October 14, 2010
It is a pleasure to join you today. It’s good to see so many familiar faces from my 18 years working with the energy industry. For those of you who don’t know me, prior to joining the Commission, I worked in the Senate for 16 years focusing on energy policy and the financing of energy projects. I also spent two years at Mirant Energy, a competitive wholesale electricity company, where I focused on corporate risk management and energy trading. I worked at Mirant during California’s energy crisis and Enron’s financial meltdown and those experiences opened my eyes to the troubles caused by flawed market design and inadequate oversight.
At the end of this week, I will complete my first year at the Commodity Futures Trading Commission. Looking back now, I thought the first six months were busy! I’ve given up on rolling up my sleeves and have just about torn them off. We’ve experienced momentous regulatory reform—the biggest, to be sure, since the New Deal. And, although it didn’t happen overnight, some days it feels like “Waking Up in Vegas.” I know I am not alone in feeling that we are all a little out of our element. The lights are on and our vision is slightly blurred. Even though Dodd-Frank, in many instances, requires that we react to what we cannot yet fully comprehend, as the Katy Perry song goes, it is time to put our money where our mouths are as we face the challenge before us: create the regulatory structure envisioned by Congress—in just one year.
As much as I want to jump into a couple of my priorities, I know that you invited me here to give you a bit of perspective on Dodd-Frank. For better or worse, this legislation will forever change the markets and the way we all take care of our day-to-day business in America and across the globe.
Dodd-Frank grants the CFTC with primary oversight over a majority of swaps. Given that our regulatory structure for the futures markets has proved largely successful in preventing the financial meltdowns that crippled so many other financial sectors, it makes sense that Dodd-Frank embraces the principles of the Commodity Exchange Act. The Dodd-Frank Act: (1) requires firms that pose a systemic risk to register and submit to additional regulatory requirements; (2) requires all swap transactions accepted by a derivative clearing organization to be cleared; and (3) mandates that all swap transactions are reported to swap data repositories for regulatory review. Within this framework, end-users are explicitly provided an exception to the clearing requirement, but the specifics of such an exception will be fleshed out in the rulemakings. The Commission also received enhanced enforcement authority including the ability to define and prohibit additional disruptive trading practices. I realize this process is daunting, and that the regulatory reform will be measured by the results of our year-long all-nighter. I believe the best results are gained from honest, principled reform that gives everyone a fair shake.
Honest reform focuses on solving problems and balancing inequities—we should draft regulations and make policy decisions supported by empirical data, and be careful not to overstep our bounds. Principled reform focuses on the core mission of this agency—protecting market participants from abuse and fostering open, competitive, and financially sound markets. Rulemakings must be transparent, logical, and predictable.
I have three goals during my time at the CFTC: (1) improve technology; (2) ensure appropriate and flexible market structures; and (3) promote competition, innovation, and growth in the markets. First, Dodd-Frank has given the CFTC a leading role in mitigating systemic risk in our financial markets. To achieve this central objective, it is critical that the CFTC has the tools it needs in order to effectively supervise the futures, options, and swaps markets. Chief among these tools is improved technology. It is unacceptable for the Commission to lag years behind the entities we regulate. For too long, our surveillance program has received neat packages of data, gift-wrapped and delivered to us by the exchanges at the end of each day. It is time for this agency to take that crucial step forward and choose how we will obtain, process, and analyze the data we need to comprehensively monitor and supervise all markets and entities under our jurisdiction.
Second, we can build a more transparent and open marketplace without sacrificing efficiency. Dodd-Frank recognizes that the swaps market is different from the current futures and options exchange traded models. The swaps market has evolved over the past decade to effectively serve the businesses it serves. Whether it is an end user or a swap dealer, I never hear, “Gee I wish I could find a better way to execute my trade, or find some way to meet my unique transaction specs.” To the contrary, market participants are seeking to protect the models they have worked hard to create and use on a daily basis.
I do think we should encourage the execution of swaps on exchanges and minimize the utilization of massive block trades. I believe exchange trading will lead to greater standardization and improved price transparency. As for the SEF (swap execution facility) definition, I believe there is room in the markets for many models, and I oppose a one-size-fits-all approach in establishing the SEF trading rules.
To be clear, regardless of what the new structures ultimately look like, hedging commercial risk will become more expensive as costs increase across the board—from trading and clearing, to compliance and reporting. I continue to assert that we must be measured and flexible in the piecemeal rulemaking process to avoid creating redundancies that result in costs without concomitant benefits.
Third, as we recover from the financial crisis, it is important to continue building upon our successes. New regulations should foster competition in the marketplace and promote innovation and growth. Maintaining financially strong and responsibly managed markets will facilitate capital formation in the United States and the world. Fair, open, and non-discriminatory access to the markets should be the norm, not the exception. Companies must continue to be able to hedge their commercial risk.
On top of all that we accomplish, we must take clear action to curb manipulation, disruptive trading practices, and other abuses in order to protect market participants and consumers from the negative effects of an unfair and disorderly market.
In achieving these goals, I am proud to lead the revival of the CFTC’s Technology Advisory Committee or “TAC.” A primary focus of the Technology Advisory Committee is to provide advice and counsel to the Commission regarding technology as it is applied throughout the industry, and how to handle the massive amount of pricing and trade information generated by markets.
The TAC’s July 14th inaugural meeting addressed the necessity of applying appropriate risk management tools and best practices to high frequency and algorithmic trading strategies. As futures and equity markets evolve, the speed and trading volumes increasingly challenge the ability of the exchanges (and the Commission) to ensure that markets accurately reflect the forces of supply and demand, and are not just pools of liquidity waiting to be swept up in the shock of an algo racing through the stack. Computer trading strategies are only as good as their human developers, and the Commission must be vigilant as it develops and enforces new principles and rules aimed at protecting the markets against disruptive trading practices.
At our second TAC meeting, which occurred just days ago, the events of May 6, 2010 and the staff report provided a lot of food for thought. I read through the report carefully, and one particular sentence stood out. It says, “As market participants had time to react and verify the integrity of their data systems, buy-side and sell-side interest returned and an orderly price discovery process began to function.” The first part of that sentence hit me: it all came down to time and data.
Technology was at the heart of the Flash Crash. It wasn’t that the technology failed; in fact, just the opposite appears to be true. The algorithms operated as programmed, and the high frequency traders operated as usual. However, on that day, the market was very nervous over the Greek debt crisis and other bad economic news, just as a large sell order came into the S&P500 E-Mini futures contract, triggering a mass exodus of buy-side liquidity. The liquidity crisis spread to the securities markets where it exposed serious structural flaws such as stub quotes and resultant broken trades.
There are going to be more meetings and discussions about the events of May 6th, and though we speak of these issues in terms of a one-day “flash crash,” this was no one-off event to close the books on now that the report is out. Working with the joint CFTC-SEC Advisory Committee, we will develop cross-market circuit breakers and other limits to slow markets down during their worst moments to prevent another chain reaction.
In light of the foregoing, it is important to note that the Dodd-Frank Act also enhances and extends the Commission’s enforcement authority. The Commission’s anti-fraud and anti-manipulation authority now covers swaps. The Commodity Exchange Act now prohibits certain disruptive trading practices, in addition to providing rulemaking authority for other nefarious practices not yet identified. It is my hope that Commission will look carefully at the empirical data to determine whether or not certain high frequency or algorithmic trading practices should be prohibited in future rulemakings.
Because violations of our Act generally require some level of intent, it can be difficult to bring enforcement actions for computer-generated violations or what I refer to as “CGVs.” I see this as a major regulatory loophole. Personally, I see the issue as one of strict liability: whoever put the algorithm in motion ought to be fully liable for the harm it causes to the market and fellow market participants. The tough part is defining harm.
It is one thing when algorithms run amok because of an input error, but how do we feel about practices such as order stacking or layering? Do we need speed limits? I have tasked the TAC members to consider what a set of best practices might look like. It is my hope that the Commission catches up on its technology needs and works closely with market participants and the exchanges to determine how best to regulate the use of technology in this manner.
Our time to act is now. Dodd-Frank has given us an unprecedented opportunity to make fundamental reforms. The essence of Dodd-Frank is the reduction of systemic risk, often cloaked in catchy, quotable terms like “too big to fail,” “too interconnected to fail,” and “dark markets.” In each rulemaking, I think it is important to ask and answer the following questions, “What is your worst day going to look like and how do we prevent that from happening?”
I certainly put my money where my mouth is today. I urge you all to do the same. We need all the input from market participants we can get. As Eminem would remind us, this is “the moment, you own it.” We’re having public roundtables, public meetings, and open comment files, and my door (and those of my fellow Commissioners) is wide open.
It is an incredibly exciting time to be at the CFTC. It is a great honor to contribute to the debate, and I approach every issue open to the possibility that there is yet another side to the story. I hope that by the end of our first year with Dodd-Frank, we will: (1) make futures and swaps markets accessible to both commercial hedgers and their speculative counterparties and continue the important role markets play in price discovery; (2) recognize the necessity of providing for the trading of customized products – despite the fact that such a position doesn’t neatly fit into a one-size-fits-all policy recommendation; and (3) improve OTC market transparency and continue working towards the goal of maximizing clearing to mitigate risk carried on corporate balance sheets.
It remains my greatest hope that we do not over-regulate by attempting to solve problems that do not exist.
I appreciate the opportunity to speak today. I am interested in receiving your input on these issues and welcome any questions you may have.
Last Updated: January 18, 2011