Allegations of fraud that rocked Chicago`s futures markets last week will force the exchanges to face up to long-overdue reforms in trading practices.
So say market experts who believe survival of the heart of the city`s financial district and its worldwide leadership in futures trading are at stake.
Disclosure that federal investigators used undercover FBI agents to document alleged trading abuses at the world`s largest futures exchanges raised the most troubling questions yet about those markets.
For the industry, the timing couldn`t have been worse. The Commodity Futures Trading Commission, which oversees futures trading, is up for reauthorization later this year in Congress.
The accusations stand to scare off business at the Chicago Board of Trade and the Chicago Mercantile Exchange.
Even more worrisome, they`re sure to fuel arguments of futures industry critics who have been pressing for regulatory reforms that Chicago exchange officials fear could further discourage use of their markets and even send customers fleeing to do their trading overseas.
”It`s a very bad time for the futures markets,” said Hans Stoll, professor of finance at Vanderbilt University and futures market expert.
”If these (allegations) are true, the exchanges better damn well get hopping and institute checks and balances to keep it from happening again,”
Stoll said.
News of the sting operation slammed the exchanges just as the controversy about their role in the stock market crash was dying down. And only months before the crash, the Merc was publicly criticized for lax enforcement of trading rules.
”It`s embarrassing and disappointing,” said Robert Zellner, president and chief executive at Barnes & Co., a Chicago-based futures trading firm.
Despite the sometimes strained relations between the Chicago markets and the New York Stock Exchange, there was little glee at the Big Board over Chicago`s comeuppance.
”The bottom line,” said one NYSE official, ”is this just reinforces in the public`s mind the idea that the markets are crooked, and that`s not good.”
”There is the feeling that the game is rigged,” said Hugh Johnson, chief investment officer at First Albany Corp. in Albany, N.Y., ”that it`s maneuvered by insiders who have better information than they do. It`s going to take an awful lot of upside steam to get the small investor to overlook all of that.”
Since an anonymous tip led federal prosecutors to the illegal insider trading of Dennis Levine, a star investment banker at Drexel Burnham Lambert Inc., in May, 1986, the uncovering of criminal and fradulent acts on Wall Street has continued at a steady pace.
The idea that the playing field is unequal and the small investor doesn`t stand a chance is hammered home with each new allegation of wrongdoing in the marketplace.
Top officials of the two exchanges were in Washington attending the inaugural festivities and were unavailable for comment.
Their absence angered local business leaders, who were concerned about the markets` tarnished image and the effect a scandal could have on the city`s financial health.
”They (exchange officials) should be outraged by these accusations,”
said a senior official at a major Chicago bank. ”They should be here ready to strip the skin off these people. That`s what they should be saying, if they believed it.
”There are hundreds of thousands of jobs at stake, not to mention very important tools used by businesses to manage financial risk,” the banker said. ”The issue is the city`s (economic) health.”
It wasn`t the first time the futures markets have come under attack in recent years.
Two years ago, around the time the sting operation got underway, The Tribune reported that fraudulent practices were widespread in the Merc`s controversial Standard & Poor`s 500 stock-index futures market.
Exchange officials reacted by instituting rule changes in stock-index trading. They tightened internal enforcement procedures but may not have gone far enough.
Several months later, the stock market crashed and an even more threatening attack was launched on Chicago`s exchanges, which were accused of contributing to volatile market swings.
Sophisticated and controversial computerized program trading techniques involving futures and stocks exacerbated the plunge, many believe, and further tipped the scales in favor of big traders.
In Chicago, the century-old open-outcry style of trading may simply have become obsolete amid the fast and furious pace of trading in a world increasingly reliant on high technology.
”This is one more nail in the coffin” for open outcry, said Robert Gordon, president of Twenty-First Securities in New York and user of the futures market.
Barnes` Zellner and other industry officials predicted the scandal will speed up the use of computers to process trades. The Merc is working on an electronic trading system called Globex, which will operate overnight to attract overseas trading in currencies and energy futures.
”What comes out of this (probe) will be significant changes that will make the public confident they`re being treated in a fair fashion,” Zellner said.
”Down the road, a lot of business, maybe all of it, will be done by computer,” Zellner said. ”In a computer, it`s very difficult to cheat.”
In large part, Chicago`s markets could become victims of their own success. Because of the explosive growth in popularity of some contracts traded at the exchanges, hundreds of traders are jammed together in some pits.
”You can stand next to a guy in a pit and not know what he`s doing,”
said Zellner, a former floor trader. ”That means the exchanges aren`t necessarily at fault here. Look, they (the FBI) had to snoop on people and bug their conversations to catch them.”
Since 1986, the Securities and Exchange Commission and the Justice Department have uncovered illegal insider trading and stock price maniuplation at the stock exchanges, in the over-the-counter market, in the so-called
”penny stocks” and in the off-exchange ”third market.”
Some of the biggest names in the takeover game broke the law to gain an edge.
However, because of the possible impact on the little guy, said an official at one major Wall Street firm, ”I think this (the Chicago probe)
will be a lot bigger than the insider-trading scandal. The Ivan Boeskys and Drexel Burnhams already had $100 million in their pockets. But in this one, this time they`re stealing from the little guy.”
Despite the growing scandals, ”The U.S. still has the best, fairest, most efficient and most heavily used stock and futures markets in the world,” said Franklin R. Edwards, director of the Center for the Study of Futures Markets at Columbia Business School. ”The amount of fraud and criminality, given the scope of the markets, is trivial,” he added.
The Chicago allegations will have an impact on the regulatory battle shaping up in Washington over who should police equity-related trading in derivative products.
Sen. Patrick Leahy (D., Vt.), chairman of the Senate Agriculture Committee, which oversees the Commodity Futures Trading Commission, said that if the investigation reveals that retail customers were cheated on a large scale, ”It would raise serious questions about the way the futures market is operating.”
Leahy said his committee would scrutinize the investigation with an eye toward possible changes in the regulatory structure.
Edwards said he doesn`t think dismantling the CFTC would solve the problem.
”The kind of alleged fraud that took place is not something the SEC would be any better at policing than the CFTC,” he said. ”Nobody can totally prevent this kind of thing from happening. The only question is whether the exchanges are monitoring and policing as good as they should.”
Jeff Miller, of the trading firm Miller, Tabak, Hirsch & Co., said the allegations do ”put the traditional defenders of the status quo on the defensive.” It illustrates that the open outcry auction market has ”certain vulnerabilities.”
But Miller said he hoped Congress wouldn`t overreact. ”I hope it`s not total moral outrage. It`s going to take a delicate hand,” he said.
Too much regulation of the markets, experts argue, could virtually wipe them out. The loss could hurt investors and corporations who have come to rely on financial futures contracts traded in Chicago to protect against financial risk.
”You`ve got to have marketplaces, and you`ve got to have liquidity,”
Miller said. ”But that gives you rough edges at times. We need market makers. We need traders. But you can get some bad apples in there. People are always going to find ways to lie, steal and cheat.”
The fundamental issue, in Miller`s view, is that ”as a broker, you`re representing your client. If you get a better price, your client gets the better price. And ultimately, what polices that is competition from the good guys.”
Frank Gallagher, director of research at Phoenix Capital Markets, a firm that trades exclusively in risk arbitrage stocks, said he didn`t think the long-term impact on the futures markets would be that great. Gallagher noted that the arbitrage market ”has had its share of scandals.”
But, in spite of that, mergers and acquisitions are at record levels, and ”there continues to be a substantial amount of funds invested in risk arbitrage. I suspect life will go on there (in Chicago) as well.”
