Gary Gensler’s Nomination Hearing

On February 25, Gary Gensler appeared before the Senate Committee on Agriculture, Nutrition & Forestry at a hearing on his nomination to be Chairman of the CFTC. The hearing went well for Mr. Gensler, and it is very likely that he will be confirmed.

Not surprisingly, Gensler stated that his views had “evolved” concerning OTC derivatives, since he was a Treasury Under Secretary advocating passage of the Commodity Futures Modernization Act of 2000. He stated that OTC derivatives dealers should be regulated but was careful not to specify under what statutory framework nor by which agency. Given that the Obama Administration will be making proposals concerning financial regulation, that was prudent on Gensler’s part.

He also spoke favorably concerning establishing clearinghouses for standardized products. That has become conventional Washington wisdom, though there may be some push back on mandating central counterparties by industry participants. Arguments against this include that the concentration of risk in a single entity is itself a source of systemic risk and that netting efficiencies may not be realized. (On the latter point, see this draft paper by Darrell Duffie and Haoxiang Zhu of Stanford University, “Does a Central Clearing Counterparty Reduce Counterparty Risk?") Arguments for a central counterparty include greater transparency, increased discipline (including consistent rules about the posting of collateral), operational efficiencies, and easier access by government regulators to information. In addition, regulators could exert more control over the market by regulating a clearinghouse and central counterparty, which, depending on who you are, is either a pro or a con.

Gensler went to great lengths to reassure the Senators that he would be a tough regulator. I see no reason not to believe him. The OTC derivatives industry will also likely not be entirely comfortable with him at the CFTC, though it is not clear at this point what the extent of his authority and influence on OTC derivatives policy issues will be.

What was somewhat surprising in the question and answer portion of the hearing was Gensler’s remarks about the price runup in tangible commodities prices, especially oil last summer. He stated that tangible commodities had come to be viewed as a separate asset class for those seeking diversification, and he said this was a major cause of the increase in prices. He also said that those who invested in commodities such as oil expected prices to increase, but like those investing in real estate, they proved to be “terribly wrong,” with adverse consequences for the American people.

The price of oil is notoriously volatile, and this has been true for a long time. It seems hard, though, to give credence to the argument that the futures markets were the cause of the increase in prices, if that is what Gensler meant. Something has to happen in the cash market for this to happen. The potential for or threat of delivery on the futures market is what causes the price of futures and the underlying cash commodity to be linked and to converge at maturity.

In this connection, Gensler talked about the Hunt Brothers and silver. It is true that the Hunt Brothers took large position in silver futures which eventually resulted in financial disaster for them when silver prices came crashing down from a high of about $50 an ounce in early 1980. But an important point to remember about that episode is that the Hunt Brothers were active in the cash market by buying physical silver and were taking delivery of silver on the futures market.

With respect to oil, it is a voluminous commodity for which there is limited storage capacity. As a CFTC economist once characterized it to me a long time ago, it is a “flow through” market. Once the oil is out of the ground and in the system of tankers, refineries, and delivery of refined products to users, it has to be kept moving and therefore sold at the market clearing price. Room has to be made for the oil that keeps coming. Very few market participants have the capacity to store a significant amount of oil somewhere and therefore drive up the price. If the futures market gets out of line with underlying cash market fundamentals, the likely result is that knowledgeable traders will take the opposite side of the trade, since they know the futures price has to converge with the cash market price. In other words, the explanation of the runup in oil price last summer has to be sought elsewhere than in the futures market.

Gensler went further in this discussion of tangible commodity prices and advocated position limits, thus implying that those in place are not tough enough. One hopes that this does not mean that the CFTC or the exchanges should use tools such as imposing stricter position limits in order to affect market prices. The CFTC prides itself on being a market neutral regulator. The futures markets, ignoring transaction costs, are a zero-sum game – the gains and losses exactly offset each other. The regulator should not be taking sides.

In any case, the imposition of stricter position limits on oil futures would be unlikely to affect the market price in any significant way. Also, the price of oil has come down – where is the chorus of complaints about the short sellers? – and OTC derivatives issues are more likely to be an immediate issue for Gensler, as well as the managing of the CFTC’s relationships with the SEC and the bank regulators.