Commodity Exchange Act (1936)

Commodity Exchange Act (1936)

Jerry W. Markham

The Commodity Exchange Act (P.L. 74-765, 49 Stat. 149) is the successor to earlier legislation that had proved ineffective in stopping the manipulation of commodity prices. Although the Commodity Exchange Act was itself later found to be a flawed mechanism for regulating the commodity markets (and was supplemented by legislation in the 1970s), it has played an important historical role.

Prior to the act's adoption in 1936, Congress had adopted the Futures Trading Act of 1921, which required all commodity futures trading to be conducted on an exchange licensed as a contract market by the federal government. This requirement was designed to allow federal scrutiny of the trading of commodity futures and to stop the so-called "bucket shops" that were essentially betting parlors for speculation in commodity prices.

After World War I, the U.S. agricultural sector experienced a recession. That economic downturn was blamed, in part, on speculative excesses occurring in the trading of commodity futures. The Futures Trading Act was the result of a massive investigation of the grain trade by the Federal Trade Commission (FTC) conducted in the wake of the recession. The FTC's massive report found that many abuses were occurring in the industry. Congress confirmed that finding in its own hearings on the Futures Trading Act.

In 1922, in Hill v. Wallace, the Supreme Court declared the Futures Trading Act unconstitutional because it was improperly based on the taxing powers of Congress. A manipulation in grain prices that occurred just after this Supreme Court finding spurred the reenactment of the Futures Trading Act, with a different name, under the commerce powers of Congress. The new act, called the Grain Futures Act, was held to be constitutional by the Supreme Court in Chicago Board of Trade v. Olsen (1923).

Commodity prices declined dramatically during the Great Depression, which followed the stock market crash of 1929. Newly elected President Franklin D. Roosevelt requested legislation for the regulation of securities and commodity futures as a part of his New Deal reforms. The commodity futures legislation, however, took a route different from that of the federal securities laws because the agriculture committees in Congress, rather than the banking committees, had jurisdiction over the exchanges that traded futures contracts. During the hearing on this legislation, Congress found numerous abuses, including what were described as speculative "orgies" and manipulations by large speculators that were thought to be driving down commodity prices.

One of the more rapacious of these speculators was Arthur Cutten, a Chicago trader who was responsible for several massive attacks on the commodity markets before moving to New York. There he became equally famous for his manipulations of the securities markets. A sensational price collapse in wheat and corn in 1933 on the Chicago Board of Trade and a dramatic drop in cotton prices in 1935 overcame industry resistance to legislative reforms, allowing the adoption of the Commodity Exchange Act in 1936.

GOALS AND FUNCTIONS OF THE ACT

The Commodity Exchange Act prohibited the manipulation of commodity futures prices and carried forward the requirement contained in the 1922 Grain Futures Act that commodity futures trading on "regulated" commodities be traded only on licensed contract markets. Fraud was prohibited and brokerage firms handling customer orders (referred to in the industry as "futures commission merchants") were required to register with the federal government. The Commodity Exchange Act was to be administered by a Commodity Exchange Commission composed of the attorney general and the secretaries of agriculture and commerce, a structure carried over from the Grain Futures Act.

Day-to-day regulatory responsibility was delegated to the Grain Futures Administration, later renamed the Commodity Exchange Authority, a bureau within the Department of Agriculture. Unlike the legislation adopted in the securities industry, no authority was given to the government to control the level of margins in the futures industry. Rather, the government was given the authority to limit the size of speculative positions by individual traders or those acting in concert with each other. The Commodity Exchange Act also sought to stop commodity options trading on regulated commodities because such instruments were viewed to be highly speculative.

EXPERIENCE UNDER THE ACT

The Commodity Exchange Act did not prove to be effective in stopping either manipulations or speculative abuses. A flaw in its provisions allowed the trading of options and futures on unregulated commodities, in other words, those not listed in the Commodity Exchange Act. The act could not be amended rapidly enough to keep up with the expansion of trading in options and futures on those unregulated commodities. This led to large losses in the early 1970s, when unregulated commodity options firms collapsed, causing losses to many unsophisticated customers. A large run-up in commodity prices during that period also raised concerns in Congress. The result was the enactment of the Commodity Futures Trading Commission Act, which created the Commodity Futures Trading Commission (CFTC), an independent federal agency intended to function like the Securities and Exchange Commission (SEC), the forceful regulator for the securities industry.

The CFTC assumed the powers of the Commodity Exchange Commission and was given broad new powers, including the authority to impose civil penalties of up to $100,000 for each violation of the Commodity Exchange Act or CFTC rules. New classes of registrants were added, including commodity trading advisers and commodity pool operators. The latter were pools of customer funds that were traded in commodity futures.

The CFTC very quickly encountered a number of problems, including the renewed fraudulent sale of commodity options to unsophisticated customers. This problem was handled by suspending commodity options trading until the exchanges allowed options trading under regulated conditions. The CFTC was also soon clashing with the SEC, as financial innovations led to futures trading on financial instruments regulated by the SEC. Such financial instruments included stock index futures and futures on fixed income instruments such as government securities. An agreement between the agencies, enacted into law, settled this dispute by drawing a boundary between their jurisdictions. That solution, however, was not long lasting.

The SEC blamed the stock market crash of 1987 on the destabilizing effects of futures trading on stock indexes. The development of over-thecounter derivatives instruments such as swaps led to other clashes between the SEC and CFTC on how those instruments should be regulated. These clashes intensified when several large institutions suffered big losses from trading those instruments during the early 1990s. A long-running debate then arose over how those instruments should be regulated. After some vacillation, the CFTC decided to deregulate the commodity markets except where retail customers are involved. That program was enacted into law through the Commodity Futures Modernization Act. This act amended the Commodity Exchange Act to free institutional traders from regulatory restrictions in their derivative transactions, provided that their counter party was also an institution. Observers criticized the 2000 legislation, however, after the failure of the Enron Corporation in 2001. Enron had used the provisions of the 2000 act to escape regulation of its broad-based commodity trading activities.

See also: Securities Act of 1933; Securities Exchange Act of 1934.

BIBLIOGRAPHY

Johnson, Philip McBride, and Thomas Lee Hazen. Commodities Regulation, 3d ed. New York: Aspen Law and Business, 1998.

Markham, Jerry W. Commodities Regulation: Fraud Manipulation and Other Claims. St Paul, MN: West Group, 2002.

Markham, Jerry W. The History of Commodity Futures Trading and Its Regulation. New York: Praeger, 1987.

Key Financial Terms for the Commodity Exchange Act

Jerry W. Markham

Commodity A commodity is defined under the Commodity Exchange Act of 1936 to include every item on which futures trading may be conducted, except onions (trading on onions is not permitted because of prior difficulties with that commodity). A commodity will include such things as interest rates and stock prices, as well as traditional commodities such as wheat and soybeans.

Futures A futures contract is a derivation of two more basic forms of contracts: cash and forward contracts. A cash (or "actual" transaction) is one for immediate payment and delivery. A forward contract calls for the delivery of the commodity at a future date. The forward contract is individually negotiated in all of its terms, including price, delivery date, grade of the commodity and its delivery point. The futures contract is like a forward contract except that all of its terms are standardized other than price, which is individually negotiated through an auction process on the floor of a commodity exchange.

Exchange and Contract Market A commodity exchange (also called a board of trade) is a centralized market where trading in futures contracts takes place. A contract market is a commodity exchange that is licensed by the federal government to trade commodity futures contracts.

Speculation Traders in the commodity markets may be speculators that are simply seeking a profit from price changes in a commodity by buying and selling futures contracts. This is not mere gambling because those traders provide valuable information to the market and lead to more efficient pricing of commodities.

Manipulation Manipulation is a term of art in the commodity markets that involves trading that causes commodity prices to reach an artificial level with the intent and ability to do so by the traders involved.

Federal Securities Laws The federal securities laws are a series of statutes that were enacted as a part of President Franklin Roosevelt's New Deal during the Great Depression. Among other things, those statutes created the Securities and Exchange Commission, an independent federal agency charged with regulating the securities markets. Securities sold to the public must be registered with that agency.

Brokerage Firms Brokerage firms accept and route customer orders to the marketplace for execution. In the commodity markets, such firms are called "futures commission merchants."

Options An options contract is an agreement that gives the holder of the option the right but not the obligation to purchase or sell a commodity. Options contracts are distinguishable from traditional futures contracts because the parties to a futures contract must make and accept delivery of the commodity unless offset by another futures contract.

Stock Index Futures A stock index futures contract is an agreement to deliver the change in value of a group of stocks that comprise a stock index such as the Dow Jones Industrial Average.

Over-the-Counter Derivative Instruments Over-thecounter derivatives are instruments with some elements of futures and options on the one hand and securities elements on the other. These instruments may be traded directly between dealers rather than through a central market or contract market.

Swaps A swap contract is simply an exchange of two sets of cash flows or other rights.