October 25, 2010
Introduction – The “House Edge”
Everyone knows that casinos operate with a “house edge”—the mathematically determined odds that ensure the house maintains an advantage over the players. Sometimes, however, there’s a player on a winning streak who keeps piling the bets back on the table—“playing with the house’s money.” That’s a sweet win for the player, if it happens, but a sore loss for the house—which is why the odds are that it’s relatively rare.
Despite what some people say, the U.S. futures markets aren’t gambling marts—they are intended to be used for risk management and price discovery. Yes, speculators play an important part in these markets—they provide necessary liquidity. But when they begin to “play with the house’s money”—that is, when they are more than just liquidity providers, when they are a new, large, potent force in the markets, making money from the markets without providing inputs that go to the core functions of the markets—then that raises some serious red flags.
That’s what we saw in 2008. When supplies of crude were at record highs, and demand was at a record low, prices skyrocketed. I asked myself, what’s going on? Part of the answer was the increase in “Massive Passives,” new speculators that were playing with the house’s money, getting in the markets and staying there, rolling from one delivery month to the next, insensitive to price. And they had an effect on prices. To what degree we can’t say, but—in hindsight—we can surely say they had an effect.
When the commodities laws were written decades ago, they didn’t contemplate this kind of tectonic plate shift—mammoth changes in asset class participants and strategies—in the use of the futures markets. They didn’t contemplate computers talking to computers, and sweeping up thousands of micro dollar profits in nanosecond trades. They didn’t contemplate the incredibly innovative and creative ways that these markets would develop and flourish, and the accompanying challenges that we face to ensure that the fundamental purposes of the markets—risk management and price discovery—remain paramount.
In one of my favorite movies, Casino Royale, James Bond is tasked with foiling the evil banker’s attempted use of the casinos to win back money that he has lost working for the bad guys. The movie actually involves shorting stock, and then setting up terrorist attacks on the targeted companies to tank the stock values. But the money is lost, and the banker goes to the casinos to try and win the money back in a high-stakes poker match. I won’t give it away (in case you haven’t seen it), but, in the movie, you can figure out pretty easily who are the good guys and who are the bad guys. Not so easy to do in real life. In real life, we want to ensure that those who truly contribute to market effectiveness and efficiency are not precluded from doing that, and, at the same time, we want to ensure we protect the markets from the ill effects of conduct that negatively impacts the ability to discover prices or manage risk. It’s not always so easy to tell, however, who’s doing what, and why.
The good news is, in July of this year Congress enacted sweeping legislation to address some of the most egregious problems facing our financial markets. Regulators were given authority over “dark markets,” and also provided with the necessary tools to oversee those OTC markets effectively.
We have some incredible challenges in front of us, however, as we implement this new regulatory reform legislation. Specifically, I’d like to talk about two areas today—position limits and the end-user exemption—that go directly to the issue of “who’s doing what” in these markets, and tee up some of these very difficult issues regarding the fundamental purposes of our regulation.
When you walk out to the casino here, there are gaming limits. Someplace in this building there’s a private high roller room, and even there, there are limits. I won’t be joining you there, by the way, if that’s where you’re headed after the session!
Limits are everywhere, even in a casino, but not much in the world of commodity trading—not yet. The new Wall Street Reform and Consumer Protection Act instructs us to place limits on the size of speculative positions in the markets we regulate. I think that’s a very good thing and something I’ve favored for some time. Here’s why: in the futures arena, we saw over $200 billion come into our markets in the several-year period leading to the sharp increase in energy prices in 2008. This $200 billion was largely made up of investments from new speculators. They weren’t the kind of investors we typically had in commodity markets. Their trading strategy was (and still is) to go long and stay long. These Massive Passives are huge and have a passive, almost price indifferent trading strategy.
We’ve always had speculators. In fact, we wouldn't have these markets or this industry without them. The Massive Passives, however, in my judgment, contributed to the wild volatility in markets a couple years ago that brought us $147 a barrel oil and $4 dollar a gallon gas.
Being big isn't in and of itself a bad thing. We want deep, liquid markets, and speculators help provide that. On the other hand, there is a point at which speculative positions are simply too big for a healthy market. It’s our job to set the limit level. Is ten percent or twenty percent of a market too much? How about thirty? How about three Massive Passives in the crude oil or natural gas market? Maybe each of them controls 20 percent of the market, for a total of 60 percent. Or how about the case of a trader with 10 percent of a market who liquidates his position all at once? Everyone knows that when contract expiration nears, the massive passives will roll their contracts and continue to go long. They say as much in their prospectuses.
Trading will occur around that roll. The U.S. Natural Gas Fund has had a multi-day roll since it started in 2007, and the roll period for the U.S. Oil Fund was increased from one to four days in 2009. The necessity for the longer roll period was based, in part, on the potential trading issues surrounding such massive rolls. Maybe having big speculative positions is okay generically, but when you combine that with a known trading strategy, or when it is combined with others who hold similarly large positions who have the same trading strategy, we have a problem.
While I favor position limits, there are dangers in the details of setting them. For example, too restrictive a limit could push trading overseas. It could harm price discovery and risk management. And, of course, setting a limit too high won’t do anything in the meaningful way Congress intended for us to set the limits.
The new law bill specifically instructs us to set limits with regard to physical and agricultural commodities. Given our experience with the Flash Crash, however, and the key role one financial futures market appears to have led in the domino decline, I’m wondering if it is appropriate to consider limits in these markets as well. For example, should there be limits on the amount of contracts that can be held by any one trader or entity in such markets, or should there be limits on how much can be traded in a given day or other time certain? Should there be a limit on robotic trading? What should the legal responsibility be to ensure that a trader-entity doesn't roil markets with trades?
We have 180 days from the day the bill was signed to write the rules, hear public comment and set the limits on physical commodities. That puts us in about mid-January, and we have 270 days, or mid-April, for agricultural commodity limit rules to go final. We need to meet those deadlines with meaningful limits. But, we’re not going to do anything that is over the top or ill-conceived. I’m talking about sensible, well-calibrated limits to give us a handle on these markets.
Another element of the regulatory reform law that I’d like to touch on today is the end user exemption. There’s been a great deal of concern that legitimate hedgers will be subject to higher margin requirements as a result of the new law. There was even a Wall Street Journal story that focused on farmers in Nebraska who were worried about getting hit with higher costs when they hedged their corn and cattle. Well, I’m here to tell you that’s not the case.
Congress did not have the intent of punishing end users when they passed the bill. And, if there was any question, it was answered by Senators Dodd and Lincoln in a letter they sent to colleagues while the bill was in conference. They also instructed us at CFTC and the SEC not to impose rules that would make hedging costlier. Our goal is not to impose margin on hedgers or to regulate end users as swap dealers or major swap participants. They can take advantage of the end-user exemption from the Act’s mandatory clearing requirement. Whether swaps are used by those Nebraska farmers or by major airlines trying to protect themselves from potentially higher fuel costs, they will not face higher costs for their legitimate hedge activities.
What the law does require we regulators to do is to set rules for margin requirements for un-cleared trades. But Congress has made it clear that the rules not require the imposition of margin requirements on the end user side that would punish those who are hedging their commercial risk.
The law also requires us to define what a swap dealer and a major swap participant is. It’s clear that we need to exercise some caution when we write those definitions so that legitimate hedgers are not inadvertently pulled into the categories.
I wanted to mention that today because I expect that some of you are end users. Hopefully, I’ve put your mind a little more at ease in case you’ve been led to believe otherwise by the swirl of rumors that have been out there.
Wall Street Reform Rulemaking
A lot has been said about the rulemaking process this law mandates. At CFTC, we are in the process of writing dozens of rules. At the outset, a lot of “princes of pessimism” said we couldn’t get it done and neither could the SEC. What you may not know is we had started the process long before the bill even became law. We divided up the list of rules into 30 clusters. We had teams in place for each one. We began to schedule public meetings. We were ready to solicit comments. We were ahead of the curve and I give the credit to Chairman Gensler, who unlike the naysayers, said that we simply have to get this done.
We, as a Commission, have already held hundreds of meetings with individuals and groups that have an interest in the law. From banks to hedge funds to technology firms—you name it—they’ve been in to see us. One of the things that has astonished me most about some of those meetings are the number of folks who are doing their best to get out of things the law clearly intended. They fought hard against it when it was being debated and they’re still fighting. Everybody wants to be exempted from one new regulation or another. Others think we should ignore the deadlines Congress gave us and phase this stuff in over years and years. Well, sorry Charlie. That’s not going to happen.
So, where do we stand today? We were given deadlines of 90 days for the forex rulemaking, and we got that done. We’ve got other rules with early deadlines—for example, the position limit rules—and most of the rest have 360-day deadlines, and are well underway.
We’re moving quickly and deliberately. But, no matter the subject, we are committed to taking the time for public input via comments and open public meetings. That’s a critical part of the process. We want to hear from you.
Flash Crash Report
Lastly, let me comment on the report released earlier this month addressing what happened on May 6th, when financial markets came unhinged for 20 minutes. In that time, many lost significant investments. Stock in Accenture, for example, went from $40.13 to just a penny before recovering. The stock market lost nearly 1,000 points, and then recovered most of it by the close of trading. If the crash had occurred earlier that day, when European markets were open, it would have rocked the entire financial world.
The report by the staffs of the CFTC and SEC did not turn out to be an exciting "whodunit" mystery, but it was a very thorough investigation of what happened. What they found is that markets were very skittish all day due to worsening economic news from Europe. Volatility was double normal levels. Sellers were having difficulty finding buyers. Then at about 2:30 in the afternoon one firm utilized a robotic trading program to sell 75,000 contracts valued at over $4 billion. That was enough to send markets into cardiac arrest.
Arbitrageurs, seeing one market plummet, recognized an opportunity to buy low at one exchange and sell corresponding contracts at a higher price elsewhere. Within minutes, the domino decline ensued as most markets plunged.
So it appears the culprit that day was the financial markets themselves. Markets today, after a decade of deregulation, operating under the free-wheeling "greed is good" mantra with vast interconnectedness and with lightening-speed trading, couldn't take it.
Nonetheless, the markets were resilient, recovering much of the loss. It’s also good news that regulators and exchanges are instituting procedures to make markets more effective and less susceptible to disruption. But these are really "band-aid" fixes. What’s needed is the kind of structural changes sought by the new financial reform law. There will be more transparency and oversight, limits on speculation, double and triple backstops that can help avoid another meltdown. With this new oversight, we will be able to say with much greater confidence, that if a similar situation happens again, we will be able to address it and swiftly identify the culprits.
But, we still have one problem: Congress gave regulators the responsibility to implement the law, but there may not be funds to do the job, to have the people power and the computer capability to institute the changes Congress itself sought. It would be nice, after getting the definitive word on the Flash Crash, to know we are going forward with confidence and clarity to ensure markets are sound and that our 401(k)s are safe. Only if Congress approves funding to implement these changes are we able to do that. Let's hope that happens or we won’t be able to say with surety that another Flash Crash won’t occur.
Finally, in this age of high-speed, high-frequency, algorithmic trading, mini Flash Crashes occur all too often. They don’t cause as much of a disruption as that of May 6 but more than once this year, runaway algos have disrupted markets. By that I mean, cost people money. We should explore ways to hold those who set off runaway robotic trades accountable.
Well, if you’re a fan of James Bond movies like Casino Royale, you know that the ending is going to be good. It usually—maybe always—involves Bond and the starlet of the show, followed by a call from headquarters, which he invariably ignores.
Well, I don’t have that exciting a conclusion for you today other than to say that I won’t ignore your calls. We all want the same thing and that is effective and efficient markets free of fraud, abuse and manipulation.
As I said earlier, these markets aren’t casinos. They affect the prices consumers pay for almost everything, from a car loan to a gallon of gas to the very food we eat. They are important markets and we need to make sure they are never run just for the sheer fun of betting. There’s nothing wrong with betting in my view. But, let’s let it happen in Vegas and stay in Vegas.
Last Updated: January 18, 2011