Below is testimony of CFTC Chairman Gary Gensler before the House Committee on Financial Services, Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises on May 11.
Good afternoon Chairman Kanjorski, Ranking Member Garrett and members of the Subcommittee. I thank you for inviting me to today’s hearing on the unusual volatility in the capital markets last week. I also am pleased to testify alongside Securities and Exchange Commission Chairman Mary Schapiro. Staff of the Commodity Futures Trading Commission (CFTC) and SEC have been in constant communication since Thursday afternoon. We will continue to work closely together to review the events of last week and make joint recommendations to protect the integrity of our markets and the American public. This afternoon, I will focus my testimony primarily on issues related to the futures marketplace and allow Chairman Schapiro to address the securities markets.
The Equity Index Futures Markets
Before I turn to the events of last Thursday, I will discuss the makeup of the stock index futures markets. I will also address the market protection mechanisms in place for orders entered into the electronic trading systems of the two U.S. futures exchanges where the highest-volume equity futures trade.
Stock index futures are derivatives contracts that trade on central exchanges. Much like a crude oil futures contract is based upon the price of crude oil, a stock index futures contract is based on the level of a broad based stock index. The stock index futures marketplace consists almost entirely of futures contracts based on four principal stock indices. Futures on many U.S. stock indices, including the S&P 500, the Nasdaq 100 and the Dow Jones Industrial Average, trade on the Chicago Mercantile Exchange (CME). Futures on other U.S. stock indices, including the Russell 2000 Index, trade on the IntercontinentalExchange, Inc. (ICE). The total outstanding notional value of the futures contracts on these indices is approximately $360 billion. This compares to a total U.S. equity market value of approximately $13 trillion.
By far the largest stock index futures contract is the E-Mini S&P 500 (“E-Mini”) contract, which is a cash-settled contract based on the level of the S&P 500 Stock Index. E-Mini futures account for more than 80 percent of the notional value of U.S. stock index futures open interest. E-Mini futures trade on the CME Globex electronic trading system, which operates nearly 24 hours a day from Sunday evening to Friday afternoon.
Electronic Futures Trading Market Protections
Both CME Globex and the ICE trading systems have automatic safety features – termed “pre-trade risk management functionality” – to protect against errors in the entry of orders (such as “fat finger” errors) and extreme price swings. These features help ensure fair and orderly markets.
First, CME and ICE electronic trading systems both automatically reject orders priced outside a range of reasonability, also known as price bands. For instance, on the E-Mini contract, such band is 12 points – or approximately 1 percent – above and below the last executed trade. This prevents clearly erroneous orders from triggering a sequence of market-moving trades that later require cancellation.
Second, both CME and ICE have maximum order size limitations that prevent entry into the trading engine of an order that exceeds a predefined maximum quantity. In the E-Mini contract, for example, the maximum quantity is 2,000 contracts. With the S&P 500 Index at approximately 1,100 points as it was on May 6, two thousand E-Mini contracts would have a notional value of approximately $110 million. The average transaction size in the E-Mini contract, however, tends to be six contracts, or approximately $330,000.
Third, both CME and ICE have protections with regard to “stop loss” orders. Such orders are triggered if the market declines to a level pre-selected by the person entering the order. CME and ICE rules provide that when the market declines to the pre-selected stop level for such order, the order becomes a limit order executable only down to a price within the range of reasonability (12 points) permitted by the system, instead of becoming a market order. Requiring that stop orders have a limit avoids the potential that such stop orders could be executed no matter how low the market goes. This requirement for all stop orders to convert to limit orders prevents, for example, any stop orders from being posted at a price unreasonably below the market, such as orders at a price of one cent.
Fourth, CME Globex has Stop Spike Functionality that protects against cascading stop orders – the domino effect of one stop order triggering others. Globex’s Stop Spike Functionality pauses trading for five to ten seconds – five seconds in the case of the E-Mini contract – when the trading engine recognizes that it has a series of resting stop orders that could lead to a cascade and move the market up or down beyond a specified amount. The pause allows new orders to enter the system to restore liquidity and balance to the order book. On May 6, the Stop Spike functionality occurred on two currency futures contracts and at a critical moment in the E-Mini contract.
One of the questions on everyone’s mind – and the topic of this hearing – is: “What happened on Thursday?” While the staffs of the CFTC and the SEC, with the cooperation of the exchanges, continue to review the events of that day, I would like to share some preliminary observations. This review is ongoing, and there is much we have yet to learn.
CFTC staff, in coordination with the SEC and the exchanges, has been working around the clock since Thursday afternoon to collect, review and analyze essential data. The CFTC receives trade and position data on a daily basis from the regulated exchanges and intermediaries. We have been in direct and regular communication with the futures exchanges, and Commission staff has interviewed a number of the major market participants. Shortly after the markets closed on May 6, staff issued “special call” requests to the ten traders with the largest positions in the June 2010 S&P 500 E-Mini futures contract. Staff subsequently sent similar letters to additional traders. The letters request information on trader positions and all communications related to trading on May 5 and May 6.