March 18, 2013
Introduction: The Gold Rush
Hi-ya! Thanks to Todd Kemp for the invitation to be with you in San Francisco, the great Dianne Feinstein's city. Nancy Pelosi's town. And a state that boasts many superb government servants like Senator Barbara Boxer and your earlier speaker Congressman Jim Costa.
It is hard to believe this is NGFA’s 117th convention. That’s way back. Your first was held in 1894. Wow!
I'm going to ask you to go with me now, to take a little trip, even further back—back to 1848.
It was a time of adventure and gambling on the future in a lawless land. That's when James Marshall discovered gold, about 140 miles from here. Not many people knew about the discovery. One fellow who had the ability to publicize the discovery, actually waited to do so. Samuel Brannan was the publisher of the San Francisco Star. Before touting the discovery, he set up a store to cater to gold prospectors. Then, he publicized the discovery. And he ran around San Francisco with a jar of gold in his clutches saying something like, "Gold, it's gold I tell ya!" And he made a fortune.
Brannan, and there's a street named after him, was the original business prospector who made it big on the Gold Rush. But there were many business prospectors who never picked up a pan or a pick themselves. Levi Strauss, whose company is still headquartered here, first profited in dry goods and then with those first-ever, blue jean baby queen, riveted, denim work pants. Henry Wells and William Fargo formed Wells Fargo with those iconic stage coaches transporting people and money. They focus on the money now, with $1.42 trillion—one of the largest banks out there. And there was John Studebaker who traveled from Pennsylvania to prospect in his own way. He made and sold wheel barrows and did extremely well. With his profits, he headed to Indiana where he started that famous Studebaker company. First they built wagons, then years later they built those wonderful cars—cars like the Silver Hawk, with those fins. My father owned one and let me drive it when I was 16. “Be safe, Bart. Two hands on the wheel at all times, 10 and 2, 10 and 2.”
The Chicago Prospectors: CBOT
In that same year, 1848, roughly 2,100 miles to the east, in Chicago, there was yet another group of business prospectors. These guys had nothing to do with the Gold Rush, but were trying to figure out a way to solve an immense problem in grain markets. You know the story: farm prices were whipsawed with wild boom and bust cycles. When farmers harvested, the cash markets usually tanked. Then, some months later, when the supply bottomed out, processors and consumers would pay profoundly for the commodities
This assemblage of 25 business prospectors, in addition to grain merchants and a banker, included a druggist, bookseller and a tanner. They met above a feed store on Water Street, and they started the Chicago Board of Trade (CBOT).
CBOT was a place to gather ‘round and haggle, and it worked. It helped even out prices and provided for some risk transfer. What this commodity cadre created was to markets what the Gold Rush was to California
With regard to markets, there remain commercial producers (farmers and processors, etc.), and speculators. The speculators, prospecting, mining and digging their way through these markets for their own riches, continue to gamble that they can make money from a futures contract by selling it later if prices change. While some things are still the same, commercials and speculators, a lot has transformed since 1848. We’ve come a long way, baby.
Morphing Market Prospectors
So here we are 164 years later, and like the gold prospectors who changed the way they ventured for gold, the markets prospectors—in particular the speculators—have also changed, or morphed. The question I ask as a regulator is this: Are markets still performing the purposes envisioned by those 25 imaginative market prospectors who met above that feed store on Water Street in Chicago?
Today, we have two new types of market prospectors, speculating in markets.
First, we have seen a “financialization” of commodity markets by a class of traders I call Massive Passives. Let me explain. Investors looking to diversify their holdings sought out the derivatives world. Between 2005 and 2008 we saw roughly $200 billion come into the regulated futures markets in the U.S.—there was even more that we don’t know about in the previously unregulated swaps world.
Say a pension fund wanted to diversify into commodities. There’s nothing wrong with that from my perspective (although I know some Members of Congress who disagree), but the type of trading that they do is different than what speculators have typically done. Instead of getting in and out of markets, maybe based upon a drought or other natural disaster, or in the energy markets getting in or out related to the driving season, these very large funds, pension funds and others like exchange traded funds (ETFs) bought and held their market positions. They invested in futures markets more like they invest in security markets. They are both massive in size, and fairly passive in their trading strategy. They are fairly price insensitive. They don’t get in or out of the market because prices change a little here or there. They are in it for the longer term.
I’m not suggesting the Massive Passives shouldn’t be allowed to do this, but it is different and it has impacted markets. It has helped push prices up at times, and when we have seen large price movements, we have then witnessed some reciprocal downturns. There are many studies that document this phenomenon.
Here’s the worrisome part: too much concentration in markets can influence prices and these Massive Passive traders, have contributed to price abnormalities.
Now, many people would say that any liquidity is good liquidity. But, are we sure? There are times when there is so much Massive Passive liquidity on the buy side—those going long and staying long—that prices cannot be based on the fundamentals of supply and demand. We’ve seen it.
Take 2008, when crude went from right around $99.62 at the beginning of the year to $145.29 in July, then all the way back to $31.41 in December. For those that claim the Massive Passives had no role in that market distortion, explain how it happened. I’ve asked hundreds of times and there have been no efforts to enlighten us.
Now, if some of you think, as I do, that the Massive Passive influx was problematic in 2008, what’s happened since then? We’ve seen well over the amount of speculation we had in 2008 at various times since then. With such large concentrations of market participants being these new speculative prospectors, it continues to raise the concern about how prices can be distorted and contorted. That’s not good for the traditional market participants like many of you. It’s not good for consumers and it isn’t good for our economy.
In response to what was going on in 2008, Congress instructed us (as part of the Dodd-Frank financial reform law in 2010) to put in place what are called speculative position limits. To date, they’re not in place. There’s fierce opposition from the largest speculative prospectors on earth. However, we are working to get them in place and we will do so. Word!
We need to have our hands firmly on the wheel to ensure markets are safe—10 and 2, 10 and 2.
In addition to the Massive Passives, we have some new prospectors speculating in markets with the most advanced computer technology. High frequency traders (HFTs), “cheetahs” I call them, due to their incredible speed, are out there 24/7/365 prospecting for micro dollars in milliseconds. That’s how speedily they trade.
If you divide a second into 1000 parts, they trade in those teeny tiny fractions of a second. If you’re going 100 miles an hour, a millisecond is the time it takes you to go two inches. I know that’s true because it’s on the Internet. You can’t put anything on the Internet that isn’t true. (I’m a French model, bonjour!)
There are some noble things about these high frequency trading cheetahs. They are, admittedly, very innovative prospectors in their own right. Some use complex algorithms that boggle the mind. The cheetahs also add some liquidity to markets. However, it is “fleeting liquidity” and at times “fantasy liquidity.” Let’s think on this a bit more, shall we?
Fleeting Liquidity: These cheetah traders want to get in and outta markets in a hurry. In fact, they don’t want to hold any risk for very long—for sure they don’t want to carry it overnight. So, when we think back to those original market prospectors in 1848, a speculator might hold a farmer’s risk for many months. Not today. If you want to off-load your wheat, bean or corn crop risk for 5 seconds, I have just the cats for you. This liquidity is, at best, fleeting liquidity, and that is different. Do the cheetahs help fulfill the vision of those original Chicago prospectors—those guys above the feed store? I’m not sayin’ what the cheetahs are doing in this regard is bad. I’m just sayin’.
Fantasy Liquidity: Then, there is the appearance of liquidity that is, in numerous instances, really an illusion—fantasy liquidity
The Commodity Exchange Act (CEA or Act) is our regulatory bible. Section 4c of the CEA says that it is: "unlawful for any person to offer to enter into, or confirm the execution of a transaction involving the purchase or sale of any commodity for future delivery … if the transaction … (i) is, of the character of, or is commonly known to the trade as, a ‘‘wash sale’’ or ‘‘accommodation trade."
And there are exchange rules out there that say, "No person shall place or accept buy and sell orders in the same product and expiration month … where the person knows or reasonably should know that the … transaction(s) [is a] wash sale(s). Buy and sell orders for different accounts with common beneficial ownership that are entered with the intent to negate market risk or price competition shall also be deemed to violate the prohibition on wash trades."
Another exchange rule says, “No Market Participant shall … c. make or report any wash trade...."
So, wash sales are clearly against the law, and against exchange rules. However, in voluminous instances these cheetahs are engaged in this activity. When they do so, it might appear to be liquidity, but it is not. It isn’t really there. It’s fantasy liquidity. The cheetahs are essentially singing that old Billy Idol tune:
“Oh dancing with myself
Well there’s nothing to lose
And there’s nothing to prove
I’ll be dancing with myself.”
Well, they have nothing to lose or prove because they aren’t taking on any risk whatsoever—zero, zippo, nada. They aren’t providing liquidity when they wash whatsoever.
Why would the cheetahs do that? Why would any exchange allow that? There are algorithms out there to stop cheetah trading programs from washing. They call this wash blocker technology. Why don’t all the cheetahs use it? We should require that they do so. Well, those are good questions which deserve more review. We need to ensure that we have the correct policies and procedures in place.
Oh, one final point: these HFT cheetahs aren’t even mentioned in Dodd-Frank. These traders were part and parcel to the Flash Crash on May 6th, 2010 when the markets dropped precipitously in 20 minutes time. However, Dodd-Frank was nearly finished and no new language was added. So I think Congress needs to act to give us some fairly basic regulatory tools to assist in our efforts to somewhat cage the cheetahs. During the Gold Rush, prior to California becoming a state, it was a lawless wild west. They set up Vigilante Committees that took the law into their hands. Well, I’m not suggesting that, but here are just some of the things that I’ve called on Congress to consider.
One: Cheetahs need to be registered. As crazy as it sounds, they don’t have to be registered now. Once they are registered, it provides us with authority to examine their books and records, among other things, which is a key to our oversight and enforcement duties.
Two: They should be required to test their programs before they are put into the live production environment. Some do that already, but it’s sort of on the honor system. Markets are too important to leave this matter to chance.
Three: These cheetah programs also need to have built-in kill switches that shut them down, should they become feral. After all, a runaway automated trading system is actually what instigated the Flash Crash. Yup, didn’t have both hands on the wheel and it caused a crash.
Four: Our penalty levels have become antiquated. In many cases, we are currently limited to $140,000 in civil monetary penalties per violation. That needs to go up—and not just for HFTs—but for all market participants, both individuals and entities, who break the rules.
With these changes, and potentially some others, we can have safer markets, 10 and 2.
When we look back at those prospectors in 1848, in California and in Chicago, they really set the stage for some unbelievable development on the coast and in markets, respectively. Both were monumental undertakings—spanning all those miles—and impact us still.
And while futures markets have worked exceedingly well since that time, we are seeing some of the new prospectors having an influence which can be problematic. Both the Massive Passives and the cheetahs raise a lot of concerns. The question, as with most things in government and life, is balance. How do we protect the good parts of what is going on while avoiding potential obstacles that can limit the important functions of these markets from the beginning? What we don’t want is another tragic story of gaming and adventure in a lawless land
What would those guys above that feed store on Water Street say? And here’s why asking that question is so important: those guys established the Chicago Board of Trade for purposes of price discovery. When markets work well, they are good for folks involved in the commercial business of the underlying commodity. It works for the prospecting speculators—be they Massive Passives or cheetahs or others, and it works for consumers. So we have a responsibility to ensure these markets are efficient and effective and that we have steady hands on the wheel—10 and 2, 10 and 2.
Last Updated: March 19, 2013