Market Madness

MF Global is the new poster child for why thoughtful financial regulation is needed more than ever. - Bart Chilton

Some excerpts from this speech given by CFTC Commissioner Bart Chilton last month (in the midst of "March Madness"):

FCIC
The Financial Crisis Inquiry Commission (FCIC) was established to look at what happened. It concluded the Troubled Asset Relief Program or TARP was needed due to two culprits to the calamity.

One culprit: regulators and regulation. You see, in 1999, Congress and the president deregulated banks. Banks were no longer bound by that pesky Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. With the repeal of Glass-Steagall, regulators got the message to let the free markets roll. And, roll they did—right over the American people.

The second culprit: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those annoying 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.

Credit Default Swaps (CDS)
CDSs were a significant component of creating this ginormously humongous dark market with no oversight by regulators. When I say ginormously humongous, that's a technical term. You see, we at the CFTC currently oversee roughly $5 trillion in annualized trading on regulated exchanges, but the global over-the-counter (OTC) market is roughly—here it comes—$708 trillion. If you Google ginormously humongous, it should say, "See OTC markets."

In the speech, Chilton goes through what he views as four of the most critical rule changes needed but have yet to be approved or implemented. Speculative position limits is one of the four. He argues that position limits have been needed for years and are now needed more than ever.

The Commission passed a final position limits rule in October but, according to Chilton, implementation has been delayed by a lawsuit and some other unfinished business with the SEC. More excerpts from the speech:

Speculation and "Massive Passives"
I know we need speculators. I know I know I know—there are no markets without them. Speculators are good. But like a lot of good things, too much can be problematic. Therefore, it is the excessive speculation that can cause problems, contort markets, and result in consumers and businesses paying unfair prices and negatively impacting our economy.

Chilton then describes what he calls "Massive Passives":

Between 2005 and 2008 we saw over $200 billion come into futures markets from non-traditional investors. I call them "Massive Passives." They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy. 

Then went on to say...

I'm not suggesting that the Massive Passives, or speculators in general, are actually driving prices. Let me be clear. I’m not proposing they were all in cahoots and decided to raise oil prices. What I am saying is that they contribute to price swings, and have a proportional impact in markets based upon their size as a whole, and certainly individual traders can push prices around if they have a large enough concentration. When prices are on the rise, like now, and the Massive Passives and others get into markets, they can push prices to levels that may be uneconomic—certainly not tied directly to supply and demand—and the prices may stay higher longer than they normally would.

The Speculative Premium
...you don't have to take it from me, from Senators or U.S. Representatives, or from the President of the United States. In fact, you don’t have to take it at all. I know that many of you in this crowd won't. Nonetheless, let me lay one more piece of research on you with regard to speculation. This one doesn’t come from some lefty activist group. It comes from one of the big Wall Street banks. Its researchers said that each million barrels of net speculative length adds as much as 10 cents to the price of a barrel of crude oil. The speculative length is a known quantity. With a little math, you can determine that the "speculative premium" on oil these days is around $23 a barrel—and that translates into about an extra 56 cents for a gallon of gas.

Considering the interests involved and the dollars at stake, I'm not surprised it has taken this long to address these kind of things. Still, we'd be smart to not wait too long. The most critical changes ought to be thoughtfully implemented well before the next financial crisis is upon us.

Not doing so is just asking for largely unnecessary self-inflicted economic pain at some unknowable point in the future.

Adam

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