March 28, 2011
Introduction: The King’s Speech
It’s great to be with you this evening. Thanks to Don Casturo for the kind invitation to speak with you and thanks to Ken Connolly who does your Washington, D.C. work and I have known for years. When Don first invited me, I must admit to feeling a little dash of doubt about the prospect of speaking to such a sophisticated group of financial market participants. However, as the great Winston Churchill once said, “There are two things that are more difficult than making an after-dinner speech: climbing a wall which is leaning toward you and kissing a girl who is leaning away from you.” I’ve never tried to climb such a wall, but have tried to kiss a girl leaning away, so I guess I’m more than half way there. My wife, incidentally, tells me she still loves me anyway. So, perhaps I can deliver this speech.
I’m sure that many of you have seen “The King’s Speech.” It won four Academy Awards, including Motion Picture of the Year. It was among the best pictures I’ve seen in a long, long time. Colin Firth did a remarkable job of playing King George VI. You couldn’t help but feel for a guy who never really asked for the job and had to overcome a stammer while serving as one of the most powerful people in the world. In real life, George VI became a beloved monarch, and of course, the movie had a joyful ending.
In the real life of financial markets, things were stammering in 2007 and 2008. The markets had been dominated by lax rules and regulators who may have looked the other way. Market participants took advantage of the circumstances. High-wire deals were the norm and bets upon bets on things like credit default swaps led to the collapse of some big, global entities, taxpayer bailouts and a reeling world economy.
So, we were asked to do a job we really hadn’t asked for either: reform our regulations. 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 (OTC) 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, Europe has been debating very similar reforms. The Japanese, who despite having a long road ahead of rebuilding their infrastructure and their economy, have put reforms in place, too. I want to talk more tonight about how we need to learn from each other and think about how we go forward in a more harmonized fashion. There are still many obstacles, but like George VI, we can overcome them if we work hard and together.
First, however, it makes sense to discuss the market environments in which we currently live. One of the reasons our financial markets and our economies are so interconnected—and we need some harmonization—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 (E.U.) and roughly a third of the trades in the United States (U.S.).
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.
Technology in markets is great in a lot of ways and it is being embraced throughout the world. Cheetah trading does add liquidity. 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. Nevertheless, like cheetahs, there is an element of danger.
U.S. financial regulators recently received recommendations from an advisory committee, which provided us with some thoughtful suggestions in light of the Flash Crash—when markets tumbled nearly a thousand points only to recover most of that lost last May 6th. 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. There are stocks and futures, which are arbitraged internationally. 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 is feral. 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.
Here are some other 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, probably by the exchanges, before they go live. In India, regulators already do test HFTs. 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.
In addition, 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.
Another market morphing area that we need to be thinking about is the market traders themselves. I call one relatively 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—all U.S. futures markets, not just the energy complex. West Texas Intermediate crude oil reached $147.27 a barrel that year. Brent crude got to $145.91. Did these new speculators cause those prices to reach historic levels? I am not saying they were the cause or the culprit. 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 pumped the petrol 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.
But, even as late as last week, some senior exchange officials denied there was any evidence whatsoever that speculators impacted prices. They didn't call the professors idiots or crack pots. Remember the exchange between Lionel, the speech therapist in the movie and the King about smoking? As, King George is lighting up a cigarette, Lionel says, “Please don’t do that.” “I believe sucking smoke into your lungs will kill you.” George says, “My physicians say it relaxes the throat,” and Lionel says, “They're idiots.” The King says, “They've all been knighted.” Lionel says, “Makes it official then.”
Well, these folks aren’t saying the studies out there are bogus or that the professors who worked on them were idiots. They said no evidence existed, as if no studies or papers or quotes existed whatsoever. Well, they are wrong. In fact, two weeks ago I spoke at a Futures Industry Association meeting and listed ten specific cites of studies, papers or quotes that illustrate a link. In fact, there are dozens of other examples. Some of these examples might even come from sources you think unlikely. Here’s one: “We estimate that each million barrels of net speculative length tends to add 8-10 cents to the price of a barrel of crude oil." Any idea where that bit of zealous craziness came from? Maybe Berkley or Oxford? Well no. That came from the March 21st issue of the Goldman Sachs “Global Energy Weekly.” So, folks can make their own decisions about any link between speculators and prices, but to say that there are no studies is simply wrong. I can continue to explain that to folks, but I can’t comprehend it for them.
Consequently, 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. We all get that. Without them, there is no market. Speculators that contribute to liquid markets can also ensure less volatility. The sheer size, however, of excessively 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.
The U.S. 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 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. Unfortunately, we are still a way off. Perhaps we can learn something from the Brazilians on position limits. Brazil boasts the second largest exchange in the Americas. They already have position limits in place and seem to be doing rather well.
On position limits and all the other rules we’re trying to get in place now, 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.
Last week our Chairman, Gary Gensler, was in Brussels before the European Parliament and spoke about how effective reforms cannot be accomplished by one nation alone. They will require a comprehensive, international response. His point is important because if we don’t do this together, at least in the same vein, we run the risk of regulatory arbitrage. I’m not suggesting that the E.U. has to do precisely what the U.S. does. We all have sovereign issues, and we have different markets, let alone different interests that we all need to consider. However, we also have a lot in common. We all want to guard against systemic risks that can result in an impact on our national or regional or our world economy. As we know, we are all linked in today’s world and one economy has an impact upon another. So, to the extent that we can approximate harmonization, we will be better off individually and collectively. The E.U. doesn’t have to do what the U.S. does. The U.S. does not have to do what Brazil or Japan or India has done. However, we shouldn’t open the door for regulatory arbitrage or trading migration to the least or most poorly regulated trading environments. Solid, but appropriate, regulation globally will lead to greater confidence and greater opportunities for consumers, businesses, markets, and economies. At the end of the day, efficient and effective financial reform cannot be accomplished by any individual nation or region. To the extent practical, reforms need to be developed and implemented in an interdependent and interactive fashion.
Conclusion: We Can Do Better
Well, I’ll come to a conclusion. As Lionel asked the King during one of their sessions in the movie, “How do you feel?” George VI answers: “Full of hot air.” And, Lionel says, “Isn’t that what public speaking is all about.”
However, before I go, I want to leave you with one last thought. I’ve been involved with government for 25 years. I see how governments operate, not only in the U.S. but in many places around the globe. Now, more than ever, with this need for harmonization and financial reform, we have to do better. We need to improve the way we all operate. Government is rarely 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 improve. We need to be more proactive—trying to prevent bad things before they happen. As Churchill also said, “You can always count on Americans to do the right thing—after they've tried everything else.”
We need to not only look for bad things that could happen, but potentially good things that can happen. Businesses need to be looked at as partners in this effort and to the extent we do our job, we need to constantly be considering the impact of regulatory actions.
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.
None of us want our markets to stammer again. We can overcome the obstacles that stand in the way of making them more efficient and effective for market participants, for business and especially for the consumers who depend on these markets for the price discovery of just about everything they purchase. I know it is a tough challenge, but I am optimistic that we can meet it.
Last Updated: March 28, 2011