Like scientists splicing genes to create a new life form, federal financial market regulators are preparing to spawn a new species of investments by grafting a bud from Wall Street onto a root from the commodity markets.
Anyone who can follow the daily rise and fall of prices on the familiar fever charts of the stock market will be able to get into the high stakes game of commodity futures trading under the proposals now awaiting government approval.
But instead of investing in soybeans or sow bellies, they'll be able to speculate directly on the stock market by purchasing "stock index futures contracts" or "stock index options" whose value goes up and down with the daily movements of the market.
The downpayment on a stock index futures contract will be only 5 to 10 percent of the cost of actually buying stock. As a result, speculators will get 10 to 20 times what they could earn investing in stocks.
In effect, stock index futures and options will permit an investor to sign an agreement to buy a group of stocks at today's prices and pay for the stocks when they are delivered sometime in the future. If the value of the stock portfolio goes up before the contract comes due, the buyer makes money. If stock prices fall, the investor loses.
Because of the small down payment, stock index speculation will be relatively more profitable than buying shares themselves.
If the value of a stock index climbs from $65,000 to $70,000, someone who owned those stocks would make a $5,000 profit on a $65,000 investment. But a $5,000 profit could be earned on a stock index futures investment of $6,500 or less.
Barring a last minute hitch --and several are possible--the first stock market index futures contract is expected to be approved Tuesday by the Commodity Futures Trading Commission. Pending at the Securities and Exchange Commission are several proposals for options based on a stock index.
The CFTC regulates futures trading, the SEC oversees the stock and options markets. Because stock index futures fall between the jurisdictions, the two agencies fought over how to regulate them for four years.
After they were appointed by President Reagan last year, SEC Chairman John S. R. Shad and CFTC chief Philip McBride Johnson negotiated a truce in the turf war. They began clearing the backlog of proposals from the options and futures industries that had been held up while the Democrats controlled the two agencies.
The new plans could be thwarted or delayed, however, by opposition from Congress and the Federal Reserve Board.
Warning that stock index speculation is nothing more than a way to gamble on the stock market, Rep. John D. Dingell (D-Mich.), introduced legislation Thursday to impose a six-month moratorium on any stock index speculation.
Dingell's House Energy and Commerce Committee, which oversees the SEC, plans to hold hearings on the issue, as do House panels headed by Rep. Timothy E. Wirth (D-Col.) and Benjamin Rosenthal (D-N.Y.).
The congressional critics contend the Reagan regulators are giving birth to a financial Frankenstein that will trap unsophisticated stock buyers by promising them big profits without revealing the risks.
Dingell complained about "jurisdictional issues posed by the trading of stock index futures, the risks to investor protection, the effects of unequal regulation, the economic purpose and public interest questions, the potential adverse impacts on the underlying equity markets and capital formation."
Both Rosenthal and Dingell last week urged the Federal Reserve Board to assert its authority to determine the size of the down payment, or margin, required on stock index futures contracts.
The Federal Reserve sets margin requirements for purchases of stocks, bonds and stock options. Until stock index futures were invented, the Fed had never claimed jurisdiction over futures contract margins. Not even the CFTC sets commodity margins now; all futures margins are set by the commodity exchanges themselves, which regard the power as vital to their cherished independence.
More than a year ago the Fed warned the CFTC that it planned to set margins for any stock index futures, and that if the CFTC does create them, it should first give the Fed six months to decide how much the margin should be.
Dingell and Rosenthal insist the Federal Reserve must have authority to set the margins to maintain equity with stock futures options. If the downpayment on stock index futures is lower than the margin on stocks or options, money will be drained away from the stock market, they contend.
Though he has settled other differences with the CFTC, SEC Chairman Shad insists that "directly competitive instruments should be subject to the same margin requirements."
Shad and Johnson met Thursday with Fed Chairman Paul Volcker but failed to resolve the impasse.
Negotiations continued into the weekend in an effort to avoid a confrontation between the Fed and the commodity markets. One possible compromise might be an agreement to voluntarily set stock index margins high enough to overcome any Fed objections. That would mean raising the margin on the first contract likely to be approved from $4,000 to about $6,500, or 10 percent of the contracts value.
If no agreement is reached and the Fed attempts to impose margins, either the commodity exchanges or the CFTC is certain to challenge the action in court.
The issue could come to a head on Tuesday, when the CFTC is scheduled to vote on a staff recommendation to approve an application by the Kansas City Board of Trade to start selling Value Line Futures, a futures contract based on the Value Line Index of 1,700 stocks.
Approval of the Value Line Futures plan would open a floodgate at the CFTC, where 17 other unconventional futures contracts await approval. The SEC has under consideration another dozen and a half applications for trading new kinds of options that will work in the same way as stock market futures.
The key difference between an option and a futures contract is the amount of money investors can lose.
A futures contract is a binding obligation to buy some commodity--a portfolio of stocks or 5,000 bushels of wheat. If you make a margin deposit of $4,000 on a futures contract for stock worth $65,000, and the price of the stock plunges to $35,000, you lose not only the $4,000 down payment, but another $31,000. (You can minimize the loss by selling the contract.)
With options, however, there is no obligation to buy. If the price of the stock index portfolio drops below the price at which you have an option, you lose the amount paid for the option, nothing more.
While stock index investments will give small speculators a cheap way to gamble on the rise and fall of the stock market, they are being promoted as a conservative method for institutional investors to minimize the risks of the stock market.
An investment company that owns large amounts of stock could hedge against the risk of a general stock market decline by selling stock index futures. If the market does drop, the loss on the value of the stocks would be made up by the profit on the stock index futures.
SEC Chairman Shad, a veteran Wall Street executive, says the new investments would "offer the opportunity to buy insurance against changes in the market." An investment banker with a corporate client that plans to issue bonds six months from now might use options on bonds to avoid the risk that interest rates will go up. By buying bond options now, the banker could "lock in today's interest rates," he explained.
Democratic CFTC member James Stone, who was chairman before Johnson, is the only official of that agency who has publicly expressed doubts about speculating on stock indexes. "The two primary concerns that I have relate to customer protection and the possible diversion of funds from capital formation markets," he said.
"The SEC and the Treasury in the past have raised doubts" about capital being drained away from the stock market, Stone noted. "I do not think anyone knows the answer, but I do think it would be hasty to go ahead and approve these without being quite sure there would be no adverse impact on capital formation."
Both sides in the debate agree the question of whether the index investments will hurt or harm the stock market is strictly speculative until the idea is tried.
"What we are saying is give it a market test," said Walter Vernon, the Kansas City Board of Trade president, who has been pushing the stock index futures idea for five years. "We believe we deserve our day in the marketplace. There is no way we're going to prove this until we try it."
The principal cause of the delay in acting on the Kansas City plan was the dispute between the SEC and CFTC over jurisdiction. Because the agencies operate under vastly different congressional mandates, the bickering involved more than just regulatory turf.
Since the crash of the stock market 50 years ago, the sales of securities have been closely regulated, while the commodity tures markets pride themselves on their almost total lack of government intervention.
Under terms of the Shad-Johnson truce, the CFTC was to permit trading commodity futures contracts in which the "commodity" traded is a group of stocks. The SEC got the green light to authorize trading in options on Treasury bills, government notes and mortgages, all of which had previously been considered commodities.
The CFTC and SEC plan to permit trading in options and futures contracts on many of the same items, including Treasury bills, foreign currencies, government insured mortgages and several stock market indexes.
The idea is being promoted agressively by the futures exchanges, whose political action committees routinely make campaign contributions to virtually every member of the congressional agriculture committees that oversee the CFTC.
The commodity exhanges stand to get millions of dollars of new business from handling the new investments. The Kansas City Board of Trade plans to raise $2.5 million simply by selling new seats to professionals who want to trade its Value Line futures contract.
Commodity lobbyists are already pushing for a special tax break for investors who use the new vehicles. In closing a billion-dollar loophole that permitted many commodity traders to escape paying any federal income tax, Congress last year cut the maximum tax rate on commodity speculating profits from 50 percent to 32 percent.
The way the law is written, stock index futures don't quality for the lower rate, and Rep. Rosenthal, a sponsor of the commodity tax bill, has vowed they won't get it.
The stock index futures idea was first floated by the Kansas City Board of Trade, a small commodity market that deals only in wheat but is looking to expand.
Kansas City originally wanted a futures contract based on the Dow Jones Industrial Average, the most widely quoted index of stock market behavior. When Dow Jones & Co., publisher of The Wall Street Journal, refused to permit its name to be linked to the controversial proposal, the board switched to the Value Line Index, produced by the owners of the Value Line Investment Service.
Also pending are plans to use the New York Stock Exchange Composite, the Standard & Poor's 500 stock index and the prime rate for futures contracts.
Staff members of the SEC and CFTC concede there is probably no need for several different stock index investments but, harkening to the deregulation chorus lead by the president, they are preparing to approve most of them anyway.
"Experience has taught us that when you have contracts that are very similar, only one of them is going to trade successfully " said James Culver, director of economics and eduation for the CFTC. "We can sit here and play God and try to pick the best one, or we can let the market decide."
The market's decision may be swayed by the regulations imposed on competing stock index investments by the CFTC and SEC, congressional critics contend.
When the CFTC first considered stock index investments two years ago, Barbara L. Leventhal, its director of policy review, warned the new products would lead to the "entrance of a multitude of unsophisticated individuals into the futures markets for the first time." A former SEC staff member, Leventhal suggested SEC-style customer protection rules.
But since Shad and Johnson announced their agreement, the CFTC staff has toned down its criticism. The official agency position now is that "stock index futures are just like any other contract" and no additional regulations are needed.
While agency staff members say the switch in position is primarily the result of changes in the Kansas City application and a long study of the idea, there is considerable evidence the change is political.
Frustrated because the CFTC under Democratic Chairman Stone had not acted on his stock index plan after four years, KCBOT President Vernon wrote the agency in November 1980 demanding a decision. If the commission won't approve stock index futures, Vernon warned, the industry would have "little recourse save the ballot box."
The threat proved prophetic. After the Reagan administration came in, Michael P. Andrews, the lawyer who handled the Kansas City Board of Trade Value Line application, was appointed top assistant to CFTC Chairman Johnson.
Johnson, too, was backing the stock index idea before he joined the Reagan administration. As the lawyer for the Chicago Board of Trade, he submitted applications for 11 of the 17 additional contracts now awaiting CFTC action.