March 17, 2011
Introduction: Timing is Everything
Good morning and thanks for the chance to be with you today. Thanks especially to Katie Walsh for her kind invitation.
Gee, could you have had this conference at a less exciting time for energy markets? What in the world are we going to talk about? Yes, your timing is spot on with energy markets that are being affected by everything from Tripoli to Texas; from Afghanistan to Alaska. Even more recently and sadly, they are being affected by the devastating destruction in Japan. Today, I want to talk about some of those fundamental issues but also about some non-fundamental realities that are affecting financial markets, especially in the energy arena.
Japan and Oil
First of all, on the most recent of many global occurrences affecting markets, 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 plant 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.
I don’t know how many of you ever watched “Third Rock from the Sun,” but the name of the show always reminded me that this planet isn’t as big as we sometimes think it is. I have a globe in my office and I sometimes think, “It’s only a few inches from Japan to the U.S., or from the U.S. to England.” Well, it’s an increasingly small world in financial markets. What’s going on today with energy market fundamentals is a good example of that shrinking world. In the same way that a disaster in Japan can literally set off a wave that is felt halfway around the world, happenings there, or in the Middle East, or in any number of other places affect financial markets.
I spoke at an international meeting of market participants earlier this week and also attended a meeting of international regulators. It’s clear that we all have many of the same concerns. It’s also clear that many of the largest nations have a goal of financial market reform like that we’ve undertaken in the U.S. That’s good, because if there’s one thing we need in our increasingly global financial markets, it’s regulatory harmonization between and among countries.
Yes, there are a number of fundamentals at work in energy markets today. Yet, we can’t deny the fact that demand is relatively flat and supplies are more than adequate, even with the geopolitical disruptions. So, is it all fundamentals or are those fundamentals masking, to some extent, the very real changes that continue to occur in our markets?
That brings me to a set of relatively new players in our financial world—what I call “Massive Passives.” 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.
Many of the speculators have a distinctive trading strategy: that is, they go long and stay long. They are typically huge hedge funds, pension funds and index funds. They have a passive, price-indifferent, long-only trading strategy that is different than we have traditionally seen in futures markets. Of course we've always had speculators and we need them. The Massive Passives, however, are different.
Many of us learned that while there may not be such a thing as too much speculative money, that same money might be too concentrated. Since 2008, we have seen concentration above 20 percent of open interest in the natural gas and crude oil markets.
While I’m not suggesting speculators drove prices in 2008 or today, they had an impact then and I think they are having some impact today. 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. Today, there are more speculative positions in commodity markets than ever before. In June of 2008, when oil was approaching a record price, speculators accounted for 617,000 futures equivalent contracts. As of January of this year, that number went over a million. That represents a 64 percent increase in energy contracts. In metals and agricultural contracts, the increase is roughly 20 percent or more.
As I’ve said many times, 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 hedgers who use markets to manage commercial business risks, and for consumers who rely upon them to fairly price just about everything they purchase, like a tank of gas, for example.
Congress got it, and that is why the new financial reform law requires mandatory speculative position limits—to ensure that too much concentration doesn’t exist. We were supposed to have a rule for that in place right now and I’m disappointed that we don’t.
More New Players
As we all know, markets have changed dramatically in the last decade. 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. 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.
I’ve been calling high frequency and algorithmic traders cheetahs. The cheetah is the fastest land animal. It 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. It 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 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.
As you may know, we recently received recommendations from the CFTC/SEC Joint Advisory Committee on Emerging Regulatory Issues. There’s a lot of good stuff in the report and both Commissions will be giving serious thought to the recommendations. 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 markets so we can stop the kind of arbitrage that created a cascading affect across all markets. Another recommendation would be for cheetah trading programs to have some kind of “kill switch” that could be activated when an algo goes wild. Most of the time, it’s innocent. But even so, there’s the possibility that these cheetahs can roil markets and that’s what regulators need to get our heads around.
Mini-flash crashes occur all the time, too. More than once last year in futures markets and several times in stocks, runaway robotic programs disrupted markets and cost people money. One company lost a million dollars in the oil market in less than a second when an algo ran wild. It was its own money but you can see how fast fortunes could be lost by innocent people.
These advanced analytic computers are intuitive. There was a recent New York Times article that made the point that one new strategy being used these days is to have mega-powered computers read news reports, blogs, even Twitter feeds and then trade on the information. Somebody is smart enough to program the computer to do all that but the computer takes it all from there.
Limiting the Cheetahs
A couple months ago, I gave a speech in New York to a group of high frequency traders—a whole room full of cheetahs. Don’t ask me why, but I chose that venue to propose putting protections on the way they trade. I expected that maybe I wouldn’t be the most popular guy in the room that day, but a strange thing happened. They didn’t raise any objections. In fact, some of them said I was on target. They were favorable to putting some limitations on market participants that would protect the markets.
Here are some of the questions I’ve been asking: should there be different rules for these market participants? Is this type of trading outside the boundaries of the fundamental purposes of capital formation and risk management in financial markets?
I believe these trading programs need to be tested, either by the exchanges or by the regulators, before they go live. Call it a “Jiffy Lube ten-point test.” You know, when you get the oil changed in your car, they give you a list of all the things they’ve checked. Why? They do a checklist so that, hopefully, you won’t have an expensive problem down the road.
Moreover, new safeguards may need to be put in place after there’s been a problem. When a plane crashes, for example, the airlines reprogram their simulators to create the exact circumstances that led to the crash so that pilots can train to avoid a future problem. We need to be able to do that after a market crashes so that we can prevent it in the future.
We also need to continue to fine tune exchange controls and “time outs” for those times when trading gets out of hand. Limit up, limit down rules, in addition to circuit breakers, are two examples.
And, we need to consider pre-trade prudential firm controls, so that we know the companies employing the programs have methods, like those kill switches I mentioned, to shut them down if they go wild.
Wall Street Reform
Last summer, one of the most significant happenings in the history of our markets occurred. Congress passed, and President Obama signed, the Wall Street Reform and Consumer Protection Act. We know that both Wall Street and Washington shared much, if not all, of the blame for the financial crisis of 2007 and 2008. Lax regulation was clearly part of the problem and Wall Street took advantage of most everything it could get away with.
The Administration and Congress reacted to the economic meltdown swiftly, and the final result was passage of the reform law. It’s a sweeping piece of financial market regulatory reform legislation that our country sorely needed. It brings “dark markets” under federal scrutiny, and increases transparency and accountability in financial markets, to the benefit of the ultimate consumers in the United States.
Unfortunately, there may be a fly in the ointment. By that I mean, although Congress gave us new authority in the act, I’m not sure we’re going to be able to carry out the mission as we should.
Let me explain what I mean. I’m a financial market regulator, and I deal in numbers all day long—and this law certainly involves a lot of numbers. It has 13 titles, 633 sections, 880 pages (in the Government Printing Office version), and approximately 352,000 words (averaging 400 words per page), mandating that the CFTC implement over 40 rulemakings and undertake several studies and reports to Congress. That’s a whole lot of law.
Here are some other interesting numbers. The CFTC oversees exchange-traded derivatives markets that execute over $5 trillion dollars worth of transactions annually. After passage of the new law, our agency’s jurisdiction now includes oversight of the swaps market, the notional value of which is estimated at about $600 trillion dollars.
And here are even more numbers. Currently, the CFTC employs 675 people, overseeing those $5 trillion dollar markets. We do that on a budget of $163 million per year. It goes without saying that the new law will increase our workload exponentially.
Here’s the kicker: there is a move on Capitol Hill to DECREASE our funding. Yep, you heard that correctly. Decrease. To 2008 levels. If that happens, we will be dry-docked. We simply will not be able to implement the rules mandated by the very law Congress gave us in any meaningful way. So, as you can see, “Houston, we have a problem.”
That frightens me because I don’t want to see another 2008. A little preventive care is a good investment, and it’s a lot cheaper for taxpayers than bailouts.
Despite the funding issue, I remain excited and optimistic about the new law. Believe me, much of the public is excited, too, in more ways than one. We’ve received thousands of comment letters on our proposed rules. We even got one the other day from Charlie Sheen. I guess maybe he’d been too busy to write earlier.
All kidding aside, however, those comments are important and all five Commissioners are adamant about every comment being heard. So, I want to encourage each of you to make your voices heard if you haven’t already. I think one thing we can all agree on is that we want markets that are efficient and effective, devoid of fraud, abuse and manipulation. We may not agree on how we get there and that’s why public comments are so important. Neither I nor any of my colleagues claim to have all the answers. That’s why we need to hear from you.
Yes, it’s a small world on this third rock from the sun when it comes to financial markets. That technology we talked about earlier makes it smaller every day. It’s another good reason for us all to work together—traders, commercial firms, regulators and especially the consumers who depend on markets to discover prices for just about anything they buy. So, I’m glad to be with you today and I always look forward to hearing from you.
Last Updated: March 17, 2011