CFTC COMMISSIONER O'MALIA SPEAKS ON 'GOOD GOVERNMENT' REGULATION

FROM: COMMODITY FUTURES TRADING COMMISSION
Commissioner Scott D. O’Malia Before Mercatus Center, George Mason University
November 13, 2012
Jim, thanks for that kind introduction.

I am happy to be here and pleased to see the Mercatus Center, as it often does, putting the spotlight today on an issue that is near and dear to my heart: how government regulation affects the real world. That’s right: government regulation has real-world consequences. What a revolutionary concept. You may take this concept for granted, but too often government regulators fail to understand, or take into account, the effect that regulations will have on markets and market participants. And this problem has been especially true in the past two plus years, as government agencies have rushed to promulgate rules under the Dodd-Frank Act. As you know, we at the CFTC have been in the trenches of Dodd-Frank implementation. I would like to take this opportunity now to provide you with some of my thoughts on this implementation process.

Don’t worry – I won’t take you through an exhaustive review of the Commission’s work because at 39 final Dodd-Frank rules and counting we would be here until tomorrow. Instead, what I would like to do is talk to you about good government. You see, I am the government employee who believes that government doesn’t have all the answers and that it must do a better job of developing "good government" solutions.

What Is Good Government?

You may ask: what do I mean by good government? In a nutshell, good government regulation strikes the right balance in order to develop beneficial rules of the road and to implement them according to a measured and reasonable timeline. This approach requires fact-based analysis in order to come up with cost-effective solutions based on a range of policy options.

So, what does it mean specifically in the context of the Commission’s rulemaking process? For rules that have not yet been proposed, good government means faithful adherence to the statutory authority and a strong understanding of the markets that will be affected by the envisioned regulation. For rules that have not yet been finalized, it means understanding and addressing the concerns of market participants and adopting final rules that are clear, consistent and create a level playing field. For rules that have already been finalized, it means providing transparent implementation guidance that is consistent with the final rules. In addition, good government means being aware of the consequences of Commission regulations on market activity and maintaining the flexibility to reassess and revise such regulations where appropriate.

If we apply this framework of good government regulation to what the Commission has done in the past two plus years, we can see many places where we have fallen short of the standard. One example is the position limits rule, which a federal court recently struck down.<sup>1 The Commission will file an appeal, which I don’t support because I agree with the judge’s ruling that the Commission failed to justify its establishment of limits as required by the statute. I would like to point out that the Commission has now been sued three times within the past year on its rulemakings.2

Today I want to focus on three areas in particular of the Commission’s implementation of Dodd-Frank. These are: the October 12 effective date for swap regulations and the resulting ‘futurization’ of the swaps world, the Commission’s final rules for swap execution facilities (SEFs), and the Commission’s guidance on cross-border issues.

The Nightmare of Friday the 12th

I would like to start with the significant date on the Dodd-Frank implementation calendar that we passed last month. On October 12, the joint CFTC-SEC definition of the term swap became effective. This triggered compliance dates for a number of other Commission swaps regulations.

As it turned out, Friday, October 12 was a day of great drama, but certainly not in a good way and certainly not by design. Friday the 13th may have been more appropriate, given the nightmare scenario the Commission was trying to avoid at the absolute last minute. In truth, the nightmare was the fact that we had reached such a point in the first place.

By that evening, the Commission had rushed out 18 no-action letters and guidance documents in a last-minute attempt to mitigate the chaotic impact of all the rules that were to take effect the following Monday. Think about that for a second: 18 relief documents issued on the day before the compliance deadline. We don’t need a study by the Mercatus Center to tell us that this last-minute flurry fell embarrassingly short of the goal of regulatory certainty and the principles of good government regulation.

Good government should take a measured, well-thought out approach to developing a new regulatory regime. To that end, I have repeatedly asked the Commission to publish a clear and specific rulemaking timeline and implementation schedule. Frustratingly, my calls have gone unheeded. A clear and well-reasoned implementation schedule would have allowed the Commission to avoid the hurried, ad-hoc process of temporary relief and interpretations that we witnessed and would have done much to put the Commission’s rulemaking process in the good government category.

Even now, we are not out of the woods yet. The temporary relief provided expires on December 31, and we can’t risk keeping the markets in the dark until the eleventh hour again. The Commission needs to take action by mid-December in order to provide adequate clarity to the markets through the new year. Think of this as the Dodd-Frank Regulatory Cliff.

Let me go back for a minute to October 12. The big storyline is the migration of cleared energy products to the futures markets. In response to regulatory uncertainty in the swaps market, energy customers of both CME and ICE demanded that the markets move to listed futures, instead of swaps. There are good reasons to stay away from the swaps market, including the expansive and ill-defined swap dealer definition and the regulatory consequences of becoming designated as well as uncertainty as to what will be permitted to trade on SEFs. In addition, the capital efficiency of margining all trades in one account is also a powerful financial incentive.

On October 15, the day the new swap rules took effect, the entire market had shifted from a swaps market to the futures market. Liquidity simply dried up in the OTC space. To me, this is evidence of the Commission’s struggle to get swap regulations right.

This futurization of the cleared energy swap market may result in reduced flexibility for some firms because futures contracts, unlike swaps, can’t be individually tailored to meet specific risk needs. However, futures markets offer greater regulatory certainty and provide high liquidity to allow for the efficient hedging of commercial risk.

It was surely not the Commission’s intention to draft rules that would send market participants fleeing from the swaps market. But good government requires more than good intent; it requires good execution of that intent as well. Instead, the Commission has created such a regulatory nightmare that the energy markets have sought cover in the relative safe haven of the futures markets.

And we may very well be at just the start of the futurization of our markets. Again, it’s hard to believe that this brave new world of futurization is what the Commission envisioned would be the end result of its new swaps regulatory regime.

Learning Lessons and Moving Forward

But I bring up these examples not simply to say that the Commission should have done better. Rather, I raise them because learning from mistakes is the crucial first step toward getting us back on the road of good government regulation. And luckily for us, there are several significant rules on the horizon that will give us that opportunity. For example, the Commission has yet to consider final rules on capital and margin requirements. The Volcker rule, which will clarify and distinguish market-making trades from proprietary trading, is also in this category.

These rules will put a final price tag on over-the-counter trades and will have broad and significant consequences for the swaps markets, so it is very important that we get them right. If we make sure to identify concerns raised by market participants and properly address them in the final rules, and then implement the rules in a measured and consistent manner, I am confident that we can get them right.

In any case, those rules are still a bit further down the road. Of more immediate interest are two areas that the Commission will likely consider before the end of the year. These are trade execution, including SEF final rules, and the cross-border guidance.

Swap Execution Facilities

Let me address the SEF rules. This is an area that I am excited about. There are new trading models that offer exciting innovations and ideas that will make the swaps market more transparent and well as more competitive.

As you know, the concept of SEFs was heavily negotiated in Congress as well as at the Commission. SEFs represent a monumental shift away from the current bilateral swap trading model to a centrally regulated trading model. Centralized swap execution should offer market participants greater price transparency, increased access to larger pools of liquidity, and improved operational efficiency. Congress envisioned that SEFs would promote price discovery and competitive trade execution in all asset classes.

The Commission published the proposed SEF rules last January. While the proposal was a good start, a broad array of market participants – from buy-side asset managers, pension funds, commercial end users, farm credit banks and rural power cooperatives to sell-side dealers and even prospective SEFs – expressed concern that if the final rules are adopted as proposed, less liquid swaps will not be able to be executed on the SEF platforms because the proposed SEF rules would limit their choice of execution.

While I am supportive of the overarching objective of promoting pre-trade price transparency, I believe that the SEF final rules should allow for flexible methods of execution including request for quote systems (RFQs). These features will protect the confidential trading strategies of asset managers, pension funds, insurance companies, and farm credit banks and will provide commercial end users access to the swap market to fund their long-term capital and infrastructure projects.

Finally, I hope that the final SEF rules will provide a clear interpretation of the "by any means of interstate commerce" clause contained in the SEF definition. Dodd-Frank defines a SEF as a platform on which multiple participants have the ability to trade swaps by accepting bids and offers made by multiple participants, through any means of interstate commerce.
3 Instead of providing further meaning to the "any means of interstate commerce" clause, the proposal focused on two methods of execution on a SEF: an electronic platform and an RFQ.

Currently, the Commission is considering the suite of related execution rules that determine the viability of SEFs and the overall OTC market going forward. These include mandatory clearing, Core Principle 9, and the block and made available for trading rules in addition to the SEF rules. These rules must work together and reflect the new realities of the evolving market in reaction to the Commission’s already finalized rules.

I remain optimistic that we can develop rules that will encourage a competitive and innovative market in swap trading as envisioned by Congress and something the market has been developing over the past decade. It would be a shame if government rules stood in the way of this opportunity.

Regulatory Overreach: The Commission’s Cross-Border Guidance

Moving now to the third topic I want to discuss: the Commission’s Cross-Border Guidance.

Last week the Commission held a public meeting with regulators representing most of the largest markets across the globe, and their criticism of the Commission’s overreaching cross-border Guidance was consistent and firm. I certainly don’t want to see this draft proposal result in a regulatory tit-for-tat that would create an environment where U.S. financial institutions and market participants are put at a competitive disadvantage based on competing regulatory regimes. I am committed to resolving this regulatory matter to the satisfaction of all regulators and minimizing regulatory overlap and confusion so that market participants have a clear understanding of the new global regulatory paradigm. As such, it means we must redraft our cross-border Guidance.

Let me give you some background. The Commission published its proposed Guidance as well as a related exemptive order in July of this year. The objectives of the Guidance were to (1) clearly define the scope of the extra-territorial reach of Title VII of Dodd-Frank and (2) reinforce the Commission’s commitment to the goals of the G-20 summit by providing a harmonized approach to derivatives regulation.
4

These are sound objectives. However, the proposed Guidance missed the mark in several respects. Start with the fact that it was issued as guidance and not as a formal rulemaking, which would have required the Commission to conduct a cost-benefit analysis. As proposed, market participants will be deprived of an opportunity to review and comment on a cost-benefit assessment despite the significant costs that the Guidance will impose on them.

More fundamentally, the proposed Guidance exceeded the scope of the Commission’s statutory mandate. The statute provides that Dodd-Frank swaps regulations shall not apply to activities outside of the United States unless those activities have a direct and significant connection with activities in the United States.
5 This provision was drafted by Congress as a limitation on our authority, yet the proposed Guidance has interpreted it as the opposite.

As a result, the proposal empowers the Commission to find virtually any swap to have a direct and significant impact on our economy and imposes U.S. rules and obligations, including requirements on transactions, on non-U.S. entities. This has set off alarm bells in foreign capitals across the globe, and the Commission received an unprecedented number of letters from foreign regulators.
6 Just a few weeks ago, a strongly worded joint letter from the top finance officials of the UK, France, EU and Japan again urged the Commission to reconsider its approach and engage much more actively with them to coordinate regulatory efforts across borders. And as I mentioned earlier, these views were strongly echoed by representatives of several foreign regulators at a meeting last week of the Commission’s Global Markets Advisory Committee.

The Commission’s statutory overreach is reflected throughout the proposed Guidance. A prime example is the definition of U.S. person, which as drafted in the proposed Guidance sweeps numerous entities that are outside the U.S. into the Commission’s jurisdiction. The proposal requires non-U.S. counterparties to treat overseas branches of U.S. banks, unlike affiliates of U.S. banks, as U.S. persons. If these foreign companies do enough business with foreign-based U.S. banks, they will be subject to U.S. regulation.

The Commission has heard concerns from a number of U.S. banks that foreign competitors are trying to tempt clients away by pointing to the potential increased costs of doing business with U.S. banks as a result of the Commission’s proposed Guidance. Even more disturbing, the Commission has received more recent indications that many foreign firms are no longer doing business with U.S. banks. I’ve said it before and I’ll say it again: I cannot support a Commission proposal that puts U.S. firms at a competitive disadvantage to foreign banks, especially those that operate in the United States.

As I mentioned earlier, good government regulations address the concerns of market participants in drafting a final Commission document. In this case, both the market and foreign regulators have spoken loudly.

So here is what the Commission should do. First, the entire Guidance should be scrapped and the document should be re-drafted as a formal rulemaking that provides an opportunity for public comment and includes a cost-benefit assessment.

Second, the proposal should provide a clear, consistent interpretation of the "direct and significant" connection with a sufficient rationale for the extent of the Commission’s extraterritorial reach. Identifying more accurately those activities that could pose a risk to the U.S. will allow the Commission to assess how such risk could be mitigated through clearing and to determine whether other transaction rules must be applied.

Third, the definition of U.S. person should be narrowed to include only those entities that are residents of the U.S., are organized or have a principle place of business in the U.S., or have majority U.S. ownership. It should exclude a foreign affiliate or subsidiary of a U.S. end user that is guaranteed by that end user. This more reasonable definition is similar to the definition articulated by Commission staff in one of the flurry of no-action letters issued on October 12.

Finally, the rule must clearly interpret the concept of "substituted compliance." The proposal indicates that the Commission will review the comparability of non-U.S. regulations with Commission rules. This review should be a broad, big-picture assessment of comparability, not a rule-by-rule analysis. A rule-by-rule comparison could result in a hodgepodge of disparate regulatory requirements that would be a compliance nightmare for market participants. It would also undermine the coordinated regulatory effort that G-20 members have agreed to support.

The bottom line is that today’s swaps markets are global in nature and interconnected. Given this reality, the Commission needs to engage much more actively and meaningfully with foreign regulators and develop a more harmonized approach in order to eliminate redundancy and inconsistency among the respective regulatory regimes.

Conclusion

To conclude, I want to emphasize how important it is for the Commission to be mindful of the real and significant impact that its regulations have on market activity. Anyone who doubted this reality needs look no further than October 12, the new world of futurization that we are seeing in our industry and the mounting lawsuits that the Commission is facing.

Therefore, it is crucial that we apply the principles of good government so that our regulations are clear, consistent and not overly burdensome to market participants. As I’ve noted, we have at times failed to live up to these standards. But if we are willing to learn from these lessons, we can do better with the rules we have before us and on the horizon.

Thank you very much for your time.</sup>

FLORIDA RESIDENT ACCUSED OF SOLICITING INVESTORS TO BE PONZI SCHEME VICTIMS

FROM: U.S. SECURITIES AND EXCHANGE COMMISSION
The Securities and Exchange Commission today charged a South Florida man with defrauding at least 14 investors by soliciting them to invest in a Ponzi scheme. A significant number of the victims were members of the gay community in Wilton Manors, Florida and included inexperienced, unaccredited investors.

In the complaint filed in the U.S. District Court for the Southern District of Florida, the SEC alleges that James F. Ellis, 69, a resident of Wilton Manors, Florida, fraudulently solicited investors for George Elia from 2004 to 2011. Elia operated pooled investment vehicles under the names Investor Funding Club and Vision Equities Funds. Elia purported to trade in stocks and earn annual returns as high as 26 percent, but was actually running a Ponzi scheme and paying returns to existing investors from new investor funds. In April 2012, the Commission charged Elia with securities fraud. See Litigation Release No. 22319 (April 6, 2012).

According to the Commission's complaint against Ellis, Ellis persuaded prospective investors by falsely telling them that he had personally invested with Elia at least $5 million that he had inherited from his parents. Ellis variously told investors that he earned 16% to 20% annual returns on his investment with Elia or that he earned $20,000 to $24,000 per month. Elia and his entities did in fact pay Ellis over $2.1 million over seven years. However, those payments were not investment returns because, as Ellis knew, he had not made an investment with Elia that would have returned such large sums of money. According to the complaint, Ellis also reassured prospective investors of the safety of the investment by falsely telling them that he had tested Elia by depositing a large amount of money with Elia, then asking for and receiving it back.

According to the complaint, Ellis bolstered his deceptive claims about the success of his investment with Elia with ostentatious displays of wealth, including expensive real estate, luxury cars, jewelry, opulent entertaining of his friends, and expensive cruises. Though Ellis claimed that his investments with Elia made his luxurious lifestyle possible, he failed to disclose to investors that his wealth derived not from legitimate investment returns but from the money that Elia paid him for fraudulently touting Elia's investment vehicles.

The Commission's complaint charges Ellis with securities fraud in violation of Section 17(a)(1), (2) and (3) of the Securities Act of 1933 ("Securities Act") and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder. The complaint also alleges that Ellis violated the registration provisions of Sections 5(a) and (c) of the Securities Act. The Commission is seeking permanent injunctions against Ellis for violating the above provisions of the securities laws, disgorgement of ill-gotten gains plus pre-judgment interest, and civil penalties.

Separately, the United States Attorney's Office for the Southern District of Florida today announced criminal charges against Ellis for his conduct in the scheme.

The Commission thanks the U.S. Attorney's Office and the Federal Bureau of Investigation for their assistance in this matter.

ALLEGED CREDIT UNION INVESTMENT FRAUD

FROM: U.S. SECURITIES AND EXCHANGE COMMISSION

SEC Charges Purported Credit Union and Its Principal with Offering Fraud

On Nov. 8, 2012, the Securities and Exchange Commission filed a civil injunctive action in the United States District Court for the District of Colorado against Stanley B. McDuffie, a resident of Denver, Colorado, and his entity, Jilapuhn, Inc., d/b/a Her Majesty's Credit Union (HMCU), in connection with a fraudulent and unregistered offering through which McDuffie and HMCU sold more than $532,000 in alleged certificates of deposits (CDs) to investors.

In its complaint, the Commission alleges that from 2008 to 2012, McDuffie and HMCU lured investors to purchase the CDs through the HMCU website and a branch office in the U.S. Virgin Islands. McDuffie and HMCU held out HMCU as a secure, legitimate, regulated credit union, promised to pay above-market interest rates, and assured investors that their deposits were insured by Lloyd's of London or the U.S. Virgin Islands' government. In reality, HMCU was an unregulated, illegitimate credit union that never held share insurance covering investor deposits, and McDuffie and HMCU misappropriated investors' funds.

The Commission alleges that McDuffie and HMCU violated Sections 5(a), 5(c) and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder, and, alternatively, that pursuant to Section 20(a) of the Exchange Act, McDuffie is liable as a control person for HMCU's violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

The Commission appreciates the assistance of the Colorado Department of Regulatory Agencies, Division of Securities, in this matter.

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CFTC COMMISSIONER CHILTON SPEAKS TO THE INVESTMENT AND COMMODITY PRICE CYCLES CONFERENCE

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.