“T Minus 0”
Speech of Commissioner Bart Chilton to the 4th Annual Risk Management in Energy Trading Conference, Hotel Derek, Houston, Texas
November 8, 2011
Introduction
It’s good to spend some time with you today in Houston. Thanks for having me. Thanks especially to Jeremy Anders for the invitation.
The watch I'm wearing—an Omega Speedster—has a date on it: July 20, 1969. Does anyone recall what took place on that date? That's the date of the first moon walk. Neil Armstrong and Buzz Aldrin wore one of these watches on the outside of their space suits. On the back side of the watch, it says, "Flight qualified by NASA for all manned space missions—the first watch worn on the moon."
When people think of Houston, it is obvious for those in the financial markets arena to be reminded of the Port of Houston and of the vast array of energy-related businesses in this area. For me, however, I also think of our space program. I remember watching that first moon walk when I was a kid. When I went to college at Purdue, I was proud to be a member of an organization that Neil Armstrong belonged to when he was at Purdue. In 1985, when I first started working on Capitol Hill, I was assigned to work on issues of the Science and Technology Committee. That Committee was responsible for oversight of NASA. I remember watching the space shuttle Challenger take off in early 1986, thinking what a neat thing it was that I could watch a lift off and that it was also part of my job. Shortly after launch, the Challenger Commander said, “Roger, go at throttle up.” Then the shuttle exploded. It wasn't neat anymore.
Within a few days, I was representing my boss, Congressman Terry Bruce (an outstanding Member of Congress and person, in general) in the NASA Administrator's office off of Independence Avenue. Of course, I was young and a non-entity in the room. We all had top secret security clearances and I just sat there listening to the briefing and the questions. After that, our Committee began an investigation into the cause or causes of the accident. Many of us recall the infamous "O-ring"—essentially a large rubber-like gasket, as it was explained to me that deteriorated between the solid rocket booster segment containers. It failed, and the Challenger was lost.
What most people don't know, although this has been in the public since then, is that our MX nuclear missiles used similar O-rings made by the same company. I'm sure they have all been replaced.
Other than Challenger, there was really only one time I recall receiving information that I guess was top secret. That had to do with the first supercomputers. The cold war was still going on and there was a race to develop the fastest computing technology. These fast computers could be used to probe the depths of physics, do enormously difficult calculations nearly instantaneously, and for good measure, assist in our national defense, on things like simulating wars (Star Wars, if you will) using some of those very same MX missiles.
Today, I'm sure some of the most sensitive things out there are actually the algorithmic programs that run things like our national defense, telecommunications and energy operations. What we know is that this technology isn’t just for breakfast anymore. Nope, algorithmic programs are part and parcel to a lot of things, including trading in financial markets.
It’s Complicated
We don't live in simple times. We live complex lives, with new and emerging technologies, intricate and inter-related global financial markets of enormous size and breadth. We have banks that were so large that when they were toppling, or about to topple, we—all of us—had to fork over hundreds-of-billions of dollars in a hideous bail out. Those that took the bailout, by and large, are doing just fine thank you. They have done so well that they've paid their senior executives millions in bonuses. I mean individuals have received millions in bonuses. And why did that all happen again?
Well, there isn't much doubt about the causes of the economic crash. The Financial Crisis Inquiry Commission (FCIC) established as part of the bailout—the Troubled Asset Relief Program or TARP—concluded that there were two culprits to the crisis. One culprit: regulators. You see, in 1999, Congress and the president deregulated banks. They were no longer bound by the pesky Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. After that, regulators got the message to let the free market roll. And, roll it did. It rolled right over the American people.
The second culprits, according to FCIC, were the captains of Wall Street. Since they were allowed to do so much more without those rules and regulations, they came up with all sorts of creative and exotic financial products. Credit Default Swaps (CDSs)—bizarre deals on mortgages for potential homeowners and bets upon bets upon bets that were sold and resold to their contemporaries on the Street—became the norm. This helped to create an entire market out of the view of regulators. Hundreds-of-trillions of dollars of trading took place completely, utterly off regulators' radar screens. The value of these things was in the eye of the beholder. Folks were over-leveraged if their books called for it to be so: think Lehman Brothers who were leveraged 30 to 1, according to its last annual financial statement. That showed that the firm had $691 billion in assets divided by only $22 billion in actual shareholder equity. And then, in 2008, it all started to unravel.
MF Global and the Mysterious Missing Millions
We don’t need to recall the events of 2008, however, to have a fresh slap-in-the-face reminder that we need appropriate regulations in place now. MF Global is the new poster child for why thoughtful financial regulation is needed, now more than ever.
For us, job one is always—no excuses—to ensure that customer funds are held sacrosanct in what are called “segregated accounts,” and that they are safe and secure. In this case, as the Stones sing, we “got no satisfaction.” Our staff scoured their books, and let’s just says we bring on the Beatles here: It’s been a magical mystery tour trying to find the loot. Half-a-billion dollars seems to have gone missing! I don’t know about you, but losing a half-billion dollars harshes my mellow. If I drop a quarter at some drive-through fast-food joint, I get out and pick it up, but, a half-a-billion dollars?
We need to ensure that customers—and markets—are protected to the fullest extent of the law. I can tell you that we are using any and all of our myriad authorities under the Commodity Exchange Act (CEA) in this endeavor.
We’ve got expert staff that have been on this around the clock and who will continue to argue aggressively in U.S. Bankruptcy Court to protect investors. We will keep on and we will continue, with whatever develops in this matter, making customers our first priority.
Segregated Accounts—Show Me The Money
Why is MF Global the new poster child for regulation? Well, it isn’t a generic claim I’m making. In 2004, the CFTC allowed for these things called internal repurchasing transfer agreements, or repos, using segregated funds—customer funds—under certain circumstances. Last year, we proposed to disallow these internal repos used by many firms, but by MF Global, specifically. I now call it the “MF Rule.” Many firms, including MF Global, asked us to hold back on tightening up this regulation. They didn’t want that rule to go into effect. In fact, they made a good case that we needed to re-open our comment period to accept additional viewpoints—something we have done on many rules. At this point, however, I think we have seen and heard quite enough on this rule and I have urged that we move forward on it at the very earliest opportunity.
I do, however, believe that we need to do something additional. Last Friday, I called on our Agency to instruct staff and our exchanges to ensure that we conduct routine and robust deep data dives on segregated accounts in conjunction with the tightening of the MF Rule (the 1.25 rule). Firms no longer should be able to simply produce bottom line totals of segregated funds, but we should also get to see the actual statements and supporting materials to ensure that the funds are really there. They need to do a Jerry Maguire and “show us the money” when it involves segregated accounts. Maybe they’ll find those mysterious missing millions under a pillow on someone’s sofa somewhere, but when it involves customer money, there shouldn’t be any mystery. We need to ensure that customer monies are actually where they are purported to be, 24/7/365, so that even intra-day transfers that could negatively affect customer funds are detected and prohibited. And let me be clear: if we catch someone doing that, we will use our prosecutorial authorities aggressively.
So now, I think it’s time to move ahead—expeditiously—and make that rule tighter, cleaner, and—ultimately—safer, for customers and for American financial markets.
Cheetahs
As I said, we live in complex times. Technology changes things every day. That’s certainly true in financial markets in these days of widespread high frequency trading. These traders, I have termed “cheetah traders” because they are so fast, fast, fast. In the animal kingdom, cheetahs are the fastest land animal, racing from zero to 60 miles per hour in a few seconds. In financial markets, this new species of speed trader, due to the advent of high-speed computing technology and sensitive algorithmic programs, races in and out of markets trying to score micro-dollars in milliseconds. They are changing the way trading is done all over the world. They create the multifaceted algorithms and the machines start trading, and then the programs may morph themselves and start trading in another method. In fact, the programs are so intricate that some of them gather information, even Twitter feeds and millions of bits of news, and use the data in a dynamic progression to trade. It is really remarkable.
I’m not being critical of their business, but if markets are going to be efficient and effective and less volatile, we regulators need to keep up with the cheetahs. 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.
It may surprise you to learn that regulators don’t even require registration of these traders—the cheetahs. We don’t know who many of them are, their locations, or if they can pass a basic due diligence test for trading. The third largest trader by volume on the CME is a cheetah based in Prague. Good for them, but I’d like to know more about who is trading on U.S. exchanges. That’s why I’ve called for cheetahs to be registered, at the very least.
Position Limits
So, the players in these markets are changing rapidly. Here’s another example: between 2005 and 2008 we saw over $200 billion come into futures markets from non-traditional investors. I call them “Massive Passives.” They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy. When I say this, I’m talking generally. I realize that all traders don’t do this all the time, but we do see a pattern.
There’s good evidence that excessive speculation sometimes heats up the market and prices get 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.
The new U.S. financial reform law (Dodd-Frank) addresses this by requiring mandatory speculative position limits—to ensure that too much concentration doesn’t exist. We passed a final rule just last month and, while it’s not going to take all speculation out of markets—it shouldn’t—it will, once fully implemented, ensure that no one player has excessive market power.
End-User Exemption
Part and parcel to limits is ensuring that legitimate commercial businesses can continue to hedge their business risk. Congress wanted that. The Commission wants that, too. So, commercial users will certainly be able to continue to use these markets. At the same time, there will be new clearing and margin requirements on traders. So that commercial hedgers can continue to use these markets, Congress sought to ensure end-users didn’t have to put forth unneeded margin. Accordingly, Dodd-Frank instructed the Agency to craft a thoughtful end-user exemption in this regard, and that’s one of the rules I expect you will see in the near future.
The law also requires us to define what swap dealers and major swap participants are. It’s clear that we need to exercise great caution when we write those definitions so that they are not so broad as to inadvertently pull in categories of market participants who shouldn’t be there.
I wanted to mention that today because I expect that some of you are end users. Hopefully, I’ve put your mind a little more at ease in case you’ve been led to believe otherwise by the swirl of rumors that have been out there.
T Minus 0
Many of the folks who’ve come to see us since the new reform law was passed—and there have been thousands—have been concerned about timing and the uncertainty of the timing of the rulemaking process. I don’t blame them. They have businesses to run, after all. I’m not suggesting the agency has done anything wrong. It’s just a long, sometimes tedious process for the staff to draft rules, put out proposals for comment, read every comment letter, redraft the rule based on the comments and then try to get at least three out of five Commissioners to vote for it.
But, it does cause uncertainty. Businesses know they will need to change once the rules are finalized. But, they are waiting for “T Minus 0.” You know: the countdown to launch. There will undoubtedly be new products, even new exchanges launched as a result of financial reform. Businesses want to know the launch date so they can count backwards to get there. I’m with them. I want more certainty, too, and—while it may not always look like it—we are working toward that end. Let me give you an example: we spoke about position limits and we have approved the rule to implement them. However, the rule won't take effect until another rule takes effect—the definition of what is a “swap.” So, a common question around our offices in Washington is, “What is T?” When does this all start?
Regulatory Re-entry
Now, more than ever, we have to do better in financial regulation. It’s not good enough for us to say “Houston, we have a problem” after the fact. We need to be more proactive, particularly in this rapidly changing market environment, trying to prevent bad things before they happen.
At the same time, we need to be careful not to create a burdensome regulatory environment. We’re trying to get it right and, in some cases, that’s why the rules are taking longer than some of us wanted.
If you remember Apollo 13, the crippled spacecraft faced a serious problem when it returned to earth. All spacecraft—crippled or not—have to thread the needle between reentering at too steep an angle and burning up or too shallow and skipping off the atmosphere. This robust regulatory re-entry that we’re undertaking needs to be done just right, too.
If we do it just right, there will be unexpected benefits. Oscar Wilde had a great quote: “To expect the unexpected shows a thoroughly modern intellect.”
He made this statement about the “modern intellect” in the late 1800’s, so perhaps his idea of modernity was a bit different from ours. Back then, people rode around in buggies drawn by horses and houses didn’t have electricity. But there was still a lot going on. Typewriters, airbrakes, metal detectors, escalators, contact lenses, radar, dishwashers, washing machines, cash registers, seismographs, rayon and tungsten steel—were all invented in the last half of the 19th century. It was an exciting time.
The point—and I do have one—is this: we’re at a similarly exciting time right now with regard to financial reform regulations.
For the first time, we are not writing rules and regulations for an exchange-trading market that is already in existence—like the securities and commodities markets. This new exchange-trading marketplace is being built from the ground up. To be sure, there are vibrant over-the-counter swaps trading systems in this country, but now they will be registered entities, overseen by a federal financial regulator. As I’ve said many times, we don’t want to do anything to hurt legitimate business, but at the same time we need to fix what got us into the mess in 2008. We’ve got real, tangible and extremely important reasons to continue to move forward to implement financial reform. Folks who are upside-down on their mortgages will tell you that. Again, let me get back to my original point: why these regulations will be a positive good for the American economy.
As I said, this industry, this exchange-trading of swaps, will be built from the ground up. The Dodd-Frank law instituted clearing requirements for swaps—the fundamental provisions to address transparency and systemic risk issues. Along with those statutory dictates are new requirements for “swaps execution facilities”—platforms on which to trade swaps. In addition, there will be “swaps data repositories,” to warehouse swaps data. All of these entities—and the participants—will be registered with the Commission and will require staff to ensure compliance with federal mandates. As this new industry develops, I am fully confident that “better mousetraps” will be developed. People will devise new and innovative—and better—ways of doing business, and we as regulators are going to need to be nimble and responsive to ensure that we accommodate that growth and at the same time protect markets and consumers. I have no doubt that these new regulations—instituting new types of clearing, trading, and reporting platforms—will foster a landslide of hiring in the financial sector.
In addition, all of this new trading activity with new regulatory oversight requirements will require the development of new technologies, both in the private and public sectors. The “language” of algorithmic trading will become the legal definition of how financial market activity is done, and new technologies will be needed to develop the methods with which we speak to each other. The possibilities for economic growth and competition here are mind-boggling. And I have great faith in the ability of American computer scientists, physicists, logicians, statisticians—inventors of all kinds—to come up with the fastest, the most capable, and the best financial market technologies in the world. So, let’s expect the unexpected.
The Brave Future
Is this all doable? I’ve been involved with government for a while now. I see how it operates and how it can change. Rather than being like a fire department coming in to hose down the charred remains, we need to be more like the police department. Government should be more like a cop on the beat looking for trouble or for opportunities to make things safer. It’s a challenge, but as Ronald Reagan said in the wake of the Challenger disaster, “The future doesn’t belong to the fainthearted. It belongs to the brave.”
Thanks for your attention. This is Apollo 13, signing off, but, I’ll be happy to take some questions.
Last Updated: November 9, 2011