Speech of Commissioner Bart Chilton at the University of Notre Dame
November 1, 2010
Introduction—Dark Markets—Fighting Futures
Good afternoon and thanks for coming out today. Thanks especially to Professor Paul Schultz for the kind invitation to talk a little bit about what’s going on in the world of financial regulation. You might have thought, “Hmm, financial regulation’s a pretty boring topic, but, hey, it gets me out of class.” Don’t feel guilty if you thought that, but I hope to convince you today that financial regulation these days isn’t boring at all. In fact, not since the Great Depression has there been a more momentous time for our financial markets and the efforts to make them more efficient, effective and devoid of fraud, abuse and manipulation.
Let me give you a small taste of what the new Wall Street Reform and Consumer Protect law that was passed by Congress and signed into law by President Obama in July seeks to do. The regulated futures markets in the United States account for roughly $5 trillion in annual trading. Those are the markets regulated by the CFTC: the InterContinental Exchange, the Chicago Mercantile Exchange and Board of Trade, the New York Mercantile Exchange and others around the nation. So, it’s a total of roughly $5 trillion.
The over-the-counter (OTC) markets, what some call “dark markets” or “dark pools” because there is no government oversight of these markets is a lot larger. The OTC markets are where things such as credit default swaps (CDSs) are traded. CDSs can be bets upon bets upon bets that bundled baskets of mortgages will fail. CDSs can be comprised in many ways, and they are. CDSs are what, in large part, led to the failure of American International Group (AIG) and the subsequent U.S. taxpayer bailout. These exotic bets and the deregulated financial environment in which we have lived since 1999 essentially paved the way our economy’s highway to hell. We are just now beginning get back on the road, but we are still a bit blurry eyed.
How big is the OTC market? Again, $5 trillion for the regulated exchanges, and…here it comes, over $600 trillion in dark OTC markets! The new law requires that the OTC markets finally be regulated. Will that avoid another economic mess in the future? Perhaps it will, however, some of the other key changes we will discuss will go a long way to making markets safer. To say that regulators have their work cut out for them is an immense understatement. It will be a colossal job, but we will do it.
But, it is really good to be here in South Bend, not far from where I grew up and in the land of the Fighting Irish—especially during football season. Purdue is actually my alma mater, and even though you handed us our hat earlier this season, I’m still a proud Boilermaker. However, the teams that have “fighting” before their name always seem intriguing. Missouri’s team is sometimes called the Fighting Tigers. In Illinois, there’s the Fighting Illini. Stephen Colbert does his hilarious segment entitled “Get to Know a District.” No matter what state or what congressional district you are “getting to know,” they are the “fighting” first, or the “fighting” second or third—whatever number it is. They are always “fighting.” The Fighting Irish is a worthy moniker, but the “Fighting Boilermakers” somehow doesn’t quite sound correct.
You know, in the commodities trading world today, there is some fighting going on too. Folks may think that sounds strange and people in and out of futures markets will disagree. Let me explain.
From the Beginning—Putting up your Dukes
When the commodities laws were first written decades ago in the 1930’s, they didn’t, one: contemplate this kind of tectonic plate shift—mammoth changes in asset class participants and strategies—in the use of the futures markets. Two: they didn’t contemplate “computers talking to computers,” and sweeping up thousands of micro dollar profits in nanosecond trades. And, three: they didn’t contemplate the incredibly innovative and creative ways that these markets would develop and flourish, and the accompanying challenges that we face to ensure that the fundamental purposes of the markets—risk management and price discovery—remain paramount.
You shouldn’t have to put up your dukes up in these markets and fight for fair access or the ability to legitimately hedge your business risks. Markets, to some extent, have become a place where sometimes bullies are accepted, and even sought after in some quarters in the deregulated environment in which we have lived.
We want to ensure that those who truly contribute to market effectiveness and efficiency are not precluded from doing so, and at the same time, we want to ensure we protect the markets from the ill effects of conduct that negatively affects the ability to discover prices or manage risk.
These markets have been working quite well for roughly 150 years. They have been, and remain, an important component of the economic engine of our democracy. When they initially began, futures markets helped farmers and ranchers get a fair price for their goods throughout the year. Instead of receiving a cheap price when there was ample supply or surplus (at harvest or when animals reached weight), or a high price when stocks were low, futures markets evened out the price—to a great extent—all year long. This meant a steadier income for farmers and ranchers—those involved in the business of farming and those who processed or otherwise used the products as components in whatever it was they made—be it bread, pasta, meatloaf, whatever. These folks were, and are still today, referred to as “commercials.” They have an underlying interest in the physical commodity.
Now, to take the other side of futures positions, there needs to be speculators. Speculators have been and will always be a part of the futures markets. By the way, we also need successful speculators. If they can’t make money, they won’t be there in the markets very long. Without speculators, there is no market, full stop.
New Speculators—Massive Passives—Large Traders
Within the last several years, however, markets have changed because, for one, speculators have changed. More and more, the new speculators have used futures markets as an asset class. That is, they invest money in these markets just as if they would into the securities markets. Investing in corn or crude futures is the same as buying IBM stock for many of these new speculators. The result: there are more speculators than ever before and they have brought more money into the futures markets than at any time in history.
Many of the new speculators also have a distinguishable trading pattern, at least during many times. For example, the new speculators may believe that, say, crude oil will be worth more in three years than it is today. Therefore, they invest in crude oil futures. When the futures contract comes to expiration in several months, these traders merely “roll” (that is, sell the expiring contract and purchase a new longer-term contract) their futures contracts to the next months. In fact, there are large firms whose business it is to invest money for folks in things like this. They have a known speculative trading strategy and many times, they are gigantic. I call them “Massive Passives” because of their size and their trading strategy, which for the most part is, not all the time but for the most part, price insensitive. Remember, their gamble is that whatever it is (crude oil or whatever) is going to be worth more in several years than it is today. While they might prefer the price to go up next week or next month, they are more concerned with where it will be in a few years.
The Massive Passives’ size and trading strategy are fairly new to these markets, and many (myself included) think they can have an aberrant impact on markets. Other market participants trade around the Massive Passives, for example. These market participants know what the Massive Passives are going to do, so they make their own decisions based upon the Massive Passive trading strategy, which again is to simply “go long,” most of the time.
I’m not suggesting the Massive Passives are evil, and again without speculators, there would be no market. While Massive Passives may not drive prices, it isn’t out of the question that they could, or could in unison with other Massive Passives given certain market circumstances. However, they have an impact, and that impact can push markets to places they normally would not go. Consumers can pay more than they should because of the Massive Passives. That’s simply not right.
For example, take crude oil in 2008. Crude went to the highest levels ever, $147.27 a barrel that June. Gasoline prices topped $4.00 a gallon in most states. Some people had to make a decision between food for their families and fuel for their cars or trucks. At that time, crude oil experienced some of the highest supplies and lowest demand in history, yet prices skyrocketed. Princeton and Rice universities and others conducted studies, which suggested these speculators had some impact on pushing prices. At certain times, the Massive Passives have become fortuitous bullies in these markets because they are so very large and have such a known trading strategy. What that means is that the primary goal of futures markets, which is not only to allow for hedging of business risks but to find the true price—price discovery—is harder to get to than it has been for over a hundred years.
However, the point is, and I do have one, is that there is a lot of fighting going on in these futures markets. The Massive Passives are part of that, but so are other large entities, traders, that are so very large that they can move markets simply by having such hefty concentrations. These traders do not necessarily have a consistent trading strategy. They go long. They go short. They, for lack of a better phrase, go both ways, sometimes many times in the same trading session. I’m not suggesting that large entities controlling 15, 20, 30 or ever 40 percent of markets at times are holding these substantial positions to manipulate markets, or do anything which currently violates the law. However, their “foot print” can be so humongous in some contract markets that prices can’t help but be moved—sometimes up and sometimes down. Occasionally that movement may be just a little, and every now and then there is a real concern that an artificial price is being created. Like the Massive Passives, these very large market participants, perhaps unwittingly, can sometimes bully markets and therefore make it more difficult for the true commercial traders (those, again, with an interest in the underlying physical commodity) to hedge their business risks. It can also make true price discovery tougher to obtain.
So, what’s to be done?
Position Limits—Financial Futures Limits
In football, there are limits. Limits on the number of players you can have on the field. Limits on the number of time-outs each team gets. There are limits on the length of time between plays. Limits are everywhere, but not so much in the world of commodity trading—not yet, with exceptions for the spot month. The new Wall Street Reform and Consumer Protection Act which I mentioned at the outset will, among other things, mandate that there are limits to the amount of certain futures contracts an individual entity may control. The law only requires that these limits be set for energy and metals contracts, and then for agricultural contracts. However, it was a financial futures contract that tipped the scales sending markets into a domino decline during the Flash Crash of May 6th.
The CFTC currently has existing authority to implement position limits on financial futures. I think we need some sort of boundary on financial futures as well as futures on commodities of finite supply like energy, metals and agriculture. How, and what those confines are, I don’t know at this time, but it seems only prudent to institute some type of restrictions to ensure we don’t again see another Flash Crash or even a mini-Flash Crash.
The Massive Passives and other large traders increased their flow of money into the futures markets by over $200 billion in the several-year period leading to the run up in energy prices in 2008 and the economic depression. They are getting right back into the markets now. Many say that money is staying on the sidelines and it isn’t being invested. That maybe true in some areas. Perhaps individual and small business loan-making isn’t what many would like, but money is flowing into the futures arena. At this pace, it could top the $200 billion in the near future, and it appears it has topped the investment in some individual commodity contracts already. That is to say, speculative money in some futures contracts now exceeds what it was in 2008, when we saw market bubbles and the economy collapsed. This highlights the need to implement the position limits on time as Congress intends us to do.
Deep, liquid markets are very good and being big certainly isn't in and of itself a bad thing. Speculators help provide that deep liquidity. On the other hand, there is a point at which gargantuan positions are simply too large for a healthy market. It’s our job to set the limit level. Is ten percent or twenty percent of a market a lot? Is thirty percent too much? How about three Massive Passives in the crude oil or the corn market, maybe each of them controls 20 percent of the market for a total of 60 percent. Is that too much? Alternatively, what about the case of a trader with 10 percent of a market who liquidates his or her positions all at once—is that acceptable? These are the types of questions that need to be asked.
While I favor limits for all futures contracts, there are dangers in the details of setting them. For example, too small a limit could push trading overseas. It could harm price discovery and risk management. Moreover, of course, setting a limit too high won’t do anything in the meaningful way Congress intended for us to set the limits.
We have 180 days from the day the bill was signed to write the rules, hear public comment and set the limits on energy and metals commodities. I’d like to try and figure out a way to do the same for the financial futures products too by that time (mid-January) or in mid-April when we are to set limits for agricultural commodities. We should certainly be asking questions about how to set appropriate restrictions or if there is a need to do so when we seek public comments. While I can’t pre-judge anything the agency may do, my colleagues are smart folks and what we do should meet the test of intent that the new law requires. I’m talking about sensible, well-calibrated limits to give us a handle on these markets.
Mr. Roboto and the Mind of the Main Frame
In this age of high-speed, high-frequency, algorithmic trading, mini-Flash Crashes occur all too often. They don’t cause as much of a disturbance as that of May 6, but more than once this year, renegade robotic trading has disrupted markets. By that I mean, cost people cash. In February, for example, one company lost a million dollars in the oil market. Guess how fast they lost that million. Less than a second. Now, the company lost its’ own money, but sometimes whole markets are affected and many innocent people are hurt. I continue to contend that we should hold those who set off runaway robotic trades accountable and we should do that as part of our new disruptive trading practice authority granted by the new law.
There’s an old song by the band Styx called Mr. Roboto. I know this shows my age, but it was a pretty good song. There’s a line in it that says, “The problem’s plain to see; too much technology.” Well, I don’t think there’s too much technology, but we know that robotic trading can run feral. Things can happen in markets so fast that all too often, we have to be the fire department that comes in and cleans up the charred remains when, in reality, we need to be more like the police department who tries to keep these disasters from happening in the first place.
These aren’t dumb computers being used in trading. They are actually intuitive. They may not be able to see individual orders out in the marketplace but they can track aggregate moves and make adjustments accordingly. They are extremely sensitive. They play off one another and react at speeds that make a split second look like an eternity. These programmers can essentially get into the mind of the mainframe of an exchange and make critical high-speed trading decisions. Regulators need to keep up. We also have to be nimble and quick because even if we get a better handle on how to regulate this breakneck speed trading, the methods, the machines and the markets will continue to change. Moreover, we shouldn’t have a system where you have to fight through all the computerized noise for fair access to the markets.
Think about it this way: if you’re a commercial trader and you are going to make some trade to hedge your business risks, on the one hand. On the other hand, you are a speculator and you want to get into the market. You may be ready to do so. You see a price point where you want to enter, you decide now is the time in the session to buy or sell. However, just before you enter the market, like a car merging onto the highway, 25 cars (my figurative algorithmic trading cars) fly by on the highway going a hundred miles an hour. They rushed in just before you, and the price has changed. The algos may pick up some micro dollars because of their speed, perhaps lots of them, because they were so very fast. Maybe that is okay. Maybe we should all be cool with that. But, I don’t think so. Like the Massive Passives and the very large traders, these folks may be impacting the ability of the markets to perform the very function for which they were originally established—hedging risk and price discovery.
Should there be some limits on robotic algo trading, on high frequency trading? I think so, but like financial futures, it isn’t clear how it would be best achieved. Technology isn’t only neat, it is imperative for businesses, our markets and our nation to be competitive. We don’t want to stifle innovation, but we should want to ensure that the original intent of these markets continues to be achieved. I think robotic algo rhythmic trading—algos gone wild if you will—have the potential to disturb what has worked so well for so long.
Wall Street Reform Rulemaking
Finally, a lot has been said about the rulemaking process this law mandates. At CFTC, we are in the process of writing dozens of rules. At the outset, a lot of “princes of pessimism” said we couldn’t get it done and neither could the SEC. What you may not know is we had started the process long before the bill even became law. We divided the list of rules into 30 clusters. We had teams in place for each one. We began to schedule public meetings. We were ready to solicit comments. We were ahead of the curve and I give the credit to Chairman Gensler who, unlike the naysayers, said that we simply have to get this done.
We, as a Commission, have already had hundreds of meetings with individuals and groups that have an interest in the law. From banks to hedge funds to technology firms—you name it; they’ve been in to see us. One of the things that’s astonished me most about some of those meetings are the number of folks who are doing their best to get out of things the law clearly intended. They fought hard against it when it was being debated and they are still fighting. Everybody wants to be exempted from one new regulation or another. Others think we should ignore the deadlines Congress gave us and phase this stuff in over years and years. Well, that’s a no go. That is not going to happen.
So, where do we stand today? We were given deadlines of 90 days for the forex rulemaking, and we got that done. We’ve got other rules with early deadlines—for example the position limits rules—and most of the rest have 360-day deadlines and are well underway.
We’re moving quickly but deliberately. But, no matter the subject, we are committed to taking the time to for public input via comments and open public meetings. That’s a critical part of the process. We want to hear from you.
I’ve only been able to watch a few football games this year (including Notre Dame and Purdue—still having bad dreams) but the ones I have watched have had very exciting conclusions, including a couple that went into overtime.
Well, there’s no exciting conclusion for you today except to say that we all want effective and efficient markets free of fraud, abuse and manipulation, but as we’ve discussed, it might not be as easy as it seems.
Imagine a football game with no referees. It might be fun to watch for a few minutes but I don’t think for very long. It’s even more important that we have referees in these markets that affect the prices consumers pay for almost everything, from a car loan to a gallon of gas, to the very food we eat.
The new game plan for financial regulatory reform is a game-changer. Sometimes, as a regulator, I’ve felt they gave me a striped shirt and a whistle but not enough authority to really enforce the rules. Now, the rulebook has been expanded. There will be more referees. The game will be a safer and sounder one. I look forward to taking part.
Last Updated: January 18, 2011