“TTF”

Keynote Address by Commissioner Bart Chilton to the Energy Bar Association, Washington, DC

May 1, 2013

Introduction

It is a real pleasure to join you today. Thank you for the invitation and especially thanks to Lisa Levine, your great executive director.

Let’s get right to it. Yesterday, I spoke to a group of energy end-users—folks who have commercial skin in the game. I’m going to re-up just a few of the things we spoke about then, because some of these issues are every bit as important to you. However, after that, I also want to try an idea on you guys for size—something new, and downright different. I think as energy folks, and particularly as energy lawyers, you will find it somewhat provocative. At least I think that will be the case. We’ll see, won’t we?

So, let’s get the policy party poppin’.

Tried and True and Seldom Blue

These commodity markets have been around for a long time. As we know, they started with ag commodities and then ultimately expanded to energy and metals and financial futures. By and large, these markets have worked exceedingly well. They have been tried and true and seldom blue.

Don’t misunderstand me; there have been issues over the years, but even if we just go back to 2008, the futures markets were not complicit in the economic meltdown. We can’t, for example, say the same thing for the over-the-counter (OTC) derivatives, for swaps.

However, even in these last few years, we have started to see not only the OTC market morph, but our tried and true futures markets, too. I often want to, and ask others to, reflect on why we have these markets to begin with. What was the point, exactly? They were for risk management and for price discovery that benefitted consumers. They provided risk transfer, from end users to speculators. The result, if it all worked, was that prices would be more stable. End-users would hedge some of their risk. Speculators betting that prices would move in their favor would make some money. And, importantly, consumers and our economy would be the beneficiaries.

This morphing of markets, however, has put us in some sort of jeopardy in my view. By that I mean, we maybe forgetting about the original intent of these markets and therefore threatening the tried and true traditions and trajectories of the markets over the decades.

In fact, I’ve felt so strongly that we have forgotten about these original special purposes that not too long ago I laid out what was termed an “End-User Bill of Rights.” There are ten rights. I won’t get into them today, but I want to mention one of the ten: The right to have confidence in the commodity markets.  End-users should be confident that their intermediaries, futures commission merchants (FCMs), high frequency traders and others are all appropriately regulated and supervised. That’s so the original intent of these markets isn’t compromised.

Tee for Two

So, what are these market morphing bogeys of which you speak and need to be addressed under your so-called End-User Bill of Rights? Wassup with all that?

Well, I’m so very pleased you asked. Thanks for the question. I even have an answer. There are actually quite a few of these bogeys, but I’ll tee up just two.

Massive Passives

Here’s the first one: The “financialization” of commodity markets by traders called Massive Passives.  Between 2005 and 2008 we witnessed approximately $200 billion that entered regulated futures markets in the U.S.—$200 large!

This $200 bil-with-“B” came from the likes of pension funds wanting to diversify into commodities.  That’s generally cool, right?  But the type of trading strategy that they, some exchange traded funds, some mutual funds and some other managed money are engaged in is different than what speculators used to do.  Instead of getting in and out of markets, maybe based upon a drought or other natural disaster, or in the energy markets getting in or out related to the driving season or a refinery breakdown, these very large funds (massive, as I say) put money in the markets and park it.  They are fairly price insensitive (passive, as I say—Massive Passives).  They don’t get in or out of the market because prices fluctuate a bit here or there. They are in it for the lengthier time. They invest more like people invest in equity markets.

Sonny Boy, Girly Sue

Back in the day, perhaps a Pop described it all to his children like this:

Sonny Boy, Girly Sue, lemme explain investing to you

As a stock holder, when we get older

you’ll recall this chat about stock this and stock that

You’ll remember I said with a grin

that these shares of FBN or something akin,

will be worth something then

So, we are gonna hold onto these bad boys….We’re gonna hang

Someday, when then arrives, we’ll be rich. It will change our lives!

That’s how wealth derives

High fives!

So, of course individual families weren’t massive, but these large funds, these Massive Passives, took this investment strategy from the world of stocks and bonds and decided to take a turn in futures. I’m not suggesting that they should be removed from the markets, but this type of trading strategy is a concern because it is one example of how markets are morphing.

Here’s how and why they are morphing. Too much concentration in markets can impact prices.  Many would contend any liquidity is worthy liquidity.  But, are we sure?  There are periods when there is so much Massive Passive liquidity on the buy side—those going long and staying long—that values cannot be based on the fundamentals of supply and demand.

Take 2008….please! Crude went from just under $100 a barrel all the way up to the mid-$140s and then all the way back down to $30.  Did supply and demand fundamentals do that?  I don’t think so, but neither do Goldman Sachs researchers, or researchers at the Federal Reserve Bank of St. Louis, and many other prominent academics.

By the way, in 2008 when the price dropped late in the year, it was when the economy was going tanking—after Lehman Brothers and the bank bailout. Even the Massive Passives weren’t so passive. They weren’t immune to the stuff.

Position Limits

In reaction to all of that, Congress and President Obama , as part of the Dodd-Frank financial reform law, required us to implement speculative position limits to avoid excessive speculation and protect consumers. However, as most of you know, those limits aren’t in place.  We’ve been lobbied, pressured, sued and screwed.  But, we have appealed a court decision in this regard. At the same time we are at work on yet a new position limits rule that will address the issues raised by the court.

Cheetahs

The other bogey, in addition to the Massive Passives, is a species of traders known as cheetahs—that is, high frequency traders (HFTs). These HFTs are so fast, like the cats, that they are out there 24-7-365 trying to scoop up micro dollars in milliseconds. And they are winning.

You may have seen a story in The Wall Street Journal today by Scott Patterson, among others, that says speedy traders exploit a loophole that allows these powerful computers to detect when their orders are executed a split second before other market participants see the data. Can you imagine the advantage that may give the cheetahs? Well, have a look at the story if you haven’t. Scott’s also written a couple great books about this new trading world, “The Quants” and “Dark Pools,” that you might also have a look at some time.

Anyway, the cheetahs are actually, in many ways, the flip side to the Massive Passives. Whereas the Massive Passives buy and hold, the cheetahs buy, then—as fast as they can like a hot potato that carries risk with it—they sell. These cats don’t want, as a strategy, to hold positions—to hold risk—for very long. They certainly don’t want to hold risk overnight. If you don’t actually hold risk for more than a few seconds is that cool in a risk management market? I’m not so sure. If you want someone to hedge your firm’s energy risk for five seconds, I have just the folks for you. Is that working for you? I’m just saying it is fleeting liquidity.

In fact, a study late last year, which was conducted in conjunction with the CFTC, said in essence that cheetah trading imposes quantifiable costs on small investors.  Aggressive cheetahs make a lot of money, and they make their biggest paydays when they trade with small, traditional traders. A cheetah trading with a fundamental trader makes $1.92 on a $50,000 trade but if that same trade is made with a small trader, the number goes up to $3.49. This could end up pushing smaller, non-cheetah traders out of markets.  From most perspectives I can think of, that sort of fast isn’t better.

So, there are many things that can be done on this front. In fact, it may interest you to learn that there are no places in Dodd-Frank these cats are even mentioned. The law is a blank slate. That’s how expeditiously these markets are morphing. Landmark legislation from not three years ago doesn’t contain a word about traders who many times make up a majority of the volume of exchange trading.

New Idea: Targeted Transaction Fee (TTF)

I said we were gonna try something on for size. Here it is…ta ta da da da.

A Targeted Transaction Fee—a TTF: Hold on! Whoa Nellie! A TT what? You didn’t see that coming did ya? Gimme a minute. I want to get out of here alive.

First, I know the concept has been around before for derivatives, but nothing has ever been done. I think that’s because nobody has figured out a good way to do it. Nonetheless, given what I’ve described today—these two bogeys in markets—I think now is a time to present something new. Hang with me guys. Here it is:

Transaction fees, as a concept, have recurred with some frequency over the years. The Office of Management and Budget has proposed transaction fees as a part of various administration budgets—Republican and Democrat administrations alike. In fact, the last four administrations proposed something but really didn’t push a specific plan like this one.  

I’ve spoken about this before, and have made the point that these are public markets, and there is a great public good to be gained by their appropriate regulation, so the users of the markets are not unfairly burdened by the institution of a reasonable user fee. Still, a targeted user fee will keep our agency able to regulate these growing and morphing markets.

First off, I propose that end-users—and I mean true end-users, hedging their commercial activity—be exempt from any fee whatsoever.  That is, if you’re truly hedging, you’re out.  No fee.  Mind you, if an end-user is engaging in speculation, that’s a different story.

That’s because I believe that speculators and particularly HFT cheetahs should have a transaction fee—a TTF—measured by their volume.  This idea would have the two-fold benefit of 1) providing necessary funding to the Commission to adequately oversee the markets, something sorely lacking, and 2) deter folks from entering into flash-in-the-pan, non-bona-fide trading.  In other words, if you’re using our markets like a slot machine, you’re gonna contribute to the oversight and enforcement services that need to be part and parcel to markets.

On the funding issue, remember that the Securities and Exchange Commission is funded through transaction fees. In fact, the CFTC is the only federal financial regulator that is not self-funded in some fashion. For our part, for the past two years, President Obama has tried to ensure we had adequate funding and requested $308 million for us to implement Dodd-Frank and do all of the new work associated with regulation of the OTC derivatives world. But, last year we only received $205 million. This year that figure, considering sequestration, was reduced to less than $200 million. So, we have a problem. By the way, this is at a time when there are more instances of malfeasance in the financial sector than ever before. Go figure.

I believe that a solid TTF, along the lines of what I’ve suggested, could go a long way toward those goals.  And the math isn’t that difficult.  For example, with an average volume of 20 million futures trades per day, assuming 95 percent of which are non-hedging, a fee of .06 cents—six one-hundredths of a cent—would result in revenue of $300 million.  And that does not include swaps, which would reduce the fee even further.

Some will yell that the sky is falling with this proposal.  They will suggest that liquidity will dry up. Price discovery will be irreparably impaired. We’ll see market migration to London or some other place.  Really, do me a solid and save it.  Get real.  Take a penny, a red cent. Divide it into 100 different pieces, that penny. Then take 6 of those pieces. That’s all I’m suggesting—six one-hundredth of a cent. Really?  It isn’t like six one-hundredth of a cent is somehow the tipping point.  I’m not making light of it, but if folks leave markets due to that, they were looking for an excuse. Hasta la vista, baby.

Will it impact the cheetahs more than others? Probably.  But: one, I’m not so sure that the fleeting liquidity that we discussed earlier is so awesome anyway. They aren’t taking on any risk. They are just mining for micro dollars.  And two, again, if you are going to treat these markets like a casino one-armed bandit, you should pay for appropriate oversight.

And put that against this backdrop. Since the financial crash of ’08, the most profitable sector in our economy—every single quarter—has been, you guessed it, the financial sector. According to the latest data from the Bureau of Economic Analysis (reflecting Q4 2012), the financial industry made approximately $506 billion in 2012. J.P. Morgan made $21.3 billion in net income in the last year, ending March 31, 2013. Goldman made $7.5 billion, just to give you a couple examples.

Nothing wrong with profits; don’t get me wrong. But, at any rate, there is a reasonable fee that can be assessed that would help markets and consumers, and I think it’s time we seriously consider it.

Conclusion

So, thanks very much for your time today. There’s much to do in this morphing market world and a lot of corners to try to see around. I mean, heck, whoda thunk five years ago that a hoax Twitter feed would lead to another market meltdown moment. That Hack Attack cost people money and that’s bad enough. But, it’s an example of the brave new world of markets where everybody’s going “where no man has gone before.”

Whether it’s Massive Passives, cheetahs or some other kind of bogey, we regulators have to keep up a little better and we have to have the resources to do so.

Thank you.

Last Updated: May 1, 2013