June 18, 2013
Introduction—All Sorts of Trouble
Thanks very much to Bill (Kane)—Kane'o to me when we were kids—for the kind introduction and the opportunity to spend some time here discussing some key policy issues addressing hedge funds and the broader financial sector. It really is a pleasure to be with you in my favorite city.
How many of you are from here in Chicago? Go Hawks! (Gosh, last night was tough.) The rest of the hedge fund guys from the Caymans? I was stunned to learn that 10,900 hedge funds were registered there, according to the Cayman Islands Monetary Authority. Not much hockey in the Islands, I suppose.
When Kane'o and I were growing up, or we were supposed to be growing up, we lived over thataway maybe 30 miles as the crow or sea gulls fly across the Lake. We’d boot the ball around on the soccer field in the summer, or maybe play a little hockey in the winter. We’d get into all sorts of trouble. And, of all things...“trouble” is what I’d like to discuss with you today. Uh huh, trouble. We're gonna rock the trouble tonight.
A fella is pulled over by the police at 2 a.m. one morning. (By the way, this sounds like a joke, but it's a story with a message—important distinction.) So, the fella gets pulled over at 2 a.m. and the officer asks where he's headed at that hour. He says, "I'm going to a lecture on trouble." The skeptical officer retorts, "Oh yeah, well at this time of night, I'm curious about this lecture. Tell me about it." To which the fella says, "Well, it’s about the trouble with drinking and gambling, hanging out with loose women and staying up too late." "And just where and by whom is the lecture on trouble being given?" asks the officer. "That would be," the fella says, "at my house by my wife."
So, while this is a talk about trouble, I assure you it isn't a lecture about trouble. We each may have had, or yet still may receive, one of those lectures on trouble by a distinguished professor of, um, marriage.
A Fairly Untroubled History
The thing is, in commodity markets, there has not been, relatively speaking, a lot of trouble since their inception back in 19 or 18 blah, blah, blah.
Actually, as many of you know, it was in 1848, and it was right here in the Second City—Chicago. There were 25 guys who got together above a feed store on Water Street and started what would become the Chicago Board of Trade. There was a cool collection of people and professions represented. There were grain merchants, a banker, and even a bookseller. There was a druggist, a hardware dealer and a tanner. It is hard to think that there would be someone tanning all the time back in 1848, but I guess this fellow longed for the light. He probably went to the gym, too.
So, this group actually figured out a solution to the problem of supply and demand and price volatility. And what that commodity consortium created still impacts us today. Sure it helps folks involved in the markets—commercials and speculators. But most importantly, it evens out prices and helps to create (most of the time) fair prices for consumers.
Fast forward to today, 165 years later. We still have commercials and speculators. The main difference is that there are contracts on all sorts of things—energies, metals and financials—beyond what those guys above the feed store started in the agriculture markets. And without both of these types of traders, of course, the entire thing would fall apart—kaput.
This all has sorta worked out in a fairly trouble-free fashion. No single firm went under, for example, because of their regulated futures trading when we had all the trouble in 2008. Now unregulated swaps, that's another matter, and not so trouble free.
The Trouble—The Euphemism
Swaps and a lot of that over-the-counter trading was a major part of what led to that with which we may not speak—the 2008 economic meltdown. In fact, let's use a euphemism for what took place in 2008. Ya know how folks talk about someone's "unfortunate incident"—like perhaps when they were arrested, or their "inappropriate behavior"—when it is too embarrassing to actually say what they did when they had one too many. Well, rather than saying something too frontally, let's call what happened with markets and our economy in 2008, "The Trouble." It fits with our theme and it is dead on.
So, how did all this trouble—The Trouble of which you speak—transpire anyway? Well, you guys are shrewd. You pretty much know the dealio, so let's just KISS—I mean keep it simple sirs (KISS)—and just paraphrase what the Financial Crisis Inquiry Commission (FCIC) concluded in their final report. The FCIC is the commission established by Congress to find out why we—all of us taxpayers in the U.S.—had to fund hundreds of billions in a big bailout.
Here it is: One—There were lax laws, rules, regulations and regulators (guys like me) who were asleep at the switch; and, two—the captains of Wall Street who took advantage of that set of circumstances.
"Trouble with you is...The trouble with me"
"Trouble with you is…The trouble with me.” You see, Wall Street deployed all sorts of exotic (as Warren Buffet calls them) financial weapons of mass destruction. These unregulated bets upon bets that something or other would fail, bunched groups of mortgages or whatever, led us directly to death's dark door. And what we found when we opened it was... Dum, dum, dum, dum, dum: The Trouble. (Sounds like a summer movie—Coming June 28th, The Trouble, with Hairy Chestman, Darla Danger and Morgan Freeman; he's in everything, and great! Forget all that. I don't wanna lose you.)
The Trouble, as it were, was a huge honker of a deal. It still is. And so, in 2010 Congress and President Obama put in place a new law: Dodd-Frank. I'm sure you guys have your own euphemism for it, but let's keep this PG.
So, the question arises, like Doctor Phil asks, "How's that working out for ya?"
Well, we are gonna answer that, but to do so, we are going to do something completely different. And now for something completely different. (Kane'o and I watched too much Monty Python.) You guys game? Good, because it is a game, sorta.
Remember the board game Trouble? It's that Milton Bradley board game. If you don't recall the game, by the way, that's Mr. Milton Bradley to you.
The key cool thing about Trouble was what? Yepper, the "Pop-o-matic" that rolled the die. I like the game, but loved—I loved (maybe I still do)—that Pop-o-matic. It made that clicking sound and you felt the action when you depressed the Pop-o-matic. You could never cheat, fix your roll, or lose the die with that thing. The die stayed in that little cute Pop-o-matic dome, which by the way seemed indestructible. (Our Saint Bernard tried.) They should use a large Pop-o-matic for Craps at casinos. I'm full of ideas, or maybe just full of it.
Truth be told, I was a closet Pop-o-matic addict, like some of you, I'd bet. Just sitting there doing whatever, watching television or something, and pop that bad boy...incessantly.
Nevertheless, if one used the Pop-o-matic as intended by Milton Bradley, the die number would tell you where to go next. So, I never use visual aids, but today I'm making an exception. We have our own Trouble game tonight.
I'd like Kane'o to use the Pop-o-matic to tell us where to go. (I know some of you would like to tell me where to go, but let's use the Pop-o-matic for now.) Each number corresponds to a different topic which Kane'o has in front of him. Some even have surprises associated with them. How exciting!
Queue the music. Oh, no music? Pick something yourself. Bag that; use the Jeopardy tune in your head. Everyone is probably using it anyway. Kane'o, if you would, let’s get this party popping with that Pop-o-matic, please.
(Okay. By the way, if folks read this in print it won't make much sense because they won't know which topic we went to or in which order. Ya know what? They can play at home. Party on!)
Pop-o-matic 1—Massive Passives
Even though futures markets have worked well, that's not to suggest, that there hasn't been some trouble brewing. "Double, double, toil and trouble; fire burn and cauldron bubble."
Speculation based on expectations about supply and demand or about consumer sentiment or any type of sound speculation is good—it adds liquidity. We want to encourage active, thoughtful speculation.
The problem is, markets are increasingly dominated by a group of traders called Massive Passives. In 2008, the massive influx of long-side speculation levels coincided precisely with the highest-ever crude oil and gasoline prices in our country—the highest prices ever. Although hundreds of people have been queried in the last four years, no one has ever provided a supply and demand, fundamentals-only explanation to support the price movement. That’s because it does not exist. On the flip side, many researchers—including folks at the Federal Reserve Bank of St. Louis, and even Goldman Sachs have shown a link between excessive speculation and price.
As part of Dodd-Frank, Congress and President Obama charged the CFTC with setting speculative trading limits to avoid excessive speculation and preserve market integrity. The law explicitly and unambiguously mandates these limits. That said, there is a group of the largest speculators on the planet who have questioned the law and won—provisionally—a court ruling. However, our Agency is appealing and we’re also promulgating another position limits rule which in my view we can't get finished soon enough.
Pop-o-matic 2—HFT Cheetahs
Technology in life and in markets is good. But is that always so? We have seen a relatively new type of tech trader. High Frequency Traders (HFTs) or Cheetahs have sprung on the scene. They are out there all the time speculating to scoop up micro dollars in these millisecond markets.
Look, these cats have some true attributes and they shouldn’t become an endangered species. At the same time, they are impacting markets in ways we barely understand, and it ain't all good all the time.
If we don’t have some rules and transparency about their activities, we run a market risk that some cheetah-related event that harms markets, could put them on an endangered list, and rapidly.
We all know that technology isn’t always what it woulda, coulda or shoulda been. We see market technology SNAFUs with regularity. That’s why in order to safeguard market integrity, it makes common sense to have some basic precautions in place to avoid market-threatening actions from occurring.
In fact, legislation in this regard was recently introduced by Congressman Ed Markey. The PROTECT Act (H.R. 2292) would not only require cheetahs to be registered, but would require that they test their programs before they are used in the live production environment, and that they have kill switches in case their cheetah programs go feral. In addition, the legislation would increase penalties for violations of the Commodity Exchange Act (CEA). Today, the puny penalties we may assess are a mere cost of doing business for some bad actors. That needs to change and I commend Congressman Markey for his leadership on these important issues.
Pop-o-matic 3—A Story About The Trouble
Guy walks into a bar. What? It's a story! Remember I said there was a difference between a joke and a story. Okay, have it your way. Once upon a time in a faraway land...a guy walks into a bar (there ya go). Dude says, “Gimme a shot of Jack before the trouble starts.” The barkeep does so and the fella tosses it back and immediately says again, “Gimme another shot of Jack before the trouble starts.” He’s obliged, drinks the shot and once again recites the refrain, “Give me one more of those shots before the trouble starts.” This continues a few more times over the next hour until the barkeep finally asks the guy, “What’s all this trouble you keep talking about?” To which the fella says, “Well, the trouble starts when you realize I don’t have any money!”
But guess what, they all lived happily ever after...in a House on the Hill. They just never got anything done and became fairly partisan, but happy, in their way, they were.
Pop-o-matic 4— Cross Border
Cross Border. These are global markets. For any of us to think otherwise is just wrong. For me, the question is: How do we in the U.S. do what Congress and President Obama required us to do as part of Dodd-Frank while being sensitive to that fact—the fact that finance, markets and regulation are all globally linked. What we should want, and what the law requires, is appropriately regulated. That is particularly important with regard to anything that—as Section 722(d) of Dodd-Frank states—has a "...direct and significant connection with or effect on commerce of the United States...".
Look, we don't have the resources to regulate beyond our borders. We aren't on some power trip trying to grab international jurisdiction. That would be nutso.
In this regard, there are some issues of particular interest to the managed funds industry, and particularly hedge funds. You guys from the Caymans or Connecticut may want to listen up. I don't want to get in the way of the funds industry doing what it does best: finding opportunities for clients wherever in the world those opportunities might lie. With this and Congress's goals in mind, here are some of my thoughts on the cross-border guidance as they relate to you guys in particular.
First, the Commission should give a clear interpretation of "principal place of business." A firm should only have one "principal place of business." The broader the set of factors we use to assign a "principal place of business" the more difficult it becomes to pin down where exactly is a fund's "principal place of business." My mantra on most of these rules is to keep it simple. Let's focus on what really matters in clarifying this term. If there’s simply a post office box or little more, that won’t cut it as a principle place of business in my book. Where is your head office? Where are your executives and trading managers located? That’s what we need to consider.
Second, what makes a heckuva lot more sense is to try and rely upon the provision in Dodd-Frank that allows us to use substituted compliance beyond our borders if the regulation in another nation is comparable. We need to be clear that comparability means something; it isn’t an escape hatch for us not doing our job.
Third, we need to give the market a reasonable amount of time to adjust to global derivatives market regulation. The markets will need time to adapt to a new interpretation of the term "U.S. person." In many instances we’ll have a pretty good idea when the first set of foreign rules come online. In Europe, trade repository reporting is likely to begin in November. We should be cognizant of that as we assign CFTC phased-in compliance.
Pop-o-matic 5—Transaction Fees
Wha, Wha, Wha, Wha? That noise means we've landed on Transaction Fees.
It’s time to consider adoption of a targeted transaction fee (TTF) in the derivatives markets. Here's why: Derivatives markets in the U.S. are growing at a crazy rate. That's good, but the trouble is it's harder to monitor all of this with lightning fast HFT cheetah trading. Plus, we have the double trouble of our expanded jurisdiction—the CFTC’s jurisdiction—which now includes previously unregulated swaps—and a lot of them. There is simply too much to effectively oversee on our current budget, which by the way is funded by taxpayers. Congress continues to flat line or cut funding, right now at about $195 million when the President asked for $315 million, so it's time for a transaction fee if we are to appropriately oversee and enforce markets. And by the way, the CFTC is the only federal financial regulator NOT to have some kind of self-funding.
Republican and Democrat Presidents, including President Bush and President Obama, have suggested such fees as part of their budgets over the years. It is a bipartisan idea.
And, the math can work without anyone taking a large hit. Using a futures volume of 20 million trades per day, and an estimated 255 trading days per year, this would result in a per transaction fee of about .06 cents (six one-hundredths of a cent) on futures transactions. The fee level would be recalibrated even lower once we include swaps transactions. We need to do futures and swaps at the same time.
You might think it's Barney—Barney Rubble trouble—but I think the amount can be so very small that it won't be a significant worry. By the way, they are considering such a fee other places around the world. The levels I've read about are much higher than what I just described.
Pop-o-matic 6—Fun Facts
Way to go, we’ve landed on fun facts. Here are a few. Dodd-Frank has 848 pages, 16 titles, 500 sections and many other numbers. Go ahead and count them. I know you won’t.
Here are a few more fun facts: as of June 3rd, 153 (38.4%) of the 398 total required rulemakings have been finalized. A little slower than we hoped, right? We’re doing better at CFTC, having completed 41 out of 60 rulemakings.
Some of us get a little impatient but there has been some greatness amongst our lateness. That is to say that we’ve listened. We never thought for a moment that we’d craft the perfect rule every time. In fact, we’ve had to throw some proposals out and start over once the public started commenting. Oops. So, we can be justifiably criticized for being slow but it’s not just that our Pop-o-matic keeps throwing out low numbers; it’s because we’ve been deliberate.
Okay, that’s Rock’n the Trouble—strange as it was—with our little policy board game played out in the fairly unknown “regulatory arts.” It’s been great to be with you. Thanks again for the invitation, Kane'o. I think there are some lovely parting gifts for our contestants.
In all seriousness, these issues aren’t just important to market participants and regulators; they’re important to us all. After all, we’re all consumers. Most of us buy gas, milk, orange juice, an occasional steak, maybe a box of Wheaties. These markets were set up for consumers and raw commodity producers for purposes of price discovery and risk management. Even though that has changed, we need to never lose sight of those critical tenets. Otherwise, as Elvis sang, we might be in T-R-O-U-B-L-E.
Thanks guys. Good luck and—hey—stay out of trouble.
Last Updated: June 18, 2013