One Taboo The Chicago Merc Should Maintain

Remember dual trading? That's the practice, commonplace in the capital markets, whereby brokers trade for their own accounts while also handling customer orders. It's also either: (a) an invitation for traders to make a nefarious buck by trading in advance of customer orders or (b) a vital contributor to liquidity in the marketplace. Hint: It does help liquidity--in the bank accounts of rogue traders.

It's not that dual trading is inherently wrong but rather that dual traders may be too easily tempted to take advantage of their customers. And it wasn't too long ago that the Chicago Mercantile Exchange agreed. The Merc banned the practice just this past May, in the wake of a government sting operation in Chicago's commodities pits. Bowing before the political firestorm that followed the indictment of 48 commodities traders in mid-1989, and with 34 of them found guilty by early '91, the Merc prohibited most forms of dual trading even as the rival Chicago Board of Trade did nothing. This move was often cited by Merc officials as proof of their fealty to ethics and fair dealing.

RESTLESS. And the Merc was justified in congratulating itself for the ban, because dual trading can spawn a host of abuses. Some brokers can't resist the temptation to illicitly make money by slipping in a personal trade just before executing a big customer order. Others illegally tip off nearby traders to their incoming order flow and, in return, get a favorable price on a subsequent trade. And dual trading enables unscrupulous brokers to steal profits from their customers by diverting the most lucrative trades to their own accounts, leaving their customers with less profitable transactions. Such activities were revealed in the government's four-year investigation of the commodities markets.

Now, less than a year after the ban took effect, some Merc brokers are agitating for a return to the old days. Some 500, of a total of 2,700 floor traders, have signed a petition requesting that the Merc lift the ban on dual trading. The Merc's board is set to deliberate the matter at a February meeting.

This is no mere intramural squabble but rather a test of the adequacy of self-regulation in the commodities business. The dual-trading prohibition was put into place to appease Congress, which was displeased by the investigation's findings. But Capitol Hill has moved on to other crises, leaving the Merc to police itself. Indeed, reviving dual trading may well arouse the suspicions of legislators and regulators who believe the Chicago exchanges never took to heart the main lesson of the trading scandal: that the pits are vulnerable to a variety of trading abuses.The Merc's chairman, John F. Sandner, is neutral in the latest debate on the issue, but he feels that the exchange is being held to a too lofty standard. After all, he notes, dual trading is commonplace on stock exchanges, in the over-the-counter market-maker system, and in almost all capital markets. "Our institution is being measured against utopia," Sandner complains. "When you're measured against utopia, you fall short."

The "nobody's perfect" justification offers little solace to victims of unscrupulous brokers. And the claim that "everybody does it" is unconvincing in light of dual-trading chicanery in other markets, such as the Milken/Drexel manipulation of the junk-bond markets or Salomon Brothers Inc.'s overbidding for government securities. And let's not forget the penny-stock ripoffs that are another manifestation of dual trading run amok.

`TWO MASTERS.' From the customer standpoint, the value of the dual-trading ban has never been in doubt. "You can't serve two masters," says William Rafter, a former floor trader, now a futures-fund manager with Prism Asset Management of New York. Others note that the open-outcry system in the pits makes dual-trading abuses hard to detect. Says John A. Wing, chairman of Chicago Corp.: "They would have to have a lot better audit-trail system before I would be satisfied with dual trading."

In fact, the Merc points out that a better audit system is under development, one that would catch any abuse of dual trading if the practice is reinstated. The Chicago exchanges are putting the finishing touches on handheld, computerized trading cards that would track trades on a real-time basis. The new audit system is indeed promising, but it should be put into operation and proven effective before a revival of dual trading is considered.

Putting aside the issue of whether dual-trading abuses exist or can be detected, there is one overriding concern: Why do it? Why lift the ban? Brokers argue that dual trading makes markets more liquid by making everybody in the pits a potential trader. But despite the dual-trading ban, the Merc last year turned in record volume. Customers have no problem getting orders filled. And seat prices of $550,000 are near the high point set just before the 1987 stock market crash. The market has assessed the dual-trading ban--and decided that the new system works. If the Merc fails to reach the same conclusion, it will be a triumph of greed over not only ethics but just plain common sense.