April 11, 2011
Thank you very much. It’s good to be with you this morning. I want to especially thank James Gillies for the kind invitation to speak with you today. If the government had shut down, I wouldn’t have been able to be with you in person. While I was one of the fortunate few who would have still been paid, traveling during a shut down isn’t allowed. The only exception is for emergencies. I don’t think one of you doubling down and splitting tens would have qualified as an emergency. But for heaven’s sake, don’t do it! Let’s get started.
Financial Crisis Inquiry Commission
Some of you may be familiar with the Financial Crisis Inquiry Commission—the FCIC—which was established by Congress to examine the economic fiasco. The FCIC web site asks the question: “How did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives—either risk the collapse of our financial system and economy, or commit trillions of taxpayer dollars to rescue major corporations and our financial markets, as millions of Americans still lost their jobs, their savings and their homes?”
The FCIC looked at what was done and determined that the crisis was avoidable. It didn’t need to take place. They note widespread failures in financial regulation, breakdowns in corporate governance, excessive borrowing and risk-taking by households and Wall Street, along with policymakers who were ill-prepared for the crisis, and systemic breaches in accountability and ethics at all levels. The bulk of the blame goes to regulators and the captains of Wall Street.
While there may have been a few wise policy decisions, the bulk were, let’s say, otherwise.
Wise and Otherwise
Have any of you ever played the board game “Wise and Otherwise?” Come on, it was “Games Magazine’s” party game of the year in 1998. You are in Vegas for gosh sakes—you must like games and parties! If you haven’t played Wise and Otherwise, here is what happens: someone reads the beginning of an old, wise, little-known saying, like maybe a Chinese proverb and then everybody writes down an ending to the saying in their own words. That, as you can imagine, can be the “otherwise” part. You get points when other players think your ending is the real one and points for guessing the real old saying.
So, for example, one of the cards reads: There’s an old Italian saying: “Don’t bite till you know whether it is…” You could devise your own answer—a particularly appropriate thing to do if you didn’t know the correct ending. Does anyone know the proper ending? How about this: “Don’t bite till you know whether it is ripened with sun and true love.” Pretty good, eh? Well, if you like that ending, I’d get points because that isn’t it. The proper ending is, “bread or a stone.” So, “Don’t bite till you know whether it is bread or a stone.”
There you have it. More than policies are wise and otherwise. There’s a board game. It is actually a pretty cool game.
Hang in there, however, as we wade into that wise and otherwise concept and the economic fiasco just a little more. In 1933, (hold your hat, this won’t take long) in the wake of that economic collapse, the Glass-Steagall bill became law. This Depression-era law prohibited investment banks from getting into a number of things. The law was wise because Congress believed certain banks took too many risks speculating with depositors’ money. These extravagant banking practices were blamed, in large part, for the financial crash at that time. Fast forward to 1999 (told you it would be quick) when a Republican Congress passed and a Democrat President signed into law the repeal of the Glass-Steagall Act.
The repeal freed banks from 60-plus years of restraint and allowed exotic mortgages and high-flying speculation. Other laws, like the Commodity Futures Modernization Act (CFMA), established principles that exchanges were supposed to follow, which replaced many prescriptive rules and regulations. That law actually worked pretty well in some regards. The U.S. futures industry grew by roughly five times during a portion of the last decade while the futures industry in the rest of the world grew three-fold. However, CFMA still allowed hundreds of trillions of dollars in over-the-counter (OTC) swaps to take place totally in the dark—unregulated. Other financial laws created additional latitude that led to a very free market.
For regulators, they were no longer required to undertake the oversight they once had spent hours on each day—maybe not so wise. To some bureaucrats, this might have seemed like a dream job. Really, I mean it. They could close their office doors and take a nap and dream. Maybe they would put a sign on the door that said, “Do Not Disturb” or “Quiet Please” or on the West Coast, “Don’t Harsh My Mellow.” Unless something was bleeding or on fire, la de dah, don’t bother us. As signs or problems started to emerge in late 2007 and early 2008, maybe some of the regulators called their lobbyists buddies to ask a question. The answer always would have been, “We have it under control.” Or perhaps “An unfettered free market works best.” As we know now, many of these large financial institutions had it “under control” until they didn’t (like Bear Sterns, then Lehman Brothers and AIG and others). However, having asked the question back then, regulators could merely check the due diligence box. To claim no responsibility for a regulator might seem normal, but to blame someone else, like the banks, showed management potential.
As for the lobbyists, there is an old saying in Washington that if you aren’t part of the solution, there is plenty of money to be made being part of the problem. And, a problem was really brewing.
That is what some of the regulators might have been doing. By the way, sarcasm is just another service I offer. To be candid, the laws really did require less regulation and the cues that Congress was giving regulators essentially said: “Let this economy rock and roll and don’t over-regulate.” But regulators went way too far. When we learned about the blind eye turned on Securities and Exchange Commission (SEC) whistleblower Harry Markopolos who for years had been telling about Bernie Madoff’s billion dollar Ponzi scam, it is enough to make us sick. Markopolos was wise. The SEC staffers who ignored the repeated attempts to stop this, well, they were otherwise.
While many regulators were asleep at the switch, what about the banks, those captains of finance that had so many fewer restrictions on what they could do? What were they doing? The free market highway was waiting there for them, wide open with no guardrails. For many of them, it was party o’clock!
On the wise front, the good news is that some of the best financial minds became incredibly innovative, devising products nobody had ever imagined. On the otherwise front, the bad news is that some of the best financial minds became incredibly innovative devising products nobody had ever imagined. Credit default swaps (CDSs), for example, where bets upon bets that bundled tranches of mortgages would fail led to overly leveraged institutions. We know the result: hundreds of billions in a hideous taxpayer bailout that essentially socialized the risks that the party o’clock mentality created.
The bailout (sought by President Bush), along with the subsequent stimulus dollars (sought by President Obama), did work to eventually cauterize the hemorrhaging economy. As this was all taking place, average folks were feeling the damage every day. As markets became increasingly squirrely, folks just wanted to protect their nuts. Their savings, retirements, college funds, and home values were all evaporating. What were some of the largest financial players doing as all of this was going on? Well, many continued handing out multi-million dollar bonuses exemplifying the Gordon Gecko “greed is good” mentality. I remember thinking of the Eagles song Hotel California: “Her mind is Tiffany-twisted; she got the Mercedes Benz…” I suppose the captains of finance may have had a Tiffany-twisted mind, and I’m sure some had a Mercedes Benz…or two. I guess someone has to set an extremely bad example.
Regulatory Reform and the Budget
Last July, Congress and the President said enough of the freewheeling unfettered free market without guardrails. They said there have to be some serious yields and cautions, some protections and some speed limits to ensure that we never again end up in such a gargantuan economic mess. In my opinion, this was very wise.
When the Dodd-Frank Wall Street Reform and Consumer Protection Act became law, there were detractors. Some thought despite the mess that had been created, things as they were still made sense.
What we have seen in the last several months, and during the last several days vis-à-vis the budget debate, is an effort by some to stop the Dodd-Frank law from actually working. While funding for financial regulatory agencies was just a small portion of the matters being debated, these financial regulatory reform issues are important nonetheless.
I talked about this last Friday, as the impending government shutdown drew closer and closer. I bet not many of you were watching the House and Senate at midnight on Friday were you?
Some of you may remember what was called the “Diamond Crash,” many years ago in 1981, a tragic loss of four pilots and their jets in a daredevil Thunderbird flying show in Arizona. Due to a rare malfunction in the lead plane, causing it to go off course, the leader of the flying “V” led the three following jets—whose pilots are taught to follow the leader with exacting, unwavering precision, blindly following the leader, if you will—into a tragic, fatal dive.
There’s a lesson in this for those that have been engaged in the budget debate, and will continue to be involved in many issues in the next several months: the debt ceiling, and the fiscal year 2012 budget to name just two. It is following a kind of blind rhetoric that has pulled some of our leaders to last Friday and a full-blown government shutdown. And, the harm that could have been caused was potentially incalculable. In our agency, we let markets and market participants know what were NOT going to be able to do during a lapse. This was very dodgy territory. As we just spoke about, we are just now crawling out of the worst economic calamity since the Great Depression, and certain individuals have been playing a game of chicken—arguing over a miniscule percentage of the total budget—putting that recovery at risk once again.
If we had shut down, our agency would not have been able to staff key market surveillance and oversight functions—only the most minimal services necessary to “protect property” and prevent market dislocations would have been undertaken, and even then only in the event of emergency situations. We would have gone from several hundred people overseeing the markets to less than a handful—roughly 25 folks. Other oversight functions, such as contract approvals, registrations, and other important transparency functions such as the availability of certain public reports, would not have been done, and anything currently on our plate would have been suspended and the timetables tolled. In other words, our current Commission activity, but for necessary market oversight, would have come to a screeching halt. Ultimately, the concern is that the costs to be borne by such a shutdown would fall on—you guessed it—the American taxpayer.
Playing catch-up, by the way, would not have been cheap either. The costs for lack of oversight during a shutdown—both in terms of economic loss and possible market harms—could be enormous.
It’s time to get a budget in place for the rest of the fiscal year and get on with figuring out how departments and agencies will be funded for the next fiscal year, which starts a scant six months from now. I am hopeful the rhetoric will be put aside, the blinders taken off and the lights will be kept on for the federal government, for the benefit of the American taxpayer and consumer. That would be the wise thing to do.
There will continue to be efforts to cut our funding in the hopes that we don’t actually have the resources to oversee the reforms that some opposed form the start. That battle will continue. All too often in Washington, temporary amnesia sets in. I hope those that have opposed regulatory reform will think back, to not too long ago, as to why this horrendous economic chaos all began, and allow regulators do the job that Congress and the President have asked us to do.
If the budget debate seems like it is taking forever, things are moving much faster in markets. We are seeing David Bowie like cha cha changes. Let’s discuss two areas where we see some wise and otherwise changes taking place.
Let’s start with 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. Make no mistake—they are very sophisticated and quite wise. 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 (U.S.). In the energy sector, crude oil has more algo trading than any other contract (31 percent of futures are traded algorithmically, and 25 percent of options).
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 fast, fast, fast. So are markets today. We regulators need to be quick and nimble, too, to keep up with the cheetahs. (That’s not cheetahs with a Boston accent).
Technology in markets is grand in a lot of ways and it is being embraced throughout the world. It is wise. HFT 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 used many times in our enforcement efforts. So, there’s a lot wise about technology. Nevertheless, there are some otherwise elements.
We 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 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.
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?
These computer programs are wise and smart. There’s no question about it. But, they are otherwise, too. Remember when Dustin Hoffman played Raymond in Rain Man? He and his brother, Charlie, came here to Las Vegas and Ray could count cards at the blackjack table, even from a multi-deck shoe. He was that wise. But, he was otherwise, too. He couldn’t take care of himself. I’m told that despite Albert Einstein’s genius, he couldn’t dress himself. Wise and otherwise. Likewise, these HFTs are wise, but can they take care of themselves? Can they just roll on independently like nobody’s watching? I don’t think so.
Just a few days ago, the folks at Nanex worried aloud that the exchanges aren’t paying enough attention to the algo programs and that the programs are contorting markets. I don’t know if they are or not but it is true that we need to pay more attention. Nanex found one algo that was trading S&P 500 E minis but was able to affect the price of related instruments elsewhere, thus creating an arbitrage opportunity for itself.
I believe these trading programs need to be tested, probably by the exchanges, before they go live. In India, regulators already do test HFTs. I have urged that our rulemaking include provisions for algos to be certified to make sure they don’t have the potential to violate the Commodity Exchange Act, Commission regulations, or exchange rules related to fraud, manipulation and trade practices.
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.
The second big change and market morphing area that we need to be thinking about is the 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.
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.
Now, some of you may have noticed that gas prices are a little high. It’s affecting the economy. Here are some rules-of-thumb from the global information company IHS: A $10 rise in the price of a barrel of crude oil translates into a 24 cent rise in the price of gas, $30 billion a year when spread across the whole economy. When that happens, in the first year, real GDP and real consumer spending are both reduced .2%. The Consumer Price Index is .5% higher, and employment is reduced by 120,000. If the higher price persists, the cumulative loss in real GDP rises to .5% in the second year, and the employment losses reach 410,000.
Here’s another example: Delta Air Lines General Counsel Ben Hirst says the airline pays an extra $100 million a year for jet fuel for every $1 increase in the cost of a barrel of crude oil. No wonder it costs to check bags.
Having said all of that in this section of the speech about speculation, you’re going to say that Chilton is blaming speculators for high prices. I am not. 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 in 2008. 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. Wise researchers 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.
However, even as late as last month, some senior exchange officials denied there was any evidence whatsoever that speculators impacted prices. They didn't call the professors whack jobs or crazy. That reminds me: A psychologist entered a patient’s room and found one of the two patients knelt down over a desk pretending to write with a non-existent pen on a non-existent pad of paper. Hanging from the ceiling, by his feet, is a second patient. His face is beet red. The doctor asked the first patient what he is doing, to which the reply comes, “I’m a researcher, doing very important research.” The doctor asks the researcher patient what his buddy is doing hanging from the ceiling. “Oh” says the patient, “He thinks he's a light bulb.” The doc says, “You should get him down from there. He may hurt himself.” To which the researcher patient says, “What, and work in the dark?”
So no, this official at an exchange didn’t say the studies are false or that the people who did them are crazy, or that they only worked in the dark. No evidence exists is what he said, as if no studies or papers or quotes exist whatsoever. Well, they are wrong. In fact, several 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. I’ll be updating the list soon. You can go to cftc.gov and look at my speeches and testimony and find it (Note: March 16, 2011).
So, if those studies are right or even if they might be hypothetically correct, what do we do to protect markets and consumers alike? Well, when you walk out to the casino here, there are gaming limits. Someplace in this building, I’ll bet (sorry for the pun) there’s a private high roller room, but even there, limits exist.
Limits are everywhere, even in a casino, but not much in the world of commodity trading—not yet. The new reform law, however, 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 what appear to be pretty wise position limits in place and seem to be doing rather well.
Energy Policy: We Need a Map
Talking about commodity prices though requires that we talk just a little about energy costs. One thing’s for sure: When gas prices are as high as they are, you don’t want to get lost and drive around wasting a bunch of fuel. Likewise, when it comes to energy policy, I think we need a map.
The unrest in the Middle East jarred the world awake to the risk that key oil supplies could be cut off, spurring a rally that sent oil prices up 25% in 13 trading days—the fastest such leap in almost two years. So, even with position limits; even with market transparency; even with sound regulatory oversight, we’re still going to have some volatility in energy markets.
I think we’ll have that volatility until we have a sound energy policy. That’s why I was pleased that the President, a few weeks ago, put forth a series of steps toward such a policy. He noted that transportation represents “the second biggest chunk of most families' budgets.” He announced a new energy goal to reduce the nation's oil imports a third by 2025 by expanding natural gas and electric vehicles, developing advanced bio-fuels, making more fuel-efficient cars, and increasing domestic oil and gas production on existing leases.
You may not agree, but I think those are good, wise steps. From a markets perspective, all of them could bring a little more certainty and, as you know, markets don’t like surprises. Just like speculation, a little volatility in markets is acceptable, but too much is not.
Conclusion: We Can Do Better
Well, I’ll wrap up. As Raymond from Rain Man said over-and-over: “15 minutes to Judge Wapner; 15 minutes to Judge Wapner.” Likewise, I want to keep you on your schedule.
Before I go, though, 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. We can’t be like those regulators I spoke about earlier. We need to be wise. Government is rarely proactive. That isn’t good. All too often, when there is a problem in financial markets, government will say, “Give us several months and we will do a report. Or, we will set up a task force or an advisory committee.” Those things may be fine. The FCIC report was a good report. The report we received on the Flash Crash was important. But, we can do better. We shouldn’t be like the original crime scene investigators here in Las Vegas, the CSI folks who go to the crime scene to do a post mortem of everything that happened. We need to be more proactive—trying to prevent bad things before they happen. The Wall Street Reform Bill goes a long way toward doing that, but it took a market meltdown before government acted, and as we have discussed, there are still folks who oppose the reforms and are looking at the budget as a way to stop or slow them.
At the same time, we need to be mindful of balance. In her seminal 1957 novel, Atlas Shrugged, Ayn Rand explored the negative effects of governmental overreaching into the private sector. As we undertake the task of developing wide-ranging rules for an entire new market structure, we are intensely aware that we must not stifle necessary and legitimate business activity that is critical to the engine of our economy. We don’t want to “shrug,” and topple the globe off our shoulders.
Tomorrow, the Commission will hold the 13th in its series of open public meetings on Dodd/Frank rulemakings. We will address what I believe to be one of the more important rulemakings—dealing with margin issues. It’s important, because we need to ensure that the appropriate lines are drawn to protect against market risks as appropriate, yet not place any unnecessary requirements that could end up harming commercial business activity. In other words, we don’t want to tie up money unnecessarily in margin when that could be better used for natural gas exploration or increased agricultural production, just to name a couple of examples. We need to hear from the market participants affected by these rules, and from all interested parties, to ensure that we get the balance right.
That’s just an example of what we need to think about—with foresight—how to be wiser, how we can do things that will be good for businesses and consumers and help the economic engine of our democracy, not just looking for problems that could be lurking out there. We need to, for example, insist on appropriate cost benefit analysis on our rules and regulations to know what we think the impact is going to be. Overall, the Congressional Budget Office says the financial reform law will reduce the U.S. deficit by $3.2 billion by 2020. That’s significant. It shows that creating this law was wise and it’s quite a counterargument to those who say otherwise—that the reforms will be harmful and costly.
If we can do better, be better public servants, it can help ensure more efficient and effective markets and economies and it will help keep markets devoid of fraud, abuse and manipulation. That’s good 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. We just need to be wise and not otherwise.
Last Updated: April 11, 2011