You're out of touch.
-- Hall and Oates
Futures; OTC derivatives; and the agency that regulates them, the Commodity Futures Trading Commission (CFTC); all have archaic names that slow the coming revolution in market efficiency. This is no accident. It was the SEC's 1970's plan to protect their old boys' markets from competitive attack when financial futures were introduced. Naming the new futures regulator the CFTC was one way to slow the Chicago barbarians. This article considers the unfortunate effects of the name "futures markets."
The CFTC's name (Commodities?? - 80% of futures trading today is financial) is twice archaic. Bank and securities regulators, circa 1980, made sure there was no smack of financial asset jurisdiction in the new agency's name. The old-school regulators, the SEC and the Fed, correctly perceived the hand of historic inevitability in the rise of financial futures. From the Visigoths to Genghis Kahn, sedentary empires have fallen to the hands of professional invaders such as those of the Chicago markets. That will happen in financial markets too. But the old boys' club that dominated financial markets before the 1970's will fight to the end.
The word "futures" slows CME Group's (NASDAQ:CME) advance.
"Futures" as a name for the Chicago markets, was self-selected. But the name "futures" is also long in the tooth. Many of the early financial futures, notably foreign exchange futures and stock index futures, would have been far more successful if they had included a spot market dimension. The "futures" label, now enshrined in regulation, served an insidious purpose that inhibited the growth of the Chicago markets, by creating an illusionary wall between the efficient, competitive, futures markets and the dominant, out-of-date, broker-dealer dominated securities markets. This heavily guarded wall separating futures markets from securities markets is based on old-school brokers' fear of Chicago aggressors. It's modern version of the Great Wall of China.
Futures trading technology, if introduced to ordinary investors in a form that meets their objectives, would send the inefficient stock exchanges packing in short order. To meet this objective, there must be a spot market with unique properties that create a futures-like cost structure. My last article shows that spot markets already trade on futures exchanges. These existing spot markets are without inter-regulator controversy since they are so poorly designed. Nobody cares because these clumsy markets pose no threat.
But it wouldn't take much to design a killer spot version of a futures-like instrument.
The securities side of the wall gets ever less efficient.
This wall-based-on-a-name has permitted the stock market brokers to cling to their old customer-indifferent, inefficient ways - safe from attack from the more aggressive, less collegial, futures brokers. And it has also allowed the SEC to introduce back-door regulations that build further on the inflated franchises of those securities market parasites, the stock exchanges.
Securities markets also have been hobbled by the SEC's National Market System (NMS) regulations. These regulations - based, perhaps, on SEC failure to realize that in an electronic world, the concept "at the same time" has no meaning - disastrously created a playground for exploitation of inefficiency in which broker-dealers may find profit opportunities by reducing the impact on customers of these inefficiencies.
The SEC has gazed upon this disaster they created with all the remorse a government regulator can muster. Ho hum.
The stock exchanges, especially, have turned these SEC regulations into a bonanza. With their new-found SEC rules forcing the broker-dealers to track the prices of every exchange with ever-more-expensive exchange-provided data feeds, the exchange management firms have seen the wisdom of multiplying the number of exchanges that can sell these data feeds, and to regularly increase their cost of each exchange feed. Tellingly, the exchange management firms are consolidating, yet the number of exchanges continues to grow.
What should be done?
Futures market technologies could easily be applied to ordinary securities trading, saving investors billions annually. Indeed, like every illusion created by an elite group to preserve their undeserved position, the securities/futures wall-based-on-a-name will one day cease to be a fortress wall, and become a prison wall.
The ultimate self-defeating result of excluding the public is the inevitable loss of public interest, which puts an end to the advantages originally created for dealer bank insiders by placing the public at a disadvantage. Ultimately the excluded barbarians of the futures market will find a way to design a product that doesn't trip the regulatory "off" switch and meets the public need.
How the wall keeps investors away from futures.
If I were an official of the CME, or alternatively, of the CFTC, I would be a very angry person these days. The signal implementation of the modern theory of finance, stock index trading, is being rapidly replaced on the center stage of stock trading. The incredibly unimaginative common stock market finally developed the index ETF, with the introduction of Standard and Poor's Depository Receipts (NYSEARCA:SPY) in 1993. And the public appears, 15 years later, to be catching on to the ETF's benefits. Thus does financial progress bumble along.
The CME believes it cannot compete, since it has been relegated by regulation to the futures ghetto. This is simply a mistake born of complacency.
ETFs are more popular because they are simpler.
Futures and derivatives are saddled by another illusion: that the futures and OTC derivatives markets are necessarily too complex to be useful to the public. While they are indeed too complex, that complexity is not a necessity. In the case of OTC derivatives, the complexity is but the product of the dealer bank oligopoly, on one hand, and dealer-bank-supportive regulation, on the other.
The wall between wholesale derivatives trading and retail securities trading is there because these alternative markets create millions in value every day for the market elite dealer banks and like investors who understand the artificial complexities created to exclude others, or alternatively, to punish others who mistakenly enter these markets for their ignorance.
Futures are the antithesis of OTC swaps.
But there is an important difference between futures and OTC derivatives. Futures are inside the derivatives wall by the design of government. Futures have always been made available by the brokers of the futures market to individual investors. Government put futures behind a wall of regulation to prevent futures brokers from invading the securities markets. Swaps, on the other hand, are so tightly controlled that the important market players can now be counted on one hand.
Time created the CFTC and stunted the growth of financial futures.
The name "futures" implies there is some meaningful distinction between futures - financial instruments traded for future delivery, and securities, traded for present delivery.
But distinguishing the futures markets from securities markets in that way ignores all the differences between securities and futures markets that really matter today, safe, efficient liquid markets, focusing instead on an anachronism, seasonal delivery, that is useful only for non-financial commodities.
Value created OTC derivatives. The name derivatives - financial instruments priced with reference to some other "underlying" asset, suggests that securities' values are not derived from the values of some other "underlying" asset. What a joke. This concept is meaningless in setting derivatives apart from other financial instruments. OTC Derivatives are assets - have a market value - and conversely, non-derivative securities have values that must be derived from other assets. Every financial asset is a claim with no inherent value, but value derived from some other, "real" asset. In this, there is no distinction between OTC derivatives and, say, a bank deposit.
These names, derivatives and futures, are signposts, memorializing the history of the attempted exclusion of the trading public from insider's trading advantages. The names create the market elite's intended public misunderstanding of the function of the futures and derivatives marketplaces - leading the public to the impression that somehow futures and swaps are a sideshow, not meant for primetime consumption. And saying so has made it so.
The notions that the elite convey, to divide the market into insider and outsider versions - the big dealers, their elected wheel horses in London and Washington, and these politicians' henchmen, regulatory agencies - is that these markets are a mystery, somehow meant only for professionals, not for the investing public.
This article - the first of those concluding my series on the coming market revolution - begins to explain what will be the most surprising revolutionary change in financial markets, the coming end of financial derivatives. Futures, in retrospect, were a partially successful end run around the established institutions and regulators when they were introduced in the early 1970's. But futures markets were, and remain, the ultimate tools for democratizing financial markets. But they must first be freed from the many artificial barriers placed in their way by market mandarins and their legion of lackeys. And freed from their own mistake - naming themselves futures markets.
The Walls of Constantinople.
In the end, Constantinople grew old and died within impenetrable walls that succeeded in keeping nothing out but the visible truth of a dying empire. The Roman empire is an apt metaphor for the empire erected by the dealer banks. The Roman Empire's fate is a parable of the fate of any empire built on preservation of things archaic.
Walls are no longer important in military defense, thanks to aircraft. Their function today is offensive, not defensive. They keep prisoners in, not enemies out. Thus, someday soon, will it be with the derivatives wall.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.