Regulation

As was mentioned, I am a recovering regulator.   I joined the NYSE Euronext management team upon leaving the Federal government in July after seven years as Commissioner and Acting Chairman of the Commodity Futures Trading Commission, the agency that oversees trading on the nation’s futures exchanges. 

Being Chairman of the CFTC had its good points.   People used to call me Mr. Chairman all the time.  In every meeting, I got to speak first.  My views were always insightful and my jokes were always funny.  Unfortunately, since leaving the CFTC I have found out that I am neither that funny nor interesting.  It turns out my wife was right again.

Being Chairman also had its challenges.   In that role, I testified nearly 20 times before Congress as oil prices rose to record levels last summer.  As Chairman, I worked with other members of the President’s Working Group on Financial Markets last fall to try to prevent financial contagion in the wake of the Lehman Brothers collapse. These were extraordinary and difficult days but there were lessons learned worth sharing today.

One lesson from the crisis—following its recent first anniversary—that should be at the top of our list is one that goes to the heart of human interaction and is fundamental to our economy and financial markets.   That lesson is how fragile trust is. 

Every dollar bill printed has the word “trust” emblazoned on its back.   Without trust, money is just colored paper without value.  Without trust, financial markets cannot operate as lenders worry that loans will not be repaid.  Without trust, entrepreneurs are not willing to take risks and innovation halts.  Without trust, the public loses faith in financial institutions and the government that exists to serve them.  NYSE Euronext stands ready to step up as a leader in restoring this public trust in our financial markets.

One year after the crisis triggered a deep, worldwide recession, the stock market is up almost 50% from its low in March, consumer confidence is on the rise, housing prices have stabilized, and financial institutions are paying back the government funds used to steady the economy. 

While high unemployment stubbornly persists, the many signs of economic progress suggest dramatic actions taken by regulators, lawmakers and the corporate sector appear to be working.   These accomplishments are noteworthy, but the recent one-year anniversary of the financial crisis highlights the necessary work that remains unfinished.   

The public, while perhaps heartened by the recent market rally, remains deeply distrustful of Wall Street.    In a recent Gallup poll, fewer than one-in-four Americans expressed confidence in the nation’s financial institutions.  Who’s to blame them? 

It takes years to build investor trust and only a moment to waste it away.  As I tell my children all the time, trust is fragile and it doesn’t take much to destroy it.  But how do we build back confidence in our financial institutions so that Americans are willing to take risks and grow our economy?

As the recovery takes hold, we have a unique opportunity to build a better and smarter financial system—one that leverages technology and that calibrates regulation according to risk rather than bureaucratic checklists.  Policymakers should not create this system alone.  Financial institutions should share in this responsibility of rebuilding a smarter financial model that does not reward excessively risky behavior and that holds companies accountability for protecting the long-term interests of shareholders.  Wall Street must build back its trust and credibility with the American public by working to find the right solutions to the financial crisis.

A few weeks back, President Obama came to Federal Hall across the street to outline some of the fundamental weaknesses in our financial regulatory structure and an underlying lack of market transparency that helped precipitate the financial crisis.   NYSE Euronext supports the Administration’s proposal on financial reform that will bring large segments of the financial markets out of the darkness and into the sunshine. 

Until we fix underlying problems in our financial system, Americans will remain skeptical of financial markets and corporate America , and the economy will have a much tougher road to full recovery.  We must bring trust and confidence back to Main Street , and get everyone to understand that Main Street and Wall Street are one in the same.

Our financial services industry is the largest and most sophisticated in the world.   Yet the crisis made it painfully clear that our existing financial regulatory structure is overly-complex and rife with perilous gaps and confusing overlaps. 

We need a regulatory system that does not allow loopholes to exist, whether for new financial products or existing companies doing business in unregulated areas.  At the same time, the regulatory system should encourage innovation, risk-taking and healthy economic activity. 

Earlier this year, Secretary Geithner rightly proposed bringing certain standardized derivatives out of the shadows and trading them in the open on exchanges and clearinghouses, just as we do equities.   One clear lesson from the crisis is the exchange-traded and cleared model work extraordinarily well under stress as the OTC derivatives markets froze up and faltered.  No clearinghouse was at risk as trading flocked in record numbers to exchanges where transparent prices could be discovered, the creditworthiness of counterparties was guaranteed and risk could be properly managed. 

While not all derivatives should be exchange-traded and cleared, regulated exchanges and clearinghouses stand ready to accommodate standardized derivatives that would benefit from this proven model.   I applaud Congress for beginning to lay out the framework for this new financial model in legislation but they should keep this momentum moving forward and not lose site of this important lesson of the crisis.

However, as we tackle this regulatory overhaul, we must remember that reform should not mean enacting gratuitous burdens or punitive rules that simply villainize Wall Street and the corporate sectors, and thereby damage a prime engine of our nation’s prosperity. 

Over-regulation is not the answer.   Smarter regulation is. 

Smart regulation is not code for less regulation.   At times, more regulation is necessary where the risks justify the need.  Such is the case with over-the-counter derivatives, which were completely devoid of regulation despite their risk to the system.  There will be times when regulation is ill-placed or excessive compared to the public risks involved.   Smart regulation simply means that we calibrate regulation based on the hazards posed by the activity.  No more and no less.

During the past year, the right steps were taken to avoid catastrophe.   Triage was necessary.  But now we need a renewed focus on the critical remaining tasks of building a stronger, more durable financial regulatory structure–one that protects the public from market failures and wrongdoing while keeping pace with innovation, rather than constantly struggling to catch up. 

The crisis created a once-in-a-generation opportunity to modernize our outdated financial regulatory structure.   We cannot let this opportunity pass.  Now is the time to build the financial infrastructure for the 21^st century with its new structures, its new rules and its smarter way of approaching risk.  The trust of the public rides on our collective efforts.

Smart regulation also requires us to harmonize and modernize the regulations already in place.   A few weeks back, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) issued a report on ways to harmonize regulatory rules for equities and futures.  This report, which follows historic hearings between the two agencies, outlines 20 constructive steps that are needed to align these two competing regulatory bodies and create a more uniform, fair, and responsive regulatory system.  This marks a good beginning but more can be done. 

The report rightly calls for rationalizing the treatment of margin for futures and securities, commonly referred to as “portfolio margining.”   Today, if investors buy securities under the SEC’s jurisdiction and hedge those securities in the CFTC-regulated futures markets, they must put up two sets of margin.  Yet, as farmers have long understood, the underlying risk of such positions is low since losses on one side of the trade are hedged by gains on the other.  

The report suggests changes in law to allow the recognition of these “portfolio” positions across the futures and securities markets.   This would enable regulators to assess capital charges based on a broader view of market risk and provide these agencies with greater transparency into the participants they police.  This change would be a win-win for both financial markets and regulators. 

NYSE Euronext believes in the merits of portfolio margining so much that we have put our money where our mouth is.   We have teamed with DTCC—the clearinghouse for cash fixed income products—to announce the formation of New York Portfolio Clearing that will combine for clearing the fixed income cash positions of DTCC with the derivatives positions of NYSE Liffe with substantial capital efficiencies for customers.  We will be working with regulators over the next several months for getting the proper approvals with the hope of a launch May of 2010.

The SEC and CFTC also identified the need to improve the approval process surrounding products that fall between the agencies.   As an example, several years ago exchange-traded funds (ETFs) for gold were approved for trading, only to have the regulatory approval of options on gold ETFs stall for more than 18 months over concern these products were both securities and futures. 

As a legal matter, this disagreement may have merit but it left “good government” types scratching their heads.   These were not unregulated products that sparked the financial crisis but fully regulated, exchange-traded contracts that would benefit retail investors. 

To address this concern, the report recommends a tie-breaking judicial review for jurisdictional fights of this type, but this is only helpful as a measure of last resort.   There needs to be hard time limits that prevent unnecessary delays in regulatory consideration of new financial products.  Absent strict time limits, these useful products for investors might not reach transparent, regulated exchanges, but instead could drift overseas or retreat to more opaque markets—outside the reach of regulators. 

The SEC and CFTC should be applauded for their initial efforts toward rationalizing these legacy regulatory systems, but Rome  wasn’t built in a day.  Getting there won’t be easy, but regulatory harmonization should remain a priority for policy-makers as we clear the way for smarter regulation. 

Another regulatory concern that directly impacts the commodities sector is the public discussion surrounding the role of speculators in our markets.   Last year when the price of crude oil spiked at $147 a barrel, lawmakers held dozens of hearings to determine whether speculators, index traders, pension funds and endowments had been one of the culprits of these record high prices. 

As head of the CFTC at that time, I was often the main witness of these Congressional inquiries as lawmakers wanted to understand the basis of the high energy prices impacting their constituents.   While this experience was not always pleasant, I understood the outrage of policymakers. 

One of the core missions of the CFTC is protecting the sanctity, effectiveness and efficiency of the central price discovery process on futures exchanges.    If prices are not reflecting fundamental factors of supply and demand, the futures markets are not functioning properly and all Americans suffer.

If there is a lack of confidence in the validity of the price of a commodity, institutional participants will be less likely to manage risk in the futures markets. Furthermore, those involved with commercial merchandising of a physical commodity, such as energy companies and agri-businesses, will be hesitant to forward contract with customers if there is doubt about the basis of a price discovered on the futures markets, as was recently displayed by the Saudi’s decision to forego the WTI Crude benchmark for a new index benchmark.   This is why the CFTC’s core mission of protecting the central price discovery process is so important.

With the growth of electronic trading, globalization and financial innovation, we have witnessed the development of satellite financial markets that complement and compete with the centralized and regulated futures markets in the United States  .  During my tenure and continuing in the current Administration, the CFTC has systematically been reviewing these developments to determine whether these satellite markets are having an impact on the centralized price discovery process.

Last year, the CFTC reviewed the evolution of Exempt Commercial Markets (ECMs)—those lesser-regulated electronic trading platforms that allow institutions to trade certain over-the-counter swap contracts.    The CFTC worked with Congress last year to close the so called “Enron Loophole” by providing the agency with additional authorities when certain OTC products on these markets begin to serve a significant price discovery function.  

Linkages between markets also exist across international borders.   Last year, the CFTC worked with the UK ’s FSA to require enhanced data sharing across borders and requiring position limits for those contracts linked to U.S. regulated contracts.  The CFTC recently announced further enhancements to this agreement. 

When I was Chairman, the CFTC also began a review of swap dealers and index traders to determine their impact on the price of commodities on futures markets.     In May of 2008, the CFTC announced that it would begin to use its special call authority to gather new detailed data from swap dealers on the amount of index trading occurring and provide a report to Congress by September 15, 2008 with recommendations.  This data was recently updated by the CFTC to now reflect 18 months of index trading data.

What this data reveals is noteworthy.   It shows that the total net amount of commodity index trading peaked at $200 billion at the end of June 2008. Of this amount $161 billion was tied to commodities traded on U.S. markets regulated by the CFTC.  Although a sizable amount of this $161 billion figure may not reach the futures markets due to internal netting by swap dealers, to put that number in context, this index number represents only 17 percent of the roughly $1 trillion of notional value for those same commodities traded on-exchange.  As the crisis took hold, these index trading figures dropped off considerably to a low of $82 billion in December 2008 and as of June 2009 stand at $117 billion.

However, notional values do not indicate whether these figures are due to new inflows of index money or the simple appreciation of the underlying commodities.   To provide an apples to apples comparison with the futures markets, CFTC staff converted the figures into standardized futures contract equivalents to show whether new index positions were being added during rising markets and being sold during falling markets as had been alleged. 

When looking at the crude oil data during the six month rise from roughly $100 a barrel to $147 a barrel, the standardized figures show an 11 percent decline in aggregate positions of commodity index participants from approximately 413,000 contracts to 366,000 contracts.   During the next six months as the financial crisis took hold and crude oil bottomed out at $45 a barrel, the updated CFTC figures show that index traders actually increased their positions by 15 percent from 366,000 contracts to 422,000 contracts. 

This is counter-intuitive to what many had suspected but not surprising to those who manage index funds where balancing portfolios requires selling during rising markets and buying during falling markets. 

Regardless of these numbers, we must recognize and can agree that commodity index trading is an important part of the market make-up in futures trading.   When this report was first published, the Commission recommended certain constructive steps be taken to bring additional transparency to the markets, including a complete review of the trader classification categories, the removal of swap dealers from the commercial category and the creation of a new swap dealer classification for reporting purposes, and the development and publication of a new periodic supplemental report on OTC swap dealer activity modeled after the report.  I am happy to report that many of these recommendations are being acted upon by the current Administration and I applaud the Commission for continuing to provide this needed transparency and statistical data on index trading. 

Lastly, I want to briefly touch on the use position limits on the futures markets and its impact on the commodity business.   Position limits have existed in the U.S. futures markets for many years and have been an effective tool at preventing market participants from gaining large concentrations of positions that could lead to price manipulation.  As the markets have evolved over time, so has the CFTC’s view and use of position limits.  Today the CFTC has the ability to impose position limits on exempt commercial markets that list significant price discovery contracts as well as foreign exchanges that link to regulated U.S. markets.  If administered correctly, position limits can be very effective at preventing manipulation. 

But position limits are not a silver bullet for fixing the volatility of pricing in the commodity markets and do have the potential to harm the marketplace if used improperly.   The threat of overly strict position limits has reportedly caused several exchange traded funds to announce that they are no longer going to manage their funds on regulated, transparent futures exchanges but will seek to manage these positions in the over-the-counter markets or on foreign exchanges. 

This runs counter to one of the clear lessons from this crisis that we need to encourage products to trade on-exchanges and clearinghouses.    When markets move overseas, we lose the ability to monitor and regulate them as well as the U.S. jobs created and revenues generated to the U.S. treasury.  Regulators must be smart about the use of this powerful and effective tool and ensure that its overuse is not causing damage to the marketplace. 

I appreciate Inside Commodities for giving me the opportunity to come here today and speak to you.   We live in a time of tremendous opportunity for positive change.  But there is also great uncertainty and fear.  Don’t sit back expecting positive change to occur.  I was honored to have served the public for 15 years working in the Federal government and I would encourage any of you to do the same if you have the opportunity.  But even if you don’t serve the public directly, you can make a difference by making your voice heard—whatever your views may be.  That is what makes this democracy strong and what makes this country great. 

Despite the difficult and uncertain times we face, I want to let you know that I remain optimistic—optimistic about our economy, optimistic about our country and optimistic about our future.   I believe that America is a nation of optimists—sometimes to a fault. 

At my farewell party at the CFTC, I was roasted as the only Chairman to have quoted in a speech the film “Dumb and Dumber,” where America  ’s optimism is hilariously on display.  This is the story of a loveable idiot, Lloyd Christmas, who falls in love with a beautiful woman way outside his league.  In one scene, he asks her the chances of “a guy like me and a girl like you” ending up together. She answers “Not good.”  Lloyd replies, “Not good like one out of a hundred?”  She replies, “More like one out of a million.”  Lloyd pauses for a moment, then shoots back, “So you're telling me there's a chance?”

Like Lloyd, all Americans aspire to succeed, sometimes despite long odds.   That is what makes our country great.  By working together, we have a unique opportunity to build a better financial model and regulatory system that serves both Main Street and the markets.  But we must be smart about it.  Only then can we gain back this optimism and trust as a nation.  Americans are counting on it.    

Thank you again for listening to me today and I appreciate Inside Commodities for inviting me here to speak.