“Policy Buffets: Plating-Up Efficient and Effective Financial Markets”
Speech of Commissioner Bart Chilton to High Frequency Trading World Amsterdam, 2011, Amsterdam, the Netherlands
June 8, 2011
It’s good to be with you today. I especially want to thank Matthew Pullan for the kind invitation to be here. It’s fitting that we’re here in Amsterdam, home of the world’s oldest stock exchange. And, you may have heard that just last month, the OECD (Organization for Economic Cooperation and Development) rated the Netherlands as the happiest country in the world. The happiest! That’s just great.
There was a popular song that some of you may recall from 1998, “Don’t Worry, Be Happy” by Bobby McFerrin. In the U.S. “Don’t Worry, Be Happy” rose to number 1 and became song and record of the year. Well, I’m happy to be here in Amsterdam, a great city in the happiest country in the world, to talk a little about global financial regulation and a few cutting edge issues. However, I can’t tell you that there aren’t some reasons to worry. So, I suppose to amend Bobby McFerrin’s don’t worry, be happy for financial markets, I’d say: don’t worry too much, be happy.
One of the things I like about Europe is the breakfast buffet hotels offer in the morning. While lots of hotels in the U.S. include breakfast with your stay, the variety of items pales compared to the European spreads. I was thinking about all of the options on buffets and how as we move forward on financial reform in the U.S. and in the E.U., how we have a buffet of policy options—a policy buffet, if you will. Today, I want to discuss how we got here and where folks are headed as they try to plate-up efficient and effective financial markets.
Financial Crisis Inquiry Commission
So, how did we get here? Earlier this year, in the U.S., the Financial Crisis Inquiry Commission (FCIC) issued a report. FCIC was established by Congress to examine the economic fiasco that started in ’07 and ‘08. By the way, many times this has been referred to as a global economic meltdown, and indeed, the hardships were felt globally. But for the West (U.S. and Europe), it was an economic calamity. I have a point about this that I’ll get to soon. Anyway, the FCIC website asks the question: “How did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives—either risk the collapse of our financial system and economy, or commit trillions of taxpayer dollars to rescue major corporations and our financial markets, as millions of Americans still lost their jobs, their savings and their homes?”
That’s a good question. FCIC concluded that the entire mess never had to take place. They concluded that the financial crisis was avoidable. They noted widespread failures in financial regulation, excessive risk-taking on Wall Street, policymakers who were ill-prepared for the crisis, and systemic breaches in accountability and ethics at all levels. The bulk of the blame went to regulators and the captains of Wall Street.
The U.S., whom for decades many had looked to as an example of how to regulate financial markets suddenly didn’t look so hot. We changed course a little over a decade ago and let the free markets go. Some of it worked out, but there were some major trouble spots. Instead of a great system of checks and balances, we temporarily became a system of just checks. In fact, as a result of lax regulation, the U.S. Government wrote a lot of checks. In fact, hundreds of billions to bail out troubled financial players in an effort to stabilize the economy. However, just because a mess was made, and is still being cleaned up, that doesn’t mean we aren’t on the road to fix the problems.
We now have 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. We regulators are trying to do the right thing as we write all the new rules associated with the law. Among the various options on our policy buffet is how we go about constructing regulations in light of similar reforms taking place here in the European Union as part of the European Markets Infrastructure Regulation (EMIR), and for that matter, the rest of the world.
We know of course, markets are truly global. Trading takes place nearly 24-7-365. Trading can migrate from New York to London to Singapore with a few clicks of a mouse. What that means when we look to regulatory reform is that there is a need for a more expansive view than ever before. If one regulatory regime clamps down too tightly in an area, trading could migrate to a less regulated arena. It is easy to recognize how such a cascade of trading migration could lead to a race to the regulatory bottom, where traders migrate to the least regulated financial environment. I do not think there is a serious likelihood that such a regulatory race to the bottom would occur over the longer haul. But, here is the point about the economic mess being centered in the West. I note with some interest, a news article from just the last several days which explains that Singapore will not change any of their rules related to oil trading, in particular. The article states that “The city-state's interests aims to maintain its allure as a global financial and trading centre rather than risk imposing regulations that might keep trade away.” The article goes on to say: “Singapore has benefited from the tightening of regulations in the West, as some players, mainly banks, boosted their presence in Asia at the expense of their trading operations in the West.” I am using this example because of the recent article but of course, trading could migrate to any jurisdiction that does not adopt equivalent protections to those of the U.S. and E.U. I’m concerned about regulatory arbitrage and about lax regulation. I certainly hope that the same troubles we have seen in markets, which are a result of, at least in part, lax regulations, don’t befall others. We learned a painful lesson with regulation that was too laidback. Perhaps others can learn from our mistakes.
However, I don’t think that businesses will be moving in mass as long as there is a coordinated and comprehensive effort to harmonize financial regulations, to the extent we can, in the U.S. and the E.U. In fact, I think strong regulations will help make the U.S and the E.U. and others that follow suit even more competitive. Look, I get it that many in the financial services sector were slow to accept that there was a need for regulation. There are still some trying to fight those battles in legislatures. I know folks don’t want excessive regulation or regulation that is extremely costly, but I think most people now have a better visual and understand the need and necessity for strong prudential regulation. They just want sensible, sound and stabile regulatory environments in which to operate. They want to know markets are safe and secure, and that they operate efficiently and effectively. I believe political leaders, even those that may have been reluctant initially, understand this and see appropriate regulation as a way to actually gain competitive advantage over those with weak, lenient or limited regulation.
What will make the path forward smoother and better in the end is if financial regulation for this environment is harmonized globally, to the extent practicable. That is, to the degree regulatory regimes in the financial services sector can be compatible; can achieve the same or similar results, the better. It will be better for markets, better for business, better for economies.
As the FCIC said, the financial crisis would have been avoidable. That is especially true if regulators had tried to see around corners, to look for trouble coming in credit default swaps, for example. That is more important now than ever because our markets are morphing rapidly. Let’s discuss two areas where we see some changes taking place and look at our policy buffet for them.
Cheetahs—Cutting the Queue
Technology is the first area where changes are occurring at breakneck speed. You already know that since you’re attending this HFT conference. Technology can be a great equalizer, bridging people across oceans, between rural and urban and rich and poor. However, there will be a steep price to pay if regulators and exchanges around the globe don't effectively manage the change taking place as a result of new computerized trading. In financial markets, folks screaming at each other in trading pits have quickly become mostly a thing of the past. Instead, computers are screaming at each other all day and all night—most times regardless of time zones around the world.
High frequency trading (HFT) does add liquidity. It adds access. Where do you think the third largest trader by volume on the Chicago Mercantile Exchange (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 used many times in our enforcement efforts.
It is amazing how quickly these markets morphed. In the U.S., well over 90 percent of the trading is done electronically. HFTs alone account for roughly 50 percent of the trades in Europe and roughly a third of the trades in the U.S.
I have a moniker for high frequency traders: cheetahs. In the animal kingdom, cheetahs can run seventy miles-per-hour. They’re the fastest animal on land. Zero to sixty in three seconds—now that’s fast, fast, fast. So are markets today.
The cheetahs are out there nearly 24-7-365 trying to scoop up micro dollars in milliseconds. We need to do a better job of keeping up with the cheetahs. Legislatures and regulators alike need to be more nimble and quick, anticipating the nature and pace of market innovation and change.
Here’s one of the potential problems I’ve been hearing about. These markets started, in large part, so that commercial entities could hedge their legitimate business risk. Today, too many of those folks—farmers, airlines and others are telling me they can’t get into markets at their price point because they get edged out by HFTs, by the cheetahs. Like when a person heads to the line at a buffet, the cheetahs cut the queue and jump in front of the commercials.
I'm also concerned about allocation algorithms, that some of the exchanges may use. These may be adding to the problem by not necessarily accepting the first or best bid or offer but weighing the size of the trade, too. From an exchange business purpose, I get it. More volume equals more money for the exchanges. However, cheetahs may be gaming the system by bidding or offering more contracts than they believe will be filled simply to cut the queue to get ahead of other traders. They may receive an advantage and then have their order partially filled. There is every reason to assume that a cheetah's algo program could determine the size of the order that would allow them to cut the queue. Regulators have, to date, simply accepted that all is well with how technology is working. That needs to stop. We need to be more inquisitive. We need to think about these kinds of things before they reach trouble points manifested in market anomalies.
In the interest of transparency, I hope that we hold a public meeting or hearing on these allocation algos and other specific issues related to cheetah trading. But, we aren’t the only ones who should be looking at these matters in public. These are global multi-market matters and others should consider what they might do to not only better understand, but inform the public about the impact of these technologies.
Now, I’m not here to criticize the way the cheetahs do business. And by the way, some of them that I have spent time with are super impressive. As a regulator, though, I do want to make sure these markets are safe for users—including cheetahs.
We don't have to look very far to see where problems have already existed, such as the Flash Crash. We recently received recommendations from an advisory committee which provided us with some thoughtful suggestions about it.
Already, circuit breakers have been put in place in some securities markets, but they need to be expanded and they need to be harmonized with other U.S. markets so we can stop the kind of arbitrage that created a cascading affect across all markets. Should these types of circuit breakers be harmonized in other nations? Maybe. Think about it. There are stocks and futures which are arbitraged internationally. Had the Flash Crash taken place in the morning instead of the afternoon, the impact could have been worse because European markets would have been open. Since it took place in the mid-afternoon, it was primarily limited to U.S. markets. We have greater coordination and controls in place both in futures and equity markets, but we still need greater harmonization between markets, both in the U.S. and abroad.
Another recommendation is for trading programs to have some kind of “kill switch” that could be activated when a program is feral. Most of the time, it’s innocent. Even so, there’s the possibility that these cheetahs can roil markets and that’s what regulators need to get our heads around. If trading becomes uncontrollable and roils markets and costs people money, there needs to be accountability. That just makes markets safer for everybody.
I also believe these trading programs need to be tested, probably by the exchanges, before they go live. At the Intercontinental Exchange—London, they do conformity testing. In India, regulators test cheetahs to ensure they don’t have the potential to violate fraud, abuse or manipulation rules or regulations.
Still, it would be naïve to think there won’t be glitches. That’s why I think additional safeguards may need to be put in place after there’s been a problem. When a plane crashes, for example, the airlines reprogram their simulators to create the exact circumstances that led to the crash so that pilots can train to avoid a future problem.
I was reading this article about airline safety that included this quote: “as an industry, we need to improve upset recovery training.” The same is true in markets. We need to improve our “upset recovery training” with regard to algos and cheetahs.
The other big market morphing area that we need to be thinking about is the traders themselves. I call one group of traders “Massive Passives.” They are the likes of pension funds, index funds, hedge funds and mutual funds. These are instruments that attract investors who could care less what a pork belly is used for or what a wheat field looks like. These funds are very large—massive—and have a fairly price-insensitive trading strategy. They are the “all-you-can-eat” of the market buffet. When they get locked onto what they think will be a winning bet, they want all they can get on their plate.
Prior to 2008, roughly $200 billion in speculative money came into the commodity markets in the U.S. alone. At the time, consumers were outraged about gas prices and food prices. So, should we be worried that maybe that’s what’s going on today? Is that at least part of the reason gas is historically high in the U.S.? Consumers are certainly outraged again. But, is speculation at the root of the problem? Here’s some food for thought: There are now even more speculative positions in commodity markets than in 2008—in fact, more than ever before. The number of futures equivalent contracts held by Massive Passives increased 64 percent in energy contracts between June of 2008 and January of 2011. In metals and agricultural contracts, those positions increased roughly 20 percent or more.
When folks pull up to gas pumps, they usually have a choice: regular, premium or super premium gasoline. Regardless of the gas grade, however, everyone at the pump is actually paying premium, at least in the U.S., a Wall Street speculative premium. Don’t get me wrong—we need speculators in futures markets—they don’t work without them. But we’re seeing new types of speculators in our markets, and in numbers we haven’t seen before, and we have to question whether that’s altogether a good thing. I think there’s good evidence that excessive speculation is heating up the market and prices have gotten out of line as a result. Rather than help to fairly discover and “make the price,” these speculators “shake and bake the price”—up or down, depending on which side of the market they’re in.
For years, we’ve heard oil companies, banks and politicians sing the same old song: that speculation in markets didn't have any effect whatsoever on the prices consumers pay. These days, though, some folks are singing a different tune. For example, the head of a major oil company recently acknowledged that speculators were “gunning” prices. In March, Goldman Sachs issued a little-noticed report linking speculation to rising oil prices. And, President Obama correctly spoke about speculators’ impact on consumers and established a high-level working group headed by our Attorney General to check into it.
You don’t have to take it from me or any of those folks, though. Researchers at Oxford, Princeton, and many other private researchers say that speculators have had an impact on prices—oil prices and food prices most notably.
Exchange officials deny there is any evidence whatsoever that speculators impacted prices. They even deny that anybody’s saying so. They don’t call the people who did these studies whack jobs or crazy. They deny the studies exist. That reminds me: A psychologist entered a patient’s room and found one of the two patients knelt down over a desk pretending to write with a non-existent pen on a non-existent pad of paper. Hanging from the ceiling, by his feet, was a second patient. His face is beet red. The doctor asked the first patient what he is doing, to which the reply comes, “I’m a researcher doing very important research.” The doctor asks the researcher patient what his buddy is doing hanging from the ceiling. “Oh” says the patient, “He thinks he's a light bulb.” The doc says, “You should get him down from there. He may hurt himself.” To which the researcher patient says, “What, and work in the dark?”
So no, these exchange officials didn’t say the studies are false or that the people who did them are crazy, or that they only worked in the dark. No evidence exists is what they say. Well, they are just wrong.
The point though, is that, if those studies have even the possibility of being credible—if they are right—what do we do to protect markets and consumers? The new U.S. reform law addresses this by requiring mandatory speculative position limits—to ensure that too much concentration doesn’t exist, and I’m pleased that it looks like that is the direction the E.U. is headed for too.
Conclusion: We Can Do Better
I want to leave you with one last thought. I’m optimistic that we can get through all of these different policy options. We can even be happy about it. However, there is some reason to worry if we aren’t serious and if we don’t do more than is common for regulators. We need to work cooperatively and try to look around the corner and see what may or may not need to be done. We need to be careful about how we plate-up with all of the various items on our policy buffet.
If you’re like me, the first thing you do when you go to a buffet is scope out all the selections and come up with a little plan for what you’re going to put on your plate—at least the first time through the line. Likewise, in regulation, we need to look ahead, scope things out, and do our best to predict the market ramifications of new products, new exchanges, cheetah traders, massive passives and whatever other new trading elements come our way.
The new U.S. law and the general direction I see in Europe is going a long way toward doing many of those things, but it took a market meltdown before government acted, and as we have discussed, there are still folks who may not see the need for reform.
If we can do better, be better public servants, it can help ensure more efficient and effective markets and economies and it will help keep markets devoid of fraud, abuse and manipulation. That’s good for commercial traders, for the cheetahs, for traditional investors, and especially for the consumers who depend on these markets for the price discovery of just about everything they purchase—no matter where they are on the globe.
Thank you for your attention. Don’t worry—much—be happy!
Last Updated: June 8, 2011