FROM: COMMODITY FUTURES TRADING COMMISSION
“Where the History Comes From”
Speech of Commissioner Bart Chilton, OpRisk Europe London, England
June 13, 2012
Introduction: Hey Lama
Hey, OpRisk Europe 2012. “Hey” isn’t one of our more formal American salutations. It is colloquial, and I mean it in a friendly way. Of course, it is still used to gain attention, “hey!” We Americans aren’t always so formal. You never hear, as a farewell, an American saying “cheerio” for example.
At any rate, thank you for that generous introduction and for the invitation to be here this morning. It really is an honor and personal privilege to be with you—folks who work to make these global economic engines, these seemingly boundless and exciting financial markets, work.
A lot of times you—the people in this room—don’t get the reverence and respect you merit. Your work is important and imperative to our economies. Being someone from government, I really know how not getting respect feels. Nonetheless, I appreciate what you do, although, the value of that praise is questionable.
Anyone recall the old movie Caddyshack? I know it wasn’t a hit in Europe, except reportedly in Denmark—those Danes have a great sense of humor. There is a scene where Carl Spackler (actor/comedian Bill Murray) tells a story about when he was a looper, a golf caddy, in the Himalayas. One day, he caddies for the Dalai Lama, the Dalai Lama! At the end of the golf round, Carl thinks he is not going to get a tip, a gratuity, so he says, “Hey, Lama, hey, how about a little something, you know, for the effort, you know.” And the Dalai Lama says, “Oh, uh, there won’t be any money, but when you die, on your deathbed, you will receive total consciousness.” And, Carl explains, “So, I got that going for me, which is nice.” Thus, I think each of you is often under-recognized for your important work, but I thank you. So, you got that going for you, which is (maybe) nice.
International Context
I speak often about what and how we are developing U.S. financial regulations in the wake of our regulatory reform law—the Wall Street Reform and Consumer Protection Act, otherwise known as Dodd-Frank. That is, however, only one part of the story. As hard as it is for many in the States to sometimes comprehend, there is an entire world out there. So today, let’s talk financial reform with a focus on the international context. This is something which we must address if these rules are going to be efficient and effective. When I say “we” must address, I am suggesting all regulators and those, including you here, involved in these incredible markets.
The only true method for financial regulations to work well is if they are harmonized, to a robust degree, among nations. I appreciate there will be individual and idiosyncratic issues. I appreciate we all need to respect each other’s sovereignty. There is no suggestion here that financial regulation has to be word-for-word identical. Of course it doesn’t have to be identical. But to the extent we can, we should realize and address the interconnectedness of these markets. Not to do so would be a faulty premise on which to establish these new and improved regulatory regimes. Sounds like a laundry detergent: new and improved regulatory regimes, with added transparency for cleaner markets!
Where the History Comes From
As we undertake these challenges, we need not only to be respectful of others, but learn from each other, from various experiences, and from each other’s history.
Eddie Izzard (another actor/comic) does a stand-up bit where he says, “I grew up in Europe, where the history comes from.” He’s so funny. I bet the Danes love him. He says, “We’ve got tons of history, lying about the place—big old castles.” He talks about Euro Disney and building the Disney fairytale castle. One of European engineers says to an American: “You’d better make it a bit bigger. They’ve actually got them here . . . and they’re not made of plastic.”
Nevertheless, this is where the history comes from. You have a lot of experience—a plentiful past. You have thousands of years of financial know-how. I’m not suggesting that the market economy from the 1500s, or joint-stock companies in the late seventeenth century are terribly apropos to our global markets these days. However, we should learn from all of our applicable experiences and be determined to craft considerate rules and regulations which reflect the experiences and history of others, while harmonizing to the greatest extent attainable.
Ace and Amazing
Just think about the improbable inter-related global markets that exist at the present time. Every single business day, there are at least 160 million, million, financial transactions. And I’m talking market-related transactions, not something resembling a check being cashed, an ATM withdrawal, or a commercial store purchase. There are 160 million global financial market transactions per day. However, it isn’t just the number that is staggering; it is how all of those mind-boggling transactions work together, in harmony, between markets, crossing borders, trading venues and regulatory jurisdictions. It is simply incredible.
It is almost too difficult to process with a normal brain. It’s ace and amazing that it all works so well. But then again, we only need to look at recent history to know it doesn’t always work so well. In fact, given 2008, “it didn’t work so well” is a fairly substantial sarcasm.
Thing One and Thing Two
There are a couple of causes to the crisis—“Things,” if you will—that led to the system pretty much failing the entire world.
Thing One—shout out to good Dr. Seuss—were lax or non-existent laws and regulations that allowed the free markets to rock ‘n’ roll so much that they rolled right over our economies—and our citizens. There is an old saying about how the best things in life are free—well, the worst things in life are also sometimes free, like unbridled free markets with no oversight. Of course, it wasn’t just the lax laws, rules and regulations. Nope, Thing One just set the table for the banquet to come.
Thing Two were the cooks in the kitchen: the Wall Street wizards, the global gatherings of gurus all things financial, the economic intelligencia. They wholly developed these very pioneering products, these innovative investments to be traded and re-traded. Don’t get me wrong. Some were full stop dodgy, but party on they did. Yep, they cooked and prepared this big buffet of myriad exotic economic products that were progressively consumed by traders, investors, big banks and small banks; a wide panoply of the financial world taste tested the treats. And, many of them did so over and over, again and again.
Even on the regulated exchanges, markets were unbelievably morphing in new and exciting ways. There were new investors bringing in hundreds of billions in fresh dough and new technologies. A lot of the trading was occurring at lightning speeds. It was all enormously exhilarating.
Boy oh boy: Thing One and Thing Two, those troublemakers. Dark markets, lighter markets, monster markets of unprecedented size and girth, mini-markets with bantam volumes trading this or that—sometimes being pushed or pulled due to the slim liquidity, here markets, there markets, now markets, later markets. Traders were burning and churning up the fiber optics, and phones were on fire, nearly 24-7-365, with all of the action-packed bartering and bargaining.
Plus, think about the portability of risk in these global markets with worldwide institutions. The risk can be true and tried, freeze dried, flash fried and moved all around. It can be done abruptly, to boot. You don’t want risk in one nation? No problemo. Hasta la vista, baby. With a few clicks of the mouse, presto change-o, your risk can be transmitted, transferred or transported from one firm to another, from one market to another, from one country to another. And from a regulator’s view, I can tell you that it might sometimes look more like of one of those shell games than anything else.
This risk transferring isn’t just hypothetical, as many of you know. We all recall American International Group (AIG) Financial Products. Well, while they were initially structured in the U.S., they were managed from here, in London. Mammoth risks ended up in the States. In fact, U.S. taxpayers, as part of the Troubled Assets Relief Program (TARP), bailed out AIG to the not-so-tasty tune of 40 billion buckaroos. Bottom line: these are global markets with interconnectedness that is simply part and parcel to the sheer existence of how the world’s finances function today.
Wow. Whew. I’m dog-tired describing it! Thing One and Thing Two: those harmless numskulls, what could gopossibly go wrong? Gulp. Wait until mom gets home.
Greatly Grubby
Well, unfortunately—shocker—we know all too well what went wrong. There were totally unregulated markets in the dark over-the-counter (OTC) space, trading in the hundreds-of-trillions of dollars.
To give you a size comparison, and size does matter, we at the CFTC currently oversee roughly $5 trillion in annualized trading volume, but the global OTC market is roughly $650 trillion—$650 trillion! That’s ginormously humongous—a term of art. The Danes are writing that one down. Plus, as I said, there was absolutely no government oversight. No government in the world had the OTC markets on their plate. Not an iota of enforcement or regulatory oversight—zippo, zilch, nil. No requirements for trades to be cleared or backed with some orderly accounting technique or standard existed. No requirements for transparency for pre-trade or post-trade reporting. There is a line that people use. I’ve used it—perhaps even today—that transparency is the best market disinfectant. Well, the OTC markets had no transparency, and it was greatly grubby. We just didn’t know how soiled or huge it was.
It’s astonishing, still today. Each party to a trade could value what was being exchanged at whatever amount they desired to accommodate their own balance sheets. Things were traded and re-traded to such a degree that nobody knew what was worth what. The result is that some firms were excessively over-leveraged—much more than made sense to any economist on the planet.
Take for example Lehman Brothers, before they were another one bites the dust, (yeah, shout out Queen). Who recalls how excessively they were leveraged? Are you ready? Are you ready for this? Are you hanging on the edge of your seat? They were leveraged at 30 to one. Their last financial report had the firm with $691 billion in assets, yet only $22 billion in shareholder equity. The trading that was going on in the OTC world allowed them to put whatever valuation they required on their balance sheets. And, it appears they did at Lehman. That risk wasn’t just a U.S. risk, but a U.K. risk and a risk transferred to other places around the globe.
What Now?
Now, there is not only an acknowledgement that Thing One and Thing Two led to the crisis, but there are laws, rules and regulations in various stages of being implemented to guard against a sequel to the economic calamity. There is an acknowledgement that new regulatory rules are required—particularly in the other major market jurisdictions like here in Europe, in Japan and in Canada. There is agreement that we should never again allow our economies and our citizens to be defenseless against unregulated or poorly regulated markets and the collateral risks associated with such markets.
The ET: Borderlines
As we seek to harmonize rules and regulations, however, there will be issues that ruffle the feathers of our colleagues here or there, and we too, will get concerned at certain points. It has happened in our history when things cross borderlines and it will continue to happen. Amongst the significant remaining issues we are communicating with our colleagues in the European Union (E.U.) and other jurisdictions is trying to ensure we have a sensible approach to the cross-border application of the Dodd-Frank swaps market reforms. This is commonly referred to as the “ET”—not E.T.: The Extra Terrestrial (although some of what we discuss seems alien)—but the extra territoriality issue, ET— extra territoriality.
On one hand, if a transaction takes place, let’s say, here in London, should I care about it as U.S. regulator? Well, I can understand the argument of those that say it shouldn’t involve anything U.S. However, on the other hand, what about that transference of risk? What about risk being shifted from one nation to another, that movement I equated to sometimes looking like a shell game. Isn’t that something which should be of interest, if not concern, for all of us? And believe me, we watch carefully when we see problems in the Eurozone—it has a direct and immediate impact on our markets. Did you know, for example, that 21% of all U.S. exports go to Eurozone countries? So when there’s a problem in one or two or three of them, it has a real impact in the States.
For our part as U.S. regulators, Dodd-Frank requires—Section 722(d)—that swaps reforms shall apply to activities outside the U.S. if those activities have “a direct and significant connection with activities in, or effect on, commerce” of the United States.
Consider JPMorgan Chase (JPM). We all know they recently experienced a multi-billion dollar trading loss. These trades were transactions out of here, out of London. But you know where the losses are being absorbed—in the United States at JPM. As a U.S. bank, JPM has direct access to the Federal Reserve’s discount window and the Federal Deposit Insurance Corporation (FDIC). So, do I care about JPM’s trading in London when U.S. consumers and taxpayers might theoretically be on the hook in the future for a loss insured by the FDIC? I sure as shooting do! Besides, as a matter of U.S. law, billions in JPM trading losses, regardless if the transactions took place in London, Luxembourg or Lisbon, would certainly constitute a direct and significant connection with activities in, or effect on, the commerce of the United States.
How do we deal with this somewhat troubling set of circumstances? Well, first we need to treat each other with dignity and respect. Regulators have done a good job on this count to date. Additionally, we need to learn from each other’s experiences, including the place where the history comes from: Europe. Vitally important is that we need to harmonize our laws, rules and regulations to the greatest extent possible. Here’s why: if we do that, for example and we have comparable rules and regulations, then there would be no need for U.S. regulators, or other global regulators, to impose some seemingly over-reaching provision involving ET.
We have the authority to rely upon another nation’s ability to oversee these things even if the trading has a direct and significant effect on U.S. commerce if the foreign nation’s regulatory structure is comprehensive and comparable. This, “substituted compliance” is how to best address the thorny ET issue. However, it requires that vital harmonization occur, and not just between the U.S. and E.U.
In that regard, one of the problems is that at this point, we (my Agency) haven’t put any more meat on the bones of the issue—our bad. In order to flesh the issue out some more, we will, I expect very soon, show a little leadership and release some interpretive guidance on the subject. We will let folks know how the reforms might apply and provide a synopsis about when and how overseas swaps market participants and swap dealers, might comply with the Dodd-Frank reforms. Significantly, we will spell out how we might be able to rely upon these comparable and comprehensive foreign regulatory regimes.
I look forward to having this proposed interpretive guidance out in the public, and soon. More importantly, however, I look forward to receiving public comments. I am confident and optimistic that we will see increased efforts at greater harmonization of the main regulatory issues being considered here, and in other nations. That really is in all of our collective interests.
Of particular consequence from my perspective are rules and regulations regarding clearing, margining, capital, trading and transparency, limits on speculation, and with regard to high frequency traders (HFTs).
Customer Protection—Full Segregation
We also need to address the protection of customer money. Recently, both in Europe and in the U.S., we’ve seen the apparent misuse of customer funds. Here is where we can take a good idea from the E.U. The European Market Infrastructure Regulation (EMIR) has some thoughtful protections for customers that the CFTC should adopt. Article 39.5 of EMIR, for example, allows customers to elect to choose between “omnibus client segregation” (which is similar to what the CFTC requires) and “individual client segregation” or what I call “full segregation.” While we don’t offer full segregation in the U.S., I believe we should. We ought to let customers elect to have their fully segregated funds and the excess margin to be deposited in a separate account under the custody of the clearing organization. We should allow customer money to literally be off-limits to a firm. If that means that a firm charges the customer extra, and the customer agrees to pay it, so be it. Let the firms compete in the free market and customers can choose that, too. (See, I’m a free market guy, too).
And by the way, we need to hold firm executives accountable for any misuse of customer funds. By that, I mean they should be personally accountable and personally liable.
The Van Gogh
Another fundamental issue that I’ve talked about for years, but which only seems to gain public attention when petrol prices are high, is speculative position limits. As we all know, prices were very high just in March and April, so there was a lot of attention to the subject. Today, not so much, although it is still very important, and I’m like a dog with a bone on this one. I won’t back down.
You may have heard about the Paris thief who tried to steal some valuable art from the Louvre. It is all very valuable there I suppose. Anyway, the thief was caught by the authorities only a few blocks from the museum when his van ran out of fuel. When he was asked about it, he said, “That was the entire problem: I had no Monet to buy Degas to make the Van Gogh.” Sorry, I wondered if I’d have de Gaulle to tell you that one. I figured I had nothing Toulouse.
Numerous studies show a link between speculation and prices. Studies from Oxford, the International Monetary Fund and from the
U.S. Federal Reserve all show it. Why does a trader need to have so much concentration that they can push prices around? I just don’t get it. So, speculative position limits are another key area where I hope we will harmonize to a great extent. I’ll leave it at that for now.
An App for That
One final policy issue I want to address is another topic that has been more of a concern in the E.U. than in the U.S., and is an example of where I think my regulator colleagues in the States need to pay more attention. Specifically, I’m talking about how the regulated markets are transforming with technology.
High frequency traders—those folks I call cheetahs due to their incredible speed, are out there all the time trying to scoop up micro dollars in milliseconds. I’m not saying they are unscrupulous or that these cheetahs should be an endangered species. What I am saying is that they are either unregulated or under-regulated and that needs to change.
The largest futures exchange in the World is in Chicago. Their third largest trader has been a cheetah based in Prague. Hooray for that cheetah. Hooray for Prague. But if we, the U.S. regulators simply want to look at books and records, that cheetah is not required to provide us with diddly squat—another term of art. We won’t get anything. Furthermore, we don’t even have the ability to command books and records information from domestic cheetahs. These cats are not required to provide a thing to the U.S. regulators, under the current set of circumstances, unless we get a judge to issue a subpoena. It is simply wacky. I do, however, have an app for that. At the very least, the cheetahs need to be registered. Yet, there are no places in the Dodd-Frank law where these traders are even mentioned. That is how quickly the markets are morphing.
Take the Flash Crash in the U.S., when the Dow Jones Industrial Average dropped by nearly 1,000 points in 20 minutes. That precipitous and speedy drop and the ensuing bounce back, would not have occurred if cheetahs weren’t involved. They didn’t start the fire. No, they didn’t light it, but they were ignited by it.
Think about this: The Flash Crash took place on May 6, 2010 at 2:45 in the afternoon. What if it had taken place very early in the trading day when these E.U. markets were open? The damage could have been much worse.
Why didn’t Dodd-Frank even address the cheetahs? Well, the legislation was in the final stages of being negotiated. It passed just over two months following the Flash Crash.
Here is what we know: There is a need for regulators to do something now to ensure that we aren’t vulnerable to some feral cheetah’s, or cheetahs’ action(s) in the future. In addition to being registered, shouldn’t the cheetahs be required to test their programs? Shouldn’t they be required to have kill switches in the event that they do go feral? I think so. I’m calling for that and today for the cheetahs to be required to establish pre-trade risk controls to prevent wash trades—period. And when I’m talking about cheetahs, I don’t only mean those with faster- than- speeding- bullet computers. This registration should include automated trading systems (ATSs), too. We need to ensure that cheetahs do not intentionally or unintentionally screw up price discovery. I’m also suggesting that there be periodic compliance reports from the cheetahs and that senior executives sign their names and be held personally liable for any false or misleading information. The days of “he said, she said” accountability in financial markets needs to stop, and now.
I anticipate our Agency will issue a concept release in the very near future to spell out some of these issues, and others. We will gather comments on this one, too. I also hope that we keep looking to the E.U. for leadership, coordination and cooperation on these critical matters that really are on the cutting edge of our markets around the globe.
The Cheerio Effect
You have an action-packed day, so in a bit here, I'll make like a tree and leave. However, I want to leave you with two quick final thoughts on what we've spoken about today.
The first involves breakfast cereals. Yeah, breakfast cereals—hang with me. As we move to harmonize rules and regulations—addressing cross border ET issues, customer segregation, position limits and caging the financial cheetahs, we understand that we aren't alone in the world. Yes, the markets in the U.S. and the E.U. are large, but we certainly aren't alone. There are a bunch of us in the bowl together.
There are other nations and other regulators looking at what we are doing. In fact, some are looking to gain from our regulation implementation. Not many people talk about it, but it has been happening for a while. Many of you may have already been given a sales pitch to move your trading to another nation. I’ve heard many stories about this. I know it to be the case.
Some believe with fewer requirements for reporting, clearing and registration that they can capture a portion of markets that are subject to new regulation. The idea is there will be some massive market migration as a result of overly-prescriptive rules and regulations. I won't mention nation names, although I have before, but there are some out there, right now.
Contrary to all that, I don't think that this market migration will occur. I don’t see a regulatory race to the bottom. The global trading environment requires thoughtful and harmonized regulations. Suitable regulations will make jurisdictions more competitive, not less. I don't believe, as long as we are cautious and careful, that we will see market migration to nations with the thinnest of rulebooks. In fact, I don’t think there will ultimately be many thin rulebooks.
Here is why, and here is where we get to what is called, in fluid dynamics, and that lovely British expression, “cheerio”—the Cheerio Effect. The Cheerio Effect is the predisposition for slight, wet-able, floating substances to attract one another. In a breakfast cereal, like Cheerios, we see a phenomenon in which the cereals tend to cluster together or stick to the edges of a bowl of milk. You’ve all seen this phenomenon at breakfast or even in a soup with oyster crackers. The Cheerio Effect: it all has to do with the surface tension and buoyancy. In the financial world these days, there certainly is tension, and if we’re going to have the buoyancy to rise above it, we, like Cheerios, need to stick together.
My point, and I do have one, is this: like the Cheerio Effect, I believe financial regulations will cling together in the proper environment. They will attract each other. So, if the U.S. and the E.U. implement harmonized financial regulations, it will attract others to adhere to similar financial rules.
Fuel-Injecting Economies
The second takeaway and final thing today, is this: there has been a lot of talk about how these regulatory changes will stifle innovation. They'll be so wicked evil restrictive that no financial business will ever survive—never—they just couldn't. The cost of compliance alone will run firms straightaway to death’s dark door.
I consider that rubbish—raving rubbish. In fact, there is an abundant amount of competition out there already, right now, today. We see it all the time. These regulatory reforms are going to create more jobs, more innovation, and fuel-inject our economies more than anyone ever would have thought possible. Firms are already making strategic moves. Their tactical teams are reckoning what to do when and how. All of this, before we have even completed all our rules. New clearing houses, swaps data repositories, and swaps execution facilities are all not only on the drawing tables; some are already up and running.
I have confidence in the Cheerio Effect and that the rest of the world will cling to our harmonized financial regulations. I believe these regulations will provide a competitive advantage to first-movers on the regulatory front.
This is all very exciting, indeed, and isn’t it neat that you are all part of it? You are right in the smack dab ma-diddle of it all. There are myriad opportunities out there and more presenting themselves all the time. It is exhilarating. There's a lot going on in these incredible financial markets, even beyond the 160 million transactions per day, and guess what? There's a lot more to come—a lot more.
So, buckle up. Enjoy OpRisk Europe 2012. The Danes and I will do a little debriefing. Hasta la vista, baby . . . and, cheerio.
Thank you.
Last Updated: June 13, 2012
