Remarks of Commissioner Thomas J. Erickson
The Lone Star Forum
Dallas, Texas
September 23, 2002
Good morning. It is a pleasure to be here with you at the Lone Star Forum.
Over the past year, I have enjoyed meeting with many of you to discuss the challenges facing our nation’s energy markets. I’ve enjoyed these discussions and learned a great deal about how the industry works. I’ve also gained a real appreciation for the commitment and seriousness with which you’ve confronted the difficult task of making our energy markets work. Like many of you, I’ve given a good deal of thought to the sequence of events that led us to the current juncture.
Certainly, the rapid demise of Enron set into motion many events that have rendered the making of markets more difficult. On the heels of the Enron episode, we have witnessed a near 70 percent decline in the market capitalization of the 12 largest energy-trading companies. Similarly, the energy trading marketplace, that just one year ago boasted competition among nearly a dozen vibrant trading venues, now counts only a handful of such markets trading cash and derivatives transactions. This one-two blow has sent shockwaves throughout the industry.
One result of these shockwaves is a crisis in confidence. The public has lost faith in energy markets. Trading counterparties have lost confidence in each other. Liquidity has evaporated.
No doubt numerous factors played roles in this market crisis. However, from my perspective as a derivatives market regulator, I am drawn to the conclusion that when participants lose confidence in markets, lack of market integrity is likely a culprit. In fact, I think one of the major factors contributing to our current state of affairs is that we lost sight of those things that build markets with integrity. Simple things, really – things like market transparency, disclosure, and reporting.
How did we as market participants and regulators lose sight of these fundamentals? Let’s take a closer look at changes in derivatives markets over the past decade. At the beginning of the 1990s derivatives markets were dominated by open-outcry exchanges. Trading between buyers and sellers could be observed in person. The good economic times triggered waves of investment in new technologies that brought with them the promise of new efficiencies. By the end of the decade, the investments in electronic trading systems brought enormous changes to derivatives markets around the world. In Europe, the technology-based exchanges have overtaken and shuttered virtually every trading floor on the continent. Closer to home, while physical markets continue to thrive, electronic trading systems have become the engines of product and market innovation.
Electronic trading systems have had the effect of eliminating longstanding physical barriers to establishing markets in an array of commodities – including derivatives in the energy complex. But despite their reputation for being lean and efficient, electronic markets seem to have thrived on two misplaced notions. First, these systems convinced many that the markets they supported were something very new and different – something so new and so different that they deserved a pass from regulatory oversight. Second, there was a general confidence among many that electronic systems were impervious to gaming. But as we learned from Enron, the “success” of some of these markets was predicated on sham transactions that created a false sense of liquidity and volume.
In reality, these electronic trading systems are just markets that happen to operate at warp speed. By the time this was realized, though, the regulatory approach for energy derivatives had changed; with the passage of the Commodity Futures Modernization Act (CFMA)[1] in December 2000, most over-the-counter (OTC) derivative transactions were left outside the regulatory interests of any federal financial regulator. This meant that electronic trading platforms like EnronOnline – platforms that performed risk shifting and price discovery functions just like regulated exchanges – operated without any regulatory oversight. Under the new law, they even appear to be immune to the Commission’s anti-fraud and anti-manipulation authorities. This result troubles me.
I am convinced that if we are to restore confidence to energy derivatives markets, we must repair the regulatory foundation. To do so, Congress will need to restore and reinforce the anti-fraud and anti-manipulation authorities the Commodity Futures Trading Commission (CFTC) once had over OTC derivatives transactions in commodities like energy. This morning, I’d like to give you a bit more detailed background on why I think this is necessary. I’d like to start by giving you some sense of the CFTC’s role in overseeing OTC derivatives in energy markets.
The CFTC’s Role in Oversight of OTC Derivatives
Traditionally, the CFTC’s jurisdiction extended to transactions involving contracts of sale of a commodity for future delivery. Thus, exchanges trading futures on commodities like oil or electricity or Treasury instruments were clearly within the Commission’s jurisdiction. OTC swaps in such commodities were not explicitly enumerated as within the Commission’s jurisdiction. Since such instruments were not generally traded on exchanges, many argued that they should not be subject to the Commission’s jurisdiction, despite the fact that they closely mimicked the function and purpose of an exchange-traded future or option. In order to provide the industry with some certainty regarding the legality of these instruments, the Commission exercised its exemptive authority – basically saying that while the Commission would not consider swaps illegal off-exchange futures, it did retain fraud and manipulation authority with regard to these instruments.
All this changed with the passage of the CFMA in December of 2000; its enactment brought sweeping change to the regulation of derivatives in the United States, both on- and off-exchange. Nowhere was the change in the law more dramatic than in its effect on OTC derivatives, or swaps.
Many of the CFMA’s changes to the Act were based on the recommendations of the President’s Working Group on Financial Markets (PWG).[2] The PWG Report recommended that bilateral transactions in financial commodities between sophisticated counterparties be excluded from the CFTC’s jurisdiction for two reasons: first, because most of the market participants were otherwise regulated by at least one of the federal financial regulators;[3] and second, because the financial markets, such as those in interest rates, were too deep and liquid to be readily susceptible to manipulation.[4] The members of the PWG stated that the same case could not be made for physical commodity markets.[5] Accordingly, the PWG did not recommend any change in the oversight of physical commodity market transactions.
The CFMA adopted a variant of the PWG recommendations and created three categories of commodities. Each category defines the CFTC’s regulatory interest in derivative instruments, including swaps. Generally, under the CFMA financial commodities are excluded from the CFTC’s jurisdiction;[6] agricultural commodities are included in the CFTC’s jurisdiction;[7] and all other commodities – including energy and metals – are exempted from the CFTC’s jurisdiction.[8] What this means in application is not so simple.
In part, the complexity stems from the fact that the regulatory framework hangs on the distinction between “excluded” and “exempted” commodities. An excluded commodity, transaction, or market indicates that the Commission has no jurisdictional interest. An exempted commodity, transaction, or market, meanwhile, means that the Commission retains a jurisdictional interest, but that the law limits its application.
Ostensibly, under the CFMA, the CFTC retains anti-fraud and anti-manipulation jurisdiction over exempt commodities.[9] However, through other provisions in the law, the vast majority of OTC swap transactions in energy and metal commodities become excluded.[10] As a result, they are not subject to the Commission’s fraud or manipulation authorities. Not only do these transactions fall outside the jurisdictional reach of the CFTC, but also, in most cases, they are beyond the reach of any other federal financial regulator.
The Case For Restoring Fraud and Manipulation Authorities Over Swap Transactions in Exempt Commodities
Thus, we have a gap in the oversight of exempt commodity transactions. And plainly, this gap was not something the PWG intended when it made recommendations in its 1999 report. First, the report stated that exclusion was warranted where most market participants were otherwise overseen as financial institutions by a federal financial regulator. I do not believe that any of the entities currently under scrutiny in the energy markets is overseen as a financial institution by any of our federal financial regulators. Second, the PWG concluded that physical commodity markets were more susceptible to manipulation. Allegations of manipulation in energy markets certainly support this conclusion. Third, despite the conclusions of the PWG Report, under the CFMA virtually all OTC transactions in exempt commodities are excluded from the anti-fraud and anti-manipulation provisions of the Act.
The gap creates a conundrum. On the one hand, the Act expects full prosecution of manipulations of exempt commodities in regulated exchange markets. On the other hand, the regulatory regime in place today turns a blind eye to the manipulation of these very same commodities, if effected through OTC derivatives transactions. I cannot believe this was the intended result of the CFMA.
From a practical perspective, the Commission’s own experience has yielded some significant results in this area – results that would be difficult to replicate under current law. For example, the Commission in 1998 reached a settlement with Sumitomo Corporation for the manipulation of global copper prices.[11] The Commission found that the manipulation imposed enormous costs on traders, manufacturers, retailers, and consumers of copper. More recently, the Commission settled with Avista Energy, Inc. for the manipulation of electricity futures.[12] Interestingly, the Commission found that the manipulation created artificial settlement prices in futures contracts and was done to enhance the value of Avista’s OTC swap positions.
I am skeptical that the Commission could replicate these cases in today’s market environment. As the Avista settlement underscores, commodity markets – cash, futures and options, and OTC swaps – are increasingly linked. We now know that wash transactions in unregulated swaps occur and, in certain cases, send price signals that raise manipulation concerns. If we are serious about detecting and deterring fraud and manipulation, these authorities must apply to all derivatives transactions.
Derivatives markets bring unquestionable efficiencies to cash commodity markets. The consequent benefits extend not only to market users, but also to consumers. Thus, I believe that derivatives marketplaces like electronic swap exchanges should adhere to certain, minimal regulatory obligations: among them are transparency, disclosure, and reporting.
Our experience with the futures markets has shown us that measures designed to increase market transparency instill confidence in markets, attract speculative liquidity, and increase market integrity by providing regulators with the means to monitor for fraud and manipulation. I believe application of these principles to derivatives markets generally is sound public policy, prudent business practice, and common sense. Unfortunately, we are presently witnessing some of the best arguments in favor of such changes.
U.S. energy markets are suffering a crisis in confidence. Six months ago we could define the scope of the crisis by the tens of millions of energy consumers in western states who believed the markets had been manipulated. To date, none of our federal regulators have been able to assure them that this was, or was not, the case, and it is not even clear which regulator should be answering these questions. More recent revelations of wash sales by numerous commercial market participants have expanded the scope of this crisis – eroding the trust and confidence firms have in each other. In this environment, liquidity dries up and the market efficiencies created by all derivatives are put at risk. I believe this crisis in confidence has shaken the very foundation of our energy markets.
Conclusion
Consumers are the ultimate beneficiaries of properly functioning derivatives markets, whether those markets are private – like EnronOnline – or public – like the New York Mercantile Exchange. By the same token, consumers are the ultimate victims when markets are manipulated, or otherwise affected by unlawful behavior.
We have a hole in our regulatory regime that allows for fraud and manipulation to operate free from sanction. We have markets experiencing a crisis in confidence. Unfortunately, legislation is the only way to mend the regulatory fabric, and I believe that modest legislation amending the commodities laws is an appropriate first step toward restoring confidence and rebuilding market integrity. Nevertheless, some legislators, industry participants, and even regulators remain resistant to the idea of requiring simple market transparency. These objections seem to be based more on a desire to eliminate all regulation rather than on a desire to build market integrity.
Frankly, this baffles me. If the last few years have taught us anything, it is that these markets play a vital role in the efficient functioning of our economy. The least we can do is provide a firm foundation and coherent framework within which markets can operate. I think we owe this both to the consumers who are the ultimate beneficiaries of these markets and to the market participants who make these markets work. Absent a coherent framework, my concern is that these markets will remain in a state of uncertainty and crisis.
Thank you for this opportunity to appear before you. I look forward to your questions.
[1] Appendix E of Pub. L. No.
106-554, 114 Stat. 2763 (2000).
[2] Report of the President’s
Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the
Commodity Exchange Act (November 1999).
[3] Id. at 16. Federal financial regulators include the Federal Reserve Board of Governors, the Department of the Treasury, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.
[4] Id.
[5] Id. (stating, “Due to the characteristics of markets for non-financial commodities with finite supplies, however, the Working Group is unanimously recommending that the exclusion not be extended to agreements involving such commodities.”).
[6] 7 U.S.C. §§ 1a(13) and 2(d).
[7] Agricultural commodities are neither excluded nor exempted under the Act, and thus remain within the exclusive jurisdiction of the CFTC.
[8] 7 U.S.C. §§ 1a(14) and 2(h).
[9] Section 2(h) of the Act affirmatively retains fraud and manipulation authorities over exempt commodities.
[10] Section 2(g) of the Act excludes from Commission jurisdiction all swaps except those in agricultural commodities. Thus, swaps in exempt commodities are, in fact, excluded from CFTC oversight. In short, the exclusion trumps the exemption. Moreover, Section 2(e) of the Act excludes, among other things, electronic trading facilities engaged in trading swaps – whether through bilateral or multilateral exchange markets. Thus, by dint of the type of trading platform, another exclusion is effected.
[11] In re Sumitomo Corp., [1996-1998 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 27,327 (CFTC May 11, 1998) (finding that Sumitomo engaged in a scheme to manipulate the price of copper through actions taken on the London Metals Exchange, which caused artificially high prices in cash and futures markets in copper, including those in the United States, and assessing a $125 million civil monetary penalty).
[12] In re Avista Energy, Inc., et al., [2000-2002 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 28,623 (CFTC August 21, 2001) (finding that Avista manipulated the settlement prices of the Palo Verde and California-Oregon-Border electricity futures contract in order to increase the company’s net gain on certain OTC options positions, whose value was based on the settlement prices at issue).