“How Big is Big?”

Speech of Commissioner Bart Chilton Presenting at “Oil and the Macroeconomy in a Changing World”, Symposium sponsored by the Federal Reserve Bank of Boston

June 9, 2010

Thank you for the opportunity to be with you today to talk about energy markets and changes in technology, energy market pricing, and markets in general. We will also spend some time on financial regulatory reform, which as you know has gained a great deal of momentum in recent weeks and from my perspective that's a really good, and long overdue, occurrence.


Remember the movie "Big”? Tom Hanks, after being humiliated when he wasn’t tall enough to get on a ride at an amusement park puts money in the mysterious “Zoltar Speaks” machine and wishes to be big. The next morning, the 13-year-old boy becomes a 31-year-old man, and he really is big. He's wearing the same kid pajamas, but he's nearly twice the size. The theme of the film is that even though he is big, he really isn’t prepared for the environment around him. So, how big is big?

Flash Crash

First, I’d like to focus on the events of May 6—the flash crash—a very big deal. It was a serious and significant event. These are markets that consumers rely upon to ensure fair and equitable pricing. They are of national importance. On that day, the Dow dropped nearly 1,000 points only to regain most of that loss. All of this took place one afternoon. To put it in perspective, how big it was, the biggest Dow point drop was 778 points on September 29, 2008. That was a 7% drop. The biggest percentage drop ever was Black Monday, October 19, 1987—508 points but a 23% drop.

While we do not yet know the impetus for the events of May 6th, we do know that the volatility was exacerbated by financial technology—fintech. A decade ago, most exchange trading took place in trading pits. That has changed dramatically. Now, more than 80 percent of trading on regulated U.S. futures exchanges takes place electronically. The new and innovative trading practices that are currently in use (and being developed) have simply moved beyond regulators’ ability to keep up with in a timely fashion. Algorithmic trading—where buy and sell orders are generated by computers making determinations by variable decision trees—are commonplace. Flash trading—which seeks to take momentary advantage of slight price changes by moving in and out of markets in large volumes and relying on computer speed gauged in nanoseconds—increases our global inter-connectedness not only in futures and equity markets, but markets all around the world. All of these factors are relatively new and regulators need to do more to ensure that fintech works for us, or it will (as we have seen) work against us.

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There is no doubt that the collapse and ultimate rebound was affected—in some form or fashion—by fintech. This is evidenced by the sheer size and speed of the trading that moved markets so dramatically in such a short time period. Fintech can be a great attribute to markets. It can make global trading accessible like never before, supply liquidity to markets and provide trading data trails for regulators and exchanges alike. However, without fully understanding all of the ramifications of this technology, we will continue to witness market aberrations. Perhaps there should be certain limits or parameters on fintech trading? Perhaps the size of trades should be regulated, or the time period in which they could occur should be limited or more closely monitored? These questions and many others need examination in detail, and urgently, by regulators, exchanges and policymakers.

One issue that I believe the regulators need to explore—and quickly—is mandatory circuit breaker rules. The SEC is moving forward on this from their perspective. Clearly, the fail-safe measures that were in place were not safe—and failed. Circuit breakers—that is, systems that trigger a trading halt and “stop logic” programs when certain market-related events occur—need to become mandatory and approved by regulators as appropriate for all markets and all contracts. These circuit breakers are currently voluntarily put in place by exchanges. Not only are such circuit breakers needed, they should have ensured consistency between securities and futures exchanges and be calibrated at appropriate levels, before serious and significant market anomalies take place. The fact that the circuit breakers were not triggered (although the CME’s stop logic programs were), and that trades on some equity exchanges were busted, indicates a clear flaw in the current fail-safe system.

I commend CFTC Chairman Gensler, SEC Chairman Shapiro and Secretary Geithner for their tireless efforts (and those of their staffs) related to the market events of May 6th. In particular, I applaud the chairmen in moving rapidly to convene a joint public meeting of the agencies’ new advisory committee, and I look forward to its report on this issue. I am also pleased that the CFTC has established an advisory committee, Chaired by Commissioner O’Malia, to look at technology issues. I know he will do an excellent job.

We need to continue to improve our regulatory regime in order to ensure that markets are efficient and effective and that they are devoid of fraud, abuse and manipulation. As we go forward, I am hopeful that we do all we can to ensure that fintech disasters are averted. The “flash crash” was a warning to us—and we need to remember the lessons from it, or, as Santayana said, we will be doomed to repeat it.

Calamity Comparison

It might be useful, in light of last month’s free fall, to look at where we are as a nation, particularly in light of the economic calamity of the last few years. Let's compare what we're seeing now to other times, including of course, the Great Depression. We all know this global economic failure is big, but again, how big is big?

Unemployment in May stood at 9.7%—15 million Americans out of work. Consumer bankruptcies totaled 136,000 in May, up 9% from a year ago. One out of every 200 families can expect their homes to be in foreclosure this year. Ten percent of borrowers were delinquent on their mortgage payments in the first quarter of this year. Those are some pretty substantial—and chilling—figures.

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If you put those numbers into the perspective of the Great Depression, however, things look absolutely robust. Back then, unemployment was 25%. Half the banks failed and the Dow Jones Industrial Average dropped 90% overall, and in 1931 alone it fell by 50%.

I don’t mean by that comparison, however, to indicate that things look rosy now. This recession has been big. However, as we know there are some very good signs the economy is turning around. In April, payrolls in the U.S. surged by as much as they had in 4 years. Existing home sales rose 7.6% in April. After the big bailout, banks are starting to show profits again. And let me say, the Administration, in the Fall of 2008 came to Congress at a time they thought we were on the brink of collapse and sought the bailout. But, Citigroup, for example, made $4.4 billion in the first quarter of 2010. Goldman Sachs, $3.46 billion (I know, I know, maybe that’s not a good example).

Whatever figures we look at, however, we can all acknowledge there’s still a long way to go. Consumer spending is still sluggish and unemployment is still way too high.

The Nice Mess

Some of us are old enough to remember the comedy duo Laurel and Hardy. That's Stan Laurel and Oliver Hardy. Ollie, the robust of the two, would often say: "Well, here's another nice mess you've gotten me into.” Well, how did we actually get into this nice mess, this economic calamity?

Banking and financial market trading laws were weakened a decade ago, and the results were disastrous. We witnessed exotic high-wire mortgages that led to a tsunami of foreclosures and bank failures, and freewheeling speculative trading arcades with virtually no oversight by federal regulators. By the time we realized what was happening, it was too late. We watched Wall Street behemoths topple—Bear Stearns, Lehman Brothers, AIG—and we chafed at taxpayer money being used to bail out firms everyone had always considered “too big to fail.” I’m pleased that the regulatory reform bill now in front of Congress includes a measure to ensure that never again will taxpayers be on the hook for such a massive bailout.

More recently, the Securities and Exchange Commission brought suit against Goldman Sachs alleging that it bilked investors by betting the housing market would fail, and not telling those investors how they were betting.

We’re in a pretty nice mess—the question is now, how do we get out of it?

New Speculators

In the futures arena, we saw over $200 billion come into these markets in a several year period leading to the run up in energy prices in 2008. This $200 billion was largely investments from what I call the "New Speculators.” Many of them have a distinctive trading strategy: that is, they pretty much go long and stay long. These are many times really big—that word again—traders. I call them the "Massive Passives" because they are so big and have a passive, price-indifferent, long-only trading strategy that is different than we have traditionally seen in futures markets. Of course we've always had speculators. We wouldn't have these markets or this industry without speculators. The Massive Passives, however, are different and I think helped contribute to the wild volatility in markets. Studies from Princeton, Rice, and Oxford Universities indicate that these New Speculators had an impact on price increases.

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OTC Markets

All the while, the regulated exchanges—the piece of the derivatives market that your government regulators actually could see—was a small percentage of the entire market. In the past few years, the regulated exchanges saw trading at roughly $5 trillion annually, while the over-the-counter (OTC) markets were in the hundreds of trillions—in fact, over $600 trillion dollars! That's big any way you slice it. At the same time, markets and the economy seemed to be running wildly hot. We all remember crude went as high as $147.27 in the summer of 2008 and gas topped $4 a gallon. The economy was more like that Jackson Browne song—it was "running on empty" and our regulatory oversight regime, as Jackson sings, was "running blind." In reality, the economy was headed for a cliff, and we all know what happened: it did a Thelma and Louise right over the edge.

As for the futures markets, regulators like my colleagues and myself, and exchange officials for that matter, like to say that there was no failure in the regulated futures exchanges during the economic chaos. Well, that's true, but that’s only part of the story. The unregulated derivatives markets—the OTC markets—were another matter entirely. That's where credit default swaps—bets upon bets that bundled mortgages would fail—had their home. Those didn't work out so well: AIG fell apart and wound up with a $182 billion bailout because of it. We know who ended up paying for that.

Financial Regulatory Reform

So back to the question, how do we get out of this big, nice mess? We deregulated to the point that these wild and exotic financial instruments were being used—bets upon leveraged bets that were so complicated and intertwined that nearly nobody knew what was going on. We also had trading taking place so far out of the view of regulators that Sandra Bullock would have a well deserved blind-side hissy fit.

If we have learned anything from this entire mess, it must be that the status quo is unacceptable. That is why I'm pleased that the Senate passed financial regulatory reform on May 21st, and the conference seems to be making progress. I think this legislation is absolutely necessary to ensure that we get back on the right track, and that we put in place essential safeguards to make sure we don’t end up in the same mess again.

I am sending a letter to the conferees today noting that there are many important things in the legislation, but highlighting a few of the absolutely critical items that need to be included in the final bill. First is the requirement to impose position limits across markets and inclusion of enhanced consumer protection measures. I also want to ensure that we have a provision granting the CFTC additional authority to go after disruptive trading practices that we haven’t been able to successfully prosecute for decades. Most important, though, is the derivatives piece of the legislation that would give regulators oversight over currently “dark” OTC markets, which we sorely need. It would require that these transactions be cleared and executed on regulated exchanges, and would provide federal regulators with the professional grade tools they need to step in if they see something going wrong. We will talk about these issues more in a moment, but suffice to say that the transparency provided by this legislation, and the protections against systemic risk, are critically important to our national economy and to the protection of the public. I hope that a strong, comprehensive bill will be in front of the President for his signature very soon.

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How Big is Big?

We’ve talked a lot about being big, but I suppose this speech could have also been called "Size Matters.” Let me explain.

Just like the New Speculators and in particular the Massive Passives, being big isn't in and of itself a bad thing. After all, we need—let me repeat—we need speculators. We want deep, liquid markets, and speculators help provide that. On the other hand, is there a point at which we say that's too big? Is ten percent or twenty percent of a market too much? How about thirty? How about three Massive Passives in the crude or Nat Gas market? Perhaps each of them controls 20 percent of the market, for a total of 60 percent. Everyone knows that when contract expiration nears, the Massive Passives will roll their contracts and continue to go long. The Massive Passives say as much in their prospectus.

Trading will occur around that roll. The U.S. Natural Gas Fund has had a multi-day roll since it started in 2007, and the roll period for the U.S. Oil fund was increased from one to four days in March 2009—the necessity for the longer roll period was based, in part, on the potential trading issues with such massive rolls. So, are these real issues? I mean, maybe having big positions is okay generically, but when you combine that with a known trading strategy, and or when it is combined with others who hold similarly large positions who have the same trading strategy, it seems to me there's at the very least, a reason for extreme caution.

Okay, let’s try this hypothetical. Say a trader in a market has 10 percent of that market. Is that big? Is it too big? Conceptually, it might not appear to be a problem. Perhaps I'd say 10% doesn't appear to be a problem. But what if that trader liquidates his position all at once? In addition, what does the market perceive is the basis for the trade? What information is the trader basing the trade on? Furthermore, who else is trading in concert with that trader, or copycatting that behavior? These are the kind of issues we need to think about in looking at whether positions are too big.

Position Limits

That leads me to my next point, whether we should be putting limits on big positions. As I noted, I think so, but not everyone agrees—which is an understatement. Last summer, the Commission held three days of public hearings on the issue of position limits in energy markets. We heard from a couple dozen witnesses from all sectors of the energy industry and from government. We received a wide variety of viewpoints, and all sides of the issue were fully, comprehensively—you might say exhaustively—debated. (In fact, at times it seemed there were more opinions in the room than there were people). For me, after reading, listening, and thinking a lot about this, the regulatory response seems very clear: We need some kind of reasonable limits in energy markets. In fact, I think we need them in all markets where there is a finite supply, like metals. We already have limits in the agriculture complex, and it has worked out fairly well over the years. Why not in the energy and metal arena?

It seems strange to me that this idea has received the incredible push-back that it has. I’ve been told that it will force markets overseas, that it will move trading into unregulated markets, that a poorly designed limit would harm price discovery and risk management. Wow. Perhaps energy position limits will start the Cold War again too, raise childhood obesity levels and create seismic disturbances in the San Andreas Fault.

Perhaps, but I doubt it. We’re not going to do anything that is over the top or ill-conceived—I’m talking about sensible, well-calibrated limits to give us a handle on these markets. This is a common-sense, reasonable solution to a real-life, real-world, real-time problem. It has worked in the past and it can work again. If the Commission doesn’t do it, I hope Congress will require us to do so as part of the regulatory reform legislation.

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Disruptive Trading Practices

One of the primary purposes of the CFTC is to protect markets and the public from manipulation practices. But for many years, (35, to be exact) the Commission labored under an impossibly difficult legal standard required to prove manipulation in court. In fact, we only were able to win one—that’s right, one—case. That’s not because we don’t have great lawyers or great cases, it’s because the case law made the standard so difficult. And there’s a reason for that: in the futures markets, we want people with market information to be bringing that into the pits, to be trading on it, to be using it for price discovery. So we don’t want a “low” manipulation standard to chill the price discovery process of the futures markets. That being said, we saw over the years so many “disruptive trading practices”—conduct that didn’t rise to the level of legal manipulation, but clearly had a negative and uneconomic impact on price, and we were basically handcuffed by the law as to how we could prosecute those cases. In the pending financial market regulatory reform legislation, thanks to the leadership of Senator Cantwell, there is inclusion of provisions to harmonize the CFTC manipulation law with the SEC’s statute, at the same time ensuring we don’t harm our critical price discovery functions, and also be able to prosecute these other harmful activities, like “banging the close” or “spoofing.” This is an excellent result, and I’m very pleased we finally have a resolution to this longstanding problem.


Well, we have covered a lot of ground today. I hope from my comments I’ve made it clear that the status quo isn’t acceptable. We need more than an amusement park arcade game like Zoltar to take us into the future. We need professional grade regulatory tools that allow us to protect consumers. We need thoughtful position limits. We need oversight of mammoth OTC trading. We need to revolutionize the way we, as regulators, look at these markets. We need statutory changes so that government regulators aren’t performing like a fire department—arriving only after the damage has already been done. Financial authorities need to be more like a police department—detecting, deterring, and preventing fraud, abuse and manipulation in these critically important markets. When the next Bernie Madoff scandal happens—and it will—we shouldn’t be coming in with fire hoses to water down the charred remains; we should be there on the front end with every sophisticated law enforcement tool at our disposal, and stop the damage before it happens.

We have some big challenges, but I know we can not only rise to the occasion, but make real changes to our laws to safeguard our financial system and protect consumers. Frankly, we’ve come to a point where as they say: failure is not an option. Financial market regulatory reform is a necessity, not a choice. We’re at a unique moment in our history where we have the opportunity to bring the pendulum back to center, to find our equilibrium, to get a handle on what is “too big.” We know now that “too big to fail” is a fallacy, so let’s throw out all those notions of size that have been proven wrong, and focus rather on what is right. That will inevitably lead us to the correct answers.

Thank you.

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Last Updated: January 18, 2011