Emerging Issues and Policy Options in the U.S. Futures Industry
Lamm, R. McFall, Jr., Business Economics
THE U.S. FUTURES industry experienced explosive growth in the 1980s as annual volume tripled to more than a quarter of a billion contracts. This surge was attributable primarily to increased trading of financial and currency futures contracts, as well as to the emergence of stock index futures. Another major factor stimulating industry growth was trading in options contracts on futures, which began in 1983. Options volume increased from nothing to more than 60 million contracts by the end of the decade. In spite of rapid expansion of the futures industry, major issues are now emerging that suggest the future might not be so bright.
CURRENT INDUSTRY SITUATION
Futures industry growth in the 1980s came largely in response to product innovation and the loosening of regulatory restraints early in the decade. For example, energy market and bank deregulation, combined with actions by the Commodity Futures Trading Commission (CFTC) legalizing futures options, led to new contracts in petroleum and financial products that brought volume into the industry at key points. In addition, technological innovation allowed computerized program trading, thereby increasing volume in stock index futures and options arbitrage. Indeed, from 1980 through the mid-1980s, whenever it appeared volume growth might diminish, new stimulus rejuvenated the industry.
By the end of the decade, however, futures market growth slowed. Trading volume that rose at double-digit rates through 1987 fell to only 5.6 percent growth in 1990. In 1991, volume actually dropped for the first time in modern history. Beyond the cyclical impact of the recession, five factors have emerged to inhibit long-run volume growth. These include: (1) reduced price volatility in the primary futures markets; (2) the "maturing" of most futures market contracts; (3) the growth of off-exchange trading; (4) mergers and acquisitions among firms that are major users of futures markets; and (5) the emergence of strong overseas competition from foreign futures and options exchanges.
The decline in long-run price volatility is reflected in the behavior of individual commodities as well as broad-based indexes. For example, the annual price volatility of gold and silver (measured as the ratio of the standard deviation to the mean) declined from double-digits in the early and mid-1980s to 5 and 8 percent, respectively, in 1990. Similarly, the price volatility of the Commodity Research Bureau Index fell by half during the 1980s. Declining price volatility generally reduces trading volume by limiting profit opportunities for speculators, as well as reducing the need for commercial firms to hedge because price risk is lower.
The second long-run factor restraining futures volume growth is the "maturation" of many futures market contracts. Futures contracts exhibit the same dynamic life cycle characteristics as other products: birth, growth, maturity, and death. Many new futures contracts introduced in the 1970s and early 1980s "matured" in the late 1980s. As a result, volume growth slowed naturally as market participants became familiar with the contracts, implemented the appropriate hedging or trading programs, and reached a steady-state or optimum levels of futures market participation.
The third factor negatively affecting futures volume is growth in "off-exchange" trading. Off-exchange activity is especially prevalent in currency markets but is also significant in precious metals, as well as for other commodities. Off-exchange markets are typically made by banks, trading companies and securities firms that either act as intermediaries by matching buyers with sellers, or make markets themselves by taking the trading position opposite the customer. These activities reduce futures market volume by moving transactions off the exchange floor.
The major attractions of off-exchange trading are that: (1) margin money is not required; and (2) products can be tailored specifically to customer needs with respect to volume (larger trades at one price), timing (off-hours), delivery location (or no delivery), and design flexibility (strike prices, expiration dates, and settlement mechanisms). …