FROM: COMMODITY FUTURES TRADING COMMISSION, GLOBALIZATION AND ENERGY MARKETS,
"Sin-Orgy and Energy"
Address of Commissioner Bart Chilton to the Globalization and Energy Markets: Investment and Commodity Price Cycles Conference, James A. Baker III Institute for Public Policy, Rice University, Houston, Texas
November 9, 2012
Introduction & Neil Armstrong
Thanks for the introduction. It’s great to be with you today at Rice. There are so many impressive things about this place; the faculty, the research, the bars. It’s hard to pick just one thing as a stand out. If I had to, however, I’d say the work with NASA and the space program is pretty neat. That’s what I’d choose as a very historic achievement.
I have a link to the space program in that I followed in the footsteps of the first man to step foot on the moon. Well, let me be clear, perhaps the link is a little bit tangential. You see, I lived in Neil Armstrong’s room for two years. The Commander went to Purdue, as I did many years later, and we were both members of the same fraternity—Phi Delta Theta. I had the honor to live in his room. There wasn’t much special about the room. Good view of the Student Union and a tarnished plaque on the door…and come to think of it, plenty of plaque throughout the room. Nevertheless, it was cool.
I did actually have the opportunity to meet Commander Armstrong a year or two after college. I was so excited about the opportunity. When I introduced myself, I said that I was a Phi Delt at Purdue and gave him what we call "the grip" which is the secret handshake. It had been decades since the Commander was at Purdue, for gosh sakes, the guy had gone to the moon and back. When I gave him the grip, he looked at me like I was a space alien. He had no clue what physically-funny thing I was doing to his hand. He quickly jerked free and excused himself. It was surely my fault. It is, however, my most notable diss.
I still feel privileged, however, to have lived in his room and been a member of his fraternity at Purdue. As a kid in 1969, I remember being glued to the television and watching the moon landing and his first steps. I had great respect for Neil Armstrong and for the space program, generally. And this superb institution, Rice University, was there through it all. What a superb achievement.
JFK
There’s that legendary JFK speech. The one he gave right here at Rice in the football stadium—The Moon Speech. It was fantastically inspirational. You can find it on-line. The President said, "We choose to go to the moon in this decade and do other things, not because they are easy, but because they are hard…" What a statement, "…because it was hard…" We did something because it was hard, challenging, and because it was troublesome. We don’t take the easy way out—nope, not us.
FCIC
Well, there’s a similarity there between what has been, and is now, going on in our financial markets. It has also been hard, challenging and troublesome. We are in the process of trying to fix it, and we are not taking the easy way out.
Let’s quickly revisit why the financial meltdown took place to begin with. We had banks and other institutions which were so large that when they were about to go bust, we—all of us—had to provide hundreds-of-billions of dollars in a hideous, budget-busting bailout.
The Financial Crisis Inquiry Commission (FCIC) was established to examine what happened. Well, they determined that it wasn’t just one thing. There was a synergy of two main culprits, although to me it was more of a "sin-orgy."
FCIC concluded that there were two culprits to the calamity—and it was the sin-orgy between them that led to the economic collapse. One culprit without the other and it wouldn’t have taken place.
Culprit One: regulators and regulation. In 1999, Congress and President Clinton deregulated banks. The banks were no longer bound by that troublesome Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money. With the repeal of Glass-Steagall, banks could invest in markets for themselves, for the house, and not just for their customers. That change was a key to the economic collapse. And with the change of the law, regulators also got the message to let the free markets roll. And, roll they did—right over the American people.
Culprit Two and part of the sin-orgy: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those pesky rules and regulations, they devised all sorts of creative, exotic and complex financial products. Some of these things were so multifaceted hardly anyone knew what was going on or how to place a value upon them.
Take for example, Credit Default Swaps (CDSs). These we're gambles that certain things would essentially fail. And these CDSs were sold and resold to the point that few understood what they had and how much they were worth. The value was in the eye of the beholder. Folks got over-leveraged as a result. A case in point was Lehman Brothers which was leveraged 30 to 1, according to its last annual financial statement. That was serious trouble.
Guy goes into a bar, takes a seat and says, "Gimme a shot of Jack before the trouble starts." He’s served and tosses it back. "Gimme another before the trouble starts." And he tosses that one back. He says the same thing again and finally, the bartender asks him, "What’s all this trouble you’re talking about?" to which the guy says, "Um, the trouble starts when you realize I don’t have any money."
Dodd-Frank
Well, Congress realized what horrific trouble we were all in. They saw what the sin-orgy had created. And while it wasn’t easy—it was hard—Congress passed and President Obama signed into law, the Wall Street Reform and Consumer Protection Act—otherwise known as Dodd-Frank.
There are 398 Dodd-Frank rules or regulations to be promulgated by various Federal agencies. To date, only 133 are complete—33 percent. The CFTC has done a little better. We’ve completed about two-thirds of our work in finalizing 39 rules of the approximately 60 on our plate.
Now, I’d like to give you an individual explanation of each of those 60 rules—just kidding. We are essentially doing three things.
One:
We are adding transparency to the hundreds-of-trillions of dollars in dark, over-the-counter (OTC) trading that got us into the mess in 2008. Trading will be done on exchanges and will be reported to electronic warehouses called Swaps Data Repositories ore SDRs.
Two:
We are instituting new capital, margin and clearing requirements to ensure that there is no longer systemic risk. If one firm goes down, it will no longer pose a systemic risk to our economy. And,
Three:
We are adding more accountability for customer funds by ensuring electronic access to records, standardized audits and liquidity level alerts and action steps.
Limits
In 2008, the massive influx of long-side speculation levels coincided precisely, exactly with the highest-ever crude oil and gasoline prices in our country—the highest prices ever. West Texas Intermediate crude oil—WTI—at $147 and gas prices at $4.10 a gallon. Although hundreds of people have been queried, not a soul has ever provided a supply and demand fundamentals-only explanation to support this price movement. That’s because it doesn’t exist.
What do exist are numerous studies that show a positive nexus between excessive speculation and prices. In fact, earlier this year the St. Louis Federal Reserve released a study on the subject. MIT (Massachusetts Institute of Technology) released one in 2008, and another that I am particularly thankful for is the one done right here at Rice, at the Baker Institute in 2009, by Professors Amy Myers Jaffe and Ken Medlock. I want to read you just a little bit from this important Rice research.
"So, as the market presence of noncommercial traders increased between 2003 and 2008, the stance of these noncommercial traders has fairly consistently been to hold bullish, long positions that supported rising prices. And, when their market share was highest, so was their net long position, which again roughly coincided (acting as a slight leading indicator) with the peak in oil prices at $147 a barrel in the middle of 2008."
The circumstance was that a lot of financial players, including the large banks who could now invest for themselves—for the house—and not just their customers, in addition to others, wanted to diversify their investment portfolios. The futures markets looked like a promising place to go. So, it is sort of like some of our parents who bought and held blue chip stocks. "Well, sonny boy, when you get older these shares of RCA or IBM or whatever, Microsoft, will be worth something. We are just going to sit on them." And that is what happened with the new money, that massive influx of about $200 billion that Professors Myers Jaffe and Medlock wrote about. They bought and held.
I call these traders Massive Passives, since they are massive, and have a fairly passive investment strategy. They go long and are relatively price insensitive.
They hold, unless something cracked happens…like crude going to near $150 per barrel and the entire economy going into the crapper. Then, they will bail. But as an investment strategy, the Massive Passives aren’t worried about the markets as reflected in the summer driving season or the temperature change from El Nino. Nah, they are in it for the long term. They are betting that, say crude, will be worth more in 2015 than it is today. That’s their gamble.
And, if there are enough of the Massive Passives, and they far out-number the shorts, as we have seen, their strategy will have somewhat of a self-fulfilling prophecy. They will help to push prices. I’m not suggesting that they drive prices, but they have an impact, and any impact that isn’t based upon fundamentals of supply and demand is problematic for markets.
Why is it a problem? Well, there are two reasons.
One:
Commercial hedgers, like energy companies in the Houston area and elsewhere, use these markets for hedging their actual business risks. They have real physical skin in the game and they need these markets to function properly. If they can do this, it makes them more proficient and effective companies, and that’s good for all of us and our economy. These are markets that were
not developed as gambling venues; they
were developed to discover price. And,
Two: Consumers and businesses alike benefit from fairly stable pricing. It enables them to plan. Gasoline shouldn’t be $3 a gallon one month and $4 the next. Sure there will be fluctuations, but there shouldn’t be extreme volatility.
So Congress, as part of Dodd-Frank, charged the CFTC with setting speculative trading limits. The law, in my opinion, plainly and clearly mandates these limits. That said, there is a group of the largest speculators on the earth who have questioned the law and want be able to have uninhibited concentration in markets. They’d suggest that there isn’t a problem with holding 30 or more percent of a given market, like we’ve seen in crude, nat gas and silver in recent years. As I’m sure many of you know, these global speculators won a recent court ruling. But our Agency will appeal and I expect we will soon promulgate yet another position limits rule.
This thing, position limits, isn’t easy. Like JFK said, it is hard. But, it is a serious matter for millions. Millions of people and businesses alike can, at times, be paying a speculative premium and that’s just not right. I will keep fighting for them.
Cheetahs
The other market integrity challenge has to do with technology and high frequency traders (HFTs) that I’ve dubbed cheetahs because of their inconceivable speed. They function in milliseconds—one-one thousandth of a second. I’m told that if you are travelling at 100 miles per hour, a millisecond is the time it takes you to go two inches—two inches—inconceivable!
I think these cats have some attributes and I’m not seeking to see them become an endangered species. At the same time, they can also cause difficulties for markets.
We all know that technology isn’t always what it woulda, coulda or shoulda been. We see market technology SNAFUs consistently. We all recollect the Flash Crash from 2010. Most of us heard about the NASDAQ Facebook IPO fiasco. Some of us heard about an oil trader who lost a million bucks in less than a second. There are lots of examples. That’s why in order to safeguard market integrity, I think we need some basic provisions to help cage the cheetahs.
One: They need to be registered. Really, they’re not even registered? Nope. They don’t have to be presently. They need to be.
Two:
They should be required to test their programs before they are put into the live production environment, have wash blocker technology to avoid cross trading, and be required to have kill switches in case their cheetah program goes feral. And,
Three:
We need to update our fines and penalties to keep pace with today’s trading world. More on that later.
Sin-Orgy
So the trouble was 2008 and that sin-orgy. The hard part was passing Dodd-Frank and now implementing these rules to address morphing markets—energy markets and others. But, there is one final challenge that may be beyond much of our control. It is also part of a serious sin-orgy. And let me say, I get no pleasure in saying the stuff I’m about to say. In fact, it truly makes me ill. I bet you can’t wait for it, can you?
Here it is. Here’s the serious sin-orgy. The financial sector had so much crap going on that it makes our heads spin. We are numb to all the violations of law. Most of us can’t even keep track of all the sins going on in our financial sector. We saw both Goldman Sachs and Citi establish these fake-out funds where they pressed their customers to participate, and then once the fake-out funds were populated with
their own customers, the banks themselves took the opposite positions.
Wells Fargo—the largest home mortgage bank in the country—entered into a $175 million settlement with the Department of Justice (DoJ)—the second-largest residential fair lending settlement ever. That case involved brokers that charged higher fees and rates to more than 30,000 minority borrowers.
And, if there are enough of the Massive Passives, and they far out-number the shorts, as we have seen, their strategy will have somewhat of a self-fulfilling prophecy. They will help to push prices. I’m not suggesting that they drive prices, but they have an impact, and any impact that isn’t based upon fundamentals of supply and demand is problematic for markets.
Why is it a problem? Well, there are two reasons.
One:
Commercial hedgers, like energy companies in the Houston area and elsewhere, use these markets for hedging their actual business risks. They have real physical skin in the game and they need these markets to function properly. If they can do this, it makes them more proficient and effective companies, and that’s good for all of us and our economy. These are markets that were
not developed as gambling venues; they
were developed to discover price. And,
Two: Consumers and businesses alike benefit from fairly stable pricing. It enables them to plan. Gasoline shouldn’t be $3 a gallon one month and $4 the next. Sure there will be fluctuations, but there shouldn’t be extreme volatility.
So Congress, as part of Dodd-Frank, charged the CFTC with setting speculative trading limits. The law, in my opinion, plainly and clearly mandates these limits. That said, there is a group of the largest speculators on the earth who have questioned the law and want be able to have uninhibited concentration in markets. They’d suggest that there isn’t a problem with holding 30 or more percent of a given market, like we’ve seen in crude, nat gas and silver in recent years. As I’m sure many of you know, these global speculators won a recent court ruling. But our Agency will appeal and I expect we will soon promulgate yet another position limits rule.
This thing, position limits, isn’t easy. Like JFK said, it is hard. But, it is a serious matter for millions. Millions of people and businesses alike can, at times, be paying a speculative premium and that’s just not right. I will keep fighting for them.
Cheetahs
The other market integrity challenge has to do with technology and high frequency traders (HFTs) that I’ve dubbed cheetahs because of their inconceivable speed. They function in milliseconds—one-one thousandth of a second. I’m told that if you are travelling at 100 miles per hour, a millisecond is the time it takes you to go two inches—two inches—inconceivable!
I think these cats have some attributes and I’m not seeking to see them become an endangered species. At the same time, they can also cause difficulties for markets.
We all know that technology isn’t always what it woulda, coulda or shoulda been. We see market technology SNAFUs consistently. We all recollect the Flash Crash from 2010. Most of us heard about the NASDAQ Facebook IPO fiasco. Some of us heard about an oil trader who lost a million bucks in less than a second. There are lots of examples. That’s why in order to safeguard market integrity, I think we need some basic provisions to help cage the cheetahs.
One: They need to be registered. Really, they’re not even registered? Nope. They don’t have to be presently. They need to be.
Two:
They should be required to test their programs before they are put into the live production environment, have wash blocker technology to avoid cross trading, and be required to have kill switches in case their cheetah program goes feral. And,
Three:
We need to update our fines and penalties to keep pace with today’s trading world. More on that later.
Sin-Orgy
So the trouble was 2008 and that sin-orgy. The hard part was passing Dodd-Frank and now implementing these rules to address morphing markets—energy markets and others. But, there is one final challenge that may be beyond much of our control. It is also part of a serious sin-orgy. And let me say, I get no pleasure in saying the stuff I’m about to say. In fact, it truly makes me ill. I bet you can’t wait for it, can you?
Here it is. Here’s the serious sin-orgy. The financial sector had so much crap going on that it makes our heads spin. We are numb to all the violations of law. Most of us can’t even keep track of all the sins going on in our financial sector. We saw both Goldman Sachs and Citi establish these fake-out funds where they pressed their customers to participate, and then once the fake-out funds were populated with
their own customers, the banks themselves took the opposite positions.
Wells Fargo—the largest home mortgage bank in the country—entered into a $175 million settlement with the Department of Justice (DoJ)—the second-largest residential fair lending settlement ever. That case involved brokers that charged higher fees and rates to more than 30,000 minority borrowers.
Then there is Barclays—one of the largest banks in the world—and its attempted manipulation of Libor rates. As you know, Libor rates affect just about everything in the world involving credit extensions. They are at the foundation of our global economic system, and Barclays tried to rig the numbers. They settled with us for $200 million. They also settled with DoJ and with the U.K.’s Financial Services Authority (FSA). And of course, there’s MF Global where, oops, millions went missing. And, there’s Peregrine Financial Group which appears to have engaged in a $200 million fraud.
Last November, Bank of America agreed to a $410 million settlement for charging excessive amounts on overdraft and debit card fees to 13.2 million customers. The bank computer system organized customer debit card and ATM transactions from high to low dollar amounts, as opposed to when the purchase was made. Consequently, customers would enter into negative balance circumstances quicker. As a result, they’d bounce more times and the banks would receive more overdraft fees. Oh, by way, somewhere around 13 banks agreed to enter into settlements for doing comparable things. Merrill Lynch, which was purchased by Bank of America in 2009, was reported to have done the same thing from 2003 to 2011. They charged excessive fees to about 95,000 of their own customers, overbilling them $32.2 million. They were fined $2.8 million. What a deal: overcharge $32.2 million and get fined $2.8 million!
All too often, it is clear that corporate executives crudely calculate fines as a cost of doing business. That’s gotta stop. For example, I was speaking about appropriate cheetah fines. We can only fine $140,000 per violation, but many times consider a day as a violation. Well, a cheetah can make a million in a few seconds, so I’m proposing that our violations should be by the second. Each second you violate the law, it could cost you $140,000. There, that’s a deterrent. If they do the crime, cheetahs or others need to pay a hefty fine and if severe enough, they should do the time. We need to get solemnly serious with the sinners. They need to clean up their acts, and now.
I know that’s a lot. Dodd-Frank will help on remedying the ills of unregulated markets. We need position limits and some policies to cage the financial cheetahs. But this other sin-orgy stuff, we can’t stand for. Look, we get the government and the financial system and the financial firms we deserve. If we have concerns, we have a responsibility to speak up and that includes speaking with our wallets. Choose where your money goes based upon firms that are good corporate citizens.
Conclusion
We all need to be involved—market participants, energy companies, consumers, and the students here at Rice who may or may not ever have anything to do with financial markets but who will nevertheless be impacted.
I’m not suggesting fixing all of this will be easy or trouble-free. It will be hard! But like President Kennedy said right here at Rice, that’s the point. It wasn’t easy going to the moon, but we did it. Rice did it. Commander Neil Armstrong did it.
All of us working together can help ensure we have a safer and more secure financial sector with no sin-orgy that is more efficient and effective and devoid of fraud, abuse and manipulation. That will be good for hedgers and speculators alike and good for markets. But, it will also be good for consumers and good for the economic engine of our democracy.
Thanks.
Posts
