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  • “Pencils Down: Let’s Take a Break”

    CFTC Commissioner Bart Chilton before the Electric Power Supply Association Annual Meeting, Scottsdale, Arizona

    January 30, 2010

    Thank you, John (Shelk) for that introduction. Thank you also, John, for being a member of our Energy and Environmental Markets Advisory Committee—a committee, which as we go forward, will be increasingly important.

    It is a real pleasure to be with you this morning. If one were to look out on the Sonoran Desert and contemplate the peaceful and serene nature of things, you might be hard pressed to be troubled by our challenging times—challenging and difficult for our nation, for our economy, and for commodity and energy markets, but most importantly, for families and consumers…for real people.

    State of the Recession

    Even here, in the desert, in Arizona, foreclosures reached new records. In fact, Arizona has the second highest foreclosure rate in the nation. One in every 132 households is facing foreclosure. Nevada was first with one in every 94. Foreclosure filings, bank repossession or auction sales notices, were up almost 15 percent nationwide in December from a year ago, according to RealtyTrac’s U.S. Foreclosure Market Report. One in every 366 households in the country had received a foreclosure filing.

    The annual Census Bureau study released in documents that the recession has plunged 2.6 million more Americans into poverty. Almost one in five children under age 18 is living in poverty. The recession has also pushed the number of people without health insurance up to 46.3 million. Folks in their prime earning years, between ages 45 and 54, took the biggest punch during the past two years, with their median income falling seven percent (everyone younger and those in the 54-64 category lost two percent).

    In addition to the troubling data, there are hearty policy debates taking place in Washington and throughout the nation: health care, global warming and cap and trade legislation, immigration, national security with two wars and terrorists threats. Of all the issues, though, the one that President Obama places as number one, numero uno, is the economy. As he said, he was dealt the recession hand before he was even inaugurated, and he has worked hard to tackle it.

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    Rational Free Markets

    Marshall McLuhan used to caution us about driving into the future using only our rear view mirror, but it is enlightening to know how we arrived at our present predicament in order to ensure we don’t turn back on ourselves and head in a similar direction. After all, we do want to make progress.

    In short, I believe we made some fundamental errors over the last decade or so in how we dealt with the free market—particularly how we over steered to the right and deregulated too much. I would like free markets as much as the next person, but I want them to be rational free markets, that is, markets that actually work for our economy and for consumers.

    Banking Deregulation

    The major misdirection, and I don’t place culpability on one party or another, but the major misdirection came, in my assessment, in 1999 with the deregulation of the banking industry by repealing the Glass-Steagall Act. That allowed banks to expand their business operations to non-traditional areas. They had already been assured relatively low-cost money, and the government guaranteed deposits. Then, when the law was changed, they got into things like exotic mortgages. They began in earnest investing in markets like those that they never had before, including the futures markets and over-the-counter derivatives. In fact, in the early 2000’s with the passage of the Commodity Futures Modernization Act (CFMA), swaps—which via rulemaking were not regulated—were legislatively guaranteed of no oversight. In the years that followed, banks and others were placing bets upon bets for bundled mortgages and loans. It was like an unregulated trading arcade. Credit default swaps (CDSs) in the hundreds of trillions of dollars were traded without any government regulation whatsoever: zip, zilch, nada. The US taxpayers forked over $180 billion to bail out insurance giant American International Group (AIG) in very large part, due to AIG’s reckless use of CDSs.

    AIG wasn’t the only entity, as we know, that took the government bailout. Most of the major banks took the cash. Fortunately, nearly all of that money has been returned to the government. The banks even made record profits in 2009. However, rather than enhancing consumer and small business lending, rather than reducing credit card rates, the banks have given roughly $40 billion in executive bonuses.

    The 22 banks that received the largest component of aid from the bailout programs have decreased their small business lending by a collective 4.3 percent, or $11.6 billion since April (to $257.7 billion). They may have decreased those loans even earlier, but it wasn’t until April that the Treasury Department required banks to file monthly reports.

    When loan and credit lines tighten, small businesses have difficulty initiating, expanding and funding their daily operations. Therefore, while as a nation we helped the banks literally carry on, they really haven’t been part and parcel to the recovery like many think they should. I hope that is changing, but I also believe it is time to reexamine whether we should have allowed all of that to take place to begin with. Should we have permitted that deregulation in banking and markets?

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    Commodity Markets

    What about the futures markets? Have they been impacted by bank and other speculation? Have other, what I call “new speculators”, changed the dynamics in these markets—which until recently were dominated by commercial interests—those with an underlying business interest in the physical commodity? There have always been speculators in these markets. They are indispensible to properly functioning markets. However, never before have there been such an elevated percentage of non-commercial speculators.

    As the economy started to fail several years ago, the securities markets weren’t doing as well as some thought they should and so many looked to the futures markets as another investment opportunity. In fact, roughly $200 billion came into the US futures markets over a three-year period ending in 2008. The US futures industry grew five-fold in the 2000s, when the rest of the world’s futures industry doubled. Instead of being a venue for commercial business interests to hedge their risks, the futures industry was becoming increasingly a private jungle gym for speculators. Some of the new speculators, what I call the “massive passives”, have a generally long-only trading strategy. Their bet is that futures prices for this or that commodity will be worth more in the longer-term than they are today. Therefore, their strategy is uncomplicated, for the most part. They go long. When a contract is about to expire, they simply sell that contract and buy additional long contracts. They turn over those positions, always going long. While that strategy may work for them, and there is certainly nothing improper about it under the law, it is a different dynamic than has been at work in these markets in the past, certainly to the degree with which that strategy has been used over the years.

    The questions arise: Is this disturbing the ability of the long-established commercial traders to legitimately hedge their own business risks? Have these markets been functioning properly? A U.S. Senate report last year clearly stated that speculative interests disadvantaged the wheat markets. Have energy markets been functioning like they were intended? Did the new speculators in general or the massive passives specifically cause oil to reach $147.29 in 2008, or did they just add to that trend, or did they simply cause supplementary volatility?

    Let’s look at the settlement prices for oil on the trading days closest to January 19th over the last four years. Let’s start with 2007 (Jan. 19) when the West Texas Intermediate (WTI) contract closed at $51.99. A year later in 2008 (Jan. 18), it was up to $90.57. Then, we recall the spike to $147 in July (11th) of 2008. A year ago in 2009 (Jan. 20), it was all the way down to $38.74, which brings us to this year (Jan. 19) where we are at approximately $80 a barrel ($79.02). The highest settlement price in 2009 occurred on October 21, 2009 when the price of WTI reached $81.37. Those indeed appear like exceedingly volatile prices to me. In fact, even if you just utilize last year, 2009, if we apply the October 21st price of $81.37 and compare it to the low last January, it represents a 110% increase in the futures price!

    One might suggest that the new speculators or the massive passives had no impact on this volatility. Perhaps, they imply, these shifts are simply a result of supply and demand. However, the fourth quarter of 2008 through the first quarter of 2009 saw the utmost supply and lowest demand in the past decade. The rest of the year certainly didn’t see vast departures from the general supply and demand statistics.

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    So, what does all that mean? I’m not an economist and I don’t play one on television. I can only make decisions based upon the experts, experts I trust, and then make best judgments.

      1. The Massachusetts Institute of Technology (MIT) study concluded that the crude oil prices from 2003-2008 were almost certainly part of the larger global asset bubble that was affected by the financialization of oil as an asset by speculators.

      2. The Princeton study last year also concluded that the financialilzation of commodities like crude oil, concurrent with the increasing presence of index investors (the massive passives), contributes to price volatility and shocks or spikes in pricing.

      3. The Rice University study last year presented evidence that speculative trading is playing an increasingly central role in the markets.

      4. The Lincoln University of Missouri concluded that speculation drove oil prices and that this speculatory force was driven by economic concerns on a global scale.

    Pencils Down

    Where does that leave us? Let’s take a break, put our figurative pencils down as it were. Let’s take a moment and try to get back to basics. I don’t know if any of you remember using those number 2 pencils for tests at school. In fact, I remember when we took a break we would all line up at the pencil sharpener. You needed a sharp pencil for any of those standardized tests. You had to use the number 2 pencil (which always seemed to be yellow), and you had to ensure that the answer bubbles were filled in completely and correctly. The machine wouldn’t read partially filled bubbles, or x’s, dashes, or light pencil markings. If you made a mistake, you had to erase the bubble totally and find the new answer and darken it. The teacher always took a few minutes to review these rules, no matter how tiresome they were. Anyway, we put our pencils down, took a break and lined up at the pencil sharpener. It was a nice hiatus—a good way to regain whatever composure you may have had prior to the test and set your sights on what really mattered at that moment.

    So, let’s get rid of a lot of the clamor that we have been hearing and get back to basics about our economy and these markets.

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    POTUS Banking Reform

    On banking: I agree with the President’s banking reform proposal from ten days ago. I think it is a common-sense approach to protecting the American people from risks taken by banks and large financial institutions. Currently, they are still allowed to imperil customers’ hard-earned funds and therefore continue to put America’s economy in jeopardy.

    Specifically, the President proposed two additional reforms—in addition to his detailed financial regulatory reform proposal from last summer (a “New Foundation”). First, he proposed what he called the “Volcker Rule” which would prevent banks from owning, investing or sponsoring, among other things, hedge funds or proprietary trading operations for their own profit. Essentially, the banks will return to being banks—their primary activities before the Glass-Steagall Act was repealed. The idea is to remove incentives for banks to act contrary to the interests of their customers and closing the loopholes that currently permit them to engage in trading activities that are not only extremely risky, but are off the regulatory radar.

    Second, the President proposed a policy initiative to prevent the further consolidation of our financial system to deal with the problem of the “too big to fails”. Our financial system’s wellbeing requires that risk be disseminated among many. Massive firms simply cannot distribute the risk to an acceptable degree no matter how many times their organizational charts contort.

    In the President’s original financial regulatory reform proposal last summer, he called for regulation of the currently “dark” over-the-counter (OTC) markets—something that is critically needed. Trillions upon trillions of dollars are traded in those venues out of the eye of government. The trades are so very large that they can have an impact on the regulated markets—markets we are entrusted to protect from fraud, abuse or manipulation. OTC oversight is vitally important to any financial regulatory reform legislation.

    CFTC Proposal

    Aside from those regulatory reforms that take Congressional action, let’s consider what to do on markets. First, let’s recognize that during the last decade, we have witnessed many new non-traditional market participants in the futures industry. On the one hand, that’s a good thing because it helped fuel the economic engine of our democracy. However, as markets and market participants change, there is a proactive responsibility for regulators to examine what impact those changing dynamics have, or may have, on the markets we oversee.

    I realize that the studies I cite aren’t the only ones out there. There is disagreement on the impact or potential impact of new non-traditional speculators on commodity markets. However, and this is important, the Commodity Exchange Act (CEA), the law that we are compelled to follow, has as its fundamental purpose to deter and prevent fraud, market abuse and manipulation—deter and prevent. For me, even the prospect that there is some new dynamic in the futures industry that can cause or facilitate market aberrations is grounds enough for us to consider taking some thoughtful action. That said we should be balanced and practical in any action(s) we take. If we steered too far to the right a decade ago, let’s not over-steer too far to the left. It is sort of like driving on ice. You don’t want to over-correct or you’ll end up in the ditch. You want to stay in the middle of the road.

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    Position Limits

    That’s why I support moving forward on the CFTC proposal that was published in the Federal Register earlier this week. Simply put, it seeks to impose mandatory hard cap position limits. Doing so, I have said, isn’t the mark of wild-eyed overzealous regulators. In fact, the position limits called for in the proposal are the same types of limits already in use for agricultural commodities. This proposal simply seeks to expand such mandatory hard cap position limits to four energy contracts (crude oil, natural gas, gasoline and home heating oil).

    Specifically, our proposal would establish four different hard cap mandatory speculative position limits. They are: an exchange-specific spot-month limit; a single month limit; an all-months-combined limit; and an all-encompassing cumulative U.S. exchange position limit for substantially similar-traded contracts. These limits would be dynamic in that they would be responsive to the size of the market and subject to annual recalculation by the Commission.

    I believe the levels set for the limits actually err on the high side. As a staunch advocate for strong position limits, it is acceptable that the proposed limits are currently higher than some may want because I judge the most important thing that we do is to actually establish a thoughtful position limit structure. The agency can always recalibrate the limits, ratchet them down or even increase them, in the future, as we see fit.

    While limits err on the high side, such levels would still ensure that the very largest traders’ positions—those with the maximum potential for causing market-contortions—would be limited. Erring on the high side at this time is also considerable because if limits were set too low, there is the chance that trading migration could take place—sending traders to over-the-counter markets or overseas exchanges. This is particularly noteworthy because, as I said, Congress has yet to pass regulatory reform legislation that would grant the ability for the CFTC to regulate properly the over-the-counter markets.


    In addition to position limits, the proposal also contains a mechanism to consider exemptions to those limits. In the past, I suggested that any exemptions should be: 1. approved by the CFTC; 2. targeted for legitimate business purposes; 3. verifiable; and 4. transparent. This proposal meets all four of those criteria.

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    Traders hedging commercial risks, i.e. those who have inventory or have an interest in the underlying physical commodity, would qualify for a bona fide hedging exemption from the proposed speculative position limits upon application to the exchange. The CFTC would audit the use of this exemption. No longer included in this class of traders would be banks or swap dealers who establish positions to offset the risk of customer initiated swap positions. Instead, those traders could apply to the CFTC for a limited risk management exemption for positions held outside of the spot month. Swap dealers who receive this exemption from the CFTC would be subject to regular reporting requirements to verify and qualify their need for the exemption. In addition, the CFTC would make the identities of those who receive exemptions public.

    I’m very supportive of this approach and hope that you, as an association and as individual members, will take the time to comment. The comment period runs for 90 days and you can get instructions on how to comment on our web site at


    Congressional passage of financial regulatory reform—including changes to banking law and providing the CFTC with oversight in the area of over-the-counter trading are significantly important. In addition, with CFTC regulatory rulemaking that I just described, we will make significant progress on heading down the right road for the future. We can look back through our rear view mirrors, but not dwell on where we have been. We can take this break and appreciate what really matters. How we can protect consumers while getting our economy back on track.

    I’m optimistic so far. In fact, some very new data exemplify that we are already headed in a encouraging direction. The number of consumer loans that are going bad is starting to level off. Metropolitan job losses have slowed significantly. While no one is declaring a full-scale recovery, executives at many banks sound confident, and most economists think things are looking up in light of quarterly indicators. Stocks this week reached a 15-month high. Yesterday, the Commerce Department announced that fourth quarter U.S. GDP was a striking 5.7 percent—up from the third quarter of 2.8 percent. That fourth quarter GDP is the fastest such growth quarter in six years. Consequently, I’m hopeful we are witnessing authentic glimmers of real transformation that will continue.

    The questions are: Will we be better prepared for the future? Will we ensure, through suitable reforms, that we don’t travel the same rough road from whence we came? Will we guarantee there isn’t another colossal bailout? I think the answers are a resonant “yes”.

    Lastly, in some sense, on Wednesday (and yesterday when he spoke to and with the Republican Congressional Caucus in Baltimore) the President said, “Pencils down, let’s take a break, let’s focus on what is important”. At that moment, perhaps someone could have reflected on the tranquil Sonoran Desert –conceivably Senator McCain. I think the President has in essence pushed the metaphorical “restart button” and that we are prepared to begin anew. For those reasons, I’m quite convinced that we can, and that we will, make genuine progress.

    Thank you again for the opportunity to be with you.

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    Last Updated: January 24, 2011