Pitfalls of Regulating Risk Taking
Keynote Address by Sharon Brown-Hruska
Acting Chairman, Commodity Futures Trading Commission
Energy Risk USA 2005
Houston, Texas, May 10, 2005
Thank you very much for the kind introduction. This is the second year that I have had the pleasure of participating in this conference. One of the things that I enjoy about addressing this group and having the opportunity to meet and chat with you, is that you put into practice what I have spent my life researching and teaching about: risk taking and risk management. It is as fundamental to business as water is to life, since without risk taking, there would be little entrepreneurship and innovation would likely move at the pace of the Stone Age. But with risk and its expeditious management, individuals and businesses can dare to specialize and innovate in order to maximize their opportunities, expand their wealth and that of investors, and expand the limits of the economy to achieve greater employment and higher welfare.
One area that has been of increasing concern to me are efforts by regulators to more vigorously regulate risk taking. Some discussion seems positive, like utilizing risk-based methods to determine exposure and set collateral requirements, but other efforts seem more prescriptive – like endowing certain valuation models to check on the leverage or the extent to which derivatives are used to manage risks. While I understand that regulation of risk taking is appropriate for banks, as a regulator, I am leery of efforts to regulate risk taking by firms. As a regulator of markets that specialize in risk shifting, I believe the model we have has proven particularly effective, without unnecessarily constraining the markets and the firms that use them.
Before I get started, let me begin by telling you a little about myself and the Commodity Futures Trading Commission, but also let me state that the opinions and views I express here today are my own and do not necessarily represent those of the Commission or its staff. As for myself, prior to joining the Commission, I was an assistant professor of finance at George Mason University, and before that, Tulane University. In 2002, President Bush asked me to serve as a Commissioner at the CFTC, and I was confirmed by the Senate and began work in August 2002. Upon the departure of Chairman James Newsome last summer, the President designated me as Acting Chairman, and I have served in that role since July of last year.
As a college professor and economist, and now as a regulator, my focus has always been the markets and the important role they play in our lives. Seemingly on their own, markets allocate resources by matching buyers with sellers at prices each side is willing to accept – this is what Adam Smith called the “invisible hand.” And what is truly remarkable is that for the most part they do so exceedingly well without a regulator or some other operator there to lord over every risk assumed, every price, and every allocation of a resource. In fact, as the Russian, the Chinese, the North Korean, and every other centrally planned economy has shown, efficient resource allocation breaks down when planners get involved.
Unfortunately when prices or price volatility increases, such as has occurred with energy prices, there are often calls for the government to “do something.” And by doing something that usually means interfering with the market process. We hear this today as some politicians and market commentators call for the government to do something about energy prices. Fortunately, cooler heads have prevailed thus far and we have avoided the disastrous economic experiment of price controls that we saw in the 1970’s. But even so, the mere fact that we hear these continual calls to “do something” tells me that we need to be vigilant to ensure that wrongheaded policies do not creep into legislation or regulation that impede market users and prevent markets from doing their job.
Alternatively, if we must to “do something,” the most effective thing we can do is to promote markets and innovations that allow them to operate more efficiently. As a proponent of competitive markets, I feel strongly that the role of government is to promote competition by ensuring the integrity of markets, but to stay neutral with respect to prices. The danger is that when government steps in to regulate prices or risk, the government, as opposed to legitimate market forces, ends up picking winners and losers.
As an example, I have been asked a number of times in the last year or so to comment on energy prices. Often the line of questioning goes something like this. “Chairman Hruska, many have observed that hedge funds and speculators have been building up long positions in oil futures and some economists estimate that these speculators are adding $5 to $10 to the price of a barrel of oil—a speculative premium, if you will. What is the CFTC’s doing to reign in these speculators and powerful interests like hedge funds who are driving up prices?”
Well, first, let me say that the CFTC actually does monitor these traders very closely. The Commission has a Market Surveillance staff of about 45 that monitors activity on the futures exchanges and the participants in those markets. Every week the other Commissioners and I receive a briefing on the markets. Part of the briefing typically includes a summary of activity by various participant categories, including hedge funds. In addition, when markets go through periods of high volatility or significant price movement, we focus additional attention on the markets involved.
With respect to the energy markets, the Enforcement Division, the Division of Market Oversight and the Office of the Chief Economist have each taken a close look at these markets. Shortly after I became Chair, economists at the Commission began a study of the role of managed funds, particularly hedge funds, in our markets. This study and its results have received a lot of attention for good reasons. First, it is an independent analysis done by scholarly economists who follow the highest standards of scientific research to ensure that the analyses would be objective and free from bias. It uses data that are uniquely available from the CFTC’s Large Trader Reporting System. The time frame covered by the data is the most recent available and not selected in a manner that would predetermine the results. This unique database allows an in depth study based on testable hypotheses of well founded theories going back to Keynes and Hicks that theorize on the role of hedger and speculator in the markets.
In the end, the results confirm what I have been observing continuously and routinely in the briefings by Market Surveillance every week. Managed money traders do not change positions as frequently as other traders in the markets – they do not create volatility by frequently getting in and out of positions. Managed funds are not driving prices, but rather the higher prices and their associated volatility are attracting those traders. Rather than increasing volatility, funds are found to be dampening market volatility by providing liquidity to the commercial hedging community. The study contradicts with force the anecdotal observations and conventional wisdom regarding hedge funds and speculators, in general.
When I first started looking at hedge funds as a professor in risk management, I saw that in addition to their lack of homogeneity and their thirst for exploiting inefficiency, they were really on the cutting edge in terms of their use of asset selection, leverage, and pricing techniques that are commonly employed by users of the derivatives markets. Hedge fund managers recognize the appeal of uncorrelated assets as tools for diversification, as well as the natural appeal of derivatives to build uncorrelated portfolios. In derivatives, going short is as legitimate as going long, and to the extent that hedge funds trade in commodity interests, they are closely akin to the funds I have seen in the futures business. In fact, recent data show that 65% of the largest hedge funds have managers that are registered with the CFTC as Commodity Pool Operators.
So do hedge fund managers require increased regulatory scrutiny? I have long agreed with Federal Reserve Board Chairman Alan Greenspan that imposing a regulatory regime that would constrain risk-taking and leverage by these funds could do significant harm in that it may deprive the markets of the efficiency enhancing liquidity that funds provide. Thus, I have repeatedly argued against additional regulation of hedge funds since I believe that the current regime in which our regulatory energies are focused on markets to ensure their efficiency and integrity has proven effective.
To date, Commission staff has not found any evidence that the prices of energy commodities or the volatility in the markets have been caused by anything other than the fundamental state of supply and demand in the markets. On the supply side, the factors that seem to be driving the market are uncertainty over oil supplies coming out of the OPEC countries and Russia, political turmoil in Venezuela and the inability to significantly increase domestic refining capacity. On the demand side of the equation, not only have the markets had to absorb increased demand from a reinvigorated U.S. economy, but demands from China and India to supply their growing economies, which have increasingly impacted the price of oil. Moreover, the demand for oil has stubbornly held up in the face of higher prices.
While what I have just described causes consternation among some, and believe me none of us like to see high prices and volatility, I believe that what we are observing are markets that are attempting to get relevant price signals out to market participants. In the long-run, the energy industry will adjust to these signals by providing more supplies, more capacity and alternative energy sources to the markets. On the demand side of the equation, consumers will use energy more wisely and efficiently, and will switch to alternative fuel sources. When that happens—and that won’t be tomorrow—prices will settle down.
In the case of power markets, the utilities have long been tightly controlled by government regulators. This tight control was the price that utilities paid for essentially being granted a monopoly to supply power to consumers. In this model, the prices consumers paid for electricity and the returns that a utility earned depended on the wisdom of regulators. Further, because of the rate setting methodology that pervaded the power markets, increases in fuel prices, whether it is crude oil or natural gas, are passed directly to the consumer. In essence, energy consumers have been forced to bear all the cost of higher prices since utilities nor their regulators had any incentive to unbundle the commodity price risks from power production.
Derivative markets like futures, options, forward, and swaps markets exist to allow companies to hedge commodity, financial, and other types of risks and provide an important way for them to focus on their primary line of business. For example, two weeks ago, the Washington Post updated us on the success Southwest Airline’s hedging program. This follows an article in the New York Times a few months back that noted that Southwest Airlines has 80 percent of its fuel needs hedged for 2005, and 30 percent for 2006, at prices below $30 a barrel. Similarly, Alaska Air has 40 percent of its fuel consumption hedged at $25 to $27 a barrel. I think the key message that these companies send is that, if you have significant fuel needs, a long term, prudent risk management strategy can help insulate firms from the ups and downs of input prices, and allow you to concentrate on your core business.
Yet, while I think the risks associated with power production should be managed, with less exposure for the individual consumer, I would also caution against utilities becoming speculators in those risk markets themselves. In my view, any solution would involve a prudent hedging program that would be implemented for the long haul. In this respect, we can learn a great deal from the financial and banking industry’s experience, and we can work to ensure that, whenever possible, the benefits of markets are captured for consumers.
An important lesson in the energy crisis that struck the California market was that competition was introduced, but only partially, and without recognition of the inherent frictions in the regulated market. For example, one aspect of the deregulatory model was that “to protect consumers,” by placing caps on retail prices while wholesale prices were allowed to float. In effect, the price restrictions that were put into place as part of California’s deregulatory experiment were such that true market signals could not reflect the fundamental state of the power markets. With retail prices capped, there was no incentive to build additional generation capacity and no incentive for consumers to conserve energy. It does not take an economist to see that the failure of this model was in the inconsistency of approaches to the retail and the wholesale sector. In my view, the California experience was not so much a failure of deregulation, but more a failure of regulation when it attempts to engineer markets without attention to market forces and incentives.
All this reminds me of an example of how government interference in markets can produce nonsensical results. Its also fitting since it involves oil, even though the commodity directly involved is wheat. The story is this. Back in the late 1970’s and 80’s there was a kingdom that had a simple desire to be self sufficient in wheat production. There was only one problem. The country was a desert and fresh water was scarce. But while the country had little water, they had a lot of oil, and oil was valuable. So they sold the oil at high prices and subsidized farmers to produce wheat at up to eight times the world price. With such prices guaranteed for their wheat, farmers could afford to put in expensive irrigations systems and pump precious water into their fields. In the end, they were successful. By 1984/1985, Saudi Arabia became a net exporter of wheat. Of course, this success has come at a high cost. Agricultural demand for water, which represents about 90 percent of total water demanded, has greatly reduced the availability and quality of water in the kingdom. In effect, Saudi Arabia, through its agricultural subsidy program, has undervalued its water and now runs the risk of running out. Without a sensible market price to guide consumption, as Ben Franklin said, “When the well’s dry, we know the worth of water.”
Even though this example points to irrationality of government planning, I believe strongly that there is an important role for the government in the regulation of markets. In the futures markets, our primary focus is on customer protection, as well as ensuring that market and financial integrity are maintained. That means ensuring that markets are free from fraud and manipulation. Manipulated prices, like those for water in Saudi Arabia, do not allocate resources efficiently. If those manipulated prices are in the futures markets, they reduce the efficiency of hedges, meaning that risk managers are less able to insulate themselves from volatile prices. Oftentimes the markets themselves will discipline the would-be manipulators, but at other times regulators must step in to ensure market integrity. And let me stress this point. When regulators “do something” about markets it should be to ensure integrity and not to affect prices. The markets will take care of prices as long as we take care of the markets.
Recently the Commission faced a situation where we felt it necessary to protect the markets from false price reporting and the attempted manipulation of natural gas prices. The Commission has aggressively pursued companies and individuals who manipulated or attempted to manipulate natural gas prices. Since 2002, we have investigated over 40 major energy companies and a number of individuals for alleged violations. Thus far, the Commission has filed over 20 actions and collected over $300 million in civil monetary penalties. In cooperation with the FERC and the Department of Justice, the Commission took action under provisions of the Commodity Exchange Act to penalize those entities and individuals who took part in the misreporting.
Finally, because of the fallout from the Enron debacle along with the false reporting claims, the market for OTC energy contracts had collapsed from a perceived lack of integrity. We at the Commission felt that to restore integrity, we needed to act to assure market participants that market abuses would not be tolerated and that these markets were safe for participants who have legitimate and vital business to transact. As for our progress, I am happy to report that 97% of the energy investigations we opened in 2002 have been resolved. In my mind, this era in which many acted with a lack of integrity and violated our laws is part of history – one that will not be repeated as a result of our enforcement actions.
In the wake of the misreporting scandal and the collapse of Enron, two things came to light, and let me deal with them in turn. First, with respect to price reporting, we found that internal controls at companies involved in energy trading and the procedures at price reporting firms were often weak or even nonexistent. For example, prices were often reported directly by the traders. Such a situation tends to create an inherent conflict of interest when a trader realizes he has an opportunity to influence the indices on which his position will settle. In other cases, price reporting firms asked traders for the “sense of the trades” they were seeing in the markets. While there is nothing inherently wrong with providing a sense of the market, such market views come with limitations and caveats and should not be passed off as true market transactions, as they were in some cases.
To deal with the price reporting problems, there have been those who have called for an invasive government presence in the price reporting business. Some have called for the creation of a centralized data hub to which all natural gas, and possibly electricity prices would be reported. Under some proposals, this would be a government-sanctioned entity with the power to force companies to report prices. In other scenarios, advocated by some in Congress, the hub would be controlled by a government regulator. As one can imagine, such an endeavor would be a huge undertaking as the regulator/data hub sought to ensure the integrity of prices in a widely diverse market. In addition, as I mentioned, I do not believe that the government should be in the business of picking winners and losers, and this is also true for market data. Our experience at the CFTC, particularly in agriculture and energy commodities, is that the incentives of government data collectors to produce accurate and high quality data are less aligned than those that do it for a living. I applaud industry initiatives such as that proposed by the Committee of Chief Risk Officers, that establishes guidelines for reporting prices and have created a voluntary reporting hub. I believe that such industry initiatives can be very effective in stemming the price reporting problems in a less costly fashion than by interposing a regulator into a job that the market can perform itself.
The second problem that became apparent with the collapse of Enron was the issue of credit risk. Following the Enron collapse, the CFTC and FERC held several public meetings to discuss the problem of credit risk in the OTC markets and the possibility of a clearing solution similar to that used in futures markets. As commercial participants in the energy industry consider clearing of OTC trades, I know many are skeptical that an exchange-based clearing model could work in the OTC energy markets. OTC markets are often not as liquid, contracts not as fungible, and quick settlements put strain on cash flows. Although a widely accepted clearing model has not yet emerged, there has been some progress towards clearing for OTC products and we continue to see innovation to provide solutions.
To date, we have seen clearing introduced for OTC swaps by the NYMEX and the Intercontinental Exchange, or ICE. Not surprisingly, however, the types of transactions that are eligible for clearing tend to be standardized contracts such as a Henry Hub natural gas swap. We also have begun to see some innovative solutions which rely on more sophisticated financial engineering to mitigate credit risk. This may involve the management of price risks through portfolio techniques or structured products that allow clearing houses to sell off the price risks much as Fannie Mae or Freddie Mac are able to sell off mortgage risks through the sale of securitized assets. Other approaches, like the North American Energy Credit and Clearing Corporation, seek to integrate the physical and financial energy markets to reduce collateral requirements and eliminate receivable risk from OTC and pooled energy markets. I am also committed to supporting futures exchanges as they seek to introduce credit risk management products that would trade in the open and competitive marketplace to complement the more structured OTC derivatives markets.
Now while credit risk management and clearing solutions do not directly prevent manipulation or market abuses, these solutions do help create liquid markets. Liquid and competitive markets enforce the market discipline that is the best defense against excessive risk taking, whether it is by companies, hedge funds, or other market participants.
Many have fretted that derivatives or significant users of derivatives like hedge funds create risks to the public if banks, insurers, pension plans, or other providers were to fail from derivatives trading misjudgments. Since these concerns were raised to me by Senator Harkin recently, I wanted to give you my response.
All markets, or for that matter any business activity, have the potential for becoming venues for manipulation, fraud and other types of abuses. At the same time, the CFTC and other market regulators (i.e., the FERC, Federal Reserve, SEC, OCC and Treasury), as well as the exchanges themselves, oversee these markets in order to minimize these abuses. While there have been instances of abuse, the record suggests they are relatively rare.
Derivative markets serve an important function in the economy in that they provide a means for businesses and individuals to transfer unwanted risks to those who are willing to accept them for a price. Knowledgeable use of derivatives to manage preexisting risks can help mitigate the potential of some types of business failures, and can help reduce the risks faced by the public who may rely on these businesses for their products or their livelihoods.
The question of potential failure of certain kinds of enterprises (e.g. pension plans, insurers, etc.) resulting from derivatives trading is a potential concern. However, derivatives should not be singled out from other financial instruments for special attention on this basis. This is because business losses are not confined to derivatives trading. Misjudgments in the use of any financial instrument can lead to large business losses. Derivative contracts are simply neutral risk management tools that can be used either wisely or unwisely. Efforts to curtail derivatives trading in order to inhibit their unwise use may have the unintended consequence of inhibiting their wise use as well.
Overall, the Commodity Futures Modernization Act, which erected our regulatory approach, has worked well for the derivatives industry as the Commission has stepped up to stress its surveillance and enforcement functions. In the almost 5 years that the Act has been in effect, we have seen a substantial increase in trading volume and a proliferation of new types of contracts, an expansion of clearing to OTC contracts, and new electronic markets. But even more significantly, we have not observed an increase in the number of trading abuses or violations of the Act. More than anything, the Act validates the concept that government can take a more oversight role in regulation, complemented by an unbending focus on deterrence in enforcement, and direct its attention on real problems in the markets rather than attempting to engineer or constrain markets or prices. By not interfering in the natural business activity of risk taking, we also can enable the markets to perform their vital functions of price discovery, risk management, and efficient resource allocation.
I appreciate the opportunity to address you today and I look forward to future opportunities to provide my thinking on the important role of derivative markets to our economy. Thank you.