“Regulatory Reentry”
Speech of Commissioner Bart Chilton to the Cadwalader Energy and Commodities Conference, Houston, TX
October 6, 2011
Introduction
It’s good to be with you today. Thanks for having me. Thanks especially to Greg Mocek for the invitation. Greg was the CFTC’s able Director of the Division of Enforcement when I arrived at the Agency in 2007. I remember the first time I visited him in his office. His walls were covered in framed news clippings of all the great cases we had prosecuted while he was Director. All those things should probably be displayed in some criminal justice museum or something.
And, I want you to know, we are carrying on your great work, Greg. Just today, it was announced that our Division of Enforcement brought 99 enforcement actions in the last fiscal year. That’s more than ever. And more than ever it’s a sign of how closely markets need to be policed. These cases included fraud, manipulation, Ponzi schemes, trading abuses and other violations of the Commodity Exchange Act. I think that especially when the economy is shaky, the swindlers swarm, but we are catching them and keeping our markets safer as a result.
So Greg really got us moving in the right direction and I miss working with him at the Agency, although, it is a pleasure to be with him here and to be with all of you in Houston.
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 still think of our space program.
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 (a gem of a guy) 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.
Today, I want to talk a little about technology in trading as well as some other emerging issues in financial markets.
Moneyball
There’s a movie that just came out two weekends ago called Moneyball. Some of you may have seen it. In it, Brad Pitt plays Billy Beane, the general manager of the Oakland As. He had a problem because his team couldn’t compete with the big money teams and the owner wouldn’t let him pay more for players. So instead, he used complicated computer analysis to acquire his players. He didn’t care about the things most team scouts looked for in players. He didn't care about RBIs, home runs, versatility, a classic swing, where they went to school, their age, or what they looked like. Nope, Billy Beane wanted to know all the various statistics related to how many times a player got on base. These complex analyses allowed Beane to bring in good players who were under-valued—players the As could afford.
I won’t give away too much, although the film is based upon real events, so some of you may recall what took place. The As started out horribly that year, 2002. I think they lost 14 of the first 17 games. Beane was routed by the critics for his unconventional strategy. But then, the As went on to have a historic winning streak—20 games—and a very good year. The use of computers changed baseball.
Now, segue with me from Moneyball and the use of the computer trading to win baseball games to trading in financial markets. Isn’t that what’s happened in the financial world? The big firms hire scores of mathematicians and physicists—the famous quants of Wall Street. Billy Beane brought in what the unenlightened might call a computer geek and made him assistant general manager—something unheard of in baseball. It was unheard of only a few years ago that Wall Street would bring in technocrats, but that’s the kind of money ball we’re playing today in financial markets.
Cheetahs
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.
The cheetahs also aren't like traditional financial speculators because, as I say, they dart in and out of markets. They don’t stay put very long, sometimes for only seconds. At the end of every trading day, most cheetahs are close to being flat or neutral in markets. They don't want to hold risk for very long, most of the time. I’m not commenting on their business model, but it is certainly different and something that we, as regulators, need to think about. One thing we know from the last ten years of deregulation: if we don’t manage the change taking place in markets, it could hit us like an asteroid.
The cheetahs did not cause the infamous Flash Crash of May 6, 2010. Nevertheless, they were part and parcel to it. We recall that markets tumbled and the Dow lost nearly 1,000 points before recovering. One thing that we are working on with our brethren regulators at the SEC is the harmonization of rules and regulations that will slow or stop trading in certain circumstances. More than ever, these markets are inter-related. And that inter-relationship doesn’t stop at our borders. Nope, these are global financial markets and regulators better get used to working better together and thinking out of the batters’ box.
Even with new rules and procedures, we may still see mini flash crashes. They haven’t stopped so far. Here too, cheetahs seem like a likely place to look for potential problems. For example, on May 1st, a Sunday, in 12 minutes the silver market plunged 13 percent. Then, on June 9, in the evening’s electronic trading, the natural gas market free fell 8 percent in 14 short seconds!
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.
With such a significant part of the trading being done electronically, it would be naïve to think there won’t be glitches. That’s why I think additional safeguards are needed before there’s a problem.
Registration
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. And, I’d like the ability to get certain information from them—something we can’t do unless we get a subpoena, without them being registered. And by the way, the information that we might need to get is a lot different than the sorts of things we traditionally gather—like emails. We actually need the algorithms, and then alterations to those algorithms (remember how dynamic they are) for a time-certain that may be an area of interest to the Commission. We can’t do that without registration, or as I, say without a subpoena. If the cheetah is based in another country and there is no registration—a big New York “forget about it.” We won’t get a thing.
Here is what we do know: there are those who want to intentionally harm financial markets—financial terrorists, if you will. I’m not saying any cheetah is a financial terrorist, but that is surely an area of concern with regulators. That’s why I called on Tuesday for cheetahs to be registered, at the very least.
And, by the way, better regulation won’t slow the cheetahs down. I want the trading business rockets to be fast. But I don’t want markets to experience a disaster because we haven’t done the proper due diligence in protecting markets and consumers alike.
Massive Passives
The second major change in markets has been another type of trader. 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.
From 2005 to 2008, roughly $200 billion in new speculative Massive Passive money came into the commodity markets in the U.S. alone. At the time, consumers were outraged about gas prices and food prices. So, should we be worried that maybe that’s what’s going on today? Here’s some food for thought: There were even more speculative positions earlier this year in commodity markets than there were in 2008—in fact, more than ever before. The number of futures equivalent contracts held by Massive Passives increased 64 percent in energy contracts between June of 2008 and January of 2011. In metals and agricultural contracts, those positions increased roughly 20 percent or more.
I think there’s good evidence that excessive speculation is heating up the market and prices have gotten 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.
You don’t have to take it from me, though. Researchers at Oxford, Princeton and right here at Rice, as well as many other private researchers say that speculators have had an impact on prices—oil prices and food prices most notably. The point is, though, that if those studies have even the possibility of being credible—if they are right, and I think they are—what do we do to protect markets and consumers?
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 were supposed to have these done earlier this year, but have failed to do so. In January, when limits were supposed to be in place, I said that we should do what we could at the time and implement some of them. I suggested spot month limits for on-exchange trades and for over-the-counter trades for which we already have data. We could have done them then. We should have them in place now. I have continued to say that we should do those. Instead, we have been trying to get a larger position limits proposal completed. What has occurred, however, is that there remain issues around which there is still disagreement. I can’t go into any of the specifics, but I can say that if we don’t come to some agreement on a full meal deal position limits plan, what we should do is what I have been saying all year and do spot month limits now.
Someone suggested the other day that perhaps I was the hold-up on getting the limits done. After I stopped laughing, I explained that I’ve been calling for position limits since 2008. I was the only Commissioner to do so. I was criticized by senior economists at the agency and from scores of others on the outside. The preponderance of evidence, in my opinion, is clear that we need limits. We need them in the energy, metals and in ag complexes. I believe it entirely, based upon my experience as a Commissioner since 2007. But, here is what I won’t do: I won’t settle for a weak position limits plan for the sake of getting “something” done. For those that think I may buckle to any plan because I’ve been the strongest advocate for limits and will settle, you don’t know me well enough. I’m sure the plan that is ultimately approved won’t be as robust as I would like. I understand compromise, but I will only support something that Congress instructed us to do. I won’t dance on the head of a legal pin and agree that when Congress told us to implement “appropriate position limits” that they really meant that “appropriate” could mean no limits whatsoever. I won’t support special exemptions for some contracts. Congress said limits, not limits where you think they are convenient. I won’t support giving the exchanges autonomous authority to approve exemptions to limits for the largest of the large traders that nobody in the public will ever find out about. And, I won’t delay this process now under the guise of being thoughtful in order to try and gather more time to actually kill position limits.
The “Artful Dodge”
While I’m at it, there is another issue that has concerned me for a while. And this has slowed our rulemaking process. It is something that is useful, but may be being misused. Because of a recent court decision, we are—like every other regulator in Washington—taking extra efforts to ensure that our cost-benefit analyses are up to snuff so that our rules aren’t struck down on that account. It may seem like a picayune thing, but it’s important.
But there is a problem: these analyses—which are required by law—may be being used in an “Artful Dodge.” You remember the “Artful Dodger,” in the Charles Dickens novel, Oliver Twist? The Dodger was a master at the sleight of hand, of misdirection, and of avoiding responsibility. Well, we’ve got some “Dodgers” today—and I’m certainly not talking about my Commission colleagues—who would like to delay, de-fund, de-fang, or just plain demolish Dodd-Frank rules by any means possible, and they’ve hit on this odd little means—cost-benefit analyses—as yet another tactic to achieve those ends. Weirdly, it’s having an effect. (By the way, Dickens ultimately sent his Dodger to an Australian penal colony, but I’m not suggesting we do that).
The thing is cost-benefit analyses are important and required. Like position limits, I will do what Congress tells us to do. That’s our job. But, cost-benefit analyses should not be used as a delaying tactic or as a partisan issue. They should be solely about enacting regulations in a common-sense, good government manner. President Obama has initiated a broad review of federal regulations, to cut out the chaff and to streamline overly burdensome rules, and cost-benefit analyses—at the forefront of rulemakings—quite simply make for better rules.
To use this good requirement of doing a cost-benefit analysis as a bludgeon to impede the promulgation of necessary financial market regulatory reform is, at best, shortsighted and, at worst, inimical to the future safety and soundness of our financial system. In a word, I believe it irresponsible. It may be a successful “artful dodge” and it may achieve the intended goal of slowing down necessary rulemakings, but it’s unwise.
I’m focused on the end game—getting these rules in place, as Congress instructed us to do, so markets can function freely, openly, safely, free from fraud, abuse and manipulation, so business can effectively manage their risks, and so consumers can be assured of fair prices for the goods and services they purchase. We’ve already seen the great costs—with a capital “C”—to our society of not having these reforms in place—lost jobs, lost production, lower GDP, lost tax base. Let’s not let the Artful Dodgers’ focus on their “cost” issue derail us on getting these good rules in place for American markets, business, and consumers.
Regulatory Reentry
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.
Folks sometimes forget we deregulated financial markets ten years ago and that lax regulation led in part to the financial crisis in 2008. That’s why Dodd-Frank came along in the first place. It will help ensure more efficient and effective markets and it will help keep markets devoid of fraud, abuse and manipulation. That’s good for market participants, for business and especially for the consumers who depend on these markets for the price discovery of just about everything they purchase.
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 reentry 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 also said, “I can resist everything but temptation,” but I’m trying to be intellectual here, so let’s go back to the first 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. You all probably know that pasteurization was invented in the 1850s, but did you know that the first plastic was made in 1862? (And we all thought it was relatively new when “The Graduate” came out). Typewriters, airbrakes, metal detectors, escalators, contact lenses, radar, dishwashers, washing machines, cash registers, seismographs, rayon and tungsten steel—all invented in the last half of the 19th century. It was an exciting time. And, speaking of inventors, today we note the passing of Steve Jobs who, as one newspaper put it, “re-imagined how people interact with technology.”
My point—and I do have one, is this: we’re at a similarly exciting time right now with regard to financial reform regulations. I’m going to invite you to do something similar—to expect the unexpected. Here is the thought: rather than producing overly burdensome rules that stifle innovation or constructing weak rules that compromise consumer protections (the argument from the left), I think this new set of rules will do something absolutely unique. I believe these rules will actually create jobs. They will create new sectors within sectors. They will create new opportunities for economic growth on American soil. Let me explain why.
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 is a vibrant over-the-counter swaps market in this country, and 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.
Just like Wilde’s vision of a modern intellect, in the financial arena I see countless possibilities, innovative horizons, unbounded opportunities that this new and novel marketplace will bring to the American economy and ultimately to the American consumer. And the new regulations framing the market’s existence—and providing needed guidelines and protections—will be the foundation for a new generation of economic growth. So, let’s expect the unexpected.
Is it Doable?
Is it doable? I’ve been involved with government for 25 years. Maybe I’m part of the problem, but I don’t think so. I see how government operates and how it can change. As I said before, we need to be more proactive. 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. We need to do our best to predict the market ramifications of new products, new exchanges, cheetah traders, other new market participants, and whatever other new trading elements come our way. 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.”
Sure, we need to do better and I can tell you we have already made good progress. That’s why we haven’t done some of the rules by the date Congress told us—by July. We are being thoughtful. We are doing them correctly. We are getting them right, and we have already started what I’m talking about. It can be done.
Thanks for your attention. One more movie reference for you: “This is Apollo 13, signing off.” But, I’ll be happy to take some questions.
Thank you.
Last Updated: October 6, 2011