate, fine art, gold, and oil. (5) It is no exaggeration to say that, at least in terms of the types of investments in which retail investors (6) may participate, there is no longer a sharp division between the banker, on one hand, and the baker, on the other.

The developments in the range of investment possibilities open to retail investors are not a product of legal and regulatory developments, however. Rather, they are a product of the same factors that led to the first use of stock options in the United States in the nineteenth century and the first modern hedge fund--the privately offered counterpart to mutual funds--in the 1940s. Those factors are entrepreneurial activity and human creativity. (7) Of course, the emergence of new products within existing regulatory boundaries raises the question of whether policymakers sufficiently considered those products' development at the time they formulated applicable regulatory strictures. After all, hedge funds are an investment product that arguably were not within Congress's realm of consideration as it drafted exclusions to the application of the Investment Company Act of 1940, the statute that defines and regulates mutual funds. And if there is any doubt about policymakers' foresight, then--given retail investors' typically more modest asset accumulation and relative lack of investment expertise, as compared with more sophisticated investors' assets and expertise (8)--there arises the further question of whether retail investors are sufficiently protected as they traverse the new investment landscape.

In that regard, one financial instrument attracting increasing amounts of retail investors' assets is troublesome: the commodity futures contract. Commodity futures contracts--also known as "futures contracts," or merely "futures"--are, in simplest terms, agreements to buy or sell a particular commodity at a later time. (9) Futures were created to help farmers and other producers of agricultural commodities ensure that their corn, cattle, cotton, or other products could be sold at reasonable prices. (10) Such protection is desirable because the market price of a commodity fluctuates throughout the year, based on both the supply and the demand for the commodity at any particular time. (11) For example, the June price of wheat in a given year may be substantially lower than the February price if June is the month in which wheat is harvested, resulting in a significant increase in supply that month. Accordingly, a wheat farmer who desires to secure a good price at harvest time may desire to "hedge" against such price fluctuations by locking in a particular price. She may do so by entering into a futures contract, pursuant to which the contract counterparty agrees to buy a certain amount of the farmer's wheat in June at a specified price per bushel.

Despite the origins of futures contracts, trading in futures, without ever receiving or delivering an actual commodity, may have value in its own right. As is the case with contracts that contemplate physical delivery, the value of a contract traded for "speculative" purposes derives from changes in the price of the commodity that the contract references. For example, if a trader expects that the price of oil will increase in the near term, she might initiate a futures contract on, say, 3000 barrels of oil. If the value of oil at the time the contract is initiated is $70 per barrel, then the value of the contract is $210,000. However, the trader will be able to trade in the contract by posting an initial margin (effectively collateral) of only a small portion of the value of the contract--say, $14,000. If, during the term of the contract, oil prices increase to $80 per barrel, then the value of the contract will increase to $240,000, meaning that the trader will be entitled to the amount of that increase, $30,000 (payable by the counterparty), assuming that the trader terminates the contract before the price falls again. From the earliest days of futures, not surprisingly, the prospect of using futures as a means of generating profit, rather than hedging against commodity price risk, did not escape financial market participants. (12)

It is also not surprising, then, that federal regulation of futures and the futures markets, which dates back to the 1920s, came to reflect that futures are used for purposes other than hedging, that some futures contracts are based on assets other than agricultural commodities, and that the label "futures market participants" encompasses more than just farmers. (13) This evolution is perhaps evidenced most starkly by the fact that the Grain Futures Act of 1922, which governed futures activities until 1936, was replaced by a statute with a rather more generic title: the Commodity Exchange Act. (14) Still, despite regulation's ostensible recognition of the breadth of futures market participation, the professed goal of futures regulation--prohibiting and punishing manipulative trading that destabilizes markets--has remained largely static. (15)

That is the problem, given the mammoth expansion of participants in the futures markets in recent years. Almost anyone is able to trade in futures simply by, for example, investing in one of the growing number of mutual funds that does so, including as a core strategy. (16) It is appropriate, moreover, that they are able to: Participation in the futures markets serves as a hedge of sorts even for the average investor because of the portfolio diversification it can provide. (17) As this Article argues, however, those investors are at risk, at least in comparison to their counterparts in the securities markets. That risk arises from the inadequate regulation of futures commission merchants ("FCMs")--that is, firms that act as brokers in the futures markets, executing orders through the relevant exchanges on behalf of their customers, (18) whether those customers be Exchange-Traded Funds or mutual funds or whether they be individual investors or their advisors.

Importantly...