March 15, 2011
Good morning. It is a real pleasure to be with you today. I was thinking about this speech which on your programs you will see was titled “Financial Tides,” but in light of the Japanese earthquakes and the tsunami that followed, I wondered if I should change the title and the speech out of an abundance of caution for good taste. After all, the earthquake and tsunami appear to be the toughest thing to hit that island nation since World War II. It is going to require a massive rebuilding. Therefore, I have changed the speech, I won’t be talking about tides today with any metaphors or analogies, but I am nevertheless going to talk a little about the disaster—which of course continues.
I was listening to President Obama’s press conference Friday where he spoke about the disaster. The last question he received was from a Japanese reporter. The President was asked about his personal feelings regarding the devastation in Japan, and about the Japanese people. I was struck by the President’s response. I’m paraphrasing, but he essentially said that it was moments like this which made people reflect upon their own lives and their own families. What would it be like to lose a loved one, to lose your life’s savings, or to see your home or property destroyed? What I gleaned from his response is that it makes one feel the humanity of the circumstances—that we are a lot more closely linked as human beings than we sometimes feel in the rush of everyday life. It is that interconnectedness that I want to discuss today, not just with physical events or natural disasters, but in financial markets and our global economy.
The Japanese earthquake, the largest one, started that tsunami which took place on the other side of the globe. As the swell of water travelled thousands of miles across the Pacific, it still had lots of energy. Governments and individuals alike took precautions. Some coastal areas closed in North, South and Central America. Refineries closed. Ports closed.
As we now know, the results were fairly benign in the Americas, but we were lucky. Not so for the Japanese who lost thousands of lives and suffered mass destruction. They are still dealing with the devastation, not to mention the nuclear plants and all of that related and pending danger.
However, just like the tsunami, financial markets are linked in very real ways. I was asked on a Sunday news program, what the impact of the Japanese disaster would be on crude oil prices. What we know is that there will be market ramifications for some time. What we know now, is that about a third of the Japanese oil refining capabilities are out of order—some due to damage and others due to a lack of electricity. That means Japanese oil consumption will decline in the short term. However, as the rebuilding effort begins, Japanese demand for many commodities, including oil, will increase. For oil, it is expected to increase to new levels. The Japanese use about 4.5 million barrels of oil a day. According to experts, the refining capacity is reduced in Japan by roughly 1.5 million barrels per day. It so happens that 1.5 million barrels per day is roughly equal to the amount of oil not being exported by Libya.
As you can tell, these markets and our financial economy are all interconnected. There are global economies and global commodities. Foreign exchange rates are traded all across the globe. Droughts or floods, hurricanes or tsunamis in one area can impact agricultural commodities in farm fields and financial markets in many places thousands of miles away. The closing of a port or a mine can have an impact in other parts of the world. The financial meltdown that began in 2007 and 2008, while starting in the U.S., had global repercussions.
We are linked. While we, of course, have sovereign issues with laws, rules and regulations, make no mistake about it: what happens in Brazil, in China, in the E.U. or in the U.S. can affect others.
Just one example of the importance of this interconnectedness comes this week as President Obama begins his Latin American trip. He will spend two days this weekend in Brasilia and Rio de Janeiro meeting with newly-elected President Dilma Rousseff. They will talk about how acting together is critical for a more stable and stronger global economic system. The President will also visit Chile and El Salvador where I am sure there will be a similar message.
So today, I want to discuss how we can work better together, and learn from each other in an interconnected way, about how those in government and those in business can seize opportunities to be more harmonized, more efficient and effective and how we can help global markets and therefore global economies.
One of the reasons our financial markets and our economies are so interconnected is because of technology. Folks screaming at each other in trading pits are quickly becoming a thing of the past. Instead, computers are screaming at each other all day and all night—most times regardless of time zones around the world. Algorithmic programs are cranking away like journeymen and high frequency traders (HFTs) are trying to scoop up micro-dollars in nanoseconds. It is amazing how quickly and vastly these markets morphed. In the U.S., well over 90 percent of the trading is done electronically. A subset of the electronic trading, HFTs, account for roughly 50 percent of the trades in the European Union and roughly a third of the trades in the United States.
I’ve been calling high frequency traders cheetahs—as in the fastest land animal. Cheetahs can run seventy miles-per-hour. Zero to sixty in three seconds—now that’s quick. So are markets today. We regulators need to be quick and nimble, too, to keep up with the cheetahs. And, when they do something to mess up a market, we need to catch the cheetahs. (That’s my Boston accent—“catch the cheetahs”).
Technology in markets is great in a lot of ways and it is being embraced throughout the world. Cheetah trading does add liquidity, although I think some of the liquidity is between computers used by traders whose positions are flat at the end of the day. In other words, it’s short-lived, it may be fleeting liquidity, but it is liquidity, nonetheless. Technology adds access. The third largest trader by volume on the Chicago Mercantile Exchange (CME) is based in Prague. Now, that’s access that wasn’t there ten years ago. For us regulators, technology also provides an electronic data trail. At the end of the trading day, exchange employees used to scoop up the little tickets on the trading floor with snow shovels and that’s the data we had to use to regulate. So, like cheetahs, there’s a lot of good about this technology animal. But, like cheetahs, there’s an element of danger.
The Flash Crash
What do I mean by danger? Think about the Flash Crash as an example. Like a cheetah taking down a deer, breakneck speed trading contributed to taking down financial markets the afternoon of May 6, 2010. I didn’t say it took them down all by itself, but it was a contributing factor.
U.S. financial regulators recently received recommendations from an advisory committee, which provided us with some thoughtful suggestions in light of the Flash Crash. Already, circuit breakers have been put in place in some securities markets, but they need to be expanded and they need to be harmonized with other U.S. markets so we can stop the kind of arbitrage that created a cascading affect across all markets. Should these types of circuit breakers be harmonized in other nations? Maybe. Think about it. If the Flash Crash had taken place in the morning on May 6th, when E.U. markets were open, it could have instigated a global economic event. Since it took place in the mid-afternoon, it was primarily limited to U.S. markets.
Another recommendation would be for cheetah trading programs to have some kind of “kill switch” that could be activated when a program goes wild. Most of the time, it’s innocent. Even so, there’s the possibility that these cheetahs can roil markets and that’s what regulators need to get our heads around. Are kill switches good for other nations? Perhaps they are.
Another market morphing area that we need to be thinking about is the market traders themselves. I call one fairly new group of traders “Massive Passives.” These are fairly non-traditional market participants who are large and have a fairly price-insensitive trading strategy. They get in markets and stay there—for the most part. In the run-up to the financial crisis of 2008, we saw an enormous shift in speculative money coming into futures markets. Over a several year period, roughly $200 billion in speculative money came into these markets. Crude oil reached $147.27 a barrel. Gasoline topped $4 a gallon. Did these new speculators cause those prices to reach historic levels? I am not saying they did. In fact, let me be clear: I do not think they drove prices up nor did they drive prices down. While I am not saying that they were the cruise control on gas or oil prices, I do think they tapped the gas pedal and prices moved up. They were a part of the price rise. Similarly, when they did get out of the markets, as the economy was melting down, prices decreased.
You don’t have to take it from me, though. Economists at Oxford, Princeton, and Rice universities and many other private researchers say that speculators have had an impact on prices—oil prices and food prices most notably.
So, is that what’s going on today, like it may have in 2008? I’ll leave it to you to decide for yourself, but let me give you a little food for thought. There are now more speculative positions in commodity markets than ever before. Between June of 2008 and January of 2011, futures equivalent contracts held by these types of speculators increased 64 percent in energy contracts. In June of 2008, the number of such contracts totaled 617,000. By September of 2010, they were 923,000. And, by January of this year, they had grown to 1,011,000. In metals and agricultural contracts, those speculative positions increased roughly 20 percent or more.
As I’ve said, we need speculators. Without them, there is no market. The sheer size, however, of concentrated speculative interests has the potential of moving markets, of influencing true price discovery. That can make life difficult for the commercial hedgers who use markets to manage commercial business risks, and for consumers who rely upon them to fairly price just about everything they purchase.
Our new reform law addresses this by requiring mandatory speculative position limits—to ensure that too much concentration doesn’t exist. We were supposed to implement those limits in January, and I’m disappointed that we have not done so. If we had the desire, we could institute limits for the spot month in over-the-counter (OTC) trading based upon the physical supply. We could put limits in regulated markets. We could have helpful limits in place that could guard against markets being adversely impacted by excessive speculation. We could do that now if we wanted. And, as you can tell, I want. And by the way, the second largest exchange in the Americas, in Brazil, has position limits. They are going gangbusters and position limits seems to have worked very well there. So, as we look to implement our limits, we need to see what has already been done.
In the United States, our President and our Congress reacted to the economic meltdown swiftly, and the final result was passage last July of the Wall Street Reform and Consumer Protection Act of 2010—a sweeping piece of financial market regulatory reform legislation that was sorely needed. The U.S. law brings “dark markets”—that is over-the-counter markets that had no regulatory oversight whatsoever—under federal scrutiny, and increases transparency and accountability in financial markets, to the benefit consumers and businesses alike. As you know, many other nations are moving in this direction too. In fact, here too, Brazil has already been keeping records of OTC transactions for several years. Here too, we need to learn from our brethren regulators and think about how we go forward.
Regulatory Arbitrage and Global Harmonization
Brazil is ahead of the United States in some areas, and the United States is ahead of the E.U. in some areas. Japan actually is also ahead of the United States in some respects with regard to market reforms. The bottom line is that nations will have to go at their own pace. Some nations won’t see a need to do anything. I do hope, however, that where there is a need for reform, that reform does take place eventually, before we have more economic disasters. Again, financial fiascos in one nation can affect other nations or the entire world.
One of the dangers of not having rules and regulations worldwide that make some sort of sense together is that it can create a regulatory race to the bottom, as it were. Some can take their business, their trading, and their banking to the least regulated markets in hopes of short or long term gains. I understand that businesses don’t like regulation in general, but when the regulation makes for more efficient and effective markets, or when it reduces systemic risk, or when it makes for a less risky economy—I think most people understand that it is needed. Therefore, any regulatory arbitrage, I believe, will be short lived and not worth the risk. Unregulated or poorly regulated markets cannot sustain themselves over the long haul.
Open and free markets are great, but as we have seen in the last several years, sometimes there needs to be appropriate boundaries and appropriate transparency. Nobody wants to see billion dollar bailouts for systemically important financial institutions.
All of these questions about cheetah traders, about the massive passives, speculative position limits, and OTC trading bring us back to the question of interconnectedness.
When I make the case for position limits, sometimes opponents say, “Won’t we see market migration outside the U.S. if limits are in place?” It is a concern. Before the new law, it was common for traders to jump into the dark, OTC pool to hide from regulation. Now that we’re going to be regulating that pool, that won’t be an option. Could traders go to other nations? Yes, if our limits are too restrictive, they could. That is why I have suggested that we err on the high side at first and then re-calibrate as we go forward, and as other nations put rules and regulations in place.
As I said earlier, however, the good news is that some nations have already moved in this direction and other nations are beginning to move in this direction of appropriate financial reforms. On position limits, for example, the E.U. is proposing much of the same language now in our law. In fact, there is a meeting of international regulators here in Florida today and I hope to meet with some of them to discuss progress.
Conclusion: We Can Do Better: What Needs to Change
So there are some specific thoughts and things that we need to be thinking about and actually doing to continue to foster harmonization.
I’ve been involved with government for 25 years and we need to do better. I see how governments operate, not only in the U.S. but in many places around the globe. Government isn’t very proactive. That isn’t good for business and it isn’t good for nations. All too often, when there is a problem in financial markets, government will say, “give us several months and we will do a report for you. Or we will set up a task force or an advisory committee.” Those things may be fine, but we can do better in government. We regulators are like CSI Miami coming in to do a post-mortem and find out whodunit. We need to be more proactive—trying to prevent bad things before they happen.
If we can do better, be better public servants, it can help ensure that our important interconnectedness is more harmonized. That will be good for all of us. It can only help ensure more efficient and effective markets and economies and it will help keep markets devoid of fraud, abuse and manipulation, not just in our individual nations, but around the world. I know it is probably a tough challenge, but if we can, in our work in finance and in government, just add a touch of humanity as part of our interconnectedness, we will all be better off.
Last Updated: March 15, 2011