SPEECHES & TESTIMONY

Remarks of DSIO Director Joshua B. Sterling Before the K&L Gates Chicago Investment Management Conference

November 14, 2019

Trillions.

Introduction.

Good morning.  I wish to begin by thanking K&L Gates for hosting this important conversation, and for the hospitality that they have extended to all gathered here today.

It is impossible to overstate the value of the bar in an open society that is sustained by a common respect for natural rights, fealty to the law, and the coruscating power of free markets.  Those markets afford a broad and grand wealth unparalleled in human history, and they operate under laws enacted with the consent of the governed.  General prosperity is only possible in such a system.  The alternative prescription of resource distribution by fiat would visit upon everyone a moribund and general destitution, delivered by a government of thuggery, cloaked in the color of law and malevolent towards the very idea that individual freedom is the birthright of all.

In our system, the bar is a protector of freedom and a guarantor against the creep of soft despotism.  So I have always been, and will remain, proud to be a member of the bar.  It has given me the great privilege of serving clients in the exercise of their rights under the law in our free society.

Today, of course, my one and only client is the greatest of all — the United States of America.  I bear in mind the lessons of my years in the private bar as I seek to walk circumspectly in overseeing registered firms that play such a vital role in our great markets.

Let us then talk about a group of registered firms that exercise tremendous power in the derivatives markets.  Given this audience, I refer to asset management firms that are commodity pool operators (CPOs) and commodity trading advisors (CTAs).  We will explore the CFTC’s role in overseeing CPOs and CTAs as we further our mission of promoting the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.  That oversight must consider the evolution of the asset management industry and the likelihood that the vital role your firms play in our markets will continue to grow.

Before going any further, and in case my “free markets forever” riff hasn’t made it clear enough, the views I express are my own and not necessarily those of the Commission or its staff.

Bigger, Faster, Stronger.

Years ago, my old football coach convinced the team that an offseason of following the Bigger, Faster, Stronger training program would help us improve on the field.[1]  By using weightlifting to shape specific muscle groups, our combined physical prowess would make for a better team that got better results.  I quit the team after my first year because I was athletically hopeless, but the idea of combining strengths across all positions on the squad made a lot of sense.

As I look at the asset management industry, I recognize a similar trend towards getting bigger, faster, and stronger.  The financial press abounds with news of the industry being shaped by competitive pressures and broader economic trends.

To wit:

  • Bigger.  Over the past several years, investors have generally pushed their assets into a smaller set of very large funds.  The funds that are winning these investor flows can deliver greater economies of scale and more attractive pricing, putting those funds that are experiencing significant outflows at a real competitive disadvantage.  Some funds have achieved such great scale that they can even offer “no fee” share classes, presumably because revenues from securities lending and other portfolio-related activities make that choice commercially viable.
  • Faster.  Technology is increasing the velocity and volume of everything, including investment decisions.  Some asset managers rely exclusively on algorithms and other quantitative tools to pursue high- and mid-frequency trading strategies, pushing the speed curve to impressive lows.  Other, more traditional managers increasingly incorporate quantitative tools into their portfolio management activities as a complement to fundamental research, factor analysis, and other longstanding investment techniques.  Even more advanced tools, like quantum computing, are on the industry’s event horizon.[2]  There are indeed many more ways that managers will seek to capture returns, ever more quickly, while asset prices take their proverbial “random walk” down Wall Street.[3]
  • Stronger.  Large managers are becoming larger still through strategic transactions and business flows driven by investor preferences.  The leadership of one global asset manager has even suggested that a third of his peer firms could cease to exist over the coming years, due to consolidation driven by competitive pressures.[4]  Firms have grown to running several hundred billion or even trillions in client assets by offering compelling products, cutting-edge technology, and excellent investor services.  Amid these large-scale transactions and the undeniable comparative advantage of scale, I am reminded of the time, not long ago, when a general counsel quipped that a trillion in assets under management would be table stakes for the next decade.

It is not the CFTC’s place to dictate the direction or pace of product development.  Nor does it get involved in strategic transactions.  Yet the evolution toward bigger, faster, and stronger in the asset management industry will undeniably affect the derivatives markets.  This ongoing change will implicate my Division’s strong interest in ensuring effective oversight of CPOs and CTAs, given the CFTC’s market oversight and investor protection mandates.

Your Market Impact and Our Market Resiliency.

Let me lay out some more plain facts:

  • As a class, asset managers have long been among the largest participants in the futures markets, measured both by transaction volume and open interest.
  • The data say much the same for our swaps markets.
  • Asset managers are also the largest providers of market liquidity that we regulate.
  • To provide liquidity is also to transmit risk.

If we take as true the proposition that asset managers will continue to get bigger, faster, and stronger, then these facts suggest a strong likelihood that asset managers will only grow to have a larger impact on our markets.  If scale in asset management leads to greater concentration in portfolio decision making and risk management, then there’s a real potential for very large managers to move markets in ever greater proportions of size and speed.  It’s reasonable to anticipate that the various dependencies in our markets will experience outsize effects from this increasing scale.  In this regard, I refer to the connections with and among FCMs, swap dealers, contract markets, swap execution facilities, and clearinghouses.

In relation to our markets, scale has to be considered in relative terms at the level of an asset management organization, less so in the absolute terms of separate client and proprietary accounts.  Putting this notion into more specific relief, if a large firm has a centralized investment function (e.g., a global CIO), we can reasonably expect coordinated decision making among several accounts when the firm seeks to express a particular view, whether in taking or offloading risk.

Even if there is no single “large” position relative to the market in question, the accumulation of several individual positions across the same organization can be quite “large” in the aggregate.  So, several investment decisions that express the same view can have a market impact that could, in certain circumstances, affect market resiliency.  And this is to say nothing of larger firms that trade “large” positions, or even the high- and mid-frequency firms that use their speed and agility to trade in and out of positions quicker than a heartbeat.

We also have to consider the impact of bigger, faster, and stronger given where asset managers lie on the continuum of liquidity and risk transmission, and the interconnectedness of our registrants that transact in client, customer, and counterparty assets:

  • Liquidity and Risk Continuum.  CPOs and CTAs lie at the outside of our markets, typically as initiators of derivatives trades.  By placing trades and maintaining positions, they push liquidity and risk along strings that are tied either to the middle of the market through FCMs, in the cleared context, or to swap dealers, in the bilateral context.  Those FCMs and swap dealers are often part of larger financial holding companies that have significant connections to the financial system.  So, as a bigger, faster, and stronger asset manager pushes or pulls on any of those strings, it can greatly affect the liquidity and risk attributes along the continuum for cleared and uncleared trades in our markets.  And our markets are tied to the broader financial system in many ways, most immediately through participation in clearinghouse guarantees and by the connections that bank-affiliated firms have to deposit taking, lending, and other banking activities.  This proposition will hold even more when multiple large asset managers push or pull these strings at the same time and in the same direction.
  • Interconnectedness.  Liquidity and risk are transmitted from the many CPOs and CTAs into the many fewer FCMs and swap dealers that take their trades.  The number of FCMs has shrunk dramatically over the past 15 years.[5]  Among the remaining 55 registered FCMs with customer business, our data indicate that just 10 firms hold about 75 percent and 93 percent of customer funds for futures and foreign futures, respectively, 17 FCMs alone are responsible for all customer cleared swaps activity.[6]  As for swap dealers, while there are 107 registered firms, our data show that, as of the end of the second quarter of 2019, just 10 swap dealers accounted for well over 50 percent of total dealer swap positions.

To sum up, I do not consider bigger, faster, and stronger asset managers as inherently good or bad.  And I recognize the potential advantages of size, speed, and scale for investors and clients.  We must also give due consideration to the existing rule framework for other registrant categories that both seek to mitigate risks — such as margin, capital, and risk management requirements — and to provide transparency through mandatory reporting.

We do, however, have to accept these facts and the propositions that flow from them as true.  When we do so, it’s undeniable that we have to evolve in how we oversee CPOs and CTAs.  But we must do so carefully.  Our role is not to call shots in the evolution of the asset management industry, but to promote the strength, resiliency, and vibrancy of the markets in which asset managers operate.

Respecting the Critical Role of Asset Managers in Society.

The CFTC’s uptake in responsibility for asset management was sudden and significant, starting in earnest earlier this decade.  Despite some hue and cry about this development at the outset, I’ve seen little in the years since that would dissuade me from carrying our oversight forward.  Your firms are getting bigger, faster, and stronger all the time, and our oversight needs our rules to keep up with how your size, speed, and agility affect our markets.  It’s as simple as that.

While that idea is simple, my own respect and admiration for asset management is profound.  The impact that your firms have on the lives of all Americans is singular.  I think of my own family, and how the transformation of income to investment, and investment to wealth, has made all the difference.

As a kid, I remember the day my father came home with a new and rather basic Ford Ranger pickup; the only extra was the red paint.  Times were tight.  But my parents always invested, and they had the opportunity to make prudent choices based on the myriad of sound investment products available to retail investors.  My parents are now enjoying their golden years with a solid nest egg built over decades of hard work and savings.

I will never forget this life lesson as I think about how we should balance our need to oversee registrants, as they put client and investor money to work, and the imperative for asset managers to deliver on the promise that our free markets offer to all.

*****

Thank you for your time.  In the end, we want our regulation of CPOs and CTAs to be smart, effective, and practical.  To do that, we have to keep up with the significant changes underway in the asset management industry.

My world-class staff and I look forward to working with you.

Thank you all again.

 

[2] Risk.net, “Barclays, IBM test quantum computing for settlement” (Oct. 17, 2019), available at https://www.risk.net/risk-management/7087566/barclays-ibm-test-quantum-computing-for-settlement.

[3] Malkiel, Burton Gordon, A Random Walk down Wall Street : the Time-Tested Strategy for Successful Investing, (New York, W.W. Norton, 1973).

[4] Financial Times, “One in three asset management firms could disappear, says Invesco Chief” (Mar. 13, 2019), available at https://www.ft.com/content/c4ff2a92-4508-11e9-a965-23d669740bfb.

[5] At the end of 2004, a total of 190 FCMs were registered with the Commission, compared to 64 registered FCMs as of the end of September 2019.

[6] See Selected Financial Data as of September 30, 2019, from reports filed by October 24, 2019, available at https://www.cftc.gov/sites/default/files/2019-11/09%20-%20FCM%20Webpage%20Update%20-%20September%202019.pdf.