April 7, 2014
Thank you for the kind introduction and for the opportunity to serve as your opening keynote speaker.
Over the next couple days, the discussion here will revolve around the intersection between the rapid innovation in global financial markets and the slowly evolving energy sector. This is where financial markets and energy policy cross paths. And for somebody who has spent his career working in both areas, this is about as close to policy nirvana as I can get.
Using this perspective, I would like to discuss how Dodd-Frank rulemakings have impacted the energy sector and its use of financial markets. Market participants are now expected to change the way they conduct their business and hedge their risk.
The Commission is also wrestling with its expanded regulatory mission to oversee the modern electronic marketplace. In order to meet this challenge, we must change the way we do business. Just because the Commission has created a new regulatory regime, it doesn’t mean that we are equipped to utilize the vast amount of data or perform expected cross-market surveillance and develop systemic risk analytics.
In thinking about our challenges, I consulted a report published by the McKinsey Global Institute. The title of the report is “Disruptive technologies: Advances that will transform life, business and the global economy.”1 This report2 identifies twelve technologies that have a “broad scope of impact on the economy” or “economic impact that is disruptive.” As you can see, some of these technologies include the mobile internet and the internet of things (meters, sensors), and advanced robotics.3
I also noticed that three of the twelve technologies focus on energy, including advanced oil and gas exploration and recovery, renewable energy, and energy storage. This highlights the important role of energy in our everyday life, its impact on the economy, and the potential to increase production and lower costs.
This McKinsey report also contains a visual representation of the most used words in this report—what is called a “word cloud.”4
So, if you look at this word cloud, words like “technology,” “internet,” “potential,” “billion,” “economic,” “advanced,” “value,” and “application” immediately jump out at you. These words are not random. They show just how important technological innovation is to the energy sector. To illustrate: technological innovation has led to an 85 percent drop in cost per watt of a solar energy cell (a device that converts energy light into electricity) since 2000, and will lead to a 100-200 percent increase in domestic oil and gas production through fracking by 2025.
The result was what looks like a really big foot and the word “Commission”—that might say it all. Other words, such as “rule,” “swap,” and “regulatory” jump out as well.
After looking at both word clouds, I have realized that, going forward, my goal should be to merge these clouds. I would like to change the debate from a big foot Commission that has focused so much on regulations to a Commission that focuses on technology, data, and innovation.
This is why I want to focus on three topics today. First, I will discuss the importance of technological innovation as the Commission moves to implement and enforce our new rules. Second, I will discuss the need to ensure that end-users are not caught by our rules. Third, I will briefly address the “futurization” of swaps and how it impacts end-users’ hedging activity.
Jumpstarting Technological Innovation at the Commission
Turning to my first topic—utilization of technological innovation.
It has been a prevailing belief that we cannot embrace technological innovations because of budget restraints and insufficient human capital. The Commission is quick to point to these problems as a justification for the lack of investment in technology infrastructure and other improvements.
Yet time and again, the private sector has proven that technological innovations drive down costs, increase efficiency, and improve services. Technology has transformed both financial and energy markets. In the past two decades, futures markets evolved from pit-traded commodity markets to highly sophisticated electronic markets that are traded around the globe and nearly around the clock. In the energy sector, thanks to technological innovations, domestic natural gas and oil production has increased dramatically. And solar, wind, and battery technologies have contributed to increased renewable utilization and lower prices.
It’s time for the Commission to keep up with the markets and start developing technology-driven policies.
In order to keep pace with growth and technological innovation in our markets, the Commission must make automated surveillance the foundation of its oversight and compliance program. Only real-time market surveillance will allow the Commission to oversee these highly sophisticated and automated markets. For example, order messaging analytics could look for data that may indicate potential market disruptions like the Flash Crash, trader collusion, rogue trading, or manipulative algorithms.
On the subject of technology, one can hardly ignore the debate around Michael Lewis’ new book, “Flash Boys.” Right now, high-frequency traders (HFTs) are estimated to make up 52 percent of the global futures markets and 56 percent of U.S. equities markets.7 In Michael Lewis’ book, he claims that the stock market is “rigged” by HFTs that are front-running other traders’ orders.
This claim has sparked extensive debate about market structure and how regulators are going to ensure that the public has the utmost confidence in our markets. From the regulator’s perspective, in order to maintain confidence in our markets, the Commission must focus on two objectives.
First, we must make sure that we have the technological capabilities to perform the required surveillance in these highly automated markets. Unfortunately, our surveillance capabilities have not kept pace with micro-second trading in the futures markets.
Second, we need to ensure that Commission regulations keep up with advancements in technology, evolving market structure, and product innovation.
The Commission Must Have the Necessary Technology
With regard to technology, the Commission must develop order message surveillance. Long before Mr. Lewis highlighted the high frequency trading behavior around the rapid cancellation of orders, I advocated for the Commission to invest in technologies that will allow us to perform surveillance on order message data. Our futures exchanges receive millions of order messages on a minute-by-minute basis. But, just 8 percent of all order messages result in completed trades.
This means that our surveillance team is not looking at roughly 90 percent of the market activity. Having the ability to perform market surveillance at the order message level (and not the stale transaction level) will help us understand the behavior of automated trading systems and identify possible violations. Unfortunately, despite the $20 million increase provided by Congress, the Commission will not spend a dime to develop this order message capability this year.
In addition, we need to develop cross-product and cross-market surveillance and analytics in order to facilitate detection of improper market conduct and systemic risks. We currently do not have the systems in place to serve this mission.
Also, the Commission should improve its automated risk management surveillance of both clearing houses and swap dealers. One of the clear directives of Dodd-Frank was for regulators to increase their ability to monitor risk in banks, intermediaries, and clearing houses.
Further, our technological capabilities do not allow us to effectively utilize the swaps data that has been reported to swap data repositories (“SDRs”) for over a year. We must rely heavily on the SDRs to manage the data for the Commission because it is beyond the Commission’s current capacity to integrate the data into our own systems.
In this regard, I am pleased that the Commission is making progress towards fixing our data rules to ensure that swap data is reported to the Commission in a consistent and harmonized manner. I look forward to market participants’ comments and recommendations that will help us improve our swap data reporting regime.
The Commission is facing serious technological challenges and I am concerned that we are turning a blind eye to these problems. It is time to stop hiding behind budget constraints to circumvent investments in technology. Yes, I agree we need to devote more human resources to technology. But I also believe budget constraints should force prioritization and support technological innovation.
Commission Regulations Must Keep up with Technology and Evolving Market Structure
As to the second objective, ensuring that our rules keep up with market innovations, last September, the Commission published Concept Release on Risk Controls and System Safeguards for Automated Trading.8 This Concept Release asked over a hundred questions in an attempt to benefit from industry knowledge about high frequency trading (HFT). Now that the comment period is closed, I am looking forward to reviewing the public comments on these important issues.
As Chairman of the Commission’s Technology Advisory Committee (TAC), I have committed considerable TAC time and resources to better understand automated markets and their evolving structures. In fact, since 2010, 10 out of 13 TAC meetings focused on some element of automated trading. Topics included the application of internal controls to traders, Futures Commission Merchants (FCMs), and exchanges to prevent runaway markets, as well as defining high frequency trading. I will continue to use the TAC to identify a path forward that will be useful to the Commission as we continue to examine this important issue.
I am confident that both consistent, workable rules and our investment and deployment of technology will boost public confidence in our markets and revolutionize the way we perform our regulatory mission. Just as technological innovation has contributed to breakthroughs in the energy sector, so too can it jumpstart the Commission’s surveillance and risk analysis programs.
End-Users—What’s in Store for Energy Traders?
Now, I will turn to my second topic, end-users.
By and large the Commission completed its Dodd-Frank rules and we are beginning to see their impact on the market.
For those of you keeping track, the Commission rushed to implement 68 rules and has subsequently issued over 180 staff no-action letters offering some relief from our hastily drafted rules. But this relief came with a price: often the relief imposed new conditions and arbitrary deadlines. And in more than two dozen cases, these no-action letters provided indefinite relief, which I believe amounts to adopting new rules outside of the requirements of the Administrative Procedure Act.
Now end-users are struggling to comply with our rules and conditional relief from compliance—even though end-users are supposed to be exempt from these rules in the first place. And on top of that, they need to hope and pray that the relief is not going to be yanked in a subsequent conditional no-action relief. I am glad that the Commission has begun recognizing these serious shortcomings and has taken steps towards making the necessary policy corrections.
I would rather address these shortcomings head-on, and do it in a way that is consistent with the Administrative Procedure Act and required cost-benefit analysis. By using the proper process, end-users will receive lasting relief, instead of temporary staff no-action. After all, it was the Commission that voted on the rules. Now, it should be the Commission’s responsibility to fix the rules.
One of the first rules that the Commission must re-visit is the swap dealer definition rule.9 The current rule does not establish a clear regulatory regime to exclude end-users from the reach of our regulations, as mandated by Dodd-Frank. Instead, it requires entities to navigate through a complex set of factors on a trade-by-trade basis, rather than provide a bright-line test. While I appreciate that the Commission set an $8 billion de minimis level to exclude trades from a swap dealer designation, it remains challenging to determine which trades will fall within the safe harbor.
To make it even more complicated, the Commission has applied inconsistent and incoherent requirements around bona fide hedging as part of the swap dealer threshold calculation. For some reason, the hedging exclusion from the dealer definition applies only to physical, but not financial transactions. To complicate things further, in the proposed position limit rule, anticipatory hedging is scaled back. This will make it even more difficult for end-users to hedge their risk.
I am pleased that we are taking steps to address some of the shortcomings in this rule. The Commission has received a draft proposed rule to fix the special entity threshold.
In the meantime, Commission staff revisited the special entity definition through another no-action letter and raised the de minimis threshold for certain special entities to $8 billion.10 Prior to the relief, under the current rule, when dealing with special entities, such as state, city and county municipal utilities, the $8 billion threshold drops to $25 million (this threshold was subsequently raised to $800 million through yet another no action). By reducing the threshold, the Commission limited the number of swap counterparties to the Wall Street dealer banks.
At last week’s staff roundtable, Owensboro Municipal Authority shared pretty gloomy numbers with us. As a result of the swap dealer/ special entity rule, they lost 30 percent of their trading counterparties that represent 70 percent of their hedging volumes. They saw their bid/ask spread widen and margin requirement increase significantly as they are now being held hostage to dealer banks. This is a serious situation for a municipality that serves 26,000 customers.
Commercial end-users also discussed Rule 1.35, which mandates the collection and storage of all electronic communications as part of a trade record. I was told that it will cost $50,000 to install a recording system to comply with our rule. Large financial institutions will have the means to absorb such costs. But commercial market participants will not be able afford this system.
This outcome could have been avoided if the Commission had first performed a cost-benefit analysis to determine the compliance costs for small market participants.
At the roundtable, end-users also raised concerns regarding the definition of a volumetric option. According to the definition, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties. This is in complete contradiction as to how volumetric options have been traditionally used by market participants. I hope the Commission will address this sooner rather than later.
It is time for the Commission to start over and carefully consider all the implications of our rules through a new, well-reasoned rulemaking that takes into account business and operational realities.
Futurization of Swaps: What Impact Will the Proposed Commission “Fixes” Have on Futures Markets?
Now turning to my third topic—futurization of swaps.
As you well know, Commission swap rules have introduced unnecessary complexity and generated additional costs in running a business. As a result, market participants (and for good reason), have been quick to convert swaps to futures and move their business to the futures markets. Futures exchanges offer clear rules and the efficiency of a one-day margining regime.
The problem for end-users, however, is that although it may be easier and cheaper to hedge exposure through futures, the standardized nature of the futures market makes it hard to customize hedging and fully cover risk. In other words, there is a good chance that end-users leave risk unhedged.
I asked our Division of Market Oversight to provide information about the volume in energy trading post-futurization (in both futures and converted swaps).11
As you will see from the charts, market participants have converted swaps to futures in the futures energy market. These charts illustrate how the futures energy market has evolved as a result of futurization of swaps. Exchanges have facilitated this transition from swaps to futures by establishing very low threshold sizes for block trades.
I am bringing these visualizations to your attention, because it is important for market participants to engage in the discussion and help the Commission understand the ramifications of a change in Commission policy on block trades in futures.
If the Commission proposes a regulation of block trades in futures, what will happen to the 80 percent of block trading in the low- and medium-volume energy contracts? Will these contracts continue trading as futures, but move to the centralized market? Will these contracts move back to swaps trading? Do these charts accurately illustrate trading in the futures energy market? Is this the right way for the Commission to interpret the data? What other issues should the Commission think about? I would like to hear your thoughts so that the Commission has all the information before putting out a futures block proposal for comment. Thus I am interested in your reaction to the following charts.
These charts provide the percentage of total monthly volume by transaction type (such as block trades, central market trades, and several types of Exchange of Futures for Related positions (EFRPs)) in the futures energy market. The charts are broken down by futures and “converted swaps.” For these purposes, converted swaps are: over-the-counter (OTC) swaps that were converted to futures as of October 2012, contracts that included the word “swap” in the contract name, and any contract that had a majority of trades executed by Exchange of Futures for Swaps (EFS) prior to October 2012.
Slide 6 illustrates low-volume energy contracts, which are the contracts with an average daily volume of less than 200 contracts.12 As you can see, once futurization occurred in October 2012, converted swaps started trading as block trades in the futures market. Block trades account for approximately 80 percent of the total monthly volume in these low-volume energy contracts. Similarly, in the chart labeled “Futures,” over 80 percent of the total monthly volume is trading as block trades in these low-volume contracts.
Slide 7 depicts a similar picture for converted swaps in the medium-volume energy contracts, which are the contracts with an average daily volume between 200 contracts and less than 100,000 contracts.13 Since futurization occurred, block trades account for over 80 percent of the total monthly volume in these medium-volume energy contracts. However, in these more liquid contracts, the futures chart shows that futures have consistently traded on the centralized market both before and after futurization.
Slide 8 shows, as expected, that in the high-volume energy contracts, which are the contracts with an average daily volume of 100,000 contracts or greater, centralized market trading is the dominant type of trading.14
The Commission is about to have a very serious debate regarding the way commercial participants are able to trade and hedge in the markets to manage their risk. It is crucially important that we receive your input before the Commission makes its recommendations. Given that the futurization of swaps continues to expand, with new products being developed and growing open interest in FX, interest rates, and credit products, the Commission must hold a hearing on these matters before it makes recommendations. A Concept Release may be useful to initiate an open, transparent dialogue and share data. My goal is for the Commission to make its determination based on data, anticipated costs to market participants, and consideration of the various alternatives.
In 2014, my goal is to take the two word clouds and merge them. I would like to change the debate from a big foot Commission that does business as usual to one that focuses on technology, data, and innovation to better oversee our markets.
It almost goes without saying that derivatives markets are becoming increasingly complex in the new post-Dodd-Frank era, as more and more transactions move to exchanges and clearing houses, and market participants are trying to respond to new regulatory demands. In this changing environment, the Commission’s oversight mission must adopt a broader and more effective technology footprint. Technological innovation is no longer a choice: it is an imperative.
Further, we cannot forget that the Commission must provide regulatory certainty to the market in order to accomplish Dodd-Frank objectives. The Commission must re-visit unworkable rules and must ensure that in implementing its Congressional mandate to regulate the derivatives markets, it does not harm the true drivers of the U.S. economy: manufacturers, energy companies, and other businesses that provide important services to the American people.
Thank you very much.
Note: Presentation is available under Related Links.
2 See slide 2 of the Presentation
3 See slide 3 of the Presentation
4 See slide 4 of the Presentation
6 See slide 5 of the Presentation
7 Financial Stability Oversight Council 2012 Annual Report, pg. 88 (citing study by Aite Group)
8 78 Fed. Reg. 56542 (Sept. 9, 2013)
9 Further Definition of “Swap Dealer,” Security-Based Swap Dealer,” Major Swap Participant,” “Major Security-Based Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30595 (May 23, 2012)
10 Staff No-Action Relief: Revised Relief from the De Minimis Threshold for Certain
Swaps with Utility Special Entities, CFTC Letter No. 14-34 (March 21, 2014)
11 See slides 6-8 of the Presentation
12 See slide 6 of the Presentation
13 See slide 7 of the Presentation
14 See slide 8 of the Presentation
Last Updated: April 7, 2014