[Senate Hearing 107-897]
[From the U.S. Government Publishing Office]
S. Hrg. 107-897
CFTC REGULATION AND OVERSIGHT OF DERIVATIVES
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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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Page
Hearing(s):
CFTC Regulation and Oversight of Derivatives..................... 01
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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
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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
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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
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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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A P P E N D I X
July 10, 2002
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