May 5, 2011
Thank you. It’s good to be with you today. I especially want to thank my friend Richard Sandor for the invitation to spend some time here. You know, he’s pretty modest but he has been a leader in markets and trading for a long time now. He’s not called the “Father of Carbon Trading” and the “Father of Financial Futures” for nothing. He has truly been an innovator and you are lucky to have him. I try to steal his time as much as possible, and always feel smarter after those times.
It’s also good to be in Chicago. It’s my favorite city in the world and if you look across Lake Michigan from here, you can almost see where I grew up in Indiana. On clear nights, we could see the lights of Chicago from our neighborhood. So, for that reason and others, I share with many people a great fondness for this city. Even when the Cubs and the White Sox are doing poorly—like, umm, so far this season—I’m still a fan. Being closer to Comiskey Park when I was a kid, I went to more Sox games, but I followed both teams, even though there has always been a competition between the two. Stop me if you’ve heard this one: A first grade teacher explains to her class that she is a Cubs fan. She asks the class to raise their hands if they are Cubs fans too. Only one little girl didn't raise her hand, so the teacher asked her why. “I'm proud to be a Chicago White Sox fan," she boasts. The teacher is a little perturbed now, her face slightly red. She asks the girl why she is a Sox fan. "Well, my Dad and Mom are Sox fans, and I'm a Sox fan too." The teacher is now angry. "That's no reason," she says loudly. "What if your mom was a moron and your dad was a moron? What would you be then?" A pause and a smile. "Then," says the girl, "I'd be a Cubs fan."
Financial Crisis Inquiry Commission
Okay, now that you’ve had your groan for the day, let’s move on. How many of you have heard of the Financial Crisis Inquiry Commission—the FCIC? It was established by Congress to examine the economic fiasco that started in ’07 and ‘08. 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?”
That defined their mission. And they concluded that what happened was avoidable. In fact, let me read you the very first line from the very first conclusion of the report: “We conclude this financial crisis was avoidable.” They note widespread failures in financial regulation, 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.
So, the message is: it was avoidable. But, Wall Street and Washington chose to avoid the avoidable.
As a result, though, Congress passed and President Obama signed into law, the most sweeping set of financial reforms in our history—the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was necessary if we were ever going to protect ourselves from the kind of financial meltdown that occurred in 2008. Congress and the President did the right thing with the new law. We regulators are trying to do the right thing as we write all the new rules associated with it. None of us wants to see a repeat of 2008.
Ever since the financial collapse, though, there are some in Washington and on Wall Street who have seen no need to reform our financial system. Maybe some thought what happened to AIG and Lehman Brothers worked out for the best, even if taxpayers footed the bill. So, they did their best to kill the bill, even though consumers and Americans everywhere were outraged. They failed. Now, some of those same folks want to repeal this important law—“Kill Bill II," if you will. Others think it would be clever to starve the new law into submission by not funding it. Still others are trying hard to delay its implementation.
Recently, a bill was introduced in the House of Representatives to delay the new rules for 18 months—after the next presidential election, which I don't think is a coincidence. Washington can be forgetful, but this seems like advantageous amnesia. Remember, the crisis was avoidable and another one will be avoidable if we get in gear and get this law implemented.
Part of the reason for the reticence among some could have something to do with money. It was just announced late last month that the financial industry spent more money lobbying in the first quarter of this year than it did in the first quarter of 2010—when the bill was being debated on the Hill. There are 10 financial service sector lobbyists for each Member of Congress. Those forces and that money are now also directed at regulators. It tells you why there’s a swarm of lobbyists and others in the lobby of our building every morning, replaced by a different swarm by noon and another in the afternoon. I’ve said often that we want to hear from people as we implement the new law, and I do, for sure. However, I don’t have much patience for those who come in and tell us how to exclude them or delay the rules.
As the FCIC said, the financial crisis would have been avoidable. That is especially true if regulators had tried to see around corners, to look for trouble coming in credit default swaps, for example. That is more important now than ever because our markets are morphing at warp speed. We are seeing David Bowie like cha cha changes. Let’s discuss three areas where we see some changes taking place.
New Markets—New Products
A major change we’re witnessing in financial markets is the advent of a number of new products and even new exchanges. The new financial reform law passed last year creates some opportunities and requirements for the markets. I’ll talk about just one today because it is one of the more important ones: swap execution facilities or SEFs. They will operate like the exchanges we currently have in place for futures trading, except that they will be a brand new animal for the execution of swaps.
At CFTC, we currently oversee $5 trillion in annualized on-exchange futures and options trading. The new law, though, is going to bring the light of day to the currently unregulated over-the-counter derivatives market, estimated at several hundred trillion dollars. Those swaps trades, if they are required to be cleared, will now need to be done on swap execution facilities. This brings a price transparency to these markets that they haven’t had before, and that’s a good thing. It’s one of the major emphases of the financial reform law. That being said, we recognize that swaps markets and futures markets are two different things, and we need to be very thoughtful in developing rules for SEFs. Wholesale adoption of futures exchange rules is not appropriate, nor is development of rules that would result in uneconomic advantages or disadvantages for swaps markets. And we are also working, in the crafting of SEF rules, to ensure that we do not mess up platforms that are currently working well. This is a delicate balancing act, and we need to hear from market participants that have the expertise and interest in this area to make sure we get it right.
The second area where changes are occurring at breakneck speed is trading technology. Technology has been called "the great equalizer" bringing remote areas together, bridging the gap between rural and urban, rich and poor. In financial markets, folks screaming at each other in trading pits have quickly become mostly 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. But in markets, technology maybe the great equalizer only as long as your computer is as fast as other computers.
Technology in markets is great. High frequency trading (HFT) does add liquidity. It adds access. Where do you think the third largest trader by volume on the Chicago Mercantile Exchange (CME) is based? Down the street here somewhere, right? Nope. 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.
It is amazing how quickly and vastly these markets morphed to where we are today as HFTs try to scoop up micro-dollars in milliseconds. In the U.S., well over 90 percent of the trading is done electronically. HFTs alone account for roughly 50 percent of the trades in Europe and roughly a third of the trades in the U.S.
I have a word for high frequency traders: cheetahs. In the animal kingdom, cheetahs can run seventy miles-per-hour. They’re the fastest mammal on land. 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. Again, we need to try to see around corners to avoid potential problems.
Tomorrow is the first anniversary of the Flash Crash—when the Dow tumbled almost a thousand points before recovering most of the loss. We 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. There are stocks and futures which are arbitraged internationally. If the Flash Crash had occurred in the morning, when European markets were open, as opposed to the mid-afternoon, the global market ramifications could have been much worse. Since it took place in the mid-afternoon, it was primarily limited to U.S. markets. We have greater coordination and controls in place both in futures and equity markets, but we still need greater harmonization between markets, both in the U.S. and abroad.
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. If trading becomes uncontrollable and roils markets and costs people money, there needs to be a punishment.
Just a few weeks ago, the folks at Nanex worried aloud that the exchanges aren’t paying enough attention to the algorithmic 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. Trading rules should include provisions for these programs to be certified to ensure they don’t have the potential to go feral or violate fraud, abuse or manipulation rules or regulations.
Moreover, additional 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 significant market anomalies so that we can learn from these experiences and avoid repeats.
The third big market morphing area that we need to be thinking about is the traders themselves. I call one relatively new group of traders “Massive Passives.” They are the likes of pension funds, index funds, hedge funds and mutual funds. These are instruments that attract investors who could care less what a pork belly is used for or what the heck Jed Clampett would do with Texas tea. These funds are very large—massive—and have a fairly price-insensitive trading strategy. In other words, if they think crude oil is going to keep rising, they stay on that bet.
Over a few short years, prior to 2008, roughly $200 billion in speculative money came into these markets—all commodity markets. That’s also when crude oil reached $147.27 a barrel.
So, should we be worried that maybe that’s what’s going on today? Is that at least part of the reason gas is almost $4.00? Here’s some food for thought: There are now more speculative positions in commodity markets than ever before. The number of futures equivalent contracts held by these types of speculators increased 64 percent in energy contracts between June of 2008 and January of 2011. In metals and agricultural contracts, those speculative positions increased roughly 20 percent or more.
When folks pull up to gas pumps, they usually have a choice: regular, premium or super premium gasoline. Regardless of the gas grade, however, everyone at the pump is actually paying premium—a Wall Street speculative premium. Don’t get me wrong—we need speculators in futures markets—they don’t work without them. But we’re seeing new types of speculators in our markets, and in numbers we haven’t seen before, and we have to question whether that’s altogether a good thing. I think there’s good evidence that excessive speculation is heating up the market and prices have gotten out of line as a result. Rather than help to fairly discover and “make the price,” these speculators “shake and bake the price”—up or down, depending on which side of the market they’re in.
For years, we’ve heard oil companies, banks and politicians sing the same old song: that speculation in markets didn't have any effect whatsoever on the prices consumers pay. These days, though, some folks are singing a different tune. For example, the head of a major oil company recently acknowledged that speculators were “gunning” prices. In March, Goldman Sachs issued a little-noticed report linking speculation to rising oil prices. And, President Obama correctly spoke about speculators’ impact on consumers and established a high-level working group headed by the Attorney General to help stop fraud, abuse and manipulation. It would seem that the "same old song" has a couple of new verses—and rightly so.
You don’t have to take it from me, or even the President, for that matter. 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, not long ago 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 for the University of Chicago 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, these exchange officials 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. 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. I’ll just share this one with you: “You’ve got speculation in a lot of commodities and that seems to be driving up the price.” That was R. Z. Aliber of the University of Chicago. But, there are lots of other examples.
So, if those studies are right or even if they might be hypothetically correct, what do we do to protect markets and consumers alike? The 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 avoid and guard against markets being adversely impacted by excessive speculation. We could do that now if we wanted. Unfortunately, we are still a way off.
Energy Policy: We Need a Map
When I was a teenager, I used to try, sometimes successfully, to impress my dates with how well I knew my way around Chicago. I never needed a map and, no, I never ran out of gas on the way home. One thing’s for sure today, though: 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. And, just last week, we learned that oil company profits were huge in the first quarter. 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 more 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 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.
Now for products that I know are near-and-dear to Mr. Sandor’s heart: environmental products. Last year the U.S. Senate had an opportunity to take up a very important cap-and-trade measure for carbon dioxide emissions, but it backed away from it. Nonetheless, I think there remains momentum for such action which would translate into a robust platform for carbon trading in this country. That momentum may come from a little national peer pressure. There is already a major cap-and-trade system for greenhouse gas emissions in place in Europe. Similar systems are being developed or are already up and running in places like Canada, New Zealand and yes, California. And, they’re being considered in Australia and Japan. So, yes, the political will isn’t there in Washington right now to do anything about cap-and-trade, but that momentum could shift, particularly after another election. For now, though, some in Congress are clamoring to include restrictions on greenhouse gas rules and other Environmental Protection Agency regulations as part of budget negotiations.
Raise the Ceiling
While we’re on the subject of Washington politics and the budget debate, let me make one last point regarding what’s going on. It is quite true that our country is having serious debt problems. Republicans and Democrats agree that the deficit has to be brought down and that spending needs to be cut. How that happens is where the agreement ends.
But, on the sidelines of that debate is a perhaps even more important discussion. Congress will debate soon whether or not to raise the county’s debt ceiling. Some are saying we shouldn’t do it. Most of those who say they’re against it are saying so for symbolic reasons, I think, or maybe to gain a little leverage. But, there are others who genuinely don’t want it raised—and they worry me. You don’t have to take it from me but there is an abundance of economists and market analysts who paint a pretty ugly picture of what would happen. Number one: interest rates would go up overnight. People with adjustable rate mortgages might have to walk away, sending us into another housing crisis. The country would be forced to pay its debt obligations before anything else, and there might not be anything else left (like, say, Social Security and Medicare) after that. Then we come to the area in which I’m most interested: financial markets. Can you imagine the panic that would occur? Markets don’t like uncertainty and investors with nest eggs riding in a tumultuous environment will be loathe to leave their money where it is. All-in-all, we’d be back in a recession at the drop of a hat to say nothing of the ramifications of the specter of default. So, do you get the idea that I’m for raising the debt ceiling? Yes, to do otherwise would be disastrous policy.
Conclusion: We Can Do Better
Well, I’ll wrap up. 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. Now, more than ever, we have to do better (sort of…like the White Sox). We can’t be like those regulators I spoke about earlier. We shouldn’t be like the CSI folks who go to the crime scene to do a post mortem of everything that happened. We need to be more proactive, particularly in this rapidly changing market environment, trying to prevent bad things before they happen. We need to look ahead and do our best to predict the market ramifications of new products, new exchanges, cheetah traders, massive passives and whatever other new trading elements come our way. We in government need to be vocal on the need for a national energy strategy and green markets.
The Wall Street Reform Bill goes a long way toward doing many of those things, but it took a market meltdown before government acted, and as we have discussed, there are still folks who oppose the reforms. Remember, the whole thing was avoidable.
At the same time, we need to be mindful of balance. There’s a new movie that came out a couple of weeks ago called “Atlas Shrugged,” based on Ayn Rand’s 1957 novel. Like the book, it explores 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.
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’s quite a counterargument to those who say 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 need to look ahead; try to see around corners; and keep a keen eye out for crises that—if we pay attention—might just be avoidable.
Last Updated: May 5, 2011