Regulation is justified when it serves the public interest, but is often motivated by the economic self-interest of powerful groups. Economists call this phenomenon “smugglers and Baptists” – those likely to profit from the illicit alcohol trade push for regulation alongside moralists who hope to protect the weak.
The battle over the future of derivatives markets, now taking place at the Commodity Futures Trading Commission, is a recent example. The debate revolves around a proposal by FTX, a licensed derivatives exchange, to allow futures contracts to be floated on margin, which would be subject to a new method of escrow accounting and handling of margin calls.
Currently, if you want to bet on the future price of corn (or the stock market or interest rates), you can do so by subtracting a fraction of the actual cost of the bet – usually 10% – with an intermediary bank. If the bet moves against you, the bank may ask you to put in more money to make sure the bet has enough collateral. Existing derivatives exchanges make these decisions at the end of each trading day.
Enter FTX, which suggests a slightly different approach. FTX wants to determine if enough guarantees are being posted twice a minute around the clock. If prices move significantly against a position, FTX will automatically remove the risk from the position by selling it and returning the proceeds to the account holder. FTX claims that this will disperse risk (which can accumulate during periods of the day or on non-trading days), require less collateral for a given level of risk, and are generally more efficient.
Defending the old-fashioned way of doing things, two current exchanges, CME and ICE, are arguing that weak derivatives investors will likely be hurt by the FTX model — farmers and others in the agricultural industry in particular.
This is a classic play for smugglers and Baptists. Concern about family farmers is an appeal to members of the House Agriculture Committee, the body with authority over the CFTC, which must approve the FTX’s request. Congress should not be deceived for four reasons.
First, FTX does not propose to introduce derivatives on agricultural products in its application. Furthermore, the CFTC has the authority to restrict the use of the FTX model to non-agricultural derivatives.
Second, even if FTX was offering agricultural products, farmers were unlikely to buy them. Existing exchanges allow farmers who buy futures contracts to use stocks (corn in a silo or in the ground, for example) as collateral, while the FTX model requires exchange-recorded cash collateral. The additional cash outlay required for farmers would be prohibitive in most cases.
Third, if the FTX model proves to be more efficient, and intermediary banks are allowed to use it, farmers will be offered the right products. For example, an intermediary bank can market a “flexible hedge” that ensures that the downside of the farmer is limited. Automation can easily maintain a hedge. If it is too expensive or too risky for farmers, they can use the existing system instead. These systems can coexist, providing more options.
Finally, corn growers want corn prices to rise. To hedge the risk of lower prices, some farmers take an equivalent short deal in corn futures – a contract that pays off if prices fall. This short position may be liquidated at midnight under the new risk pattern. This will happen if corn prices rise significantly. Such cases are incredibly rare. In the past five years, there have been more than 1,200 trading days in the corn futures markets. There was one day when prices moved more than 10%, which is a typical threshold. The average price change was zero.
Even if prices fall, the impact on farmers is not something they should lose sleep over. The only case where farmers would be worse off is if prices jumped, making a short pause, and then went down. In the past five years for corn and soybean futures prices, there have been no cases of this type of wild price movement. Dynamic contracts can easily be offered by brokers to alleviate any concerns.
According to data from the US Department of Agriculture, less than 10% of farms use futures contracts, and those that do are much larger than the average and more likely to be operated by a farmer with a college degree. This is not the vulnerable group that needs protection as the critics of the FTX proposal have portrayed it.
If the FTX model proves to be more efficient, and is eventually allowed to be used in agricultural products, these farmers, with the help of intermediaries if they want, are well equipped to navigate any change in existing exchanges in an outdated way of doing things. It is clear that existing exchanges (smugglers) benefit from maintaining the status quo, but their personal interest will not be sold on Capitol Hill or the CFTC. Instead, they hide private earnings publicly, hoping that the Committee on Agriculture and advocates of agriculture (Baptists) will play.
Mr. Henderson is Professor of Law at the University of Chicago.
Copyright © 2022 Dow Jones & Company, Inc. all rights are save. 87990cbe856818d5eddac44c7b1cdeb8