Public Statements & Remarks

“The Observer Effect”

Commissioner Bart Chilton’s Speech to Risk USA 2012, New York, NY

November 14, 2012


Good morning! It’s good to be with you today. Thank you for the kind invitation. Let’s do something a little unconventional this morning. Let’s talk about science as our guidepost for what’s going on with financial regulatory reform under Dodd-Frank—that is: the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. As part of that, we will of course want to talk risk—a reason you’re here at Risk USA.

As we get started, I’ll remember Albert Einstein’s quote: “You do not really understand something unless you can explain it to your grandmother.” So, I’ll try to keep the science and the financial markets stuff pretty straightforward.

The Catalyst

Maybe a little review will help set the stage for where we are. We all know that in 2008, we began experiencing the most disastrous economic meltdown since the Great Depression—a colossal collapse. The catalyst for all that was two-fold, according to the congressionally established Financial Crisis Inquiry Commission, or FCIC: Regulators and regulation, or lack thereof; and the captains of Wall Street who took advantage of the lax rules and regulations. Those two things together caused a reaction that created the economic chaos, our Great Recession. Institutions that were thought to be too big to fail—failed. Taxpayers were stuck with a hideous bailout. Nine million people lost their jobs and millions more their homes. It was an economic force that created havoc of which we’re still trying to pull our way out.

Fundamental Forces

That fundamental economic force led to the creation of something novel: Dodd-Frank. Now scientists, I mean regulators, are in the process of implementing that financial reform. I will be the first to admit to you that it’s been a slow process. But there were 398 rules that needed to be put into test tubes and experimented with before they were deemed appropriate. Of those 398 Dodd-Frank rules to be promulgated under the Act, only about 33 percent are complete. We at CFTC have done a little better with our experiments, having completed about two-thirds of our 60 rules. One thing is for sure, all of these rules, these different experiments, are in one way or another, inter-connected, regardless of which agency is writing them. They are not done in isolation.

The Observer Effect

Now then, maybe a little physics review is in order. No need to take notes. You won’t be tested. There’s a term in physics called the “Observer Effect.” Anybody heard of it? It refers to changes that the very act of observation causes when any phenomenon is being observed. It makes sense, really. Sometimes the very instruments used to observe something create the change. Think of a really simple example. If you go to check the air pressure in your tires—at least if you’re like me—it’s almost impossible not to let a little air out first when you put the gauge on the valve stem. So do you get a perfect reading? It’s probably a very close reading but the observer effect prevents it from being perfect. The same is true when you take your temperature. The mercury in the thermometer changes ever so slightly throwing off the result in a minuscule way. It’s so small that it’s not even observable to us.

Bear with me. In financial reform too, there is an observer effect. While it may not look like it, the Dodd-Frank implementation experiment is coming together a piece at a time. And what’s going on is influenced to a large extent by an observer effect. First, the rules aren’t written in a vacuum. Public comments are collected from interested observers. Other agencies and even brethren regulators in other countries are consulted. Whenever those things occur, rules and regulations are bound to change from those originally envisioned.

So, now let me go through all 60 rules and show you how the observer effect has affected them—just joking. What we can do is to summarize the types of things we are doing and put them into three categories: Transparency, Market Integrity and Accountability.

1—Transparency:  Has anyone heard of the Snellen Scale? It’s the eye chart you read when you visit the optometrist. Well, for years hundreds of trillions of dollars’ worth of trading taking place in the over-the-counter (OTC) space was totally off the chart. We regulators couldn’t see it. We needed an eye chart. Fortunately, Dodd-Frank has provided us with one. After all, it was those very markets that were a major part of the problem that caused those two catalysts (that we discussed earlier) to react.

To put it in perspective, the CFTC previously regulated around $5 trillion in annualized trading on registered exchanges. That was our universe.  OTC trading, however, accounts for upwards of $650 trillion! Off the chart again! That’s globally, to be fair, but a lot of it is here in the U.S.

With Dodd-Frank, that OTC trading will be conducted on regulated exchanges—many on Swaps Execution Facilitates, or SEFs.   Swap Data Repositories, or SDRs, will—guess what—collect data.  Those SDRs will afford the transparency in the particular markets that got us into trouble in 2008.

2—Market Integrity:  Like in scientific experiments, you can’t be sure of your results until you have integrity in your testing regime. Same is true for markets. They need integrity to be worth much. Therefore, we also want to guarantee that people don’t take risks that undermine the integrity of markets or the entire financial system.

Risk is part of markets; you guys know that better than anyone. Folks should be able to take as much risk as they’re comfortable with.  But, if they give themselves too much rope and hang themselves with it, the whole economy can’t be left swinging, too. Therefore, we’re instituting new capital and margin requirements and clearing.

Most of us want markets to perform the fundamental functions originally envisioned: to manage risk and discover prices. That’s good for commercial hedgers and, ultimately, it is good for consumers—heck it’s good for scientists!

One area under market integrity I’ll just mention quickly is speculative position limits. As some of you may know, this has been a particular area that has concerned me. We suffered a little setback in court last month. All I’ll say now is that we need to appeal the court’s ruling and I expect we will do so very soon. Simultaneously, we need to propose a new, revised position limits rule. There’s no reason for a long comment period. We already received more than 13,000 comment letters so we have a good idea of what people think.

I’m convinced, as are a lot of other folks, that there can be a speculative premium in markets and that skews the price discovery tenet of them and that’s not a good thing. So yes, for my part, I’ll keep fighting for position limits.

3—Accountability:  The third and final Dodd-Frank grouping is accountability. Once a scientist has demonstrated something, he or she wants to put it out for peer review. It needs to be subject to the views of others. Similarly we need to listen to others as we oversee these financial markets. Here’s a question I’ve listened to many times: why is it that nobody went to prison for what took place in 2008? Unfortunately, the answer is that nobody violated the law. Well, that’s changing with Dodd-Frank. There will now be financial firm accountability, and not a moment too soon.

Most of us can’t even keep track of all the shenanigans going on in the financial sector. We saw both Goldman Sachs and Citi establish these fake-out funds where they pressed their customers to participate, then, once the fake-out funds were populated with their own customers’ money, the banks themselves took the opposite positions. There’s something wide of the scale with that. Wells Fargo entered into a $175 million settlement with the Department of Justice for charging higher fees and rates to minority customers. Barclays attempted to manipulate Libor rates. And of course, there’s MF Global where, oops, millions-and-millions of customer bucks went missing. And, there’s Peregrine Financial Group which appears to have been a $200-plus million fraud.

There are a lot of other examples of what the financial market mad scientists have done, but I bring up those few to illustrate why accountability is the needed third leg of the stool under Dodd-Frank.

Just recently, we proposed a package of accountability and customer protection rules. I’m not going to get into the technicalities of each of those proposals due to time, but suffice it to say we need them and need them now.


There is, however, one thing that we cannot do to help futures customers. This can only be done by Congress. That is: a futures insurance fund.

How unfair is it that MF Global security customers were paid first compared to the futures customers? How unfair is it that banking and security customers both have insurance funds, yet, if you’re a futures customer, you’re outta luck.

Up until MF Global and Peregrine, I suppose people would argue there has never been a problem and that the remedy was not needed. Well, that’s a tough argument to make now. People were really harmed and I think it is irresponsible that there is not such an insurance fund for futures customers.

So that’s the big three: transparency, market integrity and accountability.

A Culture Shift

While Dodd-Frank will go a long way toward remedying the chaos created in 2008 and beyond, it won’t address all of the ills in our financial system…unfortunately. We also need a little observer effect to change the culture of Wall Street. That may mean that people should walk with their wallets if they don’t want to do business with poor corporate citizens. That’s a hefty mandate, but one that I believe is absolutely necessary. Let me explain.

I’ve been suggesting that we engage in a culture shift conversation, a shift in focus in our financial sectors. Both the government and the private sector need to be in on the discussion. This isn’t a very scientific discussion I’m suggesting. It is more about morality and good business ethics and practices. After all, government can’t regulate morality. The cultural mindset in many financial firms is something that needs to change.

What I’m suggesting is simply an effort to improve the system and move away from the Gordon Gekko “greed is good” culture in which we appear to, on many occasions, be sliding into. It will take some time and should take place in executive suites, board rooms, lunch rooms, hearing rooms, and perhaps even in court rooms.

Compensation Systems

So, what’s to be done? Well, for one, just look at the bonuses and compensation structures of these large financial firms. Of the firms I mentioned earlier, many of their CEO’s were paid extravagant amounts in 2011—from $10 to $23 million. So, they are being rewarded for how they have been operating. Way to go.

However, it surely isn’t just the people at the top. The difficulty is more deeply-rooted at firms. Lots of times, firms have been rewarding the cowboy traders. Did you read last week about the high-flying UBS trader who lost billions in London? His compensation rose dramatically, totally based upon a bonus and compensation system of rewarding high-flying trades. The problem there was he wasn’t really making money—sort of like the London Whale with JP Morgan earlier this year. There is something called a “failure to supervise” on the part of firms. Not sure what is up with the firms on these things. But the larger point is that the traders have been propelled by a compensation and bonus system which is out of whack. The firm’s short-term profit motive has been so fantastically strong—for the next quarter or next year—that they have been risking their entire firm’s reputation and existence on short-term gain.

The irony is this belief system of “profit is everything” won't generate the long-term gains the firm shareholders seek. I’m sure the boards are smarter than to only see a few months ahead. What they want is sustainable longer-term economic business growth.

Hiring and Recruitment

Here’s another thing. Rather than hiring a lot of cowboy traders, how about getting more risk professionals—those actually good at risk management. That means recruiting and hiring strategies need to change.

There needs to be a better sense of balance between profit and risk centers. The executive suite folks need to understand and create this balance as part of the corporate culture.


As I said, government can’t be culture cops and mandate morality in financial firms, but we can set the stage for avoiding bad behavior. More importantly, we can incentivize good behavior through our laws, rules and regulations. The Dodd-Frank Act goes a long way in this regard. Specifically, we can help establish an environment in which these firms operate with appropriate transparency, integrity, and standards of conduct.

And finally, in order to help spur this culture shift conversation, we need to re-focus ourselves as regulators on fines and penalties that actually mean something. Fines can’t simply be a cost of doing business. Government is strapped for funding and that means we don’t have the staff to do all that we would want. We could use more investigators and attorneys. The cost of us not having adequate resources is that we often would prefer to enter into a settlement with a firm or individual that has violated the law. That saves us scarce resources. At the same time, the nogoodniks know our deal and they continually try to low-ball on settlement amounts. They have done such a good job; executives at firms are making crude calculations about fines. When the fine is minuscule compared to what can be gained through the illegal activity, that’s not a true deterrent. Merrill Lynch, for example, over-charged their own customers for debit and over-draft fees by $32.2 million. The fine (and this was not the CFTC) was only $2.8 million. That seems like an economic no-brainier. Government needs to do better and we don’t need any scientific experiments to tell us so.

The New Frontier: SEFs

Finally, let’s discuss the Swaps Execution Facility rule.

First (my attorney always makes me say this) I’m not pre-judging what the Commission will do on this rule. I’m just going to comment on about my preferences—which, of course, happen to be correct.

This challenge is really different from just about any experiment we’ve ever conducted. It’s not like drafting regulations for the securities and futures markets that were already well-established when rules governing them were put in place. In this instance, while we had a robust swaps market in the U.S., prior to Dodd-Frank, we did not have a system making the platforms registered entities. Therefore, it’s been a challenge to design the right rules, to carry out the intent of Congress and to ensure that systems intended to be covered by the law are not over- or under-regulated.

For me, ensuring that existing systems, like appropriate voice brokerage, can continue to be used in the SEF environment, is crucial. I also want to ensure that processors—those folks who were truly just facilitating trading, not actually hosting the trading—don’t fall under the SEF umbrella. Again, that’s not what Congress intended. Finally, under the law we are not only supposed to ensure pre-trade price transparency, but at the same time we are to promote the trading of swaps on SEFs. Neither goal outweighs the other. If we pass a final rule which embodies these things, we will have done a good job in my view. And this experiment will be a success not for just a short time, but SEFs will exist for a long time. So, I’m looking forward to getting this final rule out, and moving on from there.


It has been a pleasure to be with you and run through all of these issues. I know it is a lot, but as you may have observed, there’s a lot going on in our markets today and a lot being done in financial regulatory reform.

Maybe you can recall another Einstein quote: “The world is a dangerous place to live; not because people are evil, but because of the people who don’t do anything about it.” I’m glad you guys are here and are involved in all of this. I commend you.

We’re trying to make the implementation process as transparent—as observable—as possible. We had a financial crisis caused by those catalysts – government and Wall Street. The effect was Dodd-Frank. Our work is to ensure that the new law addresses the problems in an appropriate fashion. To use another scientific rule, that there is an equal and opposite response. As I’ve tried to illustrate, the pieces of financial reform are relative to one another and relevant to all of us. I hope that in the not too distant future, we can observe this period as having been a crucial time for improving our markets and thus, the economic engine of our democracy.

Thank you.

Last Updated: November 14, 2012