MARGIN REQUIREMENTS FOR TRANSACTIONS IN FINANCIAL INSTRUMENTS THURSDAY, MAY 29, 1980 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, D.C. The committee met at 10 a.m., in room 5302, Dirksen Senate Office Building, Senator William Proxmire (chairman of the committee) presiding. Present: Senators Proxmire, Stevenson, Sarbanes, and Stewart. OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. The committee will come to order. During the next 2 days, the committee will be exploring the circumstances and consequences surrounding recent events in the futures markets. The speculative frenzy in silver prices brought our financial system perilously close to crisis. It also dramatized the direct relationship between the futures markets and the difficult tasks of controlling inflation, checking the excessive use of credit, stabilizing our economy, and promoting sound banking practices. The Committee on Banking, Housing, and Urban Affairs has responsibility over these important subjects and intends to exercise it in cooperation with others concerned about the need to prevent a reoccurrence of recent events. The United States has had firsthand experience with the dangers of runaway speculation. Excessive securities speculation in the late 1920's, made possible by unrestricted bank financing and easy credit, led our Nation into a prolonged economic nosedive, caused numerous bank failures, and eroded public confidence in the integrity of our financial system. Corrective measures were taken in the securities market and since then our stock markets have not only been stable and orderly but have been established as the preeminent capital markets in the world for a wholesome balance of freedom and responsibility. In contrast, the futures markets have become the Indianapolis 500 for individuals hoping to strike it rich in this high risk, highly leveraged, and fast moving marketplace. At times the futures market more clearly resembled a demolition derby. Now it is true that some speculation is indispensable to an efficient futures market. It is quite another matter, however, for the futures markets to become a special haven for the high rollers, where the initial entry fee is a nominal sum and the potential for serious losses to unsuspecting individuals and important national interests and economic stability are ignored. For example, a Treasury bill, with a face value of $1 million, can be purchased in the cash (1) market for $1 million, an amount which puts it beyond the reach of most individuals. Yet, a futures contract for $1 million on the same instrument can be purchased for less than $1 thousand-less than one-tenth of 1 percent. With tremendous leverage like that, it is no wonder that individuals of modest means and no great financial sophistication are being enticed into this market. It is also no wonder that such high leverage has the potential for creating problems in this cash market for Treasury bills. It is a 1980's version of Klondike fever. Nonagricultural commodities, such as futures based on Government securities, are the fastest growing segment of the futures markets since their introduction in 1974. The CFTC has approved new contracts based upon gold, silver, and other precious metals; major foreign currencies; Treasury bills and bonds, and certain Government guaranteed securities. Applications for futures contracts based upon composite stock market indexes are backlogged at the CFTC. În 1978, the dollar value of all trading in financial futures comprised 61 percent of the total futures market and I suspect the percentage is even higher in 1979. Futures markets based on Government securities have quickly become the largest trading markets in the world. Its growth has been explosive. The annual trading volume in Treasury bill futures contracts alone was $2 trillion in 1979, compared to $769 billion in 1978, $320 billion in 1977, and only $110 billion in 1976. So between 1976 and 1979, the market went from $110 billion to $2 trillion, an increase of almost twentyfold. Currently, the dollar volume amount of trading in the T-bill futures market exceeds the total volume of dealer trading in the cash market for T-bills. Undoubtedly, this new generation of financial futures are regarded as positive developments by the exchanges where they are traded, as added profits by the futures merchants who thrive on the brokerage commissions; and as Golconda-a land of great wealth and riches-by successful speculators who have realized lush profits. But, there are also significant downside risks attached to the continued and unregulated growth of financial futures trading. First, trading in financial futures poses unacceptably high financial and other risks for all but the most sophisticated and well-heeled. Low deposit or margin requirements on futures, set exclusively by the exchanges, entice entry by individuals. Unlike our securities laws, there is no well developed body of suitability and other safeguards to place an affirmative duty on a brokerage house to alert the customer to the inherent risks. Second, the fact that sizable speculative positions in gold, silver, or other unregulated financial instruments can be accumulated through the use of borrowed money creates an environment which is volatile and easily controlled by a handful of substantial and serious speculators. Aside from the low margins, credit can be used to meet initial deposit requirements to finance delivery, or to meet daily margin calls. Funds can be borrowed directly from a bank or indirectly through a brokerage firm. Funds even become available on a daily basis through variation margin calls at clearinghouses which permit a customer to use unrealized profits to pyramid additional futures contracts as the market moves up. However, once the market begins to slide and margin calls are made, the pyramid begins to crumble like a castle made of sand. Although there is no data on the amount of credit used to finance speculation, it is substantial by any yardstick. And such lending can jeopardize the lending institutions, particularly when there is a sudden and steep price break and the loans are not collaterized prudently or properly. The third danger posed by the rapid growth of trading in financial futures is that it may work to the detriment of the issuer of the underlying security-in some cases, it will be the U.S. Government. As both the Fed and Treasury have testified, I believe there is grave danger in converting Federal obligations into the vehicle for large-scale speculation. Yet this is precisely what is happening in financial futures where speculators far outnumber hedgers. Moreover, the Federal Reserve Board and the Treasury Department have expressed concern that trading in futures contracts on Treasury securities can undermine both debt management and monetary policy. Legislation I have introduced will equip the Federal Government with the tools necessary to deal with these problems. Under that bill, S. 2704, the Federal Reserve Board could prescribe margin requirements against loans used to finance the purchase of a financial instrument and set the initial and continuing deposit requirements. The important term "financial instruments" has been defined to exclude agricultural commodities and to subject only securities issued or guaranteed by the Federal Government and precious metals with monetary characteristics to the coverage of the bill. Finally, the Board could regulate the nature of the collateral used to secure loans for any of these purposes. The futures markets have become too important to the economic well-being of our country to remain beyond the reach of the Federal Government's ability to regulate the flow of money and credit. As a matter of law, the CFTC lacks the authority to set margin requirements under routine circumstances. The emergency powers in its possession are too extraordinary to have any practical significance. As a result, the responsibility to establish margin requirements has been left exclusively to the boards of trade. I believe this is wholly unsatisfactory for several reasons. The first is the difficulty the exchanges must have in reaching these economic decisions on a dispassionate basis. Exchanges compete with one another for volume and therefore have a built-in economic incentive to keep and maintain_margin levels as low as possible or send the business elsewhere. Even worse is the fact that these decisions are made not by independent, outside directors, but by individuals who have a tangible and pecuniary stake in the consequences of their own decisions. To remove the risk that margin decisions may be improperly motivated, I believe the Federal Reserve Board should exercise these powers in the first instance. Since 1934, it has regulated the use of credit in the stock market and has proved itself adept at promoting the orderly development of new instruments, such as options. The Fed has worked well with the SEC and with the selfregulatory organization under its jurisdiction. The same harmonious relationship could develop involving financial instruments and the CFTC. In this manner, I believe the growth of financial futures can be encouraged within a framework that prevents excessive speculation so destructive to our financial markets and so destabilizing to our financial system. The final issue before the committee at these hearings concerns the adequacy of our existing banking laws to prevent certain imprudent, if not improper, bank lending practices involving futures trading. In the aftermath of the silver crisis, it has become clear that the bank regulators did not discover until it was almost too late about the amount of bank credit flowing into the futures market and the failure of many banks to secure these loans adequately. This question would be important in ordinary times; it is essential since the Fed has cautioned banks specifically to avoid speculative loans as part of its anti-inflation program. Despite the recent gyrations in the silver market, there are those who argue that our present regulatory system is adequate and that no new laws or regulations are needed. This viewpoint must certainly be given attention. At a time when we are trying to reduce the amount of Government intervention in our economy, we need to be especially cautious when faced with proposals for more regulation. I am mindful of the economic benefits flowing from our futures markets and it is not my purpose to burden the industry with needless regulation. At the same time, I believe that intelligent regulation can produce positive benefits not only for the economy as a whole but for the futures industry as well. Our securities laws have helped to build public confidence in securities trading with the result that we have the most highly developed securities market in the world. Similarly, a prudent and moderate approach to futures regulation can instill a greater degree of public confidence in the futures market. If we really want to saddle the futures industry with onerous regulation perhaps the best policy is to do nothing and wait for an actual financial disaster to occur. Under those circumstances, Congress is likely to react with a massive dose of regulation that could have a long-term debilitating effect on our markets. I believe it makes more sense to anticipate and deal with some of the most serious problems today so that we are not faced with reacting to a real financial crisis tomorrow. I am pleased that so many expert Federal officials will appear this morning to help the committee get to the heart of all of these issues. Most of you are frequent visitors here. If there is strength in numbers, the CFTC's testimony later today will be overpowering. Tomorrow, respected spokesmen and exchange officials from the futures industry will appear to contribute their wisdom to our deliberations. I want to thank all of the witnesses for taking part in these hearings and for cooperating in their preparation. Chairman Volcker, we are delighted to have you as our leadoff witness. Go right ahead. STATEMENT OF PAUL VOLCKER, CHAIRMAN, FEDERAL RESERVE BOARD Mr. VOLCKER. Mr. Chairman, I welcome the opportunity to outline the preliminary views of the Board of Governors on S. 2704, which would authorize the Board to impose margin requirements on a broad spectrum of financial instruments in both the cash or spot markets and in the futures or forward delivery markets. The Board shares the concerns-growing out of recent developments in the silver market-that have prompted these hearings and, in that regard, I have appended to my statement an interim report on the financial aspects of that situation. Rather than delve further into the particulars set forth in that report, I will use the time provided for my statement to comment on underlying issues to which S. 2704 is directed. FEDERAL RESERVE AUTHORITY The Federal Reserve does not have direct statutory or regulatory authority over any commodity or financial futures market. We do have statutory authority to establish margin requirements for the purchase or carrying of equity and equity-type securities, including stock options. And, in cooperation with the Treasury, we have a more limited and informal oversight role with respect to the Government and Government-related security markets. While our direct authority does not extend to the futures markets, the commodity markets generally, or the gold and silver markets specifically, we do have a continuing interest in the performance and functioning of those markets. That interest arises in several contexts. For example, to the extent that price trends in those markets, or in segments of those markets, radically departfor whatever reasons-from general price movements-as was the case with gold, silver and other commodities during late 1979 and early 1980-they can directly and indirectly fuel inflation and inflationary expectations. Recurring headlines detailing the substantial and cumulative rise in gold and silver prices, for example, surely worked to reinforce inflationary expectations in 1979 and early 1980. Indeed, it was largely for this reason that the Federal Reserve, in October 1979 and again in March 1980, called specific attention to speculative tendencies in the commodities markets and requested banks to avoid speculative lending. The Federal Reserve's general interest in these markets also stems from its responsibilities for promoting the efficient and effective functioning of the financial markets. That interest is obviously more pointed in certain interbank and Government securities markets, but financial markets in the United States and around the world have become integrated to the point where it is very difficult, as a practical_matter, to segregate one market or one institution from others. For example, some of the institutions with the greatest exposure in the silver situation had farflung activities in many other markets. Had one of those institutions become insolvent, the problem would have quickly spread to other markets, many of which are far removed from silver. Because of the interdependence of or financial markets, the Central Bank must be prepared to take appropriate steps to insure the continued viability and integrity of the markets, particularly in times of stress. To fulfill this function, the Federal Reserve must have at least a general awareness of trends and developments in all sectors of the financial markets. Finally, the Federal Reserve has a direct and immediate interest in the extent to which credit is used to finance transactions in |