Keynote Address of Commissioner Dan M. Berkovitz at the FIA Commodities Symposium, Houston, Texas

“Take It to the Limit, One More Time” (Again)[1]

June 11, 2019

Good morning.  Thank you for the warm welcome.  I’d like to thank Mike Sorrell, Steve Adamske, and the FIA for inviting me to speak at this inaugural commodities symposium.

I’d also like to introduce two of the Commission staff who have traveled with me to this conference: Lucy Hynes of my staff, and Abigail Knauff, who is the Designated Federal Official on the Energy and Environmental Markets Advisory Committee (“EEMAC”).

Please note that the views I express are my own and do not represent the views of the Commission, its staff, or any of my fellow Commissioners.

It has been nearly nine years since Congress passed the Dodd-Frank Act.[2]  We have made great progress in achieving the goals of the Act to reduce systemic risks and improve market integrity.  By “we,” I mean both the CFTC, which is responsible for issuing the regulations to implement the Act, and market participants, who are on the front lines for implementing those regulations.  But our work is not finished.  Today, I’m going to discuss several initiatives that I believe the Commission should focus on to fully realize the objectives of the Dodd-Frank Act.

These initiatives fall into two major buckets.  Some of them relate directly to the energy markets.  Some are broader in scope.  Some are old and some are new.  The first set of initiatives concern ways to foster greater competition in the derivative markets.  The second initiative is a subject that many of you are very familiar with—establishing speculative position limits with appropriate exemptions for bona fide hedging activities.

I also strongly support many of the agency’s ongoing initiatives, such as maintaining a robust enforcement program, monitoring the markets, and updating our regulations to keep pace with evolving domestic and global markets.  Our core mission is to ensure that our futures and swaps markets provide a fair, transparent, and efficient means to discover, manage, and assume price risks.  We must continue to fulfill this core mission.

Over the last few months, I’ve been fortunate to travel to this great city of Houston several times to meet and talk with participants in our energy markets.  It’s vital for governmental decision makers to listen to market participants and understand the businesses that their decisions may affect.  There is no substitute for getting out of Washington to hear directly from you about how our derivatives markets are—or are not—working.

Of course, it still is possible to learn things even when staying in Washington.  I am privileged to be the sponsor of the EEMAC, which is composed of a diverse group of commercial end-users, dealers, consumers, public interest groups, and exchanges exploring pertinent issues in our energy derivatives markets.  This past April, the EEMAC met for the first time in several years.

At our April meeting, we heard several presentations about the ways in which the derivatives markets are responding to remarkable changes in the physical energy markets.  For example, the United States has doubled its oil production in the last ten years,[3] and the costs of producing clean energy have fallen drastically, making renewable energy sources cost competitive in many markets.[4]  The EEMAC heard from the CFTC’s Market Intelligence Branch on the impact of U.S. shale oil production on NYMEX WTI futures.[5]  Over the past ten years, the trading volume and open interest in NYMEX WTI futures contracts has doubled.  Interestingly, open interest has become more concentrated in the first two to three years of the futures curve.[6]  The CFTC staff analysis concluded that the shortened production horizon for shale oil has reduced commercial end users’ need for longer dated contracts.[7]

We also heard from the CME, ICE, and Nodal exchanges about the growth of benchmark energy futures contracts in light of expanding U.S. energy exports.  The exchanges also discussed the development of new contracts to help manage the risks associated with new global trading patterns.  For example, we heard about how liquefied natural gas (“LNG”) derivatives have emerged to help manage price risk.  Historically, LNG was indexed against oil and gas prices.  But today, rising supply and expansion in U.S. export capacity is driving LNG to become a separate market with increased derivatives trading volume.[8]  A measure of its success, the value of notional open interest in LNG derivatives has now moved above that of thermal coal, its main competitor in the seaborne market for power generation fuel.[9]

Market participants also explained how the current and proposed bank capital requirements imposed by prudential regulators are reducing the ability of energy merchants, producers, and consumers to obtain clearing services and cost-effective swaps.  Bank capital requirements are critical for financial stability.  They help reduce systemic risk.  But financial market regulation fosters other goals that also mitigate systemic risk, such as increasing the clearing of standardized derivatives and promoting competition in the derivative markets.  Regulators should continue to work together to ensure that we have strong capital requirements that do not discourage the provision of clearing and other vital risk-management services to end users.

Financial Market Reform

I’d like to turn now to the first initiative I believe should be a priority for the Commission: increasing competition in the derivatives markets.  Following the great financial crisis, in September 2009, the leadership of the G20 countries convened in Pittsburgh to agree on reforms to repair the global financial system.  World leaders called for regular assessment of these reforms to ensure that they were “sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”[10]

World leaders at the Pittsburgh G20 summit also agreed on reforms to the energy markets.  In the years preceding the financial crisis, the energy markets also were in turmoil.  There was a widespread belief the world was running out of oil.  Oil and natural gas prices were skyrocketing.  The Enron scandal, the Amaranth hedge fund’s hijacking of the natural gas market, and benchmark reporting issues called into question the basic integrity of these markets.  The G20 leaders pledged to promote the development of clean, sustainable, energy supplies and improved regulatory oversight of the energy markets.[11]  They observed that “[i]nefficient markets and excessive volatility negatively affect both producers and consumers.”[12]

Congress passed the Dodd-Frank Act less than a year after the G20 summit.  Today, almost a decade after its passage and after almost seven years of implementing regulations, our financial markets are safer and more resilient than they were in 2008.

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission.[13]  Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse.[14]  Nearly 98% of all swap transactions involve at least one registered swap dealer.[15]  The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms.[16]  In many respects, the policy goals set by the G20 leaders and Congress are being met.

Prior to joining the CFTC as a Commissioner, I counseled firms working to comply with our new financial regulatory framework.  I saw first-hand their commitment to complying with these new requirements, and the substantial resources involved.  These efforts have led to significant improvements in corporate governance and compliance.  In the energy sector in particular, the compliance record in the energy trading markets is much improved from the pre-Dodd-Frank years.

Measures to Increase Competition

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  High levels of concentration present systemic risks and provide fewer choices for end-users.  One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded.[17]  And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[18]  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

What can we do to reverse this trend?  I believe the Commission should take a number of steps to enhance participation and diversity in our derivatives markets.  Greater competition will provide tangible benefits to end users by lowering spreads and reducing systemic risk.

De Minimis Swap Dealing

The Commission took a step in this direction last November, when it set the swap dealer registration threshold at $8 billion.  The regulation required the threshold to drop to $3 billion if the Commission did not act.  However, our analysis of swap trading data showed that lowering the threshold to $3 billion would not materially increase the amount of swap activity covered by dealer regulation.^[19]  We anticipated that by lowering the threshold, many of the entities engaged in limited swap dealing—especially in the energy space—would stop dealing in swaps.  Their limited amount of ancillary dealing would not justify the cost of registration.  This would mean fewer dealers and less competitive pricing.  I therefore voted to keep the swap dealer threshold at $8 billion.

Floor Trader Registration

I have also advocated for expanding the floor trader provision in the swap dealer definition.  Fixing this existing rule will allow proprietary trading firms to trade on swap execution facilities as registered floor traders rather than registering as swap dealers.  I believe the floor trader registration category is appropriate for proprietary traders who solely provide liquidity on electronic trading platforms and do not solicit or negotiate with customers like a traditional swap dealer.

Proprietary trading firms can be a source of substantial liquidity for the swaps market.  This additional liquidity can enhance price discovery and reduce spreads.  Proprietary trading firms can also mitigate systemic risk.  They can be an opportunistic source of liquidity in times of financial market stress, particularly when traditional market making firms may reduce their participation.[20]  Permitting proprietary traders to make markets in swaps will diversify the available sources of liquidity beyond the few large bank dealers that dominate swap trading today.

While I believe expanding the floor trader provision requires an amendment to the swap dealer definition, this will not happen overnight.  In the meantime, I would support the Commission staff issuing no action relief to address this issue.

Name Give-Up

I also propose abolishing the practice of name give-up for anonymously traded and cleared swaps.  Traders should only be required to disclose their identities when necessary for counterparty risk management.  Name give-up discourages non-dealers from participating in exchange-style markets, causing market fragmentation and hindering competitive price formation.

Work with Prudential Regulators

In addition, we should continue to work with the prudential regulators to make sure that our regulations work together to support all of the goals of the Dodd-Frank Act.  We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.

Asymmetric Speed Bumps

Finally, a number of market participants have asserted that the increasing speed of trading and the attendant costs to compete at the microsecond level is a barrier to entry for many traditional market participants, and has resulted in less liquidity in some markets.

To address these concerns in what currently are illiquid markets, several exchanges have imposed speed bumps to slow down the fastest traders.  Recently, ICE Futures U.S. self-certified a rule amendment for its Gold Daily and Silver Daily contracts that would allow it to delay by three milliseconds the processing of incoming “aggressive” orders that would otherwise execute against a “resting” order.  Referred to as an “asymmetric speed bump,” this functionality would not delay the processing of passive orders, or the cancellation or modification of those passive orders.  The Commission recently permitted this asymmetric speed bump rule to become effective.  I disagreed with the Commission’s decision.

The Commission should look closely at the effects—both positive and negative—that high-speed latency arbitrage has on our markets, but it must proceed with caution when faced with fundamental alterations to market structure.

I do not support the use of asymmetric speed bumps, which purposely disadvantage particular trading entities, strategies, or technologies.  Picking winners and losers is inconsistent with the objective of the CEA “to promote responsible innovation and fair competition.”^[21]  If we begin to penalize those with better trading technologies or better information from the markets in order to protect slower or less-informed participants, where do we stop?

The Commission must endeavor to take the least anticompetitive means to achieve the objectives of the Act.  It is difficult to conceive of asymmetric speed bumps as the least anticompetitive means to foster greater liquidity in the futures markets.  It is appropriate for the Commission to more closely examine the effect of high-speed latency arbitrage, but asymmetric speed bumps are not the answer.

Speculative Position Limits

The second initiative I’d like to discuss today is completing the multi-year odyssey to impose limits on speculative positions in agricultural, energy, and metals commodities.  Meaningful position limits are critical to preventing manipulation or distortion of the price discovery process due to excessively large speculative positions.  In developing these limits, the Commission also must craft appropriate bona fide hedge exemptions.  For energy commodities, the bona fide hedge exemptions must reflect the characteristics and uses of the energy future and swap contracts that are entered into to hedge physical commodity risk.  Although it’s important for the Commission to finish its work in this area, and the agency has been at it for a long time, we must still proceed in a careful and deliberative manner.

Properly calibrated position limits, coupled with bona fide hedge exemptions, are pro-market regulations.  They help to maintain the integrity of price discovery for all market participants, while also preserving the ability of producers, end-users, and others to enter into bona fide hedges to manage their commercial risks.  I am committed to getting both position limits and hedge exemptions “done right.”  I’ve read carefully many of the comment letters on the CFTC’s prior proposals.  I will bring that same focus to any comments that we may receive on future proposals.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets.[22]  Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure”[23] to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Position Limits Are Not Intended to Regulate Commodity Prices.

Let me also be clear as to what position limits are not intended to achieve.  Position limits are not designed to regulate, manage, or control commodity prices.  They are not meant to keep commodity prices high or low, or to insulate them from the ebb and flow of trading in free markets.  And position limits are not meant to drive speculators from the market, or to “favor” other market participants over speculators.

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.[24]

Congress’ and the CFTC’s History with Position Limits

Beginning with the Food Control Act of 1917, the debate around federal speculative position limits is now a healthy 102 years old, and counting.[25]  In 1922, Congress enacted the Grain Futures Act, which notably provided statutory language around the potential effects of excessive speculation that is still familiar to us today.[26]  In 1936, Congress enacted the Commodity Exchange Act of 1936 and found that “excessive speculation” in the commodity futures markets was “an undue and unnecessary burden” on interstate commerce.[27]  Congress instructed the Commission’s predecessor[28] to “fix such limits on the amount of trading” in a commodity as it “finds necessary to diminish, eliminate, or prevent such burden.”[29]  Congress also defined bona fide hedging, and exempted bona fide hedging transactions from position limits.[30]

Most recently, Title VII of the Dodd-Frank Act amended Section 4a of the CEA by directing the Commission to establish speculative position limits for agricultural and exempt commodity futures and options listed on a designated contract market (“DCM”).[31]  Congress also directed the Commission to impose speculative position limits on swaps that are economically equivalent to such DCM commodities.[32]  Congress provided the Commission with criteria to consider in setting limits.  These included diminishing, eliminating, or preventing excessive speculation; deterring and preventing market manipulation; ensuring sufficient liquidity for bona fide hedgers; and ensuring that price discovery in the underlying market is not disrupted.[33]

The Commission’s task in proposing speculative position limit rules for the fourth time since 2011 is not an easy one.  But we’ve been down this road before and I am confident that with sufficient focus and deliberation, we can craft an effective proposal.  The Commission has a long history of successfully establishing position limits and overseeing exchange-set limits.  The Commodity Exchange Commission set position limits for grains in 1938, cotton in 1940, and soybeans in 1951.  And pursuant to a 1980 Commission rulemaking, DCMs began establishing their own position limits for physical commodities where the Commission itself has not set the numerical limits.  Based on this experience, I also support delegating to DCMs the responsibility for issuing hedge exemptions.[34]

One point of discussion in recent Commission efforts around position limits is the role of outside, third-party research.  It is the Commission’s job—and not that of outside parties—to interpret Congress’ mandate and determine whether position limits are necessary and in the public interest.  Academic and other research can play a valuable role in educating the Commission and the public.  However, the CFTC has not been charged by Congress with refereeing an academic debate about commodity price formation or the overall effect of speculative activity on commodity prices.  Rather, we are charged with using our best collective judgment on all of the evidence before us—including our experience with the markets we regulate, academic studies, and the views of market participants and the public—to protect the integrity of the futures and swaps markets.

The question before the Commission is whether, based on our collective experience and knowledge about the markets we regulate, an exceedingly large speculative position has the potential to distort markets, impede price discovery, or facilitate manipulative schemes.  The Commission has asked and answered this question before.  The record before us demonstrates that the answer is “yes.”

Lessons Learned from Significant Price Events in CFTC-Regulated Markets

The Hunt silver debacle and the Amaranth hedge fund’s distortion of the natural gas market provide clear evidence regarding the need for position limits in the futures and swaps markets.

Beginning in the summer of 1979, the Hunt brothers attempted to corner the silver market by accumulating extraordinarily large positions in both physical silver and silver futures contracts.[35]  As a result of the crisis, the Commission adopted rules requiring DCMs to establish position limits for all commodities that did not have federal limits.  In the final rules, the Commission affirmed its long-standing statutory mandate going back to 1936 and found that “the prevention of large and/or abrupt price movements which are attributable to extraordinarily large speculative positions is a Congressionally endorsed regulatory objective of the Commission.”[36]

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year.[37]  “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”[38]

Conclusion

In 2010, Congress instructed the Commission to establish certain position limits in six to nine months.  This accelerated time frame is further evidence that Congress did not intend to impose a higher burden on the Commission than it had previously faced to enact speculative position limits.  Now almost exactly nine years and three proposals later, the Commission has yet to complete its task.  This is clearly one of the important pieces of unfinished business before us.  I hope that we will complete it soon.

I look forward to working with you and other interested members of the public on this issue and to further improve the competitiveness of our derivative markets.

Thank you very much for your time and attention today.