"New Species: How Market Participants Have Evolved in Financial Ecosystems"
Speech of Commissioner Bart Chilton to the American Public Gas Association Winter Conference, Fort Myers, Florida
February 1, 2011
Thank you for the opportunity to be with you today. In October of 2007, I met with and spoke with APGA's board in Memphis. Laura Campbell, who was with APGA at the time, took me to Memphis Light, Gas & Water and I met with traders there. The speech I gave in Memphis was my first as a Commissioner and I found the experience to be very useful. So, thanks for the great working relationship. Thanks also to your Executive Vice President Dave Schryver who I’ve worked with over the years and who represents you well in Washington.
The Importance of Markets
Futures markets are an important component of our nation's economy. These markets impact just about everyone in our country because they help discover prices for everything from a home mortgage to a gallon of gas, milk or importantly here in Florida, orange juice. For commercial businesses, they have provided important risk management tools.
The markets have also served as a vehicle for speculators, not only an important, but critical, component of these markets. So, these markets are vital to consumers and businesses and are a key part of the economic engine of our democracy. They need to remain so, but markets have morphed over the years and market participants have evolved and there are actually new species of market participants. Today I want to discuss how these new species are impacting markets and ask the question: how do we ensure that these markets remain viable and how do we ensure they are efficient and effective and devoid of fraud, abuse and manipulation?
U. S. 41
U. S. Highway 41 runs just a few miles east of here and ends in the Upper Peninsula of Michigan near the town of Copper Harbor. U. S. 41 is called Indianapolis Boulevard up in Highland, Indiana, just a few miles from where I grew up.
It’s quite a famous road, too. Remember the lyrics to the old Allman Brothers song “Ramblin’ Man?” “I was born in the back seat of a Greyhound bus rollin’ down Highway 41.”
If you drive south on U. S. 41, it actually turns east and goes to Miami. From Tampa to Miami the road is called the Tamiami Trail. That part of the highway took twelve years to build; cost $8 million at the time and was completed in 1928. It was an amazing accomplishment in the 1920s.
My grandparents used to drive that road, all the way from Indiana to Miami. Now Alligator Alley is the newer road that crosses the Florida Everglades. It was first opened in 1969.
Perhaps out of curiosity, and perhaps out of some sentimentality, my wife and I drove the Tamiami Trail a few years ago from here at Ft. Myers to Miami. We stopped along the way and visited a reptile farm. It is a neat drive and I recommend it to you.
As you cross the Everglades, there is a highway information radio broadcast—you know, one of those “tune to 1650 AM for highway information” stations. One of the things I remember from the radio is the explanation of the Florida panther. You can still see it depicted on some of the license plates in the state. Supposedly, these panthers, while rare, still exist. You can't listen to that radio broadcast talking about the panthers in the Everglades and be driving across on the Tamiami Trail or Alligator Alley and not look for panthers. It is impossible not to look.
While the panthers might be rare, the Everglades continue to amaze me in that researchers are seemingly constantly finding new species of plants, animals and insects. There is this unique and special ecosystem that produces an enormous number of species, and it happens no place else on earth like it does here in Florida.
Just last year, officials found African rock pythons in the Everglades. Now, where did they come from? There’s concern that they will mate with the smaller but more common Burmese python and produce a “super snake” which would be a new species.
Our futures markets are also unique and special. They, too, have been a breeding ground for new species. New species in the wild and in futures markets are both worthy of study. In fact, I'm not sure regulators would be doing our jobs if we didn't examine the new species in futures markets and make determinations about if and how they impact our market ecosystems.
For example, how do we ensure that new species don’t become invasive? In the citrus industry there exists a dreaded bacteria that causes citrus canker. If it invades your orange grove, the whole grove has to be destroyed. In the financial markets, I want to make sure these new species don’t become invasive and threaten the existing species of commercial traders or traditional speculators.
One relatively new species in our markets are what I call “Massive Passives.” In the run-up to the financial crisis of 2008, we saw an enormous shift in speculative money coming into futures markets. Over a several year period, roughly $200 billion in speculative money came into these markets. Crude oil reached $147.27 a barrel. Gasoline topped $4 a gallon.
Many of the speculators have a distinctive trading strategy: that is, they pretty much go long and stay long. They are many times huge traders such as hedge funds, pension funds and index funds. They 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.
Many of us learned that while there may not be such a thing as too much speculative money, that same money might be too concentrated. Since 2008, we have seen concentration above 20 percent of open interest in the natural gas and crude oil markets.
While I’m not suggesting speculators drove prices in 2008 or today, they had an impact then and I think they are having some impact today. You don’t have to take it from me though. Economists at Oxford, Princeton and Rice universities all document that speculators have had an impact on prices.
One might ask if there are as many speculative positions today as there were in 2008 and the answer is yes. There are more of these speculative positions now than at any time. Between June of 2008 and October of 2010, futures equivalent contracts held by these types of speculators increased 47 percent in energy contracts, 20 percent in metals and 18 percent in agricultural commodities.
As I’ve said, we need speculators. Without them, there is no market. The sheer size, however, of concentrated speculative interests has the potential of moving markets, of influencing true price discovery. That can make life difficult for the hedgers who use markets to manage commercial business risks, and for consumers who rely upon them to fairly price just about everything they purchase.
Congress got it, and that is why the new Wall Street Reform and Consumer Protection Law requires mandatory speculative position limits—to ensure that too much concentration doesn’t exist.
We were supposed to have a rule for that in place right now and I’m disappointed that we don’t. One of the reasons it didn’t happen on time is that our rule for collecting swaps positions data, which we need if we’re going to know the market and set reasonable limits, isn’t due out until this fall. Still, I think we could have set limits for spot months and I did call for, and we are going to analyze, the positions of large traders in the meantime and use the authority we have to keep an eye on them when they get above certain position points.
As we all know, our markets have changed dramatically in the last decade. Folks screaming at each other in trading pits are quickly becoming a thing of the past. Instead, computers are screaming at each other all day long and sometimes all night long. Algorithmic programs are cranking away like journeymen and HFT computers are trying to scoop up micro-dollars in nanoseconds. It is an amazing thing how quickly and vastly these markets morphed.
For today, since we’re talking about animals, let’s call high frequency and algorithmic traders cheetahs. The cheetah is the fastest land animal—the fastest species. It can run seventy miles-per-hour. Zero to sixty in three seconds—now that’s quick. So are markets today. We regulators need to be quick and nimble, too, to keep up with the cheetahs. And, when they do something to mess up a market, we need to catch the cheetahs. (That’s my Boston accent—“catch the cheetahs”).
Technology in markets is great in a lot of ways. It does add liquidity, although I think a lot of the liquidity is between computers used by traders whose positions are flat at the end of the day. In other words, it’s short-lived, but it is liquidity, nonetheless. Technology adds access. The third largest trader by volume on the CME is based in Prague. Now, that’s access that wasn’t there ten years ago. For us regulators, technology also provides an electronic data trail. At the end of the trading day, exchange employees used to scoop up the little tickets on the trading floor with snow shovels and that’s the data we had to use to regulate. So, like cheetahs, there’s a lot of good about this technology animal. But, like cheetahs, there’s an element of danger.
What do I mean by danger? Oh, how about the Flash Crash as an example? Like a cheetah taking down a deer, breakneck speed trading contributed to taking down financial markets the afternoon of May 6th. I didn’t say it took them down all by itself, but it was a contributing factor.
Last summer, the joint SEC-CFTC Advisory Committee on Emerging Markets and the CFTC’s Technology Advisory Committee met. We explored whether the Flash Crash may have been caused by so many orders going into the order book at such a high speed that it overwhelmed the New York Stock Exchange servers, which coincidentally, were undergoing an upgrade that day. One member suggested something he called “algorithmic terrorism,” when algo programs work to instigate other algo programs into action. It happens all the time and most of the time, it’s innocent. But, you can see that there’s the possibility that these cheetahs could roil a market and that’s what regulators need to get our heads around.
Mini-flash crashes occur all the time, too. More than once last year in futures markets and several times in stocks, runaway robotic programs disrupted markets and cost people money. One company lost a million dollars in the oil market in less than a second when an algo ran wild. So, you can see the potential that exists for roiling markets.
These advanced analytic computers are intuitive animals. They track market moves and they adjust with lightning speed. They play off one another. And here’s something you may not know: there was a recent newspaper article that made the point that one new strategy being used these days is to have mega-powered computers read news reports, blogs, Twitter feeds and the like and then trade on the information. Somebody is smart enough to program the computer to do all that but the computer takes it all from there.
Here’s the problem: things can happen so fast that we regulators are like CSI coming in to do a post-mortem and find out whodunit. I don’t want to be like that. I want to be like MacGyver. Remember, he was always trying to prevent crime before it happened. That’s what we need to be like and that’s why I’m talking about some things that may sound a little out-of-the-box. I think it’s necessary to think that way, however, given the trading world in which we live.
Remember, the CFTC began operations in 1975 for human-to-human trades, not for computer-to-computer trades. Now, regulators require supercomputer-like systems to monitor the kind of trading that goes on. We need to get into the mind of the mainframe.
Limiting the Cheetahs
About six weeks ago, I gave a speech in New York to a group of high frequency traders—a whole room full of cheetahs. Don’t ask me why, but I chose that venue to propose putting protections on the way they trade. I expected that maybe I wouldn’t be the most popular guy in the room that day, but a strange thing happened. They didn’t raise any objections. In fact, some of them said I was on target. They were favorable to putting some limitations on market participants that would protect the markets.
Here’s some of what I proposed. In addition to things like better harmonization between futures and equities, including coordinated circuit breakers, we should consider whether there should be limits on advanced analytic trading. Maybe there should be specific position limits for HFTs. If, for example, we allow ten percent of open interest in a futures market to be held by one trader, should we allow high frequency traders to trade ten percent of a market ten times in ten seconds? What if five HFTs did that, maybe innocently, but in concert? Could that roil a market? It sure seems like it could.
Here are some other questions I’ve been asking: should there be different rules for these market participants? Is this type of trading outside the boundaries of the fundamental purposes of capital formation and risk management in financial markets?
I believe another way to address some of these potential problems is to impose legal responsibility on high frequency and algo robot trading that roils markets and causes concerns and obstacles for traditional traders. I think those who instigate runaway trades should be held accountable when they hurt other market participants or injure consumers. I also believe there should be some standard definition of what high frequency trading is and maybe even a kind of “Good Housekeeping Seal of Approval.” I believe these trading programs need to be tested, either by the exchanges or by the regulators, before they go live and that they should be monitored in some way when they do go on line.
I have heard from a number of commercial firms trying to hedge their risks who complain about their inability to get into the markets as they have in the past due to the sheer number and speed of HFTs. By the time a company is ready to make a trade, there are so many HFT orders jumping in front of the commercial that they cannot get in at their price point. I suppose one answer is that they need a bigger computer, but I don’t like that answer. We need commercials in these markets and the commercials certainly need the markets to hedge their legitimate business risk.
The New Ecosystem of Swap Execution Facilities
The new financial reform law passed last year also creates some other new market species. I’ll talk about just one today because it is one of the more important creatures: swap execution facilities or SEFs. They will operate like the exchanges we currently have in place for futures trading, except that they will be a brand new animal for the execution of swaps.
At CFTC, we currently oversee $5 trillion in annualized on-exchange futures and options trading. The new law, though, is going to bring the light of day to the currently unregulated over-the-counter derivatives market, estimated at about $600 trillion dollars. Those swaps trades, if they are required to be cleared, will now need to be done on swap execution facilities. This brings a price transparency to these markets that they haven’t had before, and that’s a good thing. It’s one of the major emphases of the financial reform law. That being said, we recognize that swaps markets and futures markets include different flora and fauna, and we need to be very thoughtful in developing rules for SEFs. Wholesale adoption of futures exchange rules is not appropriate, nor is development of rules that would result in uneconomic advantages or disadvantages for swaps markets. And we are also working, in the crafting of SEF rules, to ensure that we do not mess up platforms that are currently working well. This is a delicate balancing act, and we need to hear from market participants that have the expertise and interest in this area to make sure we get it right.
Ground Hog Day
One of the reasons I’ve been thinking out-of-the-box a little is because of the new regulatory world in which we’re beginning to live. Last July, Congress passed and President Obama signed, the most sweeping set of financial reforms in our history—the Wall Street Reform and Consumer Protection Act. It was necessary if we were ever going to protect ourselves from the kind of financial meltdown that occurred in 2008. The report that the Financial Crisis Inquiry Commission put out last week places the blame for the economic mess we got into (and, by the way, we’re still living with today) squarely on the shoulders of both those on Wall Street and in Washington. I think they’re right and I think Congress and the President did the right thing with the new law. We regulators are trying to do the right thing as we write all the new rules associated with it. None of us want to see a repeat of 2008.
There is, however, something wrong with our ecosystem. Let me put it this way just so I can carry on my animal theme. Tomorrow is Ground Hog Day. I noticed over the weekend that the old Bill Murray movie “Ground Hog Day” was on about every cable channel. I didn't watch it but I do like how he wakes up every day and he finds out it's the day of the year he hates the most, Ground Hog Day, and he has to go watch Punxsutawney Phil one more time.
Well, ever since the financial collapse, there are some in Washington who want every day to be the same, too. They saw no need to reform our financial system. They seemed to think that what happened to AIG and Lehman Brothers was just OK and even better, that the taxpayers paid for it. So, they did their best to kill the bill, even though consumers and Americans everywhere were outraged. They failed. But now, it's the same day all over again! Now, some of those same folks want to repeal this important law. Others think it would be clever to starve it into submission by not funding it. It's another morning where that same clock radio wakes us up to the same chatter. Well, I hope that one of these mornings those folks wake up and don't see their shadow and that this cold winter of uncertainty will end. I for one don't want to wake up to that same clock radio telling me that AIG has failed and that I need to foot the bill to bail them out for abuses that won't happen again if we fund this bill.
If we don’t get funded in the way we should, I’ve suggested instituting some kind of user fees on market participants to pay for their regulation. It pains me to even go there. I’ve never been a believer in user fees for public services. Regulating these markets is a public service and the public should pay for it and, I believe, is willing to. But, if Congress doesn’t see it that way, we may have to explore fees as a last resort. If the choice is either user fees or going back to an unregulated market ecosystem, we may need to pull the trigger.
Now remember, it isn't the regulated futures exchanges that pushed any company into failure. They worked well. And, we have the resources to regulate the existing markets. But, regulating the $600 trillion over-the-counter market is another thing. In that light, it would seem to me that swaps would be the first place to look for such user fees, as long as it was done in parity with any such fees for futures markets. Additionally, perhaps they should be imposed on the Massive Passives or the cheetah traders. I'm not sure about how such a user fee system should work. We will need additional authority from Congress, so perhaps they can give us direction. I certainly think we don't want to mess up what is already working fairly well—the currently regulated exchanges—by instituting some rash user fee proposal. Whatever we do needs to be sound policy.
If you drive across the Everglades, you can’t help but wonder what might be lurking out there in all that vegetation. Well, in our ecosystem, we’re bringing markets that lurked in the dark into the light of day. We’re examining the new species that are with us already. With the new law, we have the tools in place to make sure our markets are efficient, effective and safe and we’re the first country in the world to take that step. We will protect consumers from any dangerous new species that may come along and threaten their investments and the prices they pay. That’s our job and we have the system in place to do it even better.
Thank you very much.
Last Updated: February 11, 2011