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July 11, 2008
PRESIDENT AND CHIEF EXECUTIVE OFFICER
NATIONAL FUTURES ASSOCIATION
July 11, 2008
Our customer protection rules are all designed to ensure that customers have enough information to make fully informed investment decisions. That's why we prohibit our Members from making wildly exaggerated claims of performance and why we require Members to provide customers with full disclosure of all of the risks. I think full disclosure of risks is a good idea in Congress too, but as I have followed the debate here in recent weeks about how to deal with energy prices, I've seen a lot more wild claims than I have seen disclosure of risks.
I have seen a number of witnesses testify that Congress can reduce the price of energy by 50% within 30 days just by cracking down on futures markets. I have not heard even a shred of data or empirical information to support that claim, but it's interesting that once a third witness agrees with that proposition it moves from testimony to conventional wisdom to a God given truth with the speed of light. Other witnesses, including a Pulitzer Prize winning author and economic researcher, have cited extensive economic and geopolitical factors to caution against the fallacy of a quick fix. My point is that it is a lot easier to make wild claims than it is to back them up, and I appreciate this Committee's efforts to explore these issues in a careful, thoughtful manner. This is especially important since various proposals under consideration could have dire unintended consequences.
I should also point out that I usually view the "unintended consequences" argument with a fair degree of skepticism. It seems like every time we propose a new customer protection rule at NFA or propose customer protection legislation before this Committee, someone throws the "unintended consequences" argument at us. Usually, people are pretty vague about what those unintended consequences might be or why they might happen or why they would be so bad. That's not the case here. Various supposed quick fix solutions under consideration could have unintended consequences that are specific, foreseeable and very likely to do much more harm than good.
Take margins, for example. As I mentioned above, some have suggested that margins for energy futures contracts be raised to as high as 50%, with the prediction that with this simple stroke energy prices will fall by 50% within 30 days. Not so fast, please. First, we should recognize that in the futures industry margin is a performance bond designed to ensure that traders meet their financial obligations. Clearing organizations set margin levels with great care to cover the potential movement in the value of the futures contract in one day's trading. Used for its intended purpose, the margin setting process has been a huge success over the last 150 years in preventing defaults and insolvencies. Using margins to try to artificially lower the price of a futures contract is another thing altogether and could have the directly opposite result.
The apparent theory of these proposals is that index funds, pension funds and other institutional investors have predominantly long positions in the futures market that are driving energy prices up. These are precisely the investors, though, that have the deepest pockets and could easily meet any increased margin requirements. A dramatic increase in margins could be much more likely to drive more short positions from the market than longs. Fewer sellers with the same number of buyers means prices go higher, not lower. I do not know for sure that prices would go higher, but neither do you and neither do those that promise that energy prices will drop by 50%. That's the point. No one knows for sure and that's why there is risk. It is imperative that you recognize that risk, know that it is real, that it is substantial and know that you are being asked to roll the dice with the American economy.
We may not know for sure whether raising margins will cause energy prices to go up, but we do know for sure that it will not reduce trading activity-it will simply move it to off-shore or over-the-counter markets. The energy market is global and complex. Participants that seek to speculate can do so in centralized markets around the world or through over-the-counter transactions. Those investment decisions are based on numbers. If the cost of executing trades on regulated futures markets soars because of increased margins, those trades will simply move to a different market. And it's not just speculators that will be moving. Hedgers need liquid markets to manage their risks and they will go where the liquidity is, whether it's off-shore or off-exchange. The trading will still take place and the impact on prices will not diminish. The risk here is not a loss of profit for U.S. markets, it's a loss of transparency, of information, of regulatory authority. The notion that you can build a fence around this country to keep institutional, sophisticated market participants from trading the way they want to is simply detached from reality.
Finally, Congress should be aware that raising margins could increase systemic risk. No one knows with certainty whether increasing margins would cause a temporary drop in oil prices or drive prices higher. What we do know is that governmental actions would dramatically increase market volatility during a time when credit is tight, particularly in the U.S. No one can predict with certainty the consequences of such actions, but they would certainly subject the financial markets to turmoil and stress and a much greater risk of financial failures.
Limiting Access to the Futures Markets
Other proposals have been discussed that would either limit or completely block access to the futures markets for certain classes of investors. Completely apart from the question of whether Congress should, in effect, be making investment decisions for these market participants, hasty congressional action could again produce some very unattractive results. Many swaps dealers, including some of the most important banking institutions in the country, use futures markets to hedge the risk of their net exposure to their customers. Those customers may be speculating or may be commercial users that are hedging their own risks. When these swap dealers use futures markets to cover their exposure to their customers, they are generally not subject to speculative position limits and accountability levels because those firms are managing their risk. Some have suggested that these exemptions for swaps dealers should be eliminated, supposedly to reduce energy prices.
The CFTC has issued a special call for information to the largest swap dealers in the country to better understand the extent to which the customers of the swap dealers are engaging in speculative trading or commercial hedging transactions. Congress should not take any action regarding the swap dealers exemption until the CFTC has carefully and thoughtfully analyzed that information and reported its findings. Rash action at this time could limit the ability of both swap dealers and their commercial user clients to manage their risk at a time when risk management is more critical than ever. All too often in the recent past we have seen what happens when major firms fail to effectively manage their risk, with significant repercussions for the whole economy.
Others have proposed barring large pension funds from diversifying their portfolios by investing in agricultural and energy commodities. The health of their pension funds is critically important to literally millions of retirees. The health of their pension funds, in turn, depends on the ability of the fund managers to effectively diversify their portfolios. Barring pension funds from doing so by locking them out of certain markets makes no sense at all when retirees have to rely more and more on their pensions and less and less on social security.
Obviously, the proposals discussed above each carry the substantial risk of making a very difficult situation much, much worse. Doing nothing, however, carries risks of its own. NFA strongly supports a number of proposals that would be constructive, positive steps.
CFTC staffing levels are at historical lows while trading volume is at historical highs. Something here is not right. It is always a struggle for a regulator to keep up with an ever changing market place, but that becomes harder and harder to do when you have fewer people on hand to do more work. NFA strongly supports proposals for emergency appropriations to the CFTC to hire more people and upgrade its technology.
As an aside, I know that regulators make convenient punching bags when bad things happen. That just comes with the territory. But the CFTC is an independent federal agency, independent so that it can withstand external pressure from any source and try to do what is right. That's precisely what the CFTC has been doing throughout this process. In enhancing its information sharing agreements with FSA, working with Congress to close the Enron loophole in the Farm Bill, issuing its special call for information to major swaps dealers, forming an interagency task force to evaluate changes in commodity markets and undertaking revisions to its commitment of traders reports to improve transparency, the CFTC has worked tirelessly to do the right thing. The Commission has been hard at work in the enforcement area as well, bringing 39 actions involving energy markets alone and working with the Department of Justice on 35 criminal prosecutions involving energy market misconduct. I would like to recognize and applaud the CFTC's continuing efforts in this area.
Foreign Boards of Trade
The CFTC's recent agreement with ICE ensures that any exchange located in another jurisdiction that trades energy contracts with U.S. delivery points or that are linked to U.S. exchanges will provide the CFTC with the same type of information it gets from U.S. contract markets for surveillance purposes. We support proposals to codify that agreement. Drafting such legislation, though, can be a tricky business. The stroke of a bureaucrat's pen could change a foreign board of trade authorized to offer trading screens in the U.S. into an unregistered contract market. That could, in turn, make the positions held on that exchange illegal futures contracts, voidable at the customer's choice. Customers with losing positions could simply walk away, leaving an FCM holding the bag, and a very expensive bag at that. I know that others, including the FIA, are working on language to avoid that result and NFA supports those efforts.
Commitment of Traders Report
Transparency is everything in futures regulation. Congress should require the CFTC to enhance transparency in our markets by revising its monthly commitment of traders reports to ensure that trading by commercial users of the underlying commodity is listed separately from trading by index funds and hedge funds. The CFTC has indicated its intention to do so, but legislation to support that initiative would be helpful.
In sum, Mr. Chairman, at NFA we constantly advise customers to beware of anyone that is selling a trading program guaranteed to produce dramatic profits with little or no risk. We offer the same advice to this Committee. The quick fix solutions currently being pitched to Congress carry with them substantial risks of unintended consequences that are real, that are foreseeable and that are potentially devastating. To enact these proposals would be to roll the dice on the American economy and would make the Congress of the United States the biggest speculator in our futures markets.
As always, we look forward to working with the Committee and would be happy to answer any questions.