Forbidden fruits

December 12, 2007 08:40 AM

This past July, nearly 2,000 retail traders converged on the upscale Frankfurt suburb of Aschaffenberg, Germany. The draw was Trading Expo – an event formerly known as Futures Expo. One reason for the name change: “Futures aren’t really the big story anymore,” says Bruno Stenger, who’s been running the conferences for more than a decade.

“In Germany, the big stories are Zertifikate (certificates) and CFDs (contracts for difference),” he says, referring to two varieties of product sweeping the Continent. Germany’s Federal Financial Supervisory Authority (the Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin) believes the underlying notional value of certificate volume in that country alone will end up near €300 billion this year, and several politicians have proposed tighter regulation on the instruments (See: “Product explosion,” below).

U.S. authorities have a simpler answer: here, they’re just not allowed.

CFDs more closely resemble popular British retail products called “spread betting,” which are in fact patterned after the spread bets made every Sunday during football season in the United States, while Certificates are something akin to synthetic leveraged purchases or sales: from the customer’s perspective, it’s as if he’s purchasing the spot product on margin, often paying a monthly financing fee, while from the broker’s perspective, the company is making a market and then hedging with spot futures. The advantage for customers is that contract sizes are usually smaller than they are in futures, and there’s no need to execute rollovers every month or two.

CFDs tend to be more flexible and smaller than certificates, but also tend to have higher fees. Niche players such as CMC-Markets Deutschland dominate the CFD trade, while old guard companies like Goldman Sachs and Dresdner Kleinwort dominate the certificates markets.

In 2006, ABN Amro took the concept of certificates to the next level by launching Market Index platform ( – see: “Market index: Danger! Danger?”), which lets you define your contract size and leverage and then trade pretty much any product on which futures are offered.

Like many liquid OTC markets, exchanges want in. The Australian Securities Exchange’s exchange-traded CFDs, launched on Nov. 5, have shown immediate success (see: “Jumping out of the gate,” below).


The new products have several regulatory strikes against them, and for a change it’s not the fault of the Securities and Exchange Commission. Rather, it’s because most of the products aren’t exchange-traded instruments, but over-the-counter (OTC) instruments that are either hedged on-exchange, or not hedged at all.

The U.S. ban on such instruments flows from decisions made in the 1930s, when the Commodity Exchange Act (CEA) led to the creation of the Commodity Exchange Authority, partly to prevent traders from cornering the grain markets and partly to prevent “boiler rooms” from creating and selling fake futures contracts. The Commodity Futures Trading Commission (CFTC) succeeded the CEA in 1974, but these 1930s regulations remain in effect on most instruments.

That’s because boiler rooms made money by combining 1930s era Certificates with good, old-fashioned fraud: telling half their customers that their research indicated a price rise, and the other half a price drop. Half would go long, and half would go short, with the broker netting out the two positions and keeping the spread plus commission — and impressing half of his customers, who he’d then hit up for referrals. It’s in response to these activities that Congress passed the CEA, which among other things codified the self-regulatory mandate of exchanges and said any futures contract not executed on a regulated exchange was not only a void contract but probably an act of fraud as well.


The treatment of off-exchange retail products has softened. The first softening came in response to the introduction of swaps, which until recently were neither standardized nor traded on an exchange. In 1987, the CFTC began investigating Chase Manhattan’s commodity swap business and warned that swaps may be subject to the CEA. That raised the specter of existing swaps being declared legally void, and swap trading in the United States slowed dramatically or moved offshore.

This led then-CFTC Chairman Wendy Gramm to draw up the Swaps Policy Statement in 1989, which stated that “at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the Act.” That declaration carved out a safe harbor for swaps, which Gramm defined as being cash-settled, non-standardized transactions that weren’t cleared or offset by an exchange-style mechanism.

They also had to be transactions executed among active professionals, who could only make trades related to their “line of business,” a description that doesn’t apply to most of us.

In 1990, the Federal District Court in New York dribbled some new mud into the already murky waters when it asked the CFTC to determine whether “paper barrels” of Brent crude oil — a type of forward contract — should be regulated as futures. Although the CFTC said the paper barrels were not futures, they weren’t exactly swaps, either.

What they were was a question a growing number of participants in the hybrid instruments market were asking. After all, if the courts couldn’t figure out the legal standing of these instruments, how could they?

For a while, the CFTC managed to steer through the regulatory no-man’s zone by issuing no-action letters regarding interest rate swaps and other products, but it took what Gramm termed a “rather painful” reauthorization to clear things up in 1992. During hearings leading up to that reauthorization, exchanges fought for laws that would force swaps onto their platforms or ban them altogether, while industry players like Enron fought to keep the market unregulated.

In the end, Congress passed the Futures Trading Practices Act, which went into effect in October 1992 and authorized the CFTC to exempt certain products from the CEA. That freed the commission to adopt the “Swaps Exemption” in January 1993.

It wasn’t a law, but it was a legally sanctioned exemption, and one that explicitly exempted swaps from daily reporting requirements and the exchange-traded rule. But it also left the door open for the CFTC to investigate and prosecute cases of fraud and manipulation in those markets and, because it wasn’t a law, could be reversed if the CFTC later decided it had made a mistake.

Gramm once likened exemptions to a pruning process – where broad, sweeping rules are imposed and then pruned away from specific industries that request them. With the exemptive authority in place and a clear set of basic exemptions for swaps on the whole, she seems to have expected a flurry of requests for industry-specific exemptions.

“Unfortunately,” she said in 1998, “this exemptive authority has not been utilized much.”

One group that did take advantage of the exemption was Enron (see: “Did Enron write its own rules?”, March 2002). Enron’s business plan involved making contracts to buy gas from a producer at one price and offsetting them against contracts to sell gas to a consumer at another price while keeping a chunk of the middle, a practice that looked similar to the boiler rooms the CEA act had been drafted to combat.

The Commodity Futures Modernization Act of 2000 attempted to clarify regulation of OTC currency platforms but the 2005 Zelener court decision created more confusion that is yet to be worked out. Still, not a day goes by, it seems, without some retail forex dealer being sanctioned.

But does the structure of the product create the sleaze? With broker-designed products proliferating in Europe, it will be interesting to see whether any correlation will materialize between the existence of what U.S. regulators see as boiler-rooms and the existence of full-fledged high-pressure sales groups.

“You’re never really exempt from fraud,” says Frank Partnoy, a law professor at the University of San Diego School of Law. “Fraud is fraud, and most OTC transactions that go bad are handled not by regulators but by anti-fraud laws. [The International Swaps and Derivatives Association] set the standard that these transactions are handled by the laws of either New York or London.”

That, at least, is how things are done in the institutional world. Europe’s experience with these new products will help answer the question of how best to offer retail traders flexibility and freedom of choice while also protecting them from fraud.

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