"Texas Hold ‘Em—Time to Fold ‘Em"
Keynote Address of Commissioner Bart Chilton Before the 2012 Allegro Customer Summit, Dallas, TX
October 16, 2012
Good morning. I’m pleased to be with you at this year’s Allegro Customer Summit and excited to spend some time with you to discuss the ever-changing world of financial markets. Let’s shuffle up and deal.
Texas Hold ‘Em
How many of you have ever actually played Texas Hold ‘Em? Anyone? Anyone? Bueller? Maybe you’ve just watched it on TV, I have—more than I’ll admit. You’ve got to really like it to watch it on TV, or maybe there’s 57 channels and nothing’ on—or 1,000 and nothin’ on. There are actually a ton of TV poker viewers. It’s kind of fun to watch somebody go “all in” when they have nothing in their hand or there is some super large pot. Or maybe someone with the better hand decides it’s time to fold ‘em.
The Texas Legislature officially recognizes Robstown (just outside of Corpus Christie) as the hometown of Texas Hold ‘Em, sometime just after 1900. In 1967, the game was brought to Vegas by Texans Doyle “Big Papa” Brunson and Amarillo Slim—what a great moniker, Amarillo Slim—you can’t make that stuff up, and a few other buddies. They just called it “Hold ‘Em,” leaving the Texas part out. That’s the world-renowned Texas modesty, I suppose. Doyle, by the way, has made himself a pretty decent living writing books, doing videos, blogs—you name it. At 80 years old, he’s still playing Texas Hold ‘Em professionally. In fact, he’s a ten-time World Series of Poker Champion.
Just a few days ago, Phil Ivey was in the news—Poison Ivey Phil—nah, that’s not his name, maybe you could make the names up. Phil is an eight time World Series of Poker Champion—or in poker talk, he’s got eight bracelets. Phil took a little time off from poker and went on a European vacation (not with the Clark Griswalds for you cinefiles). Phil didn’t play poker on his holiday, but he did play a few hands of a game called “Punto Banco,” a variation of Baccarat. He won $11.7 million playing Punto Banco—$11.7 million! So far, the casino won’t pay. They say his luck was “remarkable.” I suppose that’s the polite way of saying they think he cheated. Now, everybody’s lawyered up and it’s a big mess, but it’s a remarkable story!
This was not in my introduction, but I am, by the way, a mind-reader. You see, right now, you’re asking, “Where in the name of heaven is he going with all this?” I thought this guy was supposed to talk about regulating financial markets. Told ya I could read minds. Well, thanks for your patience because that’s what I am here to discuss.
Here’s the thing: our futures markets were never established to be gaming at gambling houses. Leave that to Amarillo Slim and Poison Ivey Phil (that’s still not his name, but I like it). Leave the gaming to the poker players and the gamblers—thank you very much. How smooth was that transition? See, I did have a point. But there’s more: A new car! No, not that. These markets were established to discover prices to benefit consumers and manage risk. We can’t overlook that. Once we forget that, we have lost our way.
A little more than a decade ago, some folks thought the irksome government rules and regulations were getting in the way of the free market—that it was time to fold ‘em—and that’s what happened. Then markets, in some cases, did turn into gaming parlors. Big pots were bet on risky, incomprehensible financial products, like credit default swaps to name one. Wall Street rolled and the pots got bigger.
Anyone read the Andrew Ross Sorkin’s book, Too Big to Fail or see the movie? I recommend reading it or seeing the movie if you have not. In it, there is a scene where then-Treasury Secretary Hank Paulson comments on why there wasn’t enough regulation leading up to the 2008 economic crash. Secretary Paulson says, “No one wanted it. We were making too much money.”
While many of the folks making the money didn’t want regulation, unfortunately some of the high-rollers didn’t know when to fold ‘em. Lehman Brothers and Bear Stearns, got folded anyway. In other words, they did “the flop” (to use Hold ‘Em parlance). Heck, Lehman was over-leverage 30 to one before they folded. There were no rules to prohibit it. They took on extraordinary risk and the economy suffered. That wasn’t right.
A New Hand—Dodd-Frank
Well, we know a lot of the story after that. Once taxpayers bailed out some of the whales—these high-flying gamers—average people had just about enough. Nine million people had lost their jobs and millions more, their homes. Congress got it and the President got it and we were dealt a new hand—a new hand called the Dodd-Frank Wall Street Reform and Consumer Protection Act.
So, here’s one of the questions I’m here to discuss: How is that new hand playing out? It doesn’t matter if you’re an algo trader, a high-frequency trader, a pit trader, an investor or a consumer—you want to know the rules of the game. That is especially true if you are sitting down at a high-stakes table.
It has been four years since the economy folded and more than two years since we were dealt that new Dodd-Frank hand. There are nearly 400 rules to craft. In general, regulators considering what to do with this new hand have been sluggish in taking final actions. Most of the rules were to be completed within a year. That means the law called for almost everything to be finalized by July of 2011. Of the 398 regulations that need to be concluded, only about 131 are complete—a measly 33 percent.
The CFTC, for what it is worth, has made better progress. We’ve finalized 39 rules of roughly 60. Given this mammoth mission, it’s not unexpected that these new regulations would raise questions and anxieties regarding compliance and implementation.
Playing By The Rules
A number of these things took effect last Friday. October 12th was a cornerstone date for Dodd-Frank. However, it wasn’t like leading up to it, things were going effortlessly. That’s to be expected, I suppose, given all of the things that Congress required. We had received a couple hundred requests for clarification and or regulatory relief in some fashion on approximately three dozen distinct issues. In fact, I had never seen us busier than what I saw in the last two weeks.
At one point, it sort of brought to mind the Sabre Dance. Remember that one (written by Armenian composer Aram Khachaturian in 1942)? It’s that plate-spinning song where an act spins a large number of plates on teeny tiny poles (the world record is 108 plates). Can’t ya just hear it? At times, it seemed like we needed to choreograph our rules with that music. It was truly intense, but our staff pulled through in a miraculable manner, bustin’ long hours and doing not just adequate, but superlative work. Quite frankly, this was a fulcrum point for Dodd-Frank as far as the CFTC goes. If we had not written it, the guidance and clarity of the new law could have been stymied, but we have crossed the Rubicon and we are on our way. Since clarity has been provided, compliance with all final rules is required.
Here’s the Deal
What is: you’re welcome. That’s the Jeopardy answer to the statement: “I’m not going to go over all the individual rules.” After all, from the guv’ment—here to help. However, I will condense what we are doing by placing our deck of rules into four categories—sort of like four card suits: Transparency, Lowering Systemic Risk, Accountability, and Market Integrity.
Suit 1—Transparency: The previously unregulated, dark, over-the-counter (OTC) trading (swaps) volume is roughly $650 trillion or more worldwide. To make that relative, the CFTC currently regulates about $5 trillion in annualized trading on registered exchanges. Those dark market trades have never seen the regulatory light of day. So I guess this suit would be diamonds because for the need for clarity. With Dodd-Frank, those markets will be brought onto regulated exchanges. Data will be collected by what are called Swap Data Repositories—or SDRs. Those SDRs will provide the transparency in the exact markets that got us into such trouble in 2008.
Suit 2—Lowering Systemic Risk: We also want to guarantee that people don’t take risks that undermine the entire financial system. I suppose this is the heart of the matter. Risk is part of markets. Remember Captain Renault in Casablanca? “I’m shocked, shocked to find that gambling is going on in here!” Of course folks in financial markets should be able to take as much risk as they’re comfortable with. However, if they make a mistake—a bad bet—our economy shouldn’t pay the price. Therefore, we’re instituting new capital and margin requirements. We will also require clearing. That will avoid the over-leveraging problem that I mentioned earlier: Bear, Lehman and others.
Suit 3—Accountability: This is clubs. I am asked, a lot: How come nobody went to jail for what took place in 2008? Wassup with that? After all, we all had to ante up more than $400 billion buckaroos into the financial sector bailout pot. Much of that has been repaid, in fairness, but since that time, the sector of our economy that has made more profits than all other sectors, more than all of them, was? Cue the Concentration music—you guessed it: the financial sector. Certain individuals who inflicted indiscriminate hurt didn’t get burnt, but are, in fact, doing better than others in our economy. So, how come nobody went to jail? Much of what was done wasn't against the law, that’s why. That is changing with Dodd-Frank.
There will be more financial firm accountability to the public. We will, very soon I expect, make some substantial improvements. We will address in solid, inclusive, and clear terms, our complement of customer protection rules, with a focus on significant controls and control-based examinations. And lastly—our fourth suit if you will;
Suit 4—Market Integrity: And finally, spades because we need to dig deeper and understand what is going on in today’s markets. Most of us want markets to perform the functions originally-envisioned: to manage risk and discover prices. That’s good for commercial producers and consumers. Let's stalwartly safeguard those central core values regardless of which players are in markets—hedgers or speculators.
How About Some Honest Play?
It’s on these last two suits of accountability and market integrity that I believe we need to think a little outside the box. Lately, I’ve been calling for a culture shift in Wall Street executive offices—the suit suites. I guess you could say I’m fed up with the Gordon Gecko “greed is good” mentality that seems all too common. I’m tired of, and I gar-on-tee most people in the countryside are tired of, those that try to cheat or double-deal.
Just think about very recent history. Barclays gets caught trying to manipulate Libor. Wells Fargo settles a loan discrimination case. Peregrine Financial appears to have been an utter scam. MF Global said “I could have had a V8.” Sorry, we forgot to keep client money segregated. Bank of America and at least a dozen others overcharged overdraft and debit card fees. And in the Washington Post last week, there was an article about JPMorgan and Wells Fargo, benefiting from the $40 billion in federal mortgage stimulus but declining to actually lower mortgage interest rates for consumers because “it would be bad from a profit perspective.” I guess that shows their true corporate character, and it’s nothing to be proud of.
Here’s one that fits our refrain for today: Full Tilt Poker. Heard of it? I recall many of the TV players wearing hats with the Full Tilt logo. Full Tilt Poker, along with an outfit called Pokerstars, were shut down last year and charged with bank fraud and money laundering. The Department of Justice received a $731 million settlement and separately, Full Tilt settled allegations that it was a Ponzi scheme.
Late last year, we caught up with a couple twin brothers just outside of Dallas here and sued them for running a $5.5 million Ponzi scheme. What’s a little bit unusual about this case (although not unheard of) is that the Wagner brothers allegedly were preying on (pardon the pun) fellow parishioners at their church.
I wrote a book about some of these whacked Ponzi sleezsters: Ponzimonium: How Scam Artists Are Ripping Off America—now available on NOOK devices and apps at barnesandnoble.com, or in paperback at amazon.com or gpo.gov. Seriously, neither I nor the CFTC make any money from the sale, but I do recommend it.
It’s like some of these players—whether they’re in Dallas, Chicago, on Wall Street or elsewhere—have a gaming compulsion. By the way, did you hear about the guy who went to Gamblers Anonymous? Five-to-one, they bet him, he wouldn’t make it.
The point is, after a while, we get uncomfortably numb to what ought to outrage us. So, I think the culture needs to change in our financial sector. One thing we can do in government is to ensure that paying fines is no longer just a cost of doing business. In a couple of those cases I just mentioned, it was time to fold ‘em—fold the entire company—a fine wasn’t enough.
What I’m suggesting is that there should be a collective conscience among the captains of the Street that says we’re here for our customers and we’re here for the long term—not just next quarter’s P&L statement. Government needs to play a role and consumers especially need to play a role in this culture shift conversation. The alternative is to continue business as usual. But, as Dr. Phil says, “How’s that workin’ out for ya’.” Well, not so much.
There is one rulemaking I want to single out today. Remember that October 12th date I mentioned earlier? One rule that was supposed to go into effect that day was dealt a buzzkill by a District Court 11 days before it was to be implemented. It has been in the news some lately: speculative position limits.
Since 2008, I've been working to get these limits in place because, and this is supported by with many studies, excessive speculation can push prices around. Nobody can rationalize nearly $150 a barrel oil in 2008 based solely upon supply and demand. It cannot be done. Well, Dodd-Frank required that we implement limits to curtail excessive speculation that can lead to unfair prices. In fact, the law even instructed us to do so six months sooner the rest of the rules we spoke about earlier.
There were some, however, that loathed limits. They fought against them on the Hill as part of Dodd-Frank, and lost. They tried to weaken them during the rulemaking process. They were on us regulators like overeaters at a Las Vegas buffet. Then, as a last resort, they lawyered up. They sued us with what seem like inexhaustible resources and took us to court. By the way, the financial sector has more lobbyists and spending more money on lobbying than any other sector—ten lobbyists for each member of Congress. Well, those that wanted the ability to continue the no-limit speculation game won—temporarily. The Court stopped us from implementation of position limits on October 12th. I’ve said we should appeal, and I expect we will.
At the same time, I’ve suggested that we promulgate (a fancy government word for draft) yet another rulemaking regarding position limits. Here is why: in brief, the Court opined that the Commission could impose limits on excessive speculation in two scenarios. My thought is we state that we don’t need to use both authorities and that our previous rule was appropriate, but still go ahead and do another rule using both authorities anyway. Two, two, two authorities in one (but no Retsyn).
Speculative position limits are too important to not do all we can to put them in place pronto, as Congress and the President Obama directed.
Computer Poker—Fast, Fast, Fast
One final hand here—one final issue. We all know how markets work today—at least we think we do. Today’s reality is actually hard to keep up with.
In the old days, like ten years ago, a customer saw a price on a TV screen and called a broker. The broker would provide existing pricing and an order would be given. Then, the order would be phoned in, stamped and given to a runner to take it to the pit. It would be placed in the deck or immediately filled. The runner then went back, called the broker, and the broker called the client. That’s fairly time-consuming, right?
Today, that same customer can enter an order into the computer straightaway linked to an electronic platform for assignment in the exchange order matching engine by the futures commission merchant (FCM). The execution causes the customer to directly receive the fill from clearing. Just like that, it is complete.
But, there’s a new set of players out there who don’t trade like that customer. They don’t really care what’s going on fundamentally in markets. They are simply made for speed. I call them cheetahs—not cheaters. Cheetahs: as in the fastest land animal. And these folks I’m talking about—these high-frequency traders—care only about being fast and scooping up little micro dollars in milliseconds.
That’s right—milliseconds. A millisecond is one, one thousandth of a second. Can you guys get your minds around that? See if this helps: if you are travelling at 100 miles per hour (like you guys in the Lone Star State do all the time), a millisecond is the time it takes you to go two inches—two inches. Does that help? Not a heckava lot, right?
In real time, no human can follow this trading. Rain Man could count cards, but he couldn’t keep up with the cheetahs and their speed trading. No es posible.
Someone can follow trends in the trading, but by the time there is something to look at, what’s displayed is totally toast. It’s an illusion and not what is going on currently. It is yesterday's news, even though it happened two seconds ago. As one of our senior folks at the Agency said, what we see is a "dead carcass of something that lived, died, decayed and is now fertilizer."
That said, computerized trading technology has some attributes. It provides access. It provides liquidity—although it’s pretty fleeting since cheetahs try to be flat at the end of the trading day—if the day ever ends in this global trading world.
If there were no technology malfunctions, imaginably there would be some comfort with the technology in markets and cheetah trading. However, snafus are common. I’d disremembered where the term “snafu” originated. It is a longstanding military acronym: Situation Normal—All Fouled Up (as you might guess, that’s the sanitized description).
Two weeks ago, NASDAQ had its second high-profile technology snafu in six months when it was forced to cancel Kraft Foods trades after a technology anomaly caused the company’s shares to rise 28.9 percent. That seems bad, right? Well, it was worse. Kraft was just converting from NYSE (New York Stock Exchange) to NASDAQ. The former Kraft CEO rang the opening NASDAQ bell. In the first minute, the stock price took that giant jump of almost 30 percent. Trades were consequently cancelled. Kraft ended down on the day 1.2 percent. It was reported that the glitches were due to defective speed trading algorithms. Of course, most of us remember that NASDAQ had a giant technology problem with Facebook’s initial public offering in May.
I’m not singling out NASDAQ. These technology hiccups are taking place around the globe. A week and a half ago, the National Stock Exchange of India said 59 erroneous orders provoked a drop in equities that temporarily obliterated about $58 billion—$58 billion!—in value. That’s a huge hiccup, and a lot of rupees.
A few weeks ago, the Tokyo Stock Exchange closed due to technology problems. We’ve seen a few contracts shut down for different periods in Chicago and New York last month. We've seen market volatility increase wildly: natural gas plummeting eight percent in 15 seconds last year. One day silver plunged 12 percent in about as many minutes. One energy trader lost $1 million in one second—in a second! We saw crude tumble $3 in a minute last month. We continually see sharp rises and falls in precious metals. Knight Capital Group, in August, lost $440 million based on software trading mistakes—throwing it to the threshold of bankruptcy. There are numerous other instances and it’s a safe bet that there will be still others.
All of these snafus highlight the concern that I’ve been raising for a few years about how regulators need to get a grip on what is going on in markets with technology. Regulators have a positive duty to do so. Few others will. Why won’t others do so? Well, to paraphrase Secretary Paulson: they are making too much money. Too many folks making and baking too much dough that know they’d better not second-guess what is going on at these warp speeds. They are, however, gambling with their futures by not seeking appropriate protections.
The case that the trading and technology is fast and scary and that snafus are taking place all-too-frequently is easy to make. I just did it. But what do we do about all of this? Should we slow the cheetahs down as the European Parliament proposed very recently? Ban them? Put them on the endangered species list? Some people think so. I don’t think those are the correct approaches.
There are some things, however, that we should do and promptly. Cheetahs—HFTs—were not even mentioned in Dodd-Frank. There was not one word about them. The new law was passed and signed just shortly after the Flash Crash in May of 2010. By then it was too late to put any techno-language in the law. Heck, we didn’t even yet know all of the ramifications of the Flash Crash.
Nevertheless, we need some market protections and a balanced approach to seeking safer markets while not going all in. Here’s my list:
1. Cheetah Registration: They need to be registered. That's sort of a pedestrian first step. Can you believe they aren’t even mandated to be registered with us? If they are not registered, we can’t command their books and trading records. They gotta be registered.
2. Testing: They should be required to test their programs before they are unleashed in a live production trading environment. Most of the big cheetahs do this already.
3. Kill Switches: It should be compulsory to have kill switches in the event that cheetah programs go feral. I am pleased that the Securities and Exchange Commission (SEC), some exchanges and my Agency are working on that.
4. Wash Blocker Technology: Cheetahs should also be required to create pre-trade risk controls with available wash blocker technology to prevent wash—or cross—trading (that’s trading with themselves). After all, those trades are illegal in the United States. But, as it stands now, things are moving so fast in this gizmo-gadget trading world that some cheetahs claim they don’t even know when wash trades occurs—if their dancing with their self. That’s not a fantastical answer when regulators start asking questions.
5. Compliance Reports: I’ve also recommended that there be periodic compliance reports from the cheetahs and that the senior executives sign their names and are held accountable for any false or misleading information. The days of “he said, she said” responsibility in financial markets needs to end.
6. Penalties: Finally, and this goes to accountability, also. If there is another flash crash where people are damaged (they lose money) due to a rogue cheetah, I think there need to be steep consequences. And when I say consequences, I'm talking not just for the firm, but for individuals at the firm. If the cheetahs want to be involved in the high-flying, incomprehensible gambling world, okay, but if you cause harm to markets and consumers, we shouldn't stand for it.
In that vein, today I’m calling for significantly increased penalties for cheetah trading that results in harm to our markets. And here’s how I propose doing it: we need to re-think what the term “per violation” means. Let me explain.
Under our statute, we can fine a miscreant $140,000 per violation—and that used to be sufficient. That dollar figure made sense in yesterday’s world of human-to-human trading. But it doesn’t work in these markets, in this incredibly fast-pace, instantaneous-almost-incomprehensible world of cheetah trading. So, my idea is that we revolutionize how we determine what “per violation” means. In the past we’ve looked at, say, each day that someone breaks the law, and for each single day, make that one violation. That’s not good enough anymore.
Today I’m suggesting that we look, not at each day of trading as being one violation, but instead look at each second. That’s right: each second. So, for every second that a cheetah trader is engaged in conduct that violates our law, we could fine them the statutory maximum of $140,000—and that could add up to sufficiently high penalties so that they actually mean something. Hey, this type of unfathomably fast trading can reap millions for the guys betting with their algorithms, and at the same time it can wreak havoc on our market players and legitimate trading of investors and consumers—we need to have a fitting consequence for rule violators, a whack that actually has some teeth.
I’m calling today for this new type of calculation, because if we don’t do something like this, our fines can be essentially meaningless—just a slap on the wrist, cost-of-doing-business. It’s this simple: if you’re making millions in seconds, then you should be liable for fines for bad conduct, counted in seconds. I know this is a revolutionary way of thinking about money penalties, but I believe it’s a necessary step to take in order to both deter illegal conduct and assess sufficient penalties to bad actors in our markets.
Well, we’ve gone through the entire deck, I suppose we got our poker on. We talked Dodd-Frank, we talked about a need for a culture shift in the financial sector, betting limits for speculators, and potential issues with technology and our cheetah friends. As you may be able to tell, I don’t hold my cards too close to my chest. I appreciate the chance to speak with folks like you about some ideas and to get your thoughts especially. But, I know you’re on a schedule and I know when to fold ‘em. So, that’s it—game over. Everybody throw in your cards.
Thanks for playing.
Last Updated: October 19, 2012