“Caging the Financial Cheetahs”
Speech by Commissioner Bart Chilton to American Soybean Association Legislative Forum, Washington, DC
July 12, 2011
It’s good to be with you today. I especially want to thank John Gordley for the kind invitation to be here. John and I have kicked around this town for a long time and I’ve always admired him. So too, the ASA. You always make your positions clearly known and you are recognized here. I worked with you when I was on the Hill and at USDA and more often than not we agreed and I always respected your views and the way you presented them.
Today, I want to talk primarily with you about how rapidly commodities markets are changing and whether they still play the same role they were intended to play—that is for commercial hedgers, like some of you, to use and for price discovery. The reason I bring it up is because of new species in the markets.
If you have time while you’re in town, if you haven’t been, a great place to go is the National Zoo. They have a couple of thousand animals from about 400 species. It was started by an act of Congress in 1889. At that time, right outside of USDA, bison used to roam the National Mall. They were moved to the zoo in 1891 and became its first residents. The zoo gets new species all the time. Likewise, in markets, we’re getting new species all the time, too. Let me talk about a couple.
One big market morphing area that we need to be thinking about is the traders themselves, a new species of traders, if you will, the “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 soybean field looks like. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy.
From 2005 to 2008, roughly $200 billion in new speculative massive passive 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. Many producers are outraged at input prices. But, is speculation at the root or part 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.
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.
Still, some exchange officials deny there is any evidence whatsoever that speculators impacted prices. Some 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. Well, they are just wrong. I’ve put more than fifty studies, analyses and comments about this on the CFTC website. There was yet another study two weeks ago from the University of Massachusetts. There’s even a study that was done in 1957 linking speculators and price.
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. financial reform law addresses this by requiring mandatory speculative position limits—to ensure that too much concentration doesn’t exist. We are now in the process of trying to get these limits in place. As far as I’m concerned, the sooner the better on that front.
Caging the Cheetahs
Technology is the other area where changes are occurring at breakneck speed. 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.
In the animal kingdom, cheetahs are the fastest, racing from zero to 60 miles per hour in a few seconds. (By the way, there are four adult cheetahs and two six-month-old cubs, Maggie and Nick at the National Zoo). In financial markets today, we also have cheetahs—otherwise known as high-frequency traders or HFTs. This new species of trader, due to the advent of high-speed computing technology and sensitive algorithmic programs, races in and out of markets trying to scoop up micro dollars in milliseconds. They aren't like traditional financial speculators because they are in markets fleetingly. At the end of every trading day, the cheetah's goal is to be flat, or neutral. They don't want to hold risk for very long, most of the time for only seconds. Are any of you interested in hedging your risk for five seconds? Not only are cheetahs new, but this highly sophisticated trading strategy is new, too. It is a different strategy and the cheetahs are a different trading species than producers are used to seeing in markets.
We recall that cheetahs were part and parcel to the infamous Flash Crash on May 6, 2010 where markets tumbled and the Dow lost nearly 1,000 points before recovering. But, mini flash crashes are taking place often. Here too, cheetahs seem like a likely place to look for potential problems. For example, on May 1st, a Sunday, in 12 minutes the silver market plunged 13 percent. Then, on June 9, in the evening’s electronic trading, the natural gas market free fell 7 percent in 14 short seconds!
If markets are going to be efficient and effective and less volatile, we need to cage the cheetahs. I'm not saying they should be extinct, and overly burdensome regulations shouldn't endanger them as a species, but they need to be confined. After all, financial markets impact all of us in one way or another. Prices for everything from milk to mortgages are set in these markets. Markets need to operate without the influence of traders merely trying to prey upon infinitesimal market movements in order to survive and thrive in the trading kingdom.
We all know 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 computerized trading by cheetahs.
A range of policy reforms are needed, including: testing of algorithmic programs before they go live; some type of pre-approval or accreditation process to ensure the cheetahs are who they say they are and not those interested in financial terrorism; kill switches to stop programs that go feral; and, accountability for the cheetahs who do damage to markets and cost people money.
Exchanges welcome the cheetahs. But even the exchanges themselves may be part of their prey. Allocation algorithms that some exchanges use to direct which trades get placed where 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, and they want deep, liquid markets. However, cheetahs may be gaming the system by bidding or offering more contracts than they believe will be filled simply to cut in line ahead of other traders. They may receive an advantage and then have their order partially filled. There is every reason to believe cheetah programs determine the size of the order that would allow them to get in first and understand they won’t get a full fill.
Regulators have simply accepted that all is well with how market technology is working. That needs to stop. We need to be more inquisitive and think about these kinds of things before they reach trouble points manifested in market anomalies.
The market morphing cheetah technology has moved so fast that even the financial reform law approved a year ago in the U.S. did not address it in any way.
Simply put, regulators need to do a better job of keeping up with the cheetahs and the ramifications of technology in trading that effect consumers and investors.
Technology does add 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. I’d think we want to ensure that these market participants actually register with the agency. We need to know who they are. Without registration of cheetahs, there is no way of actually regulating these cats and the results could be horrendous. We also want to guard against financial terrorism. After all, we’ve seen a lot of hacking of entities, like Citi and the U.S. Senate and others, that is at the very least a warning for us to be careful.
Just a few days ago, a CME employee was arrested for stealing source code from the exchange. The FBI picked him up before he boarded a plane for China. Was this industrial espionage? It is too early to tell. The bottom line is that we need to be careful and have some basic accreditation of who is trading and from where in safeguarding sensitive exchange information.
High speed trading has become all about latency—how fast you can place an order given your technology. It’s not just the speed of the computer. It’s how fast you can get your order in from Prague or Chicago. I toured CME’s new data center last fall. It’s the size of four football fields and it’s where traders will be leasing space so they can be as close as possible to CME’s computers. They will have virtually no latency. Just like the zoo, where species are kept in close confines, the space exchanges lease in buildings like CME’s are called cages. Many of them are in cages already, but we need policy confines for the cheetahs, too.
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.
With such a significant part of the trading being done electronically, it would be naïve to think there won’t be glitches. That’s why I think additional safeguards are needed 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. They call this upset recovery training. In markets, we need to improve our upset recovery training with regard to cheetahs. Finally, we need the enforcement tools to go after cheaters (with a Boston accent). The cheater cheetahs.
For example, just last Thursday, we finalized rules regarding anti-fraud and anti-manipulation practices—for all types of traders—not just cheetahs. They are sorely needed. In the CFTC’s thirty-five year existence, how many market manipulation cases do you think we have successfully prosecuted? Go ahead and guess. Here’s how many: one. One. Now, we’ve settled dozens but only won one that’s gone all the way through court and the appeals process. It’s not because our lawyers are for crap. We have great lawyers. It’s because the standard of proof was so high, we could never prove it. We had to prove intent, a false price and that manipulation actually caused that false price, among other things. The new rule lowers the bar so we can get the bad guys, Batman. It gives us new ammo in our enforcement arsenal and we will use it. Specifically, pocketing profits from the misappropriation of privileged information may now be prosecuted. Also, this new regulation moves us toward a recklessness standard similar to that under securities laws as defined by the courts, and the law specifically gives us a reckless standard for false reporting.
Financial Crisis Inquiry Commission
Why do we need to be careful to monitor the markets and especially the new species? 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. 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.
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 is how we go about constructing regulations in light of similar reforms taking place the European Union and, for that matter, the rest of the world.
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. However, we need to 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.
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 law goes 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.
Thank you for your attention. Oh, and if you go to the zoo, don’t feed the cheetahs!
Last Updated: July 12, 2011