Imagine that you are a large institutional investor with billions of dollars to invest. Would you keep your money in the stock market, whose record high prices are fueled by an unprecedented amount of cheap money provided to Wall Street by the Federal Reserve System? Would you buy bonds, whose skyrocketing prices are likewise driven by Fed largesse? Or would you jump back into commodity hedge fund products — perhaps for the first time since the 2008-2009 Wall Street blowup of the stock, bond and commodity markets, which resulted in a $29 trillion Fed emergency loan package to bail out the largest banks and a $20 trillion (and still counting) hit to the U.S. economy?
According to The Wall Street Journal, you’d invest $570 billion in commodities (as of July), not directly, but through various Exchange Traded Funds (ETFs). ETF commodity products slice and dice and mix and match futures contracts to reduce investor price risk in any one contract, whether it is oil, gold or corn.
If you invested in agricultural ETFs, the low agricultural prices projected, under certain policy assumptions, by a 2020 pre-pandemic U.S. Department of Agriculture study through 2029 wouldn’t worry you much. You’re not investing for the long term, probably not even for the 90-day duration of an agricultural futures contract. Along with the largest commodity traders’ trading strategies, ETFs are traded by algorithms, computer coded trading instructions, in millisecond to nanosecond transactions bought and sold on electronic trading platforms, such as the Chicago Mercantile Exchange’s (CME) Globex. You can make a lot of money from tiny price fluctuations in millions of transactions, if your trading algorithm doesn’t trigger such extreme price volatility in several contracts that the whole market crashes.
The Commodity Futures Trading Commission (CFTC) released its first proposed rule on algorithmic and automated trading (Reg AT) in 2015, with proposed revisions in 2017. Most large investor groups and Designated Contract Markets (DCMs), such as CME, rejected the proposed Reg AT as too “prescriptive” and “too costly and burdensome” to implement. On June 25, the CFTC voted three-to-two to withdraw Reg AT and released for public comment proposed “Electronic Trading Risk Principles.” The Principles would delegate CFTC authority to the DCMs to “prevent, detect and mitigate” extreme price volatility and trading disruptions from automated trading, commonly known as “flash crashes.”
IATP commented on the proposed Principles in an August 24 letter. First, we explained our interest in the Principles. In two agricultural futures conferences co-organized by the CFTC, traditional agricultural commodity traders had said they could not effectively manage their price risks because they could not access contracts to lay off these risks, due to the amount and speed of order messaging from herds of algorithms. For example, the feeder cattle (beef cattle under 700 pounds) futures market is far more price volatile than can be explained by supply, demand, logistics and other fundamental factors. Why? ETFs that bundle feeder cattle futures as a tiny portion of their fund formula drive feeder cattle futures up and down in nanoseconds. The prices of dominant commodities in the algorithmically traded fund formula, e.g., oil and gold, drive feeder cattle price volatility by buying and selling contracts at a speed that not even the best resourced, most informed commodity trader can offset with contracts to discover the cash price of feeder cattle.
IATP urged the Commission to review its July 2000 proposal that, as finalized, allowed privatization of the DCMs to enable them to invest more in and profit from electronic trading. The original proposal would have enabled electronic trading of agricultural contracts, but not allowed the far better resourced financial speculators, such as the pre-cursors to ETFs, to compete directly with commodity traders hedging the price risks of commodities they produced, transported or processed. Unfortunately, the final rule to let the exchanges become for-profit enterprises also allowed Morgan Stanley, Goldman Sachs, etc. to “compete” with much smaller commercial hedgers in the same contracts.
We also recommended that the Commission not finalize the Principles before it had analyzed the forthcoming advisory report to the CFTC on climate change-related financial risks to commodities trading. Weather events driven by climate change will impact the value of the physical commodities that are the underlying assets of Commission regulated contracts. Designers of trading algorithms will be greatly challenged greatly to factor in the complexities of climate change to manage price risks.
Many market disruptions are manifested in extreme price volatility during the trading day. Yet the Commission staff has only studied end of the day price volatility. The Principles only required pre-trade risk controls to prevent floods of orders that could trigger extreme price volatility, but without resulting in completed transactions. Surprisingly, the Commission did not follow the recommendation of the Futures Industry Association to require post-trade risk controls to prevent traders from defaulting on contract payments. IATP recommended that the Commission order the staff to produce a report on intra-day price volatility and require post-trade risk controls in the Principles.
There is an alarming sentence in the non-binding preamble to the Principles that would delegate most CFTC authority to the DCMs to regulate the risk controls of those trading on electronic platforms. DCMs would not bear any “strictly liability” if DCM risk controls fail to prevent, detect or mitigate market disruptions by their market participants. The DCMs have only to show that their risk controls were “objectively reasonable” to receive the Commission’s assurance that they would not be subject to lawsuits by those suffering economic damages from market disruptions due to DCM oversight negligence. We wrote that the Commission must not offer this legal opinion, even in the non-binding language of a preamble. If the Commission insisted on assuring the DCMs that they would not be subject to “strict liability” in the final rule, it must analyze the Commodity Exchange Act to show the legal basis for that extraordinary opinion.
The Principles propose that every DCM be allowed to design its own risk controls according to no uniform CFTC standard. We contended that competitive pressures among DCMs, particularly to attract trade in new products, such as Bitcoin derivatives, might result in laxer risk controls in one DCM than another. The preamble rejected the possibility that a uniform risk control design standard was needed to prevent lax risk controls, either from competitive pressures or from complacency about the capacity of old risk controls to prevent market disruptions from new products.
IATP concluded by urging the Commission to heed the words of Commissioner Dan Berkovitz in his dissent to releasing the Principles for comment: “The notice of withdrawal reflects a belief that there is nothing of value in Reg AT. That is simply not true. Reg AT was a comprehensive approach for addressing automated trading in Commission regulated markets. Certain elements of Reg AT attracted intense opposition and may have been a bridge too far. . . I believe the comments received on Reg AT are worth evaluating going forward.” (Federal Register, p. 42781) Those comments are hardly mentioned in the preamble.
Following the three-to-two vote of Commissioners on June 25 to withdraw Reg AT, it may be hope in vain to ask the majority to reconsider Reg AT and comments about it. But if the near complete delegation of CFTC authority to the DCMs fails to prevent, detect and mitigate an increasing number and scale of market disruptions, the majority may rue the day when they voted to effectively allow the DCMs to self-regulate.
