U.S. Congress Creates the Commodity Futures Trading Commission

Date October 23, 1974

Through creation of the Commodity Futures Trading Commission as an independent agency with the mandate to regulate U.S. commodity futures markets, Congress sought to ensure the economic usefulness of futures markets.

Also known as Commodity Futures Trading Commission Act of 1974

Locale Washington, D.C.

Key Figures

• William R. Poage (1899-1987), U.S. congressman from Texas, chair of the House Agriculture Committee, and a strong proponent of the Commodity Futures Trading Commission Act
• Herman E. Talmadge (1913-2002), U.S. senator from Georgia, chair of the Senate Agriculture and Forestry Committee, and strong supporter of the act
• William T. Bagley (b. 1928), first chairman of the Commodity Futures Trading Commission
• George E. Brown (1920-1999), U.S. congressman from California, member of the House Agriculture Committee, and strong supporter of the act
• Carl T. Curtis (1905-2000), U.S. senator from Nebraska and member of the Senate Agriculture and Forestry Committee

Summary of Event

The Commodity Futures Trading Commission Act of 1974 made comprehensive changes in the Commodity Exchange Act of 1936. The 1974 act created the independent Commodity Futures Trading Commission (CFTC), which was charged with regulating how farm and other commodities are traded on exchanges. The CFTC was entrusted with strengthening regulation of the commodity futures trading industry in the United States to ensure fair practices and honest dealings in futures exchanges. It was empowered to regulate and control all activities on the exchanges.

Formal commodity markets developed in the United States in the late 1700’s. After keeping enough of a crop for his or her own needs, a farmer brought grain and livestock to the local market. Because of the rhythms of nature, most farmers brought their products to market at about the same time. Supplies of meat and grains generally exceeded the current demand of meatpackers and millers, causing the prices of commodities to slump. The price problem was further worsened by inadequate storage facilities and lack of standards for quality.

Several months after the harvest, the supply of commodities would shrink. With no stored commodities to draw from, prices would skyrocket, and people would often go hungry. Millers and meatpackers also faced problems when they lacked the raw materials necessary to run their operations. Closures and bankruptcies would result. The minimal proceeds that farmers received for their produce at harvest time were inadequate for the construction and development of storage and farming assets.

Transportation and storage facilities improved in response to the inadequacy of local markets in meeting the needs of suppliers and buyers of commodities. Forward contracting between farmers and merchants developed to offset, at least partially, the fundamental problem of demand and availability of the commodities. Forward contracting involved an agreement for the delivery of a commodity at a predetermined future date. All the terms and conditions of the contract regarding the price, quality, quantity, and packaging of the commodity and the place and mode of delivery were predetermined. Forward markets did little to control the risk arising out of crop failures, losses in transit, and bankruptcies in a volatile price environment. Moreover, lack of regulation resulted in lack of a reliable mechanism to ensure performance by the parties to a contract.

There were two major shortcomings of forward trading: a lack of secondary markets for forward contracts to enable the participants to “bail out” of a contract if they so desired, and a lack of a performance guarantee. These problems were eliminated as a system of futures trading developed in the United States. The development of futures markets accelerated with increasing needs for large-scale risk transfer and centralized pricing in the agriculture forward markets.

In 1848, the Chicago Board of Trade (CBOT) was formed by eighty-two merchants. While Chicago became the primary location for the distribution and export of grains, New York developed into a similar center for cotton. These centers promoted competition and attracted traders from all over the world. Participants soon developed uniform systems for trading in these centers.

Futures trading on the CBOT began in 1865. Trading in futures, or contracts to deliver a commodity at a future date, required market participants to make and rely on forecasts of supply and demand. Prices that emerged for futures contracts reflected a consensus of those forecasts. High futures prices, for example, indicated a consensus that demand would be relatively high or supply would be relatively low.

Futures trading allowed hedging of price risks. A seller or buyer could lock in a price through a futures contract rather than take the risk of the price changing unfavorably before the delivery date. This reduction of risk allowed commodity handlers to operate at lower costs.

Rules and procedures for trading, clearing, and settling contracts were adopted in the late 1800’s. Standardization of contracts and delivery dates also took place. Increased efficiency of commodity trading, however, rarely resulted in increased prices for farmers. Abuses in the commodity markets were frequent. These abuses arose from the very structure of the commodity markets. A speculator could enter into a large futures contract with a relatively small commitment of funds, since payment was promised in the future. The markets were dominated by large traders and speculators who exercised their economic power and manipulated markets to their advantage. Farmers had little faith in these markets but little choice about where to sell their produce. This lack of faith of farmers led to a revolt against the futures markets, and in 1893 the U.S. Congress came close to imposing prohibitive taxes on futures trading. During the first years of the twentieth century, the revolt against futures trading softened as a result of price increases for farm products and development of cooperative farm marketing. Pressure still was building for federal regulation to ensure more stable and reliable futures prices and markets.

With passage of the Cotton Futures Trading Act of 1914, Congress attempted to regulate a farm product market for the first time. The end of World War I saw declining farm prices and increased demands for the regulation of futures trading. By passing the Grain Futures Act of 1922, Congress extended its regulation of futures trading. The Grain Futures Act empowered the secretary of agriculture to regulate the activities of a futures exchange but not those of the futures traders. Under the act, it was the responsibility of an exchange to prevent price manipulation on the exchange. Although the act provided for legal action against price manipulators, it proved inadequate in dealing with market abuses.

The ineffectiveness of the Grain Futures Act resulted in the passage of the Commodity Exchange Act of 1936, which extended the regulatory net to other commodities and made price manipulation a criminal offense. Broader powers were granted to deal with abuses and to prosecute any offending trader. The act was also designed to curb excessive speculation and to bring commodity brokerage under regulation.

Several minor changes were made to the Commodity Exchange Act between 1936 and 1967. In 1968, Congress set minimum financial standards for commission traders and increased the penalties for certain violations such as price manipulation. Until the early 1970’s, the government’s stockpiles of commodities played an important role in stabilizing prices. The government would buy farm products in times of declining prices and high output, then serve as a supplier in periods of low farm output. As the shift to a market-oriented economy free of government interference gained strength, government reduced its role in the commodities markets, and merchants increased their reliance on futures markets to protect themselves against substantial price changes.

Although many futures markets had been regulated to varying degrees since 1914, several important markets, including metals, coffee, cocoa, and sugar, were still completely unregulated by the federal government. The volume of trading on the futures markets was rapidly increasing, by 1973 reaching $500 billion annually, much greater than the volume of financial securities trading on exchanges. It was apparent that futures markets had far-reaching effects on consumers, affecting them from their grocery bills to their housing costs. It also became apparent that commodities markets were just as important as securities markets for the country’s economic development, resulting in demands for a single regulatory authority that would oversee and regulate the activities of all commodities markets. On October 23, 1974, Congress passed the Commodity Futures Trading Commission Act, thereby creating the CFTC. On April 21, 1975, the CFTC assumed all regulatory powers and functions pertaining to futures trading.

Significance

The CFTC’s task of overseeing and regulating a rapidly expanding and growing futures market was enormous. The commission was charged with regulating “any item of goods or services traded on a futures basis.” Within a week of assuming regulatory responsibility, the CFTC proposed rules to prevent fraud in commodities options and gold and silver futures contracts. By July 18, 1975, the CFTC had expanded its scope of regulation from thirty-eight futures markets for farm products to eighty-two markets for all types of futures trading. Later in the same year, the CFTC approved trading on the first two financial futures, one for Government National Mortgage Association (GNMA) mortgage certificates and the other for ninety-day U.S. Treasury bills.

During the first nine months of its operations, the CFTC rejected a request by Jack W. Savage, who previously had been convicted of mail fraud, for registration as a commodity trading adviser. The commission also filed its first injunction proceedings against City Commodities, Incorporated, of Minnesota for fraud and other violations of futures laws.

During its first year, the CFTC put in place procedures for reparations, handling confidential data, and receiving reports required of foreign traders. It also enlarged its reporting requirements to new commodities. In 1976, the CFTC’s enforcement division launched two hundred fraud investigations. In 1977, the CFTC proposed regulating options markets and suggested rules for consumer protection. During this early period, the CFTC handled several major crises, including a rise of coffee futures from $0.55 per pound to $1.50 in response to floods in Colombia and frost damage to the coffee crop in Brazil. The CFTC also charged the Hunt family of Dallas, Texas, with taking futures positions in soybeans that far exceeded the speculative limits. The U.S. district court in Chicago found the Hunt family in violation of rules and imposed a civil penalty of $500,000. It also prohibited family members from trading soybean futures for two years.

In 1977, the CFTC declared that it was legal for floor traders to engage in dual trade—for themselves and for customers—as long as the customers’ orders were executed first. Trading firms were responsible for appropriate supervision of their employees.

On November 2, 1978, William T. Bagley retired as the first chairman of the CFTC. In his letter of resignation to President Jimmy Carter, he noted that the CFTC, after some initial start-up problems, had emerged as an efficient operating agency with a uniform set of trading rules and procedures.

The CFTC later designated several new contracts and contract markets including the Amex Commodities Exchange, Inc., for futures on GNMA certificates, the New York Futures Exchange for financial instruments and foreign currencies, and the Chicago Board of Trade for options on Treasury bond futures. Introduction of stock index futures contracts provided an effective means of hedging the overall direction of the stock market. By the end of 1982, stock index futures were trading on several exchanges.

During the last week of December, 1979, the Soviet Union invaded Afghanistan. On January 4, 1980, President Carter imposed an embargo on previously contracted wheat exports to the Soviet Union. In view of this embargo and the prospects of an abundant crop, commodity prices were expected to plummet. Traders and experts were concerned that this sudden shock, coupled with uncertainty about the price support program of the U.S. Department of Agriculture, would result in chaos in the marketplace. Large price declines were expected to result in margin calls in excess of $400 million. The CFTC, after wide-ranging consultations, called for a two-day suspension of the trading of wheat, corn, oats, soybeans, soybean meal, and soybean oil. The two-day suspension gave the markets time to consider market conditions more carefully, and an almost certain market crisis was averted. The CFTC has since effectively intervened several times to avoid or reduce crisis in several commodities, including silver and crude oil futures.

Standardized futures contracts in which quantity, quality, and location are established help meet specific requirements of buyers and sellers. Price is the only variable, and it is discovered through auction trading on the floor of an exchange. Farmers, merchants, and investors use futures contracts to protect themselves against fluctuating cash prices. Availability of nontraditional contracts such as futures on stock indexes, government bonds, foreign currencies, and other financial instruments provide means of hedging for all investors. Speculators, who generally have no trade interest in the underlying instrument or commodity, assume the risk the hedgers are attempting to avoid. Futures exchanges play the crucial role of clearing and settling contracts in these risk-transfer activities.

Bibliography

Chicago Board of Trade. Commodity Trading Manual. Chicago: Author, 1998. A well-written reference manual dealing with a variety of topics ranging from historical development to day-to-day operations of a futures exchange.

Commodity Futures Trading Commission. Commodity Futures Trading Commission: The First Ten Years. Washington, D.C.: Author, 1984. This sixty-four-page book describes events in the first ten years of the CFTC. It details the challenges faced by the CFTC and how they were managed.

Kolb, Robert W. Understanding Futures Markets. 5th ed. Malden, Mass.: Blackwell, 1997. Well-written work provides easy access to details about specific futures markets. Includes illustrations.

Kolb, Robert W., James Overdahl, and Giuseppe Bertola. Understanding Futures Markets. 6th ed. Malden, Mass.: Blackwell, 2006. A comprehensive, authoritative text of the futures markets. Covers topics such as event markets, proposition markets, weather futures, macro futures, and electronic trading platforms and the rise of electronic trading.

Schwarz, Edward W., Joanne M. Hill, and Thomas Schneeweis. Financial Futures: Fundamentals, Strategies, and Application. Homewood, Ill.: Irwin, 1986. A good source of information on the theories, applications, and strategic use of financial futures.

Teweles, Richard J., and Frank J. Jones. The Futures Game: Who Wins, Who Loses, and Why. 3d ed. New York: McGraw-Hill, 1999. The first three chapters provide insights into the nature and mechanics of futures markets. Much of the remainder of the book deals with individual futures markets.