[Senate Hearing 107-897]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 107-897

              CFTC REGULATION AND OVERSIGHT OF DERIVATIVES

=======================================================================

                                HEARING

                               before the

                       COMMITTEE ON AGRICULTURE,
                        NUTRITION, AND FORESTRY

                          UNITED STATES SENATE


                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION


                               __________

                             JULY 10, 2002

                               __________

                       Printed for the use of the
           Committee on Agriculture, Nutrition, and Forestry


  Available via the World Wide Web: http://www.agriculture.senate.gov


                                 ______

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           COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY



                       TOM HARKIN, Iowa, Chairman

PATRICK J. LEAHY, Vermont            RICHARD G. LUGAR, Indiana
KENT CONRAD, North Dakota            JESSE HELMS, North Carolina
THOMAS A. DASCHLE, South Dakota      THAD COCHRAN, Mississippi
MAX BAUCUS, Montana                  MITCH McCONNELL, Kentucky
BLANCHE L. LINCOLN, Arkansas         PAT ROBERTS, Kansas
ZELL MILLER, Georgia                 PETER G. FITZGERALD, Illinois
DEBBIE A. STABENOW, Michigan         CRAIG THOMAS, Wyoming
BEN NELSON, Nebraska                 WAYNE ALLARD, Colorado
MARK DAYTON, Minnesota               TIM HUTCHINSON, Arkansas
PAUL DAVID WELLSTONE, Minnesota      MICHEAL D. CRAPO, Idaho

              Mark Halverson, Staff Director/Chief Counsel

            David L. Johnson, Chief Counsel for the Minority

                      Robert E. Sturm, Chief Clerk

              Keith Luse, Staff Director for the Minority

                                  (ii)

  
                            C O N T E N T S

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Hearing(s):

CFTC Regulation and Oversight of Derivatives.....................    01

                              ----------                              

                        Wednesday, July 10, 2002
                    STATEMENTS PRESENTED BY SENATORS

Harkin, Hon. Tom, a U.S. Senator from Iowa, Chairman, Committee 
  on Agriculture, Nutrition, and Forestry........................    01
Feinstein, Hon. Dianne, a U.S. Senator from California...........    03
                              ----------                              

                               WITNESSES
                                Panel I

Erickson, Thomas J., Commissioner, Commodity Futures Trading 
  Commission, Washington, DC.....................................    13
Newsome, James E., Chairman, Commodity Futures Trading 
  Commission, Washington, DC.....................................    11

                                Panel II

Coffee, John C., Jr., Professor, Columbia Law School, New York, 
  New York.......................................................    38
Dodd, Randall, Director, Derivatives Study Center, Washington, DC    35
Green, Richard C., Chairman, Aquila, Inc., Kansas City, Missouri.    45
Patrikis, Ernest T., Senior Vice President and General Counsel, 
  American International Group, Inc., International Swaps and 
  Derivatives Association (ISDA), New York, New York.............    41
Wolkoff, Neal L., Executive Vice President and Chief Operating 
  Officer, New York Mercantile Exchange, Inc., Washington, DC....    42
                              ----------                              

                                APPENDIX

Prepared Statements:
    Harkin, Hon. Tom.............................................    66
    Coffee, John C., Jr..........................................   130
    Dodd, Randall................................................    90
    Erickson, Thomas J...........................................    74
    Green, Richard C.............................................   164
    Newsome, James E.............................................    69
    Patrikis, Ernest T...........................................   138
    Wolkoff, Neal L..............................................   152
Document(s) Submitted for the Record:
    Electric Power Supply Association............................   195
    Falvey, James M..............................................   189
    Leahy, Hon. Patrick..........................................   182
    Lincoln, Hon. Blanche........................................   172
    Miller, Hon. Zell............................................   175
    Wood, Pat III................................................   186

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              CFTC REGULATION AND OVERSIGHT OF DERIVATIVES

                              ----------                              


                        WEDNESDAY, JULY 10, 2002

                                       U.S. Senate,
         Committee on Agriculture, Nutrition, and Forestry,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 9:35 a.m., in 
room SD-106, Dirksen Senate Office Building, Hon. Tom Harkin, 
[Chairman of the Committee], presiding.
    Present or submitting a statement: Senators Harkin, 
Lincoln, Miller, Nelson, Lugar, Fitzgerald, and Crapo.
    The Chairman. Good morning. The Senate Committee on 
Agriculture, Nutrition, and Forestry will come to order.
    This morning, I am pleased to welcome everyone to our 
committee for a hearing on regulation of markets in over-the-
counter derivatives and the CFTC's oversight role. The main 
focus of this hearing will be the regulatory treatment of 
derivatives, based on ``exempt commodities,'' such as energy 
and metals, following the passage of the Commodity Futures 
Modernization Act of 2000. During this hearing, the committee 
intends to examine the scope of the CFTC's authority and its 
exercise of its authority to ensure market transparency, to 
prevent and punish fraud and manipulation, and to restore 
confidence in these markets.
    The impact of OTC derivatives markets reaches well beyond 
the immediate parties to the transactions. The integrity of 
these markets and the confidence in them are critically 
important to shareholders, investors, consumers, and the 
broader economy.
    The OTC derivatives markets have assumed an increasingly 
large role in the U.S. economy. A recent conservative estimate 
put the size of the global OTC derivatives markets at $111 
trillion. The U.S. share of that market is estimated to be at 
least two-thirds. Derivatives based on exempt commodities, such 
as energy and metals, make up a very small percentage, probably 
no more than 2 percent of the total OTC derivatives market. 
However, derivatives play an increasingly important role in 
energy and metals markets, which are, in turn, critical to our 
overall economy.
    When the CFMA was enacted in December of 2000, one of its 
primary goals was to ensure the legal certainty for OTC 
derivatives. For the most part, the CFMA was based on the 
recommendations of the President's Working Group on Financial 
Markets issued in 1999. The President's Working Group 
recommended that certain transactions involving financial 
derivatives be excluded from the CFTC's jurisdiction. The 
President's Working Group did not recommend a similar exclusion 
for transactions involving energy and metals derivatives.
    During development of legislation in the Senate, there was 
discussion of the issue of oversight of energy and metals 
derivatives markets. Senator Lugar and I both supported in this 
committee a version of the legislation that was consistent with 
the recommendations of the President's Working Group and 
excluded only financial derivatives, not energy and metals 
derivatives, from the CFTC's jurisdiction. The bill codified an 
exemption with specific safeguards for certain commodities, 
such as energy and metals.
    The final version of the legislation included in the 
omnibus appropriations bill differed from our committee bill 
regarding energy and metals derivatives markets. I supported 
the CFMA, although I had some concerns about its treatment of 
energy and metals products. There is a statement I gave on the 
floor to which I would refer you that is in the Congressional 
Record regarding that, because I thought at the time it had a 
number of very positive features. On the whole, I thought it 
was a good bill, and I still think it is. It is important that 
we do not undermine the legal certainty that the legislation 
brought to the CFTC derivatives market. However, if there are 
unaddressed problems with some types of derivatives that could 
give a black eye to all OTC derivatives, then we are going to 
have to take a look at that.
    Although the CFTC is currently investigating allegations of 
fraud and manipulation in the Western energy markets, some have 
suggested that the CFTC does not, because of the passage of the 
CFMA, have sufficient authority to effectively and successfully 
investigate and punish fraud and manipulation in derivatives 
markets for exempt commodities, again, energy and metals. 
Questions have also been raised about the CFTC's ability to 
prevent fraud and manipulation in the first place.
    Today's hearing will focus on these issues and I hope it 
will help answer some of these questions. We hope also to 
discuss possible legislative solutions to any problems 
identified in the existing regulatory framework for OTC 
derivatives based on exempt commodities.
    Our first witness, of course, Senator Feinstein, has 
proposed legislation to increase transparency in the energy and 
metals derivatives markets and to clarify and strengthen the 
CFTC's authority to investigate and punish fraud and 
manipulation in those markets.
    In addition to the distinguished Senator from California, 
we have two panels of witnesses here with us today. The first 
panel consists, of course, of chairman Newsome and commissioner 
Erickson of the CFTC, and we are pleased that they could be 
with us today.
    Our second panel consists of witnesses Randall Dodd, 
Director of the Derivatives Study Center; John Coffee, 
Professor of Law at Columbia; Neal Wolkoff, the Executive Vice 
President and COO of the New York Mercantile Exchange; Mr. 
Patrikis representing the International Swaps and Derivatives 
Association; and Richard Green, Chairman of Aquila, 
Incorporated, an energy trading company. We welcome all the 
witnesses to the committee and look forward to our hearing.
    With that, now I would turn to our distinguished ranking 
member, Senator Lugar, who provided such great leadership and I 
was pleased to work with him very closely in working out the 
CFMA that was passed in the year 2000, which as I just stated 
in my opening statement, I still think is a good bill and has a 
lot of good things in it. Perhaps now we have to look at some 
of the other things that are exempt and that is what the 
purpose of this hearing is. Senator Lugar was one of the 
driving forces in the Modernization Act and I turn now to him 
for his statement.
    [The prepared statement of Sen. Harkin can be found in the 
appendix on page 66.]
    Senator Lugar. I thank you very much, Mr. Chairman. I just 
ask that my statement be placed in the record in full.
    The Chairman. Without objection.
    Senator Lugar. I would just make the comment that I think 
your recitation of the history of the Commodities Futures Act 
is accurate and certainly reflects the gravity of the situation 
our committee faced. We met regularly, and, in fact, a number 
of the hearings were in this room, with Alan Greenspan, the 
Secretary of the Treasury, and other people who felt after the 
long-term capital management failure that the financial 
institutions of this country could be jeopardized and that at 
least the laws that were on the books might contribute to that 
jeopardy.
    We took that seriously and proceeded really for the better 
part of a year and a half, as you will recall, through seminars 
that involved many people in all facets of the futures 
industries, as well as experts from academia and governmental 
responsibility, and in the final stages of that Congress, the 
Act finally came from conference in the manner you suggested.
    It is fully appropriate that this committee have an 
oversight of how that has worked. We have been busy in other 
things, including a comprehensive farm bill, and it is 
appropriate we return now to some of our previous work. I 
welcome the hearing. I am delighted that our colleague, Senator 
Feinstein, leads off this morning because she has given a great 
deal of thought and leadership in this area. I thank you, Mr. 
Chairman.
    The Chairman. Thank you, Senator Lugar, and again, I thank 
you for your great leadership in this area.
    The Chairman. Now, we welcome our distinguished fellow 
Senator from the State of California who has again taken up 
this issue with great force and great intellect and has painted 
for the public the picture of what has happened in California 
and why we need to revisit this issue of whether or not they 
should be exempt or not.
    I thank Senator Feinstein for being here. Your statement 
will be made a part of the record in its entirety, and please 
proceed as you so desire, Senator Feinstein.

    STATEMENT OF HON. DIANNE FEINSTEIN, A U.S. SENATOR FROM 
                           CALIFORNIA

    Senator Feinstein. Thank you very much, Mr. Chairman, and 
thank you very much, Senator Lugar, Senator Miller, for being 
here. Mr. Chairman, I particularly appreciate your keeping your 
word. I have been pestering you for this hearing for a while 
and I thank you very much for holding it, and I want to thank 
both of you for your work.
    Mr. Chairman, you accurately quoted the record, and I 
appreciate that very much. This committee did include CFTC 
oversight over energy derivatives when the bill came out. The 
Senate bill did. As you know, in conference, that was changed.
    Mr. Chairman, last night, I was listening to some former 
CEOs on television rather critical of the Congress for not 
taking steps to really close loopholes and exert the kind of 
legislation that would produce the kind of regulatory oversight 
over the markets. This is one of those loopholes that happened 
in 2000 and I want to thank you for holding this hearing on 
this legislation which would restore oversight, transparency, 
and reporting to energy trading markets and ensure that the 
CFTC has full anti-fraud and anti-manipulation authority, 
including the authority to investigate wash trades.
    This bill closes the loophole that you refer to. That 
loophole created a kind of niche market so that derivatives 
traded online could be traded without any anti-fraud, anti-
manipulation oversight, without transparency, without net 
capital requirements, with no records and no audit trail. This 
was wrong, in my view, Mr. Chairman.
    Let me speak for a moment about what we have learned about 
the energy sector in the past couple of months and the 
operations of some of the energy companies. First, CMS Energy 
admitted that 80 percent of its trades were round-trip or wash 
trades and were made simply to increase volume. That is 80 
percent.
    Reliant admitted to $6.4 billion in wash trades from 1999 
to 2001, which the company characterized as energy swaps.
    Three, Duke confessed to $1.1 billion in wash trades and 
stated that $650 million of these trades were executed on the 
Intercontinental Exchange, an electronic trading facility 
exempt from CFTC oversight because of the Commodities Futures 
Modernization Act.
    As I understand how the Intercontinental Exchange works, 
not only does this exchange have no responsibility for trades 
or wash trades executed on its exchange, it does not take any 
responsibility for checking that a transaction has, in fact, 
even been executed. Thus, a company could manipulate prices or 
game the market without even executing a single trade.
    Now, what is a wash trade? A company sells to another who 
sells back at the same price at the same time. The result 
boosts revenue without any trade actually having taken place. 
In my view, it is flim-flam and it artificially inflates 
revenues and creates an illusion of activity to raise stock 
prices, and that is what has been going on and it goes on in 
secret. There is no audit trail. There is no record kept. There 
is no anti-fraud, anti-manipulation oversight.
    In the past year, 12 of the largest energy companies in the 
United States have lost about $188 billion of capital. That is 
71 percent of their market value. The credit ratings of several 
of those energy companies have been severely downgraded. Some 
are at junk bond or near junk bond status today.
    In the past month, Dynegy and Aquila have both halted their 
energy trading operations. I understand that Williams is on the 
verge of doing the same thing. Yet many of these energy 
companies continue to fight transparency, record keeping, and 
Federal oversight, the very components that are vital for 
markets to work and for investors to be confident of an upright 
and fair system.
    I want to briefly explain my interest in all of this. In 
May 2000, a severe energy crisis began in California. 
Electricity that had typically sold for $30 a megawatt hour all 
of a sudden started to sell for ten times that. This led to the 
bankruptcy of California's largest investor-owned utility and 
the near-bankruptcy of California's second-largest investor-
owned utility. It also resulted in overcharges of billions of 
dollars to California rate payers and taxpayers.
    In November, California encountered a natural gas crisis. 
Natural gas is the main cost component of electricity. At one 
point, what came to my attention was that natural gas was 
selling at $12 a decatherm in San Juan, New Mexico, and $59 a 
decatherm in Southern California. Now, transportation cost to 
move that gas is only a dollar and yet that gas solo for $59. 
What was happening?
    Just about the time Congress passed the Commodities Futures 
Modernization Act exempting electronic energy trading exchanges 
from oversight, the crisis began spreading to other Western 
States. For more than 6 months, Oregon, Washington, and the 
other Western States experienced the same price spikes as 
California. The entire crisis lasted for more than a year while 
energy companies like Reliant, Enron, Duke, Williams, AES 
enjoyed record revenues and profits.
    Obviously, we are all a bit wiser today about energy's 
markets and the wash trades, in particular. Wash trades, or 
round-trip trades, involve two or more companies plotting 
together to execute offsetting trades. I cannot think, really, 
of a legitimate reason for doing a wash trade, but wash trades 
can significantly enhance revenues, as I have pointed out, if 
they are done on an exchange like the Intercontinental Exchange 
and they can certainly influence price. In my book, this is 
outright fraud, and these trades would be illegal if they were 
done on the NYMEX, the Chicago Mercantile, or the Pacific 
Exchange, and those exchanges would have the responsibility to 
report it.
    However, there is no such reporting or enforcement 
requirement on electronic exchanges because of, as I have said 
before, the CFMA created a big loophole. This legislation would 
ensure that wash trades are subject to full CFTC oversight no 
matter where they are done, by telephone or by electronic 
exchange.
    Of course, there is Enron, which controlled a large share 
of the energy market while they engaged in activities that were 
downright illegal. Many of these activities could have been 
prevented or at least stopped if regulators had simply had the 
proper authority and the will.
    Now, as I understand it, if I were to trade, let us say, 
natural gas to you, Senator Harkin, and deliver it to you, that 
trade is covered by the Federal Energy Regulatory Commission. A 
record is kept and the Commission has jurisdiction. If I sell 
it to you and you sell it to Senator Lugar, who sells it to 
Senator Miller, who sells it to any other entity, none of those 
interim trades are covered. Or if you sell it back and forth, 
they are not covered, and there is no record kept, there is no 
transparency, there is no anti-fraud and anti-manipulation 
oversight. That is the loophole, and I believe companies 
stepped into this loophole and utilized this loophole to game 
the market.
    What I am asking here today, and I am joined with Senator 
Fitzgerald, Senator Corzine, Senator Durbin, Senator Wyden, 
Senator Boxer in asking you to please close this loophole.
    I am very pleased, and I would like to commend Aquila. 
Aquila came in, talked to us about the legislation, recommended 
a couple of changes. We did our due diligence on those changes 
and we made those changes, and my understanding is that Aquila 
is going to testify later this morning in support of this 
legislation.
    All I can say is that the time really has come. We have 
seen the game. We have seen the manipulation of the market. We 
see the absence of transparency. The time has come to close 
this loophole. Thank you very much, Mr. Chairman.
    The Chairman. Senator Feinstein, thank you very much for a 
very erudite statement, very clear, very concise, and that 
really drives home what we should be looking at here.
    The Chairman. As you know as well as I do, trying to 
translate this into terms that the average person understands 
and how it affects the average person is very difficult. I 
mean, you are talking about OTC derivatives and derivatives 
markets and all of a sudden eyes glaze over. How does that 
affect me? I just want to pay my gas bill and get my gas and 
that is it, or my electric bill.
    We need to be able to tell the average consumer out there 
in California, in Iowa, in Indiana, how this affects them, how 
it really affects the markets, how it affects their bottom line 
and how it affects a lot of the investors in these companies. 
That is a real challenge we have to do. It is difficult, but we 
will try our best.
    Senator Feinstein. Mr. Chairman, may I say just one thing--
--
    The Chairman. Sure.
    Senator Feinstein [continuing]. Because it is important 
that the committee know. There was concern that this amendment 
might cover financial derivatives. We have done our due 
diligence and we have redrafted it earlier to see that it does 
not cover financial derivatives. It strictly covers energy and 
metals. It does cover swaps, wash trades, as you know.
    The Chairman. Sure.
    Senator Feinstein. You are absolutely right, and, of 
course, the way this affects the individual is that it prevents 
the kind of oversight that can see that the market is 
functioning in a straight-up, straightforward way, so it allows 
gaming. Now, what does that gaming do? That gaming raises 
prices for consumers, and if you do not have the net capital in 
many of these trades, as apparently Enron did not, the house of 
cards that is built can crumble and you are left with companies 
that get into very deep financial trouble, and that has 
happened and that also affects our constituent because it 
affects the stock and people lose their money when they have 
invested in publicly controlled companies.
    It is very important. I ran into an officer of the Pacific 
Coast Stock Exchange when I was in California and he was 
adamant. He did not understand why--if somebody trades over 
that exchange, there is a record, there is transparency, there 
is oversight, there is attribution--why we would allow the 
creation of these niche entities where none of this would 
exist, and, of course, they were originally taken advantage of. 
Now, at least according to a Wall Street Journal article 
yesterday which says, ``Energy Woes Drain Online Power Trading, 
Brokers Switch Back to Telephones,'' which we would cover, 
``Exchange Pits Admit Quick Fizzle of Once Booming Business 
Niche.'' It is very important that we do our due diligence and 
provide that oversight.
    The Chairman. Thank you Senator Feinstein.
    Senator Feinstein. Thank you.
    The Chairman. Senator Lugar.
    Senator Lugar. Senator Feinstein, in your bill, and I know 
you in the draft have given a lot of thought to this, but 
explain to me why you make a distinction between trading on the 
platforms of, say, telephones and Internet, involving what are 
described as less-sophisticated retail customers--these people 
would be subject to the anti-fraud, anti-manipulation 
provisions of the CFMA, as opposed to OTC trading of physical 
commodities, including energy and metals, on bilateral 
electronic trading facilities, and these would be the 
sophisticated persons, at least as defined, who would now be 
subject to anti-fraud, anti-manipulation, but also reporting 
and record keeping provisions, and that would include the 
capital margin requirements, daily trade volume, large trader 
reports, and so forth.
    Essentially, my first question is why not apply the same 
ore rigorous standards to everybody?
    Senator Feinstein. What we have tried to do--and I am not 
averse to doing that, but what we have tried to do is to apply 
it where the most volume is, and to cover the phone 
transactions for anti-fraud and anti-manipulation oversight to 
require that a record be kept, as well as these electronic 
exchanges.
    Senator Lugar. I understand that, and, of course, the 
difficulty of all of that record keeping with phone 
transactions and the so-called less sophisticated involves a 
great deal more administration, some critics would say a 
prodigious amount. I do not know. Experts will have to----
    Senator Feinstein. That is correct. That is another reason 
why we left it out.
    Senator Lugar [continuing]. Have to take a look at this. On 
the other hand, it occurs to me as we are busy trying to close 
perceived loopholes, the sophisticated might move to the 
telephone and become unsophisticated. I do not know how 
precisely things move in this particular area, and so this gave 
me some concern as I read through, knowing that this has given 
you a lot of concern, likewise, and others who have been 
working with you. I wanted to raise it for your consideration 
and your thoughtfulness today.
    Senator Feinstein. Yes. The only way--because you are 
right. We cover it for anti-fraud and anti-manipulation 
oversight, and you are right about the paper. The other thing 
would be just to prohibit anything that is not traded over one 
of these big exchanges and we have not gone that route.
    I certainly am going to watch very carefully. If there are 
signs of gaming and manipulation, we at a later time may have 
to do this, and that is just prohibit the use of the phone for 
these kinds of trades. At this stage, we have tried to do 
just--in other words, to limit it, to provide for anti-fraud, 
anti-manipulation, that a record be kept, et cetera. We also 
provide that with respect to capital requirements, that the 
CFTC would set those capital requirements based on risk.
    Senator Lugar. Well, that is helpful, and maybe some other 
testimony today will be enlightening, too. By raising this 
early in the hour, others may have some appraisal----
    Senator Feinstein. Right.
    Senator Lugar [continuing]. Because this is a critical part 
of it.
    The other question I have is you have pinned down energy 
and metals. Some will say there are additional commodities out 
there. They have identified weather and broadband, for example, 
and asked, while we are at it, why do we not tackle weather and 
broadband. Maybe there are others in addition to that. Do you 
have any response to the inclusiveness question?
    Senator Feinstein. Yes. We, and it is controversial with 
some of our colleagues to include metals. I understand that the 
silver people do not want to be included. However, if you look 
back into the past, there has been fraud in the metals market 
and this is why--and I am glad that my co-sponsor, Senator 
Fitzgerald, has arrived--that is why we included it, because 
there have been instances of fraud and they were rather large 
when they took place. I do not quite see, if we are going to 
cover energy, why we should create a loophole and allow metals 
out of it.
    Senator Lugar. No, I was not suggesting that. I was 
suggesting that some would say beyond metals and energy----
    Senator Feinstein. In broadband?
    Senator Lugar [continuing]. How about broadband and 
weather?
    Senator Feinstein. We have not had any experience with that 
to be able to go back and say there was fraud. I am not averse. 
I believe, and history is going to show this to be correct, 
that we should not create any loopholes, that what we need to 
do to provide for investor confidence is to have transparency. 
Transparency is good. If people can examine a trade or the CFTC 
or the FERC or the SEC, whatever the appropriate body is, can 
examine a trade and say, this trade is forthright, it is 
straight-up, it stands the test of scrutiny, that is fine.
    To create an anonymity where all these things can take 
place without records, without capital requirements, without 
audit trails, without oversight, is a mistake and I think it 
creates the opportunity for the hot-shot young trader, bright 
but perhaps with not the level of ethics that we want, to make 
a lot of money and to game the system, and I do not want to see 
us do that and I do not believe stockholders do, either.
    Senator Lugar. I thank you for your testimony. Let me just 
say that I feel equally outraged, as you do, about the energy 
trading business. We have to have reform. The purpose of my 
questions is to see how broad the reform ought to be, and not 
to rebut the need.
    Senator Feinstein. Right. I understand that.
    Senator Lugar. It seems to me there is a glaring problem 
here that really demands public attention, and so I appreciate 
the hearing and I thank you for your work.
    Senator Feinstein. Thank you very much.
    The Chairman. Thank you, Senator. I know that you have a 
schedule conflict, Senator Feinstein. I would ask other members 
if they would be so kind as to permit Senator Feinstein to 
leave, if that is all right, and then we can move on to our 
panel.
    Senator Fitzgerald. If I could just thank Senator Feinstein 
for appearing before our committee. I co-sponsored the 
legislation with Senator Feinstein when we offered it as an 
amendment. I am supportive of this legislation as we try to 
bring forward a full bill.
    I would point out that the President's Working Group 
specifically recommended, unanimously, that the exclusion that 
is available for financial commodities with infinite supply not 
be extended to non-financial commodities with a finite supply. 
Somehow, while we tried to craft a bill that met the 
recommendations of the President's Working Group, somehow, 
somewhere in the process, somebody slipped in this mysterious 
exemption for energy and metals trading and they are being 
treated differently than all other non-financial commodities 
that have a finite supply.
    We have to close the loophole and I thank Senator Feinstein 
and compliment her for her tenacity on this issue. I will be 
with you every step of the way on this. I was much chagrined 
that we could not pass that very simple reform on the Senate 
floor.
    Senator Feinstein. I want to thank you, Senator. You have 
been with me all the way. You were there when we tried to 
settle problems with Senator Gramm, were not able to do so, and 
I really appreciate your work on this, as well. Thank you.
    Senator Fitzgerald. Thank you.
    The Chairman. Senator Lincoln or Senator Miller.
    Senator Crapo. Mr. Chairman, I just had a question that I 
was going to ask with regard to what happened back with the 
CFMA, but I could ask that of the chairman, since you were 
there at the time, and we could let Senator Feinstein leave.
    Senator Feinstein. Thank you. Thank you, Mr. Chairman, and 
thank you, Mr. Crapo.
    The Chairman. Thank you, Senator Feinstein, very much.
    Now we would like to bring to the witness table Mr. James 
Newsome, the Chairman of the Commodity Futures Trading 
Commission, and Mr. Tom Erickson, a commissioner of the CFTC.
    Senator Crapo. Mr. Chairman, while they are taking their 
seats----
    The Chairman. Senator Crapo, yes. You had something you 
wanted to ask.
    Senator Crapo. Yes. In your opening statement, you 
indicated that when the Senate was dealing with the CFMA a few 
years ago, that the bill that the Senate voted on was changed 
in conference in a specific way that you had concern about. 
Could you tell me what that--I did not quite understand what 
that change was that you were describing there.
    The Chairman. What happened was when Mr. Ranier, at that 
time, had testified--there was a President's Working Group that 
had made recommendations to this committee under the leadership 
of Senator Lugar, and perhaps he could best answer that 
question rather than me because he was chairman at the time, 
but we agree that we worked very closely on this. When we 
passed it, we kept the distinction between the financial 
derivatives--and help me out here, Dick--the financial 
derivatives and those other derivatives that covered things 
that were in limited supply, like energy and metals.
    We felt at the time, that because of the--the amount of 
interest rate trading and things like that in financial 
markets, that you could make that distinction, and so we left 
it that way, and that is how it passed the committee. We never 
got it on the floor and it was wrapped into the omnibus 
appropriations bill. When it was wrapped in the omnibus 
appropriations bill all of a sudden, that distinction 
disappeared. Therefore, the exemption that we had had for the 
financial derivatives was then applied to the metals and energy 
derivatives.
    We were confronted at that time with a vote on whether to 
pass the CFMA as a part of the omnibus appropriations bill or 
to let the whole thing fall. Well, it was part of it. I made a 
statement on the floor at the time saying that there were a lot 
of good things in the Act. This committee, under Senator 
Lugar's guidance, had done great work, I think, in modernizing 
the Act. I said at the time I did not agree with erasing this 
distinction between financial derivatives and energy and 
metals, but in the overall interest of getting the bill passed, 
we would do it and get it passed, and that is exactly what 
happened.
    Senator Crapo. Just so I understand, as I understand the 
bill that passed, it had an exclusion for financial 
transactions----
    The Chairman. That is right.
    Senator Crapo [continuing]. An exemption for energy and 
metals and some other transactions----
    The Chairman. Right.
    Senator Crapo [continuing]. Then complete coverage for 
other, like farm commodities and other types of transactions. 
It created three categories, and I am just trying to understand 
whether this change that you are talking about was the 
establishment of the middle category or whether that exemption 
category was in the original proposal.
    The Chairman. Say that again.
    Senator Crapo. Interestingly, this Act created, as I 
understand it, and I was not here when that happened in the 
Senate, but as I understand it, what happened was it created 
three categories, basically, excluded transactions, which were 
totally not covered----
    The Chairman. That is right.
    Senator Crapo [continuing]. Exempted transactions, which 
were subject to anti-fraud and price manipulation and other 
protections, and then totally covered transactions, which would 
be subject to over-the-counter trading requirements and so 
forth. Were those three categories in what the Senate 
originally considered or was the situation you are talking 
about where it was changed something that created one of those 
three categories?
    The Chairman. Mr. Erickson is going to testify to that, but 
again, as I understand it, the Senate bill fully and clearly 
maintained CFTC's anti-fraud and anti-manipulation authority 
over exempt commodities, such as energy and metals. Now, there 
seems to be an ambiguity as to their authority to do this and 
that is really what we are trying to clear up, that ambiguity, 
and to make sure that they do have that authority.
    Senator Crapo. All right.
    The Chairman. Senator Lugar.
    Senator Lugar. Let me just add one thought, and others may 
have more, but essentially, the bill that came out of this 
committee had no exemptions for metals and energy. Somewhere in 
the conference procedure, and I do not really remember when 
because we were at the end of the session. This bill had been 
given up for dead a long while back, that is, the totality of 
it, despite Alan Greenspan, the Secretary of the Treasury, the 
President's Working Group, and almost everybody who was worried 
about the financial condition of the country centered upon this 
as a salvation.
    Somebody in the process of that conference talked about 
exemption of bilateral trade on electronic platforms, precisely 
the sort of thing that Enron was to be involved in.
    Senator Crapo. All right. Just so----
    Senator Lugar. We all should have been brighter, perhaps, 
in reading the type, but nevertheless, that is one that already 
occurred and that is why it is there.
    Senator Crapo. For the benefit of the chairman and the 
ranking member and the witnesses, I guess the question I am 
getting at is it seems to me that complete coverage under the 
Act requires basically that the transactions be handled on the 
Chicago and New York Exchanges and a very major change in terms 
of how they are handled from today. The Act created a middle 
category that had the protections for transparency and price 
manipulation and anti-fraud provisions and so forth but did not 
require a certain category to be subjected to being traded on 
the exchanges.
    The question I am trying to get at, and I guess maybe the 
witnesses can help answer this, is whether the original 
approach of the President's Commission contemplated that 
everything would be traded on the exchanges except financial 
transactions, or whether this middle category was initially 
there and somehow there is now a question as to whether there 
is complete transparency.
    The Chairman. Mr. Crapo, I think that is the question, and 
I hope that Mr. Newsome and Mr. Erickson are going to address 
that in their testimony.
    Senator Crapo. Thank you, Mr. Chairman.
    The Chairman. If not, we will get into it. Thank you very 
much.
    Now we welcome James Newsome, chairman, and Tom Erickson, 
commissioner. Both of your testimonies will be made a part of 
the record in their entirety and we welcome you here. Please 
proceed, Mr. Newsome.

           STATEMENTS OF JAMES E. NEWSOME, CHAIRMAN, 
             COMMODITY FUTURES TRADING COMMISSION, 
                         WASHINGTON, DC

    Mr. Newsome. Thank you very much, Mr. Chairman, Senator 
Lugar, and members of the committee. I am honored to have the 
opportunity to testify before you today along with my 
colleague, commissioner Erickson from the CFTC.
    In my written submission, I have provided an update on a 
number of important issues that the Commission is addressing, 
issues that I think you are interested in. Certainly, the 
Commission has been very busy since the passage of CFMA. 
However, this morning, I will focus directly on energy markets.
    The CFTC is an independent Federal regulatory agency whose 
mission is to oversee the futures and options markets in the 
United States. We take very seriously our mission to ensure 
that these platforms provide safe, sound, and transparent 
markets for risk management and price discovery for a variety 
of commodities, including agricultural, financial, metals, and 
energy products.
    The energy markets are among the largest and most dynamic 
in the United States. Hundreds of billions of dollars in energy 
products, which would include electricity, natural gas, crude 
oil, and gasoline, are traded each year in the United States, 
both on exchange and in over-the-counter or the OTC markets.
    The CFTC regulates the on-exchange futures and options 
energy markets, which provide significant risk management and 
price discovery functions for both the retail and institutional 
investors. Energy products are primarily traded on the New York 
Mercantile Exchange, which is CFTC registered and regulated.
    There is also significant trading in energy products in the 
OTC markets. As a general matter, the CFMA provided legal 
certainty for OTC trading in exempt commodities, such as energy 
products. In addition, the CFMA promoted the growth of 
electronic trading systems for these commodities. The level of 
CFTC jurisdiction regarding the OTC market is tailored to the 
nature of the participant and the commodity. The OTC markets in 
energy products are generally restricted to large institutional 
investors that do not need the same protections as retail 
investors.
    The CFMA provided the CFTC with the ability to investigate 
and prosecute fraud and manipulation in the exempt commodity 
markets, with some limited exceptions. Enron Online operated an 
electronic trading platform which accounted for a sizable 
percentage of the OTC energy product market. It was not 
registered with the CFTC.
    We are all aware of the tragedies that occurred last fall 
surrounding the collapse of Enron. There have been numerous 
stories in the press regarding allegations of manipulations in 
energy markets. Currently, we are conducting a comprehensive, 
detailed investigation of allegations raised by the Enron 
collapse and we will continue such investigative efforts to 
detect and to deter illegal contact in the markets we oversee.
    Albert Einstein once said, if you have 7 days to solve a 
problem, spend the first 6 days defining it. From the beginning 
of the discussions on these energy issues, my position has been 
that we need to find the facts first before proposing a 
solution. My position has not changed.
    As to allegations made earlier this year about Enron's role 
in certain energy market problems, let me assure you that this 
matter is my highest priority. We are deep into a comprehensive 
investigation of both the public allegations and other 
allegations we have uncovered which may involve violations of 
the Commodity Exchange Act. During the course of our 
investigation, the Commission has closely coordinated its 
efforts with the SEC, the FERC, and the Justice Department so 
that all relevant information is shared and so that 
investigations continue to proceed without delay.
    If violations of the Commodity Exchange Act are uncovered, 
we will aggressively prosecute those responsible to the fullest 
extent of the law. The markets for commodity futures and 
options serve an important role in our economy and I am 
committed to protect their safety and their integrity.
    As I have said before, the CFMA, in my opinion, created a 
proper regulatory balance regarding exempt OTC markets to 
protect the public interest by providing the CFTC with 
appropriate authority to require transparency when needed for 
price discovery, to demand records for viewing, and the ability 
to prosecute fraud and manipulation, at the same time while 
creating legal certainty and allowing the flexibility needed 
for market innovation and growth to occur within our 
jurisdictional boundaries, and it provided market participants 
with a choice based upon their business needs.
    However, Mr. Chairman, if after or even during our 
investigation it becomes apparent to me that CFMA changes are 
needed in order for the CFTC to fulfill its mission, I will 
immediately relay those needs to the committees of our 
jurisdiction.
    Mr. Chairman, I continue to offer a detailed briefing of 
our investigation at your convenience, and certainly I look 
forward to answering any questions that you might have.
    The Chairman. Thank you, Mr. Newsome.
    [The prepared statement of Mr. Newsome can be found in the 
appendix on page 69.]
    The Chairman. Before beginning questions, the chairman will 
now turn to Mr. Erickson, a commissioner of the Commodity 
Futures Trading Commission. Mr. Erickson.

        STATEMENT OF THOMAS J. ERICKSON, COMMISSIONER, 
             COMMODITY FUTURES TRADING COMMISSION, 
                         WASHINGTON, DC

    Mr. Erickson. Thank you. Chairman Harkin, Senator Lugar, 
distinguished members of the committee, thank you for this 
opportunity to appear before you this morning.
    I have been asked to comment on three things: First, the 
scope of the Commission's existing regulatory authority over 
OTC derivative markets; second, the need for increased 
Commission authority to prevent fraud and manipulation; and 
third, the legislative proposals pending before the Senate that 
would address any deficiencies.
    Passage of the CFMA in December of 2000, as you have 
indicated, brought sweeping change to the regulation of 
derivatives in the United States, both on- and off-exchange. 
Nowhere was the change in law more dramatic than its effect on 
over-the-counter derivatives, more commonly referred to as 
swaps.
    Many of the CFMA's changes to the Act were based on the 
recommendations of the President's Working Group on Financial 
Markets. Although the PWG report recommended that bilateral 
swap transactions in financial commodities be excluded from the 
CFTC's jurisdiction, it concluded the same case could not be 
made for physical commodities. The PWG was unanimous in its 
agreement that the exclusions should not extend beyond 
financial products.
    The CFMA adopted a variant of the PWG recommendations and 
created three tiers or categories or commodities. Each category 
defines the CFTC's regulatory interest in derivative 
instruments, including swaps. Generally, financial commodities 
are excluded from the CFTC's jurisdiction. Agricultural 
commodities are included. All other commodities, including 
energy and metals, are exempted from the CFTC's jurisdiction.
    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. 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 its jurisdictional interest, but that the 
law limits its application.
    Ostensibly, under the CFMA, the CFTC retains its anti-fraud 
and anti-manipulation authorities over exempt commodities. 
However, through other provisions in the law, the vast majority 
of swap transactions in energy and metals commodities markets 
become excluded. As a result, they are not subject to the 
Commission's fraud or manipulation authorities.
    Thus, we have a gap in the oversight of the regulation of 
exempt commodity transactions. On the one hand, the Act expects 
full prosecution of manipulations in exempt commodities in 
regulated exchange markets. On the other hand, the regulatory 
regime turns a blind eye to the manipulation of these very same 
commodities if effected through over-the-counter derivative 
transactions. I cannot believe this was the intended effect of 
the CFMA.
    From a practical perspective, the Commission's own 
experience has yielded some significant results in these areas, 
results that would be difficult, if not impossible, to 
replicate under the current law. For example, the Commission in 
1998 reached a settlement with Sumitomo Corporation for the 
manipulation of global copper prices. The Commission found that 
the manipulation imposed enormous costs on traders, 
manufacturers, and ultimately consumers of copper. More 
recently, the Commission settled with Avista Energy, 
Incorporated, for the manipulation of electricity futures.
    I am skeptical the Commission could replicate these cases 
in today's market environment. As the Avista settlement 
underscores, commodity markets, cash, futures and options, and 
over-the-counter swap transactions, are increasingly linked. We 
now know that wash trades and transactions in unregulated swap 
markets occur, and in certain cases send price signals that 
raise manipulation concerns. Thus, if we are serious about 
detecting and deterring fraud and manipulation, these 
authorities must apply to all derivative transactions on those 
commodities.
    Derivatives markets bring unquestionable efficiencies to 
the cash markets. The consequent benefits extend not only to 
market participants, but also to consumers. Thus, I believe if 
Congress were to restore to the Commission its fraud and 
manipulation authorities, it must also provide the Commission 
with the tools to enforce these authorities.
    Derivatives marketplaces, like electronic swap exchanges, 
should adhere to certain minimal regulatory obligations, among 
them, transparency, disclosure, and some 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/or manipulation. I believe application of these 
principles to derivatives markets more broadly is sound public 
policy, prudent business practice, and common sense.
    Unfortunately, we are presently witnessing some of the best 
arguments in favor of reinstating these principles into our 
markets. U.S. energy markets are suffering a crisis in 
confidence. Six months ago, we could define that crisis by the 
tens of millions of energy consumers in Western States who 
believed the markets had been manipulated. Today, none of our 
Federal regulators has been able to assure them that this was 
or was not the case, and it is not even clear which regulators 
should be answering the question.
    More recent revelations of wash sales by numerous 
commercial markets 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. Modest 
legislation is a good first step toward restoring the lost 
confidence and returning to the energy industry the ability to 
grow those markets and make them efficient.
    The only legislation I am aware of currently that is 
pending is that introduced by Senator Feinstein, and she was 
here to testify this morning about that. I will limit my 
comments to that bill.
    Generally the legislation would address the essential 
concerns I have outlined in my testimony today. Moreover, the 
bill hues more closely to the recommendations of the 
President's Working Group, as well as to many of the expressed 
concerns of this committee during the debate over the 
Commodities Futures Modernization Act. Could it do more? 
Certainly. Is it the right thing to do? In my opinion, yes.
    Ultimately, Senator Feinstein's bill is pragmatic. It 
recognizes the benefits of market innovation by preserving the 
long-sought legal certainty for swaps. They remain, for the 
most part, exempt from the CFTC's jurisdiction. At the same 
time, however, the bill ensures that all transactions in those 
commodities are fully subject to the Commission's anti-fraud 
and anti-manipulation authority.
    It would not require registration of swap counterparties, 
but it would require they maintain books and records, something 
that is probably a routine practice in the industry.
    Finally, the legislation recognizes that all exchange 
markets serve price discovery and hedging purposes and imposes 
modest transparency disclosure and reporting requirements.
    I would be remiss if I did not mention one other aspect of 
Senator Feinstein's bill that I think is absolutely critical 
for the Commission. An issue that we have struggled with for 
some years is the current extent of our fraud authority. Just 
prior to passage of the CFMA, the Seventh Circuit Court of 
Appeals indicated that our fraud authority extended only to 
agency relationships, which means that it would apply only to 
transactions where there is an intermediary or a broker doing 
the business on behalf of a customer. Thanks to clarification 
in the CFMA, we now have some authority over dealer markets in 
foreign currencies, but our fraud authority continue to be 
limited in that respect. Certainly it would be similarly 
limited on the bilateral dealer markets in energy markets for 
the same reason. Senator Feinstein's bill addresses that 
problem in the existing legislation and would fix our fraud 
authority so that it would apply to non-intermediated markets.
    Consumers are the ultimate beneficiaries of properly 
functioning derivatives markets, whether they are private, like 
Enron Online, or public, like the NYMEX. By the same token, 
consumers are the ultimate victims when markets are manipulated 
or otherwise affected by unlawful behavior. Whether there is 
anything found in the current investigations of energy markets 
is really irrelevant. We have a hole in the regulatory regime 
that allows for fraud and manipulation to operate free from 
sanction. We have markets experiencing a crisis in confidence. 
Modest legislation amending the commodities laws is 
appropriate, in my view, to restore confidence and build 
integrity.
    Thanks very much for your indulgence. I look forward to 
your questions.
    The Chairman. Thank you very much, Mr. Erickson.
    [The prepared statement of Mr. Erickson can be found in the 
appendix on page 74.]
    The Chairman. I will start with you, commissioner Erickson. 
Mr. Newsome in his testimony emphasized that the CFTC is 
proceeding with an investigation of energy trading companies 
under its anti-fraud and anti-manipulation authority. Your 
interpretation of CFMA's exemptions and exclusions, however, is 
that, in fact, it is unclear that the CFTC has anti-fraud and 
anti-manipulation authority over certain transactions in exempt 
commodities. How do you explain this?
    Mr. Erickson. I am fully supportive of any enforcement 
endeavors that we might undertake. I would just point out that, 
yes, I am certain and convinced and confident that we do have a 
gap in what actually is covered by those fraud and manipulation 
authorities.
    I know that you have all been provided with some slides 
that I have used for some other presentations, and I think that 
this will also get to Senator Crapo's initial question.
    Mr. Erickson. On the surface, Section 2(h) of the Act 
affirmatively does retain and apply our anti-fraud and anti-
manipulation authorities to certain transactions. Section 2(g) 
of the Act is an exclusion for swap transactions, and that 
provision says that in all commodities except agricultural 
commodities, swap transactions are completely excluded from the 
Commission's jurisdiction. That takes them out of the 
jurisdiction for all purposes, including fraud and 
manipulation.
    The California activity certainly occurred prior to 
implementation of the Commodity Futures Modernization Act, so I 
would expect that we will have some activities that are 
currently under investigation that would be activities that 
occurred prior to implementation of the Commodity Futures 
Modernization Act. For those that occurred after, the 
Commission will have to assess what kind of case we have to 
move forward on either side of that line.
    The Chairman. Let me see if I understand this. Part of the 
Act exempts them, and there is another part of the Act that 
excludes them.
    Mr. Erickson. Right.
    The Chairman. Which trumps which?
    Mr. Erickson. Well, that the exclusion trumps and nothing 
applies. The Section 2(g) transactions are swap transactions 
that are among sophisticated counterparties.
    The Chairman. Right.
    Mr. Erickson. They are subject to individual negotiation, 
and they are also conducted in these commodity markets. There 
are limitations. The swaps market largely is a market of these 
kinds of transactions between sophisticated counterparties. 
They are done with some opportunity for negotiation and they 
have individual creditworthiness that applies.
    The Chairman. Mr. Newsome, what is your authority, then, to 
obtain information and oversee the markets and investigate and 
punish fraud and manipulation if they are excluded? What is 
your authority?
    Mr. Newsome. Thank you, Mr. Chairman. There are two points, 
if allowed, that I would like to try and make, both brought up 
by Senator Crapo and discussed earlier.
    The first point is what was the intent of the President's 
Working Group toward exemptions or exclusions. We need to point 
out that the CFMA had the unanimous support of the President's 
Working Group, so it is very difficult to say that the CFMA did 
not follow their intent when they unanimously supported the 
legislation.
    The President's Working Group also did specifically address 
the energy exemption. Some of the discussion we have heard 
today, certainly while it is very accurate, I do not think told 
the whole story, and I will quote from the President's Working 
Group report, which said, ``The CFTC should, however, retain 
its current authority to grant exemptions from derivatives 
involving non-financial commodities as it did in 1993 for 
energy products, where exemptions are in the public interest 
and otherwise consistent with the CEA.'' The PWG went on to say 
that, ``Nothing in this report should be construed to affect 
the scope of exemptions that are currently in effect.''
    The reality was that, administratively, in 1993, the 
Commission, following the advice of Congress, exempted--had the 
energy exemption which removed them from Commission oversight. 
The CFMA codified that exemption.
    As we look at the difference between exemption and 
exclusions, it is very technical and it is very legalistic and 
at times, I think it is difficult to understand. Obviously, 
people that are very sincere in fulfilling the mission of the 
Commission do not agree in all aspects of that. Wise people 
today have shown that we do not agree in exactly what the 
language says. I would like to try to address now most 
specifically your question, what I consider a misunderstanding 
of the CFMA regarding the Act's exclusions versus its 
exemptions.
    Some have said, and some very sincerely feel that, in 
effect, the exclusions trump the exemptions, thereby 
undermining the fraud and manipulation authority of the 
Commission. In my opinion, this is a misreading of the statute. 
The intent and effect of the CFMA was clearly not to undermine 
the CFTC's authority, but to provide legal certainty to markets 
and tailor regulation to the nature of the participants and to 
the commodities traded. Simply stated again, swaps transactions 
were excluded from our jurisdiction prior to the CFMA by 
administrative action of the CFTC and they were excluded after 
the CFMA by codification of Congress. Whether the swaps are in 
T-bills or in natural gas, the analysis is the same.
    However, as Senator Crapo pointed out, the CFMA did provide 
another level of regulation, that of regulation for exempt 
commodity transactions that are not determined to be swaps. At 
this level of regulation, it provides certain fraud and 
manipulation authorities and, indeed, transparency 
requirements, as determined by the CFTC. This provision is not 
related to swaps transactions, nor do I believe that it is 
trumped by the swap's exclusion for transactions in energy 
products that are not deemed to be swaps transactions.
    The Chairman. I have some followup questions I will ask, 
but my time is obviously up now. I turn to Senator Lugar.
    Senator Lugar. Thank you, Mr. Chairman.
    Let me just ask each one of you, I appreciate the informed 
discussion as to exclusion and exemption, what the President's 
Working Group wanted and what was always there. It seems to me 
that everybody was operating in a way, as you say, to enhance 
the CFTC's authority, and likewise, to save the financial 
system of the country at the time. However, something went 
wrong.
    Clearly, the Enron circumstances--and that is not the only 
situation, perhaps, but that is pretty evident--was a disaster 
for a lot of people in America. Leaving aside all the rights 
and privileges of the traders, as Mr. Erickson has said, the 
consumers, ordinary people finally have to enter into this 
situation. We may have worked very hard to make certain that 
everybody who is a professional in the business, who has a 
stake and so forth, is accommodated, but we have worked very 
hard, say, prior to long-term capital management, and that was 
a disaster of unbelievable dimensions, so complex that most 
Americans do not realize what might have hit them, but at the 
same time, we ought to, somebody, regulators, legislators. We 
got busy and we tried to get our arms around this thing.
    I remember going to a meeting involving not only Wall 
Street people, but Federal Reserve people, and others in the 
aftermath of long-term capital management. There was an 
extraordinary gloom about all of our exchanges all over the 
world among people who were the largest players, leaving aside 
the public, that only was mildly interested in what seemed to 
be a debacle of some very bright people who thought they had 
finally, with Nobel Prize winners, beat the system.
    In this situation, the thing I am wondering is Senator 
Feinstein has come forward with a piece of legislation, but at 
this point, I would have hoped that CFTC would have come 
forward with a piece of legislation. In other words, you are 
the most informed people. You understand the requirements that 
you have to meet. You are struggling, as you pointed out, 
trying to go through all the circumstances of Enron or others 
trying to see whether you have jurisdiction. Whether somebody 
did something and should be prosecuted, all of that is 
important, although we are talking today about whether we have 
jurisdiction at all, quite apart from whether anybody did 
anything wrong. Clearly, something has to change here.
    Now, Senator Feinstein has offered a bill. I have not been 
one of the original co-sponsors because I hoped that there 
would be something forthcoming from those who are responsible 
and who were informed. Nothing is forthcoming. Essentially, 
they are saying they need more time. They are still working 
their way through all the circumstances of this situation.
    Maybe because of the discouragement of this, as you pointed 
out, energy trading is so far down that we temporarily do not 
have to worry about it, but I doubt whether that will be the 
case for long.
    In my own view, I suppose we will be, in absence of a 
better alternative, to co-sponsor the Feinstein legislation and 
try to get it passed. We are going to have testimony today why 
that is good or bad or indifferent, but there is no doubt in my 
mind something has got to happen and it is very important it 
happen quickly rather than in the hereafter, given an egregious 
failure, and it is every bit of that.
    Now, is it possible that the two of you or your colleagues 
or anybody in the CFTC is going to come forward, really, with 
some remedy that you think makes sense in terms of the public, 
not just the traders, not just the pros, but the general public 
of this country that is looking to you, that is looking to us 
for somebody to get a handle on something that egregiously is 
wrong? What do you have to say to that?
    Mr. Newsome. Thank you very much, Senator Lugar. You raise 
very legitimate issues and points, and certainly, I am not here 
to say that absolutely nothing should be done. It is very 
prudent for we as regulators and you as the Congress to 
continually look at all legislation to see if it continues to 
serve the purpose that was intended.
    My thoughts simply are this. As Chairman Harkin commented 
earlier, we spent almost 2 years in the drafting of the CFMA. 
There were very deliberate discussions and debate leading up to 
the passage of the CFMA and there was very broad acceptance of 
what Congress passed.
    There are discussions of wide, sweeping changes to the Act 
that will totally change the regulatory direction that was 
taken just a short time ago. Certainly, that in order to make 
such broad, sweeping changes, there needs to be more deliberate 
debate over whether or not that is the direction that needs to 
go, what potential impact that could have on markets.
    With regulation comes a cost, and in this area, I think 
very substantial regulatory cost, both in terms of taxpayer 
dollars to the Commission to fulfill what its new mission 
potentially might be, and huge costs to market participants. I 
do not feel comfortable recommending that cost to producers or 
to market participants until we have spent our time making sure 
that whatever legislation passes does, indeed, solve the 
problems that have been created by the Enron collapse and the 
energy situation.
    Senator Lugar. Mr. Erickson, what is your view?
    Mr. Erickson. I personally would be pleased to work toward 
a solution. We absolutely should. It seems that there is 
general acceptance of the idea that fraud and manipulation 
ought to apply to these physical commodity markets. Perhaps 
there are other ways to just cement that in the law. Currently, 
there is, at best, an argument about whether the law applies in 
certain situations. That certainty will really build confidence 
in this market and I would be pleased to pursue legislative 
avenues. The unfortunate reality is, it is a legislative 
solution in this case and I think it is necessary.
    Senator Lugar. The legislative solution Senator Feinstein 
and others have proposed is that clearly sophisticated traders 
be subject to reporting, the transparency, the rest of it. The 
question I raised of her is what about the risks, people 
dealing over the telephone without records and so forth. Once 
again, I admit probably a much broader cost, as Chairman 
Newsome has said, getting into all of that. At this point, my 
suspicion of the ability of people to create fraud knows almost 
no bounds when it comes to this energy thing.
    We really have to get a handle on it, and this is why, 
ideally, Chairman Newsome, the perfect would be great and we 
would have endless meeting of this committee and get the 
President's Working Group revved up again and so forth. After 
all of that, let me just simply say, legislatively, it was very 
hard to get that Act passed. It occurred almost in the dead of 
night, at the end of a Congress, in the middle of an 
appropriations hassle. That was not the ideal circumstance. 
That is the legislative reality of these situations.
    I am just saying the Feinstein bill, as you have said, Mr. 
Erickson, is a modest attempt. I hope while we are doing any 
attempt, because we do not have very many opportunities, we try 
to get it as right as we can, but we really need help.
    Here, we have Senator Feinstein. She is working from her 
constituency in California in which people feel badly 
aggrieved, understandably, given all the public testimony about 
the manipulation that occurred. This is no longer speculative. 
People were doing wrong.
    What do we do about it, aside from wait for the best 
solution to come along, and not unintended consequences and all 
the rest of that? That is not good enough. It just seems to me 
that we need some help technically from CFTC as opposed to at 
least rationalizations that the jury is still out. Well, it 
will be out, I think, for a long while. We have to act, I 
believe.
    Are you about to make another comment?
    Mr. Erickson. If I might, one of the things that strikes me 
is that the Feinstein bill really does put these commodities 
back where they were 18 months ago. To the extent that there 
was a cost associated with monitoring for manipulation in 
swaps, it is the same cost. We had electronic trading systems 
in existence prior to the CFMA.
    The difference between before and after, under our 
regulatory exemptions, is that the agency previously retained 
its authority. It had the ability to do the investigation where 
it saw the potential for wrongdoing. The Feinstein bill simply 
applies fraud and manipulation back to those transactions. I am 
sympathetic with your concerns about the phone trade, but that 
has been around. We have had some experience with those 
transactions for 10 or 12 years.
    What she tried to do was pretty pragmatic and just makes 
sure that fraud and manipulation affirmatively applies to the 
bilateral marketplace, those transactions that might occur 
between the two of us. Once you have some kind of a 
marketplace, whether it is electronic or physical, you have 
additional transparency obligations that attach because that is 
where I see, that you run the greatest risk of price signals 
being sent, and uneconomic price signals being sent into these 
markets that can have a manipulative effect. That is why I 
called the solution that she brought forward to be pragmatic. 
Thank you, Senator.
    The Chairman. I will proceed in order that Senators arrived 
to the committee. It will be Senator Miller, Senator Crapo, 
Senator Fitzgerald, Senator Lincoln, and Senator Nelson. 
Senator Miller.
    Senator Miller. Thank you, Mr. Chairman, and thank you for 
holding this hearing.
    Perhaps--well, not perhaps, I know that this is 
oversimplifying a very, very complex issue and problem, but is 
not what we are trying to get at, all of us, a way to protect 
the American consumer, not disrupt the success of honest 
companies, not cripple the entire energy trading market, but 
protect, as I said in the very beginning, the American 
consumer?
    I want to ask this of each one of you, and if you want, you 
can just answer it yes or no or you can elaborate as much as 
you want to. Do you believe that the Feinstein amendment would 
have prevented the fall of Enron or the California energy 
crisis?
    Mr. Newsome. Thank you, Senator Miller.
    Senator Miller. That is, by the way, why I liked your 
Einstein quotation, of 6 days of looking at what we are trying 
to get at, the goal, before we do anything else. Excuse me.
    Mr. Newsome. That is fine. In regard to your specific 
question, my answer today would have to be no, I do not think 
it would. If we look at what we know about that situation, we 
know that energy prices were very high and volatile in the 
West. We know that there was round-tripping that was confirmed 
by the companies themselves, and I might add that wash trades 
are illegal in futures markets. They are wrong, they are 
fraudulent, and they should be considered such in all markets.
    At the end of the day when we look at what created the 
Enron situation, I think at least it appears that the majority 
of their problems had to do with accounting fraud, as are a lot 
of the other companies that we are looking at. Now, that said, 
that does not mean that we should not take another look at 
where we are with the CFMA and what is going on.
    Certainly, as Senator Lugar suggested, the CFTC is more 
than happy to provide whatever thoughts, technical assistance 
to this committee in terms of looking at Senator Feinstein's 
legislation or any other legislation that could have an impact 
on the CFMA. As you indicated, Senator Miller, the majority of 
the people in this business, like any other business, are good 
people. We all want to make sure, even though we have differing 
opinions of how to do it, we all want to make sure that the bad 
players in these markets are removed from the markets and that 
they are justly punished.
    In my opinion, as we look at this situation, it is more 
appropriate to make sure that we have strong, swift enforcement 
to serve as the deterrent to wrongdoers, and I would add that 
as this committee looks at what should be done to the CFMA, my 
suggestion would be that we need to make sure that we 
strengthen the Commission's authority in fraud and manipulation 
and that we strengthen our enforcement actions, and I think 
that can have as strong a deterrent as anything that we may 
talk about today.
    Senator Miller. commissioner Erickson, do you think that 
the Feinstein amendment, if it had been in effect, would have 
prevented the California energy crisis?
    Mr. Erickson. Regulation is never a panacea. It does not 
answer every question. Part of it is the willingness of the 
independent regulators to exercise their authority. You cannot 
give any guarantees that the Enron bankruptcy would not have 
occurred if we had some authority over its trading environment.
    Now, there are a couple of points that I would like to 
expand upon. What we have is a situation where we know that 
there are parts of this market where fraud and manipulation can 
take place and it is outside our ability to sanction. That is 
the hole that needs to be filled. The Feinstein bill does that. 
It gives us the tools that would be necessary to surveil and 
have a chance at detecting some kind of risk exposure that 
Enron had taken on through Enron Online that was otherwise not 
apparent.
    If we had had capital requirements attached to Enron 
Online, as any banking regulator would have required, we may 
have had information. I cannot promise a result. It would have 
given us a chance, a better chance, at detecting any kind of 
overexposure that they had financially.
    Dynegy gave us a real breather during those 3 weeks of 
November. They came in and held an offer on the table for the 
merger and acquisition of Enron, and it allowed all these swap 
counterparties to Enron, either individually or through Enron 
Online, to reassess their credit exposure to Enron and try and 
exit those positions. Now, I understand some people were not as 
successful as others and they still had a day of reckoning 
where they lost several millions of dollars because of their 
Enron exposures.
    If Dynegy had not been there to allow people to reassess 
their exposure, we may have seen a little bit more systemic 
risk in the market and a much more hurtful effect of the Enron 
winding down, because what we know is the day Enron went 
bankrupt, Enron Online went dark. If you had been in that 
marketplace at that point, you would have had naked exposures.
    The Chairman. Thank you, Senator Miller.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Mr. Erickson, as I understand your testimony, your 
concern--tell me if I am correct about this--your concern is 
essentially that Section 2(g) of the Act excludes from the 
fraud, manipulation and transparency provisions the 
jurisdiction of the Commission over derivatives transactions or 
swap transactions, is that correct?
    Mr. Erickson. In all commodities except agriculture.
    Senator Crapo. Correct, in all commodities except 
agriculture.
    Mr. Erickson. Yes, that applies to the energy and metals 
markets.
    Senator Crapo. If I understand Mr. Newsome's testimony, he 
does not read the Act that way, but if we were to make it clear 
that Section 2(g) did not exclude these transactions from the 
fraud, price manipulation, and transparency provisions, would 
that address your concern, Mr. Erickson?
    Mr. Erickson. Yes, and it does get to the heart of what the 
Feinstein bill does. It says transactions, even those conducted 
pursuant to 2(g), would be subject to our fraud and 
manipulation authority.
    Senator Crapo. Well, let me get into that, then, because I 
am reading a summary of the bill--I have not got the bill 
itself before me, but the summary that I am reading seems to be 
much, much broader than that. Let me first just ask you a 
question. Do you believe that all of these other transactions 
that we are talking about, other than the agriculture 
transactions and the financial transactions, do you believe 
that they should all be subject to full coverage, full trading 
on the commodities exchanges and so forth?
    Mr. Erickson. Absolutely not. Our history over the last two 
decades has really demonstrated the absolute need for all of 
these kinds of derivatives, whether they occur on- or off-
exchange. They are integrally linked. They are global markets. 
They add incredible efficiencies to all commodity markets. I 
just think in this area of exempt commodities, most of these 
commodities are of limited supply. Many of them are physical 
commodities, and our experience with those kinds of commodities 
is that they are more susceptible to manipulation.
    Senator Crapo. Let me just say, my reading of the act that 
is being proposed, of the Feinstein bill that is being 
proposed, is that it literally repeals the definition of exempt 
commodities, and if I read that correctly, it leaves us with a 
situation where you are either excluded totally or you are 
covered totally. Am I wrong in that?
    Mr. Erickson. I believe the first bill that was introduced, 
S. 1951, would have eliminated 2(g) completely and would have 
started out with a new exempt commodities section that would 
just affirmatively have applied fraud and manipulation 
authority.
    What is in place now is there is no change to the 
framework, and, in fact, the exempt status of all the exempt 
commodities is retained. This is absolutely critical for the 
legal certainty of the transactions so that we do not run into 
the problem that you previously identified that would 
potentially force them all onto an exchange environment. That 
is something that nobody, I think, would make an argument for.
    Senator Crapo. Then we can agree, though, that with regard 
to the issue that we need to address, as I see it, from your 
testimony, it is rather specific. We need to address the 
concern that you have identified with what Section, in your 
opinion, Section 2(g) has done to the rest of the Act.
    Mr. Erickson. Yes, and I can maybe provide a little bit 
more. The definitions of exempt commodity transactions and the 
swap transactions are slightly different, and that is why I 
believe 2(g) trumps, because the definition of swap transaction 
in 2(g) is composed of three parts and the definition of 
transactions exempt commodities is only composed of two parts. 
They are nearly identical. In 2(g), if you have the opportunity 
for individual negotiation, they are excluded. That is why I 
think it trumps for that broad swath of the swap market, which 
is 80, 90 percent of all derivatives trading.
    Senator Crapo. It seems to me that whether you are right or 
wrong about that, at least the issue, as I see it, from your 
perspective, is that interpretation of Section 2(g) and the 
resolution of the issue would be simply clarifying that your 
interpretation is corrected and that the application is 
thorough with regard to the fraud, price manipulation, and 
transparency provisions.
    Mr. Erickson. That is the heart of the issue. Everything 
else is providing the obligation for markets to have some level 
of transparency in their marketplaces.
    Senator Crapo. I assume that you are aware of the testimony 
that came in before the Banking Committee and in other contexts 
about the value of derivative transactions to our economy, Alan 
Greenspan having said that they may have provided the stability 
that kept us from going deeper into the trough during this last 
troubled time. Do you agree with that?
    Mr. Erickson. Absolutely. There is no question about the 
value of these transactions, and my concern about this market, 
in particular with energy, is the market is fading away. By 
attaching some key elements of market integrity to the 
regulatory regime you would really let the marketplace itself 
take off again. The participants in energy markets do not have 
the confidence to trade with one another. Most of the energy 
platforms that are sanctioned under the law are not in 
operation today.
    Senator Crapo. Thank you. Mr. Newsome, I understand that 
you disagree with Mr. Erickson in terms of the interpretation 
as to whether 2(g) does what he believes it does, but do you 
agree that energy and minerals transactions should not be 
subject to full coverage and to required trading on commodities 
exchanges?
    Mr. Newsome. It depends upon the trading system and the 
nature of the participants that are doing the trading, and I 
think there underlies the premise of the whole CFMA, because 
the regulatory structure was based upon the product, the type 
of trading system, and the participant involved in the trade of 
the product. I would still agree that the criterion in which we 
should move forward with still should be based upon those 
different criteria.
    Senator Crapo. Thank you. Mr. Erickson, one last question. 
Are you aware of any evidence at this point in time that would 
indicate that a cause of the Enron situation was related to 
transactions in derivatives?
    Mr. Erickson. No, I am not aware of any direct evidence. I 
am concerned, though, that when we have a corporate bankruptcy, 
a marketplace evaporates.
    Senator Crapo. Thank you.
    The Chairman. Thank you, Senator Crapo.
    Senator Fitzgerald.
    Senator Fitzgerald. Thank you very much, Mr. Chairman, and 
at the outset, I would say that I guess we have invited the 
International Swaps Dealers Association to testify later. I 
would actually like to hear testimony from ICE, the 
Intercontinental Exchange, that is lobbying so heavily against 
closing this loophole because I really think the bill concerns 
them more specifically than swaps dealers in general. I would 
hope we could get to hear from ICE specifically, as their 
owners are a number of large banks that are heavily lobbying 
Congress not to close this exemption and I would like to hear 
from them publicly.
    I have some questions for both the members, and thank you 
both for being here. I guess under the old Act and under the 
new Act, we have the Section 4(c) exemption authority where the 
Commission can grant a no-action letter. Would it not be 
better, Mr. Newsome, to go back to the old laws where we had 
some authority over these now totally excluded energy and 
metals online trading facilities, and if the Commission wanted 
to exempt the Intercontinental Exchange or Enron Online, there 
could be a vote and you guys could send Enron Online a letter 
exempting them?
    Mr. Newsome. The 4(c) exemptive authority of the Commission 
is extremely important, I think, because it gives the 
Commission some flexibility, and I think flexibility is key in 
terms of how we move forward from a regulatory standpoint.
    Senator Fitzgerald. Even if we closed off this 2(g) 
exemption, you would still have the flexibility to exempt Enron 
Online if the Commission wanted to do that. You could have 
hearings on it. You could take a vote, and if the Commission 
voted to send a no-action letter to Enron Online or the 
Intercontinental Exchange, you could do that. You would still 
have the flexibility, would you not?
    Mr. Newsome. That may be the case. That is not something 
that I have looked at specifically. I know that the flexibility 
of the CFMA, the flexibility of the Commission to utilize 4(c) 
is extremely important because there is no way we can sit here 
and look at how the markets might move or what problems we 
might face in the future, so----
    Senator Fitzgerald. Right now, you do not have the 
flexibility because Enron Online and Intercontinental Exchange 
are just exempt by statute here with Section 2(g).
    Mr. Newsome. Exactly. Exactly.
    Senator Fitzgerald. You do not have flexibility.
    Mr. Newsome. Flexibility is a good thing.
    Senator Fitzgerald. By closing off 2(g), you would still 
have the flexibility provided by 4(c). OK. You said that wash 
trades are illegal in all markets at all times, and I would 
assume you would mean in energy and metals trading online. Is 
that the case? Is it illegal to make a wash trade on one of 
these exempted online energy trading facilities?
    Mr. Newsome. My Southern slang is difficult to understand, 
Senator. I said in our markets.
    Senator Fitzgerald. In the ones you regulate?
    Mr. Newsome. In the ones we regulate, there is----
    Senator Fitzgerald. You do not have authority to pursue a 
wash trade in an online energy trading facility, do you?
    Mr. Newsome. No, I would not say that. To me, when you look 
at round-tripping or the activity that is taking place, and 
that is something that we are very aggressively investigating, 
but when we look at that, I think it brings up two points. One, 
it appears to me to be fraudulent. Two, we are looking at 
whether or not that was used to manipulate the market. In 
either of those cases, it would be illegal and we would have 
the authority to bring charges.
    Senator Fitzgerald. Do you not have the authority to the 
extent it occurred under the old Act under the authority you 
had 18 months ago? If the new Act were in effect the whole time 
these transactions were occurring, is it not true that under 
the current Act, you could not go after a wash trade occurring 
on one of these online energy or metals facilities?
    Mr. Newsome. I think----
    Senator Fitzgerald. Could you point to the section of the 
Act that would give the ability to go after that wash trade?
    Mr. Newsome. Unfortunately, I could not point to that 
section this morning. The new Act took out the specific 
language regarding the Commission's ability to prosecute wash 
sales in the type of markets that you are talking about, the 
exempt markets. However, I still believe that through our anti-
fraud, anti-manipulation authority, the Commission has the 
ability to prosecute in this instance. We are agreeing that we 
can do it. It may not be quite as simple now as it was 18 
months ago because of the removal of the specific wash sale 
language.
    Senator Fitzgerald. Mr. Erickson, would you have a response 
to that? Do you think you have the authority to go after wash 
trades in Enron Online under the current Act?
    Mr. Erickson. No, I do not. I do not think the Commission 
retains its direct authority to pursue wash sales as a 
violation.
    Senator Fitzgerald. Everybody agrees that wash trades are 
bad. Do we not want to give the Commission that authority to go 
after and prevent wash trades? It is an outrage. It was an 
enormous outrage, what was going on in the energy trading 
market. Do you both not agree, we want to be able to clear your 
authority to pursue wash trades?
    Mr. Newsome. There is no question that they are bad. They 
are wrong. They are illegal. Given our anti-fraud, anti-
manipulation authority, we do have the ability to go after them 
for that and we are currently investing that.
    Senator Fitzgerald. Are these online energy trading 
facilities not exempt under Section 2(g) from you going after 
them for fraud? Mr. Erickson thinks they are exempt. You do not 
think they are exempt.
    Mr. Erickson. Not only exempt, but excluded.
    Mr. Newsome. They are exempt. The question is whether or 
not they are excluded and I continue to believe that we have 
the authority to go after them for these instances.
    Senator Fitzgerald. Are you going to pursue action for 
trades at Enron Online for wash trades?
    Mr. Newsome. Sir?
    Senator Fitzgerald. Are you going to pursue action against 
Enron Online for wash trades?
    Mr. Newsome. We are currently investigating that matter 
now.
    Senator Fitzgerald. OK. Have you encountered any arguments 
from Enron Online's lawyers that you do not have the authority 
to do that?
    Mr. Newsome. I have not spoken personally to Enron Online's 
lawyers, but I will be glad to followup on that and give you a 
more specific briefing, Senator, of exactly what we have.
    Senator Fitzgerald. Thanks, Jim. Thank you both. I 
appreciate the time.
    The Chairman. Thank you, Senator Fitzgerald.
    I have to leave. My bill is up in another committee and I 
have to go work that, because it is my bill. Senator Lugar is 
going to take over and finish chairing the hearing.
    I just have to say again that I have been, as I am sure 
Senator Lugar has been, involved in the CFTC since its 
beginning in 1975, when I first came on the Agriculture 
Committee in the House, and I have talked with my staff and I 
am trying to remember through all those years why it is that we 
need this exemption. Why is it that we carved out a certain 
exemption? I know why we did exclusions. That is clear, why we 
have exclusions, covered by other entities, that type of thing. 
Why we have an exemption, I do not know. Maybe it is just 
something we wrote in there to give lawyers a lot of work. I do 
not know.
    I guess I am of the position now that I am thinking that, 
sort of along the lines of Mr. Fitzgerald, I do not know and I 
do not want to put words in his mouth, maybe we really ought to 
reexamine whether or not we need an exempt category. Maybe 
there ought to be exclusions or not exclusions. If they are 
excluded, fine. If they are not, you ought to have 
jurisdiction.
    The questions on Enron and stuff, maybe not. Maybe having 
them regulated and not exempt may not have stopped Enron, but 
it may have at least precluded whatever part or whatever role 
the derivatives played in the collapse of Enron. That might 
have helped to do that. It might have served as an early 
warning signal to others as to what Enron might have been up 
to.
    I leave the committee and I am going to turn it over to 
Senator Lugar, but I just ask the question. Maybe we ought to 
really take a look again at 2(g) and why it is even there in 
the first place. Thank you very much.
    I guess Senator Nelson is next. Thank you, Senator Lugar.
    Senator Nelson. Thank you, Mr. Chairman.
    First of all, I want to thank the gentlemen for being here 
and to commend Senator Feinstein for working so diligently with 
so many stakeholders to come up with legislation that at least 
addresses the question about structure and transparency, and so 
I truly appreciate that.
    I also would like to note that Mr. Einstein seemed to 
presume that things might happen in 7 days, 6 days of study, 1 
day of decision. I notice more than 6 days have gone by 
studying and we have not come to the seventh day for a decision 
about how to fully investigate or get an investigation 
accomplished.
    From my particular perspective, having had Enron located in 
Nebraska before it suddenly uprooted and went to Houston, with 
hundreds of people affected with their retirement accounts 
riddled by the Enron collapse and numbers of people in Nebraska 
and related to Nebraskans left out of work, it is going to be 
very difficult for me to go back and tell them that what we 
have here is a problem of exclusion versus exemption. You can 
appreciate they are not interested in hearing that. What they 
are interested in finding out is whether the derivatives issue 
contributed in any significant way, and if it did at least in 
part in some way to the collapse of Enron and their complete 
demise in terms of their financial security, they want to know 
that, first of all, it has been studied, investigated, and that 
some appropriate action has been taken.
    I have some questions I would like to ask you. First of 
all, I think I understand, Mr. Erickson, you are suggesting 
that the Feinstein legislation would, first of all, do no harm, 
and second, though, the question is, will this grant you the 
authority to investigate and continue the process that seems to 
be ongoing right now, to come up with some conclusions about 
what, in fact, happened, and then second, is it sufficient to 
protect the public as you move forward.
    Mr. Newsome, since you brought up the question of--I will 
leave Feinstein to Mr. Erickson and I will leave Einstein to 
you. How much time do we need to take to study before we come 
to that day when we now decide this is, in fact, the answer?
    Mr. Erickson.
    Mr. Erickson. Are you sure we cannot swap those?
    Senator Nelson. No, no.
    [Laughter.]
    Mr. Erickson. You are right on the timing issue. Markets 
are funny. The next event may be in 1 day, it may be 1 week, it 
may be 1 year. We cannot really define the time.
    With respect to Senator Feinstein's legislation, I continue 
to look at it as a pragmatic and modest approach. It 
affirmatively confers to this Commission fraud and manipulation 
authority, which is essential. The reinstatement of those 
authorities clearly over the derivatives in these markets would 
have a prophylactic effect on what people are willing to do.
    There is a Governor in place and if people understand that 
the transactions are subject to some regime, they may temper 
the questionable kinds of transactions they are entering and 
the purposes for which they are entering those transactions. 
They also, may temper the leverage, because I think that is 
something we really do not remember all the time, that these 
are leveraged transactions and they operate pursuant to 
agreements where, if you are concerned about credit, you can 
ask for a bigger pot of money to be held in basically a deposit 
account.
    I am generally pleased with the Feinstein bill. Yes, it 
could do more. We could say that if you are running a 
marketplace where price discovery occurs, it ought to take 
place in a registered marketplace.
    Senator Nelson. A framework.
    Mr. Erickson. Yes.
    Senator Nelson. Transparency.
    Mr. Erickson. Yes, within our two categories of 
marketplaces. We have the most highly regulated market, the 
designated contract market, which is for retail customers. That 
is what most futures and option markets are today. We also have 
what currently is an unused part of the framework, which I 
think is really innovative, and that is the derivative 
transaction execution facility, which is designed for markets 
like ICE to find a place in the regulatory regime and yet have 
a much lighter regulatory treatment.
    That is something that is not in the Feinstein bill, but if 
you really wanted to cement down what kind of transparency you 
are expecting out of a marketplace, that is something you could 
look at and just require marketplaces to have some category of 
registration.
    Senator Nelson. Now the question, of course, chairman 
Newsome, is how much time does it take to conclude the 
investigation to come up with some conclusion?
    Mr. Newsome. If you will allow me, I would like to expand 
beyond that time just to----
    Senator Nelson. Sure.
    Mr. Newsome. It is very difficult to say. We are 
investigating numerous allegations, of which manipulation is 
one. Manipulation cases are very complex. They take a lot of 
time. For example, the two manipulation cases that commissioner 
Erickson brought up, Sumitomo and Avista, those occurred on our 
most regulated markets. It is impossible to prevent 
manipulation. They occurred on the very regulated markets and 
they were very time consuming. Sumitomo, in fact, took almost 5 
years with access to all of the information.
    I do not mean to say that Enron is going to take that long 
because we are very aggressively pursuing that and we have 
assistance from other agencies and we are going to move as 
quickly as possible. I cannot give you a specific timeframe 
because as we go forward, we have uncovered additional 
information which we have to move on.
    I suspect that it is not an all or nothing situation, that 
there are going to be stages. We are going to finish parts of 
the investigation. If there are violations, we will bring 
charges and then we will move forward with the additional parts 
of the investigation.
    Back to your initial comment about constituents, I could 
not agree more. We want real solutions. If there are problems 
there, we want to address them. In order for us to look at real 
solutions, we have to first determine what the real problems 
are, and therefore, I think the importance of our investigation 
is we move forward in trying to find out what we have learned.
    Clarification and commissioner Erickson and I are in full 
agreement that clarification of anti-fraud and anti-
manipulation authority is a good thing. I mean, if there are 
players who are not operating by the guidelines, we want to 
make sure that we have the ability to go out and prosecute 
those people. I do not think there is any question about that 
by anyone.
    The real discussion goes back to the front-end regulation, 
when we start looking at market surveillance and transparency. 
I do not think the debate has been held that what is the real 
cost to the front-end regulation? What does it mean?
    I want to take, for example, transparency. Transparency is 
like motherhood and apple pie. Transparency is a good thing and 
we all want very transparent marketplaces, and in markets which 
we oversee that serve a price discovery function, those markets 
are transparent and the CFMA gives the authority to the 
Commission in exempt marketplaces to require transparency if 
that market comes to serve a price discovery function.
    To say that across the board, all of these markets should 
be transparent is something that deserves a closer look. 
Transparency in small, illiquid, or very specialized markets 
could actually have a negative impact. They could distort 
market prices more than they could help. I do not know that, 
but we need to look at it, because when you have the non-
standard contracts that we are talking about in many instances 
in these exempt markets, they are differing in size, they are 
differing in terms, they are differing in conditions, they are 
different because of differences in counterparty risk.
    What does all of that mean in terms of making this 
transparent? What kind of distortion could that have on our 
very standard markets which we utilize for price discovery? It 
simply needs to be looked at.
    Senator Nelson. I thank you for your answers.
    Mr. Chairman, if I might just conclude, I agree with 
transparency and it would seem to me that even though you might 
have some distortion to the market by transparency in certain 
cases, that the market would adjust to that over some period of 
time, that it would recognize and take that into account.
    Let me conclude by saying that understanding leverage, only 
from the standpoint of the insurance industry, it does not 
matter how much surplus you have against the risks you have 
taken if you do not have any losses. The reason you compare 
surplus to the liabilities and exposure of the insurance 
business is because there are going to be losses and the 
question is what will those losses be.
    I suspect in the case of transparency and in the case of 
understanding these transactions, you want to know what the 
potential exposure is if everything goes wrong. Can they 
withstand that kind of exposure? Hopefully, this legislation 
would help you be in a position, and/or others looking at the 
transparency of the transactions, to make that kind of 
conclusion, not the average person on the street, but those who 
are sophisticated in this market, in this kind of business.
    I thank you. Thank you, Mr. Chairman.
    Senator Lugar [presiding]. Thank you very much, Senator 
Nelson.
    Senator Crapo, do you have additional questions?
    Senator Crapo. Yes. Thank you, Mr. Chairman.
    I know we have gone over this before, but I want to be sure 
that I have it right. As I listened to the testimony of both of 
you, it seems to me that there is actually a lot more agreement 
than disagreement with regard to what we ought to be doing and 
where we ought to be. The disagreement, as I understand it, is 
over whether 2(g) excludes from the fraud and manipulation 
provisions swaps transactions. Am I correct about that? Would 
the two of you agree that that is the core of the disagreement 
between your testimony?
    Mr. Newsome. 2(g) certainly does exclude swap transactions. 
I do not think there is----
    Senator Crapo. It excludes them from fraud and manipulation 
protections?
    Mr. Newsome. Two-g excludes them from jurisdiction of the 
CFTC, period.
    Senator Crapo. All right. Then I guess I am 
misunderstanding what the difference is. How would you 
characterize the difference of your testimony, then, Mr. 
Newsome, between you and Mr. Erickson?
    Mr. Newsome. In a nutshell, you have the exclusions. You 
have the exemptions. Under the exemptive category, we have 
appropriate anti-fraud, anti-manipulation authority. We have 
appropriate authority to require transparency if that market 
comes to serve a price discovery function.
    Senator Crapo. Regardless of Section 2(g)?
    Mr. Newsome. Well, they are obviously separate. There are 
criteria for exclusions under 2(g) and there are criteria for 
exemptions under 2(h). Another thought process is that 2(g), 
the exclusion of 2(g) trumps the exemption of 2(h) and I do not 
think that is correct.
    Senator Crapo. All right. That is what I was trying to say. 
Mr. Erickson, do you agree with that as the characterization of 
the difference between you in your opinions today?
    Mr. Erickson. Yes, I would concur with what the Chairman 
has said. It is just a matter of how you look at the way these 
markets are structured, as well. You have the exclusion that 
attaches just to swaps and swaps are defined by 2(g). My view 
is that anything that fits in 2(g), is out. It is out as a 
bilateral transaction, but it is also out if it is done on an 
electronic exchange marketplace because of another section 2(e) 
of the Act, which excludes electronic trading facilities.
    Senator Crapo. As I see it, both of you agree that Section 
2(g), in the way the Act should be drafted, the Section 2(g) 
should not exclude these transactions from the fraud and 
manipulation provisions. Your disagreement is whether it does 
or not, am I correct in that?
    Mr. Newsome. Yes. Certainly, when we look at exempt 
markets, I believe that we should have--I think that we do have 
the proper anti-fraud, anti-manipulation authority. If there is 
question about that, then clarification, I think, would be 
helpful.
    Senator Crapo. Mr. Erickson.
    Mr. Erickson. Senator, I would just add that I think it 
would be important to just cement the idea that fraud and 
manipulation authority apply and attach to the exempt commodity 
transactions. What you raise may be a distinction that I 
previously had not seen. For transactions energy products, by 
dint of being an energy product and exempt, fraud and 
manipulation authority ought to attach, no matter if you are 
trading a swap or some other kind of over-the-counter product.
    Senator Crapo. All right. Mr. Erickson, I apparently do not 
have, or maybe we just got a copy of the latest version that 
you have been working on of Senator Feinstein's proposal, but I 
have not read it yet. The latest copy that I read does actually 
repeal the exempt commodity provisions, and if I understand it 
correctly, it would then subject all of these transactions to 
full coverage by the CFTC and trading on the commodities 
exchanges. That is not what you are suggesting we should do, is 
it?
    Mr. Erickson. No. That, I think, is a debate that is taking 
place a little bit at the hearing today about whether one, two, 
or three classifications of commodity are appropriate. I am 
comfortable with the idea of the three categories. The idea of 
the exempt category was really to make sure that fraud and 
manipulation attached across the board. That is not the case. I 
have not seen this legislation. I would be surprised if it 
completely took out any references to exempted categories, but 
I will be happy to take a look at it.
    Senator Crapo. All right. Thank you very much.
    Senator Lugar. Thank you. Do you have further questions, 
Senator Miller?
    Senator Miller. No.
    Senator Lugar. Senator Fitzgerald, do you have further 
questions of these witnesses?
    Senator Fitzgerald. I do. I was wondering about record 
keeping, whether under current law the online energy and metals 
trading platforms are required to keep records and are those 
records available to the CFTC, either of you?
    Mr. Newsome. I will start. No, there are no record keeping 
requirements to the section that you are referring to. Do 
companies keep records? Obviously, they do. As we look at 
clarifying anti-fraud, anti-manipulation authority, I think we 
need to look at all activities that could make sure that the 
Commission has a strong enforcement program and approach to 
dealing with fraud and manipulation. To my knowledge, I do not 
believe----
    Senator Fitzgerald. They are not required to keep the 
records, so we could see a bunch of wash trades between these 
online energy or metals trading firms, and they are not 
required to keep any records, so even if there was a lawsuit by 
somebody, there is no statute that requires them to keep 
records. They could just shred any written records they have 
and destroy computer records. Do you think that is the case? 
Mr. Erickson, would you care to comment?
    Mr. Erickson. It is the case, and it is something that is 
not required under our Act. Presumably, depending on how you 
are otherwise--regulated, if you are a publicly held company, 
there may be some prohibitions on that.
    My concern with the wash trading is that there are a lot of 
different aspects to wash trading. You have the accounting 
issue. You have the fraud on investors that the SEC would be 
looking at. With wash trading on these electronic exchanges, it 
gives people the ability to send false price signals. A lot of 
these markets are being viewed by thousands of market 
participants and these transactions are going across these 
lines potentially and sending a false price, and that is not 
precluded under the Act as it is written and there are no 
reporting requirements or other paperwork requirements to 
require their keeping those. Yes, the answer is they----
    Senator Fitzgerald. I grew up and still live outside the 
Chicago area. Every day, I can open my papers and I can find 
out the price of a September corn contract or a September pork 
bellies contract or soybean contract and I can find out the 
volume of trades on our exchanges in Chicago. Is there anyplace 
that I can find the same volume price and open interest 
information for online energy and metal trading firms? Would 
either of you care to answer that?
    Mr. Newsome. That information is not widely available, and 
currently, it is not required to be made transparent. As you 
know, the Commission has the authority if it makes the 
determination that these markets serve a price discovery 
function to require transparency and there are several markets 
that we are looking at now to make that determination.
    We had some of this discussion a few moments ago and I 
would like to go back, if I may, Senator Lugar, and discuss 
this with Senator Fitzgerald about transparency. There is no 
question that general transparency in marketplaces is a good 
thing. This goes toward some of the front-end regulation that 
is being talked about, and whether or not in these markets, is 
required transparency a good thing.
    I am not going to argue either side of that today, but 
simply point out that these markets are very different than the 
standardized markets that you just referred to from Chicago. 
Some are small, some are illiquid, certainly many are non-
standardized. You are talking about a completely different set 
of, or a different type of information than you would receive 
on the standard markets in either Chicago or New York, and what 
kind of impact will that have?
    The fact that it is non-standardized, that there are 
differences in size, differences in terms, differences in 
condition, differences in counterparty risk, could even the 
release of that information lead to distortion to some of our 
standardized markets because of the differences in standards? I 
do not know that, but I think it is something that we need to 
look at and something that I think we need to realize when we 
just talk about transparency in general.
    Senator Fitzgerald. Is there any self-regulatory function 
that these excluded energy and metals trading online platforms 
have? I mean, what SRO function does the Intercontinental 
Exchange provide? Does anybody know?
    Mr. Newsome. To my knowledge, none.
    Mr. Erickson. None that I am aware of.
    Senator Fitzgerald. OK. Now just finally, I guess, if we 
were to eliminate the exclusion for online trading of energy 
and metals derivatives contracts or swap contracts, that does 
not mean that we would be regulating these online platforms in 
the same way we regulate a facility like the Board of Trade in 
Chicago or the NYMEX in New York. They could become DTEFs, 
right, which would be subject to a mid-tier level of 
regulation, is that not correct?
    Mr. Newsome. Yes, sir. Still, through the CFMA and as we 
move forward, I still think it is as important now as it has 
been to look at the nature of the product, the type of 
facility, and who is trading the product in order to determine 
the proper regulatory scheme, and you are correct, they could 
move into a lesser-regulated----
    Senator Fitzgerald. Right now, they are excluded from any 
category. They do not have heavy. They do not have middle. They 
do not have light. They do not have any.
    With that, thank you both very much.
    Senator Lugar. Thank you very much, Senator Fitzgerald.
    I just have a final question. I am intrigued. Mr. Erickson, 
you pointed out that the lights really went out in the Enron 
market. Describe what that means. Who was still left in the 
market and who won and lost in that situation? In other words, 
most of us have not had an experience in which a market that 
had considerable volume and a lot of money, the lights just 
went out, as you suggested. What happened, and describe at 
least the final day of that.
    Mr. Erickson. I really think for a lot of this, Senator 
Lugar, time will fill in many of the gaps in the details that 
we have. I just personally think it is striking and shocking, 
really, that you could have an event like that where a 
marketplace is just gone. That is why I look at this from the 
perspective that we really dodged the bullet. We had this 
period of 3 weeks where the operations were able to continue.
    Senator Lugar. In other words, the Dynegy situation you 
described that allowed traders who were in this market to 
disengage----
    Mr. Erickson. Exactly.
    Senator Lugar [continuing]. That is, to close their 
positions, sometimes at losses or whatever, but to get out. 
They were not there when the lights went out.
    Mr. Erickson. Exactly.
    Senator Lugar. But, now, somebody was. Who was there when 
the lights went out?
    Mr. Erickson. I have made a couple of unfortunate 
statements in various public places and I think that we are all 
under the impression that virtually everyone did have the 
opportunity to exit. I made that statement to a group of pretty 
good-sized energy companies in Texas about a month ago and was 
quickly taken to task for making that statement with a few 
folks saying that they were not so successful as I might 
otherwise have presumed and that they had just delayed taking 
several million dollars in losses for a period of months.
    I do not know the scope of it, but I think that we were 
able to dodge a bullet. It was just luck in this case. To the 
extent something like this happened again and we did not have 
some willing buyer out there, people may have just been left in 
that market and unable, really, to trade out, and that concerns 
me.
    Senator Lugar. I will not argue the transparency thing. Mr. 
Newsome has made a very good case that we need to take a look 
at all the source of that issue.
    This Enron market strikes me as something that was not very 
transparent. As a matter of fact, even though some of us knew 
that such a thing existed, what was going on in there 
concerning not very transparent--now, some would argue, no need 
to be. You have sophisticated people. They were aware of their 
risks and so, therefore, back in the back room if people are 
being clobbered, that is their tough luck.
    The dilemma is, of course, when huge sums of money are 
taking place like this, some of the people had other 
stockholders, had some public consumers that were behind them, 
why, there are some implications for people other than these 
sophisticated persons. They were not operating as individuals, 
I suspect, most of them, with their own net worth in these 
markets. This is what I am worried about, is the fallout. 
Something that was meant for people who were very sophisticated 
but in their operations, others are caught in the wake of this.
    I have no idea who was there, and that is why I was just 
simply curious. You say most, somehow, given the Dynegy, 
scrambled and got free of it and reported their losses, 
hopefully by this time, do not have bookkeeping problems of 
their own, describing what they were doing back there in the 
markets. This is something that, it seems to me, between the 
Commission and the committee, we have to grapple with, not that 
that was the end of Enron. Lots of other things happened 
before. Our particular piece of the situation we take 
seriously, derivatives, commodities regulation. We really want 
to make certain we perfect as much as possible the Act that we 
were all involved in a while back, and so that is the purpose 
of my querying this.
    We thank both of you very much for your testimony. Both 
Chairman Harkin and I have allowed members of the committee as 
much time as they needed, and likewise you, because it was very 
important that this be a part of our record as we are literally 
consulting together in the midst of a public hearing. We thank 
you for coming.
    Mr. Erickson. Thank you, Senator.
    Mr. Newsome. Thank you, Senator.
    Senator Lugar. The chair would like to call now our second 
panel that will include Mr. Randall Dodd, Director of the 
Derivatives Study Center; Mr. John Coffee, Professor of 
Columbia Law School; Mr. Neal Wolkoff, Executive Vice President 
of the New York Mercantile Exchange; Mr. Ernest T. Patrikis, 
Senior Vice President and General Counsel from American 
International Group, Incorporated, International Swaps and 
Derivatives Association, ISDA; and Mr. Richard Green, Chairman 
of Aquila, Incorporated, of Kansas City, Missouri.
    Gentlemen, unlike the more permissive regime that has 
operated in this committee this morning thus far, let me ask 
each one of you, if you can, to summarize your testimony in 5 
minutes. We will not be rigid on that because in some cases, 
that may be impossible. Given the hour and, likewise, retaining 
the attention of members, we would like to hear from each one 
of you ad seriatim and then have opportunities for rounds of 
questions as committee members might desire.
    Mr. Dodd.

STATEMENT OF RANDALL DODD, DIRECTOR, DERIVATIVES STUDY CENTER, 
                         WASHINGTON, DC

    Mr. Dodd. Thank you very much. I wanted to start by saying 
I am very honored to be here today and I want to be able to 
provide my insight into the nature of derivatives markets and 
to also offer an economic analysis that will probably help us 
better understand what should be the proper level of regulation 
in these markets.
    Now, unfortunately, though, we are being brought together 
today by a large number of problems that have cast a pall over 
our financial markets. Some of these are sort of bad apples--
executives, accountants, auditors, financial analysts, people 
reporting in the media, but there are also a lot of bad non-
apples, failures in our accounting rules, our financial 
reporting rules, but also failures in the way we have used 
derivatives.
    I would like to focus on the role of derivatives today 
because I think that we need to solve the problem of the way we 
treat over-the-counter derivatives in order to solve the 
problems with these accounting rules. In fact, I do not think 
it is going to be possible to solve accounting, auditing, and 
financial reporting problems without more transparent 
derivatives markets, and I believe we cannot expect to maintain 
safe and sound and orderly trading markets for commodities and 
for other financial instruments until we have the same basic 
rules applying to over-the-counter derivatives markets as we 
have with banking, security, and insurance. Let me elaborate on 
those points in order to justify them.
    The over-the-counter derivatives markets, as we know, have 
grown rapidly in the last 20 years. Chairman Harkin mentioned 
that they are now $111 trillion worldwide, quite a bit of that 
here in the U.S. It is now multiple times the size of our GDP.
    If you compare these markets to the size of our securities 
markets or banking markets or insurance markets, they certainly 
rival, if they do not exceed, them. Today, derivatives are very 
much the fourth leg of the table that might be thought of as 
comprising our financial system. However, unlike the other legs 
of the table, banking, securities, and insurance, there are no 
regulations substantially regarding these over-the-counter 
derivatives markets, aside from some semantic difficulties we 
have seen in trying to define that subset of them known as 
exempt commodities.
    The reason derivatives have grown so much is because they 
provide two very important economic functions, that is, price 
discovery and risk shifting or hedging or risk management. They 
have also grown because they provide some unproductive uses, 
some downright nefarious uses, and we have had those 
highlighted to us due to the failure of Enron. We have seen 
that they can be used to hide debt, hide losses, fabricate 
income, conduct wash trades, to manipulate markets. They also 
can be used to avoid taxes. They can also be used to avoid or 
outflank the regulations that apply to banking, securities, and 
insurance. We have seen how they can fabricate a loan by using, 
for example, offsetting forward contracts in natural gas. Also, 
prepaid swaps have done the same thing.
    We need a regulatory framework that encourages their use 
for risk shifting and for price discovery while prohibiting 
their use for these unproductive, if downright nefarious, 
activities. That is the goal here today and I am hoping to help 
in doing that.
    Given that these derivatives markets are large, they are an 
important part of the economy, and might I add also they are an 
especially important part of the energy industry. Our $600 
billion use of energy every year involves a large number of 
derivatives contracts. We do not know exactly, of course, 
because there are no reporting requirements and so there is no 
hard data on the amount of derivatives, over-the-counter 
derivatives in energy products or metal products.
    However, I did take the opportunity a few months ago to 
estimate the size of Enron's derivatives book. Enron alone had 
at the end of 2000, the last year they reported, $758 billion 
worth of derivatives in energy products on their books. Now, 
you add to that Duke, Dynegy, Williams, El Paso, Aquila, the 
others, and you have the size of an energy derivatives market 
in the U.S. that is multifold the size of this $600 billion use 
of our energy, so those markets are very important.
    Because they are important, it is important that they work 
efficiently. The conditions for these markets working 
efficiently are that, one, the prices are transparent, that 
everyone can see them. Everyone can also see market volume, 
open interest, and the like. Also, that large traders' 
reporting data is given to the government authority so that we 
can detect and deter manipulation.
    Transactions in these derivatives instruments should also 
be conducted in a way that is orderly, where markets do not 
just freeze up, they do not just suddenly stop trading, where 
there are not excessive price movements. After all, that is the 
way we treat the New York Stock Exchange and that is the way we 
treat our other exchange-traded instruments.
    Last, derivatives instruments should have proper credit 
management practices. Derivatives dealers should have capital. 
Derivative instruments should have collateral attached to them 
that is adequate for the risks that are involved in those 
transactions.
    Now, those are what is needed for an efficient working 
market that is tied to this key energy and metal and other 
financial markets in our economy. Yet, we do not see that 
actually occurring in the market today. The private sector has 
not produced market practices that are consistent with those 
needs for an efficient market, and that why I think it is so 
good that we can come here today to talk about what might be 
the remedies for this problem, and I would like to propose in 
the brief time I have remaining three basic remedies to this 
problem.
    The first one is to establish registration and reporting 
requirements for over-the-counter derivatives. Anyone dealing, 
selling, participating in the transaction should be registered. 
They should have a background check to make sure they have not 
been convicted of fraud or embezzlement. If you get convicted 
of securities fraud, you are barred from that industry for life 
as a securities broker, but tomorrow, you can go get a job 
working for Dynegy, El Paso, or Williams, and that is a 
tragedy. Also, the institutions should be registered so we know 
who they are.
    Finally, they should also have reporting requirements. 
Enron and the like had no reporting requirements as a 
derivatives dealer. We know very little about them. We can only 
infer a little bit, what we get from their quarterly and annual 
statements. They should also report their large trader 
positions to the government so that we can detect and deter 
manipulation and other market problems.
    In addition to registration and reporting, the second thing 
we need is collateral and capital requirements. Enron had no 
capital requirement as a derivatives dealer, even though they 
were a large financial institution. Similarly, for that matter, 
GE and some of these other near-financial institutions also 
have no capital requirements. It also would apply to the El 
Paso, Williams, and the others. As a result, when Enron fails, 
the effect is not buffered and instead is felt immediately by 
other participants in the industry and, in fact, other firms 
throughout the economy, and today we have this pall over our 
entire financial market.
    In addition to capital is collateral requirements. The 
organized futures exchanges, such as NYMEX, have margin and 
their clearinghouse has capital and that is why when Enron 
failed and this market started to melt down, there was a flight 
to quality, and where did they flee to? They flew to the high-
capitalized, well-margined markets in the NYMEX and they were 
able in some cases to get out of Enron and into that market to 
protect themselves from credit failure or performance failure 
on their derivatives contracts. If it were not for that flight 
to quality, for having a safe harbor of where to go, surely the 
consequences would have been much more difficult. To avoid the 
deeper problems in the future, we need to start thinking and 
establish today about how to adequately collateralize these 
contracts.
    In addition to reporting and registration requirements, 
capital and collateral requirements, last would come what I 
would consider orderly market rules, and these would require 
the derivatives dealers to act as dealers do in other markets, 
which is to maintain liquidity by posting bid and ask prices 
throughout the trading day. It is used in the over-the-counter 
market for U.S. Government securities. It is even required 
there. It is used on the stock exchange as the specialists 
maintain bid/ask prices. It should also be the case for over-
the-counter derivatives dealers in order to maintain an orderly 
market and market liquidity.
    We should also have spec limits and we should also have 
excessive price movement limits, again, just as we do in the 
New York Stock Exchange and the other futures exchanges. This 
will help make these markets more efficient. It will help 
prohibit the unsavory, nefarious, unproductive uses that we are 
witnessing today, and I think it will go a long way to try to 
solve the problems that have been highlighted by the failure of 
Enron and the subsequent calamities that we have seen in our 
financial markets. Thank you.
    Senator Lugar. Thank you very much, Mr. Dodd.
    [The prepared statement of Mr. Dodd can be found in the 
appendix on page 90.]
    Senator Lugar. Mr. Coffee.

   STATEMENT OF JOHN C. COFFEE, JR., PROFESSOR, COLUMBIA LAW 
                   SCHOOL, NEW YORK, NEW YORK

    Mr. Coffee. Thank you again for inviting me. I want to 
briefly address three questions. First, will the Feinstein 
amendment produce undesirable uncertainty, and my answer will 
be no. Second question, do we need greater transparency in the 
energy derivatives market, and my answer will be yes.
    Third, the question I think we really should be focusing on 
in most detail, are there any aspects of the Feinstein 
amendment that might produce undesirable or unnecessary 
restraint on future competition within this industry, and my 
answer here is yes, there might be. The amendment is a good 
answer, a workable answer, but probably not the optimal answer. 
There is some over-regulation in it that is not necessary for 
its basic core purpose.
    Now, let me remind you of something you already know, but I 
think the record should set this forth clearly, the 2000 Act 
was precipitated by a turf war between the SEC and the CFTC, 
and as a result of that, there was suddenly a serious question 
about the legal status of swaps and the possibility that the 
longstanding 1993 swaps exemption might be repealed suddenly. 
That sent a friction of fear across Wall Street and the 
President's Working Group understandably recommended that 
financial derivatives be deregulated to the extent they traded 
over-the-counter.
    Now, the President's Working Group, as you all know, did 
not extend that recommendation beyond financial derivatives, 
and in a very simple sentence, we ought to state the rationale 
for that, which Senator Fitzgerald has stated and you have also 
repeated, but it should be fully in the record. The position of 
the President's Working Group is that financial derivatives are 
not vulnerable to manipulation, corners, or swaps because they 
have infinite supply, whereas physical commodities are 
vulnerable to corners and swaps because there is finite supply, 
and that has always got to be your polestar when you come back 
to exempt commodities.
    If there is a physical commodity or there is something that 
is in finite supply, there is a potential for manipulation, and 
the most important thing to take from Senator Feinstein's very 
succinct testimony this morning was that there has been a wave 
of wash transactions and they raise the strong inference, the 
strong smell that there is a manipulative intent in someone's 
mind. Investigations will tell us later who did it, and I raise 
no charges, point no fingers, but if you get those many wash 
transactions, someone has improper purposes someplace and you 
have to respond to that.
    Now, let me go back to the three questions that I raised. 
First, is there going to be undesirable legal uncertainty if 
the Feinstein amendment were passed? Well, I think not because 
the SEC is now out of the picture. There is no possibility 
again that we will have a swap being alternatively 
characterized as a future by one agency and an option by the 
other agency because the SEC's jurisdiction has been taken 
away.
    The issue that comes up in this area is whether or not the 
exchange traded facility, ETFs, deserves to be regulated on a 
totally different basis than the futures exchange. Now, as a 
generalize, I would start out this analysis by looking at the 
status of Nasdaq and the New York Stock Exchange. They differ 
in the same way that the electronic traded facility, the ETF, 
differs from the futures exchange. One has open outcry, one is 
electronic. They are different in the same way that our current 
energy market is different with two kinds of trading 
institutions. Both Nasdaq and the New York Stock Exchange are 
regulated the same way when it comes to transparency, 
reporting, and disclosure, and I think that, again, should be 
the polestar. There are relevant differences. Nasdaq is not yet 
an exchange. They have the same obligations when it comes to 
fraud disclosure reporting obligation.
    There has been an issue raised about whether the overlap of 
the FERC and the CFTC will also give rise to undesirable 
competition or undesirable uncertainty, and I would have to 
point out that the FERC and the CFTC are very different 
agencies with very different regulatory missions. Thus, they 
should overlap. The CFTC is basically an investor protection 
agency and the FERC is basically concerned with consumer 
protection. It is not safe to cut one agency back when the 
other agency's jurisdiction begins because they are trying to 
protect different constituencies and they have different 
priorities.
    The second question, is there a need for greater 
transparency? Again, I think that the Feinstein testimony this 
morning pointed out that there is a huge volume of wash 
transactions, and what is the motive for a wash transaction, 
the dominant motive? Maybe not the exclusive motive, but the 
dominant motive is to send a false price signal, a false price 
signal that signals either that there is demand at a particular 
price level or that there is market depth and liquidity at that 
particular price level, and that is a signal that can distort 
not only the market that the signal is entered into but the 
other market. The fundamental question is, why do we have to 
regulate a market full of only sophisticated participants, and 
the answer is because false signals can be sent from that 
market that have an externality, that create an externality, 
because they affect other markets.
    Again, as a generalist, let me take you back very quickly 
to 1987 and the Brady Commission, which was one of the most 
authoritative studies after the 1987 stock crash of how markets 
operate, and they developed the one market concept. There was 
an issue about whether certain transactions in stock index 
futures in Chicago destabilized the New York Stock Exchange and 
what they concluded was that there was a realistic scenario 
that when information was suddenly suspended from Chicago and 
you no longer knew what was happening in the stock index future 
market, that that could send a wave of fear and change trading 
behavior on the floor of the New York Stock Exchange.
    This concept from the Brady Commission carries over today. 
There is one market and we have two functional substitutes. We 
have futures exchanges and we have electronic trading 
facilities, and while I think both should survive, both should 
be encouraged, they should be allowed to compete fairly, we 
have to recognize that signals from one market will affect both 
markets. We have to have integrated functional regulation that 
treats them similarly to the extent there is a danger of 
deception and a danger of lack of transparency, because 
transparency affects the other market, as well.
    Last question, is there a danger of over-regulation? I 
heartily endorse the transparency, the disclosure, the 
reporting requirements. The burdens of that kind of regulation 
are small, the benefits are great, and the injury to other 
participants is enormous because the lack of transparency 
affects other markets. There is always that externality.
    I am more concerned about some other areas that I think are 
necessarily adopted. For example, the net capital rules, I do 
not think that the net capital rules should be imposed on the 
electronic trading facilities. I do not think that serves 
anything like the same purpose of ensuring disclosure. The net 
capital rules are basically there from the broker-dealer 
history to protect retail customers against the danger of 
broker insolvency because brokers hold money and property.
    I am not sure we have the same need to protect 
paternalistically the users of electronic trading facilities. 
Now, I have used that just as an illustration. There is a 
certain amount of over-breadth in the proposals and I think the 
core idea of ensuring that there be greater transparency, 
greater disclosure and regulation is necessary, vital, and 
fairly low-cost, but I think there is some excess regulatory 
baggage that at least should not require a priority and it 
could deserve some further examination.
    At this point, I will stop and take any questions that you 
later want.
    Senator Lugar. Thank you very much, Mr. Coffee.
    [The prepared statement of Mr. Coffee can be found in the 
appendix on page 130.]
    Senator Lugar. Mr. Patrikis.

         STATEMENT OF ERNEST T. PATRIKIS, SENIOR VICE 
            PRESIDENT AND GENERAL COUNSEL, AMERICAN 
INTERNATIONAL GROUP, INC., INTERNATIONAL SWAPS AND DERIVATIVES 
             ASSOCIATION (ISDA), NEW YORK, NEW YORK

    Mr. Patrikis. Thank you, Senator Lugar. I would like to 
start off by saying that every morning when I get up, I wonder 
what disgusting new story will surface from the deeds of 
certain members of corporate America. I joined AIG 4 years ago 
after a 30-year career at the Federal Reserve Bank of New York. 
I was the No. 2 officer of the bank. In moving to the private 
sector, I asked myself, how would it stand up compared to 
working at the Fed as far as ethical matters were concerned, 
and to date have not found that a problem, but I find all of us 
tainted by what is going on in the marketplace today.
    That is much of the theme of the statement that we have 
submitted to you this morning. The horrendous activities 
generated by a few represent a failure of corporate governance 
and ethics. It would not be accurate or fair to blame Enron or 
any of the lapses of business morality on the over-the-counter 
derivatives. A better question is, what is wrong with business 
school curriculums?
    Your inquiry is timely. You should be asking the questions 
you are asking. We appreciate Senator Feinstein's concerns 
about what happened with electricity and natural gas trading in 
California. At ISDA, we believe the case has yet to be made 
that regulation of OTC swaps in privately negotiated 
derivatives as futures is warranted. While I am not an expert 
in derivatives or in energy trading--perhaps I know enough to 
get myself into trouble--I have read accounts of energy trading 
activities in the press but have learned over the years not to 
believe all that I read.
    I understand that the FERC and the CFTC, which, in our 
opinion, has ample authority to address fraud and market 
manipulation with respect to non-financial derivatives, has 
several investigations underway. I hope that the committee 
awaits the results of those investigations before deciding on a 
legislative course.
    Of course, there are many questions surrounding energy 
trading. Some of these relate to California's electricity and 
natural gas deregulation regime and how it may well have 
invited traders to take advantage of it through proper and 
improper means. One key issue here is whether improper 
activities involved any use of over-the-counter derivatives as 
opposed to cash-settled spot trades.
    In any event, the major issue you have posed is whether the 
CFTC has the authority to deal with fraud and market 
manipulation that might involve OTC non-financial derivatives. 
That question has been best answered by the Chair of the CFTC 
this morning. At ISDA, we share that view. We believe the CFTC 
has that authority. However, if it is ultimately determined 
that it does not, then we will work with you on legislation to 
provide the appropriate agency with that authority.
    You are probably asking yourselves, why does ISDA oppose 
legislation that would regulate OTC derivatives as futures? The 
answer is that it would result in less liquidity in the 
marketplace and would create new uncertainties. As the members 
of the President's Working Group on Financial Markets have 
pointed out, OTC derivatives are a valuable risk management 
tool used all over the world. They are a form of financial 
insurance, spreading risk or loss to those who can best bear 
it.
    Businesses that are now carrying on activities that would 
in the future subject it to regulation may well stay away from 
markets that they now use to hedge risks, or they might shift 
risk management activities offshore. These non-financial 
derivative markets are not public retail markets similar to 
those of the futures exchanges, where futures style regulation 
is needed. These markets are composed of sophisticated 
participants. If there is a lack of liquidity in some of the 
energy markets today, it probably does not result from the lack 
of regulation but is a market, including rating agency, 
response to the fact that trading profits do not make up for 
lack of capital or that more capital is needed to cover trading 
risks. We need more, not fewer, participants in these markets.
    It is not clear to me that the legislation proposed would 
address the alleged electricity and natural gas trading abuses. 
Futures regulation for these OTC derivatives will not stop 
fraud. Indeed, as I recall it, several past infamous cases of 
market manipulation involved significant use of futures 
exchanges.
    In closing, the Commodities Futures Modernization Act is 
about 18 months old. It has brought needed certainty to the OTC 
derivatives market, not through deregulation but codification. 
This has made it possible for businesses and other OTC 
derivative users, including governments, to better manage their 
risks.
    It assisted in the Enron situation. Enron counterparties 
did not walk away from their trades. Your work on the 
Commodities Futures Modernization Act and support of bankruptcy 
legislation aided the markets to work as well as they could in 
a difficult situation. In addition, even though Enron was the 
largest bankruptcy to date, it did not lead to systemic failure 
in the markets.
    Let us give the FERC and the CFTC the opportunity to finish 
their work before we conclude that legislation is the answer. 
Thank you.
    Senator Lugar. Thank you very much, sir.
    [The prepared statement of Mr. Patrikis can be found in the 
appendix on page 138.]
    Senator Lugar. Mr. Wolkoff.

         STATEMENT OF NEAL L. WOLKOFF, EXECUTIVE VICE 
           PRESIDENT, NEW YORK MERCANTILE EXCHANGE, 
                         WASHINGTON, DC

    Mr. Wolkoff. Mr. Chairman, thank you for allowing me to be 
here today. Thank you for holding the hearing. My name is Neal 
Wolkoff. I am the Executive Vice President and Chief Operating 
Officer of the New York Mercantile Exchange. The NYMEX has the 
world's largest regulated energy marketplace, and as far as 
precious metals, I can say the same thing.
    For myself, my career in commodities regulation and market 
operations goes back 22 years, initially as a trial attorney 
with the CFTC's Division of Enforcement, and for the last 20 
years specifically working in the areas of energy and metals 
marketplaces. I will do my best to distill that 20 years into 
the 5-minutes permitted to me. If I go over, feel free to cut 
me off.
    A little bit of context is very helpful because there has 
been an awful lot said today, all of it obviously well meaning, 
but much of it incompatible.
    To start with, swap transactions or unregulated over-the-
counter derivative transactions are their own instrument. 
Nobody is saying that they should be treated like futures 
transactions. Nobody is looking for them to be put into the 
same box as regulated futures transactions.
    A little bit of history, prior to the CFMA being adopted, 
in the early 1990's, I believe it was 1991, as a result of a 
case involving a Brent transaction which threw legal 
uncertainty into the energy cash marketplace, the CFTC adopted 
the energy swap exemption, which the NYMEX supported and we are 
big believers in liquid and competitive cash markets, and that 
includes over-the-counter swap transactions.
    In 1993, to provide legal certainty to all swaps, including 
financial swaps, the CFTC adopted what was called Part 35, and 
Part 35 set forward standards for what participants could 
appropriately participate and also established that swap 
transactions could not be standardized and, likewise, could not 
be cleared, which were two distinctions that were made with the 
exchange traded world.
    The CFMA then effectively overrode Part 35, and I think 
Professor Coffee established perfectly sound reasons why that 
took place. It excluded financial swaps from CFTC oversight, 
which was consistent with the President's Working Group. It 
allowed for standardization in energy and metals contracts, 
which was consistent with what the marketplace had been 
evolving to, and it permitted the clearing of energy and metals 
derivative transactions because following Long Term Capital and 
various other near misses, there was a belief that perhaps 
clearing was not something that should be withheld from the 
over-the-counter market but encouraged.
    Those were generally pretty good things. Part 35 applied 
prohibitions against wash trading. It made fraud impermissible 
as far as swaps, and it outlawed manipulation if conducted via 
swap transactions, all very straightforward and simple. There 
was no confusion until the jurisdictional dispute came into 
effect, none of that having anything to do with energy and 
metals.
    The CFMA with respect to energy and metals swaps removed 
the prohibition on wash trading and, in fact, it created 
regulatory uncertainty, as we heard the two commissioners, the 
chairman and commissioner Erickson before with respect to the 
application of the anti-fraud and anti-manipulation rules on 
those over-the-counter markets.
    Much about the CFMA has been beneficial and forward-looking 
in a number of respects, but it is important to note that by 
permitting metals and energy swaps to become standardized and 
traded on electronic trading systems, the law enhanced the 
roles of those over-the-counter markets in price determination 
of very important strategic commodities, which metals and 
energy clearly are. Transactions previously had been 
individually negotiated and tailored to the needs of the two 
parties. The resulting price was both hard to compare, as 
suggested before, because the transactions themselves were so 
different, and there was no vehicle to publicize the 
transaction price to the wider marketplace.
    Electronic transactions provided that vehicle and 
standardization allowed the comparison of transactions so that 
parties could easily see what a particular standardized 
instrument was trading for. It was not dissimilar in particular 
from the price dissemination function that a regulated exchange 
has.
    In doing some very good things, however, there were some 
regulatory black holes that were created, and I will not get 
into the history of how the law was adopted. It was recognized 
that there was some particular perhaps carelessness. It would 
not be the lesson in civics that I would want my small children 
following.
    Under the CFMA, certain markets, including, for example, 
the Enron Online system--which is still in business, the assets 
of that system are now used by USB Warburg and many of the same 
traders and management is now working for USB--falls outside of 
the definition of a trading facility and it is clearly outside 
the CFTC's regulatory powers.
    Other markets that operate in the new regulatory tier 
called exempt commercial markets, they do not have transparency 
to the broader marketplace. You need to actually be a member or 
an active participant in order to have the screen. Yet, they 
serve a vital price discovery function because the participants 
are generally the larger users, producers and merchants of the 
particular commodity and they are using these systems to 
determine what their price should be. The CFTC, without doubt, 
does not have effective tools to conduct oversight of these 
markets or to deter wrongdoing or punish wrongdoing once it is 
uncovered.
    The CFMA, finally, removed the prohibition on wash trading, 
which previously under Part 35 applied to all of these 
transactions, and it is hard to imagine what public benefit 
would accrue for companies freely being allowed to wash trade 
under commodities law. I have scratched my head on that quite a 
few times and it is still not apparent.
    How can Congress fix these problems? Clearly, I am here 
supporting the Feinstein amendment. Perhaps there may be some 
tweaking on capital provisions, but I think that is a very 
small item. The Feinstein-Fitzgerald amendment is pragmatic, it 
is moderate, and it is narrowly tailored. It preserves legal 
certainty for swaps. It still exempts transactions from 
prescriptive regulation. It does not tell companies what to do 
and how to do it. It tells them that if you do things in a 
fraudulent or manipulative way, you can be punished for that. 
That is not saying, do it this way but not another way. It is 
not prescriptive regulation. That is very important. 
Importantly, as well, it provides the CFTC tools to ensure 
accountability and transparency and to deter misconduct.
    It seems difficult to understand why we would want to have 
educated people and attorneys argue, and eventually argue in 
front of a judge, an argument similar to how many angels are on 
the head of a pin. Does the CFTC, in fact, have jurisdiction 
over this transaction but not over that transaction, not really 
depending on the nature of the trade but where the trade 
occurred? Those are the kinds of technicalities that I think 
people find outrageous when there is wrongdoing but there is no 
clear avenue of investigation or punishment. That is not good 
deterrence and that is not effective for an appropriate market.
    With the Feinstein amendment, it provides for an 
application clearly across the board of anti-fraud and anti-
manipulation rules and the prohibition against wash trading is 
clearly and evenly applied across the over-the-counter market 
that remains regulated.
    In fact, we believe that the Feinstein-Fitzgerald amendment 
should be enhanced and improved in one regard, and that is that 
the CFTC should have discretionary authority to create certain 
self-regulatory obligations on the part certainly of the larger 
centralized electronic systems that are playing a key and 
important role in price determination. Otherwise, the burden to 
surveil the market and enforce rules would fall entirely on the 
CFTC, which is a resource drain to government regulators.
    The commercial platforms, in our view, should stand behind 
not just the technology of their systems, but the integrity, as 
well, and we have provided specific language to Senator 
Feinstein's office in this regard.
    Last, I would just like to conclude, why does NYMEX care 
about this issue? As stated before, we have been unambiguously 
supportive of the various swap exemptions since the early 
1990's. A liquid over-the-counter market gives business to 
NYMEX. It is good for us. It is good for competition. It is a 
pro-competitive move. What these markets have lately done to 
themselves, unfortunately, is not pro-competitive. It is not 
good for the marketplace. It is not good to NYMEX.
    It is a bit scary, in fact, when you consider that under 
recent electricity deregulation, the generation has been taken 
away from the utilities and provided to the merchant class, 
which, as said before, has now lost $188 billion of market 
capital during the last year. They are controlling power 
generation. This is a bit of a frightening world here at this 
point.
    Does this bill solve everything? No, it does not solve 
everything. Is it a good step forward to what it intends to 
solve? Yes, it is, and we heartily support it. Thank you, 
Senator.
    Senator Lugar. Thank you very much.
    [The prepared statement of Mr. Wolkoff can be found in the 
appendix on page 152.]
    Senator Lugar. Mr. Green.

 STATEMENT OF RICHARD C. GREEN, CHAIRMAN, AQUILA, INC., KANSAS 
                         CITY, MISSOURI

    Mr. Green. Thank you, Chairman Lugar and members of the 
committee. As Chairman of Aquila, I appreciate the opportunity 
to testify today and want to emphasize that I am speaking for 
Aquila today and not anyone else in our industry. You should 
understand that Aquila is an integrated energy and risk 
management company based in Kansas City, Missouri, with 
customers and operations across the United States, Canada, 
Europe, New Zealand, and Australia. We own traditional 
investor-owned utilities in Missouri and Kansas, Colorado, 
Nebraska, Iowa, Michigan, and Minnesota. We also own and 
operate generation, transmission, distribution, and gas storage 
facilities.
    Until recently, we were very active in the energy trading 
business, both in electricity and natural gas. In fact, we were 
in that business from its inception 17 years ago, rising to be 
consistently the nation's No. 2 or No. 3 trader in natural gas 
or electricity. Recently, we initiated a restructuring that 
included a significant downsizing of our trading operations for 
both electricity and gas due to the tightening credit and 
capital requirements for energy traders.
    I have three main points that I want to make today. First, 
it is clear that the Enron collapse has had an enormous impact 
on shareholders and employees of energy trading companies, 
irrespective of the company's track record or its soundness. A 
crisis of confidence exists, especially from rating agencies 
and capital markets.
    Second, I need not tell this committee how valuable 
derivatives have been for agriculture. Derivatives are no less 
important in the energy industry. The loss of a substantial 
portion of energy traders will ultimately have an adverse 
effect on energy supply and prices as competition diminishes.
    The third point that I want to make is that it is critical 
for bodies such as this committee to work quickly to remove 
uncertainty from the markets, to make corrective remedies where 
warranted, and to allow the energy industry to get back to the 
business of building critically needed infrastructure. The 
entire energy sector has experienced a state of upheaval since 
the California energy crisis and the Enron bankruptcy. The 
troubling effects of these events have expanded to affect all 
energy traders, even those who had nothing to do with either 
the California market or Enron's inappropriate practices.
    My company withdrew temporarily, but significantly, from 
the California markets in the fourth quarter of 2000. We saw 
instability in the market, which made the level of risk to 
participate too high. Moreover, we did not engage in the kinds 
of improper accounting or trading practices for which Enron has 
become notorious. We played by the rules. Yet, we as well as 
many others were swept up in the same wave of uncertainty and 
lack of confidence that has resulted in credit downgrades and 
investor flight. Consequently, a substantial portion of the 
trading industry has reduced their trading activities or 
withdrawn altogether.
    The Commodities Futures Modernization Act of 2000 was a 
significant step forward for financial market development. Its 
primary act was to provide legal certainty for the over-the-
counter or off-exchange derivatives markets. Congress provided 
the legislation necessary to enable companies to actively 
engage in transactions with derivative products, to manage 
their price risks, and provide stability in their business.
    We at Aquila do not believe that the current CFMA led to 
the crisis in the industry. We are not sure that one can put 
the responsibility on the wording of any specific Federal law. 
Today, we believe that the Act gave ample authority to address 
fraud and market manipulation. However, we are here to decide 
whether the current law should be modified, given the current 
situation.
    We believe that restoration of public confidence in this 
industry does require revision in the current law. The current 
business climate, not just in energy, is, frankly, perilous. 
The difficulties are both structural and psychological. The 
country as a whole has been distrustful about business ethics, 
financial reporting, accounting practices, and the use of 
financial instruments, such as derivatives. Companies have gone 
out of their way in annual reports to say that they do not use 
derivatives. Credit agencies, in response to the Enron 
collapse, are exercising heightened scrutiny of energy 
companies using business practices that were perfectly 
acceptable only 3 months ago.
    You have a right, and perhaps an obligation, to ask, does 
the activity of energy traders add value to the marketplace and 
do energy initiatives matter? The answer is, yes. Derivatives 
have been shown to be a critical factor in investment and 
growth of the economy. By utilizing futures, options, swaps, 
Aquila and companies like it are able to take price risks from 
someone who does not want it and distribute it to someone who 
will accept it. The use and value of derivatives in the energy 
industry is no different than the more mature industries like 
agriculture and banking.
    Chairman Harkin earlier asked about how these derivatives 
affect people. Well, here are a couple of examples. Aquila has 
a custom derivative product called the guaranteed bill that a 
Midwestern regulated utility offers to its residential 
customers that provides for a fixed monthly bill on natural gas 
with no surprise adjustment at the end of the period.
    Another example of the benefits of customized derivatives 
is our contract with the Sacramento Municipal Utility, which 
provides them power or cash when there is insufficient rainfall 
for their hydroelectric generation to operate. This allows the 
Sacramento utility to protect its customers from rate increases 
to cover the costs of purchasing last-minute power at high 
prices on the open market during periods of drought. These 
benefits need and should continue.
    We urge this committee to take action to quickly put 
remedies and safeguards in place to help restore the confidence 
in the beneficial reliance on energy derivatives. To that end, 
we at Aquila especially appreciate Senator Feinstein's 
willingness to listen to industry concerns as she moved forward 
with her proposal. S. 1951 ensures that information necessary 
for review and oversight by the CFTC to do its job is provided 
on a timely basis. We support Senator Feinstein's latest 
version of her bill as it provides the necessary safety nets to 
restore public trust while not impeding the dynamics of the 
marketplace.
    These proposed changes in the current law will increase 
transparency through better and more detailed reporting of 
transaction data, give the appropriate regulatory agencies 
abundant and unambiguous authority to investigate anti-fraud 
and anti-manipulation tactics that have been so critical in 
destroying investor confidence, and require for bilateral 
dealer markets the use of value-at-risk models, or in very 
limited circumstances and where the Commission determines the 
risk demands it, the application of minimal capital 
requirements. These measures will provide the openness and 
accountability so that we start the task of rebuilding 
confidence in the energy trading industry.
    I have talked a great deal about public trust, the 
importance of instilling it. I know that this committee will do 
what it can to restore certainty in the marketplace and provide 
protection for consumers. However, it will be up to corporate 
America to behave in a way that earns the public trust. Thank 
you for the opportunity to appear before this committee.
    Senator Lugar. Thank you very much.
    [The prepared statement of Mr. Green can be found in the 
appendix on page 164.]
    Senator Lugar. I want to thank each one of you for 
extraordinary testimony, and by unanimous consent, all of the 
testimony you have offered in prepared form will be made a part 
of the record, in addition to comments that you made this 
morning. This abbreviated testimony was a desire to make sure 
all could be heard.
    Let me just at this point defer to my colleagues. We are 
going to have a roll call vote on the Senate floor, I 
understand, in about 3 minutes' time, and that will probably 
effectively bring to a conclusion the hearing this morning. 
Before that occurs, let me call first of all on Senator 
Fitzgerald.
    Senator Fitzgerald. Thank you. Mr. Patrikis, I gather you 
are from the International Swaps and Derivatives Association.
    Mr. Patrikis. I am a Director of the Association, yes.
    Senator Fitzgerald. I have been reading the prepared 
testimony during the course of this hearing and I wanted to ask 
you some questions about it. You state in the prepared 
testimony a very good case for legal certainty in the financial 
derivatives industry, but I do not think anybody is arguing 
about the need for legal certainty. Everybody agrees that there 
is that need and nobody wants to undermine that. However, in 
non-financial commodities, such as energy or metals trading 
online, do you not think it is reasonable to have a prohibition 
in the Act against wash trades?
    Mr. Patrikis. What we heard today was that the CFTC 
believes that it already has jurisdiction to deal with that. If 
that is the case, as the Chairman of the CFTC said, I agree 
with him. Wash trades are bad----
    Senator Fitzgerald. Well, we had, I would say, substantial 
conflict on that. Mr. Erickson said he did not believe they do 
and Mr. Newsome was not quite so sure.
    Mr. Coffee, you are a law professor. Do you think the CFTC 
right now could pursue an online energy exchange for wash 
trades? Is there that----
    Mr. Coffee. There is a regulatory hole. If 2(g) is read 
with a plain meaning analysis, it says there is no authority 
over someone who falls in 2(g). There could be issues about 
whether Enron online truly qualified as an electronic trading 
facility. I am not saying litigation could not try to fight at 
the edges as to whether you fell within 2(g). If you fall 
within 2(g), the plain meaning says there is no authority.
    I understand Mr. Erickson's position. Commissioner and 
chairman Newsome was a little bit more equivocal, and I am not 
sure I fully understand the basis for his position.
    Senator Fitzgerald. Mr. Patrikis, you agree wash trades 
should be banned, that they should not be legal.
    Mr. Patrikis. Correct.
    Senator Fitzgerald. You think they should be banned?
    Mr. Patrikis. No, I think they are banned. If the issue 
is--we get back to the same question again. If they already are 
subject to the authority----
    Senator Fitzgerald. They are banned on the NYMEX or the 
Chicago Board of Trade. Everybody agrees with that. I have been 
looking through the Act, trying to find someplace where the 
CFTC would have authority to go after a wash trade on Enron 
Online, now owned by USB Warburg, or on the Intercontinental 
Exchange. I do not find it. You just had a distinguished law 
professor say he does not see it. Mr. Wolkoff, do you believe 
that the CFTC has that authority right now?
    Mr. Wolkoff. No. It is unambiguous. Under the rules 
preventing wash trading, specifically state that they apply to 
futures transactions, the Part 35 prohibition, which was 
explicit in applying wash trading prohibitions to swaps. That 
language has been removed in 2(g) and 2(h). Regardless of which 
section you believe Enron Online or any of these other 
facilities falls under, the wash trading provision is 
conspicuously not there. It is simply not there and you cannot 
imply a statutory prohibition when the statute expressly 
excludes the prohibition.
    Senator Fitzgerald. Now, given that confusion, Mr. 
Patrikis, what is the problem with making it clear that the 
CFTC, for example, could go after and pursue enforcement 
actions against people engaging in wash trades on these online 
energy and metals exchanges?
    Mr. Patrikis. I said in my statement this morning that if 
the CFTC does not have authority to go after these trades, it 
should have the authority. The difference is, does it have the 
authority? I go with the Chairman. I work for a chairman. I 
like to follow that chairman. We have heard the Chairman of the 
CFTC speak. I assume he has a general counsel who is helping 
him. He thinks he has the authority.
    I say, first, let us wait and see what the abuses are. Has 
it involved swaps or does it involve cash spot trades, and then 
see if he has the authority he has. He says he has the 
authority. We think he does. I am not an expert in this area of 
the law, but he speaks for the Commission.
    Senator Fitzgerald. I have an article from the Chicago 
Tribune right here talking about wash trades and saying that 
they have occurred in the online energy industry. It seems 
clear enough for the Chicago Tribune, which is a very careful 
newspaper. They say that wash trades are used to inflate 
numbers on both sides. They serve no other economic purpose. 
They have a chart here, one company selling a power contract to 
the other company at a certain price and that other company 
selling it right back to the first seller at the same price, 
returning the power. Also, both sides are recording revenue 
from these sales.
    The Tribune asks, why do it? They say companies could use 
these sales to inflate their numbers, making the companies 
appear bigger than they really are. Then they ask, is it legal? 
They say, because the wholesale energy market is not regulated, 
such transactions appear to be legal. Similar sales, however, 
are prohibited in regulated financial markets. Now, according 
to the Chicago Tribune, I am saying that this is the Chicago 
Tribune saying this--I have not independently verified it--but 
they say CMS Energy Corporation, Dynegy, Inc., and Reliant 
Resources took part in wash sales.
    It seems to me we have a lot of people saying this is going 
on. Why not let us just make it crystal clear that the CFTC has 
the authority to ban these wash trades? Is there any public 
benefit to wash trades? Does anybody want to defend wash 
trades?
    [No response.]
    Senator Fitzgerald. Nobody wants to defend it. It seems to 
me that one of the reasons I understand the NYMEX's volume has 
been going way up is that people are migrating away from these 
unregulated companies, companies that have no regulation at 
all. People do not want to participate in that now after all 
the disclosures have come out about abuses in wash trades in 
the energy market, and I do not even think it is in the long-
term best interest of companies such as the Intercontinental 
Exchange to fight some simple level of regulation that would 
bring some transparency and some ability to ban practices that 
everybody seems to agree should be illegal, like wash trades.
    I wonder if Mr. Wolkoff could address what has happened to 
the NYMEX's volume recently.
    Mr. Wolkoff. For the first 6 months of this year, our 
energy volume is up about 30 percent, and due to a number of 
factors, but one of which clearly has been the loss of market 
confidence in over-the-counter markets. Notwithstanding that, I 
think that for the long-term health and well-being of the 
market, it is not a positive that there is a loss of confidence 
in the over-the-counter markets and I do not think it is a 
positive going forward for market competition and I do not see 
it as an ongoing positive for the NYMEX to have this situation.
    Senator Fitzgerald. I could actually argue that you should 
maybe be arguing on the other side, let us not close this 
loophole, because you are benefiting from it. All this business 
is migrating from the wild West over to where customers have 
some confidence that there is some ability on the part of 
regulators to ban fraudulent practices and to have some price 
discovery.
    Senator Lugar. Senator Fitzgerald, let me just interrupt 
for a moment, if I may, to recognize our colleague, and then we 
will come back.
    Senator Crapo.
    Senator Crapo. Thank you very much. I would like to just 
get into a couple of quick issues. One of the allegations that 
is very regularly thrown around here is that the Enron collapse 
is somehow attributable to the failure to properly regulate 
derivatives, and I have asked most witnesses we have had before 
us on this issue if they are aware of any evidence of that 
fact. Is anybody on the panel aware of any evidence, and I am 
not talking about this argument about impact on prices in the 
market in general of improper uses of swaps or whatever, but is 
anybody on the panel aware of any evidence that shows that the 
Enron collapse is attributable to the derivatives market?
    Mr. Dodd. I can offer an explanation. If you look at, 
first, the role that derivatives were used to hide the debt, 
hide the losses and fabricate income, and generally distort 
their balance sheet and financial reports in a way that caused 
the larger market to lose confidence in Enron, I think in the 
first act, they played a very critical role in undermining that 
market confidence and sending Enron into deep trouble.
    Now, when that happened and people ceased to trade with 
Enron Online because no one wanted as a counterparty an entity 
whose credit rating was in a great deal of doubt because their 
past reporting was not what they thought it was, and when 
people----
    Senator Crapo. So----
    Mr. Dodd. Just one last point, please, sir. I am sorry. 
When people ceased trading with Enron Online, then they lost 
liquidity. They no longer made their income as a dealer. They 
no longer earned their bid-ask spread. That was the remaining 
profitable part of the corporation, and then they no longer had 
a profit source.
    Then when their credit rating did drop and they were hit as 
sort of being super-margined, by having to come up with more 
collateral for their derivatives contracts, that was, in fact, 
the day they declared bankruptcy because that is when they 
could no longer feasibly operate and the lights went out on the 
trading platform.
    Senator Crapo. You are testifying that Enron's use of 
derivatives contracts is what allowed Enron to distort its 
financial picture?
    Mr. Dodd. Yes. They used them in conjunction with the 
special purpose entities to hide debt. They moved it into these 
special purpose entities, as you recall, right, and showed that 
they sold the products for an exaggerated price, and then they 
used the swaps to then pay back the Enron parent a profit from 
the transaction, so they reported that as income. They also 
borrowed money, as we saw in this case with the insurance 
companies, from J.P. Morgan Chase----
    Senator Crapo. Now were those, what we are seeing here, 
called the illegal swap transactions or the wash transactions?
    Mr. Dodd. They were legal, and I think that is one of the 
problems, that it is not just a matter of bad apples but we 
have some bad rules.
    Senator Crapo. Legal or not, were they wash transactions 
that you are talking about?
    Mr. Dodd. Some of them were, some of them were not. It goes 
beyond wash transactions because it was not even with another 
entity. It was just, if you will, within Enron, between the 
parent and the----
    Senator Crapo. Well, that is my point. If you are saying 
that a derivatives transaction was used in one of these other 
relationships that you are talking about, I mean, a regular 
contract that we all learn about in contract law in law school 
could have been used, as well. Does the fact that you can find 
a totally legal derivatives transaction involved in the Enron 
circumstance, does that mean that the derivatives transaction 
itself was suspect?
    Mr. Dodd. I do think it was an unproductive use of the 
derivatives contract to avoid financial reporting rules to 
disclose their debt from their investors, and in that regard, I 
do think the derivatives were critical----
    Senator Crapo. I am having a hard time seeing how a 
derivatives contract could be used to avoid financial reporting 
rules.
    Mr. Dodd. They used them not to avoid the rule. They used 
them to outflank the rule, if you will, because they moved 
their debt into the special purpose entities. They disclosed 
some of the losses by moving those into the special purpose 
entities through these derivatives trades. Then to cap it all 
off, they sold their stock to some of these special purpose 
entities to enable the special purpose entity to pay off a 
profitable swap they did back to the parent Enron and they 
reported that as income.
    Senator Crapo. Mr. Patrikis has been trying to get in here. 
Let us let him----
    Mr. Patrikis. It is a little difficult to conclude that 
swaps caused Enron's collapse.
    Mr. Dodd. I did not say caused.
    Mr. Patrikis. Well, are a major contribution.
    Mr. Dodd. I said they were used----
    Mr. Patrikis. I would like to continue testifying.
    Senator Crapo. Certainly. Go ahead.
    Mr. Patrikis. That the firm lacked profit. It had losses. 
It made acquisitions. It could not afford it. It had debt. It 
could not cover its debt. It did everything it could to hide 
the debt. It used a variety of sources to do it. I do not think 
swaps was a major contribution to that. The company had a good 
name. It was able to sell off these SPEs to parties who were 
dealing with a good name. That is the source of it.
    As to the Enron dealing subsidiary, we heard today, well, 
Dynegy saved everybody. As Enron's trading subsidiary got into 
trouble, it was willing to close out trades with 
counterparties, as is typical in the case. If we want to know 
who was hurt by Enron, want the trading subsidiary, we can go 
to the bankruptcy court and see that there were companies who 
were in the money, who owed Enron money, they had trades that 
were favorable to Enron that were not closed out and they are 
debtors of the estate. They will be paying money into the 
estate. The swap agreement provides for this.
    The fact that people were able to close out trades was not 
due to Dynegy, it was due to this legislation that this 
committee has fostered, including the bankruptcy legislation, 
that allowed orderly close-out of trades. That is something 
ISDA and this committee have worked on very hard. That the work 
this committee did helped facilitate Enron not being a systemic 
situation.
    Now, the companies dealing with Enron were much better off 
than we go to long-term capital management because of risk 
management. The companies in this business have market risk and 
credit risk people working. We at AIG do it through our profit 
centers where there is market risk and credit risk and we do it 
at the holding company overlooking it. Those firms manage their 
risk well. We had losses from Enron. The losses were 
containable. The losses were not material. Why? Because we 
managed risk.
    That is a better part of the Enron story, is how can you 
have the largest bankruptcy in the history of the United States 
and not have dominoes. It shows, yes, people will make 
mistakes, people can be misled, shareholders can be hurt, 
employees can be hurt, but it was managed. We can contain it.
    Senator Crapo. Mr. Coffee, you are the law professor here 
and so you have been approached several times in questions on 
that issue. Let me just go to you on this. I realize that there 
is an investigation underway and we may find more, but based on 
what you are aware of at this point, is there any evidence that 
you can see that the use of derivatives or swaps by Enron 
caused its collapse?
    Mr. Coffee. In my judgment, on the available evidence, 
Enron's failure was caused by accounting irregularities and 
corporate governance failures. There may be some, what I will 
call spurious hedging, in which Enron moved assets from its 
left pocket to its 97-percent-owned right pocket, but I do not 
think that that reflects on the market as a whole. That was 
self-deception by which Enron convinced itself and its 
shareholders that it did not have liabilities that it really 
did have, and I consider that to be fundamentally a corporate 
governance failure and an accounting failure.
    Senator Crapo. Thank you. I realize my time is running out, 
as well. Thank you, Mr. Chairman.
    Senator Lugar. Thank you, Senator Crapo.
    Gentlemen, Senator Fitzgerald has indicated that he wishes 
to return and ask some more questions. I hesitate to ask you to 
stay indefinitely, and I will not do that. We do have a roll 
call vote underway, so I am going to declare a recess of the 
hearing pending the reemergence of my colleague, Senator 
Fitzgerald. At that point, he will preside over the meeting as 
he completes his questioning.
    I want to take this occasion again to thank each one of you 
for your extraordinary patience. This has been a hearing now of 
well over 3 hours, but one that I believe has been productive 
for our understanding and for that of the public. We will 
proceed at least as constructively as we can on the basis of 
the wisdom you have given to us.
    For the moment, the hearing is recessed, and I will ask the 
staff to at least be referees in terms of a reasonable time. I 
presume my staff will be back soon. He left that impression as 
he departed. At a reasonable time, in the event he does not 
return, then the recess should be concluded and the hearing 
adjourned. I thank each one of you.
    [Recess.]
    Senator Fitzgerald [presiding]. Thank you for sticking 
around. I just have a few remaining remarks and I think the 
other Senators are probably headed to the lunch now following 
our vote, but I do want to give each of you the opportunity to 
wrap up your thoughts on the issue.
    I do want to call to everybody's attention, on July 6, just 
a few days ago, in the Washington Post, they reported, ``Energy 
Firm Restates by $7.8 Billion,'' and if I could read you this 
paragraph, ``Reliant Resources restated its results for a 3-
year period during which the company said it engaged in trades 
that artificially inflated its revenue by more than $7.8 
billion. It said cash-flows, operating income, and net income 
were not affected. In its filing with the Securities and 
Exchange Commission, Reliant said, 'round-trip trades' the 
company engaged in during 1999, 2000, and 2001 should not have 
been reflected in its revenues or expenses. The trades added 
$6.4 billion to the company's revenue during that period. The 
company's revenue also was inflated by nearly $1.5 billion 
because of how it accounted for four other energy contracts. 
Reliant described those deals as swaps.''
    Professor Coffee, would you care to comment on what I just 
read to you, what implications that has for our discussion here 
this morning?
    Mr. Coffee. I would say that the obvious implication of 
that article is that that company, a publicly held company, 
must have believed that the CFTC lacked jurisdiction over these 
kinds of transactions. Now, they could have been right or they 
could have been wrong, and I understand that there is a 
sincere, good faith belief of some in the CFTC leadership that 
they do have jurisdiction. The industry does not agree with 
them and we once again have legal uncertainty, and I think the 
simplest way to resolve that is for Congress to speak. They 
could resolve this question much quicker than would be the 
process of litigation if the CFTC found an appropriate case to 
bring.
    Senator Fitzgerald. Now, you are a securities law 
professor, correct? In fact, did I have a textbook of yours? 
Did you write a----
    Mr. Coffee. There may be. I am co-author of the best-
selling securities regulation textbook.
    Senator Fitzgerald. How long has it been out?
    Mr. Coffee. It was the first one. It is in the ninth 
edition now. It came out in about 1980.
    Senator Fitzgerald. Well, I graduated from law school in 
1986, and so that may have been your casebook. I guess you 
might be responsible if I do not know enough about securities 
laws. You might be partly responsible.
    Mr. Coffee. I am responsible for thousands, then.
    Senator Fitzgerald. Clearly, Reliant could have a 
securities law problem, possibly----
    Mr. Coffee. Oh, certainly. There is no question that they 
have overstated their revenue. They may not have overstated 
their net income because this is a wash transaction.
    Senator Fitzgerald. Right, but the SEC might take the 
position that the revenue and the expenses from those wash 
trades should not have been included in their statements, their 
financial statements.
    Mr. Coffee. Certainly, that is a point that the SEC could 
raise, but I thought for purposes of this hearing it seems to 
me strongly apparent that the company must have felt that it 
was not illegal to engage in wash trades, which is the critical 
question for this body.
    Senator Fitzgerald. For CFTC purposes. Now, Mr. Patrikis, 
you seem vastly outnumbered, I think, based on----
    Mr. Patrikis. That is OK.
    [Laughter.]
    Mr. Patrikis. My first question really is, is the 
Washington Post better than the Chicago Tribune in terms of the 
accuracy of the reporting? I do not know what ``swaps'' means 
in this instance. I do not know if it is two spot trades back 
and forth. It sounded like there were two simultaneous trades 
the same day. I do not know enough. I will go to the Financial 
Times, February 19 of this year, the need for better financial 
reporting, the SEC and proposals for accounting regulatory 
board will deal with that. It seems to me the issue like this 
wash trades also, but the accounting side, public companies 
doing things like that to puff up the balance sheets. It is 
just a despicable practice all around.
    Senator Fitzgerald. Do you think this problem could be 
addressed just by the SEC making clear that wash trades should 
not be accounted for on the income statements, and then, 
therefore, there would be no reason for a company to engage in 
wash trades because you would not get the inflated revenue from 
the wash trades?
    Mr. Patrikis. No, I do not say that. I say that is one 
reason why it is bad, and wash trades are bad and the CFTC says 
it has jurisdiction over wash trades. It is doubly bad.
    Senator Fitzgerald. Now, do you think there are any banks, 
for example, that engage in interest rate swaps, for example, 
that amount to wash trades? Do you think that is going on? That 
is really not the subject of the Feinstein bill----
    Mr. Patrikis. I have never heard of it. I do not know what 
they would accomplish. The interest rate in our markets is set 
in the Federal funds market. It is the largest free market, 
outside the government securities market, in the world, and the 
only person who manipulates that market that I know of is the 
Fed, which presumably does it legally.
    Senator Fitzgerald. Would anybody care to comment on that? 
Does anybody think wash trades would be going on with 
financial----
    Mr. Coffee. It would not be going on with the purpose of 
trying to create a short-term spike in the market price. It 
might occur in the energy market, but the real motive was not 
to overstate your revenue but to create a short-term spike in 
the market price to affect consumer prices.
    Senator Fitzgerald. To establish a price. There would be 
two reasons for a wash trade, one to goose your revenues, but 
two, also to set a fictitious price.
    Mr. Dodd. Senator, I think, also, it raises the next 
question. We focused a whole lot of our time here just on 
ascertaining whether or not the Commission has authority over 
wash trades. Even once we have clarified that and established 
it once and for all, you are still left with the critical 
problem of how are they going to enforce that, and without 
reporting requirements, they are going to have a very hard time 
actually enforcing that prohibition in any effective way, and I 
think it is worthwhile pointing out at this juncture, then, how 
easy reporting requirements and how costless reporting 
requirements are because people that trade derivatives nearly 
all through the instant master agreement, they all confirm the 
trades through electronic messages between the counterparties.
    All that is required to report this vast world of over-the-
counter derivatives transactions is to ``cc'' the government on 
the electronic confirmation messages, and that would give an 
extraordinarily cheap and standardized audit trail and paper 
trail for any supervisor to use to try to detect this activity. 
You could, if it was properly standardized, just do a computer 
algorithm to run through the data to catch trades that occur 
between counterparties on the same day at the same price. Those 
are things that could be made available to regulators for 
practically nothing.
    Senator Fitzgerald. Would there be another possibility, and 
I will get to Senator Crapo and certainly give him plenty of 
time. There are a lot of motivations that people could be 
opposed to Senator Feinstein and my amendment, but one of the 
concerns I have is that with a lack of transparency on online 
energy trading platforms and metals trading platforms, is it 
not possible for the customer of that facility to not be 
getting the best price?
    Could I call Enron Online, or USB Warburg Online now, ask 
them to pick up a natural gas contract for me at, say, 265? 
Could they then go online, and maybe they could buy it at 263 
but sell it to me at 265? I would really never know that I got 
shaved, would I, because I have no ability to--there is no 
transparency in this market. Would Mr. Wolkoff want to address 
that?
    Mr. Wolkoff. I do not actually think there is anything 
illegal about that. Many participants in the market would 
simply say that that is good trading unless there was some sort 
of a brokerage, a fiduciary duty between them and you.
    It becomes very hypothetical and I think that there are 
many possibilities, and part of the problem right now is that 
without knowing the realities, people are free to have 
imagination run wild, because there are some pretty bad stories 
that have been confirmed, including the ones you have read, out 
in the----
    Senator Fitzgerald. A retail investor could not go online--
--
    Mr. Wolkoff. No. The retail investor is prohibited unless 
they meet certain asset requirements which bring them into a 
sophisticated investor category, like $10 million of net worth 
type of thing.
    Senator Fitzgerald. Then could that sophisticated investor 
call Enron Online and ask them to buy a natural gas contact for 
them?
    Mr. Wolkoff. I am not as familiar with exactly how that 
system works now, but my understanding of it is that they are 
not operating in a brokerage capacity. They are operating as a 
principal in a market, and so that when you do business on that 
platform against UBS, UBS is a buyer or a seller and you, as 
the counterparty, are the reverse of that. If UBS is able to 
sell to you at a higher price than they have been able to buy 
from somebody else, they owed you no obligation to lose money 
on your behalf. They are not a fiduciary in that regard. If it 
were a system where they are operating as a broker, 
essentially, where they are taking orders and then taking 
obligations----
    Senator Fitzgerald. Who is trading on those online energy 
platforms?
    Mr. Wolkoff. Nowadays?
    Senator Fitzgerald. Yes.
    Mr. Wolkoff. Very few. In the past, it was----
    Senator Fitzgerald. Well, who would be some of the 
examples?
    Mr. Wolkoff. Many of the merchant companies. You have the 
large----
    Senator Fitzgerald. Could you give some examples?
    Mr. Wolkoff. AEP, Aquila, whether on that particular system 
or not, you certainly had Enron, you had J. Aaron, you had 
Morgan Stanley. These are large participants in the energy 
world, Dynegy. I am sure Mr. Green would be more adept at 
reeling these names off.
    Senator Fitzgerald. Mr. Green, you are a part owner of the 
Intercontinental Exchange, correct?
    Mr. Green. Yes.
    Senator Fitzgerald. You also trade on that exchange?
    Mr. Green. To a lot lesser extent today, since we are 
shutting down the business, our selling business.
    Senator Fitzgerald. You do favor some, even though you are 
an owner of the Intercontinental Exchange, you do favor some 
greater regulatory oversight?
    Mr. Green. Oh, no question about it. What we have seen 
happen in this marketplace and the colossal breach of trust by 
corporate America, we have to start building it back and you do 
not build it back by saying, let us wait and see. You start 
taking steps, and that is why we are in favor of your 
amendment.
    Senator Fitzgerald. The other owners of the company do not 
agree with you, is that correct, and that is why they have Mr. 
Patrikis----
    Mr. Patrikis. No, we do not participate. To the best of my 
knowledge, my company does not participate in it.
    During the break, I talked with someone about it since I 
did not understand it, and I will try to give you how I think 
it works, but maybe Mr. Green can correct me. Instead of a 
telephone, we have a computer facility that allows parties to 
be introduced to each other. It replaces the telephone. There 
is no broker. There is no intermediary. There are a standard 
contract similar to the foreign exchange market or the interest 
rate swap market. There are some basic terms that are 
standardized in it.
    In order to go into business, ICE has to file notice of its 
existence with the CFTC. It has to tell the CFTC that its 
owners are not criminals. It has to make its rules available to 
the CFTC. The CFTC has online connection. It has access to the 
trading platform for information.
    Two counterparties in the marketplace, two of these 
sophisticated investors are introduced to each other and say, 
let us do a deal. Then they go offline and they negotiate the 
credit terms. Do I want collateral?
    I also think the system has built into it that----
    Senator Fitzgerald. They go offline?
    Mr. Patrikis. They have to then negotiate the credit terms. 
In other words, I may require collateral of you. I may require 
collateral of you if my exposure to you is more than $10 
million or $25 million. The credit risk is managed bilaterally, 
or I think the system has built into it that I just may not do 
business with a certain party. I do not like Goldman Sachs. I 
can say I will not do any trade with Goldman Sachs because I 
already have too much credit risk to Goldman Sachs.
    We finish negotiating the terms of the swap agreement. It 
is the terms that are the financial terms of the transaction 
are standardized, but then we go offline. This just replaced 
the telephone. That is all it has done, is replaced the 
telephone and through these standard terms makes it easier to 
do business.
    My understanding from what we heard from the Chairman of 
the CFTC today, if this system, which does not have retail, 
does not do clearing, and may not do price discovery, if it 
becomes a price discovery vehicle, then the CFTC has 
jurisdiction under the existing rules. I do not know what he 
was--when he was referring to what they were looking into, 
but----
    Senator Fitzgerald. What section of the law gives----
    Mr. Patrikis. I am not an expert on this statute.
    Senator Fitzgerald. Now, if two sophisticated principals 
like you just described were trading agricultural commodities 
in an online platform like that, that would be regulated by the 
CFTC. They could ban wash trades. What is the public policy 
rationale for picking out energy contracts, which are also in 
finite supply, just like agricultural commodities and other 
non-financial commodities, and metals contracts, which metals 
also have a finite supply, what is the public policy rationale 
for this special carve-out for energy and metals? Why do they 
get this special treatment?
    Mr. Patrikis. I, frankly, do not know, and we heard this 
morning from earlier witnesses, I do not think there is anyone 
around that does, who did the deal. The people who did that 
transaction had a motivation. I do not know what it was.
    Senator Fitzgerald. Who put the bill together?
    Mr. Patrikis. Right, in conference.
    Senator Fitzgerald. As we had it in Senate committee, it 
did not have that special carve-out and somehow, this----
    Mr. Patrikis. In conference.
    Senator Fitzgerald [continuing]. Special carve-out came and 
it does not seem to have a father. No one can figure out who 
did it.
    Back to Mr. Green. Have you talked to the other owners of 
ICE about this issue, and how many owners of ICE are there? Is 
there publicly available information? I know I have seen some 
reports of who the owners are.
    Mr. Green. I would think so. I am not sure. There are maybe 
15. I am not really sure.
    Senator Fitzgerald. Some banks, some energy companies, 
right?
    Mr. Green. Yes, and certainly, and that is why I said in my 
testimony very clearly I was speaking for Aquila and not beyond 
that, because there is not unanimous agreement on how we 
approach this situation.
    Part of it is an effort to keep the good, positive effect 
of derivatives going on in the market like what we have done in 
Sacramento and what we do with homeowners in the Midwest and 
their gas bills, you need an over-the-counter off-exchange 
market to be able to put together those derivatives.
    Take the Sacramento derivative that we have with that 
municipal utility. When you talk about putting a package 
together that starts to take away rainfall risk and power price 
risk and a list of other risks, you need to be able to go over 
and put all those risks somewhere else and that takes a complex 
kind of conversation with sophisticated players. It is not a 
simple, standard commodity that you could do on the NYMEX. 
There is a need for that.
    Now, at the same time, we need transparency and make it 
open so you cannot have other things happen, but there is a 
need for that, in general.
    Senator Fitzgerald. Senator Crapo, you have been waiting 
patiently, so please, take your time here.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Actually, you asked the question that was going to be my 
first question, although I was going to ask it a little 
differently, and I will ask it differently to see if it evokes 
a different piece of the response.
    As I read the Act, and I am trying to learn just what 
happened myself when the CFMA was passed, it creates three 
categories, one called excluded transactions, which are 
financial derivatives; one called everything else, which are 
exempted derivatives--one is called everything else but 
agriculture transactions, and that is called exempted 
transactions as opposed to excluded transactions; and then 
there is agriculture.
    My question is, why was agriculture carved out? Does 
anybody know? I mean, agriculture is all by itself----
    Mr. Dodd. Farmers would not prohibit the bill from passing.
    Senator Crapo. Is that what it was?
    Mr. Dodd. Yes, sir, I think that is a very succinct answer.
    Senator Crapo. Basically, the agriculture community wanted 
to be an exchange-traded market, and had it not been for the 
agriculture position there, they would have been in the 
exempted category.
    Senator Fitzgerald. Can I clarify that a little bit?
    Senator Crapo. Sure. If anybody can clarify it, I would 
appreciate knowing.
    Senator Fitzgerald. There are three levels. I mean, there 
is full regulation like you have at the Boards of Trade in New 
York and Chicago. Then there is a middle-tier category for 
online trading facilities. Then there is no regulation for, 
like, financial derivatives. Even if you were to trade 
agriculture commodities, I think it would be possible, if you 
were to trade them online, you would get this middle-tier 
regulation.
    Senator Crapo. That is not how I read the Act. Is that 
correct?
    Senator Fitzgerald. All agricultural commodities have to be 
traded on--it would be impossible to set them up--Mr. Wolkoff?
    Mr. Wolkoff. My understanding, and it may not be a perfect 
understanding, is that agricultural----
    Senator Fitzgerald. You could not have the DTEF, in other 
words, that----
    Mr. Wolkoff. Agricultural commodities could be traded on a 
DTEF but could not be traded on an exempt transaction facility. 
The three levels are contract market, which is a regulated 
change; a DTEF, which is a hybrid of an unregulated market and 
a regulated market; and an exempt transaction facility, which 
is where, say, the Enron Online and the Intercontinental 
Exchange fall out. As an exempt transaction facility, you are 
not permitted to have under that exemption agricultural 
commodities trading. It does not obligate----
    Senator Fitzgerald. OK, but you could trade them on a DTEF, 
right?
    Mr. Wolkoff. I believe that is correct, only with certain 
participants.
    Senator Fitzgerald. You could trade them on a contract 
market, like the Board of Trade----
    Mr. Wolkoff. I did not hear you. I am sorry.
    Senator Fitzgerald. You could trade agricultural 
commodities on a contract market or on a DTEF but not on an 
exempt----
    Mr. Wolkoff. That is my understanding.
    Senator Crapo. That would be my understanding. The 
definition is really clear for exempt commodities. It is 
everything that is not excluded and not agriculture.
    Mr. Patrikis. One of the reasons is there was no over-the-
counter market for agriculture at the time.
    Senator Crapo. They did not want one to become.
    Mr. Patrikis. The committee did not want one to become.
    Senator Crapo. OK. I guess----
    Mr. Patrikis. I would like to go back to what Senator 
Fitzgerald--I have been handed a cite for you, Section 
2(h)(4)(D), which provides for anti-fraud, anti-manipulation, 
and does give the CFTC the price discovery authority on----
    Senator Fitzgerald. Section 2(h)(4)----
    Mr. Patrikis. Section 2(h)(4)(D).
    Senator Crapo. That is the one I was looking for earlier 
today. Mr. Erickson referred to Section 2(h). I assume that is 
what he was referring to.
    Let me go on then. I guess the answer to why agriculture is 
treated differently is basically that there never was a 
different treatment of agriculture and the committee just 
decided to keep it that way and the agriculture community 
wanted it kept that way. What I am understanding here is that 
agriculture was treated as it is now in what I would call the 
fully regulated category. Then we created the other two 
categories, which is financial transactions, which are 
commodities which were excluded, and everything else which was 
exempted. Am I in the ballpark?
    Mr. Wolkoff. At the risk of further muddying the waters, 
there are also a category called forward contracts----
    Senator Crapo. Great.
    Mr. Wolkoff [continuing]. Which are unregulated cash, 
physical delivery contracts in which--a very common transaction 
for agricultural contracts to be traded forward from the 
planting through the harvest season, of course----
    Senator Crapo. That would be in the agriculture arena?
    Mr. Wolkoff. Well, it is not a derivative. It is a forward 
contract, so that is really a physically delivered marketplace 
that is unregulated but not covered by either the Feinstein 
amendment or the 2(h) section.
    Senator Crapo. All right. From there, then, I am assuming 
from what I have heard from every witness today that there is 
nobody who is suggesting that we should treat the exempt 
category or everything but financial transactions and 
agriculture, that we should treat that category like 
agriculture. Does anybody here believe we should just move the 
exempt category into the agriculture category?
    Senator Fitzgerald. Nobody is for requiring them to be 
traded on a board of trade like the Chicago Board of Trade and 
subjecting them to the full-blown regulations.
    Senator Crapo. That is what I understand. That is what I 
wanted to get clarified. OK. We have all these categories, and 
it is agreed by everybody that the exempt category is a 
legitimate category that needs to be maintained and we may need 
to revise----
    Mr. Coffee. I would want to clarify that I think what is 
really driving these distinctions is not the nature of the 
category but the nature of the trading market. Many of these 
commodities trade among very sophisticated parties. Agriculture 
has classically traded among farmers who are retail players in 
these markets, and for that reason, we wanted to protect and 
have the highest level of regulation where we know the large 
percentage of the users of derivatives are people who cannot be 
called sophisticated financial players.
    Senator Crapo. That is a good explanation. That helps me 
understand a little better why the agriculture was so distinct. 
Nobody is proposing that we move the rest of it into the 
agriculture-type treatment.
    From there, as I am understanding the testimony today, 
there seems to be some pretty solid consistency on the notion 
that wash transactions should be prohibited. There is 
disagreement about whether there are prohibited or not, but 
there is really no disagreement about the fact that they should 
be. Is there any disagreement about that?
    [No response.]
    Senator Crapo. OK. The same thing could be said about the 
question as to whether transactions in the exempt category 
should be subject to the fraud and price manipulation 
provisions of the Act. Any disagreement of that, with regard to 
that?
    [No response.]
    Senator Crapo. Again, there is disagreement as to whether 
they already are or are not, but not disagreement as to whether 
they should be.
    From there, it seems to me that we start to break down. I 
mean, there are some other collateral issues that have been 
raised about different types of collateralization requirements 
or reporting and that kind of thing which may result in debate, 
but it seems to me that there is quite a bit of consensus on 
those basic points. Does anybody disagree with that?
    [No response.]
    Senator Crapo. Now, I have not had a chance to thoroughly 
review the Act that is being proposed now. The one we debated 
in March was distinctly different than the one we are talking 
about today, is it not, Senator Fitzgerald?
    Senator Fitzgerald. I do not think so. I have not done a 
side-by-side comparison--it is? It is completely different?
    Senator Crapo. Yes and no.
    Senator Fitzgerald. Depending on which side you are on----
    Senator Crapo. The answers are yes and no. Well, it is 
different than what I thought it was, and maybe I did not 
understand it in March as well as I should have, but I 
understood in March that it was different than what I am 
hearing today it is, and I guess what I am getting at is if the 
Act that we are talking about does nothing other than what I 
have just talked about, namely make it clear that wash trades 
are not legal and make it clear that the fraud and manipulation 
provisions are applicable to the exempt category, then I think 
we may have the ability to come together on some type of a 
consensus as to what needs to be done.
    I would just say, I am going to have to leave, but Senator 
Fitzgerald----
    Senator Fitzgerald. I guess I think it is also important to 
have some transparency on these markets, in addition to just 
banning wash trades, so that people can see the volume and the 
open interest and just disclosure requirement. It is helpful 
for the public to know what the prices are. I do not know if 
anybody else would want to comment on that.
    Mr. Coffee. I would suggest that you cannot define fraud as 
just boiling down to wash trades. There are other kinds of 
manipulations, bucket orders. There is a history of various 
kinds of manipulative games and I think the best prophylactic 
reform is disclosure, as you were saying.
    Mr. Patrikis. Price discovery, if you want transparency, 
depends on the market, the standardization, the volume, that 
you do not want it to be misleading, you do not want it to 
destroy the market. That is the issue. It is not clear with 
these markets that having price discovery mechanism in, if they 
are not at that point----
    Senator Crapo. Is the question----
    Mr. Patrikis [continuing]. That that will help the market 
grow.
    Senator Crapo. Is the question then--is this really the 
conflict?
    Mr. Patrikis. I think so.
    Senator Crapo. The conflict, then, is whether the 
disclosure requirements, the price discovery requirements----
    Mr. Patrikis. Capital.
    Senator Crapo [continuing]. Capitalization requirements or 
whatever.
    Mr. Patrikis. It is the other futures-style regulation 
raises----
    Senator Crapo. Whether that will impact the market in a 
negative way and take away the benefit that derivatives now 
provide to us.
    Mr. Patrikis. That we will not have an ICE for some other 
product, that no one will go to the effort and the expense of 
starting that market up. That is the risk. To me, we want to 
bring more capital into the market, not set up barriers to 
bringing more capital into the market.
    Senator Crapo. Mr. Chairman, I apologize. I am going to 
have to leave, but I am very interested in seeing where we can 
go from here. At least, if I do not find out that I understand 
it wrong again as I leave the room, it seems to me that we have 
found some areas where there is not disagreement and I think 
maybe I am starting to focus on where the conflict is. 
Hopefully, from there, we can resolve some of these issues.
    Senator Fitzgerald. Thank you. We are going to probably 
want to wrap this up. I want to thank Senator Crapo for working 
hard to get his arms around this big issue and I am glad not 
just people representing Chicago are interested in the 
commodities futures issues.
    I would like to close with one final thought, that I think 
that the opposition to Senator Feinstein and my bill is wrong-
headed, that it is not in the best interest of the people who 
are opposing it, because I think confidence in the online 
energy and metals trading platforms might be restored by 
allowing for some minimal government regulation. In the last 
few months, business has been migrating away from this 
completely unregulated area back to the fully regulated 
exchanges, and I do not think that Intercontinental Exchange 
has thought through its best interest on this. I do not think 
it is in their long-term interest.
    This online industry could dry up in the absence of 
regulations, and I would point out that many people were 
fearful when we adopted the Securities Act in the 1930's that 
it would kill capital markets. But, in fact, it gave us the 
greatest capital formation markets in the world, and that the 
right level of regulation that provides for, largely, 
disclosure, can be a great source of reassurance for people who 
potentially may want to participate in the market.
    I would agree that you can suffocate a market by over-
regulating it, but I do not think that the Feinstein-Fitzgerald 
bill comes close to doing that. It would actually help the 
interest of the online energy trading industry.
    With that, I want to thank all of you for your time. It has 
been a very good discussion. You have all been very patient, 
waiting through votes and so forth. Thank you all very much for 
coming.
    This meeting is now adjourned.
    [Whereupon, at 1:27 p.m., the committee was adjourned.]
      
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