For a moment in 1973, the Nixon administration considered putting the futures markets under the jurisdiction of the Securities and Exchange Commission, which had been the nation’s primary market regulator for forty years.
Had that been done, it would have prevented decades of bureaucratic warfare, but the chairman of the SEC at the time fatefully declined. Instead, the CFTC was created and put under the supervision of the congressional agriculture committees, which had overseen its tiny predecessor, the Commodity Exchange Authority.
Some of the wealth generated by the futures market had been spent to cultivate the Farm Belt’s powerful congressional delegation, which meant that the Chicago exchanges played a muscular role in drafting the 1974 law that created their new regulator. The Chicago Board of Trade, with Richard Sandor’s new Ginnie Mae futures in mind, told its lawyer, Philip Johnson, to make sure that the bill defined “futures contracts” as broadly as possible and gave the new agency exclusive jurisdiction over them.
Phil Johnson, a small, elegant man with peachy skin and bright eyes, had begun his Chicago legal career in the mid-1960s as an antitrust lawyer at Kirkland and Ellis. Along the way, he developed a passing fluency in the language of the futures market, so when the law firm’s partner assigned to the Chicago Board of Trade retired, Johnson was drafted to replace him.
And in the 1974 wrangling over the CFTC’s creation, Phil Johnson more than earned his keep.
The old law that set up the Commodity Exchange Authority limited its reach to futures contracts based on a list of specific tangible products. Wheat was on the list, for example, but silver and foreign currencies weren’t. The first impulse of those designing the new regulatory agency was predictable.
“Someone suggested that we just add ‘securities’ to the list,” Johnson recalled, but he felt that would have been “a red flag” to the SEC and its backers in Congress. Instead, he proposed that the new agency be given jurisdiction over the futures exchanges themselves, not just over the specific contracts that traded there.
Johnson also helped draft a clause that would ward off the SEC in countless future battles: the new CFTC, by regulating the futures exchanges, would have jurisdiction over all exchange-traded futures contracts, no matter what they were based on, and those contracts could be based on all “goods and articles except onions” but also on “all services, rights and interests.” (Because of an onion futures trading scandal on the Merc years earlier, federal law prohibited futures contracts based on onions, a bizarre restriction that continues to this day.) Thus the new CFTC would regulate all futures contracts, even those based on mortgage securities and foreign currencies, unless Congress explicitly took such jurisdiction away.
The result was that Chicago created the regulatory agency it wanted, or at least one it could tolerate: a small agency that would monitor a vast market on short rations, a commission further weakened by the fact that it had to beg Congress every few years to renew its very existence through a “reauthorization” bill.
One of the new agency’s first acts was to approve the Chicago Board of Trade’s request to start trading Ginnie Mae futures. Ginnie Mae certificates were clearly “securities,” and the new contract drew immediate howls from the SEC, the first quarrel in a long, bitter jurisdictional argument.
In 1975, a CFTC lawyer and Phil Johnson, representing the Chicago Board of Trade, were summoned to a meeting with Harvey Pitt, the SEC’s strong-minded young general counsel. When they arrived at Pitt’s large office, they found it packed with SEC lawyers perched on radiator covers and the backs of armchairs, leaning against the walls, even sitting on the floor. Pitt’s message was firm and clear: if Ginnie Mae futures started trading in Chicago, the SEC would go to court.
The CFTC’s counterargument was simple: The law that had created the CFTC gave it exclusive jurisdiction over futures contracts based on anything except onions. And the Chicago Board of Trade’s new product was indisputably a futures contract; that it was based on an SEC-regulated mortgage security didn’t matter.
The SEC argued that the law that had created the SEC in 1934 gave it jurisdiction over securities trading, and Ginnie Mae mortgage certificates were clearly securities! How on earth could the CFTC trump that?
The dispute remained unresolved until July 1975, when the Chicago Board of Trade started trading Ginnie Mae futures—leaving the SEC fuming and unpersuaded, but with no option but an unseemly lawsuit against a fellow regulator. Ultimately, the SEC decided not to fight it out in the courts—and an early chance to avoid fragmented supervision of two closely linked markets was lost.
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FACED WITH THE Chicago Board of Trade’s coup in developing the first interest rate futures, Leo Melamed was determined to keep the Chicago Mercantile Exchange at the head of the financial futures parade. In May 1976 he received CFTC approval for futures pegged to the interest rates on short-term Treasury bills. In response, the Chicago Board of Trade promptly launched a futures contract pegged to ten-year Treasury bonds. It would prove to be the more popular contract.
Soon, the financial futures trading pits of Chicago became almost as busy as the pits trading pork bellies, wheat, and soybeans. Almost anyone who wanted to hedge interest rate risks—and more people did, as rates became more volatile—had to do business with Chicago.
In 1978 the CFTC had to seek reauthorization from Congress to continue in operation. Before a vote, Congress asked the General Accounting Office to review how the new agency was doing. The result was a report card that nobody would want to take home to the parents, one that identified weaknesses that would be evident during the silver crisis in 1980 and that would linger throughout the decade to follow.
The GAO’s conclusions: The CFTC was beset by weak management and high staff turnover. It had not pushed futures exchanges to set rules that were fairly and vigorously enforced, which meant that self-regulation by the exchanges “is not yet a reality.” And CFTC regulation was not filling the gap. The commission’s market surveillance program, the only way it could spot manipulative or collusive trading, was hampered by a lack of accurate price data from the cash markets for commodities. The agency was “understaffed, overextended, and lacking in the ability to enforce compliance effectively” in some of the markets it regulated, the report said.
The new agency had dealt so ineptly with its many regulatory burdens, the GAO concluded, that Congress ought to shift authority over most financial futures (notably, those based on stocks and bonds) to the more seasoned regulators at the SEC.
The Farm Belt members of Congress, grateful for Chicago’s support and skeptical of the SEC’s grasp of futures markets, fought back fiercely and warded off any shift in jurisdiction. Thus, yet another opportunity to streamline market regulation was lost. Looking to make a stronger argument at the next reauthorization hearings, set for 1982, the Fed joined with the SEC and the Treasury to conduct a formal joint agency study of the economic impact of the new products, which were just beginning to be called “derivatives.”
With that review under way, two things happened that lit the fuse for a regulatory showdown.
First, a delay in the sale of new Treasury bills in March 1979 put sudden and unexpected pressure on the Merc’s Treasury bill futures contracts. The Fed and the Treasury had been alarmed: was someone trying to push futures prices up by getting control of a substantial share of the market’s supply of Treasury bills, as the Hunts would later do with silver? Those Treasury contracts had expired without a crisis, but a similar incident occurred early in 1980, this time on Paul Volcker’s watch. He had been sufficiently shaken to urge the CFTC to impose a moratorium on new financial futures until the joint agency study was done.
At the time, the Chicago Merc had four contracts based on short-term Treasury bills, contracts expiring in March, June, September, and December. The Board of Trade had four contracts based on Treasury notes, which had longer maturities than Treasury bills and also expired in those months. The Treasury and the Fed wanted the CFTC to impose a moratorium on any additional contracts of that sort. Archival documents show that the Merc and the Board of Trade were aware of the pressure the CFTC was facing, especially from Volcker.
Then, a second development persuaded Melamed that Chicago had no choice but to defy its regulators, regardless of the political consequences.
For years, Chicago had endured New York’s contempt for the commodities markets, expressed largely by simply ignoring them and treating them as irrelevant to the “real” Wall Street. Then, in the summer of 1980, the New York Stock Exchange paid Chicago the sincerest compliment: it imitated Chicago and opened its own financial futures market. It then asked the CFTC to let the new exchange trade Treasury futures expiring in February, May, August, and November—different months from the Chicago products, but still a competitive threat. To Chicago’s chagrin, the CFTC did not reject New York’s application.
That was where these twin rivalries—Chicago vs. New York, and Chicago vs. the CFTC—stood in early July 1980.
Both the Merc and the Chicago Board of Trade instantly announced that they were adding those additional four months to their existing Treasury contracts. The CFTC asked them, and then told them, to hold off. The agency was on somewhat shaky ground, given its willingness to let the NYSE get into the act. Still, it delivered an ultimatum: the Merc must announce by 5:30 p.m. on July 7 that it was withdrawing its new products.
The day following the ultimatum, the Merc’s board of directors voted unanimously to ignore the CFTC’s order. The Chicago Board of Trade followed suit. The new contracts opened for trading on July 11.
It was a remarkable act of rebellion and another insult to the CFTC—one that gave its rival regulators fresh reasons to be skeptical of its ability to supervise the financial futures market.
Paul Volcker found the whole episode “troubling,” and believed that the Fed or the Treasury should have “veto power” over any new futures contracts on Treasury securities, and perhaps on foreign currencies, too. He also thought the SEC should be able to veto futures contracts that were based on stocks and stock indexes.
In response, the Chicago exchanges claimed that their new contracts were “grandfathered” under the CFTC’s original approval of their Treasury contracts for the other months. They refused to back down.
Coming just months after the silver crisis, the fight drew media attention, and the CFTC sought to reassert its authority. It promptly adopted rules unambiguously requiring the exchanges to receive permission whenever new contracts were added. Yet when the dispute came before a federal judge months later, he sided with the exchanges. All that remained were the sour headlines and the worrisome impression in Washington that, once again, rough and rowdy Chicago had gotten the best of its young regulator.
The CFTC wasn’t really Chicago’s primary target in this skirmish, of course. Its real foe was the New York Stock Exchange.
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“WHATEVER CHICAGO CAN do, we can do better,” boasted the mayor of New York, Ed Koch, his impish grin firmly in place and his balding head reflecting the spotlights. The crowd cheered and hooted as the puns and clichés piled up.
“We have seen the futures and they are ours,” said the state’s slightly more decorous governor, Hugh Carey. The governor paused for the boisterous approval from the crowd, and added, “You’re never going to sell New York short!”
It was August 7, 1980, the first day of trading on the New York Futures Exchange—known as the NYFE, pronounced “knife.” The newly built trading floor was encircled by huge banks of electronic monitors showing flickering trade data. Printers and Teletype machines filled niches at the side of the floor. Jacketed traders, whose oversize name tags identified their firms, milled cheerfully among the celebrities in tailored suits.
Beaming in the opening-day crowd was the proud father of the new futures exchange, John J. Phelan Jr.
The forty-nine-year-old Phelan had been president and chief operating officer of the New York Stock Exchange for barely a month. A tall, solid man with dark slicked-down hair and a cleft chin, Phelan had an Irish wit that softened the commanding bark he had adopted as a marine in Korea—he still wore his watch military-style, with its face on the underside of his wrist.
Phelan had deep roots in the stock exchange culture. His father had served two terms on the NYSE governing board in the 1960s and had spent a lifetime on the exchange floor, most of those years as a “specialist.”
Specialists had the exclusive right to oversee trading in specific stocks, and in return they received a tiny slice of each trade. Their lucrative monopoly carried with it the obligation of making sure there was a ready market for those stocks whenever the exchange was open for business. The stock exchange was essentially a vast auction house where stocks were continually put up on the block for bids; in that sense, the specialists were the auctioneers, the key drivers of the auction machinery. Unlike at Sotheby’s or Christie’s, these auctioneers could raise their own paddles to bid, and indeed were expected to do so if public bidding flagged or faltered.
“The market is a great equalizer,” the junior Phelan once observed. “If you really think you’re smart, you should trade the market for a while.”
The family story that anchored John Phelan’s career was similar to the stories of other men in leadership roles at the exchange, whether their heritage was Jewish, Irish, Polish, Italian, or Anglo-Saxon. The senior John J. Phelan had been a proud and generous Irish Catholic; he enjoyed membership in the Friendly Sons of St. Patrick, one of the oldest fraternal societies serving the city’s Irish American community, and he was inducted into the Knights of Malta. He started work in his mid-teens, experienced the crash of 1929, and survived the Great Depression. In 1931, still in his mid-twenties, he bought a two-story Dutch Colonial home in the Long Island suburb of Garden City. His only son and namesake was born that same year and grew up in the home his parents would occupy for thirty-five years.
By the 1970s, the Phelan firm handled trading in about fifty stocks, including prestigious companies such as Kaiser Aluminum—proof of its good reputation on the trading floor. Beginning when he was sixteen, John Jr. spent summers working on the trading floor with his father, complaining that “the pay was low, the trip [from home] was terrible, and the job was awful.” He told his dad, “There must be a better way to make money.” After high school, he put in two years at Adelphi University, but he dropped out in 1951 and enlisted in the U.S. Marines. He returned from Korea in 1954, signed up for night classes at Adelphi, and went to work for the family firm. For the next decade, he and his father worked side by side in the world they both knew best—the trading floor, the Irish societies, the Catholic charities. When John Phelan Sr. died at age sixty-one in 1966, his funeral service was a pontifical requiem mass at St. Patrick’s Cathedral in Manhattan.
Tradition, linking generations of fathers and sons, was the lifeblood of the NYSE trading floor. The NYSE traced its roots to two dozen stock traders who in 1792 drew up rules to govern the trading they regularly conducted, first under a fabled buttonwood tree and then in a nearby coffeehouse. As the young country grew, the NYSE, familiarly known as the “Big Board,” emerged as its premier stock market, first among a host of smaller city exchanges scattered from Boston to San Francisco. Since 1903, the NYSE’s working day had begun with the insistent clang of a bell rung on a handsome stone balcony at one end of the trading floor. The exchange drew about a half million tourists each year, and its iconic marble-columned building at the corner of Wall and Broad Streets in Lower Manhattan was declared a historic national landmark in 1978.
A year after that, as an active but unpaid vice chairman of the NYSE board and head of a new committee on technology, John Phelan started remodeling. The work wouldn’t change the market’s magnificent Greek Revival façade, but Phelan sincerely hoped it would radically change what happened inside the building—because he knew, firsthand, how very close the exchange had come to falling apart a decade earlier.
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TO ITS RIVALS in Chicago, the Big Board may have looked impregnable and powerful, but that image was the product of exceptional secrecy and deft public relations. In truth, the mighty NYSE had barely survived a financial crisis that climaxed in 1970.
That crisis was born in the “back offices” of Wall Street, where clerks carried out the unexciting but critical functions of documenting trades and then delivering money to the sellers and stock certificates to the buyers. For most firms at that time, the “back office” was a pencil-and-paper operation augmented by a few battered typewriters and Teletype machines and plagued by low wages and high turnover.
The long fuse for this crisis was lit by the market rally that began in 1949, lasted for more than a decade, stalled briefly in early 1962, and then continued almost nonstop into the late 1960s. Brokerage firms advertised heavily and hired more salesmen in more branch offices. Wall Street grew sleek, rich, and careless. By 1968, the pace of trading had become feverish; new trading volume records were set every few weeks.
As the number of trades rose, orders were lost, stock certificates were lost, cash and checks were lost. One visitor behind the scenes reported that “stacks and stacks of stock certificates with pieces of paper clipped or stapled to them lie on tabletop after tabletop.” The back offices of Wall Street were being buried by the paperwork generated by this remarkable bull market, and the resulting errors were costing firms a lot of money.
After reaching a record high in December 1968, the Dow dropped relentlessly, falling 36 percent by May 1970. The volume of orders followed the Dow downward, easing the back-office backlog but cutting Wall Street’s revenues and its partners’ profits. This ebbing tide showed that many firms no longer had enough capital to continue trading. Hundreds of member firms were in danger of bankruptcy, including six of the ten largest firms. In 1970, about 16,500 Wall Street workers lost their jobs, and brokerage firms shut down hundreds of branch offices across the country. Arguably, 1970 was the darkest year the NYSE had experienced since the Great Depression.
Typically, in bad markets, small, shaky partnerships close their doors or quietly merge themselves into stronger firms. Unfortunately, by the summer of 1970, even big firms with iconic names were in desperate trouble.
The leaders of an NYSE committee dealing with the crisis feared that the collapse of a major firm, with its resulting customer losses, would kick off a “run” on other firms that would bankrupt the exchange. If investors panicked and closed their accounts, weaker members would go under. If that happened, stronger members would likely resign from the NYSE rather than pay to cover the failed firms’ losses. The Big Board would be left with the tab.
One committee member later recalled, “Everybody seemed to come to a decision that we just couldn’t let a major firm go bankrupt … that if we did let one go under, there would be a panic.” Tens of millions of dollars were raised to rescue firms or indemnify wary merger partners—and the danger slowly receded.
Somehow, the crisis was largely hushed up. One veteran of the experience noted later that the public had no idea how close to destruction the NYSE actually came.
Yet the crisis was no secret to John Phelan. He had been a floor official at the exchange since 1967 and helped muster membership votes in support of the crisis committee. In 1971 he was elected to his first term on the exchange’s board, which brought him even closer to the harrowing rescue missions, and he was elected vice chairman in 1975. Over the next few years, his influence grew, and in 1979 his colleagues begged him to stay on for an unusual second term as vice chairman.
It was a time of almost constant turmoil for the NYSE. Just as this desperate financial crisis was playing out, regulators in Washington became increasingly determined to radically change the way the NYSE did business.
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SINCE FRANKLIN ROOSEVELT’S New Deal of the 1930s, populist politicians had seen the NYSE as a privileged and greedy club that was scornful of “the little guy,” and they weren’t far wrong. In the late 1960s its clubby traditions gave rise to abusive trading that went unchecked and unpunished by exchange officials. The paper crunch further angered the SEC, although the agency bore some of the blame after letting firms neglect their back-office infrastructure.
Market regulators began to demand that the NYSE erase the fixed commission rates it had enforced for 180 years—“price-fixing,” muttered lawyers with the Justice Department. Regulators also urged the NYSE to repeal a rule that required member firms to trade Big Board stocks only on the exchange floor—“restraint of trade,” grumbled the government’s antitrust experts. That rule gave rise to an over-the-counter market for Big Board stocks, conducted by firms that were not Big Board members. This informal market was serving primarily big professional investors, who sometimes got better prices than small investors could get on the Big Board. “Healthy competition,” said advocates of unfettered markets. “Unfair to small investors!” said populist lawmakers suspicious of Wall Street.
The Big Board found few friends in Washington willing to defend its cherished traditions or to argue that this deep, centralized marketplace, where fully 90 percent of America’s daily stock trading was conducted, was a national asset worth preserving.
The NYSE’s image problem in Washington had far-reaching consequences. In 1975 a testy Congress ordered the SEC to foster a “national market system” linked electronically, to diminish the Big Board’s monopolistic power. The same year, the NYSE bowed to years of pressure and eliminated fixed commissions, a step that brought a fresh string of Wall Street bankruptcies and vastly increased the bargaining power and trading activity of giant institutional investors, especially the pension funds and mutual funds responsible for a growing share of NYSE trading volume. These giant investors wanted cheaper, faster ways to trade shares and were not going to take “tradition” as an excuse. Congress seemed to be fully in their corner.
The financial bloodbath of 1970, a brutal bear market in 1973–74, the slashing of commission revenue in 1975, and continued nibbling by competitors decimated the leadership ranks on Wall Street. By 1980 the NYSE executive offices were populated by hardened, pragmatic survivors. Anyone incapable of adapting quickly to radical change or inclined to cling too tightly to tradition had been driven out.
In June 1980, John Phelan, emphatically a pragmatic survivor, became the first paid president of the exchange, working closely with William M. “Mil” Batten, the retired CEO of J.C. Penney who had served as chairman since 1976. Batten became the friendly face of the exchange on Main Street and in Washington, while relying on Phelan to lead the exchange’s modernization effort. Batten could see that Phelan was the man to get the job done.
Both knew what the Big Board was up against. “Nobody wants to change anything until it’s raining disaster, and then they all start running around,” Phelan said. He had no intention of idly waiting for some disastrous downpour.
One of Phelan’s projects was to take a page from Chicago’s playbook. In 1979 he leased space in a nearby office building for a new futures market. The NYSE’s lawyers quietly assured the CFTC that the new exchange would have an experienced supervisory staff and robust trading rules. The NYFE then applied to the CFTC for permission to trade a roster of new contracts, including Treasury futures—and ignited the regulatory showdown in Chicago.
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WHEN PHELAN BECAME the stock exchange’s president, its vast central trading floor was a village of beautifully crafted wooden trading posts: U-shaped structures, each with dozens of slots and niches and tiny brass-trimmed drawers. The kiosks were arranged in pairs to form room-size ovals, and they were tailored perfectly for the face-to-face trading of the previous century.
Phelan replaced these traditional posts with fourteen sleek new laminated versions. Filing slots and tiny drawers were out; electronic screens and more telephones were in. Thin arching rods, like spider legs, sprouted from the top edges of each structure and held computer monitors out over the trading floor. To some of the old-timers, the new trading posts looked like alien spaceships.
It was the most sweeping renovation in the history of the exchange, though some people on Wall Street still considered the NYSE to be antiquated compared to its younger, more automated stock-trading rivals—chiefly the increasingly competitive Nasdaq market.
Nasdaq proclaimed itself to be the “Stock Market of Tomorrow—Today.” Its traders were not clustered around kiosks on an Edwardian-era trading floor in Lower Manhattan. They were at firms across the country, following stock price movements on flickering television-size computer monitors stacked on their desks. Huge mainframe computers and massive telephone cables in remote office parks linked their monitors to other dealers and to some institutional customers. The fledgling Apple Computer company was one of its high-tech listings; other young, flashy technology companies were flocking to be listed there as well. Nasdaq’s traders were certain their market would soon supplant the older exchanges.
Phelan emphatically disagreed, almost as a matter of faith. He believed that face-to-face trading, the specialist-led “auction market” of the NYSE, was the best way to arrive at a fair price and maintain an orderly market. Within that vision, though, he was determined to move the Big Board along the technology curve as quickly as he could, to preserve its primacy as America’s stock market.
Phelan’s dream of modernizing the NYSE was constrained by the reality that greeted him, literally, on the trading floor each day: namely, the men (and a few women) who traded stocks there, amid the ghosts of those who had done the same job a century before. Phelan’s makeover would speed up the collection of orders and the processing of paperwork, but all those automated tributaries, growing larger and moving faster every day, still flowed into one big reservoir: a trading floor populated entirely by human beings.
Even in the Nasdaq market, the shiny new computer monitors only reported current prices. To make a trade, dealers still had to pick up the telephone and call another human being. For all the space-age claims, these were still human markets, moving at the speed of life.
As Phelan watched the ribbon cutting at the New York Futures Exchange in August 1980, Mayor Koch unwittingly hit a nerve when he joked, “I don’t know how you all make money in this venture, but I hope you make lots of it.” The exchange wasn’t quite sure it would make money with this new venture, either. The rebellious exchanges fighting for their franchise in Chicago had an enormous advantage over the infant NYFE, despite the prestige of its famous parent.
John Phelan merely smiled at the mayor’s joke, and shook a few more hands. The future had to start somewhere, and this was as good a place as any.