New contracts: what makes them fly or fail?

New contracts: What makes them fly or fail? When leaders of exchanges ponder "which comes first, the chicken or the egg," they're not recalling the broiler and the egg futures conce traded on the Chicago Mercantile Exchange (CME).

Theyre are addressing that age-old dilemma of starting

Some elements can help break this "Catch 22" of futures trading (see checklist). The right mix of factors, in the Chicago Board of Trade's (CBOT) U.S. Treasury bond futures for example, can make a contract fly. The lack of them can make even a seemingly good idea such as listing futures on the Consumer Price Index (CPI) flop.

No one foresaw how popular the bond contract would eventually become when it opned Aug. 22, 1977. The exchange had already blazed the interest-rate trail with GNMA futures in 1975. In 1976, the CME had introduced T-bill futures.

Thomas Coleman, vice president and director of economic analysis and planning at the CBOT, remembers speculation back then as to whether GNMA's or the bond futures would ever trade as much as the exchange's wheat contract.

"Today we've lost tract of that," Coleman muses. "Bonds are the biggest thing in the world."

Many factors underlie the bonds' success. Traders were receptive to new ideas after suffering through low-volume agricultural markets in the late 1960s and early 1970s. Even after volume shot up 36% in 1973 due to the United States' grain deal with the Soviets, the CBOT saw opportunity in the size of the underlying markets in GNMAs and bonds.

"The deliverable supply of bonds was about $20 billion (by 1979) -- at least twice as big as the bean market," Coleman explains.

Since then, the underlying bond market has grown more than 10-fold to $210 billion in 1988.

Seemingly "debt became one of the best growth markets in the world, particulary in the United States," Coleman says.

Adding volatility

The next ingredient needed was volatility, which was fueled by high inflation and changes in Federal Reserve policy. Beginning in 1979 the long-term bond market roller-coaster ride began that would take interest rates from 9% to more than 15%. By then, banks and government securities dealers who were skeptical of, as Coleman recalls, "trading bonds next to soybeans," began using the futures. Bonds traded a record 70 million contracts last year.

Many observers believe bond futures provide a better hedge against inflation than even gold. Yet, hedging against inflation was what the Coffee, Sugar and Cocoa Exchange's (CSCE) had in mind with its CPI futures.

In the early 1980s, inflation as measured by the CPI hit double digits. The monthly CPI figure was watched almost as closely as the Dow Jones Industrial Average. But when the CSCE listed its contract, it fell victim to a classic case of bad timing.

"It's really rare when you launch a contract and the market is ripe," says Todd Petzel, CME vice president of research and the former chief economist at the CSCE. "When the CPI contract started at the (CSCE), the next quarter was the first quarter of deflation the country had in 30 years.

"The biggest stumbling block of the CPI in my opinion was ... no dealer community in CPIs," says Petzel." Nobody holds an inventory of inflation."

James Bowe, CSCE senior vice president echoes those points:

"There was no arbitrage, no underlying cash market. We were trying to create a primary market for inflation where one didn't exist and that's not what futures markets exist for."

The contract, which hasn't traded since 1986, is now dormant. Even if there were such an underlying market, there would still be the liquid bond futures to contend with.

Competition can trip up the most well-planned new contract. This is especially true of "me too" contracts.

The "me too" contracts have a long history: Chicago exchanges listed energy and precious metals; East Coast exchanges tried currencies and interest rate futures. But, inevitably, once a commodity found a niche at an exchange, volume generally stayed.

As an example, in 1985, four exchanges listed futures and/or cash options on no less than three versions of over-the-counter stock indexes. In 1987, the New York Futures Exchange (NYFE) introduced futures on the institutionally oriented Russell Indexers. And in 1988, the CBOT in a joint venture with the Chicago Board Options Exchange (CBOE) launced the CBOE 250 futures.

"The question to ask as: Is there something already out there that provides the same purpose?" suggests Bruce Collins, an economist with Shearson Lehman Hutton.

No need perceived

For the four new indexes, the apparent answer was "yes" -- Standard & Poorhs 500 Index futures, the most liquid of the stock index futures contracts, started trading in 1982.

Institutions and speculators knew they could get in and out of the market with little problem, whereas the lack of liquidity caused a lethal "chicken or egg" problem in the fledgling contracts.

In the interest rate arena, the New York-based Financial Instruments Exchange (FINEX) and NYFE have invaded the Chicago market's hold on the yield curve with five- and two- year note futures and a recently launched NYFE bond contract.

The FINEX is trying to be more compatible than suicidal, hoping the same contracts with minor design differences can feed off each other.

"Right now the (CBOT bond) contract has all the capital gravitating to it," says Richard Jaycobs, FINEX managing director. "When the NYFE contract opens up, and once you get the NYFE floor traders trading it, you're going to get arbitrageurs trading it because undoubtedly, just due to supply and demand factors, (the two bond contracts) are not going to be at the same price always."

Then there are the "try agains," markets that seem so ligically fit for a futures contract that exchanges just can't leave them alone -- even when they've failed more than once. Top honors in this list would have to go to past (and present) contracts on mortgage rates. The CBOT lead the pack in listing a GNMA futures contract in 1975 -- a few years before its New York competitors did the same.

Its largest prolem was contract design. The fact that shorts were delivering high coupon certificates while hedger demand was concentrated in the lower coupon certificates rendered the conract useless as a hedging instrument.

This "try again" suffered the same fate as the OTC stock indexes, getting jilted for a more popular contract.

The CBOT's T-bond contract that was launched two years later pulled many mortgage rate hedgers into the bond market despite the inherent basis risk. That happened to many shorter-term interest rate futures the CBOT and other exchanges tried to list in the late 1970s and early 1980s.

"As (bonds) continued to grow and succeed, more people tried cross hedging GNMA's in the T-bond futures. It's still true today," Coleman says.

But the tempting fact that the underlying market in mortgages is larger than that of bonds has made tha CBOT fight on. After the original GNMA contract was delisted in 1988, the exchange also tried three other versions with little success.

In June, the CBOT launched the mortgage-backed securities (MBS) futures contract. The CBOT also began to list shorter-term interest rate contracts like the five-year note and planned two-year note futures.

"The differences now is the market is much more sophisticated," Coleman says. "(Contracts) failed back then because the market wasn't ready for that degree of sophistication."

The CBOT has learned a design lesson from its previous GNMA failures. It now lists the MBS contract monthly based on the current GNMA coupon. The conract, traded four months in the future, is also cash-settled in contrast to the original deliverable GNMA futures.

The Kansas City Board of Trade (KCBT) has a "try again" category entry with its grain sorghum contract -- the fourth try at a contract last actively traded in 1977.

The KCBT also cites user sophistication and contract design as keys to re-introduction. Studies revealed significant basis risk in the hedging of sorghum with corn futures, at times much more risk than hedging corn with corn futures. Four delivery points are in place instead of one to assure adequate supplies year-round and avoid price distortion.

The "too sophisticated" aspect of contracts could make today's newcomers tomorrow's try agains." Booming Eurodollar and foreign currencies markets at the CME led to the launch of futures on Euro rate differentials in July. The DIFFs encompass the other two contracts by locking in a rate differential between Eurodollar bank deposits and other Eurocurrency bank deposits.

"Whenever you start a futures contract in a new area, that is the hurdle you have to overcome with commercials," Petzel says. "How do you get them to stop using their old tools and recognize the benefits of these hopefully more efficient tools? That sometimes is a tough learning curve."

It may be too tough, says Arnold Staloff, former president of the Philadelphia Board of Trade, which considered DIFFs two years ago.

"Contracts really have to be simple," he says. "If you can't explain it to somebody in high school, it's going to have problems."

When given the high probability of failure if the right combination of factos isn't present, it's little surprise the majority of new conracts over the past five years have been options on already liquid futures contracts.

"We need an infusion of bright new thoughts," contends Les Rosenthal, general partner of Rosenthal Collins Group and a former chairman of the CBOT's financial instruments committee. "We're getting stodgy."

Exotic new products

Maybe, but not unimaginative. The idea of trading futures on semiconductor chips, for one, has been quite the rage lately. No fewer than three exchanges -- the Twin Cities Board of Trade, the Pacific Futures Exchange (PFE) and the New York Mercantile Exchange -- have floated proposals.

The market in dynamic random access memory (DRAM) chips appears to have all the right ingredients: in addition to a lack of any existing contracts, there's a huge, inelastic supply and demand and plenty of volatility.

"Economically, they act like commodities," says William Tai, Alex. Brown and Sons semiconductor industry analyst in San Francisco. Tai is advising the PFE on its proposal.

As for volatility, the price of one megabyte (1 MB) DRAMs, used in everything from desktop computers to autofocus cameras, was near $40 at its 1986 inception but fell to $20 when Japanese models hit the market. The 256K DRAM dipped from $14-$16 to $1. A 1987 trade agreement between Japan and the U.S. guarantees the domestic market can't fall below the cost of manufacture.

Will this be the next raging success story? One of many questions industry officials raise is how the contract will address the variations in chip quality. That was a major reason the Minneapolis Grain Exchange (MGE) rejected the idea, according to former president Paul Tattersall.

"Those questions haven't been answered. Normally the buyer works closely with the manufacturer for the specifications," says Jean Alford, spokesperson with the Semiconductor Industry Association (SIA).

Buyer-manufacturer relationships are so close that procurement is done through price-locking contracts. Loyalty to similar agreements helped fell the ill-fated high-fructose corn syrup futures at the MGE.

Judith Burns in New York also contributed to this article.