The commodity markets impact almost everybody on the planet, every single day, because some derivative or variant of about everything that they consume is impacted by those prices. Whether it’s a home loan, or a piece of jewelry, or a fill up at the gas station, or a gallon of milk, or a loaf of bread — commodity pricing is vastly more important than most people actually realize.~ Former CFTC Commissioner Bart Chilton
In theory, regulation is supposed to set and enforce the rules of the game that market participants play by, in order to ensure that price discovery remains efficient, effective — and most important — fair.
In practice, there's plenty of debate to be had on how successful our regulators are in effecting their mission. And one investment class in particular, commodities, frequently comes under criticism for questionable price action.
So, this week we talk with Bart Chilton, former Commissioner of the Commodity Futures Trading Commission (CFTC), about price discovery within the commodity markets, and whether investors can have confidence in the "fairness" of the current system.
Perhaps it will come as little surprise that Commissioner Chilton, a longtime inside player, does not see the current environment as 'broken' or 'unfair', as some critics claim. And as a former regulator, there are certain topics he is not allowed to comment on. But that said, he's a vocal advocate for several reforms that he believes will reduce the chances for manipulation within the market — particularly position size limits and better rules for high-frequency trading (HFT) algorithms:
[Position] size is an important thing to look at. That’s why in my career as a financial regulator I sought to have limits placed on speculative positions. And unfortunately, there haven’t been. Even though it’s law now, my former agency has not sought to finalize those rules.
Size does impact markets and it can push prices around. In electronic trading, even a small size can move prices just because they’re so quick. You don’t need just to have size. If you control 20% of the crude oil market, and I’ve seen that in the past, you make a big trade you can move a market. Well, today with electronic markets and high frequency traders you don’t have to have 20%. You just need 2-3%. If you put a price out there very quickly, it can move markets.
When asked directly if there's a manipulation problem in the precious metals market — silver, especially — he did not confirm or deny. Instead, he laid out the 4 pillars of evidence the CFTC looks for in determining whether manipulation can be proven: intent, size, trading action, and impact on price. From his experience during his tenure, it sounds like there were a lot of cases where many of the pillars were present, but few where all 4 were in enough abundance to overcome the "dueling economists" quagmire that ensued when bringing the case into a courtroom.
Commissioner Chilton is sympathetic to the perception many frustrated and bruised investors have about the precious metals markets — he himself is on record saying that the large short position concentrations have been outrageous — and he urges them to share their observations and demands for reform with their elected legislators. Why not the CFTC directly? Sadly, Commissioner Chilton notes, "regulators by and large aren't listening to average people".
Click the play button below to listen to Chris' interview with Bart Chilton (27m:35s)
Chris Martenson: Welcome to this Peak Prosperity podcast, I am your host Chris Martenson. Now, whatever our personal views are on how financial markets operate today it’s essential to know what the game is and how it’s being played. Ignorance of the rules is no excuse, even if those rules are unwritten and constantly changing. What do I mean by that? Beginning around 2007 the rise of computer driven trading algorithms changed the rules, and the markets have not been the same since. They now trade at lightning fast speeds where quotes are massively dominated by computer algorithms, which also account for more than half the volume on the visible portion of the market while so called "dark pools" are more than a third of overall market volume. In short, markets today are not even remotely the same as the markets of just 10 years ago. They are too fast to comprehend and more increasingly hidden from view than ever before.
To help us understand the pitfalls and the blessings of these new markets is Bart Chilton, a former commissioner on the United States Commodity Future’s Trading Commission, or CFTC, from 2007 to 2014, and in April 2014 he joined the Law firm DLA Piper as Senior Policy Advisor. He is the author of the agency’s best selling investment fraud book Ponzimonium: How Scam Artists are Ripping off America. Commissioner Chilton has graciously agreed to join us for an explanation of how the US commodities markets work. It’s a topic many of our resource focused members are heavily invested in, both figuratively and literally. And in particular those who track the commodity markets, like myself, have questions about the mechanics and dependability of the price discovery process and I can think of few people more knowledgeable on this topic than Commissioner Chilton.
Commissioner Chilton, I’m extremely grateful that you’ve taken time from your busy schedule to join us, welcome.
Bart Chilton: Thank you Chris it’s great to be with you.
Chris Martenson: So let’s begin with a brief summary of the role of the CFTC. What’s its mission?
Bart Chilton: The mission is to do what you talked about just a moment ago and that is to ensure efficient and effective price discovery. These markets—many of the people who listen to you and watch you know this but not everybody does, that the commodity markets really impact almost everybody on the planet every single day because some derivative or variant of about everything that they consume is impacted by those prices. Whether or not it’s a home loan or a piece of jewelry or a fill up at the petrol, at a gas station or a gallon of milk or a loaf of bread. They are vastly more important than most people actually realize and the job of the CFTC is to insure that the prices that are developed that they’re not high or they’re not low, but that they’re fair. And that the price discovery process is efficient and effective.
Chris Martenson: So at a very high level then how does the commodity market work in terms of setting those efficient prices?
Bart Chilton: It takes bids and offers from myriad traders and comes up with a price and then it’s agreed on, it’s actually transacted and those prices make up the basis on which all these variants of the price can affect people in everyday life.
Chris Martenson: So then let’s talk about the enforcement powers that the CFTC has. What are they and how does it typically go about applying them?
Bart Chilton: Well they’re vast actually. When people think of enforcement and financial regulator in the commodity space, they think about manipulation as probably the first one but there's other authorities fraud, in particular is one that the agency has looked after for decades. But all the things that go into making those markets efficient and effective. The enforcement division tries to root out any nefarious actions whether or not its fraud, manipulation. Whether or not it’s pushing prices around one way or another and they have a full load, believe me. At any one time Chris, it may surprise people, at any one time there are between 750 and 1,000 individuals or entities who are under investigation by the CFTC. And that’s with a staff in the enforcement division of just 250 folks, just under 250. So they’ve got a big job and they aren’t actually able to get to all of these cases as much as they would like and that’s a big problem going forward.
Chris Martenson: Well certainly just from a capacity standpoint but also I would imagine that with the rise of the computer trading there’s been just whole new technologies to understand, new approaches, new processes. There’s quite a lot to just stay current on let alone prosecuting the existing case load, right?
Bart Chilton: You’re spot on Chris and it’s not just the people power. With the advent of electronic trading and of high frequency trading, the technology needs at the agency are greater than they’ve ever been. In the recent budget request just a few weeks ago they requested upwards of 50 million dollars for increases in technology to try and keep up with the market. That’s accompanied also by staff but trying to figure out what’s going on based upon the old way of thinking and the old tools just doesn’t work anymore. These markets have changed in monumental ways. You noted that almost 100%, I mean it’s just shy of 100% of markets are electronic trading now—99 plus percent. And of that, roughly 50% depending upon which market it is or which exchange is taking -- looking at the trades, that’s high frequency trading. It’s usually described between 30 and 50% in commodity markets and then about 50% in equity markets but that’s been increasing of late in commodity markets and at some point I think most of the trading will be high frequency trading in all of these markets ultimately.
Chris Martenson: So I’d like to talk about that high frequency trading. You’re talking with a gentleman here who has spent a lot of time actually trading on futures markets. I did it for a number of years and so I got very used to the rhythm and the flow of the market seeing what bids were there, what the ask structure would look like and there was some rhythm to them. Now when I look at a market—and it could be gold, it could be silver, it could be oil, it could be wheat, but I will notice that to understand what happened in a severe price moving event sometimes requires us to parse the data down to millisecond resolution and notice that an entire bid stack was destroyed in maybe 200 milliseconds or maybe a second. A concentration of orders will just flood in at very precise moments in time. First your comment on that, and second: Is it unfair for me to say that doesn’t look like legitimate price discovery?
Bart Chilton: Well two things, one it doesn’t mean that there’s not some value still even though it’s going to be small with regard to floor traders. As a former trader yourself my guess is that you would tell us you think there’s a lot of value to what those guys do. And I still think there is particularly at the open and close when there are lots of bids and offers and I think floor traders actually have a way of keeping some order to markets, many times through loud voices or hand signals. But I still think there’s a value there but the business proposition for the exchanges for keeping the lights on and the heat running at these -- air conditioning at these trade floors probably just isn’t there in the long term. It doesn’t mean there wasn’t some value that computers don’t have is my main point.
So the question about whether or not a flood of orders is good or bad or is it the right price discovery is one that a lot of people have been thinking about lately and by and large the research that’s come out even just in recent days from the bank of England show that actually price discovery is improved through all of these orders. And it goes back to a very basic premise of liquidity. So the more people that are trading the greater liquidity, and the greater liquidity the better price discovery because there’s more people out there to either make bids or offers. And again if it was just me or you contending one way or the other it would be hard to defend, but the numerous studies that are out there sort of showed that price discovery is better with more trading. There’s also just really in the last several days a Baron’s report that showed similar results. So it’s almost to the point now where people are accepting that it’s good but the issue that I’ve been raising over the years is there’s something that regulators need to do differently because of these metastasizing and morphing markets and I think there is.
Chris Martenson: It’s interesting, what I notice is seeing -- like I was watching this in the oil market and it happened for awhile, somebody would go out and take a lot of positions, say, put positions on USO. They would take some put positions over on the major equity indices and then there would be this flood of sell orders that would come into oil in the futures market. And so it feels for me it’s not just a single market anymore, that there are trading strategies which straddle markets and allow certain individuals who have the ability to move prices to do so in a way that seems to—obviously they do it because they make money doing it. But to me that feels more like a trading strategy than legitimate price discovery. Is the argument then that even those strategies such as they are, which are merely executed to scoop money from the market, that that still provides an important market service?
Bart Chilton: It does provide an important market service. Now look, don’t get me wrong I mean there are many as you say complex trading strategies that look at multiple products at the same time and make determinations about what bets they should place and it’s more complicated than ever. But different doesn’t mean that it’s you know derogatory, that it’s negative in any way. It just means that we need to look at things differently. And be careful, we shouldn’t just accept it with open arms and open eyes, let’s be careful about how we deal with these things. The size is an important thing to look at and that’s why for my career as a financial regulator I sought to have limits on speculative positions and unfortunately that hasn’t been, even though it’s law now my former agency has not sought to finalize those rules.
So size does impact markets and it can push prices around. In electronic trading even a smaller size can move prices in a way just because they’re so quick. So you don’t need just to have size. So if you control 20% of the crude oil market—and I’ve seen that in the past—just by moving your trades, it doesn’t have to be fast trades, you make a big trade you can move a market. Well today with electronic markets and high frequency traders you don’t have to have 20%. Just 2-3%, if you put a price out there very quickly it can move markets.
But that doesn’t necessarily mean it’s bad if you are abiding by all the rules and regulations. So you’ve seen recently a number of cases regarding spoofing, and that is putting out bogus bids or offers in order to try and move a market. So there are rules, regulations, laws that guard against these things but regulators shouldn’t just assume that everything should be static. They need to look and be more nimble and quick and look around the corner at how markets are changing in the future to ensure that the price discovery process is continuing to be efficient and effective.
Chris Martenson: Well let’s talk about the size and concentration of orders in a market or concentration of holdings. There are many out there—I’ve been reading this for years—who watch the precious metals market, in particular the silver market, feel frustrated by what they perceive as clear evidence of price manipulation and have the CFTC looked into it. I’d love to get your comments both in terms of what the CFTC found or didn’t find in terms of price manipulation and importantly the concentration of positions held by a couple of big players out there.
Bart Chilton: Sure. And I’m somewhat limited Chris as you know in what I can say; I can’t release any confidential information from the investigation that the agency had. But I would tell you that there are four different criteria for manipulation. When people talk around their dinner table or with their neighbors over a beer, they talk about manipulation and in a context of what they think it means. But they don’t talk about it from a legal standard. From a legal standard there’s really four pillars in the commodities world. There’s a different set of pillars under the SEC’s 10B5 rule but in the CFTC it’s a 6C rule that deals with these four pillars.
The pillars are intent, size, trading action and then an impact on price. And let me just spend -- if you allow me a little bit of time explaining these things in more detail.
Chris Martenson: Sure.
Bart Chilton: So intent means I have to find something. It could be an email; it could be a wire recording because all the traders are required to record their telephone conversations. And by and large you know traders talk with a lot of bravado about what they might do, whether or not they do or not is one thing. But such evidence, as you might imagine—and we looked at the LIBOR scandal, there was plenty of evidence where traders talked about pushing the LIBOR rates around and use sort of out their language and talked about “If you do this for me I’ll buy you a bottle of Bollinger” or “I’ll send over some Thai food," things like that. So the intent is actually something that was pretty easy to get because of how traders operate.
But then you have to have size, so you had to have a large enough position that if you used it, if you traded it, that it could roil a market, and then you actually have to show the trade. So you can’t just say I’ve got the size and talk tough, you actually have to make the trade. And even if you found all those three pillars Chris, you’d still have to hurdle over the last one which is that trade impacted the price.
And what happens a lot with those is that if you were going to go to court with somebody and say “Look you had these four pillars and you impacted price” well they’ll hire their economist to say “How can you say that this trade impacted price when there’s so many things going on in markets that can impact the price?” So it gets to be dueling economists.
So the standard is a fairly high standard, those four pillars for proving manipulation, and with regard to silver, the agency never got to where they had all four of those pillars. And while I can’t talk in detail, I’ll just say that didn’t mean that there weren’t some of those pillars. But there were not sufficient to reach that level where you could go forward with manipulation. There were significant concentrations of size in excess of 30% of the silver market at one point and I spoke about that years ago publically, it was something that drove me crazy that we would continue to allow one trader to have such a large concentration. It’s one of the reasons why I continued to say that we need speculative position limits and I’m amazed that the agency still to this day has not finalized a rule in that regard.
Chris Martenson: And what’s the hold up on that? It seems pretty obvious to everybody that makes sense that concentrations of size are market moving events and also they create the potential for market weakness or structural weakness if that one position gets in trouble one way or the other. What’s the hold up do you think?
Bart Chilton: Well I know what the hold up is but I don’t buy it; so I’ll give you the argument. The argument is that a law went too far and end users, those that actually have skin in the game whether or not it’s an oil company or an agriculture company that actually are hedging their price risk in the market whether or not they should be exempt from limits and I think they should be. They weren’t why we have a big problem. Now if it was speculative positions that a large agriculture company or large oil company has that’s a different matter. But if they’re just hedging their risk they should just be exempt. But what the agency has been doing is trying to slice and dice different variations of what an end user should be required to do and it gets very complicated very quickly. But there are agreements to buy energy in the future if certain conditions are met. They call it volumetric optionality. So you have an option to enter into a contract in the future. Should that be allowed? And if that’s allowed, does that constitute a hedge?
So there’s slicing and dicing this thing and I think sort of dancing on the head of a pin here and to me we should just exempt end users from anything that remotely looks like they’re hedging the risk and get the rule in place for the excessive speculation folks, which is what has been the problem and the reason that I fought for these position limits that were part of Dodd Frank passed in the summer of 2010. But the reason that I sought them—I was the lead guy seeking them—was not because of the end users of course, it was because of unbridled speculation that was I am sure, and studies have proven it, was the speculation was causing divergent price moves. All you have to do is go back to 2008 and look at crude oil at 147.27 and supply and demand had stayed relatively constant for several months prior to that when prices were down in the 90’s. There's no explanation other than speculation for those price moves. So I hope the agency will get on the horse again and get these things passed as soon as possible.
Chris Martenson: Oh absolutely because as you mentioned at the outset the things that trade on the commodities futures board, those impact everything, every facet of life, whether it’s the price of oil across the whole globe or the price of wheat or the price of gold, silver, all these things. Everything is sort of hinged off of that. So from my mind these position limits seems like a very obvious, easy way to start. We’ve been looking at it for a long time though so, how do concerned Americans weigh in on the conversation if they wanted to?
Bart Chilton: Well it’s difficult because this is like in the bowels of a regulatory agency and my experience, although I think I was different, is that the commissioners don’t listen a whole lot to average folks, unfortunately. Maybe that’s changing; I hope that’s changing. Kudos to any of the commissioners that respond to individual emails. I did that all the time, 24/7, 365. Since they don’t by and large -- since they aren’t very responsive to individual citizens who write to the agency, the way to pressure them is to actually go to your member of congress and tell your member of congress that the law requires position limits to be implemented and the agency has not done so and members of congress should put pressure on the CFTC to do so. It’s a little bit of a contorted way to influence regulators but my experience has been that the regulators by and large aren’t listening to average folks, very unfortunately.
Chris Martenson: Yeah that is unfortunate. So, long process when you have to get Congress involved, but it may be worth it because it’s an important issue. So as a final question: Obviously trading in futures is risky business, maybe not for the average person but for people who are interested in potentially becoming involved in using futures as a means of diversifying their portfolio or as a stance, would you at all advise an average person this day that this is something that they should think about with some cautious study, maybe dabble in, or just no way, this is just a pros game now; you have no chance?
Bart Chilton: No I wouldn’t say that people shouldn’t get involved in it but I’d be very careful and do your homework. And you’re not going to just -- it’s different than it was sort of back in the day where you said “Hey I’m going to go long on Microsoft” or IBM and you let it sit there in your portfolio and you checked it every week or so and decided whether or not you want to continue to take the risk. That’s an investment strategy that’s worked for people and it still works for people. But futures are a lot different than that and prices move around a lot and you need to know what you’re doing and there are expirations to contracts so by and large you’re not going to be in it for years and years. So just be very cautious and have due diligence. And particularly you mentioned Ponzimonium, my book, How Scam Artists are Ripping Off America, do due diligence with whom you trade. So if you have a broker or somebody that’s doing your bidding for you, insure that they’re the real deal.
These fraudsters pop up, Chris, and they do some crazy things. There is even one that created a fake website, and you might not think that’s too unusual, they create a fake business website. But here’s the nutty thing, this particular firm even created a link to a fake regulatory body. I forget exactly what they called it but it sounded a lot like the Commodities Future Trading Commission, it might have been the Commodities Future Trading Association. And then this person fabricated a letter that said that the bogus company was in good standing with the Commodities Future Trading Association. So my only point is that the scamsters and fraudsters out there are very creative and folks need to be sure that they’re investing their money with real folks. A lot of these people that take advantage of average folks are neighbors. They are what we call affinity fraud; they’re a relationship that somebody knows and "you’ve got to get into this good deal."
So anyway, be careful and Ponzomonium: How Scam Artists are Ripping Off America is now free online at GPO, government printing office, at GPO.gov and so there’s listed in there I think it’s 20 red flags of fraud. So I encourage your folks who are paying attention to this before they invest their hard earned money check it out.
Chris Martenson: Well fantastic and along with those red flags is there any guidance on where to go to do your due diligence? Maybe the FINRA website, other places, do you help people with the process?
Bart Chilton: Yeah the National Futures Association is a good place to go. You can check with the exchanges where your contracts are being traded. If you want to trade in metals, you’re going to be trading probably at the New York Mercantile Exchange and you can go to their website which is the Chicago Mercantile Exchange Groups website. If you’re going to be trading in things that are traded on the Intercontinental Exchange, go to their website. All those things are good and one of the places that’s relatively new, but people can go, is the Consumer Financial Protection Bureau, the CFPB, just to ensure that people are in good standing before you, again, invest your hard earned money. People just need to be careful.
Chris Martenson: Well fantastic and in closing with everything you know that you can talk about with respect to silver, would you invest in it today?
Bart Chilton: I really don’t want to say whether or not I’d invest or not. Silver is I think probably going to go up in what looks to me like it might go up but I never want to give investment advice, I’m not a trader, I’m a regulator guy. But it looks like there’s room for growth there but people want to listen to folks a lot smarter than I on this.
Chris Martenson: I wasn’t looking for price advice, I was just wondering how the market is structured, if that was a place you feel is legitimate at this stage.
Bart Chilton: I wouldn’t be concerned about how the market operates right now. But you know regulators need to stay on top of this and insure that that’s the case; so I would encourage anybody who sees any anomalies in markets, whether or not it’s silver or anything else, that they do report them to the regulator. As much as people think that they don’t pay attention to all these things, you do the best you can do in life and sending it forward certainly can’t hurt.
Chris Martenson: Fantastic. Well Commissioner Chilton, thank you so much for your time today.
Bart Chilton: Great to be with you Chris, thank you.