“Regulatory Relativity”

Commissioner Bart Chilton’s Keynote Address to the 7th Annual OTC Derivatives Operations & Processing Conference, New York, NY

November 14, 2012


Hello! It’s good to be with you today. Thank you for the kind invitation. Let’s do something unconventional, shall we? Let’s discuss financial regulatory reform with some scientific metaphors. Let’s talk regulatory relativity. Let’s talk Dodd-Frank—that is: the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

As we begin, recall that Albert 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.


Perhaps a slight review will aid in setting the stage for where we are. We all know that in 2008, we began suffering from the most catastrophic economic collapse since the Great Depression—a colossal collapse. The catalyst for the collapse was two-fold, according to the Financial Crisis Inquiry Commission (FCIC) which was charged by Congress with determining what went wrong. Their summary: government, regulators and regulation, or to be precise, lack thereof; and second, the captains of Wall Street who—given this lax regulatory environment—pillaged it until the economy collapsed. There, pretty simple, right? Well, obviously it is more complicated than that. But, let’s stick with that since we have so much to get to.

Here is what we know. We bailed out some of the largest financial firms in the nation with over $400 billion of taxpayer dollars. What did we get for that? Well, nine million people lost their jobs and millions more their homes. The top executives at the firms who received the bailout still received multi-million dollar bonuses. And, as the rest of us are still struggling to overcome that economic collapse these many years later, guess what sector of the economy has done better than all others. You guess it: the financial sector.


Now then, maybe a little physics review is in order. There isn’t a need to take notes. There will be no test. But, let’s just review something to put this relativity idea in perspective. Everybody remembers Sir Isaac Newton, right? (Well, maybe not personally but you know the name). Newton’s theory of gravitation was accepted for decades without question. But, then along came our previously quoted Albert Einstein. He came up with his Special Theory of Relativity in 1905 and his General Theory of Relativity in 1915, totally shaking the foundations of physics. He showed that Newton's Three Laws of Motion were only approximately correct but that they broke down when speeds approached that of light. He also showed Newton's Law of Gravitation was only kinda correct, but that it broke with very strong gravitational fields.

The point is people thought Newton was right, but it turns out Einstein corrected Newton. In science, and yes, in financial reform, there is relativity. Things are changing all the time. What we think we know isn’t always right, like Einstein proved. While it may not look like it, what you may think is a puzzle is coming together a piece at a time. Let me explain.

There were 398 rules that needed to be promulgated by various financial regulators as a result of Dodd-Frank. Of those, only about 33 percent are complete—133. We at CFTC have done somewhat better, having finished roughly two-thirds of our 60 rules. One thing is for sure, all of these rules, are in one way or another, inter-connected, regardless of which agency is writing them.

Rather than go through all of the 60 CFTC rules and regulations, let’s summarize the types of things we are going to do and put them into three groups: Transparency, Market Integrity and Accountability.

1—Transparency:  Has anyone been to the optometrist lately? The eye chart you read when you visit the optometrist is called the Snellen Scale. 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. Happily, Dodd-Frank has provided us with one. After all, it was those very markets that were a major part of the problem that caused the colossal economic collapse.

To put it in perspective, the CFTC previously regulated around $5 trillion in annualized trading on registered exchanges. That was our space.  OTC trading, however, according to brand new estimates, accounts for $639 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 provide the transparency in the precise markets that got us into distress 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. The same is proper for markets. They need integrity to be valuable. Consequently, we also want to assure that people don’t take risks that destabilize the integrity of markets or the complete financial system.

Risk is part of markets—sure—you know that better than most. People 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 entire economy can’t be left swinging, too. Therefore, we’re instituting new capital and margin requirements and clearing.

Most of us want markets to accomplish the fundamental functions originally intended: to manage risk and discover prices. That’s good for commercial hedgers and, eventually, it is good for consumers.


One area within market integrity I’ll note in passing is speculative position limits. As you may know, this has been a specific area of concern for me and many others. We experienced a trifling setback in court recently. We will appeal, and I believe we will do so very soon. Concurrently, we need to propose a new, revised position limits rule and I’m confident we will do so. There’s no reason for an extensive comment period on the new rule. We already received more than 13,000 comment letters, so we have a more than decent idea of what people believe.

I’m convinced, as are a lot of other folks, that there can be a speculative premium in markets and that tilts their price discovery function. That’s not a good thing. So we’ll keep fighting for position limits.


And, a final market integrity area that wasn’t even mentioned in Dodd-Frank: High Frequency Traders. Those cats I call cheetahs because they are so fast, fast, fast. They are out there 24-7-365 trying to scoop up micro-dollars in milliseconds—milliseconds. That’s one-one-thousandth of a second. I’m told from the authoritative source, the internet, that that if you are traveling at 100 miles per hour, a millisecond is the time it takes you to travel two inches—two inches!

Cheetahs have some positive attributes for markets, yet their trading is totally unchecked by regulators. In fact, they aren’t even required to be registered. So, we should do that, and require that they test their programs, have kill switches and when they violate the law, we should fine them by the second. They can make millions in seconds and our fine regime should be updated to reflect the new clip of trading.

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 myriad mischief 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 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 change in 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.

This isn’t a very scientific discussion I’m suggesting. Both the government and the private sector need to be in it. And what we should be talking about is more about good business ethics and practices. After all, government can’t regulate morality. I do believe the cultural mindset in many financial firms needs to change. I say that based upon some of the examples I cited earlier and others in the media, but I also know from what we have been looking at from an enforcement perspective that there are a lot of other shenanigans taking place. It really is enough, already.

What I’m suggesting is simply an effort to improve the system and move away from the Gordon Gekko “greed is good” philosophy 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.

The Volcker Rule

Finally, I want to talk just a bit about the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker. What the Rule says—and this is a law, it is part of Dodd-Frank—is that banks, with some exceptions, may not trade for their house account. The point of this is to ensure that banks don’t put their own interests ahead of their customers.

When the Depression-era Glass-Steagall Act was repealed in 1999, that allowed banks to engage in all kinds of trading on both sides of the fence, for proprietary accounts and for customers. That’s what Goldman and Citi did to their own customers because they—the banks—could trade for themselves. So, it created a conflict: were they trading to make money for themselves or for their customers? Sure those two things could go in sync, but they don’t have to, and as it turns out on a few memorable occasions, they didn’t. Therefore, the need for the Volcker Rule, which essentially reverts, to a large extent, to how banks operated prior to the Glass-Steagall repeal.

There is a problem, though. There is the possibility of a loophole. You see, there is a provision of Volcker that says regulators must allow banks to trade if they are merely hedging their own risk. Under Volcker, the banks can’t speculate in the markets for themselves, but they will be allowed to trade in order to hedge their own business risk. The difference between hedging and speculating, however, isn’t always black and white.

Say I work at one of these banks and I place a hedge for some business concern the bank holds. Everything’s okay so far. But what if that hedge gets into the money? What if it turns out that the trade was something that made a lot more money than the loss on the underlying risk. Doesn’t that cross the line into speculative, proprietary trading?

Getting the Volcker Rule correct is fundamental to ensuring that Dodd-Frank works the way Congress intended. It is at the core of the foundational regulatory changes to the financial system. Will it change the culture? No, not by itself. As I said, we need that culture shift conversation and we need all those Dodd-Frank rules and regs. At the same time, a strong Volcker Rule will help immensely.

The New Frontier: SEFs

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

I can’t speak for the commission on this, but I can say what I think and hope will happen with our SEF proposal. I hope we finish it by the end of this year, although 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. 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.

Conclusion: The Observer Effect

A final physics thought as I leave you. There’s a term in physics termed the “Observer Effect.” Anybody heard of it, Bueller? It refers to changes that the very action of observation causes while any phenomenon is being observed. It makes sense, actually. Sometimes the exact instruments used to observe something create the alteration. Think of a really simple example. If you check the air pressure in your vehicle tires—at least if you’re like me—it’s virtually impossible not to let some air out when you put the gauge on the valve stem. So, do you get an unspoiled reading? It’s probably a very close reading, but the observer effect foils it from being perfect. The same is true when you take your temperature. The mercury in the thermometer deviates ever so marginally throwing off the result in a minuscule manner. It’s so trivial 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, like many of you. Other agencies and even fellow regulators in other countries are consulted. Whenever those things happen, rules and regulations are bound to change from those originally proposed. It’s the Observer Effect and it isn’t only a principle of physics, it is a principle of good government. I encourage you to be a part of it.

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