On March 20, 2013, Commodity Futures Trading Commission Chair Gary Gensler gave a speech at an International Monetary Fund conference focused on commodity price fluctuation. For the uninitiated, such an event would seem meaningless. However, Chairman Gensler gave a surprisingly succinct explanation of the futures and swaps markets and more importantly, explained why regulation is so important. Here is the transcript of that speech:
Good afternoon. Thank you, José, for the kind introduction. I also want to thank the International Monetary Fund and Christine Lagarde for the invitation to speak today at your conference on commodity markets.
Farmers, ranchers, producers, commercial companies and other end-users across the globe depend on well-functioning derivatives markets. These markets are essential so that end-users seeking to hedge a risk can lock in a future price of a commodity and thus focus on what they do best – efficiently producing commodities and other goods and services for the economy. Derivatives markets have existed in the United States since the time of the Civil War. Initially, there were futures on agricultural commodities, including wheat, corn and cotton. Futures allowed farmers to get price certainty on their crops. As they were planting their fields, farmers could lock in a price for harvest time. Farmers and producers also benefited from prices established in a central market, rather than just relying on competition for their harvested crops among local merchants.In these central markets, hedgers seeking to reduce risk may meet other hedgers, but often meet speculators on the other side of the transaction.
In the 1920s, Congress brought the first federal oversight to the futures market. These reforms included bringing transparency to the marketplace by requiring that all grain futures be traded on central exchanges. A federal regulator was established within the U.S. Department of Agriculture to oversee the grain futures market.
During the 1930s, President Roosevelt and Congress strengthened the common-sense rules of the road for these markets by adopting new prohibitions against manipulation, protections for customer funds and speculative position limits to promote market integrity.
By the 1970s, the futures market had expanded to include contracts on additional agricultural commodities, as well as metals.
Market participants also were considering further innovations to trade contracts on other risks in the economy, such as on energy products and financial instruments. Congress understood this and broadened oversight of the futures markets to all commodities, including any that might be developed in the future. The Commodity Futures Trading Commission (CFTC) was established as in independent regulator in 1975, and took on this broader role from our predecessor in the Department of Agriculture.
The word commodity in our oversight regime covers agricultural, metals, energy and financial commodities, as well as any other future to manage risk based on any “services, rights and interests.” Thus, the word “commodity” in our oversight regime is more expansive than you are generally discussing at this conference.
In 1981, a new derivatives product emerged. These derivatives, called swaps, were initially transacted bilaterally, off-exchange. While the futures market has been regulated by the CFTC, the swaps marketplace in the United States, Europe and Asia lacked oversight. What followed was the 2008 financial crisis. Eight million American jobs were lost. In contrast, the futures market, supported by the 1930s reforms, weathered the financial crisis.
President Obama and Congress responded and crafted the swaps provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). They borrowed from what has worked best in the futures market for decades – clearing, oversight of intermediaries and transparency. The law gave the CFTC responsibility for swaps and the Securities and Exchange Commission responsibility for security-based swaps.
As of last year, the CFTC is charged with overseeing both the commodity futures market and the swaps market. The CFTC is not a price-setting agency. The mission of the CFTC is to ensure market transparency – both pre- and post-trade. Transparency lowers costs for investors, consumers and businesses. It increases liquidity, efficiency and competition. The mission of the CFTC is to promote market integrity – to ensure that that the price discovery process is open, competitive and efficient. The mission of the CFTC is to police the derivatives markets for fraud, manipulation and other abuses. The mission of the CFTC is to lower the risks to the economy of clearinghouses and intermediaries, as well as ensuring for the protection of customer funds. And the mission of the CFTC is to ensure these markets work for the real economy – the non-financial side that employs 94 percent of private sector jobs – so that hedgers and investors may use them with confidence.
Three years after the passage of the Dodd-Frank Act, the CFTC is nearly complete with the law’s swaps market reforms. The swaps marketplace is increasingly shifting to implementation of these common-sense rules of the road. For the first time, the public is benefiting from: Greater access to the swaps market and the risk reduction that comes from centralized clearing; Oversight of swap dealers; and the transparency of seeing the price and volume of each swap transaction, available free of charge on a website like a modern-day ticker tape.
Looking forward, it’s a priority that the Commission finishes rules to promote pre-trade transparency, including those for a new swaps trading platform, called swap execution facilities (SEFs), and the block rule for swaps. Pre-trade transparency will allow buyers and sellers to meet and compete in the marketplace, just as they do in the futures and securities marketplaces. SEFs will allow market participants to view the prices of available bids and offers prior to making their decision on a swap transaction. It’s also a priority that the Commission ensures the cross-border application of swaps market reform appropriately covers the risk of U.S. affiliates operating offshore.
If a run starts in one part of a modern financial institution, whether it’s here or offshore, the risk comes back to our shores. That was true with Bear Stearns, which failed five years ago this month, AIG, Lehman Brothers, Citigroup and Long-Term Capital Management.
Thus, as the CFTC completes guidance regarding the cross-border application of swaps market reform, I believe it’s critical that the Dodd-Frank Act’s swaps reform applies to transactions entered into by branches of U.S. institutions offshore, between guaranteed affiliates offshore, and for hedge funds that are incorporated offshore but operate in the U.S. Where there are comparable and comprehensive home country rules and enforcement of those rules abroad, we can look to substituted compliance, but the transactions would still be covered.
Since the 1980s, the swaps market has grown in size and complexity. It is now eight times as big as the futures market. From total notional amounts of less than $1 trillion in the 1980s, the notional value now ranges around $250 trillion in the United States. Together, the notional value of the U.S. futures and swaps markets is approximately $300 trillion – or roughly$20 of derivatives for every dollar of goods and services produced in the U.S. economy.
The futures market has changed dramatically as well. There has been a significant increase in electronic trading. Instead of face-to-face trading on an exchange floor, more than 85 percent of the futures volume in 2012 was traded electronically. In addition, the makeup of the market has changed. While the futures market has always been where hedgers and speculators meet, today a significant majority of the market is made up of financial actors, such as swap dealers, hedge funds, pension funds and other financial entities.
For example, based upon CFTC data as of last week, only about 14 percent of long positions and about 13 percent of short positions in the crude oil market (NYMEX WTI contracts) were held by producers, merchants, processors and other users of the commodity.
Similarly, only about 18 percent of gross long positions and about 27 percent of gross short positions in the Chicago Board of Trade wheat market were held by producers, merchants, processors and other users of the commodity.
Furthermore, CFTC data published in 2011 shows the vast majority of trading volume in key futures markets – more than 80 percent in many contracts – is day trading or trading in calendar spreads. Only a modest proportion of average daily trading volume results in reportable traders changing their net long or net short futures positions for the day. This means that about 20 percent or less of the trading is done by traders who bring a longer-term perspective to the market on the price of the commodity.
Modern technology has led to other dramatic changes in the markets. With advancements in cell phone technology, a farmer in Africa or Asia can see the world prices for these markets, whether set in Chicago or elsewhere. This technological advancement greatly increases access to the markets. Farmers around the globe can more fully benefit from the competitive market. But modern technology also more tightly connects us all and highlights why we have to ensure the markets are transparent and free of fraud, manipulation, and other abuses.
Position Limits and Enforcement Authority
Since the reforms of the 1930s, the CFTC’s predecessor and now the CFTC have promoted market integrity with position limits, as well as the agency’s enforcement authority to police manipulative conduct.
Since the 1930s, Congress has prescribed position limits to protect against the burdens of excessive speculation, including those that may be caused by large concentrated positions. When the CFTC set position limits in the past, the agency sought to ensure that the markets were made up of a broad group of participants. At the core of our obligations is promoting market integrity, which the agency has historically interpreted to include ensuring that markets do not become too concentrated. Position limits are a critical tool to ensure that a single trader does not accumulate an outsize position that could potentially affect integrity or liquidity in the marketplace. As required by Congress in the Dodd-Frank Act, in October 2011 the CFTC finalized a rule to establish position limits for futures, options and swaps on 28 physical commodities.
A group of financial associations is challenging this rule in court. I believe it’s critical that we continue our efforts to put in place aggregate speculative position limits across futures and swaps on physical commodities.
In the United States, we have strong prohibitions against misconduct that can affect the integrity of our markets, which were further strengthened by Congress in the Dodd-Frank Act. Our laws prohibit successful manipulations, where the wrongdoer intended to and actually did manipulate a price. But we also cover a much broader swath of misconduct.
Our laws prohibit all attempts at manipulation, and all manipulative or deceptive schemes, where the wrongdoer acted recklessly. In addition, our laws prohibit the transmission of false information that may tend to affect the price of a commodity. These laws, aggressively and fairly enforced, are designed to protect market participants and the integrity of our markets. The international community can draw on these provisions to enhance their own regulatory regimes.
Other market jurisdictions have made progress on position limits and attempted manipulation provisions. In November 2011, the G-20 leaders endorsed an International Organization of Securities Commissions (IOSCO) report noting that market regulators should have and use formal position management authorities, including the power to set position limits, to prevent market abuses. Most jurisdictions with commodity derivatives markets have subsequently implemented or are moving forward on position management authorities. For instance, the European legislative bodies are considering a position limit regime for the European Union. In addition, European legislative bodies are considering proposals that would include attempted market manipulation within its regulatory framework.
As the CFTC works with our global counterparts on swaps market reform, we are advocating for a consistent approach with regard to these reforms.
The Importance of an Effective Market Regulator
In conclusion, farmers, ranchers, producers and consumers need to have confidence that derivatives markets are free of fraud, manipulation and other abuses. The end-users in the non-financial side of the economy benefit from transparency both before and after the trade. End-users benefit from open and competitive markets where no one party has an outsized position.
The CFTC is nearly complete with the swaps market reforms that have brought clearing, oversight of intermediaries and transparency to the once dark swaps market. But for the CFTC to effectively ensure market integrity, it is critical for the agency to be well-resourced. At 684 people, we are just 7 percent larger than we were 20 years ago. Simply put, the CFTC is not the right size for the new and expanded mission Congress has directed it to perform.
U.S. Commodity Futures Trading Commission, “Remarks of Chairman Gary Gensler Before the International Monetary Fund Conference,” March 20, 2013, http://www.cftc.gov/PressRoom/SpeechesTestimony/opagensler-137