[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW TRADING OF ENERGY-BASED DERIVATIVES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
GENERAL FARM COMMODITIES
AND RISK MANAGEMENT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
THURSDAY, JULY 12, 2007
__________
Serial No. 110-26
Printed for the use of the Committee on Agriculture
agriculture.house.gov
U.S. GOVERNMENT PRINTING OFFICE
48-942 WASHINGTON : 2009
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gov Phone: toll free (866) 512-1800 Fax: (202) 512-2250 Mail: Stop IDCC, Washington, DC 20402-0001
COMMITTEE ON AGRICULTURE
COLLIN C. PETERSON, Minnesota, Chairman
TIM HOLDEN, Pennsylvania, BOB GOODLATTE, Virginia, Ranking
Vice Chairman Minority Member
MIKE McINTYRE, North Carolina TERRY EVERETT, Alabama
BOB ETHERIDGE, North Carolina FRANK D. LUCAS, Oklahoma
LEONARD L. BOSWELL, Iowa JERRY MORAN, Kansas
JOE BACA, California ROBIN HAYES, North Carolina
DENNIS A. CARDOZA, California TIMOTHY V. JOHNSON, Illinois
DAVID SCOTT, Georgia SAM GRAVES, Missouri
JIM MARSHALL, Georgia JO BONNER, Alabama
STEPHANIE HERSETH SANDLIN, South MIKE ROGERS, Alabama
Dakota STEVE KING, Iowa
HENRY CUELLAR, Texas MARILYN N. MUSGRAVE, Colorado
JIM COSTA, California RANDY NEUGEBAUER, Texas
JOHN T. SALAZAR, Colorado CHARLES W. BOUSTANY, Jr.,
BRAD ELLSWORTH, Indiana Louisiana
NANCY E. BOYDA, Kansas JOHN R. ``RANDY'' KUHL, Jr., New
ZACHARY T. SPACE, Ohio York
TIMOTHY J. WALZ, Minnesota VIRGINIA FOXX, North Carolina
KIRSTEN E. GILLIBRAND, New York K. MICHAEL CONAWAY, Texas
STEVE KAGEN, Wisconsin JEFF FORTENBERRY, Nebraska
EARL POMEROY, North Dakota JEAN SCHMIDT, Ohio
LINCOLN DAVIS, Tennessee ADRIAN SMITH, Nebraska
JOHN BARROW, Georgia KEVIN McCARTHY, California
NICK LAMPSON, Texas TIM WALBERG, Michigan
JOE DONNELLY, Indiana
TIM MAHONEY, Florida
______
Professional Staff
Robert L. Larew, Chief of Staff
Andrew W. Baker, Chief Counsel
April Slayton, Communications Director
William E. O'Conner, Jr., Minority Staff Director
______
Subcommittee on General Farm Commodities and Risk Management
BOB ETHERIDGE, North Carolina, Chairman
DAVID SCOTT, Georgia JERRY MORAN, Kansas, Ranking
JIM MARSHALL, Georgia Minority Member
JOHN T. SALAZAR, Colorado TIMOTHY V. JOHNSON, Illinois
NANCY E. BOYDA, Kansas SAM GRAVES, Missouri
STEPHANIE HERSETH SANDLIN, South CHARLES W. BOUSTANY, Jr.,
Dakota Louisiana
BRAD ELLSWORTH, Indiana K. MICHAEL CONAWAY, Texas
ZACHARY T. SPACE, Ohio FRANK D. LUCAS, Oklahoma
TIMOTHY J. WALZ, Minnesota RANDY NEUGEBAUER, Texas
EARL POMEROY, North Dakota KEVIN McCARTHY, California
Clark Ogilvie, Subcommittee Staff Director
(ii)
C O N T E N T S
----------
Page
Etheridge, Hon. Bob, a Representative in Congress from North
Carolina, opening statement.................................... 1
Graves, Hon. Sam, a Representative in Congress from Missouri,
prepared statement............................................. 4
Moran, Hon. Jerry, a Representative in Congress from Kansas,
opening statement.............................................. 2
Prepared statement........................................... 2
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 3
Prepared statement........................................... 3
Witnesses
Lukken, Hon. Walter, Acting Chairman, Commodity Futures Trading
Commission, Washington, D.C.................................... 4
Prepared statement........................................... 7
Williams, Orice M., Director, Financial Markets and Community
Investment, U.S. Government Accountability Office, Washington,
D.C............................................................ 14
Prepared statement........................................... 16
Newsome, Ph.D., James E., President and CEO, New York Mercantile
Exchange, Inc., New York, NY................................... 39
Prepared statement........................................... 41
Sprecher, Jeffrey C., Founder, Chairman, and CEO,
IntercontinentalExchange, Inc., Atlanta, GA.................... 47
Prepared statement........................................... 48
Pickel, Robert G., Executive Director and CEO, International
Swaps and Derivatives Association, New York, NY................ 53
Prepared statement........................................... 55
Corbin, Arthur, President and CEO, Municipal Gas Authority of
Georgia, Kenesaw, GA; on behalf of American Public Gas
Association.................................................... 60
Prepared statement........................................... 62
Cicio, Paul N., President, Industrial Energy Consumers of
America, Washington, D.C....................................... 68
Prepared statement........................................... 69
Eerkes, Craig, President, Sun Pacific Energy; Chairman, Petroleum
Marketers Association of America, Kennewick, WA; on behalf of
New England Fuel Institute..................................... 71
Prepared statement........................................... 72
Submitted Material
Submitted question............................................... 85
HEARING TO REVIEW TRADING OF ENERGY-BASED DERIVATIVES
----------
THURSDAY, JULY 12, 2007
House of Representatives,
Subcommittee on General Farm Commodities and Risk
Management,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 10 a.m., in Room
1300 of the Longworth House Office Building, Hon. Bob Etheridge
[Chairman of the Subcommittee] presiding.
Members present: Representatives Etheridge, Scott,
Marshall, Boyda, Space, Walz, Pomeroy, Peterson (ex officio),
Barrow, Moran, Graves, Boustany, Conaway, Neugebauer, McCarthy,
and Goodlatte (ex officio).
Staff present: Tyler Jameson, Scott Kuschmider, Clark
Ogilvie, John Riley, Sharon Rusnak, Debbie Smith, Kristin
Sosanie, Bryan Dierlam, Kevin Kramp, and Jamie Weyer.
OPENING STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN
CONGRESS FROM NORTH CAROLINA
The Chairman. This hearing of the Subcommittee on General
Farm Commodities and Risk Management to review the trading of
energy-based derivatives will come to order. Let me welcome
you. After months of working on the farm bill, this
Subcommittee turns its attention to an area that not only
impacts our farmers, but every man, woman and child in America,
the trading of energy-based derivatives.
The futures industry impacts our lives every single day.
Derivatives trading provides customers with forms of price
discovery and price hedging for a wide variety of commodities
and financial instruments. We are talking about a trillion
dollar industry that impacts the price of corn, wheat, soybeans
that go into our food products; the price of meat at the
grocery store; price of gas we are paying for at the pumps;
price of energy to heat our homes; the interest rates we pay on
our credit cards; the interest you pay on your mortgages; the
price of metals that go into products that we buy and many
other things that we use every single day.
In 2000 Congress took a bold step in dramatically amending
the Commodities Exchange Act and changing our system of
derivatives markets regulation. As you will recall, it wasn't
easy. Congress was faced with several different and often
conflicting paths toward change offered by a wide variety of
industry participants, but boldness was necessary in the face
of technological advances within the industry and increased
foreign competition in derivative business. With the Commodity
Futures Modernization Act of 2000, Congress delivered.
And we have seen the results of the work of Congress. The
volume of derivatives and option contracts traded have more
than tripled; the number of tradable products have increased by
almost as much. The number of participants trading in this area
has likewise skyrocketed, all of which has provided more
opportunities for price discovery and more opportunities to
hedge against risk. Now here we are, almost 7 years removed
from that point and perhaps naturally, people are starting to
feel the 7 year itch. They are asking questions about whether
the regulatory regime we created in 2000 is appropriate for
every commodity; or whether we should increase the Commodity
Futures Trading Commission's authority in some areas.
Therefore it is an appropriate time for us to review what
is happening in the energies derivative market, as well as the
CFTC's oversight of these markets. Today we hear from the
regulators of these markets, as well as from the government's
accounting arm, which has been conducting its own review of
what has taken place in these markets. We will also hear from a
variety of players who will bring different perspectives to
what role the government should play in overseeing these
markets.
I hope my colleagues will find this hearing informative. I
know I am looking forward to hearing today's testimony from our
witnesses; want to welcome all of you here this morning; and
thank those of you who are going to testify for being here.
Now I turn to my colleague, the gentleman from Kansas, Mr.
Moran, for his opening statement.
OPENING STATEMENT OF HON. JERRY MORAN, A REPRESENTATIVE IN
CONGRESS FROM KANSAS
Mr. Moran. Mr. Chairman, I am pleased to join you here this
morning. I appreciate the opportunity to hear from these
witnesses. I thank them for their time and their expertise.
This Committee, the House Committee on Agriculture, takes its
jurisdiction of the commodities futures industry seriously.
This hearing is one more example of our efforts to make certain
that adequate oversight is being provided to an industry that,
as you described, is very important to the consumers in the
U.S., as well as the world economy. So I am anxious to hear
what our witnesses have to say and with that, Mr. Chairman, I
would ask you to proceed.
[The prepared statement of Mr. Moran follows:]
Prepared Statement of Hon. Jerry Moran, a Representative in Congress
From Kansas
Thank you Mr. Chairman. We are here today to gather information
regarding energy markets in the United States. We have before us a
diverse group that includes witnesses from the Commodity Futures
Trading Commission (CFTC), which is tasked with overseeing the
commodity futures and options markets; a designated contract market
(DCM); an exempt commercial market (ECM); and industry users of energy
products. It is my hope that we can have an open discussion about how
energy markets function in this country and how oversight levels of
those markets can be properly established, while at the same time
maintaining vibrant markets that allow adequate risk management
mechanisms for all market participants.
Recently, there has been much discussion about the level of market
surveillance and position regulation needed in regard to ECM's. This
Subcommittee has an important role in ensuring that the CFTC has the
necessary tools it needs to monitor markets and provide enforcement
against market participants that might choose to manipulate markets. In
making determinations of whether existing oversight and enforcement
tools are sufficient, however, Congress must proceed in a deliberate
and adequately informed manner.
Issues regarding commodity markets are without doubt complex. In
crafting market regulations, proper consideration must be given to the
differences between ECM's and DCM's. For instance, we must recognize
that DCM's involve commodities of finite supply that are subject to
delivery upon contract expiration, whereas ECM's typically involve
contracts where no deliverable commodity is involved. Furthermore, we
must consider the type of participants that are involved in each
respective market. The underlying fundamentals of the cash market
should also be taken into account. Finally, it should be considered
what affect imposing further limitations on ECM's will have on
commodity and derivative markets. If position limits are imposed on
ECM's will participants in these markets shift their business to fully
exempt over-the-counter bilateral markets and result in less oversight;
or will these market participants simply shift their transactions to
foreign exchanges?
These are all questions that must be answered. Since passage of the
Commodity Futures Modernization Act (CFMA), commodity markets have
exponentially increased in size and scope. Arguably, this has helped to
promote competitive markets and bring new liquidity to traditional
commodity markets. It is Congress' responsibility to hear from today's
witnesses and determine what action is needed to ensure that CFTC has
the necessary authority to carry out its mission to protect the public
and market users from manipulation and fraud and ensure competitive and
open commodity markets. I would like to thank all the witnesses for
appearing today and I look forward to your testimony.
The Chairman. I thank you and I now recognize the Chairman
of full Committee, Mr. Peterson, for any comments he might
have.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. I thank you, Mr. Chairman, and I want to
thank you and the Ranking Member for your leadership and
continuing attention to this issue and others under your
jurisdiction. And I want to associate myself with your and the
Ranking Member's remarks. I have a statement I will just make
part of the record because we all have plenty to do and we
might as well get on with things.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
Thank you, Mr. Chairman, for calling this hearing today.
Today, we will look into trading of energy derivatives, the growth
of the derivatives industry, and what that growth means in the
establishment of fuel prices. Since 2000, the last time Congress
addressed the derivatives markets, the volume of futures and options
contracts trading on U.S. exchanges have more than tripled. The number
of tradable products available on these exchanges has also increased
dramatically.
We all recognize the importance of derivatives markets and the role
that producers, hedgers, and yes, even speculators play in them.
Active, transparent markets provide valuable benefits to the public in
the form of efficient price discovery and the ability for businesses to
hedge risks, allowing them to withstand periods of unfavorable or
volatile prices. Every farmer, food processor and energy consumer
benefits from open, transparent markets. Consequently, every one of us
pays the price if the futures markets are manipulated or distorted.
Farmers are especially affected by volatility and price run-ups in
these markets and are not able to pass costs along to consumers the way
other industries can in the form of surcharges. Throughout the farm
bill debate, for example, I have heard from farmers everywhere that,
yes, commodity prices are high, but so are input costs like gasoline,
diesel fuel and fertilizer.
A major issue confronting futures market regulators is the growth
of exempt commercial markets and the over-the-counter (OTC) market for
energy derivatives, which are subject to different levels of oversight
under the Commodity Futures Modernization Act of 2000. For example,
trading on exempt commercial markets like IntercontinentalExchange is
not subject to position limits like its competitor, the New York
Mercantile Exchange.
The CFTC believes it has sufficient oversight capabilities through
existing anti-fraud and anti-manipulation measures to deal with market
problems. I am sure the members of our second panel will have points of
view that both agree and disagree with this assessment. I look forward
to their testimony and for their thoughts with regard to the structure
of our regulatory system.
I welcome today's witnesses and I yield back my time.
The Chairman. I thank the gentleman and the chair would
request that other Members submit their opening statements for
the record so the witnesses may begin their testimony and will
ensure ample time for questions.
[The prepared statement of Mr. Graves follows:]
Prepared Statement of Hon. Sam Graves, a Representative in Congress
From Missouri
The natural gas trade concerns me greatly because of the impacts on
the end-users including farmers, manufacturers, and seniors on a fixed
income. Spikes in price that have been created artificially through
speculation and manipulation should not be tolerated in any venue where
the commodity is traded, including on exempt commercial markets (ECM)
(i.e., ICE) and on over-the-counter (OTC) markets. For these reasons, I
support expanding transparency and oversight to these areas. My
intention is to eliminate market manipulation.
Please know that as we move forward in this debate that I plan to
engage on this issue to see my concerns addressed.
Thank you,
The Chairman. We would like to welcome our first panel to
the table, the Honorable Walter Lukken, Acting Chairman of the
Commodity Futures Trading Commission, and Ms. Orice M.
Williams, Director of Financial Markets and Commodity
Investments of U.S. Government Accounting Office. Mr. Lukken,
please begin when you are ready, sir, and your full statements
will be made a part of the record and if you would, please, try
to summarize your statement within 5 minutes.
STATEMENT OF HON. WALTER LUKKEN, ACTING CHAIRMAN, COMMODITY
FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Lukken. Thank you, Mr. Chairman, Representative Moran
and Members of the Subcommittee. I am pleased to testify on
behalf of the Commodity Futures Trading Commission, and I
appreciate the opportunity to discuss the CFTC and our role
with respect to the energy markets. The CFTC pays close
attention to the futures trading in energy commodities because
of the importance of energy prices and supplies to our nation's
consumers, producers and the economy, in general. Our agency is
well aware of the reliance of the agricultural sector on
various sources of energy. Based on our surveillance efforts
today, we believe that energy futures have, over all, been
reflecting the underlying fundamentals of supply and demand.
The futures industry plays a critical role in the U.S. and
global economy. It provides risk management tools that
producers, distributors and commercial users of commodities use
to protect themselves from unpredictable price changes. These
markets also play a price discovery role for commercial
interests seeking a centralized price reflective of supply and
demand. Both functions would be harmed by manipulation or the
perception of foul play. The success of these markets can be
attributed, in part, to the principles-based approach that
Congress adopted with the Commodity Futures Modernization Act
in 2000 under the leadership of this Subcommittee. Trading
volume on U.S. futures markets has expanded 400 percent in less
than 10 years due to the flexibility of the CFMA and the
rejection of the one-size-fits-all prescriptive approach to
regulation. As we discuss energy derivatives today, we must be
mindful of how successful the U.S. futures industry has been
under the current regulatory framework.
The Commission has exclusive jurisdiction over commodity
futures and options contracts traded on Designated Contract
Markets, or DCMs. The CFTC's market surveillance mission
regarding DCM activity is to ensure that commodity futures and
options operate in an open and competitive manner, free of
price distortions. The CFTC fulfills this obligation through a
comprehensive program that is designed to identify and mitigate
the potential for manipulation and other market abuses. CFTC's
staff closely monitors trading on exchanges to detect unusual
activity or price aberrations that may indicate manipulation.
The cornerstone of our market surveillance program is a
large trader reporting system which requires traders to file
daily reports concerning their positions in a particular
contract. Through large trader reports, the CFTC becomes aware
of concentrated positions that might be used to manipulate the
market. When the CFTC's surveillance staff identifies a
problematic situation, the CFTC engages in an escalating series
of communications to work to resolve the situation. The traders
are advised of the CFTC's concern and reminded that they are
expected to trade in a responsible manner. This activity by
CFTC is usually quite effective. Should more action be needed,
however, the CFTC has the authority to limit, liquidate or halt
trading through its emergency powers.
Should a violation of our Act occur, the CFTC aggressively
pursues any individual that intentionally seeks to disrupt the
integrity of our markets. The CFTC's Division of Enforcement
investigates and prosecutes violations of our Act, including
manipulation, false reporting and trade practice abuses.
Sanctions and prosecuted cases serve as a powerful deterrent
for would-be violators and send a clear message that improper
conduct will not be tolerated.
In addition to energy futures traded on a regulated
exchange, Congress included a provision in the CMFA permitting
a new type of trading facility known as an Exempt Commercial
Market, or ECM, on which exempt commodities, such as energy
products, may be traded. Only eligible commercial entities,
generally, institutional traders, may trade on ECMs, ensuring
that these markets are open only to sophisticated parties. ECMs
are exempt from most provisions of the Act, however, the CFTC
does retain fraud and manipulation authority over ECMs. ECMs
are subject to certain limited reporting requirements to the
CFTC. In addition, ECMs must maintain, for 5 years, certain
records, including audit trail information sufficient to
reconstruct trading activity. The Commission also has the
authority to issue what is known as a special call for any
information that the ECM may have of interest to us.
The futures markets have changed dramatically since the
passage of the CFMA and the creation of the ECM category. This
designation has encouraged tremendous innovation and growth for
these institutional markets, while attempting to calibrate the
amount of oversight to the risks associated with them. These
exempt markets have increased competition, advanced the
adoption of electronic trading and lowered costs for
derivatives trading. However, certain contracts on regulated
futures markets and ECMs have become increasingly linked and as
a result, the public risks associated with these products may
have changed.
The CFTC has recognized this and exercised its existing
authorities in order to keep pace. For example, through our
special call authority, the CFTC is now obtaining, daily,
natural gas trading information from the
IntercontinentalExchange that is similar to our large trader
reports, providing a more comprehensive picture of the
marketplace. More recently, the CFTC proposed to clarify that
large traders on DCMs are required to keep information
regarding all their related positions, including over-the-
counter data and to provide that information to the Commission
upon request.
These measures have and will improve our oversight of these
markets. However, the CFTC is nearing the boundaries of its
authorities in this area. A part of the CFTC's reauthorization
debate, and the broader energy policy discussion, has been the
question of increased regulation of ECMs. Several legislative
ideas have been suggested and all are worthy of thoughtful
discussion. As this Committee fully understands, this is a
complicated matter with difficult legal and policy issues.
However, protecting the integrity of the price discovery
process should be our utmost priority, given its broad impact
on consumers and the Commission stands ready to lend its
expertise in finding the right solutions.
Lawmakers should be precise when considering additional
regulation, given these electronic markets can move off-shore
or into more opaque venues. In our capital markets,
policymakers are focusing on whether current regulatory
structures are having a negative effect on U.S.
competitiveness, as evidenced by three independent bipartisan
studies on the subject. Fortunately, the U.S. derivatives
markets enjoy a competitive advantage internationally and have
grown their market shares since the passage of the CFMA.
As policy changes are contemplated, Congress should be
mindful of these global market concerns and should not undo the
broader benefits that the CMFA has provided this industry. In
my new role as acting Chairman, I look forward to working with
this Committee, others in Congress and my fellow regulators to
ensure that the nation's energy markets remain open and
competitive, free from price distortions and fraud. The
Commission will continue to devote all necessary resources and
expertise to achieve this important national goal. Thank you
and I look forward to your questions.
[The prepared statement of Mr. Lukken follows:]
Prepared Statement of Hon. Walter Lukken, Acting Chairman, Commodity
Futures Trading Commission, Washington, D.C.
Thank you, Mr. Chairman and Members of the Committee. I am pleased
to testify on behalf of the Commodity Futures Trading Commission (CFTC
or Commission), and I appreciate the opportunity to discuss the CFTC
and our role with respect to energy derivatives trading.
The CFTC continues to pay close attention to futures and options
trading in energy commodities because of the importance of energy
prices and supplies to our nation's consumers, producers, and its
economy in general. Our agency is also well aware of the reliance of
the agricultural sector on various sources of energy that provide fuel
for field implements, feedstock for fertilizer and power for grain-
drying equipment, to name a few uses. Based on our surveillance efforts
to date, we believe that energy futures markets have been reflecting
the underlying fundamentals of these markets.
Futures and options markets play a critically important role in the
U.S. economy. They provide risk management tools that producers,
distributors, and commercial users of commodities use to protect
themselves from unpredictable price changes. The futures and options
markets also play a price discovery role as participants in related
cash and over-the-counter markets look to futures markets to discover
prices that accurately reflect information on supply, demand, and other
factors. Both functions would be harmed by manipulation of prices.
Overview of Energy Trading
Trading in energy commodities takes place principally in three
different ways: (1) on designated contract markets (DCMs), such as the
New York Mercantile Exchange (NYMEX); (2) on exempt commercial markets
(ECMs), such as the IntercontinentalExchange (ICE); and (3) in over-
the-counter bilateral transactions.
On-exchange trading of energy commodities takes place on DCMs,
which operate as price discovery and risk management facilities. Off-
exchange trading of energy commodities can take place on electronic
trading facilities known as ECMs, which operate without being
designated as contract markets by the CFTC. Transactions on ECMs are
entered into on a principal-to-principal basis only between ``eligible
commercial entities'' as defined by the Commodity Exchange Act (CEA).
Finally, off-exchange trading of energy commodities among wealthy,
sophisticated participants, ``eligible contract participants'' as
defined by the CEA, can also occur in bilateral transactions that do
not take place on a trading facility. Each of these three ways of
trading energy commodities is subject to varying levels of CFTC
regulation under the CEA.
CFTC Mission
The CFTC's mission is two-fold: to protect the public and market
users from manipulation, fraud, and abusive practices; and to promote
open, competitive and financially sound markets for commodity futures
and options.
Congress created the CFTC in 1974 as an independent agency with the
mandate to regulate commodity futures markets, and later option
markets, in the United States. To do this, the Commission employs a
highly-skilled and dedicated staff who work within three major
programs--Market Oversight, Clearing and Intermediary Oversight, and
Enforcement. These divisions have distinct and separate charges and
standards to meet, while working in conjunction to ensure market
integrity and economic opportunity. The three major Commission programs
are complemented by other offices, including the Office of the Chief
Economist, Office of the General Counsel, Office of International
Affairs and Office of Proceedings. The Chairman and Commissioners'
offices provide agency direction, and stewardship over CFTC's human
capital, financial management, and information technology resources.
CFTC Division of Market Oversight
The CEA provides that the Commission has exclusive jurisdiction
with respect to accounts, agreements, and transactions involving
commodity futures and options contracts that are required to be traded
or executed on a designated contract market, also known as a DCM or an
exchange. One of the purposes of the CEA is ``to serve the public
interests . . . through a system of effective self-regulation of
trading facilities . . . under the oversight of the Commission.'' \1\
DCMs are regulated entities that are self-regulatory organizations
(SROs) subject to comprehensive oversight by the CFTC. DCMs can list
for trading any type of contract, they can permit intermediation, and
all types of traders (including retail traders) are permitted to
participate in their markets. The CFTC's Division of Market Oversight
(DMO) is responsible for monitoring and evaluating a DCM's operations
and it conducts surveillance of all activity on DCMs, as described
below.
---------------------------------------------------------------------------
\1\ CEA Section 3(b), 7 U.S.C. 5(b).
---------------------------------------------------------------------------
DCMs must comply with a number of designation criteria and core
principles as a condition for initial CFTC approval and continuing
operation. Once operational, DCMs, as SROs, must establish and devote
resources toward an effective oversight program, which includes
surveillance of all activity on their markets to detect and deter
manipulation and trading abuses. That responsibility includes, among
other things, ensuring that listed contracts are not readily
susceptible to manipulation, addressing conflict of interest
situations, ensuring fair trading, providing for the financial
integrity of contracts, utilizing effective rules to deal with market
emergencies, and complying with comprehensive reporting and record
keeping requirements. DMO staff review all exchange new product and
rule filings to ensure that they comply with the core principles set
forth in the Act and the Commission's regulatory requirements.
DMO's market surveillance mission regarding DCM activity is to
ensure market integrity and customer protection in the futures markets.
Traders establishing positions on DCMs are subject to reporting
requirements so that DMO staff and the DCM can evaluate position sizes
to detect and deter manipulation. In addition, trade practice
surveillance involves compilation and monitoring of transactional-level
data by the Commission and the DCM to detect and deter abusive trading
such as wash sales, money laundering and trading ahead of customers
(trade practice surveillance). The surveillance staff conducts active
market and trade practice surveillance of all futures and options
trading activity that occurs on DCMs.
Under the CEA, the primary mission of market surveillance is to
identify situations that could pose a threat of manipulation and to
initiate appropriate preventive actions. Each day, for the estimated
1,400 active futures and option contracts in the U.S., DMO market
surveillance staff monitors the activities of large traders, key price
relationships, and relevant supply and demand factors to ensure market
integrity.
The market surveillance staff focuses, for example, on looking for
large positions, especially in comparison to potential deliverable
supply of the commodity. Such a dominant position might provide a
trader an opportunity to cause a price manipulation, such as in a
``squeeze,'' in which, for example, a single trader might hold a large
long (buy-side) position and demand delivery of more of a commodity
than is available for delivery. In such a situation, traders holding
short (sell-side) positions may have no alternative but to buy back
their positions at artificially high prices dictated by the dominant
long trader.
The market surveillance program uses many sources of daily market
information. Some of this information is publicly available, including
data on: the overall supply, demand, and marketing of the underlying
commodity; futures, option and cash prices; and data on trading volume
and open contracts. Some of the information is highly confidential,
including position and trading data that the Commission regularly
receives from DCMs, intermediaries, and large traders.
DCMs report to the Commission the daily positions and transactions
of each of their clearing members. The data are transmitted
electronically during the morning after the ``as of'' trade date. They
show separately, for proprietary and customer accounts, the aggregate
position and trading volume of each clearing member in each futures and
option contract. The data are useful for quickly identifying the firms
that clear the largest buy or sell volumes or hold the biggest
positions in a particular market. The clearing member data, however, do
not identify the beneficial owners of the positions.
To address this limitation, DMO uses a large-trader reporting
system. Under this system, clearing members, futures commission
merchants (FCMs), and foreign brokers (collectively called ``reporting
firms'') electronically file daily reports with the Commission. These
reports contain the futures and option positions of individual traders
that hold positions above specific reporting levels set by Commission
regulations, and allow DMO staff to review the beneficial owners of
futures positions. If, at the daily market close, a reporting firm has
a trader holding a position at or above the Commission's reporting
level in any single futures month or option expiration, it reports that
trader's entire position in all futures and options expiration months
in that commodity, regardless of size.
Since traders frequently carry futures positions through more than
one FCM, and since individuals sometimes control or have a financial
interest in more than one account, the Commission routinely collects
information that enables its surveillance staff to aggregate related
accounts. Reporting firms file information with the CFTC to identify
each new account that acquires a reportable position. In addition, once
an account reaches a reportable size, the account owner periodically is
required to file a more detailed report to further identify accounts
and reveal any relationships that may exist with other accounts or
traders.
Surveillance economists prepare weekly summary reports for futures
and option contracts that are approaching their expiration periods.
Regional surveillance supervisors immediately review these reports.
Surveillance staff advises the Commissioners and senior staff of
significant market developments at weekly surveillance meetings (which
are non-public, closed meetings) so they will be prepared to take
action if necessary.
Typically, the Commission gives the DCM, as the front-line
regulator, the first opportunity to resolve any issue arising in its
markets. If a DCM fails to take actions that the Commission deems
appropriate, the Commission has broad emergency powers under the CEA to
order the DCM to take specific actions. Such actions could include
limiting trading, imposing or reducing limits on positions, requiring
the liquidation of positions, extending a delivery period, or closing a
market. Fortunately, most issues are resolved without the need to use
the Commission's emergency powers. The fact that the Commission has had
to take emergency action only four times in its history demonstrates
its commitment to refrain from intervening in the futures markets
unless all other efforts have been unsuccessful.
In addition to market surveillance, DMO staff monitors trading
activity on DCMs in order to detect and prevent possible trading
violations. To help accomplish this mission, staff engages in various
analyses to profile trading activity and conducts trade practice
investigations. These functions require the collection of trade data
and the ability to process those in various ways for further analysis.
In this regard, DMO currently operates the Electronic Database System
(EDBS), a system developed in the mid-1980s, to process and maintain
information concerning trading activity on DCMs. EDBS is an older
system with limited capabilities, especially with respect to trading
data collected from electronically traded markets. The Commission is in
the process of replacing EDBS with a more robust tool, the Trade
Surveillance System (TSS). The primary function of TSS is to collect
and make all trade data accessible to staff so they can retrieve,
organize, and analyze trade data to assess DCM compliance with the Act
and Commission regulations. TSS will assist staff in conducting timely,
customized analyses of all trading activity; examining side-by-side
trading (same contract trading simultaneously on an exchange floor and
an electronic trading platform) and cross-market activity (similar or
identical contracts trading on different exchanges); and detecting
novel and complex patterns of potential trading violations involving
electronic trading. TSS also will allow DMO staff to respond to fast-
moving market events, which is crucial to effective trade practice
surveillance. The identification of potential trading violations
results in referrals to relevant DCMs and to the Commission's Division
of Enforcement.
It should be noted that surveillance of DCM trading is not
conducted exclusively by the Commission. As SROs, DCMs have significant
statutory surveillance responsibilities.\2\ Typically, however,
surveillance issues are handled jointly by Commission staff and the
relevant DCM. Surveillance information is shared and, when appropriate,
corrective actions are coordinated. Situations of particular
surveillance interest are jointly monitored and, if necessary, verbal
contacts are made with the brokers or traders who are significant
participants in the market in question. These contacts may be for the
purpose of asking questions, confirming reported positions, alerting
the brokers or traders to the regulatory concern regarding the
situation, or warning them to conduct their trading responsibly.
Throughout its history, the Commission, together with the DCMs, has
been quite effective in using these methods to resolve issues at an
early stage.
---------------------------------------------------------------------------
\2\ See, e.g., Sections 5(b)(2) and 5(d)(4) of the CEA, 7 U.S.C.
7(b)(2), 7(d)(4).
---------------------------------------------------------------------------
Another key DMO oversight role involves staff oversight and
assessment of the regulatory and oversight activities of DCMs. This
involves periodic examinations of DCMs' self-regulatory programs on an
ongoing, routine basis to evaluate their compliance with applicable
core principles under the Act and the Commission's regulations. These
examinations, known as ``Rule Enforcement Reviews,'' result in reports
that evaluate a DCM's compliance and surveillance capabilities. The
reports set forth recommendations for improvement, where appropriate,
with respect to a DCM's trade practice surveillance, market
surveillance, disciplinary, audit trail, and dispute resolution
programs. These reviews promote and enhance continuing, effective self-
regulation and ensure that exchanges rigorously enforce compliance with
their rules. The reports are made public and are posted on the
Commission's website.
In conclusion, the Commission has a comprehensive market oversight
program to detect and prevent disruption of the economic functions of
all the commodity futures and option markets that it regulates.
CFTC Division of Clearing and Intermediary Oversight
The Commission's Division of Clearing and Intermediary Oversight
(DCIO) is responsible for and plays an integral role in ensuring the
financial integrity of all transactions on the markets that the CFTC
regulates.
DCIO meets these responsibilities through an oversight program that
includes the following elements: (1) conducting risk-based oversight
and examinations of industry SROs responsible for overseeing FCMs,
commodity trading advisors, commodity pool operators, and introducing
brokers, to evaluate their compliance programs with respect to
requirements concerning fitness, net capital, segregation of customer
funds, disclosure, sales practices, and related reporting and record
keeping; (2) conducting risk-based oversight and examinations of all
Commission-registered derivatives clearing organizations (DCOs) to
evaluate their compliance with core principles, including their
financial resources, risk management, default procedures, protections
for customer funds, and system safeguards; (3) conducting financial and
risk surveillance oversight of market intermediaries to monitor
compliance with the provisions of the CEA and Commission regulations;
(4) monitoring market events and conditions to evaluate their potential
impact on DCOs and the clearing and settlement system and to follow-up
on indications of financial instability; and (5) developing
regulations, orders, guidelines, and other regulatory approaches
applicable to DCOs, market intermediaries, and their SROs.
Collectively, these functions serve to protect market users, the
general public and producers, to govern the activities of market
participants, and to enhance the efficiency and effectiveness of the
futures markets as risk management mechanisms. DCIO's most important
function is to prevent systemic risk and ensure the safety of customer
funds.
The DCOs that the Commission currently regulates are located in New
York, Chicago, Kansas City, Minneapolis and London, England. The
intermediaries overseen by the Commission are located throughout the
United States and in various other countries.
CFTC Division of Enforcement
At any one time, the Division of Enforcement (Enforcement) is
investigating and litigating with approximately 700 to 1,000
individuals and corporations for alleged fraud, manipulation, and other
illegal conduct. Working closely with the President's Corporate Fraud
Task Force, Enforcement is staffed with skilled professionals who
prosecute cases involving complex over-the-counter and on-exchange
transactions. Enforcement also routinely assists in related criminal
prosecutions by domestic and international law enforcement bodies.
During the last 5 years, Enforcement has maintained a record level
of investigations and prosecutions in nearly all market areas,
including attempted manipulation, manipulation, market squeezes and
corners, false reporting, hedge fund fraud, off-exchange foreign
currency fraud, brokerage compliance and supervisory violations, wash
trading, trade practice misconduct, and registration issues.
In the energy sector alone, Enforcement investigated Enron and
dozens of national and international energy companies, as well as
hundreds of energy traders and hedge funds around the country. As a
result of those efforts, the Commission prosecuted numerous traders and
corporate entities. At the same time, in other market sectors,
Enforcement prosecuted more than 50 hedge funds and commodity pool
operators for various violations, and filed actions against more than
360 individuals and companies for off-exchange foreign currency fraud
and misconduct.
Enforcement receives referrals from several sources: the CFTC's own
market surveillance staff; the compliance staff at exchanges; market
participants and members of the public; and other state, Federal, and
international regulatory authorities. During an investigation, the CFTC
may grant formal administrative subpoena authority, which enables
Enforcement to obtain relevant materials (for example, audio
recordings, e-mail and trade data) and testimony from witnesses.
If warranted, at the conclusion of its investigation, Enforcement
will recommend to the Commissioners that the CFTC initiate a civil
injunctive action in Federal district court or an administrative
proceeding. The CFTC may obtain temporary statutory restraining orders
and preliminary and permanent injunctions in Federal court to halt
ongoing violations, as well as civil monetary penalties, appointment of
a receiver, the freezing of assets, restitution to customers, and
disgorgement of unlawfully acquired gains. Administrative sanctions may
include orders suspending, denying, revoking, or restricting
registration; prohibiting trading; and imposing civil monetary
penalties, cease and desist orders, and orders of restitution.
The CFTC also refers enforcement matters to the Department of
Justice. Criminal activity involving commodity-related instruments can
result in prosecution for criminal violations of the CEA and for
violations of Federal criminal statutes, such as mail fraud or wire
fraud.
Oversight of Exempt Commercial Markets
Congress included a provision in the Commodity Futures
Modernization Act of 2000 (CFMA) to govern a new type of trading
facility known as an ECM.\3\ As outlined in Section 2(h)(5)(F) of the
CEA, ECMs are not ``registered with, or designated, recognized,
licensed or approved by the Commission.'' ECMs, as well as transactions
executed on ECMs, are statutorily exempt from most provisions of the
CEA. Trading on an ECM such as ICE is not subject to regular, ongoing
market surveillance oversight by the Commission. Under current law, the
Commission does not have the legal authority to limit the size of a
trader's position on an ECM. Nor are ECMs required to comply with the
self-regulatory obligations required of DCMs, such as adopting position
limitations or position accountability rules. The Commission does
retain fraud and manipulation authority over ECMs. To assist the
Commission in carrying out its fraud and manipulation authority, ECMs
are required to maintain a record of allegations or complaints received
by the trading facility concerning instances of suspected fraud or
manipulation and to forward them to the Commission.\4\
---------------------------------------------------------------------------
\3\ CEA Sections 2(h)(3)-(5), 7 U.S.C. 2(h)(3)-(5).
\4\ Commission Regulation 36.3(b)(iii), (iv), 17 C.F.R.
36.3(b)(iii), (iv).
---------------------------------------------------------------------------
ECMs are also subject to certain limited reporting requirements
that are authorized under Section 2(h)(5)(B)(i) of the CEA and spelled
out in Commission Regulation 36.3(b).\5\ Pursuant to these provisions,
an ECM is required to identify those transactions conducted on the
facility with respect to which the ECM intends to rely on the statutory
Section 2(h)(3) exemption, and which averaged five trades per day or
more over the most recent calendar quarter. With respect to such
transactions, the ECM is required to transmit weekly to the Commission
certain basic trade information, including ``the commodity, the
[delivery or price-basing] location, the maturity date, whether it is a
financially settled or physically delivered instrument, the date of
execution, the time of execution, the price, [and] the quantity.'' \6\
The reports filed pursuant to Regulation 36.3(b) can provide Commission
surveillance staff with information regarding price spikes or unusual
divergence between the price of a commodity traded on an ECM and the
price of a related commodity traded on a DCM. The Regulation 36.3(b)
reports, however, do not require ECMs to identify the individual
traders holding positions on the ECM.
---------------------------------------------------------------------------
\5\ 17 C.F.R. 36.3(b).
\6\ ICE has been submitting such trade data for natural gas
transactions meeting the regulatory reporting threshold since January
1, 2005.
---------------------------------------------------------------------------
In addition, an ECM must maintain for 5 years, and make available
for inspection upon request by the Commission, records of its
activities related to its business as an electronic trading facility,
including audit trail information sufficient to enable the Commission
to reconstruct trading activity, and the name and address of each
participant authorized to enter into transactions on the facility.\7\
Should the Regulation 36.3(b) reports, or other information obtained by
surveillance staff (including information from futures market large
trader reports), indicate a need for further information from an ECM,
Section 2(h)(5)(B)(iii) of the CEA and Commission Regulation 36.3(b)(3)
give the Commission authority to issue what is known as a ``special
call.'' Under the CEA, the Commission can obtain from an ECM ``such
information related to its business as an electronic trading facility
exempt under paragraph [2(h)](3) . . . as the Commission may deem
appropriate.'' The issuance of a special call to an ECM is simply an
indication that the Commission's staff is seeking additional
information. A special call, in and of itself, is not evidence of
improper or illegal market behavior.
---------------------------------------------------------------------------
\7\ CEA Section 2(h)(5)(B)(ii), 7 U.S.C. 2(h)(5)(B)(ii).
---------------------------------------------------------------------------
Finally, if the Commission determines that an ECM performs a
significant price discovery function for transactions in the cash
market for the commodity underlying any agreement, contract, or
transaction traded on the facility, the ECM must publicly disseminate,
on a daily basis, information such as contract terms and conditions,
trading volume, open interest, opening and closing prices or price
ranges, or other price information approved by the Commission.\8\ To
date, the Commission has not made such a determination.
---------------------------------------------------------------------------
\8\ CEA Section 2(h)(4)(D), 7 U.S.C. 2(h)(4)(D); Commission
Regulation 36.3(c)(2), 17 C.F.R. 36.3(c)(2).
---------------------------------------------------------------------------
Since the fall of 2006, the CFTC has been regularly utilizing its
special call authority to request information from ICE. This
information assists us in the regulation of activities on DCMs, and we
believe it helps us to get a more comprehensive picture of the
marketplace, given the similarity of ICE's natural gas contracts to
those traded on NYMEX. On September 28 and December 1, 2006,
respectively, the Commission issued two special calls to ICE that
required ICE to provide position data to the Commission, on an ongoing
basis, related to transactions in ICE's most heavily traded natural gas
swap contracts. Specifically, these separately-issued special calls
required that ICE provide the Commission with clearing member position
data and individual trader position data in the various ICE natural gas
contracts that are cash-settled based on NYMEX natural gas contracts.
The special call for clearing member position data was issued by
the Commission on September 28, 2006, and the Commission has been
receiving responsive data from ICE, on a daily basis, since October 10,
2006. The individual trader position data special call was issued on
December 1, 2006. ICE found it necessary to make various technical
adjustments to its systems in order to produce the requested materials,
which it has done. Those adjustments are now in place, and the
Commission received the first batch of individual trader daily position
data on February 16 (showing positions as of February 15) and continues
to receive that information on an ongoing basis.
These two special calls were issued primarily in order to assist
Commission staff in its surveillance of the related NYMEX natural gas
contracts. Compliance with special calls is not voluntary, but
mandatory. The special calls were not issued as part of an
investigation of any particular market participant or trading activity
on either ICE or NYMEX. Nor were they issued in order to conduct
regular market surveillance of ICE contracts themselves. The
information provided by ICE through the special calls is comprehensive,
but it does not duplicate the information that the Commission collects
through its DCM surveillance programs.
Despite the difference in regulatory authorities over DCMs and
ECMs, the Commission is aware that when markets trade similar products
or products that can be arbitraged, information regarding activity in
one market tends to be incorporated into the other. This is almost
certainly the case when large numbers of traders operate in both
markets, as is the case between NYMEX and ICE.
CFTC Coordination With the Federal Energy Regulatory Commission
The Energy Policy Act of 2005 (EPAct) marked an important milestone
in the on-going debate over the appropriate policy for regulating
trading activities in our nation's energy markets. The EPAct
established the Federal Energy Regulatory Commission's (FERC) anti-
fraud and anti-manipulation authority in the natural gas and
electricity cash markets. At the same time the EPAct initiated this
upgrade in FERC's authority, it also maintained the CFTC's longstanding
anti-manipulation authority in these cash markets. Recognizing the
CFTC's successes in combating abusive trading practices, the EPAct
preserved the CFTC's exclusive jurisdiction over commodity futures and
options transactions, and accordingly its enforcement authority to
proceed against abusive energy trading and false reporting under the
CEA.
As called for by the EPAct, the CFTC and FERC in October 2005
entered into a Memorandum of Understanding (MOU) to coordinate their
activities. Accordingly, the respective staffs of the Commission and
FERC are authorized to efficiently share information concerning various
issues in the energy markets without the need for cumbersome access
requests for each particular matter. To that end, designated Commission
staff remain in regular contact with counterparts at FERC, and FERC
staff is routinely invited to attend Commission enforcement briefings
and surveillance meetings. The Commission's Enforcement staff also
meets with FERC counterparts on a quarterly basis to share information
on issues and matters of mutual interest.
While this inter-agency MOU has helped bridge some of the day-to-
day matters that have arisen, certain issues remain. For instance,
since the EPAct was enacted, the CFTC and FERC now have different legal
standards required to prove a violation of their respective anti-
manipulation provisions. The FERC anti-manipulation language parallels
the language in Section 10(b) of the Securities Exchange Act of 1934.
As a result, the elements of a manipulation case for FERC differ
significantly from the elements of a manipulation action brought by the
CFTC pursuant to the CEA and related judicial precedent. Under the FERC
legal standard, the language contemplates that in order to prove a
violation, FERC must prove that a defendant intentionally or knowingly
engaged in the proscribed conduct. It appears that the courts could
interpret ``reckless conduct'' as an acceptable standard for FERC's
``intent'' requirement. In contrast, for manipulation cases under the
CEA, the CFTC must prove specific intent, arguably a higher standard
than ``recklessness.'' The CFTC must also show that the defendant had
the ability to influence market prices, that artificial prices existed,
and that the defendant caused the artificial prices.\9\
---------------------------------------------------------------------------
\9\ See In re Cox, [1986-1987 Transfer Binder] Comm. Fut. L. Rep.
(CCH) 23,786 at 34,061 (CFTC July 15, 1987.
---------------------------------------------------------------------------
We continue to work to resolve how each agency should enforce its
mandate in the absence of a bright-line delineation of the boundaries
of the respective agencies' authorities. These issues affect the
agencies' regulatory efforts in the energy markets, and possibly
undermine the effectiveness of Congress's intent to end those types of
trading abuses that hurt energy consumers and undercut public
confidence in fair and orderly energy markets. The CFTC will continue
to monitor the ongoing interactions between our agencies in this area
and will report to Congress as to whether it may be appropriate to
harmonize FERC's and the CFTC's manipulation authorities.
CFTC Budget
The current budget that funds the divisions, the technology and
surveillance operations, and other support staff, is approximately $98
million for the current Fiscal Year (FY). The FY 2008 President's
Budget request for the CFTC is for an appropriation of $116 million and
475 staff--an increase of approximately $18 million and 17 staff over
the FY 2007 continuing resolution appropriation which supports a level
of 458 staff.
We are grateful for the Administration's recognition of the need
for increased funding for our agency. The FY 2008 Budget request is a
good down payment in an effort to reverse a recent downward trend in
resources at the Commission, but it is, in perspective, a small
recognition of the challenge we face.
Since the CFMA was enacted, there has been a seven-fold increase in
the rate of new product listings by U.S. exchanges. Nine new DCMs and
nine new DCOs have been approved by the CFTC. Electronic trading has
soared to approximately 60 percent of total volume this year, and that
percentage is steadily increasing. The competition, product innovation,
and increasing use of technology fostered by the CFMA meant exponential
growth in the futures and option markets, especially during the last
few years. It has also meant continuing evolution of these markets in
the form of new trading venues, new trading strategies, new risk
management tools, and new customers.
The CFMA replaced the prior ``one-size-fits-all'' regulatory model
with a flexible, practical, principles-based model for exchanges. U.S.
exchanges also were given the authority to approve new products and
rules through a self-certification process without prior CFTC approval,
which encouraged innovation and enabled exchanges to act quickly in
response to fast-changing market conditions. The CFMA also permitted
the establishment of non-intermediated trading platforms such as ECMs,
the growth of which has rapidly matured in recent years.
During this period of unprecedented growth for the futures
industry, however, the CFTC's resources have been steadily diminishing.
The CFTC needs additional staff resources in almost every program area.
Currently, the Commission operates with a staff of 436--an historic low
at a time when the industry we regulate is at an all-time high by
almost any measure: more volume, more trading platforms, more products,
more complexity and a more global marketplace. Commission employees
work hard, work smart, and use technology effectively, but given the
complexity of the markets we oversee, they are stretched. We have the
resources to carry out the Commission's mission on a daily basis--by
asking more of staff and putting off some technological needs and other
programs--but it is clear that the agency can continue at this funding
level only for the short-term.
With regard to the adequacy of our surveillance resources, it is
useful to consider that the number of actively traded contracts trading
on U.S. exchanges has more than quintupled in the last decade, with
most of that growth seen in the last 5 years. Staff devoted to
surveillance today is 46; ten years ago, it was 58.
As for Enforcement, staff has fallen from 154 to 110 during the
same ten year period. The CFTC prides itself on its vigorous
enforcement efforts. However, in derivatives markets that are exploding
in size and complexity, coupled with its reduced staffing, the CFTC's
enforcement professionals are struggling to keep up with the volume and
size of its cases. For comparison purposes, the enforcement division at
the Securities and Exchange Commission is funded with a budget that is
more than twenty times larger than that for the CFTC's enforcement
operations. We are forced to make hard choices every day on how to
prioritize our investigative and litigation efforts.
Technology is critical to enable our professional staff to
adequately oversee the markets. However, budget constraints have
required the Commission to put new systems development initiatives and
hardware and software purchases on hold. For example, Commission
investment in technology, as a percentage of total budget, has fallen
from approximately 10 percent to around seven percent. This trend is
unsustainable given that so much of the growth in the futures industry
is directly attributable to investments in technology. It is important
that the Commission not be overwhelmed by the technologically
innovative industry we regulate.
Conclusion
The CFTC's last reauthorization expired in 2005, and Congress has
worked hard during the past 2 years to try to reauthorize the CFTC and
update our statutory mandate. We appreciate the efforts of this
Subcommittee, the full Committee and your Senate counterparts, as you
continue those efforts.
In order to clarify the CFTC's anti-fraud authority with respect to
transactions in energy commodities, it is important that Congress
clarify that the CFTC's primary anti-fraud provision in CEA Section 4b
\10\ applies to principal-to-principal transactions. We appreciate that
such a clarification was included in H.R. 4473, the CFTC
reauthorization legislation reported out of the House Agriculture
Committee and adopted by the House of Representatives in December 2005.
---------------------------------------------------------------------------
\10\ 7 U.S.C. 6b.
---------------------------------------------------------------------------
Apart from enforcement, another part of the reauthorization debate
has been about regulation of energy markets. It is a complicated policy
decision that encompasses consideration of a number of issues,
including: economic opportunity and competition at home and abroad;
ensuring customer protections and market integrity; promoting growth
and innovation of U.S. exchanges; and ensuring a level playing field
for competitors. Congress, regulators and industry participants have
varied opinions on the topic and the debate continues. It is important
to hear all sides to strike the right balance in this complex economic
and policy discussion.
This is truly a dynamic time in the futures markets, given the
growth in trading volume, product innovation and complexity, and
globalization--in all commodities, including energy. The Commission
will continue to work to promote competition and innovation by
proactively taking down unnecessary barriers to trading in our markets,
while at the same time, fulfilling our mandate under the CEA to protect
the public interest and to enhance the integrity of, and public
confidence in, U.S. futures markets.
In closing, I appreciate the Committee's inquiries into this
complex and important area as well as the opportunity to testify. I
look forward to answering any questions you might have.
Thank you.
The Chairman. Thank the gentleman. Before we move to Ms.
Williams, let me recognize the Ranking Member and welcome him
and any comments he might have, before we move, if you have
something.
Mr. Goodlatte. Thank you, Mr. Chairman. I appreciate your
holding this hearing.
The Chairman. And we thank you. And now we recognize Ms.
Williams for her opening comments.
STATEMENT OF ORICE M. WILLIAMS, DIRECTOR, FINANCIAL MARKETS AND
COMMUNITY INVESTMENT, U.S.
GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, D.C.
Ms. Williams. Mr. Chairman and Members of the Subcommittee,
I am pleased to be here today to discuss our preliminary
findings on the trading of derivatives for energy commodities.
As energy prices have increased in recent years, the trading
volume of exchange traded futures, off-exchange traded swaps
and other types of derivatives have also experienced
significant growth. Increased energy prices have generally been
attributed to normal market forces of supply and demand, but
trends in energy derivatives markets have increased questions
about whether this trading activity has placed additional
upward pressure on the prices of physical energy commodities.
My remarks today focus on (1) trends in the energy
derivatives and physical markets and the effect of those trends
on energy prices; and (2) the regulatory structure of the
various markets where energy commodities and derivatives are
traded. The futures and physical markets for crude oil,
unleaded gasoline, heating oil and natural gas have experienced
substantial changes in recent years. First, from January 2002
to July 2006, monthly averaged futures and spot prices for
crude oil, gasoline and heating oil registered an increase of
over 200 percent.
Second, the volatility of energy prices generally remained
above historic averages for most of the period, but declined
for most energy commodities during 2006 to levels at or near
their historical average.
And third, trading volumes for futures increased, at least
in part, as a growing number of managed money traders,
including hedge funds, began to see energy futures as
attractive investment alternatives. While these changes were
occurring in the futures market, the physical market was
experiencing tight supply and increase in global demand,
ongoing political instability in oil producing regions, limited
refining capacity and other ongoing supply disruptions.
Some observers believe that higher energy prices were
solely the result of supply and demand fundamentals, while
others believe that increased derivatives trading activity may
have also contributed to higher prices. Given the changes that
have occurred in both markets over this period, the extent of
impact of any one of the changes in either market is unclear.
Now, turning my attention to CFTC's authority: Energy
products are traded on futures exchanges, exempt commercial
markets and over-the-counter, or OTC, markets. Some of these
markets are subject to CFTC oversight and some are largely
unregulated. Under the Commodity Exchange Act, CFTC regulatory
oversight is focused on the surveillance of futures exchanges,
protecting the public and ensuring market integrity. CFTC does
not, however, have oversight authority over exempt commercial
markets, which are electronic trading facilities that trade
exempt commodities, including energy commodities, on a
principle-to-principle basis solely between persons that are
eligible commercial entities.
Moreover, the volume of off-exchange transactions has
increased significantly in recent years. Also, certain parties,
those who qualify as eligible contract participants, can enter
into contracts directly. Both the exempt commercial market and
the OTC market are exempt from general CFTC oversight. However,
both markets are subject to CFTC's enforcement of the CEA's
anti-manipulation and where appropriate, anti-fraud provisions.
Given these varying levels of CFTC oversight, some market
observers question whether CFTC needs additional resources and
broader authority over all derivatives markets, particularly
those involving exempt commodities. CFTC generally believes
that the Commission has sufficient authority over OTC
derivatives and exempt energy markets, however, CFTC has
recently taken an important step in clarifying its authority to
obtain information about pertinent off-exchange transactions.
In closing, our work to date shows that the derivatives and
physical markets have both undergone substantial change and
evolution and warrants ongoing monitoring and analysis to
protect the public and ensure the integrity of the markets. Mr.
Chairman, this concludes my prepared statement. I would be
happy to respond to any questions that you or other Members of
the Subcommittee may have. Thank you.
[The prepared statement of Ms. Williams follows:]
Prepared Statement of Orice M. Williams, Director, Financial Markets
and Community Investment, U.S. Government Accountability Office,
Washington, D.C.
Energy Derivatives
Preliminary Views on Energy Derivatives Trading and CFTC Oversight
What GAO Found
Rising energy prices have been attributed to a variety of factors,
and recent trends in the futures and physical markets highlight the
changes that have occurred in both markets from 2002 through 2006.
Specifically:
Inflation-adjusted energy prices in both the futures and
physical markets increased by over 200 percent during this
period for three of the four commodities we reviewed.
Volatility (a measurement of the degree to which prices
fluctuate over time) in energy futures prices generally
remained above historic averages during the beginning of the
time period but declined through 2006 for three of the four
commodities we reviewed.
The number of noncommercial participants in the futures
markets including hedge funds, has grown; along with the volume
of energy futures contracts traded; and the volume of energy
derivatives traded outside traditional futures exchanges.
At the same time these changes were occurring in the futures
markets for energy commodities, tight supply and rising demand in the
physical markets pushed prices higher. For example, while global demand
for oil has risen at high rates, spare oil production capacity has
fallen since 2002, and increased political instability in some of the
major oil-producing countries has threatened the supply of oil.
Refining capacity also has not expanded at the same pace as the demand
for gasoline. The individual effect of these collective changes on
energy prices is unclear, as many factors have combined to affect
energy prices. Monitoring these changes will be important to protect
the public and ensure market integrity.
Based on its authority under the Commodity Exchange Act (CEA), CFTC
primarily focuses its oversight on the operations of traditional
futures exchanges, such as NYMEX, where energy futures are traded.
However, energy derivatives are also traded on other markets, namely
exempt commercial markets and over-the-counter (OTC) markets--both of
which have experienced increased volumes in recent years. Exempt
commercial markets are electronic trading facilities that trade exempt
commodities between eligible participants, and OTC markets involve
eligible parties that can enter into contracts directly off-exchange.
Both of these markets are exempt from general CFTC oversight, but they
are subject to the CEA's anti-manipulation and anti-fraud provisions
and CFTC enforcement of those provisions. Because of these varying
levels of CFTC oversight, some market observers question whether CFTC
needs broader authority over all derivative markets. CFTC generally
believes that the Commission has sufficient authority over OTC
derivatives and exempt energy markets. However, CFTC has recently taken
additional actions to clarify its authority to obtain information about
pertinent off-exchange transactions.
* * * * *
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss our preliminary views on
the trading of derivatives for energy commodities such as natural gas
and crude oil. As energy prices have increased in recent years, the
trading volume of exchange-traded futures, off-exchange traded swaps,
and other types of derivatives have also experienced significant
growth.\1\ Increased energy prices generally have been attributed to
normal market forces of supply and demand, but these trends in energy
derivatives markets have raised questions about whether this trading
activity has placed additional upward pressure on the prices of
physical energy commodities. The prices of futures contracts, like
those of all derivatives, are in large part based on prices in the
physical spot (cash) market where commodities are sold. At the same
time, buyers and sellers of natural gas, crude oil, gasoline, and other
energy products use exchange-traded futures prices, which are published
daily, when determining prices in the physical markets. The extent to
which off-exchange prices are used for determining prices of the
underlying commodity, however, is unclear. The growth in energy futures
trading since 2001 has in part been fueled by new market participants
such as hedge funds and by increased investment in commodity index
funds, which are funds whose prices are tied to the price of a basket
of various commodity futures.
---------------------------------------------------------------------------
\1\ Our analysis of energy prices and energy financial markets is
generally limited to the time period from January 2002 to December
2006.
---------------------------------------------------------------------------
My testimony today is based on an ongoing engagement on trading
activity in energy derivatives markets--primarily the futures market--
and the oversight role of the Commodity Futures Trading Commission
(CFTC). Because of the broad interest in this subject, our ongoing work
has been initiated under the authority of the Comptroller General. My
remarks today present our preliminary views on (1) trends in the energy
derivatives and physical markets and the effect of those trends on
energy prices, and (2) the regulatory structure of the various markets
where energy commodities and derivatives are traded.
In conducting this work, we obtained and analyzed energy futures
prices and trading volumes from the New York Mercantile Exchange, Inc.
(NYMEX). Specifically, we collected data for crude oil, heating oil,
natural gas, and unleaded gas for the period January 2002 through
December 2006. We also obtained and analyzed data on market
participants and the outstanding trading positions of different
categories of traders from CFTC. In addition, we reviewed publicly
available information, including academic studies and reports and
market data. Finally, we interviewed a broad range of market
participants and observers, representatives of energy trading markets,
and government regulators and agencies involved with the energy
markets. This work is being done in accordance with generally accepted
government auditing standards.
In summary, derivatives and physical markets for crude oil,
unleaded gasoline, heating oil, and natural gas have experienced
substantial changes in recent years. From January 2002 to July 2006,
monthly average futures and spot prices for crude oil, gasoline, and
heating oil registered increases of over 200 percent.\2\ The volatility
of energy prices also generally remained above historic averages for
most of the period but declined during 2006 to levels at or near the
historical average. At the same time, trading volumes for futures
increased, at least in part because a growing number of managed-money
traders (including hedge funds) began to see energy futures as
attractive investment alternatives. While these changes were occurring,
the physical market was experiencing tight supply and rising demand
from increasing global demand, ongoing political instability in oil-
producing regions, limited refining capacity, and other ongoing supply
disruptions. Some observers believe that higher energy prices were
solely the result of supply and demand fundamentals while others
believe that increased futures trading activity may also have
contributed to higher prices. But the effect on energy prices of
individual changes in these markets is unclear, as many factors have
combined to affect energy prices. Monitoring these changes in the
future will be important in protecting the public and ensuring market
integrity.
---------------------------------------------------------------------------
\2\ To account for the effects of inflation on prices, prices are
adjusted to reflect prices in the base year of 2006.
---------------------------------------------------------------------------
Energy derivatives are traded on futures exchanges, exempt
commercial markets, and over-the-counter (OTC). Some of these markets
are subject to CFTC oversight and some are largely unregulated. Under
the Commodity Exchange Act (CEA), CFTC regulatory oversight is focused
on the surveillance of futures exchanges, protecting the public, and
ensuring market integrity. CFTC does not, however, have oversight
authority over exempt commercial markets--electronic trading facilities
that trade exempt commodities, including energy commodities, on a
principal-to-principal basis solely between persons that are eligible
commercial entities--and the volume of off-exchange transactions has
increased significantly in recent years. Also, certain parties--those
who qualify as eligible contract participants--can enter into contracts
directly (over-the-counter). Both the exempt commercial market and the
OTC market are exempt from general CFTC oversight. However, both
markets are subject to CFTC's enforcement of the CEA's anti-
manipulation and, where applicable, anti-fraud provisions. Because of
these varying levels of CFTC oversight, some market observers question
whether CFTC needs broader authority over all derivative markets,
particularly those involving exempt commodities. CFTC generally
believes that the Commission has sufficient authority over OTC
derivatives and exempt energy markets. However, CFTC has recently taken
additional actions to clarify its authority to obtain information about
pertinent off-exchange transactions.
Background
Energy commodities are bought and sold on both the physical and
financial markets. The physical market includes the spot market where
products such as crude oil or gasoline are bought and sold for
immediate or near-term delivery by producers, wholesalers, and
retailers. Spot transactions take place between commercial participants
for a particular energy product for immediate delivery at a specific
location. For example, the U.S. spot market for West Texas Intermediate
(WTI) crude oil is the pipeline hub near Cushing, Oklahoma, while a
major spot market for natural gas operates at the Henry Hub near Erath,
Louisiana. The prices set in the specific spot markets provide a
reference point that buyers and sellers use to set the price for other
types of the commodity traded at other locations.
In addition to the cash markets, derivatives based on energy
commodities are traded in financial markets. The value of the
derivative contract depends on the performance of the underlying
asset--for example, crude oil or natural gas. Derivatives include
futures, options, and swaps. Energy futures include standardized
exchange-traded contracts for future delivery of a specific crude oil,
heating oil, natural gas, or gasoline product at a particular spot
market location. An exchange designated by CFTC as a contract market
standardizes the contracts, which participants cannot modify. The owner
of an energy futures contract is obligated to buy or sell the commodity
at a specified price and future date. However, the contractual
obligation may be removed at any time before the contract expiration
date if the owner sells or purchases other contracts with terms that
offset the original contract. In practice, most futures contracts on
NYMEX are liquidated via offset, so that physical delivery of the
underlying commodity is relatively rare.
Options give the purchaser the right, but not the obligation, to
buy or sell a specific quantity of a commodity or financial asset at a
designated price. Swaps are privately negotiated contracts that involve
an ongoing exchange of one or more assets, liabilities, or payments for
a specified time period. Like futures, options can be traded on an
exchange designated by CFTC as a contract market. Both swaps and
options can be traded off-exchange if the transactions involve
qualifying commodities and the participants satisfy statutory
requirements. Options and futures are used to buy and sell a wide range
of energy, agricultural, financial, and other commodities for future
delivery.
Market participants use futures markets to offset the risk caused
by changes in prices, to discover commodity prices, and to speculate on
price changes. Some buyers and sellers of energy commodities in the
physical markets trade in futures contracts to offset, or ``hedge,''
the risks they face from price changes in the physical market. Exempt
commercial markets and OTC derivatives can serve the same function.
Price risk is an important concern for buyers and sellers of energy
commodities, because wide fluctuations in cash market prices introduce
uncertainty for producers, distributors, and consumers of commodities
and make investment planning, budgeting, and forecasting more
difficult. To manage price risk, market participants may shift it to
others more willing to assume the risk or to those having different
risk situations. For example, if a petroleum refiner wants to lower its
risk of losing money because of price volatility, it could lock in a
price by selling futures contracts to deliver the gasoline in 6 months
at a guaranteed price. Without futures contracts to manage risk,
producers, refiners, and others would likely face greater uncertainty.
The futures market also helps buyers and sellers determine, or
``discover,'' the price of commodities in the physical markets, thus
linking the two markets together. Price discovery is facilitated when
(1) participants have current information about the fundamental market
forces of supply and demand, (2) large numbers of participants are
active in the market, and (3) the market is transparent. Market
participants monitor and analyze a myriad of information on the factors
that currently affect and that they expect to affect the supply of and
demand for energy commodities. With that information, participants buy
or sell an energy commodity contract at the price they believe the
commodity will sell for on the delivery date. The futures market, in
effect, distills the diverse views of market participants into a single
price. In turn, buyers and sellers of physical commodities may consider
those predictions about future prices, among other factors, when
setting prices on the spot and retail markets.
Other participants, such as investment banks and hedge funds, which
do not have a commercial interest in the underlying commodities, use
the futures market strictly for profit. These speculators provide
liquidity to the market but also take on risks that other participants,
such as hedgers, seek to avoid. In addition, arbitrageurs attempt to
make a profit by simultaneously entering into several transactions in
multiple markets in an effort to benefit from price discrepancies
across these markets.
Multiple Factors in the Derivatives and Physical Markets Have Impacted
Energy Prices
Both derivatives and physical markets experienced a substantial
amount of change from 2002 through 2006. These changes have been
occurring simultaneously, and the specific effect of any one of these
changes on energy prices is unclear.
The Energy Futures Markets Experienced Rising Prices, High Volatility,
Increased Trading Volume, and Growth in Some Types of Traders
Several recent trends in the futures markets have raised concerns
among some market observers that these conditions may have contributed
to higher physical energy prices. Specifically from January 2002 to
July 2006, the futures markets experienced higher prices, relatively
higher volatility, increased trading volume, and growth in some types
of traders. During this period, monthly average spot prices for crude
oil, gasoline, and heating oil increased by over 200 percent, and
natural gas spot prices increased by over 140 percent.\3\ At the same
time that spot prices were increasing, the futures prices for these
commodities showed a similar pattern, with a sharp and sustained
increase. For example, the price of crude oil futures increased from an
average of $22 per barrel in January 2002 to $74 in July 2006. At the
same time, the annual historical volatilities--measured using the
relative change in daily prices of energy futures--between 2000 and
2006 generally were above or near their long-term averages, although
crude oil and heating oil declined below the average and gasoline
declined slightly at the end of that period. We also found that the
annual volatility of natural gas fluctuated more widely than that of
the other three commodities and increased in 2006 even though prices
largely declined from the levels reached in 2005. Although higher
volatility is often equated with higher prices, this pattern
illustrates that an increase in volatility does not necessarily mean
that price levels will increase. In other words, price volatility
measures the variability of prices rather than the direction of the
price changes.
---------------------------------------------------------------------------
\3\ To account for the effects of inflation on prices, prices are
adjusted to reflect prices in the base year of 2006.
---------------------------------------------------------------------------
We also observed that at the same time that prices were rising and
that volatility was generally above or near long-term averages, futures
markets saw an increase in the number of noncommercial traders such as
managed money traders, including hedge funds.\4\ The trends in prices
and volatility made the energy derivatives markets attractive for the
growing number of traders that were looking to either hedge against
those changes or profit from them. Using CFTC's large trader data, we
found that from July 2003 to December 2006 crude oil futures and
options contracts experienced the most dramatic increase, with the
average number of noncommercial traders more than doubling from about
125 to about 286. As shown in Figure 1, while the growth was less
dramatic in the other commodities, the average number of noncommercial
traders also showed an upward trend for unleaded gasoline, heating oil,
and natural gas.
---------------------------------------------------------------------------
\4\ CFTC collects data on traders holding positions at or above
specific reporting levels set by the Commission. This information is
collected as part of CFTC's Large Trader Reporting System.
Another notable trend, but one that is much more difficult to
quantify, was the apparently significant increase in the amount of
energy derivatives traded outside exchanges. Trading in these markets
is much less transparent, and comprehensive data are not available
because these energy markets are not regulated. While the Bank for
International Settlements publishes data on worldwide OTC derivative
trading volume for broad groupings of commodities, this format can be
used only as a rough proxy for trends in the trading volume of OTC
energy derivatives.\5\ According to these data, the notional amounts
outstanding of OTC commodity derivatives excluding precious metals,
such as gold, grew by over 850 percent from December 2001 to December
2005.\6\ In the year from December 2004 to December 2005 alone, the
notional amount outstanding increased by more than 200 percent to over
$3.2 trillion. Despite the lack of comprehensive energy-specific data
on OTC derivatives, the recent experience of individual trading
facilities further reveals the growth of energy derivatives trading
outside of futures exchanges. For example, according to its annual
financial statements, the volume of non-futures energy contracts traded
on the IntercontinentalExchange, also known as ICE, including
financially settled derivatives and physical contracts, increased by
over 400 percent to over 130 million contracts in 2006.
---------------------------------------------------------------------------
\5\ The Bank for International Settlements (BIS) is an
international organization that fosters international monetary and
financial cooperation and serves as a bank for central banks.
\6\ The notional amount is the amount upon which payments between
parties to certain types of derivatives contracts are based. The
notional amount is not exchanged between the parties but instead
represents a hypothetical underlying quantity upon which payment
obligations are computed. The BIS data on OTC derivatives includes
forwards, swaps, and options.
---------------------------------------------------------------------------
Further, while some market observers believe that managed money
traders were exerting upward pressure on prices by predominantly buying
futures contracts, CFTC data we analyzed revealed that from the middle
of 2003 through the end of 2006, the trading activity of managed money
participants became increasingly balanced between buying (those that
expect prices to go up) and selling (those that expect prices to go
down). That is, our preliminary view of these data suggests that
managed money traders as a whole were more or less evenly divided in
their expectations about future prices than they had been in the past.
We found that views were mixed about whether these trends had any
upward pressure on prices. Some market participants and observers have
concluded that large purchases of oil futures contracts by speculators
could have created an additional demand for oil that could lead to
higher prices. Contrary to this viewpoint, some Federal agencies and
other market observers took the position that speculative trading
activity did not have a significant impact on prices. For example, an
April 2005 CFTC study of the markets concluded that increased trading
by speculative traders, including hedge funds, did not lead to higher
energy prices or volatility. This study also argued that hedge funds
provided increased liquidity to the market and dampened volatility.
Still others told us that while speculative trading in the futures
market could contribute to short-term price movements in the physical
markets, they did not believe it was possible to sustain a speculative
``bubble'' over time, because the two markets were linked and both
responded to information about changes in supply and demand caused by
such factors as the weather or geographical events. In the view of
these observers and market participants, speculation could not lead to
artificially high or low prices over a long period of time.
Various Patterns in the Physical Markets Also Explain Rising Energy
Prices
The developments in the derivatives markets in recent years have
not occurred in isolation. Conditions in the physical markets were also
undergoing changes that could help explain increases in both derivative
and physical commodity prices. As we have reported, futures prices
typically reflect the effects of world events on the price of the
underlying commodity such as crude oil.\7\ For example, political
instability and terrorist acts in countries that supply oil create
uncertainties about future supplies that are reflected in futures
prices in anticipation of an oil shortage and expected higher prices in
the future. Conversely, news about a new oil discovery that would
increase world oil supply could result in lower futures prices. In
other words, futures traders' expectations of what may happen to world
oil supply and demand influence their price bids.
---------------------------------------------------------------------------
\7\ See GAO, Motor Fuels: Understanding the Factors that Influence
the Retail Prices of Gasoline, GAO-05-525SP (Washington, D.C.: May
2005).
---------------------------------------------------------------------------
According to the Energy Information Administration (EIA), world oil
demand has grown from about 59 million barrels per day in 1983 to more
than 85 million barrels per day in 2006 (Fig. 2). While the United
States accounts for about a quarter of this demand, rapid economic
growth in Asia has also stimulated a strong demand for energy
commodities. For example, EIA data shows that from 1983 to 2004,
China's average daily demand for crude oil increased almost fourfold.
The growth in demand does not, by itself, lead to higher prices for
crude oil or any other energy commodity. For example, if the growth in
demand were exceeded by a growth in supply, prices would fall, other
things remaining constant. However, according to EIA, the growth in
demand outpaced the growth in supply, even with spare production
capacity included in supply. Spare production capacity is surplus oil
that can be produced and brought to the market relatively quickly to
rebalance the market if there is a supply disruption anywhere in the
world oil market. As shown in Figure 3, EIA estimates that global spare
production capacity in 2006 was about 1.3 million barrels per day,
compared with spare capability of about 10 million barrels per day in
the mid-1980s and 5.6 million barrels a day as recently as 2002.
Major weather and political events can also lead to supply
disruptions and higher prices. In its analysis, EIA has cited the
following examples:
Hurricanes Katrina and Rita removed about 450,000 barrels
per day from the world oil market from June 2005 to June 2006.
Instability in major oil-producing countries of the
Organization of Petroleum Exporting Countries (OPEC), such as
Iraq and Nigeria, have lowered production in some cases and
increased the risk of future production shortfalls in others.
Oil production in Russia, a major driver of non-OPEC supply
growth during the early 2000s, was adversely affected by a
worsened investment climate as the government raised export and
extraction taxes.
The supply of crude oil affects the supply of gasoline and heating
oil, and just as production capacity affects the supply of crude oil,
refining capacity affects the supply of those products distilled from
crude oil. As we have reported, refining capacity in the United States
has not expanded at the same pace as the demand for gasoline.\8\
Inventory, another factor affecting supplies and therefore prices, is
particularly crucial to the supply and demand balance, because it can
provide a cushion against price spikes if, for example, production is
temporarily disrupted by a refinery outage or other event. Trends
toward lower levels of inventory may reduce the costs of producing
gasoline, but such trends may also cause prices to be more volatile.
That is, when a supply disruption occurs or there is an increase in
demand, there are fewer stocks of readily available gasoline to draw
on, putting upward pressure on prices. However, others noted a
different trend for crude oil inventories. That is, prices have
remained high despite patterns of higher levels of oil in inventory.
---------------------------------------------------------------------------
\8\ See GAO, Energy Markets: Factors Contributing to Higher
Gasoline Prices, GAO-06-412T (Washington, D.C.: Feb. 1, 2006) and GAO-
05-525SP.
---------------------------------------------------------------------------
In addition to the supply and demand factors that generally apply
to all energy commodities, specific developments can affect particular
commodities. For instance, the growth of special gasoline blends--so-
called ``boutique fuels''--can affect the price of gasoline. As we have
reported, it is generally agreed that the higher costs associated with
supplying special gasoline blends contributed to higher gasoline
prices, either because of more frequent or more severe supply
disruptions or because the costs were likely passed on, at least in
part, to consumers.\9\
---------------------------------------------------------------------------
\9\ GAO, Gasoline Markets: Special Gasoline Blends Reduce Emissions
and Improve Air Quality, but Complicate Supply and Contribute to Higher
Prices, GAO-05-421 (Washington, D.C.: June 17, 2005).
---------------------------------------------------------------------------
Like the futures market, the physical market has undergone
substantial changes that could affect prices. But market participants
and other observers disagree about the impact of these changes on
increasing energy prices. Some observers believe that higher energy
prices were solely the result of supply and demand fundamentals, while
others believe that increased futures trading activity contributed to
higher prices. Another consideration is that the value of the U.S.
dollar on open currency markets could also affect crude oil prices. For
example, because crude oil is typically denominated in U.S. dollars,
the payments that oil-producing countries receive for their oil are
also denominated in U.S. dollars. As a result, a weak U.S. dollar
decreases the value of the oil sold at a given price, and oil-producing
countries may wish to increase prices for their crude oil in order to
maintain the purchasing power in the face of a weakening U.S. dollar.
The relative effect of each of these changes remains unclear, however,
because all of the changes were occurring simultaneously. Monitoring
these trends and patterns in the future will be important in order to
better understand their effects, protect the public, and ensure market
integrity.
CFTC Oversees Exchanges and Has Some Authority Over Other Derivatives
Markets
Energy products are traded on multiple markets, some of which are
subject to varying levels of CFTC oversight and some of which are not.
This difference in oversight has caused some market observers to
question whether CFTC needs broader oversight authority. As we have
seen, under the CEA CFTC's regulatory authority is focused on
overseeing futures exchanges, protecting the public, and ensuring
market integrity. But in recent years two additional venues for trading
energy futures contracts that are not subject to direct CFTC oversight
have grown and become increasingly important--exempt commercial markets
and OTC markets. However, traders in these markets are subject to the
CEA's anti-manipulation and anti-fraud provisions, which CFTC has the
authority to enforce. Also, exempt commercial markets must provide CFTC
with data for certain contracts.\10\
---------------------------------------------------------------------------
\10\ 17 C.F.R. 36.3; see 7 U.S.C. 2(h)(4)(D).
---------------------------------------------------------------------------
Futures exchanges such as NYMEX are subject to direct CFTC
regulation and oversight. CFTC generally focuses on fulfilling three
strategic goals related to these exchanges. First, to ensure the
economic vitality of the commodity futures and options markets, CFTC
conducts its own direct market surveillance and also reviews the
surveillance efforts of the exchanges. Second, to protect market users
and the public, CFTC promotes sales practice and other customer
protection rules that apply to futures commission merchants and other
registered intermediaries.\11\ Finally, to ensure the market's
financial integrity, CFTC reviews the audit and financial surveillance
activities of self-regulatory organizations.
---------------------------------------------------------------------------
\11\ See 17 C.F.R. Parts 155, 166.
---------------------------------------------------------------------------
CFTC conducts regular market surveillance and oversight of energy
trading on NYMEX and other futures exchanges.\12\ Oversight activities
include:
---------------------------------------------------------------------------
\12\ NYMEX conducts its own surveillance activities and may bring
enforcement actions when violations are found.
detecting and preventing disruptive practices before they
occur and keeping the CFTC Commissioners informed of possible
---------------------------------------------------------------------------
manipulation or abuse;
monitoring NYMEX's compliance with CFTC reporting
requirements and its enforcement of speculative position
limits;
investigating traders with large open positions; and
documenting cases of improper trading.
In contrast to the direct oversight it provides to futures
exchanges, CFTC does not have general oversight authority over exempt
commercial markets, where qualified entities may trade through an
electronic trading facility. According to CFTC officials, these markets
have grown in prominence in recent years. Some market observers have
questioned their role in the energy markets and the lack of
transparency about their trading activities. Trading energy derivatives
on exempt commercial markets is permissible only for eligible
commercial entities--a category of traders broadly defined in the CEA
to include firms with a commercial interest in the underlying
commodity--as well as other sophisticated investors such as hedge
funds. These markets are not subject to CFTC's general direct oversight
but are required to maintain communication with CFTC. Among other
things, an exempt commercial market must notify CFTC that it is
operating as an exempt commercial market and must comply with certain
CFTC informational, record-keeping, and other requirements.
Energy derivatives also may be traded OTC rather than via an
electronic trading facility. OTC derivatives are private transactions
between sophisticated counterparties, and there is no requirement for
parties involved in these transactions to disclose information about
their transactions. Derivatives transactions in both exempt commercial
markets and OTC markets are bilateral contractual agreements in which
each party is subject to and assumes the risk of nonperformance by its
counterparty. These agreements differ from derivatives traded on an
exchange where a central clearinghouse stands behind every trade.
While some observers have called for more oversight of OTC
derivatives, most notably for CFTC to be given greater oversight
authority over this market, others consider such action unnecessary.
Supporters of more CFTC oversight authority believe that more
transparency and accountability would better protect the regulated
markets and consumers from potential abuse and possible manipulation.
Some question how CFTC can be assured that trading on the OTC market is
not adversely affecting the regulated markets and ultimately consumers,
given the lack of information about OTC trading. However, in 1999 the
President's Working Group on Financial Markets concluded that OTC
derivatives generally were not subject to manipulation because
contracts were settled in cash based on a rate or price determined in a
separate highly liquid market and did not serve a significant price
discovery function.\13\ Moreover, the market is limited to professional
counterparties that do not need the protections against manipulation
that CEA provides to retail investors. Finally, the group has recently
noted that if there are concerns about CFTC's authority, CFTC's
enforcement actions against energy companies are evidence that the CFTC
has adequate tools to combat fraud and manipulation when it is
detected.\14\
---------------------------------------------------------------------------
\13\ The President's Working Group was established by executive
order in 1988 following the 1987 stock market crash. Its purpose was to
enhance the continued integrity, competitiveness, and efficiency of
U.S. financial markets and maintain the public's confidence in those
markets. See the Report of the President's Working Group on Financial
Markets, Over-the-Counter Derivatives Markets and the Commodity
Exchange Act (Washington, D.C.: 1999).
\14\ June 11, 2003, letter signed by the members of the President's
Working Group to the Honorable Senator Michael D. Crapo and the
Honorable Zell B. Miller.
---------------------------------------------------------------------------
The lack of reported data about off-exchange markets makes
addressing concerns about the function and effect of these markets on
regulated markets and entities challenging. CFTC officials have said
that while they have reason to believe these off-exchange activities
can affect prices determined on a regulated exchange, they also
generally believe that the Commission has sufficient authority over OTC
derivatives and exempt energy markets. However, CFTC has recently begun
to take steps to clarify its authority to obtain information about
pertinent off-exchange transactions. In a June 2007 proposed
rulemaking, CFTC noted that having data about the off-exchange
positions of traders with large positions on regulated futures
exchanges could enhance the Commission's ability to deter and prevent
price manipulation or any other disruptions to the integrity of the
regulated futures markets.\15\ According to CFTC officials, the
Commission has also proposed amendments to clarify its authority under
the CEA to collect information and to bring fraud actions in principal-
to-principal transactions in these markets, enhancing CFTC's ability to
enforce anti-fraud provisions of CEA.
---------------------------------------------------------------------------
\15\ According to CFTC, the purpose of the proposed regulation is
to make explicit that persons holding or controlling reportable
positions on a reporting market must retain books and records and make
available to the Commission upon request any pertinent information with
respect to all other positions and transactions in the commodity in
which the trader has a reportable position, including positions held or
controlled or transactions executed over-the-counter and/or pursuant to
Sections 2(d), 2(g) or 2(h)(1)-(2) of the Commodity Exchange Act (Act)
or Part 35 of the Commission's regulations, on exempt commercial
markets operating pursuant to Sections 2(h)(3)-(5) of the Act, on
exempt boards of trade operating pursuant to Section 5d of the Act, and
on foreign boards of trade; and to make the regulation clearer and more
complete with respect to hedging activity. 72 Fed. Reg. at 34413.
---------------------------------------------------------------------------
In closing, our work to date shows that the derivatives and
physical markets have both undergone substantial change and evolution.
Given the changes in both markets, causality is unclear, and the
situation warrants ongoing review and analysis. We commend the
Subcommittee's efforts in this area. Along with the overall concern
about rising prices, questions have also been raised about CFTC's
authority to protect investors from fraudulent, manipulative, and
abusive practices. CFTC generally believes that the Commission has
sufficient authority over OTC derivatives and exempt energy markets.
However, CFTC has taken an important step by clarifying its authority
to obtain information about pertinent off-exchange transactions.
GAO Contacts
For further information about this testimony, please contact Orice
M. Williams on (202) 512-8678 or at [email protected].
Staff Acknowledgments
Contact points for our Offices of Congressional Relations and
Public Affairs may be found on the last page of this statement.
Individuals making key contributions include John Wanska (Assistant
Director), Kevin Averyt, Ross Campbell, Emily Chalmers, John Forrester,
and Paul Thompson.
The Chairman. Thank you, Ms. Williams, and the chair will
recognize Members, those who were present at the fall of the
gavel and others as they came to the meeting, but before we
begin the questions, I would ask unanimous consent that the
gentleman from Georgia may sit with the panel during this
hearing. No objection, so ordered. I will now recognize myself
for 5 minutes.
Commissioner Lukken, during your appearance before the
Senate Permanent Investigations Subcommittee, you said that the
CFTC decided that the markets on New York Merc and ICE were
linked with respect to certain types of traded energy-based
derivatives, that one affected the other. Wouldn't such linkage
call for a review by the Commission as to whether ICE is
performing a significant price discovery function with regard
to the affected derivatives?
Mr. Lukken. Mr. Chairman, absolutely. We do have a rule on
the books dealing with whether the statute requires that if
there is a significant price discovery function being performed
by one of these ECMs, that that could trigger reporting of
volume, open interest, high and low closing ranges, so forth.
We need to review that rulemaking to make sure. When this was
put on the books, this was prior to the phenomena of these
linked contracts between regulated exchanges and exempt
exchanges. Obviously, now that the two interplay with each
other, there is a relationship there, an important
relationship. This is one of our rules that we need to review
to make sure that it encompasses that type of relationship that
has developed rather recently over the last couple years.
The Chairman. Let me follow that up a bit because I would
appreciate you talking with us about the process the Commission
uses to evaluate ECMs for that function. Also, what is the
standard that the Commission uses to determine it?
Mr. Lukken. The rulemaking, itself, looks to whether
outside entities are utilizing, on a regular basis, prices on
an exempt commercial market. So if a utility or somebody is
quoting those prices or basing contracts on those prices, on an
ongoing basis, that is evidence that somebody is discovering
prices from that marketplace. Again, that was not thought
through with this linkage idea, however. This was looking only
at ICE and whether people were discovering products off of ICE
and now that the two interact with each other in some ways, we
didn't consider this link sufficiently and weren't aware of it
when we put together this rulemaking. So, I think this might be
an area we might need to clarify in this rule and they may be,
after review, serving as a significant price discovery market.
The Chairman. I think this Committee would be very
interested in that information as you develop it.
Mr. Lukken. Well, we are going to make this a priority.
The Chairman. All right. Thank you, sir. Ms. Williams, I
understand that GAO will be issuing a report looking at trading
of energy derivatives in the near future. Can you give us a
timeline as to when we can expect the report, and will it
include recommendations? Can you give us any sense of what
those could be so we might get a glimpse of what the future is
going to look like?
Ms. Williams. We do hope to issue a report later this year
in terms of the areas that we focused on in addition to the two
areas that I discussed today in my prepared statement.
The Chairman. I hate to interrupt you. When you say later
this year, can you give me a little bit better window?
Ms. Williams. In the next several months.
The Chairman. I agree with the Ranking Member, you are
good. And that could be 3 to 6 months.
Ms. Williams. That is a safe range. Hopefully, closer to
the 3.
The Chairman. That is close. Any thoughts of what kind of--
--
Ms. Williams. Well, in addition to looking at trends in the
futures and physical market that I briefly discussed, we also
are looking at, kind of, the CFTC's authority and also their
surveillance and enforcement activities. So to the extent that
we do have any recommendations, it would be focused on those
last two areas.
The Chairman. Well, certainly this Committee would be quite
interested in that.
Ms. Williams. Absolutely.
The Chairman. And sooner rather than later.
Ms. Williams. We understand.
The Chairman. Even with the preliminary report, it would be
quite helpful, given that we operate on a timeline here.
Ms. Williams. Okay. Right.
The Chairman. It is pretty tight now and the days of the
legislative calendar are drawing nigh, they are running out.
Ms. Williams. We understand.
The Chairman. Thank you. With that, I yield to the Ranking
Member.
Mr. Moran. Mr. Chairman, thank you very much. Commissioner
Lukken, welcome back to the House Agriculture Committee. My
thought would be this is your debut appearance as the acting
Chairman and so welcome. First of all, I would like for you
just to describe for me, for the Committee, the function, the
manner in which the Commission is currently functioning. I
would be happy to have your reassurance, but the Commission has
been short of Commissioners. There has been change and turnover
in regard to its Chairman and there are constant concerns about
the level of the budget and appropriations for the CFTC. And so
as we look at your capabilities, the CFTC's capabilities, I
would like to have your report on the current status of how the
Commission is functioning given the lack of Commissioners,
perhaps lack of money and an acting Chairman.
Mr. Lukken. Thank you, Congressman. Obviously, that was
mentioned by the Chairman's opening statement and your
statement. Our industry has experienced significant growth
since the passage of the CFMA. Markets were experiencing really
flat growth coming into the CFMA. Since then, they have taken
off; 343 percent since 2000 through 2006. We have gained market
share globally; 34 percent in 2000. We are now at 43 percent,
globally, the U.S. So we are gaining on the world in futures
volume and that is great.
You know, we are also seeing more contracts than ever
before. Where 250 contracts may have been listed at any one
time, we are experiencing over 1,400 actively traded futures
contracts. As an industry, we should applaud that growth. But
that has to be juxtaposed with what we are doing, as a
Commission, which we are struggling with the resources we have.
We are at historically low levels. In the 1970s, when this
industry was much smaller, we were over 500 individuals, as an
agency. Now we are at historical lows of 450 or so individuals
at the CFTC.
Budgets have been flat recently, as has ours. It is almost
a demographic phenomenon, but our agency, as it approaches 35
or so years of service, people who are in the agency are
starting to retire and that institutional knowledge is walking
out the door when we have been under a hiring freeze. So we are
struggling to keep pace and we are keeping pace because we have
talented individuals, but we are stretched. And so thankfully,
the Senate, yesterday, gave us an appropriations mark of $116
million for our annual budget, which is the same as what the
President had asked for. I am hopeful today that the House does
the same.
You also mentioned what the Commission is doing as a
Commission, itself. The Commissioners, and we are down to two,
in fact, Commissioner Mike Dunn is in the audience supporting
me today and it is just the two of us. And the Sunshine laws
prevent us from talking to each other, which is problematic.
You know, we want to, just as the House and Senate want to,
collaborate and discuss. These are serious issues that we need
important discussions about and we are not able to do that. We
have to relay messages through staff. It is difficult. The
President has nominated two individuals. I hope that the Senate
is able to move on those individuals quickly so that we have a
full or nearly full complement of Commissioners and we are able
to do the serious business before the Commission.
Mr. Moran. I am confused as to how you can speak for the
Commission when you and Mr. Dunn can't communicate with each
other, but there was some, at least in the press, criticism may
be too strong of a word, but there was some exception taken to
your testimony recently in the Senate. It was as if you were
close minded to, at least this is my impression, close minded
to additional regulation of the energy markets.
My impression of what you said today is that that is not
the case, and my impression is also that you are saying
something that every Commission Chairman that has testified
before this Committee in past years has said something very
similar. So I wanted to give you the opportunity to clarify
your thoughts or your statement about this topic, but also to
tell me whether you are deviating in your remarks or testimony
today from past testimony of the Commission and whether you and
Commissioner Dunn, as Commissioners are generally in agreement,
to your testimony today.
Mr. Lukken. My written testimony is the testimony of the
Commission in its entirety, Mike and myself. But I think a good
mark of a regulator is somebody who is open to ideas, that can
adapt with change. And certainly, this market is evolving and
we have to keep pace with that change. We have tried to do
things within our existing authority to keep pace with that
change. However, as I note, we are nearing the outer edges of
that authority. So I think the ideas that are being discussed
are important ideas, but as this Committee knows, and you have
the battle scars from 2000, these are complex matters.
If we start to wade into this, there are questions of
whether that provides additional uncertainty to the swaps
markets. Do we only go after this one market we are talking
about and limited products within that market? Are we only
talking natural gas or are we talking energy products? Are we
talking metals, which are also an exempt commodity? A lot of
these smaller ECMs are incubator exchanges. They are
innovative, they are growing. We want to encourage that.
Additional regulation on these exchanges might shut them down.
There is a potential that a regulation could drive markets
overseas or maybe into the more opaque over-the-counter
markets. So this shouldn't deter us from trying to ask these
questions and trying to find solutions. But I am just saying
that this is complex and we just have to be cautious and
precise as we approach these things. I am open to all ideas,
including the ideas that were suggested in the PSI report on
Monday, but it is going to take some precision and some caution
and a lot of discussion before we can reach the right solution.
Mr. Moran. Commissioner, thank you very much for your
testimony and for your leadership at the CFTC.
The Chairman. I thank the gentleman and the chair would now
be happy to yield 5 minutes to the gentleman from Virginia, Mr.
Goodlatte.
Mr. Goodlatte. Mr. Chairman, thank you very much.
Commissioner, Ms. Williams, welcome. Let me start with you,
Commissioner Lukken. I would like to follow up on the gentleman
from Kansas' questions. What would be the impact on your budget
and staffing if you are required to regulate more markets?
Mr. Lukken. It depends on what the breadth of the new
authority might be, but it would be significant. Currently, we
had looked at maybe, if extended to ECMs and other over-the-
counter products, of having to hire 30 or 40 new surveillance
economists. Some of the legislation covers products not even
traded on futures exchanges, so this would be a significant
amount of new resources that would have to be devoted to this.
As we approach this, I think these two have to go hand-in-hand,
that if new authority is given, there has to be assurance that
resources come along with that authority.
Certainly, we don't want to have to choose between what we
do, as an agency, because all of our mission is important. I
would hate to pursue energy manipulations but allow fraud on
forex markets, allow that to occur. So right now our plate is
full and we are approaching having to make those decisions
currently, given our budget situation. I think the new budget
number is appropriate and will help with that. But new
authority will again task us and this is going to be difficult,
but it is something I think we can do.
Mr. Goodlatte. The CFTC has previously testified that you
do continual oversight of market conduct. Have you stepped up
that oversight and surveillance efforts in response to the
increase in energy prices?
Mr. Lukken. Absolutely. More economists are now being
devoted to the energy complex than ever before. We have
developed software to allow better analytical tools when
looking at the energy complex. The data we see is being
analyzed differently and more in-depth by our economists,
looking at different types of information that may interact
into these markets. Our chief economist office is now doing
more studies, primarily in the energy area, so that we know
trends, understand price relationships better, understand the
role of speculation volatility. And certainly, with energy, we
should also mention our enforcement section because they are
complementary to any of our regulatory functions, as well. We
have taken significant steps to take enforcement actions; over
55 individuals and entities have been prosecuted over the last
several years.
Mr. Goodlatte. Let me interrupt you. You mentioned the
types of evidence you look at. What kind of market anomaly
would trigger greater oversight attention?
Mr. Lukken. Well, typically, an expiration month of a
futures contract, it is a large position going into that with
tight, deliverable supply. Also there are trading ranges, when
prices are being set. If we see anomalies in trading activity,
that will raise the eyebrows of our surveillance economists and
we will look further into that, that type of an issue.
Mr. Goodlatte. And have you found any evidence of
manipulation in the trading of gasoline or oil contracts?
Mr. Lukken. Absolutely. We have taken several actions at
any one time. Currently, in fact, we have over a hundred
individuals and entities under investigation for attempting to
manipulate the energy markets. Not all of those turn into an
actual case, but we are turning over the rocks to make sure
that manipulation is not occurring and if it does, we are ready
to take real-time enforcement action against that.
Mr. Goodlatte. Ms. Williams, your testimony describes how
the CFTC conducts market oversight. Do you think that they do
it effectively?
Ms. Williams. At this point, given that our work is ongoing
in the area, we will be in a position, in our final report, to
discuss CFTC's oversight program and get into greater detail
exactly what they do in terms of oversight, surveillance and
enforcement.
Mr. Goodlatte. And Mr. Lukken, we have heard, in fact, you
mention in your testimony the success that we have had with
U.S. markets in trading futures, generally. How do these
futures markets compete internationally with other markets and
what could help or hinder that?
Mr. Lukken. Well, part of it is the success of the
principles-based system that this Committee helped to
implement. We need flexibility when going into other markets.
Part of my charge, as Chairman of the Global Markets Advisory
Committee, is to seek out markets overseas that our futures
markets can enter into. Again, we are gaining on the world in
this area, so that is important. But some of it is just making
sure you understand regulatory frameworks around the world so
that they are compatible, that we are engaged with the
International Organization of Securities Commissions so that we
are setting high global standards for regulation in these
areas.
It is interesting because, 10 years ago, when we looked at
whether to allow foreign competitors to come into the United
States and compete with domestic exchanges, there was a lot of
resistance from domestic exchanges to allow that to occur. When
we recently reviewed this, they were in full support of
allowing global competition because they knew that they were at
a competitive advantage. They didn't want foreign markets to
raise barriers for them getting into their marketplace. So the
fear was if we raised our barriers that others would do the
same and the right call was made, that competition, whether it
is domestic or global, is important and really lets our markets
grow.
Mr. Goodlatte. Thank you, Mr. Chairman.
The Chairman. Thank the gentleman. The gentleman from
Georgia, Mr. Scott, for 5 minutes.
Mr. Scott. Thank you very much, Mr. Chairman, and welcome,
Mr. Lukken and Ms. Williams. I would like to talk a minute
about these recent calls for additional regulation and it seems
that these calls for more regulation of the over-the-counter
markets have risen out of two specific situations, namely,
Enron and the Amaranth situation. Let me first talk about the
Enron situation, Mr. Lukken. Is there anyone operating, to your
knowledge, under what is referred to as the ``Enron Loophole''
at this time?
Mr. Lukken. I am a little unclear of what the ``Enron
Loophole'' is. It was discussed, actually, on Monday. There is
some uncertainty of what people term the Enron Loophole. But I
think what Enron was performing in 2000, in 2001, was a one-to-
many market, where they were dealer and everybody was
transacting with them as sort of the hub of the spoked wheel
system. I am unaware, most of the trading has moved to a multi-
lateral type system, which is like what exchanges currently
perform where anybody can hit a bid or an offer in order to
make a contract. So I am unaware of anybody performing a
dealer-like market in energy similar to Enron was doing in
2000.
Mr. Scott. On that line, do you believe that you have the
authority necessary to monitor the activities that brought
about the Enron situation in an effort to prevent another Enron
disaster from happening? Do you think that you have sufficient
tools and authority to make sure that this kind of disaster
does not happen again?
Mr. Lukken. Well, we have, in that area, broad fraud and
manipulation authority to take action. In fact, against Enron
we took action and over $35 million of civil monetary
penalties. The markets, as they exist today, as we have talked
about, ECMs, where most of this trading is occurring, we have
limited authorities where we do see trading positions every
day. We see where large traders might be, both on the regulated
market and the ECMs. But as I mentioned, we are nearing the
outer limits of that authority. That is something that is
worthy of discussion.
Mr. Scott. A more recent situation with Amaranth presents
some interesting situations. I am not so sure that that there
was an attempt to have market manipulation, but rather, the
situation at Amaranth might have been simply created by a fund
manager who was not very good at his job and bet wrong. Am I
off on that analysis?
Mr. Lukken. I think you point out correctly that market
discipline worked in this area, especially, we are talking
about more market surveillance issues today. But from a
financial integrity side, Enron made the wrong decision. We
like speculators in our markets because they provide liquidity
to our markets and allow commercials to get in and out of the
markets when they need to. However, Amaranth made the wrong
decision and the market disciplined it in a brutal fashion.
Mr. Scott. Let me ask you this. Would additional regulation
of the over-the-counter market have helped prevent this sort of
situation with Amaranth?
Mr. Lukken. I think with Amaranth, a lot of this was
occurring on the regulated exchanges. Prices were moving
against them regardless of whether it was on-exchange or off-
exchange. I think, by the time they did shift to ICE in the
latter parts of August and September, that the market was
already moving against them. It is still important to point
out, that there was this shift which we weren't able to see at
the time and now we see it. But I don't think it would've
changed the Amaranth situation at all.
Mr. Scott. Would an additional regulation push investors to
an even less regulated or transparent overseas market?
Mr. Lukken. Possibly.
Mr. Scott. And so in essence, it seems that if someone
wants to act foolishly investing other people's money, there
will always be a way to do so. No amount of regulation can
prevent this.
Mr. Lukken. Absolutely.
Mr. Scott. Okay. Thank you, Mr. Chairman.
The Chairman. Thank the gentleman. The gentleman from
Texas, Mr. Conaway, for 5 minutes.
Mr. Conaway. Thank you, Mr. Chairman. Mr. Lukken, you made
a startling statement a second ago. What I heard was a
startling statement that the crude oil and gasoline markets
have been manipulated?
Mr. Lukken. Correct.
Mr. Conaway. There have been people who tried to manipulate
it and you are looking into whether or not they----
Mr. Lukken. I have just been informed by my enforcement
director that we have evidence of manipulation in these
markets, but we are still building cases in this area.
Mr. Conaway. Okay.
Mr. Lukken. You know, this is a very legal and evidence
intensive process and something that we are looking into.
Mr. Conaway. Okay. What is the average length of time it
takes you to open a case and close a case on these
manipulations?
Mr. Lukken. It is significant. If not months, years.
Mr. Conaway. And are there ways to shorten that time?
Mr. Lukken. Well, we have tried to through different
methods, to make it more real-time, as I have said, to try to
make sure that the crime and the punishment were more timely
together. We try by devoting significant staff resources to
certain cases that we find, our public policy interest, and
other methods to try to move up those time-frames.
Mr. Conaway. But you do acknowledge a keen interest in
shortening that length of time that those cases are open? I
mean, that doesn't do anybody any good, particularly the
markets, themselves. What is your relationship with the
exchanges, themselves? Do you have an ongoing relationship with
them? And how do you assess their self-disciplinary actions?
Mr. Lukken. We have a very close relationship with the
exchanges and this is built over the 150 years of self-
regulation that the exchanges have had in place. We check our
surveillance economists, talk to exchanges daily about what
they are seeing. A lot of our eyes and ears are the exchanges,
themselves. We do duplicate certain things, such as the
surveillance of the markets, themselves; also, trade practice
abuses, whether traders are trading ahead of other traders with
certain information, because that is very important to our
mission. However, a lot of things we defer to the exchanges and
talk to them on a regular basis.
Mr. Conaway. But you would characterize your relationship
as generally positive and appropriate at this stage?
Mr. Lukken. Yes, and it has to be. We have to work hand-in-
hand with the exchanges in order to police these markets.
Mr. Conaway. Okay. Ms. Williams, you used the phrase ``some
observers'' and then you would follow that phrase by some
negative information. Is that just open source information that
you are conveying to this or ``some observers,'' is that code
for GAO?
Ms. Williams. No. We actually, as we have conducted our
work in the area, we have talked to a broad cross-section of
market observers. We have talked to investment banks, we have
talked to energy companies, we have talked to various Federal
regulators, academics, so it is a cross-section.
Mr. Conaway. All right. And then, I am assuming that you
will follow up, in your report that is coming, within 3 to 6
months, as to your findings or your evaluation of the validity
of those observations of these outsiders.
Ms. Williams. We hope to be able to speak to the trends and
patterns that we have observed.
Mr. Conaway. All right. Back to Mr. Lukken again. Back to
the enforcement. My background is with regulating CPAs and so
you mentioned 55 cases that have actually gone completely
through the process. Is that since 2000?
Mr. Lukken. I think it is since 2002, actually.
Mr. Conaway. 2002?
Mr. Lukken. Roughly, the time of the California energy
crisis, when a lot of this was going on.
Mr. Conaway. Okay. Can you give us some sense, a little
more detail? You said evidence of manipulation in the markets.
Can you give us some sort of a range as to what the impact of
that manipulation was that you are looking at?
Mr. Lukken. Well, this is 55 individuals and entities, so
there may have been fewer----
Mr. Conaway. No, no. I am talking about the cases that are
currently under investigation, the evidence of manipulation.
Can you give us some sense of what impact, unproven at this
point, but what impact it had on the markets dollar-wise? Did
it move crude oil $10 a barrel? What did the manipulation do
that you think happened?
Mr. Lukken. Well, the policy of the Commission is not to
openly discuss, in public----
Mr. Conaway. No, I am not asking for any names.
Mr. Lukken. Right.
Mr. Conaway. We have a hundred cases out there. I don't
know that anything you could tell us right now would link back
to that hundred, but can you give us some sense of what the
range of the impact on the market was for the manipulations
that you are investigating?
Mr. Lukken. I will be honest. I am not aware of the ranges
of some of these manipulations, but what I can do is I can
certainly brief you privately with our enforcement director on
what is going on and we can get into details of some of these
investigations.
Mr. Conaway. Okay. That is fair. Thank you. I yield back.
The Chairman. I thank the gentleman. The gentleman from
Georgia, Mr. Marshall, for 5 minutes.
Mr. Marshall. Thank you, Mr. Chairman. Ms. Williams, did
you testify before the Senate the other day?
Ms. Williams. No.
Mr. Marshall. Okay. So are you familiar with the testimony
that was given to the Senate?
Ms. Williams. Generally.
Mr. Marshall. Later this morning, Arthur Corbin, who is
with the Municipal Gas Authority of Georgia, is going to be
testifying and he will testify, and he has already testified,
that he believes that gas consumers in Georgia were
essentially, I don't know whether it would be defrauded or
what, but essentially, they had to pay about an additional $18
million as a result of the Amaranth speculation. And what would
be helpful, perhaps, to GAO, but certainly, to me and to many
others, is if in the course of GAO completing its
investigations into this entire area, you spoke specifically to
Mr. Corbin and specifically took him to account what he
believes occurred in Georgia.
Ms. Williams. Okay.
Mr. Marshall. And whether it is in your report or it is
somewhere else, if you would specifically comment upon not only
what happened, but also the suggested fixes that Mr. Corbin is
offering so that this sort of thing does not happen again, if,
in fact, something inappropriate did occur. The argument,
effectively, is that somebody who has a legitimate need for
natural gas, the Municipal Gas Authority of Georgia is just one
of many, is almost a pawn sort of caught and tossed by these
much larger forces that are speculating upon the future where
natural gas is concerned.
And if you have one large, very large trader heading in a
very bad direction, just making a big mistake, that big mistake
made by that trader not only affects the trader, but it affects
an awful lot of legitimate hedgers, entities that actually
consume and actually take delivery as opposed to just playing
the financial end of it. And so if you would specifically work
with him, I would appreciate that.
Ms. Williams. Absolutely. We will contact him.
Mr. Marshall. Mr. Lukken, I guess, congratulations on your
chairmanship. I will call you Mr. Chairman. The questions I had
for you have already been asked by Mr. Moran and Mr. Goodlatte.
I would like to elaborate a little bit, though, on the problem
that you identified in your Senate testimony. I took it to be
your view that perhaps some additional regulation should be
considered, but that we should go slow in trying to figure out
what that regulation might be and in response to Mr. Goodlatte,
you specifically said, ``We have to be very cautious and
precise,'' and it is not just the Commission, it is also the
lawmakers here.
And being cautious and precise requires that we understand
the possible impacts, very sophisticated possible impacts, that
any move that we make might have that could be detrimental to a
wide range of individuals, including consumers. And you have
already listed, for our benefit, in your testimony, in response
to questions from Mr. Moran and Mr. Goodlatte, the various
things that need to be taken into account. And I guess, as I
listened to that and I think about our current status, it seems
to me we ought not to be trying to do these things piecemeal, a
little dabble here, a little dabble there, let us do something
with energy over here with a little piece of legislation maybe
in another Committee, et cetera. Maybe we ought to be trying to
consider this as a whole cloth when we do CEA reauthorization.
And among the things we have to take into account is if we
give you additional responsibilities or requirements, what your
additional needs will be. What do you think? Should this be CEA
reauthorization and all folded into that or should we be doing
it piecemeal?
Mr. Lukken. I think that is logical, to try to do this as
part of CEA reauthorization. This is the Committee of
jurisdiction and expertise in this area. Many of you worked in
2000 on this bill and understand the participants, the players
and the concerns of this industry, so I think that that would
make perfect sense to try to do, along with GAO's
recommendations. Certainly, the Commission, hopefully, if we
have a full complement of Commissioners, can provide some
expertise and views on this, as well, to make sure that we
avoid these pitfalls in trying to find the right solution.
Mr. Marshall. I appreciate that. Back to Ms. Williams very
briefly. In addition, could GAO, assuming that the Georgia
Municipal Gas Authority and consumers in Georgia were
specifically hurt by Amaranth, could you make suggestions for
how to avoid that kind of thing in the future? I yield back.
The Chairman. I thank the gentleman. Let us see. Mr. Graves
for 5 minutes.
Mr. Graves. Thank you, Mr. Chairman. I have to tell you, I
appreciate you having this hearing. I just got a call. My
daughter got a Reserve Grand Champion Marking Guild at the fair
and I would much rather be there than here, but regardless, I
do appreciate this hearing and I don't know if I have so much a
question as a statement. Mr. Barrow and I introduced a bill
last year and he has introduced it again this year, with me on
there, that increased transparency considerably and oversight,
and I hope you take a good close look at that.
Your lack of staff or shortage of staff is well noted and
we understand that and you talk, too, about the prosecutions
being up. The only thing that concerns me about that is once it
gets to, at least the majority, to prosecutions, the impact on
the market has already been felt. We would much rather see this
prevented rather than it getting that far and that is the
reason for the oversight and more surveillance, and that is
what this bill specifically deals with. But I would very much
like to keep moving in that direction and improve that
considerably and I hope you will do that. Thank you, Mr.
Chairman.
The Chairman. The gentleman yields back?
Mr. Graves. Yes.
The Chairman. I thank the gentleman. Mr. Boustany.
Mr. Boustany. Thank you, Mr. Chairman. Ms. Williams, on
page 12 of your testimony, you talk about, in addition to
supply and demand factors that generally apply to energy
commodities, specific developments can affect particular
commodities, and you talk about special gasoline blends, the
so-called boutique fuels. We all know that the presence of a
number of boutique fuels does run up the cost because you have
a segmented market and so forth. Can you talk a little bit
about how does this complicate the work of the CFTC in terms of
looking for price manipulation?
Ms. Williams. Well, I think the bottom line in our
statement is that it complicates the analysis and it makes
establishing causality unclear because in the futures market,
as well as the physical market, you have a number of dynamics
going on and you have a lot of changes going on in each
marketplace, so it does complicate the analysis.
Mr. Boustany. Thank you. Commissioner Lukken, do you want
to comment on that?
Mr. Lukken. Well, traditionally, our job was much easier.
There was number two corn, there was wheat, these products. But
as these niche products have developed and the
interconnectedness between those products has increased, it
makes our surveillance economists' job much more difficult.
They have to look at much more information, trying to find out
where correlations might occur, so it is difficult. Technology
helps. We are able to, hopefully, bring some analytical tools,
with computers, to help bring some of these issues to bear, but
it is definitely a difficult job.
Mr. Boustany. Thank you. Since we last had you before the
Committee, we have seen the advent of ethanol futures. Can you
give us some observations, any ongoing issues with your work
with regard to monitoring ethanol futures?
Mr. Lukken. I think they were listed on the Chicago Board
of Trade, was it a year and a half ago or so? Yes, it is not
currently a very active contract on the Board of Trade, but I
think the thinking is that if there is a product there for risk
management, that those are involved in either the purchasing or
production of ethanol, have a risk mitigation device in the
futures markets that they can develop and be a part of. We
think it is a product that maybe hasn't reached its day, but
certainly will as ethanol production increases.
Mr. Boustany. Thank you. Given that most oil transactions,
I guess all oil transactions have been conducted in dollars,
but Iran recently made the announcement that they were going to
switch to Euros. Do you see this broadening on international
markets and how will this complicate what you do?
Mr. Lukken. Well, there are Middle East futures exchanges
now being developed. NYMEX is in partnership with the Dubai
Mercantile Exchange and there is now a Middle East crude oil
contract being traded there and these are all linked and
cleared through the United States. So it is bringing money and
dollars back into the United States as a result of that. So
this again, as you noted earlier, makes our job more difficult
because the more products, the more interconnectedness of these
products, the more difficult it is to surveil them. But we
have, hopefully, the analytical tools in place to keep an eye
on these markets.
Mr. Boustany. Thank you. Mr. Chairman, I yield back.
The Chairman. I thank the gentleman. Mr. Pomeroy for 5
minutes.
Mr. Pomeroy. Pass.
The Chairman. Wow. Thank you. Mr. Neugebauer for 5 minutes.
Mr. Neugebauer. Mr. Pomeroy's response has left me
speechless, Mr. Chairman.
The Chairman. But he did not yield his 5 minutes to you.
Mr. Neugebauer. I really just have one question, Mr.
Lukken. Of the cases of manipulation that you are currently
investigating, how many of those were brought to you by the
exchanges themselves or are those cases you originated on your
own?
Mr. Lukken. About 35 percent come from the exchanges or the
ECMs and the rest are developed either on our own or from tips.
Mr. Neugebauer. And since 100 is a good number to work with
percentages on, so on cases where you have manipulation alleged
or you open up a case on that, what would you say the
percentage of cases that you close and say, ``Well, in fact,
after further investigation, there was no manipulation.'' What
are the percentage of the cases where you said there was
manipulation?
Mr. Lukken. I would say a majority we end up closing. I
don't know percentage-wise what that might be, but it is
significant. It is more than 50 percent that we don't have the
evidence to prove that manipulation or attempted manipulation
occurred.
Mr. Neugebauer. And you may now have this number and you
could get it to me, I would be interested to know of the, say,
30 percent of the cases that the exchanges bring you, what the
closure rate is on that, also. I do have a second question. Are
you in any way alarmed right now that there is not currently a
system in place with the industry regulating itself? Obviously,
they have a vested interest in protecting the integrity of
their marketplaces or their exchanges because if it is
perceived that on a certain exchange that there is not
appropriate protection, would cause folks maybe not want to
trade with that exchange, but are you concerned? Obviously, we
would like to see nobody trying to manipulate markets and in
many cases, 50 percent of the people really aren't, but it
appears, because of their trading patterns, that they might be
doing something, so are you concerned?
Mr. Lukken. Well, we do the best we can. Our mission is to
detect and deter and try to prevent manipulations from ever
occurring. Oftentimes our surveillance, itself, deters this
from occurring. We talk people off the ledge and we call them
up and ask them what are they doing. Why are you doing it. So
oftentimes we never get to that hundred that I mentioned
earlier.
But once they get to that, there is evidence that something
occurred. We have to take strong enforcement action and look
into it vigorously and that is the complement of trying to
prevent it while also going after it once it does occur. And
oftentimes, this is coming from things outside the marketplace,
information or activities outside the marketplace that we
weren't able to surveil. We have to go after that vigorously
and we have done so, so I am very confident in our staff and
what we are doing in this area.
Mr. Neugebauer. That was a good answer, but that wasn't the
question. The question was are you concerned, currently? I mean
in other words, at the level of activity going on right now, do
you see any trend that makes you believe that we are out of
control, that we aren't policing the markets appropriately. Or
do you think that there is adequate protection and transparency
in the system today?
Mr. Lukken. I think we are adequately protecting the
regulated futures marketplace, yes.
Mr. Neugebauer. Thank you.
The Chairman. The gentleman yields back? I thank you. The
gentleman from Georgia, Mr. Barrow, for 5 minutes.
Mr. Barrow. Thank you, Mr. Chairman. I want to thank you,
Mr. Chairman, and the Ranking Member and all the other Members
of this Committee for the courtesy you extended me today of
allowing me to participate in your proceedings, knowing, as you
do, of mine and Mr. Graves' keen interest in this subject.
Thank you for your thoughtfulness.
The Chairman. With that, we would just remind you, we are
not going to extend more than 5 minutes.
Mr. Barrow. I am not going to take more than 5 minutes. And
I appreciate that reminder, too. I need that.
Mr. Commissioner, I just want to take the Amaranth
situation as a starting point, just to make sure I understand
at least part of what is going on here. Am I correct in
understanding that they had an over-the-counter position that
was a whole lot bigger than their market position, their
exchange position?
Mr. Lukken. Well, over time, Amaranth first began
exchanging on NYMEX and had a position on NYMEX and that
position, over time, shifted.
Mr. Barrow. My point is at the time of its collapse, their
over-the-counter position was a whole lot bigger than their
position in any regulated exchange?
Mr. Lukken. That is correct.
Mr. Barrow. And what kind of real-time notice did you all
have of that?
Mr. Lukken. We were not aware of the shift to ICE at the
time.
Mr. Barrow. Now, Mr. Graves and I are introducing a bill
today which really doesn't do very much, but I would like your
assessment of it. All it does is give you guys the direction to
go out there and pass a rule that defines what a ``large
position trade'' is or a ``large position trader.'' It gives
you all the discretion to say how big is enough to be reported
and how small is small enough not to be reported. It gives you
all the flexibility and the discretion to do that, but then it
tells you to go forth and do that and imposes a record keeping
requirement on folks.
Now, it seems to me just to be common sense that if folks
who had been trading without your notice and occupying much
larger positions in a completely unregulated marketplace, just
to know that someone has the opportunity to know what their
position is, if it is growing. But if someone obtains a legal
right to demand a whole lot more than any existing supply, or
any real world demand is, that someone is going to be able to
notice that as it is going on. It seems to me that would deter
a lot of misbehavior at the front end. What is wrong with that?
Can't you all handle that?
Mr. Lukken. I think the concept that you mention of
additional transparency in record keeping is a good one. Since
Amaranth, we have started to receive additional data from ICE.
Mr. Barrow. And I want to commend the representatives of
ICE, who will be testifying on the next panel, for their
initiative in this. My point is, they are only dealing with the
next level of lack of transparency outside the regulated
exchange. Beyond that are the bilaterals and the folks who want
any kind of regular exchange, regulated or otherwise. And my
question to you is, is it important to know, since the game is
now pretty much out there--isn't it important to know what kind
of position folks have so we can monitor or at least measure
the gap between the legal right to demand something and the
real demand for the commodity?
Mr. Lukken. Obviously, we have identified a similar risk
here with trying to get more information from ICE on the
regulated exchanges. As I mentioned earlier, and I am not sure
if you were here at the time, but by extending it more broadly
to the over-the-counter market raises concerns about us only
having jurisdiction over futures contracts and there had been,
in 2000, this debate over swaps versus futures. By trying to
pull them into our jurisdiction, that might have the reaction
of sending these markets overseas or to London or anywhere
where those markets can exist. And so I understand what you are
trying to do to bring greater transparency and record keeping
in this area. All I would ask is that this Committee, when it
considers these things, be precise, that there are difficult
legal questions here. But we would certainly welcome, our staff
would welcome, an opportunity to look at your legislation, give
views on what might be necessary to improve it.
Mr. Barrow. If it would put you all in the driver's seat in
deciding what has to be reported and what doesn't, can you
handle that?
Mr. Lukken. Again, within our current legal authorities,
yes. We are stretched to our legal bounds at the moment.
Mr. Barrow. Thank you, and thank you, Mr. Chairman. I yield
back.
The Chairman. I thank the gentleman. Commissioner Lukken,
Ms. Williams, thank you both for your testimony. We appreciate
you being with us and my guess is, as this is ongoing, you will
be together again in the not-too-distant future. Thank you.
Now we will welcome our second panel, if they get set up,
et cetera. Just so Members will know and you will know, we are
anticipating a vote somewhere around 11:30 plus. We are not
real sure exactly what time, depending on the action on the
floor. So hopefully, we will get through the opening statements
before we have to take a break.
Okay, I think we got everybody seated. Thank you and we
welcome the second panel to the table. Our first panelist is
Dr. James Newsome, President and CEO of the New York Mercantile
Exchange, New York. We welcome you here. And the next two I am
going to ask Mr. Scott, if he will, to introduce those since
they are from his home district in the State of Georgia.
Mr. Scott. Thank you very much, Mr. Chairman, and it
certainly is a great pleasure to welcome a couple of very fine
Georgians to this Committee; first of all, Mr. Jeff Sprecher,
who is the Chairman and CEO of IntercontinentalExchange.
Welcome and we are delighted to have you. And also, Mr. Arthur
Corbin of the Municipal Gas Authority of Georgia. We are
delighted to have you before this Committee and we look forward
to your testimony and thank you for coming.
The Chairman. Thank you. Mr. Robert Pickel, Executive
Director and CEO of the International Swaps and Derivatives
Association of New York. Welcome. We are glad to have you. Mr.
Paul Cicio, Industrial Energy Consumers of America in
Washington. And Mr. Craig Eerkes, President of Sun Pacific
Energy on behalf of the Petroleum Marketers Association of
America. Thank you for coming and Dr. Newsome, please begin
when you are ready. And please try to limit your testimony, as
much as you can, to 5 minutes. Your testimony and your full
statement will be included in the record. Thank you. Dr.
Newsome.
STATEMENT OF JAMES E. NEWSOME, Ph.D., PRESIDENT AND CEO, NEW
YORK MERCANTILE EXCHANGE, INC., NEW YORK, NY
Dr. Newsome. Thank you, Mr. Chairman and Members of the
Committee. I am Jim Newsome and I have the honor of serving as
President and the Chief Executive Officer of the New York
Mercantile Exchange, which is the world's largest forum for
trading, clearing physical commodity-based futures contracts,
including both energy and metals. NYMEX is fully regulated by
the CFTC under the Commodity Exchange Act, both as a clearing
organization and as a designated contract market, or DCM, which
is the highest and most comprehensive of regulatory oversight
to which a derivatives trading facility may be subject under
current law and regulation.
Mr. Chairman, I thank you and the Members of the Committee
for the opportunity to participate in today's hearing on energy
derivatives trading. Prior to joining NYMEX, I served as CFTC
Chairman. Mr. Chairman, I led the CFTC's implementation of the
Commodity Futures Modernization Act of 2000 and worked very
closely with this Committee in doing so. I tend to agree
completely with acting Chairman Lukken that the vast majority
of the CFMA has been very, very successful.
The CFMA streamlined and modernized the regulatory
structure of the derivatives industry and also permitted
bilateral trading of energy on electronic platforms. Under CFTC
rules, these electronic trading platforms are called ECMs, or
exempt commercial markets, and are subject only to the CFTC's
anti-fraud, anti-manipulation authority. Unlike the designated
contract market, the ECM is exempted from some statutory CFTC
regulation and also has no self-regulatory obligations to
monitor its own markets.
A series of significant changes has occurred in the natural
gas market since the passage of the CFMA, including
advancements in trading technology, such that NYMEX, the
regulated DCM, and the IntercontinentalExchange, ICE, an
unregulated ECM, have become highly linked trading venues. As a
result, which could not have been reasonably predicted just a
few short years ago, the current statutory structure, in my
opinion, no longer works for certain markets now operating as
ECMs. Specifically, the regulatory disparity between NYMEX and
ICE, which are functional equivalents, has created serious
challenges for the CFTC, as well as for the NYMEX in its
capacity as an SRO.
In August of 2006, NYMEX proactively took steps to maintain
the integrity of its markets by ordering Amaranth to reduce its
positions in the natural gas futures contract. However,
Amaranth then increased its positions on the unregulated and
non-transparent ICE electronic trading platform. Because the
ICE and NYMEX trading venues for natural gas are tightly linked
and highly interactive with each other, they are, in essence,
components of a broader natural gas derivatives market.
Therefore Amaranth's response to NYMEX's regulatory directive
did not reduce Amaranth's overall market risk. Furthermore, the
integrity of NYMEX markets continued to be affected by, and
exposed, to Amaranth's positions in the natural gas market.
Finally, NYMEX had no means to monitor Amaranth's positions
on ICE, or to take steps to have Amaranth reduce its
participation on that trading venue. Based upon these
experiences, I believe that ECMs such as ICE, that function
more like a traditional exchange, and that trade products that
are linked to an established exchange, should be subject to
regulation of the CFTC. Consequently, legislative change may be
necessary to address the real public interest concerns created
by the current structure of the natural gas market and the
potential for systemic risk.
Mr. Chairman, I would like to address two additional things
that were brought out with the previous panel. One, there was
quite a bit of discussion about the special call authority and
that is the authority that I used when I was Chairman of the
CFTC. It is very effective authority, particularly from an
enforcement standpoint, that allows the enforcement agency to
collect information and to use that information to build an
enforcement case. But the role of the Market Oversight Division
of the CFTC is to prevent that manipulation or that systemic
risk from occurring in the first place, and it is impossible to
do so when you only collect information after the fact. So that
was a point that I wanted to bring out.
The second point is with regard to the fear of flight to
offshore markets. Certainly, that is a potential risk and it is
a risk in a number of markets and situations that we talked
about. But I think here today we are specifically talking about
natural gas and the way that natural gas has evolved related to
other markets. In natural gas, I think one of the things that
is really different is the fact that even in the over-the-
counter space, 90 percent of the natural gas markets are now
cleared. They are cleared either at NYMEX or they are cleared
on Jeff's exchange at ICE. Because of that you are aggregating
that risk in an exchange type manner, but customers want to
clear those contracts. So I think because of the high
percentage of cleared contracts in natural gas, the fear of
that offshore risk is much decreased as compared to other
markets.
Thank you, Mr. Chairman.
[The prepared statement of Dr. Newsome follows:]
Prepared Statement of James E. Newsome, Ph.D., President and CEO, New
York Mercantile Exchange, Inc., New York, NY
Introduction
Mr. Chairman and Members of the Subcommittee, my name is Jim
Newsome and I am the President and Chief Executive Officer of the New
York Mercantile Exchange, Inc. (NYMEX or Exchange). NYMEX is the
world's largest forum for trading and clearing physical-commodity based
futures contracts, including energy and metals products. NYMEX has been
in the business for more than 135 years and is a federally chartered
marketplace, fully regulated by the Commodity Futures Trading
Commission (CFTC) both as a ``derivatives clearing organization'' and
as a ``designated contract market'' (DCM), which is the highest and
most comprehensive level of regulatory oversight to which a derivatives
trading facility may be subject under current law and regulation.
Prior to joining NYMEX, I served as a CFTC Commissioner and,
subsequently, from 2001 to 2004, as the Chairman. As Chairman, I led
the CFTC's implementation of the Commodity Futures Modernization Act of
2000 (CFMA). The CFMA streamlined and modernized the regulatory
structure of the derivatives industry and provided legal certainty for
over-the-counter (OTC) swap transactions by creating new exclusions and
exemptions from substantive CFTC regulation for bilateral transactions
between institutions and/or high net-worth participants in financial
derivatives and exempt commodity derivatives, such as energy and
metals.
On behalf of the Exchange, its Board of Directors and shareholders,
I thank you and the Members of the General Farm Commodities and Risk
Management Subcommittee for the opportunity to participate in today's
hearing on energy-related derivatives trading.
Statutory Background
In order to better understand the situation regarding energy-based
derivatives, it is useful to review a bit of history leading up to the
CFMA. For many years, the CFTC has had exclusive jurisdiction over the
regulation of contracts for a commodity for future delivery, i.e.,
futures contracts. Moreover, a longstanding requirement was that
futures contracts could only be traded on a futures exchange that was
directly regulated by the CFTC. A contract deemed by the CFTC to be a
futures contract that was not executed on a regulated futures exchange
was viewed as an illegal off-exchange transaction and would be subject
to CFTC enforcement action. Additionally, there was legal uncertainly
concerning the execution of swaps, including energy swaps, on an
electronic trading facility. During the 1990s, the OTC swap market
began to increase substantially in size, and swap agreements began to
be more standardized and strikingly similar to futures contracts. This
transition created additional legal uncertainty around the trading of
OTC swaps.
Because of the growing legal uncertainty regarding whether such
products were or were not futures contracts, Congress directed the
President's Working Group on Financial Markets (PWG) to conduct a study
of OTC derivatives markets and to provide legislative recommendations
to Congress. The PWG Report entitled ``Over-the-Counter Derivatives
Markets and the Commodity Exchange Act,'' was issued in 1999 and
focused primarily on swap and other OTC derivatives transactions
executed between eligible participants. Among other things, the PWG
Report recommended exclusion from the Commodity Exchange Act (CEA) for
swap transactions in financial products between eligible swap
participants. However, the PWG Report explicitly noted that ``[t]he
exclusion should not extend to any swap agreement that involved a non-
financial commodity with a finite supply.'' (Report of the PWG, ``Over-
the-Counter Derivatives Markets and the Commodity Exchange Act''
(November 1999) at p. 17.) The collective view at the CFTC at that time
was that the jury was still out as to whether or not energy commodities
were susceptible to manipulation and, therefore, energy commodities
should not be excluded from the Act.
In December 2000, Congress enacted the CFMA, which is widely
credited for the phenomenal growth and innovation of the futures
industry. The CFMA provided greater legal certainty for derivatives
executed in OTC markets; established a number of new statutory
categories for trading facilities; and shifted away from a ``one-size-
fits-all'' prescriptive approach to futures exchange regulation to a
more flexible approach that included use of core principles for DCMs.
The Congress included provisions in the CFMA which exempted energy
commodities from CFTC regulation and allowed the trading of energy
swaps on an electronic trading platform. Under CFTC rules, these
trading facilities are known as ``Exempt Commercial Markets'' (ECM).
While transactions executed on an ECM generally are subject to anti-
fraud and anti-manipulation authority, the ECM itself is essentially
exempt from all substantive CFTC regulation and oversight and has no
self-regulatory responsibilities.
NYMEX's Role and Responsibilities as a DCM
NYMEX is fully regulated by the CFTC as a DCM, which is the highest
level of regulation for a trading platform under the CEA. As a DCM,
NYMEX has an affirmative responsibility to act as a self-regulatory
organization (SRO) and to monitor and to police activity in its own
markets. The CFMA established a number of ``Core Principles'' for DCM
regulation. The CFMA also permitted bilateral trading of energy on
electronic platforms. Under CFTC rules, ECMs are subject only to the
CFTC's anti-fraud and anti-manipulation authority. Unlike the DCM, the
ECM is completely unregulated by the CFTC and thus has no self-
regulatory obligations to monitor its own markets or otherwise to
prevent market abuses. The IntercontinentalExchange (ICE) is an ECM.
As the benchmark for energy prices around the world, trading on
NYMEX is transparent, open and competitive and fully regulated by the
CFTC. NYMEX does not trade in the market or otherwise hold any market
positions in any of its listed contracts and, being price neutral, does
not influence price movement. Instead, NYMEX provides trading fora that
are structured as pure auction markets for traders to come together and
to execute trades at competitively determined prices that best reflect
what market participants think prices will be in the future, given
today's information. Transactions can also be executed off-Exchange,
i.e., in the traditional bilateral OTC arena, and submitted to NYMEX
for clearing via the NYMEX ClearPort' Clearing website
through procedures that will substitute or exchange a position in a
regulated futures or options contract for the original OTC product.
Unlike securities markets, which serve an essential role in capital
formation, organized derivatives venues such as NYMEX provide a very
different, but equally important economic benefit to the public by
serving two key functions: (1) competitive price discovery and (2)
hedging by market participants.
The public benefits of commodity markets, including increased
market efficiencies, price discovery and risk management, are enjoyed
by the full range of entities operating in the U.S. economy, whether or
not they trade directly in the futures markets. Everyone in our economy
is a public beneficiary of vibrant, efficient commodity markets, from
the U.S. Treasury, which saves substantially on its debt financing
costs, to every food processor or farmer, every consumer and company
that uses energy products for their daily transportation, heating and
manufacturing needs, and anyone who relies on publicly available
futures prices as an accurate benchmark.
Under the CFMA, NYMEX must comply with a number of broad,
performance-based Core Principles applicable to DCMs that are fully
subject to the CFTC's regulation and oversight. These include eight
Core Principles that constitute initial designation criteria, as well
as 18 other ongoing Core Principles for DCMs.
NYMEX has an affirmative obligation to act as a SRO. As such, NYMEX
must police its own markets and maintain a program that establishes and
enforces rules related to detecting and deterring abusive practices. Of
particular note is the series of Core Principles that pertain to
markets and to market surveillance. A DCM can list for trading only
those contracts that are not readily susceptible to manipulation. In
addition, a DCM must monitor trading to prevent manipulation, price
distortion and disruptions of the delivery or cash-settlement process.
Furthermore, to reduce the potential threat of market manipulation or
congestion, the DCM must adopt position limits or position
accountability for a listed contract, where necessary or appropriate.
NYMEX has numerous surveillance tools that are used routinely to
ensure fair and orderly trading on our markets. The large trader
reporting system is the principal tool that is used by DCMs to monitor
trading for purposes of ensuring market integrity. For energy
contracts, the reportable position levels are distinct for each
contract listed by the Exchange for trading. The levels are set by
NYMEX and are specified by rule amendments that are submitted to the
CFTC, typically following consultation and coordination with the CFTC
staff.
The NYMEX Market Surveillance staff routinely reviews price
activity in both futures and cash markets, focusing, among other
things, on whether the futures markets are converging with the spot
physical market as the NYMEX contract nears expiration. Large trader
data are reviewed daily to monitor customer positions in the market. On
a daily basis, NYMEX collects the identities of all participants who
maintain open positions that exceed set reporting levels as of the
close of business the prior day. These data are used to identify
position concentrations requiring further review and focus by Exchange
staff. These data are also published in aggregate form for public
display by the CFTC on its website in a weekly report referenced as the
Commitments of Traders (COT) report. Historically at NYMEX, the open
interest data included in large trader reports reflects approximately
80% of total open interest in the applicable contracts.
Any questionable market activity results in an inquiry or formal
investigation. NYMEX closely monitors its futures market at all times
in order to enforce orderly trading and liquidations. NYMEX staff
additionally increases its market surveillance reviews during periods
of heightened price volatility.
By rule, NYMEX also maintains and enforces limits on the size of
positions that any one market participant may hold in a listed
contract. These limits are set at a level that greatly restricts the
opportunity to engage in possible manipulative activity on NYMEX. It is
the tradition in futures markets that futures and options contracts
generally are listed as a series of calendar contract months. When
position accountability levels are exceeded, exchange staff conducts
heightened review and inquiry, which may result in NYMEX staff
directing the market participant to reduce its positions. Breaching the
position limit can result in disciplinary action being taken by the
Exchange. Finally, NYMEX also maintains a program that allows for
certain market participants to apply for targeted exemptions from the
position limits in place on expiring contracts. Such hedge exemptions
are granted on a case-by-case basis following adequate demonstration of
bona fide hedging activity involving the underlying physical cash
commodity or involving related swap agreements.
Beyond the formal regulatory requirements, NYMEX staff works
cooperatively and constructively with CFTC staff to assist them in
carrying out their market surveillance responsibilities. NYMEX staff
and CFTC staff regularly engage in the informal sharing of information
about market developments. In addition to the Exchange's self-
regulatory program, the CFTC conducts ongoing surveillance of NYMEX
markets, including monitoring positions of large traders, deliverable
supplies and contract expirations. The CFTC also conducts routine
``rule enforcement'' reviews of our self-regulatory programs. NYMEX
consistently has been deemed by the CFTC to maintain adequate
regulatory programs and oversight, in compliance with its self-
regulatory obligations under the Commodity Exchange Act.
Moreover, NYMEX staff can and do make referrals to CFTC staff for
possible investigation, such as with respect to activity by a market
participant that is not a NYMEX member or member firm. Thus, for
example, in an investigation of a non-member market participant, the
Exchange would lack direct disciplinary jurisdiction and the consequent
ability to issue effective sanctions (other than denial of future
access to the trading of our products). In that situation, NYMEX staff
could and has in the past turned over the work files and related
information to CFTC staff. All such referrals are made on a strictly
confidential basis. Similarly, CFTC staff on occasion makes
confidential referrals to NYMEX staff as well.
Overall, there is a strong overlap between the CFTC's regulatory
mission and NYMEX's SRO role in ensuring the integrity of trading in
NYMEX's contracts. NYMEX itself has a strong historic and ongoing
commitment to its SRO responsibilities. As noted in the Report, the
NYMEX regulatory program has a current annual budget of approximately
$6.2 million, which reflects a significant commitment of both staff and
technology.
Linked Trading Venues
At the time that the CFMA was being formulated in Congress, there
may have been a notion that the public interest was not implicated by
trading on markets such as ICE because larger market participants did
not need a regulatory agency to protect them from trading with each
other. Yet, what has become clear in the last several years is that the
changing nature and role of ECM venues such as ICE do now trigger
public interest concerns in several ways, including with respect to the
multiple impacts on other trading venues that are regulated as well as
through the exchange-like aggregation of financial risk.
A series of profound changes have occurred in the energy markets
since the passage of the CFMA, including technological advances in
trading, such that the regulated DCM, NYMEX, and the unregulated ECM,
ICE, have become highly linked trading venues. As a result of this
phenomenon, which could not have been reasonably predicted only a few
short years ago, the current statutory structure no longer works for
certain markets now operating as ECMs. Specifically, the regulatory
disparity between the NYMEX and the ICE, which are functionally
equivalent, has created serious challenges for the CFTC as well as for
NYMEX in its capacity as an SRO.
We do not believe that the case has been made and, thus, we do not
support any new regulation of derivatives transactions that are
individually negotiated and executed off-exchange i.e., not on a
trading facility, between eligible participants in the traditional
bilateral OTC market. On the other hand, we do believe that ECMs such
as ICE that function more like a traditional exchange and that are
linked to an established exchange should be subject to the full
regulation of the CFTC. In addition, the continuing exchange-like
aggregation and mutualization of risk at the clearinghouse level from
trading on active ECMs such as ICE, where large positions are not
monitored, raise concerns about spill-over or ripple effects for other
clearing members and for various clearing organizations that share
common clearing members. Consequently, legislative change may be
necessary to address the real public interest concerns created by the
current structure of the natural gas market and the potential for
systemic financial risk from a market crisis involving significant
activity occurring on the unregulated trading venue.
In 2001, when the CFTC was proposing and finalizing implementing
regulations and interpretations for the CFMA, and shortly following the
Enron meltdown in late 2001, the natural gas market continued to be
largely focused upon open outcry trading executed on the regulated
NYMEX trading venue. At that time, NYMEX offered electronic trading on
an ``after-hours'' basis, which contributed only approximately 7-10% of
overall trading volume at the Exchange. Electronic trading (of
standardized products based upon NYMEX's natural gas contracts) was at
best a modest proportion of the overall market. Moreover, it was more
than 6 months following the Enron meltdown before the industry began to
offer clearing services for OTC natural gas transactions.
In determining to compete with NYMEX, ICE copied all of the
relevant product terms of NYMEX's core or flagship natural gas futures
contract, and also misappropriated the NYMEX settlement price for daily
and final settlement of its own contracts. ICE's misappropriation of
NYMEX's intellectual property remains a matter of dispute in ongoing
litigation between the two exchanges that is now under judicial appeal.
However, as things stand today, natural gas market participants have
the assurance that they can receive the benefits of obtaining NYMEX's
settlement price, which is now the established industry pricing
benchmark, by engaging in trading either on NYMEX or on ICE.
For some period of time following the launch of ICE as a market,
ICE was the only trading platform that offered active electronic
trading during daytime trading hours. In September 2006, NYMEX began
providing ``side-by-side'' trading of its products--listing products
for trading simultaneously on the trading floor and on the electronic
screen. Since that time, there has been active daytime electronic
trading of natural gas on both NYMEX and ICE. The share of electronic
trading at NYMEX as a percentage of overall transaction volume has
shifted dramatically to the extent that electronic trading now accounts
for 80-85% of overall trading volume at the Exchange. The existence of
daytime electronic trading on both NYMEX and ICE has fueled the growth
of arbitrage trading between the two markets. Thus, for example, a
number of market participants that specialize in arbitrage activity
have established computer programs for electronic trading that
automatically transmit orders to one market when there is an apparent
price imbalance with the other market or where one market is perceived
to offer a better price than the other market. As a result, there is
now a relatively consistent and tight spread in the prices of the
competing natural gas products. Hence, the two competing trading venues
are now tightly linked and highly interactive and in essence are simply
two components of a broader derivatives market. No one could have
predicted in 2000, when the exemption was crafted for energy swaps, how
this market would have evolved.
When the price of a product trading on one venue (ICE) is linked to
the final settlement price of a product trading on another venue
(NYMEX), trading on one venue contributes or influences the price of
that product trading on the other venue. The CFTC acknowledged in its
recent proposed rule-making that there is ``a close relationship among
transactions conducted on reporting markets and non-reporting
transactions.'' (72 Fed. Reg. 34413, at 34414 (2007) (proposed June 22,
2007.) It is also relevant to consider the recent statement issued on
June 14, 2007 by the Department of Justice (DOJ) Antitrust Division
announcing the closure of its review of the proposed acquisition by
Chicago Mercantile Exchange Holdings Inc. of CBOT Holdings Inc. based
upon the DOJ's determination that neither that acquisition nor the
clearing agreement between the two exchanges was likely to reduce
competition substantially. NYMEX believes that this announcement is
based upon a tacit recognition by the Antitrust Division that, with
regard to analysis of the relevant market, at a minimum, regulated
futures trading and over-the-counter trading are simply components of a
broader market (that also might be defined to include some cash market
activity as well).
In addition to the misappropriation of NYMEX's settlement price,
the ICE market now has a significant market share of natural gas
trading, and a number of observers have suggested that most of the
natural gas trading in the ICE Henry Hub swap is subsequently cleared
by the London Clearing House, the clearing organization contracted by
ICE to provide clearing services. Thus, there is now a concentration of
market activity and positions occurring on the ICE market as well as
the exchange-like concentration and mutualization of financial risk at
the clearing house level from that activity.
A clear illustration of the negative implications of unregulated
ECMs linked to regulated DCMs can be seen in the demise of Amaranth, a
hedge fund that actively traded natural gas on both NYMEX and ICE. In
August 2006, NYMEX proactively took steps to maintain the integrity of
its markets by ordering Amaranth to reduce its open positions in the
Natural Gas futures contract. However, Amaranth then sharply increased
its positions on the unregulated and nontransparent ICE electronic
trading platform. Because the ICE and NYMEX trading venues for natural
gas are tightly linked and highly interactive with each other and
essentially are components of a broader natural gas derivatives market,
Amaranth's response to NYMEX's regulatory directive admittedly reduced
its positions on NYMEX but did not reduce Amaranth's overall market
risk nor the risk of Amaranth's guaranteeing clearing member.
Furthermore, the integrity of NYMEX markets continued to be affected by
and exposed to Amaranth's outsize positions in the natural gas market.
Moreover, NYMEX had no efficient means to monitor Amaranth's positions
on ICE or to take steps to have Amaranth reduce its participation in
that trading venue.
Because ICE price data are available only to market participants,
NYMEX does not have the means to establish conclusively the extent to
which trading of ICE natural gas swaps contributes to or influences or
affects the price of the related natural gas contracts on NYMEX.
However, what is clear is that, as a consequence of the extensive
arbitrage activity between the two platforms and ICE's use of NYMEX's
settlement price as well as other factors, the two natural gas trading
venues are now tightly linked and highly interactive. These two trading
venues serve the same economic functions and are now functionally
equivalent to each other. NYMEX staff has been advised that, during
most of the trading cycle of a listed futures contract month, there is
a range of perhaps only five to twelve ticks separating the competing
NYMEX and ICE products. (The NYMEX NG contract has a minimum price
fluctuation or trading tick of $.001, or .01 cents per mmBtu.) NYMEX
staff has also been advised by market participants who trade on both
markets that a rise (fall) in price on one trading venue will be
followed almost immediately by a rise (fall) in price on the other
trading venue. This may occur because prices rise first on ICE and then
follow on NYMEX, or because prices rise first on NYMEX and then follow
on ICE. These observations of real-world market activity support the
conclusion that trading of ICE natural gas swaps do in fact contribute
to, influence and affect the price of the related natural gas contracts
on NYMEX.
Aside from a lawsuit brought by NYMEX against ICE for the use of
NYMEX's settlement prices, which as noted is a matter that remains
under appeal in a Federal court of appeals, NYMEX does not otherwise
have any other ongoing formal relationship with ICE. In particular, as
ICE and NYMEX are in competition with each other, there are currently
no arrangements in place, such as information-sharing, to address
market integrity issues. As stated previously, NYMEX as a DCM does have
affirmative self-regulatory obligations; ICE as an ECM has no such
duties. Yet, from a markets perspective, the ICE and NYMEX trading
venues for natural gas are tightly linked and highly interactive;
trading activity and price movement on one venue can quickly affect and
influence price movement on the other venue.
In a recent report by the Senate Committee on Homeland Security and
Government Affairs' Permanent Subcommittee on Investigations regarding
``Excessive Speculation in the Natural Gas Market'', the Subcommittee
made a number of findings concerning the demise of Amaranth. Among
other things, the Subcommittee report concluded that in August 2006
Amaranth traded natural gas contracts on ICE rather than on NYMEX so
that it could trade without any restrictions on the size of its
positions. The report also concluded that ICE and NYMEX affect each
other's prices in natural gas trading. Furthermore, the report found
that the CFTC lacked effective statutory authority to establish or
enforce speculative position limits for the trading of natural gas on
ICE or on other exempt commercial markets. The report then called for
the CFTC to receive such additional authority.
The lack of effective position limits is of broader significance
because the issue also arises with respect to energy products other
than natural gas. Specifically, ICE Futures (a subsidiary of ICE and a
foreign board of trade regulated by the UK Financial Services
Authority) lists for trading a crude oil contract that replicates the
terms of the NYMEX West Texas Intermediate Crude Oil (WTI) contract,
including the daily and final settlement prices. ICE Futures has no
direct regulatory relationship with the CFTC, and continues to rely on
a ``no action'' letter that the CFTC issued to its predecessor back in
1998. ICE Futures now has a market share of approximately 40 percent of
the WTI crude oil futures volume, but none of that volume is subject to
U.S. regulation. Under the U.K. Financial Services Authority regulatory
structure, trading of the WTI contract on ICE Futures is not subject to
any position limit requirements. Thus, there is also a regulatory
imbalance in crude oil trading that provides a clear incentive for
market participants to shift trading in order to be able to trade
without any effective restrictions on the size of their positions.
NYMEX Natural Gas Expiration Advisory
On February 16, 2007, in an effort to cooperate with the Federal
Energy Regulatory Commission and following consultation with CFTC
staff, NYMEX issued a compliance advisory in the form of a policy
statement related to exemptions from position limits in NYMEX Natural
Gas (NG) futures contracts NYMEX adopted this new policy on an interim
basis in a good faith effort to carry out its self-regulatory
responsibilities and to address on an individual exchange level the
market reality demonstrated by Amaranth's trading on both regulated and
unregulated markets. However, as detailed below, this experience has
had an adverse impact on NYMEX's trading venues and is seemingly
creating the result of shifting trading volume (during the critically
important NG closing range period at NYMEX on the final day of trading)
from our regulated trading venue to unregulated trading venues.
Pursuant to that advisory, NYMEX instituted new uniform
verification procedures to document market participants' exposure
justifying the use of an approved hedge exemption in the NG contract.
These procedures apply to all market participants who carry positions
above the standard expiration position limit of 1,000 contracts going
into the final day of trading for the expiring contract. Specifically,
prior to the market open of the last trading day of each expiration,
NYMEX now requires all market participants with positions above the
expiration position limit of 1,000 contracts to supply information on
their complete trading ``book'' of all natural gas positions linked to
the settlement price of the expiring NG contract. Positions in excess
of 1,000 contracts must offset a demonstrated risk in the trading book,
and the net exposure of the entire book must be no more than 1,000
contracts on the side of the market that could benefit by trading by
that market participant during the closing range.
NYMEX has now experienced five expirations of a terminating
contract month in the NG futures contract since this new compliance
advisory went into effect. To date, only two market participants have
participated in this advisory and supplied information to the Exchange
on their complete trading book. By comparison, NYMEX staff has observed
a number of instances where market participants have reduced their
positions before the open of the final day of trading rather than share
sensitive trading information about proprietary trading with Exchange
staff. As a result, NYMEX has observed reduced trading volume on the
final day of trading in an expiring contract month relative to the
final day of trading for the same calendar contract month in the prior
year. The average volume on the final day of trading for the March,
April, May, June and July 2007 NG contracts was 30,400 versus 37,122
for the corresponding contract month in the prior year, or an 18%
reduction
Even more significantly, the closing range volume for the 30 minute
closing period on the final day of trading is sharply lower than for
volume during the final day closing range for the same calendar
contract month in the prior year. In most instances, the volume in the
closing range is less than half of the volume in the closing range for
the same calendar contract month in the prior year. The average closing
range volume on the final day of trading for the March, April, May,
June and July 2007 NG contracts was 14,048 versus 23,165 for the
corresponding contract month in the prior year, or a 39% reduction.
Overall market volatility in the natural gas market is somewhat
lower this spring and summer than from comparable periods a year ago.
This lower volatility stems from a lack of price volatility in the
underlying physical cash commodity and in our opinion not from our
implementation of this advisory. That stated, the lower volumes seen
during the recent 30 minute closing ranges on the final day of trading
since the implementation of the new policy actually create the
potential for even greater volatility in the event of any significant
market move. Thus, the new interim policy implemented by NYMEX on a
good-faith basis has not only led to reduced volume on NYMEX during the
critical 30 minute closing range period, which presumably has shifted
to the unregulated trading venues, but has also failed to solve the
structural imbalances brought to light by Amaranth's trading. In
addition, this policy could create new problems by diminishing the
vitality of the natural gas industry's pricing benchmark. Consequently,
NYMEX believes that legislative change may be necessary and
appropriate.
Conclusion
A series of profound changes have occurred in energy-related
derivatives markets since the passage of the CFMA, including
technological advances in trading, such that the regulated DCM, NYMEX,
and the IntercontinentalExchange, an unregulated ECM, have become
highly linked trading venues. As a result of this phenomenon, the
regulatory disparity between NYMEX and ICE, which are functionally
equivalent to each other, has created serious challenges for the CFTC
as well as for NYMEX in its capacity as an SRO.
We do not support any new regulation of derivatives transactions
that are individually negotiated and executed off-exchange between
eligible participants in the traditional bilateral OTC market. On the
other hand, we do believe that ECMs such as ICE that function more like
a traditional exchange and that are linked to an established exchange
should be subject to the full regulation of the CFTC. In addition, the
aggregation and mutualization of risk at the clearinghouse level from
trading on active ECMs such as ICE, where large positions are not
monitored, raise concerns about spill-over or ripple implications for
other clearing members and for various clearing organizations that
share common clearing members. Consequently, legislative change may be
necessary to address the real public interest concerns created by the
current structure of the natural gas market and the potential for
systemic financial risk from a market crisis involving significant
activity occurring on the unregulated trading venue.
I thank you for the opportunity to share the viewpoint of the New
York Mercantile Exchange with you today. I will be happy to answer any
questions Members of the Subcommittee may have.
The Chairman. Thank you, sir. Mr. Sprecher.
STATEMENT OF JEFFREY C. SPRECHER, FOUNDER,
CHAIRMAN, AND CEO, IntercontinentalExchange, INC.,
ATLANTA, GA
Mr. Sprecher. Thank you, Mr. Chairman, Subcommittee Members
and staff members. My name is Jeff Sprecher and I am the
Chairman/Chief Executive Officer of IntercontinentalExchange,
which is also called ICE. We very much appreciate the
opportunity to appear before you today to discuss the
operations of ICE, and to share with you our views on the
regulation of the energy derivatives markets. ICE operates a
leading global commodity marketplace comprising of both futures
and over-the-counter markets across a wide variety of product
classes, including agriculture and energy commodities, foreign
exchange and equity indices.
ICE owns and operates two regulated futures exchanges. ICE
Futures, which is a London-based energy futures exchange, and
it is overseen by the UK Financial Services Authority, and we
own the Board of Trade of the City of New York, which is an
agricultural commodity and financial futures exchange regulated
by the CFTC. ICE's electronic marketplace for OTC energy
contracts is now serving customers in Asia, Europe and the U.S.
and it is operated under the Commodity Exchange Act as a
category of marketplace known as the ECM. As an ECM, these
markets are subject to the jurisdiction of the CFTC and to
regulations of the CFTC which impose record keeping, reporting
and other requirements on us.
In addition, ICE has established an automated, daily
position reporting system to the CFTC in our cleared natural
gas markets, which we continue to work with them to enhance and
support. ICE has always been, and we continue to be, a strong
proponent of open and competitive markets in energy commodities
and their related derivatives, and of regulatory oversight of
these markets. As an operator of global futures and over-the-
counter markets and as a publicly traded company, we strive to
ensure the utmost confidence in the integrity of the markets
and the soundness of our business mode. So to that end, we have
consistently worked with the CFTC and regulatory agencies in
the U.S. and abroad to make sure that they have access to all
relevant information that is available to ICE regarding the
trading activity in our markets. And we are going to continue
to work with all relevant agencies in the future.
We strongly support legislative and regulatory changes that
will enhance the quality of oversight and available information
with respect to natural gas in the United States. For example,
we are in favor of increases to the CFTC's budget and the
enhancement of its access to trading information. However, we
do not believe that a complete overhaul of the current
regulatory structure is either warranted, or is it advisable.
Moreover, any regulatory changes that are made need to reflect
the nature of ICE and its markets and the significant
differences that exist between the many venues for over-the-
counter trading of swaps and derivatives that exist today.
We also believe that any consideration of possible changes
to the current regulatory structure must be based on an
understanding of the operations of an ECM market such as ICE
and the balance that was struck by Congress and the CFTC
between overseeing these markets, while still allowing them to
function in the context of OTC trading by commercial and
institutional participants. We welcome the opportunity to work
with the Subcommittee and its staff on these important issues
and thank you.
[The prepared statement of Mr. Sprecher follows:]
Prepared Statement of Jeffrey C. Sprecher, Founder, Chairman, and CEO,
IntercontinentalExchange, Inc., Atlanta, GA
Mr. Chairman, Subcommittee Members and Staff Members, my name is
Jeff Sprecher and I am the Chairman and Chief Executive Officer of
IntercontinentalExchange, Inc., or ``ICE.'' We very much appreciate the
opportunity to appear before you today to discuss the operations of ICE
and to share with you our views on the regulation of the energy
derivatives markets.
ICE operates a leading global commodity marketplace, comprising
both futures and over-the-counter (``OTC'') markets, across a variety
of product classes, including agricultural and energy commodities,
foreign exchange and equity indexes. ICE owns and operates two
regulated futures exchanges--ICE Futures, a London-based energy futures
exchange overseen by the U.K. Financial Services Authority, and the
Board of Trade of the City of New York, or ``NYBOT,'' an agricultural
commodity and financial futures exchange regulated by the Commodity
Futures Trading Commission (``CFTC''). ICE's electronic marketplace for
OTC energy contracts serves customers in Asia, Europe and the U.S. and
is operated under the Commodity Exchange Act (``CEA'') as a category of
marketplace known as an ``exempt commercial market,'' or ECM. As an
ECM, these markets are subject to the jurisdiction of the CFTC and to
regulations of the CFTC imposing record keeping, reporting and other
requirements. In addition, and as I will discuss later, ICE has
established a daily position reporting program to the CFTC in its
cleared natural gas markets that we continue to enhance and support.
ICE has always been and continues to be a strong proponent of open
and competitive markets in energy commodities and related derivatives,
and of regulatory oversight of those markets. As an operator of global
futures and OTC markets and as a publicly-held company, we strive to
ensure the utmost confidence in the integrity of our markets and in the
soundness of our business model. To that end, we have continuously
worked with the CFTC and other regulatory agencies in the U.S. and
abroad in order to ensure that they have access to all relevant
information available to ICE regarding trading activity on our markets
and we will continue to work with all relevant agencies in the future.
ICE strongly supports legislative and regulatory changes that will
enhance the quality of oversight and available information with respect
to the natural gas markets. For example, we are in favor of increases
to the CFTC's budget and the enhancement of its access to trading
information.
However, we do not believe that a complete overhaul of the current
regulatory structure is either warranted or advisable. Moreover, any
legislative or regulatory changes that are made need to reflect the
nature of ICE and its markets and the significant differences between
ICE and the many other venues for OTC trading that exist today. In
particular, as I will discuss, while the New York Mercantile Exchange
(``NYMEX'') natural gas futures contract is subject to position limits
in the last 3 days of trading, such limits are neither appropriate nor
necessary in connection with ICE's OTC natural gas swap. Indeed, the
NYMEX natural gas swap, like ICE's contract, is not subject to position
limits. We also believe that any consideration of possible changes to
the current regulatory structure must be based upon an understanding of
the operations of ``exempt commercial markets,'' such as ICE, and of
the balance struck by Congress and the CFTC between overseeing these
markets while still allowing them to function in the context of OTC
trading by commercial and institutional participants. We welcome the
opportunity to work with the Subcommittee and its staff on these
important issues.
ICE Operates Its Over-the-Counter Platform as an ECM and Is Not
``Unregulated''
Broadly, because OTC markets tend to be global in nature, most OTC
markets are now conducted electronically across asset classes,
including OTC markets for U.S. interest rate instruments, foreign
exchange and debt securities. ICE responded to the transparency and
speed enjoyed in other OTC markets by establishing its many-to-many
electronic marketplace for trading physical energy commodities and
financially-settled over-the-counter derivatives, primarily swaps, on
energy commodities. ICE in effect performs the same function as a
``voice broker'' in the OTC market, but does so through an electronic
platform that provides full market transparency to market participants,
timely market information, greater speed of trade execution, record
keeping efficiency and a more reliable and complete audit trail with
respect to orders entered, and transactions executed, on our platform
than exists with respect to traditional, non-electronic OTC venues. The
introduction and development of ICE's platform have promoted
competition and innovation in the energy derivatives market, to the
benefit of all market participants and consumers generally. The
reliability of ICE's markets has also resulted in an increasing
preference for electronic trading in these markets. NYMEX itself, in
its recent testimony before the Senate Permanent Subcommittee on
Investigations (the ``Senate PSI''), noted that 80-85% of its volume is
now traded electronically, a development driven largely by competition
from ICE. The CFTC also pointed out, in its Senate PSI testimony, that
``the ability to manipulate prices on either [NYMEX or ICE] has likely
been reduced, given that ICE has broadened participation in contracts
for natural gas.''
Participants on ICE enter bids and offers electronically and are
matched in accordance with an algorithm that executes transactions on
the basis of time and price priority. Participants executing a
transaction on our platform may settle the transaction in one of two
ways--on a bilateral basis, settling the transaction directly between
the two parties, or on a cleared basis through LCH.Clearnet using the
services of a futures commission merchant that is a member of
LCH.Clearnet. In addition to providing the clearing house with daily
settlement prices, ICE is also responsible for maintaining data
connectivity to the clearing house.
It is important to note that there are substantial differences
between ICE's OTC market, other portions of the OTC market, and the
NYMEX futures market, and that these differences necessarily inform and
guide the appropriate level of oversight and regulation of our markets.
First, ICE is only one of many global venues on which market
participants can execute OTC trades. A significant portion of OTC
trading in natural gas is executed through voice brokers or direct
bilateral negotiation between market counterparties. Of the available
fora, only ICE (and any other similarly-situated ECMs) is subject to
CFTC jurisdiction and the CFTC's regulations, or to limitations on the
nature of its participants. ICE also provides far greater transparency,
efficiency and data reliability for the benefit of market participants
and regulators alike than voice brokers or other OTC market mechanisms.
Second, participants in the futures markets must either become members
of the relevant exchange or trade through a futures commission merchant
that is a member. In contrast, ICE's OTC market, by law, is a
``principals only'' market in which participants must have trades
executed in their own names on the system, providing greater
transparency with respect to trader-level transaction data due to the
absence of a ``middle man.'' Third, the OTC market offers a
substantially wider range of products than the futures markets,
including, for example, hundreds of derivatives contracts on natural
gas and pricing against a large number of delivery points, of which
there are approximately 100 in North America.
Fourth, the financially-settled swaps traded on ICE's OTC market
require one party to pay to the other a cash amount determined by
reference to settlement prices in the corresponding futures contracts
but do not, and cannot, result in the physical delivery or transfer of
energy commodities. Our natural gas contract, for example, constitutes
an important commercial hedging vehicle and has served as an important
complement to and a hedge for the NYMEX natural gas futures contract.
However, our contract cannot affect physical delivery in the market and
it therefore ultimately has limited ability to drive the pricing of
natural gas, particularly as the relevant futures contract approaches
delivery. An understanding of the differences between the NYMEX and ICE
markets and contracts is critical to any determination of the
appropriate regulation of these markets, as I will explain more fully
later.
ICE operates its OTC platform as an ``exempt commercial market,''
or ``ECM,'' under the CEA. The ECM category was adopted as part of the
Commodity Futures Modernization Act of 2000 (``CFMA''). The creation of
the ECM category reflected Congress's recognition that ``electronic
voice brokers,'' such as ICE, occupy a middle ground between completely
unregulated OTC brokers and market participants and fully regulated
exchanges. Congress therefore sought to strike a balance between
providing for oversight and regulation of these electronic markets, due
to the more extensive participation in their markets by commercial and
institutional entities, while still allowing them to function as OTC
markets, which hold a vital place in commodity market structure, rather
than as futures markets, which would alter their role as a hedging
mechanism. The ECM category accomplished this objective. Pursuant to
the CFMA, an electronic market can operate as an ECM if it limits its
participants to ``eligible commercial entities,'' or ``ECEs.''
Transactions and participants on ECMs are fully subject to the anti-
fraud and anti-manipulation provisions of the CEA and the CFTC has
jurisdiction over such transactions and participants.
As an ECM, ICE is itself subject to a certain level of regulation
by the CFTC. In particular, ICE is required, pursuant to the CEA and
CFTC regulations specifically addressed to ECMs, to:
prepare and maintain for 5 years records of all transactions
executed on its markets;
report to the CFTC certain information regarding
transactions in products that are subject to the CFTC's
jurisdiction and that meet specified trading volume levels;
report to the CFTC certain trader information on the
execution of transactions in ICE's cleared natural gas market,
pursuant to a special call for information from the CFTC;
record and report to the CFTC complaints of alleged fraud or
manipulative trading activity related to certain of ICE's
products; and
if it is determined by the CFTC that any of ICE's markets
for products that are subject to CFTC jurisdiction serve a
significant price discovery function (that is, they are a
source for determining the best price available in the market
for a particular contract at any given moment), publicly
disseminate certain market and pricing information free of
charge on a daily basis.
The information that ICE reports to the CFTC on a daily basis
regarding natural gas contract positions for transactions executed on
our platform is particularly instructive. This information is being
provided pursuant to a special call from the CFTC for this data, which
illustrates the CFTC's statutory and regulatory authority to obtain
available information regarding transactions executed on ICE. It also
illustrates ICE's commitment to ensuring that the CFTC has access to
the information it needs, to the extent available to ICE, to conduct
appropriate market surveillance or to take appropriate actions. ICE has
worked extensively with the CFTC, and has expended substantial
resources, to develop and provide position reporting information to the
CFTC notwithstanding the fact that ICE does not have this information
readily available due to the fact that, unlike NYMEX, it is not the
party that actually clears such transactions (this is done by
LCH.Clearnet). This information can be used by the CFTC alongside the
information that NYMEX provides for a more comprehensive, but not
complete, view of the market. The fact that ICE does not itself clear
transactions executed on its platform, and does not control the
clearing house through which transactions are cleared, means that there
are certain limitations on the position information that ICE can
provide in that positions can be moved within a clearing house. In
addition, the fact that ICE represents only a small portion of the much
larger OTC marketplace means that the CFTC's view will necessarily be
incomplete. However, we will continue to work with the CFTC to enhance
the nature and quality of the information that we provide and we are
committed to furnishing any information needed by the CFTC that is
available to ICE.
The CFTC and NYMEX Have Access to Information Regarding Trading on ICE
As noted above, the CFTC has the authority to make special calls to
ICE for any information that it requires, and the CFTC has in fact
exercised this authority to require additional information from ICE
both before and since the events related to Amaranth in 2006. In
addition, the CFTC recently proposed amendments to its regulations
clarifying its existing requirement that large traders on DCMs maintain
books and records of their transactions and to make such books and
records available to the CFTC. In proposing these amendments, the CFTC
noted that ``The Act [the CEA] provides ample authority to require
keeping books and records and providing pertinent information with
respect to non-reporting transactions [i.e., those not executed on a
futures exchange].'' 72 Fed. Reg. 34413 (June 22, 2007). It also
pointed out that the CFTC previously interpreted its rules ``to include
position and transaction data for non-reporting transactions'' and that
it ``has received such information in response to requests made
pursuant to the Regulation.'' While the CFTC believed it appropriate to
clarify the obligations of participants in the futures markets,
therefore, it also made it clear that the CFTC currently has the power
to obtain the information.
In a recent speech, CFTC Commissioner Walter Lukken noted that:
ICE is prominent in the trading of natural gas swaps that are
pegged to regulated NYMEX futures contracts. This competition
has led to significant innovation over the last several years
both in the OTC and regulated marketplaces. From a risk
perspective, this competition raises the possibility that
traders could take positions on one market in order to profit
off positions on the other. To address this concern, the CFTC
has recently utilized its authorit[y] to request information
from ICE regarding trader position data for these pegged
contracts on an ongoing basis similar to what we receive from
large traders on regulated exchanges. This has allowed our
surveillance staff a more comprehensive view of this
marketplace. These tailored actions developed from risk
considerations--primarily protecting the financial integrity of
the regulated marketplace and the price discovery process for
energy products.
Speech by Commissioner Walter Lukken, May 3, 2007.
As a self-regulatory organization, or ``SRO,'' NYMEX similarly has
the power under its rules to request information from its members
regarding their trading on other markets, including ICE, and to compel
its members to produce such information, in connection with assessing
positions held in its portfolio. Specifically, even prior to the events
related to Amaranth, NYMEX rules required its members to disclose to
NYMEX, upon its request, their trading strategies, including those on
other markets, in connection with positions exceeding NYMEX
accountability levels. Moreover, if NYMEX believes that its current
rules are inadequate to permit it to view members' positions on other
markets, including ICE, it clearly has the power to amend its rules or
adopt new rules to compel members to provide this information. NYMEX,
in its testimony before the Senate PSI, noted that it now requires its
members to provide information about their trading on other markets
under certain circumstances. The CFTC noted in its testimony that it
has been receiving daily position reports from the CFTC ``on an ongoing
basis.'' These statements reflect the authority of NYMEX and the CFTC
under current law to obtain the relevant information. To the extent
that they require additional information about trading on ICE, it is
clear that they are able similarly to obtain that information as well.
Position Limits or Accountability Requirements on ICE's Markets Are Not
Necessary and Are Inappropriate
Because of the fundamental and important differences between ICE's
OTC market and NYMEX's futures market, we do not believe that the type
of position limits applied to NYMEX's futures contract are necessary or
appropriate in the context of trading on ICE. ICE's natural gas swap,
as noted, is a cash-settled contract, with settlement priced against
the physical NYMEX natural gas futures contract. The CFTC itself has
acknowledged that there is less of a need for market surveillance in
connection with cash settled contracts. Specifically, the CFTC has
stated that ``[t]he size of a trader's position at the expiration of a
cash-settled futures contract cannot affect the price of that contract
because the trader cannot demand or make delivery of the underlying
commodity. The surveillance emphasis in cash-settled contracts,
therefore, focuses on the integrity of the cash price series used to
settle the futures contract.'' (CFTC website, www.cftc.gov/opa/
backgrounder/opasurveill.htm; emphasis added.) For this reason, the ICE
cash-settled swap--like the NYMEX cash-settled swap--is not subject to
position limits.
As previously stated, NYMEX offers a cash-settled natural gas swap,
through its ``Clearport'' facility. Because the NYMEX swap is cash-
settled, there are no position limits on this contract, which is
subject only to position accountability. As an article in ``The Desk''
recently reported, ``NYMEX puts limits on NG [the natural gas futures
contract] but not NN [the cash-settled natural gas swap]. NN has no
limits. The [June 25 Senate PSI] Report never mentions this. Yet for
some reason, financial contracts on ICE should be limited. Where is the
logic there? NYMEX lifted the NN limits earlier in the year and clamped
down on NG, which is the true pricing mechanism. NN reporting is still
there but not the limits. It was a brilliant and appropriate
maneuver.'' The Desk, June 29, 2007. We believe that there are
compelling reasons for different treatment of the NYMEX natural gas
futures contract and ICE's cash-settled swap; there is no clear reason
whatsoever to treat the ICE contract differently from NYMEX's identical
cash-settled swap. If Congress seeks to implement a ``level playing
field,'' it should be between substantively similar contracts and, if
ICE's natural gas swap is to be compared to any other product, it
should be the NYMEX natural gas swap and all other OTC swaps offered by
voice brokers, not the NYMEX futures contract. Otherwise, the impact
would be commercially-oriented rulemaking that codifies preference for
one venue despite identical products and reporting structures.
Moreover, we note that NYMEX (not the CFTC) imposes position limits
on its physical natural gas futures contract only during the final 3
days of trading in its natural gas futures contract and, at all other
times, requires only accountability reports from certain participants.
In addition, during the events related to Amaranth's trading, NYMEX
took no action over the course of several months as Amaranth
consistently exceeded its accountability levels; in fact, NYMEX
increased the limits applicable to Amaranth, apparently based solely on
Amaranth's unsubstantiated requests and without seeking information
about Amaranth's trading on ICE or other markets, despite its ability
to request and obtain such information from market participants.
As noted previously, ICE currently provides the CFTC with reports
of all transactions executed by participants in its Henry Hub cleared
natural gas swaps, pursuant to a special call from the CFTC issued
after the trading losses experienced by Amaranth. Because ICE is a
principals-only market, this information is provided at the trader
level and therefore gives the CFTC information on the activity of
participants in our markets and facilitates the ability of the CFTC to
take appropriate action in connection with potentially problematic or
illegal conduct. Further, the CFTC has ample authority under current
law to require ICE to obtain or provide to the CFTC additional
information regarding its participants' trading activities if the CFTC
believes such action to be necessary or appropriate.
The balance created under the CFMA was designed to allow ECMs to
function effectively in the OTC market while providing the CFTC with
ample authority to oversee their activities and trading by their
participants. ECMs like ICE operate in an environment that is
qualitatively distinct in a number of fundamental respects from that of
the futures markets, despite the surface similarities. Congress and the
CFTC recognized these distinctions and have sought to create a
regulatory environment that allows OTC markets to perform their
important role in the markets while still ensuring market integrity and
the protection of participants, as well as using technology,
transparency and innovation to promote the advancement of these goals.
The judgments made by Congress and the CFTC are fair, appropriate and
effective and have promoted competition and transparency in the OTC
markets and in the broader derivative markets as well. Indeed, the
development of markets, such as ICE, has benefited users of the energy
markets by tightening market spreads centralizing liquidity and
attracting participants by bringing more transparency to the markets.
This evolution has also forced member-dominated exchanges, such as
NYMEX, to overcome their traditional hostility to electronic trading
and preference for floor-based markets to provide a more efficient,
accessible and transparent means of trading to end-users of the
markets. As Senator Coleman noted in his statement in the Hearings on
the Senate Permanent Subcommittee Report, ``If we extend CFTC oversight
and regulation to electronic, over-the-counter exchanges, we must avoid
unintended consequences. These exchanges have brought vital liquidity
and increased transparency to our energy markets. Therefore, we cannot
create incentives for traders to shift their business from over-the-
counter electronic exchanges like ICE, to far less transparent and
unregulated markets.''
ICE Supports Legislative and Regulatory Changes
Notwithstanding the issues raised above, we believe that there are
a number of steps that Congress and the CFTC can take that will result
in further enhancements to the current regulatory structure. First, we
believe that the funding of the CFTC should be increased and its
staffing and resources significantly expanded. The CFTC is obviously a
critical component in the system of market controls and oversight and
its role is critical in ensuring the continued integrity of all markets
within its jurisdiction. With the growth of these markets and the
introduction of new types of market participants, it is essential that
the CFTC have the tools it needs to oversee the markets and to perform
its vital functions. In addition, we fully endorse enhancements to the
quality and quantity of information currently available to the CFTC
and, in particular, its ability to integrate data from ICE and NYMEX.
We understand the surface appeal of the so-called ``level playing
field'' argument for treating and regulating ICE and NYMEX's futures
market similarly. However, these markets are fundamentally different in
significant respects, and any regulatory approach must take those
differences into account. Also, this argument ignores the much larger
OTC market outside of both ICE and NYMEX. Indeed, as we have noted, if
there is a comparison between ICE and NYMEX products to be made, it is
the comparison between ICE's OTC market and NYMEX's cash-settled swap,
not its futures market. While we support the maintenance of a ``level
playing field,'' we do not believe that this can or should result in
regulating cash-settled OTC contracts in the same manner as physically-
settled futures contracts because they are fundamentally different
products.
Thank you for the opportunity to share our views with you on these
important issues. I would be happy to answer any questions you may
have.
The Chairman. Thank you, sir. Mr. Pickel.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CEO,
INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, NEW YORK, NY
Mr. Pickel. Thank you, Mr. Chairman and Members of the
Committee. I very much appreciate the opportunity to have ISDA
testify this morning. The work which this Committee has done in
the past and which it continues to do today plays a critical
role in creating active markets for risk management. ISDA
represents participants in the privately negotiated derivatives
industry. Since its inception, ISDA has pioneered efforts to
identify and reduce the sources of risk in the derivatives and
risk management business.
Energy derivatives are used by a wide range of market
participants, including energy companies, financial
institutions such as banks and hedge funds, and traditional
end-users of energy. The motivations of these market
participants differ and can include those looking to hedge
price risk, as well as those looking to take a view on, or
speculate on, the movement of energy prices. The growth of
these markets has coincided with volatility in energy prices,
leading some to question whether the growth in derivatives
markets and the influx of new market participants has led to
this volatility. Even more sinister, some have alleged that
volatility is the result of attempts to manipulate the prices
of energy commodities.
Fortunately, there is little evidence that markets of
energy commodities are subject to widespread manipulation. As
noted by the Bank for International Settlements, in a recent
quarterly update, several recent studies which explore the
relationship between investor activity and commodity prices
indicate that price changes have led to change in investor
interest rather than the other way around. The BIS cites
studies conducted by the CFTC and the International Monetary
Fund. In addition to these studies, the Government
Accountability Office, the Federal Trade Commission, the
Department of Energy and numerous academics likewise have
examined the question of whether manipulation of energy prices
exists and is having an adverse effect on consumers.
All have reached the same conclusion. Energy prices are
caused by the external forces of supply and demand influenced
by factors such as refinery capacity and hurricane activity,
and not by the derivatives markets. Both exchange traded and
privately negotiated derivatives contribute to more stable and
more efficient commodity markets.
The CFMA greatly increased American competitiveness in both
the exchange traded and OTC derivatives industries. For futures
exchanges, the law created a principles-based regulatory regime
that greatly increased the flexibility and efficiency of those
markets. For OTC derivatives, the law removed legal
uncertainty, protected the right of sophisticated
counterparties to engage in individually negotiated swap
transactions, and retained anti-fraud and anti-manipulation
authority over the OTC commodity markets.
OTC derivatives remain subject to a broad range of
regulation. OTC market participants, themselves, such as
commercial banks and broker/dealers are subject to regulation
by their respective regulators. In addition to the regulations
of the counterparties, themselves, certain OTC energy
derivative transactions are subject to CFTC oversight.
Oversight of the energy markets in the United States is
thorough and effective. Enforcement efforts by Federal
regulators have been very successful in detecting, deterring
and punishing misbehavior. The CFTC has brought numerous
actions against defendants accused of wrongdoing in the energy
markets. Among ISDA member firms, there is no doubt that there
is strong oversight of these markets. They report regular
visits and requests for information from Federal regulatory
officials as part of the routine operation of their businesses.
Almost immediately after Congress passed the CFMA, there
were calls in some quarters to repeal parts of that law.
Fortunately, Congress has time and again rejected efforts to
repeal the balance between legal certainty for sophisticated
institutional market participants and the need for Federal
oversight provided by the CFMA. For the most part, calls to
revisit the CFMA rest upon claims of a lack of transparency in
the markets, as well as suggestions of impropriety. However, as
I described before, there are no studies which demonstrate a
cause and effect relationship between activities in the
derivatives markets and consumer energy prices.
More to the point, as the members of the President's
working group have repeatedly noted, there is no change in
Federal law as applied to derivatives that could alleviate the
volatility in energy prices which have existed over the last
several years. Energy prices respond to a variety of supply and
demand factors which have in recent years been aggravated by
events such as: active hurricane seasons; lack of refinery
capacity; unusual weather patterns; and military and political
crises in major oil producing regions.
Changing the CFMA will not address those factors nor will
it do anything to alleviate consumer concerns about high energy
prices. You can't amend the law of supply and demand. Instead,
amending the legal certainty for OTC energy derivatives
provisions of the CEA will serve only to make business less
attractive in the United States. As acting Chairman Lukken
noted, American competitiveness in the financial service arena
is under assault from foreign markets which are eager to
attract lucrative U.S. financial services activity. There is
simply no reason that energy transactions which do not call for
the actual physical delivery of a commodity need be done in the
United States. Therefore Congress should tread carefully if
considering legislation in this area.
Mr. Chairman and Members of the Committee, thank you very
much for your time today. This is an important issue and
leadership which this Committee has shown on this topic over
the last several years has greatly improved the legal and
regulatory environment in the United States. Going forward, we
are confident that you will continue to play a leading role in
promoting the healthy growth of these markets. Thank you again
and I would be privileged to answer any questions that you may
have.
[The prepared statement of Mr. Pickel follows:]
Prepared Statement of Robert G. Pickel, Executive Director and CEO,
International Swaps and Derivatives Association, New York, NY
Mr. Chairman and Members of the Committee:
Thank you very much for inviting ISDA to testify this morning. The
work which this Committee has done in the past, and which it continues
to do today, plays a critical role in creating healthy, active markets
for risk management. Thank you very much for your leadership in this
important area.
About ISDA
ISDA, which represents participants in the privately negotiated
derivatives industry, is the largest global financial trade
association, by number of member firms. ISDA was chartered in 1985, and
today has over 800 member institutions from 54 countries on six
continents. These members include most of the world's major
institutions that deal in privately negotiated derivatives, as well as
many of the businesses, governmental entities and other end-users that
rely on over-the-counter derivatives to manage efficiently the
financial market risks inherent in their core economic activities.
Since its inception, ISDA has pioneered efforts to identify and
reduce the sources of risk in the derivatives and risk management
business. Among its most notable accomplishments are: developing the
ISDA Master Agreement; publishing a wide range of related documentation
materials and instruments covering a variety of transaction types;
producing legal opinions on the enforceability of netting and
collateral arrangements (available only to ISDA members); securing
recognition of the risk-reducing effects of netting in determining
capital requirements; promoting sound risk management practices, and
advancing the understanding and treatment of derivatives and risk
management from public policy and regulatory capital perspectives.
Overview of Derivatives
Derivatives are critical risk management tools which allow
producers and end-users of commodities to hedge the risk of adverse
price movements. In the most basic type of derivative, an option, the
option writer will sell to the buyer the right (but not the obligation)
to purchase or sell a fixed quantity of a good, at a fixed price, in
some future period. Options provide the basic building block of
derivatives, and other types of derivatives can be seen as a
combination of options. For instance, a long futures contract can be
seen as the purchase of an option to purchase a commodity combined with
the simultaneous sale of an option to sell that same commodity. Futures
contracts are traded on organized exchanges regulated in the United
States by the Commodity Futures Trading Commission. Privately
negotiated derivatives, such as swap agreements, are a type of
derivative subject to negotiation between the parties as to the
fundamental material economic terms of the transaction. Privately
negotiated derivatives differ from exchange traded futures contracts in
that they are not fungible nor by their terms subject to offset through
the purchase of a contract with the opposite characteristics (e.g., a
counterparty cannot cancel out its contractual obligations under a swap
agreement to sell a fixed interest rate by simply purchasing a swap
agreement to buy the same fixed rate). Another important
differentiation is that OTC derivatives are typically transacted
between counterparties that meet certain standards for wealth and
sophistication.
Allegations of Market Manipulation
The growth of these markets has coincided with volatility in energy
prices, leading some to question whether the growth in derivatives
markets and the influx of new market participants has led to this
volatility. Even more sinister, some have alleged that volatility is
the result of attempts to manipulate the prices of energy commodities.
For instance, on June 25, 2007 the Senate Permanent Subcommittee on
Investigations claimed that ``excessive speculation distorts prices,
increases volatility, and increases costs and risks for natural gas
consumers, such as utilities, who ultimately pass on inflated costs to
their customers.'' These very serious charges are of concern to
everyone involved in these markets, as no one, be they consumers, end-
users or market participants themselves, would benefit from the
intentional manipulation of prices.
Intuitively, one might expect large inflows of funds into
commodity markets to cause prices to rise sharply, possibly to
higher levels than are justified by economic fundamentals. The
prima facie evidence seems to support this view, as financial
activity has broadly increased in parallel with prices during
the past 4 years. However, the results of empirical work on the
impact of the growing presence of financial investors on
commodity prices are less clear-cut. Several recent studies,
which explore the relationship between investor activity and
commodity prices, indicate that price changes have led to
changes in investor interest rather than the other way around.
The BIS cites in support of this thesis studies conducted by James
Overdahl, Chief Economist of the Commodity Futures Trading Commission,
as well as a report by the International Monetary Fund. In addition to
these studies the Government Accountability Office, the Federal Trade
Commission, the Department of Energy and numerous academics likewise
have examined the question of whether manipulation of energy prices
exists and is having an adverse effect on consumers. All have reached
the same conclusion: energy prices are caused by the external forces of
supply and demand, influenced by factors such as refinery capacity and
hurricane activity, and not by the derivatives markets. As succinctly
stated in testimony before the House Energy and Commerce Committee by
W. David Montgomery, Vice President for CRA International, regarding
gasoline prices: ``There has never been a finding that . . . price
increases were caused by any manipulation of the markets.''
Given the overwhelming evidence that derivatives do not lead to
manipulation of energy markets, it makes sense to ask what role these
instruments do play. In addition to serving as risk management tools,
the experience of market participants and academic research alike
confirms that on a macro level energy derivatives increase market
liquidity and depth and stabilize commodity markets. Both exchange
traded and privately negotiated derivatives contribute to more stable,
more efficient commodity markets.
The Evolution of the Commodity Exchange Act
Given the tremendous growth of the energy derivatives industry and
the role these products play in helping manage risk and stabilize
markets, it is worth considering how government policy in the United
States helped promote such a beneficial result. Even before the passage
of the Commodity Futures Modernization Act of 2000 the CFTC realized
the inappropriateness of applying a ``one-size-fits-all'' standard to
derivatives. Beginning in 1990 the Commission began creating
protections for energy transactions, such as the ``Statutory
Interpretation Concerning Forward Transactions'' and the 1993 Exemptive
Order. These administrative decisions provided some comfort to market
participants that their individually negotiated contracts would be
protected from unwarranted regulatory intervention, while at the same
time ensuring that market participants would be subject to the anti-
manipulation provisions of the Commodity Exchange Act (CEA).
Nevertheless, market participants were still exposed to the risk
that their contracts would be held legally unenforceable because of the
inappropriate application of the CEA to their private contracts.
Because the CEA was originally written to address exchange traded
agricultural commodities the law contained a provision making any off-
exchange future-like contract illegal (and thus unenforceable). This
``legal uncertainty,'' which threatened to undermine an important and
growing market, caused this Committee and its Senate counterpart, the
House and Senate Banking Committees, the House Commerce Committee and
the President's Working Group on Financial Markets to jointly undertake
an historic effort to improve and reform the CEA.
The Commodity Futures Modernization Act of 2000 greatly increased
American competitiveness in both the exchange traded and OTC
derivatives industries. For futures exchanges, the law created a
principles-based regulatory regime that greatly increased the
flexibility and efficiency of those markets. For OTC derivatives the
law removed legal uncertainty, protected the right of sophisticated
counterparties to engage in individually negotiated swap transactions
and retained anti-fraud and anti-manipulation authority over the OTC
commodity markets.
Regulation of OTC Derivatives
It is important to recognize that OTC derivatives are subject to a
broad range of regulation. OTC market participants themselves, such as
commercial banks and broker dealers, are subject to plenary regulation
by their respective front line regulatory agencies (for example, the
Federal Reserve and the SEC; the CFTC likewise retains regulatory
authority over the operations of registered commodity trading advisors
and commodity pool operators.) This is important, since these OTC
dealers are the counterparty on the overwhelming majority of
transactions conducted in the over-the-counter markets. In addition to
the regulation of the counterparties themselves OTC energy derivative
transactions are subject to CFTC oversight under section 2(h) \1\ of
the Commodity Exchange Act.
---------------------------------------------------------------------------
\1\ Section 2(h) is sometimes derogatorily called the ``Enron
Loophole,'' because of allegations that the provision was ``snuck in at
the last minute'' in H.R. 5660, the legislation which contained the
CFMA. In fact, numerous hearings were held on H.R. 4541, the original
version of the CFMA. H.R. 4541 contained a similar provision to current
2(h) entitled ``Exempt Commodities''; the bill was the subject of
numerous hearings in the House, including four hearings in the House
Agriculture Committee. In addition to H.R. 4541 the companion Senate
legislation, S. 2697, likewise contained a provision regarding energy
commodities; S. 2697 was also the subject of legislative hearings.
---------------------------------------------------------------------------
Section 2(h) deals with exempt commodities. These are commodities
which are neither financial nor agricultural, and include oil, natural
gas, coal and precious metals. Under 2(h) contracts between eligible
contract participants which are not traded on a trading facility are
exempt from most provisions of the CEA except for the Act's anti-fraud
and anti-manipulation provisions. Section 2(h) also exempts trades
between eligible commercial entities \2\ done on a principal-to-
principal basis when transacted on an electronic trading facility. In
addition to being subject to the anti-fraud and anti-manipulation
provisions of the CEA, exempt electronic trading facilities are subject
to record keeping requirements and must provide price, trading volume
and such other trading information as the CFTC determines is
appropriate if the Commission determines the entity serves as a price
discovery market for the underlying exempt commodity.
---------------------------------------------------------------------------
\2\ Eligible commercial entities are a narrower subset of eligible
contract participants that, in general, are in the business of dealing
in the underlying exempt commodity as a routine part of their
operations.
---------------------------------------------------------------------------
In addition to the Commodity Exchange Act, Federal oversight of
energy products is also provided by the Federal Energy Regulatory
Commission (FERC). Amendments passed by Congress as part of the Energy
Policy Act of 2005 provided FERC with anti-fraud and anti-manipulation
authority over transactions in electricity and natural gas. These
amendments to the Federal Power Act and the Natural Gas Act are modeled
after the Securities and Exchange Commission's authority under section
10(b) of the 1934 Securities and Exchange Act. The FERC's authority
applies to physical transactions in a commodity, as opposed to
derivative transactions which are under the exclusive jurisdiction of
the CFTC. Nevertheless, the two agencies' authorities in this area
provide an overarching web of regulation of both the physical and
derivative energy markets, giving a holistic view of these interlinked
areas. CFTC and FERC likewise have a Memorandum of Understanding
allowing for information sharing between the two agencies.
Oversight of the energy markets in the United States is thorough
and effective. Enforcement efforts by Federal regulators have been very
successful in detecting, deterring and punishing misbehavior. Between
December 2002 and May 2007 the CFTC has collected over $307 million in
civil penalties from defendants accused of wrongdoing in the energy
markets. Among ISDA member firms there is no doubt that these agencies
are providing strong oversight of these markets; they report regular
visits and requests for information from Federal regulatory officials,
as part of the routine operations of their businesses.
Calls for Greater Regulation Are Unwarranted
Almost immediately after Congress passed the CFMA there have been
calls in some quarters to repeal parts of that law. Nowhere have these
calls come more loudly than with regard to energy commodities.
Fortunately Congress has time and again rejected efforts to repeal the
balance between legal certainty for sophisticated institutional market
participants and the need for Federal oversight provided by the CFMA.
For the most part, calls to revisit the CFMA rest upon claims of a
lack of transparency in the markets as well as insinuations of
impropriety. However, as discussed earlier in this testimony, there are
no credible studies which demonstrate a cause and effect relationship
between activities in the derivatives markets and consumer energy
prices. More to the point, as the Members of the President's Working
Group have repeatedly noted, there is no change in Federal law as
applied to derivatives which could alleviate the volatility in energy
prices which have existed over the last several years. As Federal
Reserve Chairman Ben Bernanke noted in response to questioning in the
Senate last Congress: ``I am unaware of any evidence that supports the
view that additional reporting requirements or other new regulations
would reduce energy prices or energy price volatility.''
Energy prices respond to a variety of supply and demand related
factors, which have in recent years been aggravated by events such as
an active hurricane season, lack of refinery capacity, unusual weather
patterns and military and political crises in major oil producing
regions. Changing the CFMA will not address those factors, nor will it
do anything to alleviate consumer concerns about high energy prices.
Consequences of Rewriting the CFMA
Instead, amending the legal certainty for OTC energy derivatives
provisions of the Commodity Exchange Act will serve only to make
business less attractive in the United States. Already, American
competitiveness in the financial services arena is under assault from
foreign markets which are eager to attract lucrative U.S. financial
services activity. As recently noted in the paper ``Sustaining New
York's and the U.S.'s Global Financial Services Leadership,'' sponsored
by New York Mayor Bloomberg and U.S. Senator Charles Schumer:
``Europe's also the center for derivatives innovation. `People
feel less encumbered overseas by the threat of regulation and
so are more likely to think outside of the box,' notes one
U.S.-based business leader.''
OTC energy trades are done in the U.S. by the choice of the market
participants, who favor the current regulatory environment and prefer
the strength of U.S. courts and their respect for privately negotiated
agreements. But there is simply no reason that energy transactions
which do not call for the actual physical delivery of a commodity need
be done in the United States. Indeed, because these transactions can be
done electronically their execution can be readily relocated to more
favorable regulatory environments should they feel that the costs and
burdens of regulation have become too onerous.
Therefore Congress should tread carefully if considering
legislating in this area. To date the OTC derivatives markets have been
robust, stable and liquid, and provided the means for end-users of
energy products to manage the risks of recent price volatility in a
cost-efficient manner. Making the use of these products too costly,
through the application of an inappropriate regulatory regime, would
serve only to hurt American businesses and ultimately consumers, while
doing nothing to alleviate energy prices.
Conclusion
Mr. Chairman and Members of the Committee, thank you very much for
your time today. This is an important issue, and the leadership which
this Committee has shown on this topic over the years has greatly
improved the legal and regulatory environment in the United States.
Going forward we are confident that you will continue to play a leading
role in promoting the health and growth of these markets. Thank you
again and I would be privileged to answer any questions you might have.
The Chairman. Thank you, sir. Mr. Corbin.
STATEMENT OF ARTHUR CORBIN, PRESIDENT AND CEO,
MUNICIPAL GAS AUTHORITY OF GEORGIA, KENESAW, GA; ON BEHALF OF
AMERICAN PUBLIC GAS ASSOCIATION
Mr. Corbin. Mr. Chairman and Members of the Committee, I
appreciate this opportunity to testify before you today on the
important issue of energy based derivatives trading and in
particular, natural gas market transparency. Again, my name is
Arthur Corbin and I am President and CEO of the Municipal Gas
Authority of Georgia. The Municipal Gas Authority of Georgia is
a nonprofit natural gas joint action agency that supplies all
the natural gas requirements of its 76 member cities. I am
testifying today on behalf of the American Public Gas
Association.
APGA is the national association for publicly owned not-
for-profit natural gas distribution systems. These retail
distribution systems are owned by public agencies and
accountable to the citizens they serve. There are approximately
1,000 public gas systems in 36 states and almost 700 of these
systems are APGA members. APGA's top priority is the safe and
reliable delivery of affordable natural gas. To bring gas
prices back to an affordable level, we ultimately need to
increase the supply of natural gas. However, equally critical
is to restore public confidence in natural gas pricing. This
requires the natural gas market be fair, orderly and
transparent so that the price consumers pay reflects
fundamental supply and demand forces, and not the result of
manipulation or other abusive conduct.
An appropriate level of transparency does not exist and
this has led to a growing lack of confidence by our members in
the natural gas market. Without question, natural gas futures
contracts traded on NYMEX and those financial contracts of
natural gas traded in the over-the-counter markets are
economically linked. A participant's trading conducted in one
venue can affect and has affected the price of natural gas
contracts in the other. A recent report released by the Senate
Permanent Subcommittee on Investigation affirmed these economic
links. The impact of last year's activities of the Amaranth
Advisors hedge fund is a perfect example of these economic
links between markets.
When the excessively large positions accumulated by
Amaranth began to unwind, gas prices decreased. Unfortunately,
many distributors, including the Municipal Gas Authority of
Georgia, had already locked in prices prior to that period at
levels that did not reflect fundamental supply and demand
conditions, but rather were elevated during this period when
Amaranth held these exceedingly large positions. As a result of
the elevated prices, the Gas Authority's members were forced to
pay an $18 million premium and pass it through to their
customers on their gas bills.
Today the Commodity Futures Trading Commission has
effective oversight of NYMEX and the CFTC and NYMEX provide a
significant level of transparency. Despite the economic links
between prices on NYMEX and the OTC markets, the OTC markets
lack such transparency. The simple fact that the CFTC's large
trader reporting system, its chief tool in detecting and
deterring manipulative market conduct, generally does not apply
to transactions in the over-the-counter market.
This lack of transparency in a very large and rapidly
growing segment of the natural gas market leaves open the
potential for a participant to engage in manipulative or other
abusive trading strategies, or simply to accumulate excessively
large positions with little risk of early detection by the CFTC
until after the damage has been done to the market. It simply
makes no sense to have transparency in one small segment of the
market and none in a much larger and growing segment.
Accordingly, APGA believes that transparency in all
segments of the market, including those transactions that take
place off-exchange and platforms are critical to ensure that
the CFTC has a complete picture of the market. The CFTC has
stated that it is nearing the outer limits of its authority. We
believe that the CFTC does not currently have the tools
necessary to police its beat. Today Congressman Barrow and
Graves introduced legislation entitled the Market TRUST Act
that would provide the CFTC with the tools to police their
beat.
The level of transparency created by this legislation will
significantly reduce opportunities for market manipulation and
restore public confidence in natural gas markets. APGA strongly
supports this legislation and commends Congressmen Barrow and
Graves for their efforts on behalf of consumers. The CFTC has
done a good job in catching market abuses after the fact.
However, by the time these cases are discovered, using the
tools available to government regulators, our members and their
customers have already suffered the consequences of those
abuses in terms of higher natural gas prices.
Whether or not Amaranth's trading meets the legal
definition of the manipulation, it is beyond dispute that the
CFTC did not have a complete picture of the full extent of
Amaranth's trading position until after Amaranth's collapse.
Greater transparency with respect to large trader positions,
whether entered into on a regulated exchange or in the over-
the-counter market in natural gas will provide the CFTC with
the tools to detect and deter potential manipulative activity
before our members and their customers suffer harm.
The current situation is not irreversible. Congress can
provide American consumers with the production they deserve by
passing the Market TRUST Act, which would turn the lights on in
these currently dark markets. APGA looks forward to working
with you to accomplish this goal and I will be happy to answer
any questions you have.
[The prepared statement of Mr. Corbin follows:]
Prepared Statement of Arthur Corbin, President and CEO, Municipal Gas
Authority of Georgia, Kenesaw, GA; on Behalf of American Public Gas
Association
Chairman Etheridge, Ranking Member Moran and Members of the
Committee, I appreciate this opportunity to testify before you today
and I thank the Committee for calling this hearing on the important
subject of energy derivatives. My name is Arthur Corbin and I am the
President and CEO of the Municipal Gas Authority of Georgia. The
Municipal Gas Authority of Georgia is the largest nonprofit natural gas
joint action agency in the United States. Our agency is made up of 76
publicly-owned natural gas distribution system members in five states:
Georgia; Alabama; Florida; Pennsylvania; and Tennessee. Our principal
role is to supply all the natural gas requirements of these systems.
Together, our members meet the gas needs of approximately 243,000
customers.
I testify today on behalf of the American Public Gas Association
(APGA). APGA is the national association for publicly-owned natural gas
distribution systems. There are approximately 1,000 public gas systems
in 36 states and almost 700 of these systems are APGA members.
Publicly-owned gas systems are not-for-profit, retail distribution
entities owned by, and accountable to, the citizens they serve. They
include municipal gas distribution systems, public utility districts,
county districts, and other public agencies that have natural gas
distribution facilities.
APGA's number one priority is the safe and reliable delivery of
affordable natural gas. To bring natural gas prices back to a long-term
affordable level, we ultimately need to increase the supply of natural
gas. However, equally critical is to restore public confidence in the
pricing of natural gas. This requires a level of transparency in
natural gas markets which assures consumers that market prices are a
result of fundamental supply and demand forces and not the result of
manipulation or other abusive market conduct. APGA strongly believes
that this level of transparency currently does not exist, and this has
directly led to a lack of confidence in the natural gas marketplace.
The economic links between the natural gas futures contracts traded
on the New York Mercantile Exchange (``NYMEX'') and those contracts,
agreements and transactions in natural gas traded in the over-the-
counter (``OTC'') markets are beyond dispute. Without question, a
participant's trading conduct in one venue can affect, and has
affected, the price of natural gas contracts in the other.\1\ Today,
the Commodity Futures Trading Commission (``CFTC'') has effective
oversight of NYMEX, and the CFTC and NYMEX provide a significant level
of transparency with respect to NYMEX's price discovery function. But,
the OTC markets lack such price transparency.
---------------------------------------------------------------------------
\1\ See ``Excessive Speculation in the Natural Gas Market,'' Report
of the U.S. Senate Permanent Subcommittee on Investigations (June 25,
2007) (``PSI Report''). The PSI Report on page 3 concluded that
``Traders use the natural gas contract on NYMEX, called a futures
contract, in the same way they use the natural gas contract on ICE,
called a swap. . . . The data show that prices on one exchange affect
the prices on the other.''
---------------------------------------------------------------------------
This lack of transparency in a very large and rapidly growing
segment of the natural gas market leaves open the potential for a
participant to engage in manipulative or other abusive trading
strategies with little risk of early detection; and for problems of
potential market congestion to go undetected by the CFTC until after
the damage has been done to the market. It simply makes no sense to
have transparency over one segment of the market and none over a much
larger segment, especially when the OTC markets are the fastest growing
sectors of the natural gas marketplace. APGA strongly believes that it
is in the best interest of consumers for Congress to rectify this
situation by passing legislation that would ensure an adequate level of
transparency with respect to OTC contracts, agreements and transactions
in natural gas.
The Market in Natural Gas Contracts
The market for natural gas financial contracts is composed of a
number of segments. Contracts for the future delivery of natural gas
are traded on NYMEX, a designated contract market regulated by the
CFTC. Contracts for natural gas are also traded in the OTC markets. OTC
contracts may be traded on multi-lateral electronic trading facilities
which are exempt from regulation as exchanges. They may also be traded
in direct, bilateral transactions between counterparties, through voice
brokers or on electronic platforms. OTC contracts may be settled
financially or through physical delivery. Financially-settled OTC
contracts often are settled based upon NYMEX settlement prices and
physically delivered OTC contracts may draw upon the same deliverable
supplies as NYMEX contracts, thus linking the various financial natural
gas market segments economically.
Increasingly, the price of natural gas in many supply contracts
between suppliers and local distribution companies (``LDC''), including
APGA members, is determined based upon monthly price indexes closely
tied to the monthly settlement of the NYMEX futures contract.
Accordingly, the futures market serves as the centralized price
discovery mechanism used in pricing these natural gas supply contracts.
Generally, futures markets are recognized as providing an efficient
and transparent means for discovering commodity prices.\2\ However, any
failure of the futures price to reflect fundamental supply and demand
conditions results in prices for natural gas that are distorted and
which do not reflect its true value. This has a direct affect on
consumers all over the U.S., who as a result of such price distortions,
will not pay a price for the natural gas that reflects bona fide demand
and supply conditions. If the futures price is manipulated or
distorted, then the price a consumer pays for the fuel needed to heat
their home and cook their meals will be similarly manipulated or
distorted.
---------------------------------------------------------------------------
\2\ See the Congressional findings in Section 3 of the Commodity
Exchange Act, 7 U.S.C. 1 et seq. (``Act''). Section 3 of the Act
provides that, ``The transactions that are subject to this Act are
entered into regularly in interstate and international commerce and are
affected with a national public interest by providing a means for . . .
discovering prices, or disseminating pricing information through
trading in liquid, fair and financially secure trading facilities.''
---------------------------------------------------------------------------
Regulatory Oversight
NYMEX, as a designated contract market, is subject to oversight by
the CFTC. The primary tool used by the CFTC to detect and deter
possible manipulative activity in the regulated futures markets is its
large trader reporting system. Using that regulatory framework, the
CFTC collects information regarding the positions of large traders who
buy, sell or clear natural gas contracts on NYMEX. The CFTC in turn
makes available to the public aggregate information concerning the size
of the market, the number of reportable positions, the composition of
traders (commercial/non-commercial) and their concentration in the
market, including the percentage of the total positions held by each
category of trader (commercial/non-commercial).
The CFTC also relies on the information from its large trader
reporting system in its surveillance of the NYMEX market. In conducting
surveillance of the NYMEX natural gas market, the CFTC considers
whether the size of positions held by the largest contract purchasers
are greater than deliverable supplies not already owned by the trader,
the likelihood of long traders demanding delivery, the extent to which
contract sellers are able to make delivery, whether the futures price
is reflective of the cash market value of the commodity and whether the
relationship between the expiring future and the next delivery month is
reflective of the underlying supply and demand conditions in the cash
market.\3\
---------------------------------------------------------------------------
\3\ See letter to the Honorable Jeff Bingaman from the Honorable
Reuben Jeffery III, dated February 22, 2007.
---------------------------------------------------------------------------
Although the CFTC has issued ``special calls'' to one electronic
trading platform, and that platform has determined to voluntarily
provide the CFTC with information on traders' large positions,\4\ the
CFTC's large trader reporting surveillance system does not routinely
reach traders' large OTC positions.\5\ Despite the links between prices
for the NYMEX futures contract and the OTC markets in natural gas
contracts, this lack of transparency in a very large and rapidly
growing segment of the natural gas market leaves open the potential for
participants to engage in manipulative or other abusive trading
strategies with little risk of early detection and for problems of
potential market congestion to go undetected by the CFTC until after
the damage has been done to the market, ultimately costing the
consumers or producers of natural gas.
---------------------------------------------------------------------------
\4\ Id, at 7. The CFTC presumably issued this call for information
under Section 2(h)(5) of the Act.
\5\ As explained in greater detail below, special calls are
generally considered to be extraordinary, rather than routine,
requirements. Although special calls may be an important complement to
routine reporting requirements in conducting market surveillance, they
are not a substitute for a comprehensive large trader reporting system.
---------------------------------------------------------------------------
Amaranth Advisors LLC
Last year's blow-up of the Amaranth Advisors LLC and the impact it
had upon prices exemplifies these linkages and the impact they can have
on natural gas supply contracts for LDCs. Amaranth Advisors LLC was a
hedge fund based in Greenwich, Connecticut, with over $9.2 billion
under management. Although Amaranth classified itself as a diversified
multi-strategy fund, the majority of its market exposure and risk was
held by a single Amaranth trader in the OTC derivatives market for
natural gas.
Amaranth reportedly accumulated excessively large long positions
and complex spread strategies far into the future. Amaranth's
speculative trading wagered that the relative relationship in the price
of natural gas between summer and winter months would change as a
result of shortages which might develop in the future and a limited
amount of storage capacity. Because natural gas cannot be readily
transported about the globe to offset local shortages, the way for
example oil can be, the market for natural gas is particularly
susceptible to localized supply and demand imbalances. Amaranth's
strategy was reportedly based upon a presumption that hurricanes during
the summer of 2006 would make natural gas more expensive in 2007,
similar to the impact that Hurricanes Katrina and Rita had had on
prices the previous year. As reported in the press, Amaranth held open
positions to buy or sell tens of billions of dollars of natural gas.
As the hurricane season proceeded with very little activity, the
price of natural gas declined, and Amaranth lost approximately $6
billion, most of it during a single week in September 2006. The
unwinding of these excessively large positions and that of another
previously failed $430 million hedge fund--MotherRock--further
contributed to the extreme volatility in the price of natural gas. The
Report by the Senate Permanent Subcommittee on Investigations affirmed
that ``Amaranth's massive trading distorted natural gas prices and
increased price volatility.'' \6\
---------------------------------------------------------------------------
\6\ See PSI Report at p. 119.
---------------------------------------------------------------------------
Many natural gas distributors locked-in prices prior to the period
Amaranth collapsed at prices that were elevated due to the accumulation
of Amaranth's positions. In the case of the Municipal Gas Authority of
Georgia, Amaranth's activities had a significant impact on the price
we, and ultimately our members' customers, paid for natural gas. To
reduce volatility and mitigate additional price spikes on supplies of
natural gas, the Gas Authority's hedging procedures required that we
hedge part of our 2006-2007 winter natural gas in the spring and summer
of 2006. In the spring of 2006 we knew natural gas prices were still
extremely high, but it would have been irresponsible if we were to
gamble and not hedge a portion of our winter gas in the hope that
prices would eventually drop. As a result, we hedged half of our winter
gas prior to September 2006. By hedging earlier in 2006 when natural
gas prices were high as a result of Amaranth's market activities, our
members incurred hedging losses of $18 million over the actual market
prices during the winter of 2006-2007. The Gas Authority's members were
forced to pay an $18 million premium and pass it through to their
customers on their gas bills as a result of the excess speculation in
the market by Amaranth and others.
The lack of OTC transparency and extreme price swings surrounding
the collapse of Amaranth have caused bona fide hedgers to become
reluctant to participate in the markets for fear of locking-in prices
that may be artificial.
Greater Transparency Needed
Our members, and the customers served by them, do not believe there
is an adequate level of market transparency under the current system.
This lack of transparency leads to a growing lack of confidence in the
natural gas marketplace. Although the CFTC operates a large trader
reporting system to enable it to conduct surveillance of the futures
markets, it cannot effectively monitor trading if it receives
information concerning positions taken in only one segment of the total
market. Without comprehensive large trader position reporting, the
government is currently handicapped in its ability to detect and deter
market misconduct. If a large trader acting alone, or in concert with
others, amasses a position in excess of deliverable supplies and
demands delivery on its position and/or is in a position to control a
high percentage of the deliverable supplies, the potential for market
congestion and price manipulation exists. Unless Congress moves forward
to enable the CFTC to increase transparency with respect to OTC
financial contracts, agreements or transactions in natural gas, the
government will continue to be woefully unprepared to: (1) detect a
problem until it is too late; (2) protect the public interest; and (3)
ensure the price integrity of the markets, thus impairing our ability
as a nation to maintain the flow and deliverability of a fundamental
fuel.
Over the last several years, APGA has pushed for a level of market
transparency in financial contracts in natural gas that would
routinely, and prospectively, permit the CFTC to assemble a complete
picture of the overall size and potential impact of a trader's position
irrespective of whether the positions are entered into on NYMEX, on an
OTC multi-lateral electronic trading facility which is exempt from
regulation or through bilateral OTC transactions, which can be
conducted over the telephone, through voice-brokers or via electronic
platforms.
Bilateral Trading
Because Amaranth's trading was largely conducted on both a
regulated futures exchange and on an unregulated electronic trading
facility, the immediate focus has been confined to the relative
inequality of transparency between those two multi-lateral trading
venues. Moreover, because the volume of transactions in bilateral
markets may not be as apparent as the volume of transactions on
exchanges or electronic trading facilities there may be a tendency to
discount the impact that the bilateral markets have upon the price
discovery process. APGA believes that, to be comprehensive, a large
trader reporting system must include large positions amassed through
the OTC bilateral markets in addition to those accumulated on futures
exchanges or on OTC electronic trading facilities.
Bilateral trading can also take place on an electronic trading
venue that may be as attractive to traders as multi-lateral trading
facilities. Enron On-line, for example, was an all-electronic,
bilateral trading platform. Using this platform, Enron offered to buy
or sell contracts as the universal counterparty to all other traders.
On the Enron On-line trading platform, only one participant--Enron--had
the ability to accept bids and offers of the multiple participants--its
customers--on the trading platform. This one-to-many model constitutes
a dealer's market and is a form of bilateral trading.\7\
---------------------------------------------------------------------------
\7\ This stands in contrast to a many-to-many model which is
recognized as a multi-lateral trading venue. This understanding is
reflected in section 1a(33) of the Act, which defines ``Trading
Facility'' as a ``group of persons that . . . provides a physical or
electronic facility or system in which multiple participants have the
ability to execute or trade agreements, contracts or transactions by
accepting bids and offers made by other participants that are open to
multiple participants in the facility or system.''
---------------------------------------------------------------------------
Section1a(33) of the Act further defines bilateral trading by
providing that, ``the term `trading facility' does not include (i) a
person or group of persons solely because the person or group of
persons constitutes, maintains, or provides an electronic facility or
system that enables participants to negotiate the terms of and enter
into bilateral transactions as a result of communications exchanged by
the parties and not from interaction of multiple bids and multiple
offers within a predetermined, nondiscretionary automated trade
matching and execution algorithm. . . . .'' This means that it is also
possible to design an electronic platform for bilateral trading whereby
multiple parties display their bids and offers which are open to
acceptance by multiple parties, so long as the consummation of the
transaction is not made automatically by a matching engine.
Both of these examples of bilateral electronic trading platforms
might very well qualify for exemption under the current language of
sections 2(g) and 2(h)(1) of the Commodity Exchange Act. It is entirely
foreseeable that if a CFTC large-trader reporting regime were expanded
to require the reporting of positions entered into only on multi-
lateral electronic trading facilities and does not include bilateral
electronic trading platforms too, traders who wish to evade the new
reporting requirement would simply be able to move their trading
activities from an electronic trading facility to a bilateral
electronic trading platform, just as Amaranth moved its trading from
NYMEX to ICE.
Moreover, even in the absence of electronic trading, the ability of
traders to affect prices in the natural gas markets through direct or
voice-brokered bilateral trading should not be underestimated. For
example, a large hedge fund may trade bilaterally with a number of
counterparty/dealers using standard ISDA documentation. By using
multiple counterparties over an extended period of time, it would be
possible for the hedge fund to establish very large positions with each
of the dealer/counterparties. Each dealer in turn would enter into
transactions on NYMEX to offset the risk arising from the bilateral
transactions into which it has entered with the hedge fund. In this
way, the hedge fund's total position would come to be reflected in the
futures market.
Thus, a prolonged wave of buying by a hedge fund, even through
bilateral direct or voice-brokered OTC transactions, can be translated
into upward price pressure on the futures exchange. As futures
settlement approaches, the hedge fund's bilateral purchases with
multiple dealer/counterparties would maintain or increase upward
pressure on prices. By spreading its trading through multiple
counterparties, the hedge fund's purchases would attract little
attention and escape detection by either NYMEX or the CFTC. In the
absence of routine large-trader reporting of bilateral transactions,
the CFTC will only see the various dealers' exchange positions and have
no way of tying them back to purchases by a single hedge fund.
Legislation is needed to remedy this critical lack of transparency.
The CFTC recently proposed an amendment to its Rule 18.05 ``special
call'' provision to make explicit that its special call authority to
traders applies to OTC positions, including bilateral transactions and
transactions executed on the unregulated electronic trading facilities
where the trader has a reportable position on a designated contract
market in the same commodity.\8\ This amendment, however, merely makes
explicit authority that the CFTC has previously exercised under Rule
18.05.\9\ Moreover, special calls are extraordinary in nature and will
not be used until a problem has been detected by some other means.
Thus, this special call requirement is not an effective tool for
conducting routine market surveillance. Moreover, the provision, even
as it is proposed to be amended, only applies when a trader has a
reportable position on a regulated futures market. Thus, by maintaining
positions in the regulated futures market below the reporting level, a
trader can avoid being required to report, even on a special call
basis. This is exactly the path that Amaranth took when ordered to
reduce its NYMEX position.
---------------------------------------------------------------------------
\8\ ``Maintenance of Books, Records and Reports by Traders,'' 72
Fed. Reg. 34413 (June 22, 2007).
\9\ The CFTC stated in its Federal Register release that,
``Commission staff has interpreted Regulation 18.05 to include position
and transaction data for non-reporting transactions [transactions
executed over-the-counter and or pursuant to Sections 2(d), 2(g) or
2(h)(1)-(2) of the Act] and has received such information in response
to requests made pursuant to the Regulation.'' Id. at 34415.
---------------------------------------------------------------------------
Only a comprehensive large trader reporting system that includes
all segments of the market would have enabled the CFTC to spot the
relative size of Amaranth's OTC position prior to its collapse. A
comprehensive large trader reporting system would enable the CFTC,
while a scheme is unfolding, to determine whether a trader is using the
OTC natural gas markets to corner deliverable supplies and manipulate
the price in the futures market.\10\ A comprehensive large trader
reporting system would also enable the CFTC to better detect and deter
other types of market abuses, including for example, a company making
misleading statements to the public or providing false price reporting
information designed to advantage its natural gas trading positions, or
a company engaging in wash trading by taking large offsetting positions
with the intent to send misleading signals of supply or demand to the
market. Such activities are more likely to be detected or deterred when
the government is receiving information with respect to a large
trader's overall positions, and not just those taken in the regulated
futures market.
---------------------------------------------------------------------------
\10\ See e.g., U.S. Commodity Futures Trading Commission v. BP
Products North America, Inc., Civil Action No. 06C 3503 (N.D. Ill.)
filed June 28, 2006.
---------------------------------------------------------------------------
The need to provide the CFTC with additional surveillance tools is
not meant to imply that the CFTC has not been vigilant in pursuing
wrongdoers. Experience tells us that there is never a shortage of
individuals or interests who believe they can, and will attempt to,
affect the market or manipulate price movements to favor their market
position. The fact that the CFTC has assessed over $300 million in
penalties, and has assessed over $2 billion overall in government
settlements relating to abuse of these markets affirms this. These
efforts to punish those that manipulate or otherwise abuse markets are
important. But it must be borne in mind that catching and punishing
those that manipulate markets after a manipulation has occurred is not
an indication that the system is working. To the contrary, by the time
these cases are discovered using the tools currently available to
government regulators, our members, and their customers, have already
suffered the consequences of those abuses in terms of higher natural
gas prices. Greater transparency with respect to traders' large
positions, whether entered into on a regulated exchange or in the OTC
markets in natural gas will provide the CFTC with the tools to detect
and deter potential manipulative activity before our members and their
customers suffer harm.
Accordingly, APGA has petitioned Congress to pass legislation that
would expand the large trader reporting system to mandate the reporting
of positions held in financial contracts for natural gas in all
segments of the market. Specifically, we believe that large traders
should report their positions regardless of whether they are entered
into on designated contract markets, on electronic trading facilities,
on OTC bilateral electronic trading platforms, in the voice-brokered
OTC markets or in direct bilateral OTC markets. This would treat all
trading positions in financial natural gas contracts equally in terms
of reporting requirements. Extending large trader reporting to OTC
natural gas positions and to positions entered into on electronic
trading facilities will provide the CFTC with a complete picture of the
natural gas marketplace and ensure that the cop on the beat has the
tools necessary to be effective.
Greater Transparency Is a Reasonable Response to Conditions in the
Natural Gas Market
It is important to note that APGA's proposal is narrow in scope.
First, APGA is requesting a comprehensive large trader reporting system
only with respect to financial contracts, agreements and transactions
in natural gas. The legislation that APGA is seeking is not intended
to, and would in no way effect financial swaps. Natural gas contracts
are more susceptible to manipulation than other commodities or
instruments because the deliverable supply of natural gas is often
small relative to the size of the derivatives positions held by large
traders and, as mentioned previously, natural gas is constrained by the
manner in which it can be delivered. These conditions do not
necessarily pertain to other commodities or instruments which are
``exempt commodities'' under the Act \11\ and they most certainly do
not pertain to contracts, agreements or transactions in the ``excluded
commodities'' under the Act.\12\ Accordingly, it must be emphasized
that APGA's proposal is limited to contracts in natural gas. It would
have no effect with respect to the OTC markets in financial swaps or in
any other contracts, agreements or transactions on an ``excluded
commodity'' or in any ``exempt commodity'' other than natural gas.
Moreover, APGA's proposal with respect to financial contracts,
agreements or transactions in natural gas is merely a reporting
requirement and would not impose any regulatory requirements with
respect to such transactions.
---------------------------------------------------------------------------
\11\ ``Exempt commodities'' are defined in Section 1a(14) of the
Act as, ``a commodity that is not an excluded commodity or an
agricultural commodity.'' Thus, for example, exempt commodities include
other energy commodities and base and precious metals.
\12\ ``Excluded commodities'' are defined in Section 1a(13) of the
Act and include interest rates, currency, indexes and various other
types of financial instruments or interests.
---------------------------------------------------------------------------
Second, the CFTC's large trader reporting system would not in any
way result in the public release of information relating to an
individual entity's trading positions. Information collected through
the CFTC's large trader reporting system is used for the government's
market surveillance purposes only and is kept confidential by the CFTC
in accordance with Section 8 of the Act. Any information which is made
publicly available by the CFTC, as described above, is on an aggregated
basis and does not disclose individual trading positions. APGA is not
advocating a change in this practice.
Finally, although some have raised concerns about the costs of
expanding the large trader reporting system, we believe the costs would
be reasonable. Insofar as the CFTC's large trader reporting system is
already operational, the CFTC will not be creating an entirely new
program to collect this information. In addition, large traders, such
as those which would be required to report to the CFTC, will likely
have automated record keeping systems for their own internal risk
management purposes that could be adapted for the purpose of reporting
positions to the CFTC. Finally, as discussed above, certain trading
facilities have already taken steps to make information available to
the CFTC. Accordingly, APGA believes that the costs of a comprehensive
large trader reporting system for natural gas would be reasonable and
are far outweighed by the benefits in terms of helping assure consumers
that the market price is a reflection of appropriate market forces.
* * * * *
Natural gas is a lifeblood of our economy and millions of consumers
depend on natural gas every day to meet their daily needs. It is
critical that the price those consumers are paying for natural gas
comes about through the operation of fair and orderly markets and
through appropriate market mechanisms that establish a fair and
transparent marketplace. Without giving the government the tools to
detect and deter manipulation, market users and consumers of natural
gas who depend on the integrity of the natural gas market cannot have
the confidence in those markets that the public deserves. The current
situation is not irreversible. Congress can provide American consumers
with the protection they deserve by passing legislation that would
expand the CFTC's large trader reporting requirements to include
financial contracts for natural gas that are currently exempt from
reporting. APGA and its approximately 700 public gas system members
stand ready to work with you towards accomplishing that goal.
The Chairman. Thank you, sir. Mr. Cicio.
STATEMENT OF PAUL N. CICIO, PRESIDENT, INDUSTRIAL ENERGY
CONSUMERS OF AMERICA, WASHINGTON, D.C.
Mr. Cicio. Thank you, Mr. Chairman. The Industrial Energy
Consumers of America is a nonprofit trade association whose
membership are significant consumers of natural gas and from
every major energy intensive manufacturing sector. At the heart
of the matter is that every consumer in the county assumes that
the government is protecting their interests and that energy
markets are working fairly, without manipulation, and operating
with a level playing field. Nothing could be further from the
truth.
The subject of excessive financial speculation, and market
power, manipulation first came to our attention starting in
2001 with the implementation of the Commodity Futures
Modernization Act and concerns have continued to grow. The
signs were obvious, but the lack of data, we could never prove
it. This all changed with the implosion of the Amaranth
Advisors hedge fund. The June 2007 Senate Permanent
Subcommittee on Investigations report entitled, Excessive
Speculation in the Natural Gas Market provides a clear and
troubling picture of how easy it is for a large hedge fund or
funds and Wall Street trading companies to potentially
manipulate the market to the benefit of their investors, to the
detriment of every consumer in the country. Amaranth completely
dispels the Wall Street myth that the market is too large for
one company to manipulate.
All market inefficiencies are paid for by us, the consumer.
And even a relatively small increase in the price of natural
gas of just 25 cents over the course of a year would cost
consumers $5.5 billion. Unlike other major commodities like
currencies or gold, excessive speculation of natural gas has a
direct impact on real people, homeowners, farmers and our
manufacturing competitiveness. And because natural gas supply
is fragile, it is particularly vulnerable to manipulation. We
can't assume that had Amaranth not continued to increase their
control of price by continuing to add to their positions,
market conditions would have driven the price lower because
national inventories of natural gas were above a 5 year average
and production was stable.
In fact, after Amaranth collapsed, so did the price of
natural gas. In September 2006 the price was $6.81; after the
collapse, it fell to $4.20. If we simply assume that $1 of that
$2.61 was due to Amaranth's activities, consumers would have
paid some $9 billion over the period of April to August of
2006. The Amaranth event raises several important questions for
Congress to address. The CFTC has known for a long time that a
significant market oversight gap existed. Why didn't the
Chairmen of the CFTC step forward to say there is a problem?
Why wasn't the CFTC responsive and accountable to the public
interest? Did the Commodity Futures Modernization Act of 2000
go too far? Did it weaken CFTC's market oversight
accountability? Is the relationship between CFTC and the
exchanges and Wall Street too cozy? Why aren't there time
limits to prevent CFTC officials from taking top positions in
the exchanges?
It is not without notice that last year Wall Street trading
companies weighed in on Congress to oppose the same reporting
and transparency provisions that we are asking for that would
have prevented Amaranth activities. Interestingly, these same
companies do mark to market position accounting at the end of
each trading day and they do it for their internal financial
management. It is also safe to say that companies currently
reporting to NYMEX and to CFTC are the same companies that are
not being required to report their positions through ICE.
IECA recommends that Congress take immediate action to give
CFTC regulatory oversight over ICE, and the OTC markets, in
general; require large traders to report their positions daily
to CFTC; give CFTC the ability to aggregate positions taken on
these exchanges and OTC markets; establish responsible daily
volume trading limits; increase monitoring in future months;
and increase the funding to allow for better enforcement. Thank
you.
[The prepared statement of Mr. Cicio follows:]
Prepared Statement of Paul N. Cicio, President, Industrial Energy
Consumers of America, Washington, D.C.
Chairman Etheridge and Ranking Member Moran, thank you for the
opportunity to testify before this Subcommittee on the important issue
of trading of energy-based derivatives.
The Industrial Energy Consumers of America (IECA) is a nonprofit
trade association whose membership are significant consumers of natural
gas and from every major energy intensive manufacturing sector.
Corporate Board Members are top energy procurement managers who are
leaders in their industry, technical experts, strongly committed to
energy efficiency and environmental progress. IECA membership
represents a diverse set of industries including: plastics, cement,
paper, food processing, aluminum, chemicals, fertilizer, brick,
insulation, steel, glass, industrial gases, pharmaceutical,
construction products, automotive products, and brewing.
At the heart of the matter is that every consumer in the country
assumes that the government is protecting their interests and that
energy markets are working fairly, without manipulation and operating
with a level playing field. Nothing could be further from the truth.
The subject of excessive speculation, market power and market
manipulation first came to our attention in 2001 and has continued to
grow in concern. The signs were obvious but because of the lack of
transparency, we could never prove it. This all changed with the
implosion of the Amaranth Advisors hedge fund. The fund reportedly lost
$6.0 billion on natural gas trades.
The June 2007 U.S. Senate Permanent Subcommittee on Investigations
report entitled ``Excessive Speculation in the Natural Gas Market''
confirms that Amaranth controlled 100,000 natural gas contracts which
mean they controlled the equivalent of 1 trillion cubic feet of natural
gas--the equivalent of 54 percent of our country's monthly demand.
Clearly, this looks like market power and market manipulation to a
consumer. We strongly encourage each Member of Congress to read the
Senate report that provides a startling reality check on how markets
are being manipulated.
Amaranth provides a clear and troubling picture of how easy it is
for large hedge fund and Wall Street trading companies to manipulate
the market to the benefit of their investors and to the detriment of
every consumer in this country. Amaranth completely dispels the Wall
Street myth that the market is too large for any one company to
manipulate.
The Commodity Futures Trading Commission (CFTC) knows there are
significant market oversight gaps and have failed to act in the public
interest. There is excessive speculation but we can deal with it `if'
we have transparency for the regulators to monitor the size of the
natural gas volumes that any one player is controlling on NYMEX, the
IntercontinentalExchange (ICE) and other over-the-counter (OTC)
markets. Today, under existing law, regulators can only monitor trading
volumes on NYMEX.
We believe that markets work better when market participants know
there is strong government oversight that has the ability to catch and
severely penalize market manipulation. Unfortunately there is neither
sufficient government oversight nor sufficient penalties to deter
manipulation.
All market inefficiencies are paid for by us, the consumer. And,
even a relatively small increase in the price of natural gas such as
$0.25, amount to significant cost impact of $5.5 billion over the
course of a year. And, unlike, many other commodities such as
currencies or gold, excessive speculation of natural gas has a direct
impact on all sectors of the economy including homeowners, farmers and
the manufacturing sector.
IECA member companies are some of the world's largest consumers of
natural gas. Natural gas is used as a feedstock and fuel. Member
company competitiveness is impacted directly and indirectly from the
price of natural gas and the functioning of natural gas markets.
Indirectly, the higher price of natural gas is increasing the price of
electricity across the country.
For example, natural gas represents 85% of the cost of making
anhydrous ammonia which is used to make fertilizer for our farmers.
Much of our plastics today are made from either ethylene or propylene
and a substantial portion of U.S. capacity is produced using natural
gas as the feedstock. In this case 93% of the cost of ethylene and
propylene is attributable to the cost of natural gas. Most
manufacturers use natural gas as a fuel for their boilers and to co-
generate electricity and steam to operate their facilities. There is
virtually no substitute.
Member companies historically use hedging practices to protect
themselves from volatility and to increase predictability of the
purchase price of natural gas. Since 2001, volatility has significantly
increased in large part due to excessive speculation which has also
increased the cost to hedge. For example, using a ATR (Average True
Range 15 week moving average) and comparing May 2000 to June 2007, the
volatility is up greater than 100%. If we compare May 2000 to the
September 2006 (the time period after the Amaranth implosion) the
volatility increased by 475%. Volatility is a manufacturer's nightmare
and a trader's dream. Volatility makes it extremely difficult for
manufacturers to plan product pricing, capital expenditures and plant
operations.
It is now a well known fact that Amaranth continued to increase the
volume of natural gas they controlled on the NYMEX and
IntercontinentalExchange (ICE) during the spring and summer of 2006.
Doing so resulted in higher prices than what would have otherwise been
the case. National natural gas inventories at the time were above the 5
year average and domestic production was stable. It is impossible for
anyone to accurately determine the premium consumers paid because of
Amaranth. However, we can provide perspective.
We can assume that had Amaranth not continued to increase their
control of the price by continuing to add to their positions, market
conditions would have driven the price lower. In fact, after Amaranth
collapsed, so did the price of natural gas. In September 2006, the
price was $6.81 per mm Btu and after the Amaranth collapse the price
fell in October 2006 to $4.20 per mm Btu, a $2.61 difference. If we
assume that only $1 of the $2.61 price was due to Amaranth, it would
have cost consumers an estimated $9 billion over the time period of
April thru August of 2006!
The clear responsibility of the CFTC is to ensure that the natural
gas market is functioning efficiently, fairly and that the derived
market price is trustworthy. That is, without manipulation. They cannot
succeed in doing so without greater jurisdiction to provide oversight
of the over-the-counter markets (OTC) including ICE. It is well known
to all market participants that because CFTC has oversight of NYMEX and
requires large players to report their positions to the ``Commitment of
Trader Report'', that traders have moved much of their trading volumes
to ICE where there is no reporting. Without jurisdiction over ICE, it
is impossible for the CFTC to reduce excessive speculation and make
sure that market power and market manipulation does not occur.
The Amaranth event raises several important questions for Congress
to address. The CFTC has known for a long time that a significant
market oversight gap exists. Why hasn't the Chairman of the CFTC
stepped forward to say there is a problem? Why isn't the CFTC
responsive and accountable to the public interest? Did the Commodity
Futures Modernization Act (CFMA) of 2000 go too far and did it weaken
CFTC's market oversight accountability? Is the relationship between the
CFTC and the exchanges to cozy? Why are there not time limits that
prevent CFTC officials from taking top positions with the exchanges?
At least one CFTC Commissioner has said there is a problem. Below
are the remarks of CFTC Commissioner Michael V. Dunn before the
National Grain Trade Council on September 8, 2006.
``However, a large portion of energy trading occurs in the
over-the-counter market, mostly beyond the scrutiny of any
Federal agency. The Commission's enforcement actions continue
to uncover repeated examples of people and companies trying to
game the energy markets, often in the belief that no one is
watching, or that if someone is, there is nothing that can be
done to them.''
``Because the CFTC is barred from regulating the OTC energy
markets, it cannot collect large trader data from unregulated
energy markets, or conducting regular surveillance of them. It
is virtually impossible to know, therefore, the extent of fraud
and manipulation that may be occurring in the over-the-counter
markets.''
CFTC opines it has subpoena power. It does. But that is not the
type of government oversight that is needed. Subpoena power is used
after the damage to markets has already been done. We want a preemptive
approach that effectively monitors markets and prevents manipulation.
IECA recommends that Congress take immediate action to give CFTC
regulatory oversight of ICE and other over-the-counter markets; require
large traders to report their positions daily to CFTC; give CFTC the
ability to aggregate positions regardless of where they are held;
establish daily volume trading limits; increase monitoring in all
months, not just near term months; increase CFTC funding for monitoring
and enforcement; and lastly, increase the supply of natural gas.
Asking OTC `large traders' to report their position to the CFTC
just like the NYMEX does today, is not asking too much of these
companies. These same companies do `mark-to-market' position accounting
at the end of each trading day for internal financial management
reasons anyway. Plus, it is safe to say that the same companies who are
reporting to CFTC thru NYMEX are the same companies who are not
reporting thru ICE. Reporting large positions to the CFTC is not asking
much when the public trust is at stake.
Thank you.
The Chairman. Thank you, sir. Mr. Eerkes.
STATEMENT OF CRAIG EERKES, PRESIDENT, SUN PACIFIC
ENERGY; CHAIRMAN, PETROLEUM MARKETERS
ASSOCIATION OF AMERICA, KENNEWICK, WA; ON BEHALF OF NEW ENGLAND
FUEL INSTITUTE
Mr. Eerkes. Chairman Etheridge and Ranking Member Moran and
the distinguished Members of the Committee, thank you for the
opportunity to testify before you today. My name is Craig
Eerkes and I appreciate the opportunity to provide some insight
on the way that the energy-based futures markets affect
independent petroleum marketers. I am here today offering
testimony on behalf of the Petroleum Marketers Association of
America and the New England Fuel Institute. Both PMAA and NEFI
have worked together to advocate increased CFTC oversight of
the energy futures markets.
PMAA is a national federation of 45 state and regional
associations representing some 8,000 independent petroleum
marketing companies from coast to coast. NEFI is a regional
trade association representing over 1,000 fuel marketers in the
New England region. Combined, our members own or supply
gasoline and diesel to 100,000 convenience stores and sell 90
percent of the heating oil and farm fuel sold in the United
States.
My petroleum marketing company, Sun Pacific Energy, owns
and operates 32 gas stations and convenience stores in
Washington State and we also supply Shell and ExxonMobil
gasoline to 75 independent dealers. Independent marketers began
to pay closer attention to futures markets in the aftermath of
September 11, 2001. Many petroleum marketers were stunned by
the immediate price volatility that spiked from coast to coast.
Many marketers in the Pacific Northwest were hit with dramatic
wholesale price increases on 9/11 and we did not think it
correlated to supply and demand. Our area refineries were not
affected, our terminals had plenty of supply, yet wholesale
prices quickly increased up to 40 cents per gallon.
First of all, I want to stress that we are not alleging any
wrongdoing by any person or any company. Our point of view is
really quite simple: Because the futures markets have become
the basis for the daily wholesale price of gasoline, diesel and
heating oil, it is imperative that Federal regulators monitor
all significant trading activity. Several weeks ago the House
of Representatives passed a gas price gouging bill that will
severely restrict my ability to operate my company during a
national emergency. I can say with firm conviction that my
marketer colleagues did everything possible to hold down gas
prices following 9/11 and Hurricane Katrina.
By contrast, one oil trader bragged that his profits
following Hurricane Katrina, in an industry newsletter, this
particular futures marketer bragged that he made enough money
in the week following Katrina that he would not have to work
the rest of the year. Can you imagine what would happen if a
gas station owner made a similar comment? If you want to do
something meaningful about retail petroleum prices, make sure
the energy futures markets are effectively monitored by the
CFTC. Because of the ``Enron Loophole,'' 75 percent of futures
trading which occurs on the over-the-counter exchanges,
including offshore exchanges such as ICE, are completely opaque
and are not accountable to U.S. law.
This is unacceptable. There needs to be transparency,
accountability and the rule of law on all energy commodity
markets. We urge you to close the ``Enron Loophole'' and give
the CFTC the authority and the tools to do the job. Please
ensure that energy futures trades are made subject to the same
oversight as wheat, corn and pork bellies. Energy consumers are
affected by excessive speculation and price volatility in the
energy commodity markets in profound ways. When excessive
speculation and volatility results in high prices for gasoline
and diesel, few Americans have transportation alternatives.
When heating oil, natural gas and other fuels skyrocket, it
places at risk the health and welfare of American families who
need heat for their homes. The commodity markets are the price
discovery points for all energy commodities. Excessive
speculation and questionable trading practices have an instant
and tremendous impact on the consumer. American families and
small businesses are at the financial whim of the energy trader
and the hedge fund manager. It is time that Congress stepped in
and said, ``Enough is enough.''
Please make sure that these markets are completely driven
by supply and demand for the benefit of all U.S. citizens. I
thank you for permitting me to participate in today's hearing
and I look forward to answering any questions you may have.
Thank you.
[The prepared statement of Mr. Eerkes follows:]
Prepared Statement of Craig Eerkes, President, Sun Pacific Energy;
Chairman, Petroleum Marketers Association of America, Kennewick, WA; on
Behalf of New England Fuel Institute
Chairman Etheridge and Ranking Member Moran and distinguished
Members of the Committee, thank you for the invitation to testify
before you today. I appreciate the opportunity to provide some insight
on the way that the energy based futures markets affect independent
petroleum marketers. I hope that my many years of experience in the
industry will help shed light on this issue and assist you in your
policy-making and oversight endeavors.
I am here today offering testimony on behalf of the Petroleum
Marketers Association of America (PMAA) and the New England Fuel
Institute (NEFI). Both PMAA and NEFI have worked together to advocate
increased Commodity Futures Trading Commission (CFTC) oversight of the
energy futures markets. PMAA is a national federation of 45 state and
regional associations representing some 8,000 independent petroleum
marketing companies from coast to coast. NEFI is a regional trade
association representing over 1,000 fuel marketers in the New England
region. Combined our members own or supply gasoline and diesel to
100,000 convenience stores and sell 90% of the heating oil sold in the
U.S. Also, of particular interest to this Committee, PMAA and NEFI
member companies supply an estimated 90% of the gasoline, diesel,
kerosene and heating oil to our nation's farms.
My petroleum marketing company, Sun Pacific Energy, owns and
operates 32 gas stations and convenience stores in Washington State. We
also supply Shell and ExxonMobil gasoline to 75 independent dealers.
Independent petroleum marketers began to pay closer attention to
futures markets in the aftermath of September 11, 2001. Many petroleum
marketers were stunned by the immediate price volatility that spiked
from coast to coast. Many marketers in the Pacific Northwest were hit
with dramatic wholesale prices increases on 9/11 and we did not think
it correlated to supply and demand fundamentals. Our area refineries
were not affected; our terminals had an abundance of product yet
wholesale prices increased up to 40 cents per gallon at some terminals.
From that day forward, PMAA and NEFI leaders began to take a hard
look at the futures markets and their correlation to supply and demand.
First of all I want to stress that we are not alleging any wrong
doing by any person or any company. Our point of view is really quite
simple. Because the futures markets have become the basis for the daily
wholesale prices for gasoline, diesel and heating oil, it is imperative
that Federal regulators monitor all significant trading activity. It is
unacceptable for Federal law to shield some energy trading activity
from needed oversight.
Several weeks ago, the House of Representatives passed a ``gas
price gouging bill'' that will severely restrict my ability to operate
my company during national emergencies. I can say with firm conviction
that my marketer colleagues did everything possible to hold down gas
prices following 9/11 and Hurricane Katrina. By contrast, one oil
trader bragged about his profits following Hurricane Katrina in an
industry newsletter. This particular futures market trader bragged that
he made enough money in the week following Katrina that he would not
have to work the rest of the year. Can you imagine what would happen if
a gas station owner made a similar comment?
If you want to do something meaningful about gasoline, diesel and
heating oil prices, make sure the energy futures markets are
effectively monitored by the CFTC. Because of the ``Enron Loophole,''
which Congress passed in 2000 at the behest of Enron lobbyists, the 75%
of futures trading which occurs on the over-the-counter (OTC)
exchanges, including off-shore exchanges such as the
IntercontinentalExchange, are completely opaque and are not accountable
to U.S. law. This is unacceptable--there needs to be transparency,
accountability and the rule of law on all energy commodity markets. We
urge you to close the ``Enron Loophole'' and give the CFTC the
authority and the tools to do the job. Please insure that energy
futures trades are made subject to the same oversight as wheat, corn
and pork bellies.
Energy consumers are affected by excessive speculation and price
volatility in the energy commodity markets in profound ways. When
excessive speculation and volatility result in high prices for gasoline
and diesel, few Americans have transportation alternatives. When
heating oil, natural gas and other heating fuels skyrocket it places at
risk the health and welfare of Americans families who need heat for
their homes.
The commodity markets are the price discovery points for all energy
commodities. Excessive speculation and questionable trading practices
have an instant and tremendous impact on the consumer. American
families and small businesses are at the financial whim of the energy
trader and the hedge fund manager. It is time that Congress stepped in
and said, ``Enough is enough.''
We and our customers need our public officials, including those in
Congress and on the Commodity Futures Trading Commission (CFTC), to
take a stand against a loophole that artificially inflates energy
prices. We deserve to have confidence that the prices established in
futures markets are in fact market based prices and not vulnerable to
inappropriate trading practices.
Do not be mistaken. We very much support the free exchange of
commodity futures on open, well regulated and transparent exchanges
that are subject to the rule of law and accountability. Many PMAA and
NEFI members rely on these markets to hedge product for the benefit of
their business planning and their consumers. Reliable futures markets
are crucial to the entire petroleum industry and that is one reason why
I am here today. I think it is so important for Congress to improve the
futures markets for the benefit of all U.S. citizens.
As I mentioned earlier, the futures markets have become the price
point for wholesale refined product pricing in the U.S. Please make
sure that these markets are competitively driven by supply and demand.
I thank you for permitting me to participate in today's hearing and
I look forward to answering any questions you may have.
The Chairman. Thank you, sir. We have just gotten a call
for voting on the floor. We will have three votes. They are
probably going to take about 20 minutes at most, hopefully, and
we will hustle right back. If you will just hang around, take a
little break, we will try to get back as quickly as we can. I
was hoping we would get through before they called the vote.
[Recess]
The Chairman. Let me thank you for your indulgence. It took
longer than we thought. You know, they start the vote and they
start dragging it out and it took a bit, but we appreciate you
waiting around for us until we got back. We are going to move
to our question area and we will allow each Member 5 minutes
and I recognize myself for the first 5 minutes. And my first
question will be to Dr. Newsome.
Dr. Newsome, during the Senate hearing on Monday, the New
York Merc, ICE and the CFTC were all in agreement that the ICE
and New York Merc trading venues are now pretty tightly linked
and strongly interactive with each other. My question to you is
what consequences does this have for the price discovery role
of the two venues?
Dr. Newsome. Mr. Chairman, I think it links the price
discovery role, as well. I mean, if you look at trading on both
ICE and NYMEX, either exchange can lead the other exchange very
quickly which follows within that price direction and even
though NYMEX trades a physical contract, ICE trades a financial
contract, the reality is that less than \1/10\ of 1 percent of
NYMEX contracts go to physical delivery. Now, they trade
functionally as a financial contract, so I think the two are
definitely linked. The two markets can move each other and
while the price that is published is officially the NYMEX
price, I don't think there is any question that the activity on
ICE is a component of that price is discovered.
The Chairman. Okay. Mr. Sprecher, you said, at the Senate
hearing, that ICE would support implementation of
accountability levels to require traders to provide the
exchange more information about their positions. Could ICE not
implement this independently of any Commission authority or
action?
Mr. Sprecher. It is a very good question. We could. I think
what the real issue is, is that ICE only has a limited view
into the market. If you ask Dr. Newsome, he would tell you he
only has a limited view into the market and increasingly, what
we really need is for, in my mind, a central person, most
likely the CFTC, to have an entire view of the market. If, in
the context of that, the CFTC or Congress would like us to take
some role in identifying large positions, that would be fine,
but while I say we would be open to it, I don't necessarily
think it is the best way of solving this. I actually think the
CFTC, with an entire view of the market, is best positioned to
decide who should be accountable and for what.
The Chairman. Dr. Newsome, let me put you on the hot seat
again with that very same question, because I think that is
part of what some of the issues are as it relates to large
positions and concerning, I would hope, all others who are
concerned.
Dr. Newsome. I think I definitely agree with Mr. Sprecher
that the CFTC is the appropriate overseer. They are the ones
that should have the global view of who is in these markets,
how large they are in these markets, so Jeff and I are
completely on the same page there, Congressman.
The Chairman. Mr. Pickel, along that same line, you heard
some of your fellow panelists call for greater reporting to the
CFTC, but only of positions of large traders, as we just talked
about here. Can you break down for us the potential cost to a
large trader in complying with such a provision?
Mr. Pickel. If we look at it from the perspective of the
sector that we represent, the privately negotiated business,
those are all bilateral contracts. There is not the building up
of a market position in the way you would do certainly on an
exchange and perhaps, to some extent, through an ECM, such as
ICE. So you don't have that building up of a market in the same
sense. You have a series of bilateral trades between parties
and both of those parties typically will be looking at the
market prices, typically the NYMEX price, to determine whether
the price of that individual trade, which they have negotiated,
is an appropriate price to enter into a contract.
The Chairman. So give me a for instance, say on a $100,000
position or a half million dollar position.
Mr. Pickel. In terms of the cost of----
The Chairman. Yes. If you know.
Mr. Pickel. I don't have those numbers, specifically. It is
fair to say that the members that we represent, and I think
most people who are active in these markets, will be, as a risk
management issue, collecting information and keeping records
just for either accounting purposes, regulatory purposes or
just good business sense.
The Chairman. Okay, thank you. I yield back. Mr. Moran.
Mr. Moran. Mr. Chairman, thank you. Let me talk to Mr.
Sprecher and Dr. Newsome about Amaranth. What I am interested
in knowing is who knew what when? And as I understand, there
were positions taken on both of your exchanges. What I don't
know yet is whether each of you knew about the positions taken
on the other's exchange, and second, what the CFTC knew about
both of those positions or both of those exchanges and its
dealings with Amaranth.
Dr. Newsome. Who do you want to go first?
Mr. Moran. Well, you two are getting along so well, I will
let you decide.
Mr. Sprecher. We actually do get along.
Dr. Newsome. I think both of us are in the position of
saying, ``You can only manage what you can see.'' We could see
the positions on NYMEX, the CFTC could see the positions on
NYMEX, that is not the case, wasn't the case at the time in the
ECM marketplace.
Mr. Moran. And so you, Mr. Sprecher, only knew about the
positions of Amaranth on your exchange; Mr. Newsome only knew
about the positions that they took on his exchange. Is that
true?
Mr. Sprecher. That is correct.
Mr. Moran. And then CFTC?
Mr. Sprecher. At the time, which is not the case today, ICE
was not giving the so-called large trader report information to
the CFTC, so they would not have had a real-time way of looking
at Amaranth. They would have been able to see it and I do
believe they did see it through its special call provision
after the fact. Today, with the more near real-time reporting,
in other words, we send the positions every day, at the end of
every day, they would have a near real-time view of the
positions both on ICE and NYMEX, which didn't exist at the
time.
Mr. Moran. And what precipitated that change in that
reporting?
Mr. Sprecher. A special call from the CFTC, and as I said
in our testimony, we believe that the CFTC has the authority to
make that special call and indeed, we complied with it.
Mr. Moran. And what would CFTC, they would be able to do
something with that information, share it between the two
exchanges, investigate positions taken in both places?
Mr. Sprecher. Well, they have, with respect to ICE, they
have tremendous authority over these over-the-counter markets
as they affect Dr. Newsome's markets, to take broad action. But
I should let you speak to----
Dr. Newsome. Congressman, I don't think the CFTC would
share each other's exchanges with another exchange. They will
take the higher level picture, deal directly with the customers
and say, ``We notice your positions on either exchange,'' start
asking the questions, for instance, ``What is your intent,''
the `jawboning' that Chairman Lukken talked about earlier.
Mr. Moran. Well, Doctor, the reason, that was at least an
important question to me, is because of NYMEX's decision to
allow an increase or change in their position eight times. My
question is, if you had information related to what that hedge
fund was doing in ICE, would you reach a different conclusion?
And if the answer to that is yes, then that information is
valuable to you.
Dr. Newsome. Well, I mean, we certainly could have reached
a different conclusion. Again, you can only manage what you can
see. In those circumstances, and it was brought up in the
Senate hearing and again, earlier today, when we look at
positions, position limits, position accountability, the eight
cases, as you just mentioned, is accurate. But is very
difficult to pull out a position in a particular month and say
they were over or they were below, because when we look at it,
we are looking at trying to prevent manipulation. We are
looking at trying to stem undue risk. We look at the entire
position.
So if you had a position in September that may be
completely offset by a position in October, so from the
exchange standpoint, we are looking at the aggregation of risk
across all positions. That is typically the way the CFTC has
done it. That is what our rules currently allow for. Now, that
said, given the situation that happened with Amaranth, we have
started paying much closer attention to futures only position
and back months, where in the past, we never felt that it was
necessary to do so. We are doing that now and in fact, we are
adopting rules that relate to that, as well, so that is
something that we have learned through the situation with
Amaranth.
Mr. Moran. Are there other exchanges in which Amaranth or
any hedge fund could have taken positions in addition to NYMEX
and to ICE that it is important for CFTC or you, internally, to
know about? So now that this information is being gathered,
have we got every exchange that is important to know about a
hedge fund's position going to the CFTC?
Dr. Newsome. Well, I think whether you are talking about
exchanges or ECMs that function in an exchange-like manner, at
least, in my opinion, and Mr. Sprecher can provide his
comments. I think ICE and NYMEX provide the vast majority of
the information that is necessary, given today's environment,
because, to my knowledge, ICE and NYMEX are the only two that
have the tight linkage in the natural gas market. They are the
only two that function as equivalents and therefore the only
two that it would have been necessary to look at the Amaranth
positions as it occurred.
Mr. Moran. My time is expired. In the past year, I would
have been able to continue asking questions, but at the moment,
I cannot. But in case the Chairman will allow me a second round
of questions, I have a few things I would like to follow up on,
Mr. Chairman. I may try to assume the time of any of my other
Republican colleagues.
The Chairman. I thank the gentleman. Mr. Scott.
Mr. Scott. Thank you very much, Mr. Chairman. Mr. Sprecher,
this is a very complex issue and I think it might be helpful to
us on the Committee if you could share with us just how ICE
operates, and second, how ICE operates differently from NYMEX.
Mr. Sprecher. Sure. As it has been testified to, we are
this category of ECM, which is different than Enron On-line,
which sought and received an exemption from any oversight. We
applied for and received designation as an ECM, which has
certain anti-fraud, anti-manipulation record keeping
requirements, to the CFTC. NYMEX is, as a full so-called DCM,
is the designated contract market. Its market is designated as
the source of price discovery for natural gas and outside of
NYMEX's market exist ICE and many other bilateral markets. In
fact, there are global markets that trade swaps and derivatives
that are related to NYMEX, but are not designated by the
government as a source of price discovery.
And it is that distinction that I think was carefully
crafted in the Commodity Futures Modernization Act and it is,
in a large part, the underpinning of what we are discussing
today, which is now that markets are increasingly linked
globally, electronically, and investment dollars continue to
come into this space as energy prices climb--what is the role
of a marketplace that is not designated as a source of price
discovery?
Mr. Scott. Let me ask you this, too. My time is limited and
I got to get a question to Dr. Newsome. You recently came out
for agreeing to increase regulation, in light of the
differentiation that you mentioned between yourself and ICE,
how would that relate? Were you talking about increased
regulations for yourself or would that apply to NYMEX, as well?
And second, what would consist of your accountability stand and
if you could be very brief with that, I would appreciate it.
Mr. Sprecher. Yes. I think, as everybody has testified to
today, giving the CFTC more information is a better thing, so
while I don't believe we need a wholesale overhaul, I think the
CFTC has, at least with respect to ICE, as an ECM, the
authority it needs to gather that information. I think it is
for you all to debate whether that should be broadened to non-
ECMs and I won't take a position on that.
Mr. Scott. Thank you very much. Dr. Newsome, let me just
add that I read in The Wall Street Journal recently, I think it
was yesterday or the day before, that no less than eight times
in 2006, NYMEX allowed Amaranth to trade far beyond its
established accountability limits, seemingly at the request of
Amaranth. In addition, the article states that although you
issued warning letters to Amaranth, you rescinded the
violations without explanation. So in light of that, I am
having a little bit of trouble understanding why it is that you
are pushing so hard for regulation of ICE when, in fact,
according to this latest situation with Amaranth, you,
yourself, refused to abide by already established
accountability limits. Could you explain that, please?
Dr. Newsome. Absolutely, sir. I would love to. As I was
trying to refer to Congressman Moran's question, when you look
at positions, you can't just look at individual months. I mean,
we are talking about trying to prevent manipulation and trying
to manage systemic risk. You have to look at the positions in
an aggregate manner. Now, we have far tougher rules with regard
to hard position limits on the front months, more flexible
rules with regard to position accountability in the back
months.
But we do look at the positions across all contracts, not
only futures contracts, but there are options contracts, as
well, there are swaps contracts, and in many times these
positions are offsetting to get to total futures position or
risk position. In those instances, we looked at those
positions, not necessarily by that exact month, but in
aggregate. When we became concerned that in the aggregate
position Amaranth had too much market power, that was the point
in which we forced them to start liquidating those positions.
Mr. Scott. I want to give you an opportunity to respond to
something there, because Michael Greenberger, who is a former
CFTC official who oversaw exchange trading in the late 1990s,
mentioned this. He said that NYMEX is making a lot of money off
these trades and they are very conflicted about what to do. I
think it is a very powerful statement that has been made
against NYMEX and I would like to give you an opportunity to
clear that up and respond to that.
Dr. Newsome. And I appreciate you giving me that
opportunity, Congressman Scott. I cannot disagree with Mr.
Greenberger more on this instance. In fact, if you look at our
compliance department, you look at the firewall that we have
between the compliance department and the business units of the
exchange, at no point in time did the compliance department
ever come to the business units or the Board to ask for
permission to decrease the Amaranth positions, at no time.
Mr. Scott. All right. Thank you very much, Mr. Chairman.
The Chairman. Thank you. Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. The Chairman has a
scheduling problem with going beyond 1 p.m. and consequently,
you all have come a long way and offered testimony and not had
much of an opportunity to have exchange with one another and
with us. What I would like to propose is that once the hearing
is adjourned, if you have time on your schedules and I trust
that you do, that all six of you gentlemen join me.
We are trying to locate a room where we can have a more
informal discussion which I will chair, but it will be pretty
informal chairing, so that I can get--and those who wish to
join me. I think Mr. Moran will join me and I expect Mr. Barrow
will, if his schedule permits and perhaps Mr. Scott--so that I
can get a better feel of the differences of opinion among you
with regard to these different issues. What do you say? Anybody
cannot do that? Great. That is very helpful.
Mr. Pickel, in the past we have talked about reporting and
record keeping in your industry and I am sure all the reputable
players in your industry are keeping appropriate records.
Frankly, all of the reputable characters in your industry are
reporting as well, not necessarily to the CFTC, but they are
divulging, at the request of brokerage houses and others, their
positions so that houses can appropriately gauge risk with
regard to different transactions.
I know it is Mr. Corbin's view that an essential part of
transparency in the market would be to have some kind of
reporting and both NYMEX and ICE probably agree with that as
long as they are going to have to be divulging things. What
would be the problem with a simple reporting system as it
affects the over-the-counter market?
Mr. Pickel. I continue to go back to the fundamental nature
of what I would call the pure OTC, or pure bilateral contract,
that we represent and that is two parties getting together,
individually negotiating a trade. Yes, they may do many trades,
but it is an individual contract that ultimately they have
entered into and there are protections under the CFMA for those
types of contracts. You are certainly correct that the
information is collected. It is just good business sense to
collect that information and I know that our member firms, the
reputable firms that you refer to are very cooperative with the
CFTC and other agencies when they are investigating these
situations.
Mr. Marshall. When it is a special call?
Mr. Pickel. Yes.
Mr. Marshall. CFTC is not particularly anxious to have, to
be flooded, frankly, with the details of all of the
transactions that those you represent enter into. It doesn't
have the capacity to actually analyze, wouldn't know what it
received, would be worried that there is some sort of bombshell
and consequently would have to devote resources. We might not
provide adequate resources, devote resources to that and hence,
take resources away from other oversight activities that it
engages in; so there are real challenges here--but say, ``Let's
narrow it to a certain market.''
Let us say natural gas, which has had some obvious problems
recently, and reporting where that narrow market is concerned.
Make the reporting a very narrow question, just a few pieces of
information about the trade; who the parties are, what the
price was and try to take that, whatever the transaction is as
between those bilateral entities and have those entities
characterize that transaction so it fits into a simple
reporting system; which then enables the CFTC, in advance, to
anticipate problems with--and it is not just market
manipulation here. Everybody is talking about the CFTC having
authority where market manipulation is concerned or fraud, and
that is the special call.
The argument by Mr. Corbin, and others, is that these
markets are not properly finding the price. If you have
somebody like Amaranth out there that has a trading strategy
that proves to be erroneous, but is willing to back that
strategy despite the wisdom of the market. The market prices
change rather dramatically as a result of the influence of that
entity, the CFTC, seeing that in advance, could conceivably
avoid the problem for purchasers like Mr. Corbin and others.
And so what would be the problem with doing that from the OTC
perspective?
Mr. Pickel. I think, from our perspective, these individual
transactions, the parties will typically reference prices on
the NYMEX, perhaps over time. If ICE develops a certain
reference price or there is a price discovery function there,
they might reference those prices. And they will need to take
positions and hedge on those regulated markets and therefore
the information regarding the underlying, even if not regarding
the individual transaction, the information regarding the
strategies will play out in the regulated markets.
Mr. Marshall. And assuming that is the case and I accept it
is, what would be the harm with divulging the transaction in
some simple way to the CFTC? Since you are the only market
anyway.
Mr. Pickel. Well, I think they would look at that
information in the way that Dr. Newsome and Mr. Sprecher have
described. They would have access to that information. I think
that if they saw that that indicated some abnormalities in
trading activities, they would certainly be in a position to
ask for that information. I think that our member firms have
been very good in turning over that information.
Mr. Marshall. Dr. Newsome, you keep waving your hand there.
Dr. Newsome. Yes, I wanted to make a comment on that, kind
of as a non-OTC player. NYMEX, and I just want to get it clear
for the record, NYMEX is in no way suggesting that the true,
individually negotiated off-exchange bilateral markets should
be subject to CFTC oversight and I think there are a couple of
reasons. Just the fact that they are individually negotiated in
terms of the size of the contract, the price of the contract
and the fact that there is no aggregation of risk, like we have
on our exchange, like Jeff has on his exchange. I think there
is very little public good that can come out of that
information.
Mr. Marshall. Can I interrupt? Was Amaranth doing, in
addition to things on your exchanges, things in the over-the-
counter market which were fairly similar to what it was doing
in your exchanges?
Mr. Pickel. I don't have the exact answer to that. My
assumption would be that the bulk of their activity was on both
NYMEX and ICE. They may have had some, but again, even if they
were, there was no----
Mr. Marshall. Well, hypothetically, let us assume Amaranth
did, that a whole lot of what it was doing were bilateral
trades, like you just described, on the OTC market. How does
the CFTC adequately see the dangers, the risks, not just to
Amaranth, but to the market and to market price discovery
caused by a situation where a large player is just really going
whole hog in a particular direction that the rest of the market
thinks is crazy, but it is going to have to follow?
Mr. Pickel. Well, I think the protections are self-built
in. Again, since you have no aggregation of risk as you would
on an exchange-type manner, I think the risk of a systemic
problem is very, very small. Particularly, in natural gas,
where somebody has to be able or the willingness to accept the
counterparty credit risk, which in natural gas people are
typically not willing to do so, that is why you see 90 percent
of the natural gas market now cleared, either through ICE or
NYMEX, because they don't want to accept that counterparty
credit risk. So I totally understand the line of questioning,
but I think, in terms of natural gas, it is not as big a risk
as it could be and potentially other markets.
Mr. Marshall. If I could just finish this line?
The Chairman. Okay, quickly.
Mr. Marshall. I will. By the end of your statement just
now, I take it that you think that this risk could exist in
other markets, not necessarily in natural gas, and that am I
also to assume that it could well be that a large trader who is
doing not only trades on your exchanges that are visible, but
in addition, trades OTC, same commodity that that large
trader's risk to the market, to itself, to consumers, et
cetera, wouldn't be seen by the CFTC unless there was
reporting?
Mr. Pickel. I am not aware of any risk in other
marketplaces. Certainly, if that risk was there, the CFTC would
not currently be able to see it.
Mr. Marshall. Thank you. Thank you, Mr. Chairman. I thank
you for your generosity.
The Chairman. I thank the gentleman. Mr. Moran.
Mr. Moran. Mr. Chairman, I will try to be brief. I, too,
have a 1 p.m. appointment that I must keep. Let me just follow
up with a couple of thoughts that I wanted to explore further.
In this regulatory world that we are talking about, is there a
transaction cost, a differential between a DCM and an ECM based
upon the regulatory structure that CFTC provides?
Dr. Newsome. There is some cost, Congressman. I couldn't
quantify that cost for you today. I think, looking at the cost
of having to acquire and staff a compliance department, as we
do, is certainly substantial cost for NYMEX. That is a more
easily quantifiable cost. Position limits, there would be a
cost there. Price reporting, that reporting is congregated at
the clearinghouse level and submitted to the CFTC, so I don't
think there would be any real cost on reporting.
Mr. Moran. Thank you. And then, we heard, as we discussed
CFTC reauthorization, about the unique nature of peculiarities
of forex contracts, that at least allegedly make them more
susceptible to manipulation fraud. Is there anything inherent
in natural gas, oil, and gasoline contracts that you could say
the same thing about them? Is there any inherent opportunities
for fraud or manipulation?
Dr. Newsome. I don't think there are more inherent
opportunities other than we have seen more substantial
volatility within the energy sector, so you have much more
price movement and through that price movement, I guess there
could, theoretically, be more opportunity.
Mr. Moran. And finally, this is directed at Mr. Corbin. Mr.
Corbin, there should be a gain that, in the cash market, that
offsets losses if you are doing an appropriate hedge, so I
assume that there were gains in the cash market that perhaps
offset your losses?
Mr. Corbin. No, there wasn't. What happened was, most of
our members' consumption is in the wintertime and so what we
are trying to do is hedge the risk of prices spiking in the
winter, hitting levels that consumers literally have struggled
to pay. And so here we are, earlier in the year, and we can't
wait, hoping that prices are going to come down, so we saw them
keep going up and up and up. You hope is not a risk management
strategy, so we put on those hedges, in the summertime, prior
to the Amaranth collapse. We locked in a price that may have
been $9 or $10 a unit for wintertime gas. Following the
collapse, those prices came down significantly. Yes, we bought
gas. You are right. We physically bought gas cheaper, but you
then have to add that loss that you incurred on your hedge that
gets you right back up to $10 or $9. So the loss isn't offset
in the physical market. It is a real loss.
Mr. Moran. I assume that part of the losses are unrelated
to Amaranth, they are related to the market, the volatility,
the supply and demand.
Mr. Corbin. Yes, we tried to simply look at that
afterwards. We didn't go with where the market ultimately
settled out, which I agree with you. Once it ultimately settles
out, there are fundamental reasons, as well, for it to continue
to move. We just tried to look at what was happening right at
the time they were collapsing, how much did it decline right as
they were exiting the market, and just use those numbers.
Mr. Moran. Mr. Chairman, thank you for allowing me the
opportunity to ask these questions. I would ask if anybody
would like, not at this point, but in the future, in writing or
in a conversation with me, I have heard about the ``Enron
Loophole'' today and there is a suggestion that the ``Enron
Loophole'' needs to be fixed. I would be happy to have the
definition. Mr. Eerkes, you, in particular, used that in your
testimony, but we heard it in the earlier panel. If there is an
``Enron Loophole'', I would like to know what it is and what
the potential fix that any of you see is required or not
required. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. Mr. Barrow, 5 minutes.
Mr. Barrow. I thank the Chairman. I have a few matters I
want to follow up on, but out of consideration for the chair's
conflict and in light of the informal meeting that Mr. Marshall
is going to convene, I will pass on this opportunity, but once
again, I want you to accept my thanks for the opportunity to
participate in this hearing. Thank you, sir.
The Chairman. I thank the gentleman. Dr. Newsome, I am just
going to ask you a question and in the expediency of time and
everyone's schedule that it would be in writing, if I may get
it? According to the Senate Investigative Subcommittee, in a
report on, this by and large is a natural gas market. It said
from almost every day from mid-February through July of 2006,
Amaranth held more than 50 percent of the open interest on New
York Merc and in January of 2007, as well as in November of
2006, contracts.
My question is, is this common or normal for a trader to
hold such a large position or contract? Second, does holding
such a position trigger action at the exchange or the CFTC, for
that matter? And finally, if so, what did New York Merc do with
regard to Amaranth's position as it relates to this? And I
would be happy to have that in writing so we can expedite this
and allow you gentlemen to get on the road because you have
been very kind with your time today and we do appreciate you
staying with us through the votes we have had today. And with
that, unless the Ranking Member has a further comment?
Mr. Moran. No, sir. Thank you, Mr. Chairman.
The Chairman. Under the rules of the Committee, the record
of today's hearing will remain open for 10 days to receive
additional material and supplementary written requests and
responses from witnesses to any question posed by a Member of
this panel. This hearing of the Subcommittee on General Farm
Commodities and Risk Management is adjourned. Thank you.
[Whereupon, at 12:56 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Question
Response from Orice M. Williams, Director, Financial Markets and
Community Investment, U.S. Government Accountability Office,
Washington, D.C.
Question Submitted By Hon. Hon. Jim Marshall, a Representative in
Congress From Georgia
Question. Please review how the Municipal Gas Authority of Georgia
(MGA) calculated the $18 million in losses for 2006 that were
attributed in the futures market because of the trading practices of
Amaranth Advisors, LLC; and analyze MGA's recommendations for changes
to the Commodity Futures Trading Commission's (CFTC) oversight
authority.
Answer. At the July 12, 2007, House Committee on Agriculture's
Subcommittee on General Farm Commodities and Risk Management hearing on
energy-based derivatives, you asked that we (1) review how the
Municipal Gas Authority of Georgia (MGA) calculated the $18 million in
losses for 2006 that were attributed in the futures market because of
the trading practices of Amaranth Advisors, LLC; and (2) analyze MGA's
recommendations for changes to the Commodity Futures Trading
Commission's (CFTC) oversight authority. On July 20, 2007, we spoke
with Arthur Corbin, President and Chief Executive Officer of MGA, and
Jeff Billings, the head of risk management for MGA. We also reviewed
data that MGA used to arrive at its $18 million loss estimate.
According to MGA officials, they estimated the $18 million loss by
calculating the difference between the prices MGA members paid for
futures contracts and what members would have actually paid for natural
gas in the physical markets in 2006. This analysis assumed that
Amaranth's trading was the only factor affecting natural gas prices in
2006, and did not include the possible effect of other factors such as
changes in supply and demand or the trading activities of others. MGA
officials acknowledged that other factors could have also played a role
in futures prices during this period. As we testified, the factors
affecting energy prices, including natural gas are complex and
attributing a change in prices to any one fact is difficult. Therefore,
we are unable to make any specific conclusions based on this analysis.
MGA recommended that CFTC have the same oversight authority over
all markets that trade derivatives in energy. Specifically, they noted
that even though off-exchange transactions lack the requirement for
physical delivery of exchange-traded contracts, the absence of the
requirement does not preclude a trader from manipulating commodity
prices. Further, they said that without a complete picture of trading
in all of the energy markets, particularly by large traders, CFTC can
not adequately protect consumers from artificial prices. They also
noted that CFTC's special call authority, while helpful, does not
provide for routine monitoring and oversight of trading in natural gas
derivatives; and that CFTC's authority to expose manipulative behavior
after it occurs does little good because, as they said, contract prices
already would have been affected. The issues raised are consistent with
those raised by others who support greater CFTC authority over certain
derivatives markets. Given the growth in energy trading in the exempt
and over-the-counter markets, further debate and analysis is warranted
including whether CFTC's current authority is sufficient in light of
recent events.