The Chicago Board of Trade and the Chicago Mercantile Exchange are debating the best way to develop risk-based capital requirements for futures traders.
The two exchanges submitted competing proposals at a roundtable discussion hosted this week by the Commodity Futures Trading Commission.
The proposals differed principally on how to measure risk.
Trading industry experts said the debate is a first step toward an industry consensus on how to change a rule that most agree is outmoded.
"The capital rule has been in existence for nearly 20 years," said Dan Driscoll, vice president of compliance with the National Futures Association, an industry group that sets standard practices. "It's certainly time to review it and see what changes need to be made."
The proposals agree that regulators should consider the risk of the open positions carried by futures trading firms. They disagree, however, on whether the industry's standard margin system can adequately measure risks across different markets, products, and exchanges.
Both exchanges have suggested that the current "funds-based" method of calculating capital requirements is outdated.
The rules, adopted in 1978, require futures firms to hold capital equal to at least 4% of segregated customer funds. Risks associated with positions taken by a firm's customers, affiliates, or even its own trading account are disregarded.
The two exchanges agree that regulators should base new rules on the market risk of all a firm's open positions.
Participants at the trading commission's roundtable included the two exchanges as well as representatives from the Securities and Exchange Commission, the Federal Reserve, the New York Stock Exchange, and individual brokerage firms.
In its proposal, the Board of Trade argued that the estimated $1.33 billion loss taken by the futures affiliates of the German conglomerate Metallgesellschaft AG highlighted the changes that have occurred in the industry.
The exchange argued that trading firms often face significant risks as a result of activities conducted by affiliated companies. Under current rules, the trading volume associated with the business of these affiliates can exceed a trading firm's capital.
"Not only have our markets experienced enormous increases in trading volume and open interest, but the size of orders being executed is considerably larger," Patrick Arbor, the Board of Trade's chairman, said in a prepared statement.
To overcome problems associated with large concentrations of risk at one client or affiliate, the Board of Trade proposed a special charge on any account whose position exceeds a specified percentage of a trading firm's capital.
Besides imposing an arbitrary capital requirement, the Board of Trade also argued that the current regulations penalize firms wanting to impose higher margins on higher-risk customers. By basing capital requirements on customer funds instead of risk, the current rules force trading firms to hold extra capital on this excess margin despite the reduced risk.
It is on measuring the risk where the two exchanges part ways. The Mercantile Exchange said its Standard Portfolio Analysis of Risk Margin, or Span, system, is flexible enough to do the job.
However, the Board of Trade, which uses the system to determine its daily performance bond requirements, or daily margin, said the system would suffice only until a more flexible and comprehensive system is developed.
The Board of Trade said the system gives undue weight to short-term market risk, which may ultimately cause daily swings in capital requirements for some trading firms.
"Our feeling is that this system doesn't go far enough, and the (trading firms) we talked to feel the same way," said David Prosperi, a spokesman for the Board of Trade.
But Jerry Roberts, vice president of the Mercantile Exchange's risk management division, said the system has the capability to measure the risk of trades like these.
"These are just control decisions that whoever is running the system can make," Mr. Roberts said. "It's just a question of what you choose to calculate risk for."
The National Futures Association declined to endorse either proposal, said Mr. Driscoll. Instead, he advised the parties to continue to discuss possible solutions to the outdated capital rules.
"The industry needs to come up with a consensus," he said.
Among other changes proposed, both the Board of Trade and the Mercantile Exchange suggested harmonization of capital requirements and other regulations between the CFTC, the SEC, and other self-regulatory bodies. The reason for this suggestion is that many trading firms are also registered with other regulatory bodies as broker-dealers.
