Commodity Futures Trading Commission: Trends in Energy
Derivatives Markets Raise Questions about CFTC's Oversight
(24-OCT-07, GAO-08-174T).
Energy prices for crude oil, heating oil, unleaded gasoline, and
natural gas have risen substantially since 2002, generating
questions about the role derivatives markets have played and the
scope of the Commodity Futures Trading Commission's (CFTC)
authority. This testimony focuses on (1) trends and patterns in
the futures and physical energy markets and their effects on
energy prices, (2) the scope of CFTC's regulatory authority, and
(3) the effectiveness of CFTC's monitoring and detection of
abuses in energy markets. The testimony is based on the GAO
report, Commodity Futures Trading Commission: Trends in Energy
Derivatives Markets Raise Questions about CFTC's Oversight
(GAO-08-25, October 19, 2007). For this work, GAO analyzed
futures and large trader data and interviewed market
participants, experts, and officials at six federal agencies.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-08-174T
ACCNO: A77548
TITLE: Commodity Futures Trading Commission: Trends in Energy
Derivatives Markets Raise Questions about CFTC's Oversight
DATE: 10/24/2007
SUBJECT: Commodities exchanges
Commodity futures
Commodity marketing
Commodity sales
Energy demand
Energy industry
Energy marketing
Federal regulations
Financial analysis
Financial futures
Financial institutions
Performance measures
Petroleum prices
Petroleum products
Prices and pricing
Regulatory agencies
Reporting requirements
Trade regulation
Supply and demand
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GAO-08-174T
* [1]Summary
* [2]Background
* [3]Several Factors Have Caused Changes in the Energy Markets, P
* [4]Various Changes in the Physical Market Contributed to Rising
* [5]The Effect on Prices of Relatively High but Falling Volatili
* [6]CFTC Oversees Exchanges and Has Limited Authority over Other
* [7]CFTC Has General Oversight Authority over Futures Exchanges,
* [8]CFTC Authority over Exempt Commercial Markets and OTC Market
* [9]CFTC Engages in Large Trader Reporting, Surveillance, and En
* [10]CFTC Oversight Includes Surveillance of Energy Futures Tradi
* [11]CFTC Energy-Related Enforcement Actions Generally Involved A
* [12]GAO Contacts
* [13]Staff Acknowledgments
* [14]Order by Mail or Phone
Testimony
Before the Subcommittee on General Farm Commodities and Risk Management,
Committee on Agriculture, House of Representatives
United States Government Accountability Office
GAO
For Release on Delivery
Expected at 1:30 p.m. EDT
Wednesday, October 24, 2007
COMMODITY FUTURES TRADING COMMISSION
Trends in Energy Derivatives Markets Raise Questions about CFTC's
Oversight
Statement of Orice M. Williams, Director
Financial Markets and Community Investment
GAO-08-174T
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss our recent report on the trading
of derivatives for energy commodities, including crude oil and natural
gas, and the Commodity Futures Trading Commission's (CFTC) oversight of
these markets.1 The expansion of derivatives trading in energy markets,
particularly by participants such as hedge funds, and rapid growth in
trading off regulated exchanges have raised questions about the quality
and quantity of reporting on and oversight of these trading activities.2
Specifically, I will discuss (1) trends in the physical and energy
derivatives markets and their effect on energy prices, (2) the scope of
CFTC's authority for protecting market users in the trading of energy
derivatives, and (3) CFTC's monitoring and detection of market abuses in
energy futures markets. I should point out that our review was intended to
identify trends in both the physical and derivatives energy markets and to
provide information on the current regulatory structure for energy
derivatives trading, including analyzing the various perspectives of
market participants on these issues. While our report frames issues that
need to be addressed, we do not offer specific policy solutions.
During the course of our review, 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 from January 2002 through December 2006. We
also analyzed data obtained from CFTC on market participants and the
outstanding trading positions of different categories of traders. 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 was done in accordance with generally accepted government auditing
standards.
1GAO, Commodity Futures Trading Commission: Trends in Energy Derivatives
Markets Raise Questions about CFTC's Oversight, [15]GAO-08-25 (Washington,
D.C.: Oct. 19, 2007).
2Our analysis of energy prices and energy financial markets is generally
limited to the time period from January 2002 through December 2006.
Summary
Physical and derivatives markets for crude oil, unleaded gasoline, heating
oil, and natural gas have experienced substantial changes in recent years.
Within the physical market, tight supply and rising global demand, ongoing
political instability in oil-producing regions, limited refining capacity,
and other supply disruptions all contributed to higher prices. While these
changes were occurring in the physical markets, in the derivatives markets
volatility of energy prices generally remained above historic averages for
most of the period but declined during 2006 to levels at or near the
historical average. Moreover, 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. Another change occurring during this time was the increased
trading of energy derivatives outside the organized exchanges. Trading in
these markets--specifically electronic commercial markets and
over-the-counter (OTC) markets--is much less transparent than trading on
futures exchanges, and comprehensive data are not available because these
energy markets are not regulated. Given that the developments in the
physical and derivatives markets were occurring simultaneously,
determining their effect on energy prices is difficult. Continued
monitoring of the various factors that affect market prices, and how those
factors are changing, will be important in protecting the public and
ensuring market integrity.
Energy derivatives are traded on futures exchanges and off-exchange in
exempt commercial and OTC markets.3 Exempt commercial markets are
electronic trading facilities that trade exempt commodities, including
energy commodities, on a principal-to-principal basis solely between
commercial entities meeting certain eligibility requirements. In the OTC
markets, parties meeting certain requirements can enter into bilateral
energy derivatives transactions. Unlike the futures exchanges, which are
subject to comprehensive oversight by CFTC, exempt commercial markets and
OTC markets are not subject to general CFTC oversight, although CFTC can
enforce the CEA's antimanipulation provisions and, where applicable, the
antifraud provisions. To provide transparency about trading on the futures
exchanges, CFTC routinely publicly reports aggregate information on
trading by large commercial (such as oil companies, refineries, and other
hedge traders) and noncommercial (such as hedge funds) participants that
occurs on the exchanges. However, in the way the data are currently
categorized, no distinction is made between commercial traders who use the
exchanges to hedge their positions in the physical markets and those
commercial traders, such as investment banks, who trade futures to hedge
their trading in off-exchange derivatives. Given the developments and
growth in the energy trading markets, questions have been raised over
whether CFTC needs broader authority over the off-exchange derivative
markets, particularly those involving exempt commodities and exempt
commercial markets.
3Energy swap transactions also may be conducted off-exchange if they
satisfy the requirements for excluded swap transactions contained in
section 2(g) of the Commodity Exchange Act.
At an operational level, we also reported that while CFTC conducts
reporting, surveillance, and enforcement activities in the energy markets
to help provide transparency to the public, detect fraudulent or
manipulative trading practices, and deter abuses, the effectiveness of
these efforts is unclear. For example:
o Although CFTC monitors exchange trading activity through its
surveillance program and gathers additional information from NYMEX
officials, traders, or other sources to determine if further
action is warranted, staff did not routinely document the results
of these inquiries. Instead, they kept formal records of their
findings only in cases in which improper trading was identified.
As a result, CFTC may be limiting its opportunities to identify
trends and its ability to measure the extent and usefulness of its
monitoring activities.
o We also found that CFTC has successfully pursued energy-related
cases, but we were not able to determine how effectively CFTC's
enforcement activities were in identifying violations and
deterring misconduct because the agency lacked meaningful
outcome-based measures.
Our report includes a matter for congressional consideration and
three recommendations to CFTC. In light of recent developments and
the uncertainty over the adequacy of CFTC's oversight, we
recommend that Congress, as part of the CFTC reauthorization
process, further explore whether the current regulatory structure
for energy derivatives, in particular for those traded in exempt
commercial markets, adequately provides for fair trading and
accurate pricing of energy commodities. To improve the
transparency of market activities and the functioning of CFTC's
oversight, we recommend that CFTC reconsider how information it
publishes in trading reports for energy products could be improved
and CFTC has agreed to reexamine the classifications used in these
reports. CFTC also agreed with our recommendations aimed at better
documenting its surveillance activities and developing more
outcome-based performance measures and has taken steps to
implement them.
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 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 spot 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. 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.
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 are
also used to hedge this risk. The ability to reduce their 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.
By establishing prices for future delivery, 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. Markets are best able to perform price discovery 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, generally use the futures market 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.
Several Factors Have Caused Changes in the Energy Markets,
Potentially Affecting Energy Prices
The physical markets for energy commodities underwent change and
turmoil from 2002 through 2006, which affected prices in the spot
and futures markets. We reported that numerous changes in both the
physical and futures markets may have affected energy prices.
However, because these changes occurred simultaneously,
identifying the specific effect of any one of these changes on
energy prices is difficult.
Various Changes in the Physical Market Contributed to Rising Prices
The physical energy markets have undergone substantial change and
turmoil during this period, which can affect spot and futures
markets. Like many others, we found that a number of fundamental
supply and demand conditions can affect prices. According to the
Energy Information Administration (EIA), world oil demand has
grown since 1983 from a low of about 59 million barrels per day in
1983 to more than 85 million barrels per day in 2006 (fig. 1).
While the United States accounts for about a quarter of this
demand, rapid economic growth in Asia also has stimulated a strong
demand for energy commodities. For example, EIA data show that
during this time frame, China's average daily demand for crude oil
increased almost fourfold.
Figure 1: Increase in World Demand for Crude Oil (Actual and Estimated),
1980-2006
Note: The world oil demand data for 2006 represent a preliminary estimate.
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 2, 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 about
5.6 million barrels a day as recently as 2002.
Figure 2: Estimates of World Oil Spare Production Capacity, 1991-2008
Major weather and political events also can lead to supply disruptions and
higher prices. In its analysis, EIA has cited the following examples:
o Hurricanes Katrina and Rita removed about 450,000 barrels per
day from the world oil market from June 2005 to June 2006.
o Instability in major oil-producing countries of the Organization
of Petroleum Exporting Countries (OPEC), such as Iran, Iraq, and
Nigeria, have lowered production in some cases and increased the
risk of future production shortfalls in others.
o 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.4 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 also may 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.
Another consideration is that the value of the U.S. dollar on open
currency markets could 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 also
are 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 to the extent they can.
The Effect on Prices of Relatively High but Falling Volatility and
a Growing Volume of Trading in Derivatives Is Unclear
As you can see, conditions in the physical markets have undergone
changes that can help explain at least some of the increases in
both physical and derivatives commodity prices. As we have
previously reported, futures prices typically reflect the effects
of world events on the price of the underlying commodity such as
crude oil.5 For example, political instability and terrorist acts
in countries that supply oil create uncertainties about future
supplies, which are reflected in futures prices. Conversely, news
about a new oil discovery that would increase world oil supply
could result in lower futures prices. In other words, changes in
the physical markets influence futures prices.
At the same time that physical markets were undergoing changes, we
found that financial markets also were amidst change and
evolution. For example, the annual historical volatilities between
2000 and 2006--measured using the relative change in daily prices
of energy futures--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.
4GAO, Motor Fuels: Understanding the Factors That Influence the Retail
Price of Gasoline, [16]GAO-05-525SP (Washington, D.C.: May 2005).
5 [17]GAO-05-525SP .
6CFTC 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.
Elsewhere in the futures market, we found an increase in the
number of noncommercial traders such as managed money traders.6
Attracted in part by the trends in prices and volatility, a
growing number of traders sought opportunities to 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 3, 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.
Figure 3: Average Daily Number of Large Commercial and Noncommercial
Traders per Month, July 2003-December 2006
Not surprisingly, our work also revealed that as the number of traders
increased, so did the trading volume on NYMEX for all energy futures
contracts, particularly crude oil and natural gas. Average daily contract
volume for crude oil increased by 90 percent from 2001 through 2006, and
natural gas increased by just over 90 percent. Unleaded gasoline and
heating oil experienced less dramatic growth in their trading volumes over
this period.
While much harder to quantify, another notable trend was the 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. However,
using the Bank for International Settlements data as a rough proxy for
trends in the trading volume of OTC energy derivatives, the face value or
notional amounts outstanding of OTC commodity derivatives excluding
precious metals, such as gold, grew from December 2001 to December 2005 by
more than 850 percent to over $3.2 trillion. 7
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).
Using CFTC large trader reporting data, we found that from July 2003
through December 2006, managed money traders' ratio of buying (long) to
selling (short) open interest positions was 2.5:1 indicating that on the
whole, this category of participants was 2.5 times as likely to expect
prices to rise as opposed to fall throughout that period, which they did.
However, as figure 4 illustrates, by 2006, this ratio fell to 1.2:1,
suggesting that managed money traders as a whole were more evenly divided
in their expectations about future prices. As you can see, managed money
trading in unleaded gasoline, heating oil, and natural gas showed similar
trends.
7The Bank for International Settlements is an international organization
that fosters international monetary and financial cooperation and serves
as a bank for central banks.
Figure 4: Percentage of Long and Short Open Interest in Futures and
Options for Managed Money Traders, July 2003-December 2006
Note: Data for 2003 were for July through December. The percentages
indicate what portion of long and short open interest was held by managed
money traders. For example, in 2004, managed money traders held 14.5
percent of the total long open interest for crude oil and 7.1 percent of
the total short open interest. Because data are not included for all
categories of traders, the percentages for these three categories within a
particular period do not total 100. These data should be viewed as a
general overview of managed money traders' positions. They do not provide
insights into how traders' individual positions changed over time. Our
data for 2006 include contract trading data for NYMEX reformulated
gasoline blendstock (RB) and for the NYMEX gasoline contract (HU) that
began to replace RB.
Overall, we found that views were mixed about whether these trends put 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. Conversely, 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.
CFTC Oversees Exchanges and Has Limited Authority over Other Derivatives Markets
Under CEA, CFTC's authority for protecting market users from fraudulent,
manipulative, and abusive practices in energy derivatives trading is
primarily focused on the operations of traditional futures exchanges, such
as NYMEX, where energy futures are traded. Off exchange markets, which are
available only to eligible traders of certain commodities under specified
conditions, are not regulated, although CFTC may enforce antimanipulation
and antfraud provisions of the CEA with respect to trading in those
markets. The growth in trading off exchange has raised questions about the
sufficiency of CFTC's limited authority over these markets. These changes
and innovations also have brought into question the methods CFTC uses to
categorize published data about futures trading by participants in the off
exchange markets and whether information about their activities in off
exchange markets would be useful to the public. CFTC is taking steps to
better understand these issues. Most importantly, it is currently
examining the relationship between trading in the regulated and exempt
energy markets and the role this trading plays in the price discovery
process. It is also examining the sufficiency of the scope of its
authority over these markets--an issue that will warrant further
examination as part of the CFTC reauthorization process.
CFTC Has General Oversight Authority over Futures Exchanges, but Information on
These Exchanges Reported to the Public Has Not Kept Pace With Changing Market
Conditions
To help provide transparency in the markets, CFTC provides the public
information on open interest in exchange-traded futures and options by
commercial and noncommercial traders for various commodities in its weekly
Commitment of Traders (COT) reports.8 As we reported, CFTC observed that
the exchange-traded derivatives markets, as well as trading patterns and
practices, have evolved. In 2006, CFTC initiated a comprehensive review of
the COT reporting program out of concern that the reports in their present
form might not accurately reflect the commercial or noncommercial nature
of positions held by nontraditional hedgers, such as swaps dealers.9 A
disconnect between the classifications and evolving trading activity could
distort the accuracy and relevance of reported information to users and
the public, thereby limiting its usefulness for both.
In December 2006, CFTC announced a 2-year pilot program for publishing a
supplemental COT report that includes positions of commodity index traders
in a separate category. However, the pilot does not include any energy
commodities. Although commodity index traders are active in energy
markets, according to CFTC officials, currently available data would not
permit an accurate breakout of index trading in these markets. For
example, some traders, such as commodity index pools, use the futures
markets to hedge commodity index positions they hold in the OTC market.
However, these traders also may have positions in the physical markets,
which means the reports that CTFC receives on market activities, which do
not include such off-exchange transactions, may not present an accurate
picture of all positions in the market place for the commodity. In
response to our recommendation to reexamine the COT classifications for
energy markets, CFTC agreed to explore whether the classifications should
be refined to improve their accuracy and relevance.
8These reports include the number of traders, changes since the last
report, and open positions.
971 Fed. Reg. 35627, 35630-31 (June 21, 2006).
CFTC Authority over Exempt Commercial Markets and OTC Markets Is Limited, and
Views Vary about the Sufficiency of Its Regulatory Authority with Respect to
Off-Exchange Energy Derivatives
Now let me address some of the larger policy issues associated with CFTC's
oversight of these markets. Under CEA, CFTC's authority for protecting
market users from fraudulent, manipulative, and abusive practices in
energy derivatives trading is primarily focused on the operations of
traditional futures exchanges, such as NYMEX, where energy futures are
traded. Currently, CFTC receives limited information on derivatives
trading on exempt commercial markets--for example, records of allegations
or complaints of suspected fraud or manipulation, and price, quantity, and
other data on contracts that average five or more trades a day. The agency
may receive limited information, such as trading records, from OTC
participants to help CFTC enforce the CEA's antifraud or antimanipulation
provisions. The scope of CFTC's oversight authority has raised concerns
among some members of Congress and others that activities on these markets
are largely unregulated, and that additional CFTC oversight is needed.
While some observers have called for more oversight of OTC derivatives,
most notably for CFTC to be given greater oversight authority of this
market, others oppose any such action. Supporters of more CFTC oversight
authority believe that regulation of OTC derivatives markets is necessary
to protect the regulated markets and consumers from potential abuse and
possible manipulation. One of their concerns is that, due to the lack of
complete information on the size of this market or the terms of the
contracts, CFTC may not be assured that trading on the OTC market is not
adversely affecting the regulated markets and, ultimately, consumers.
However others, including the President's Working Group, have concluded
that OTC derivatives generally are not subject to manipulation because
contracts are settled in cash on the basis of a rate or price determined
in a separate, highly liquid market that does not serve a significant
price discovery function.10 The Working Group also noted that if
electronic markets were to develop and serve a price discovery function,
then consideration should be given to enacting a limited regulatory regime
aimed at enhancing market transparency and efficiency through CFTC, as the
regulator of exchange-traded derivatives.
However, the lack of reported data about this market makes addressing
concerns about its function and effect on regulated markets and entities
challenging. In a June 2007 Federal Register release clarifying its large
trader reporting authority, 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 other disruptions to the integrity of the
regulated futures markets.11 According to CFTC officials, the commission
has proposed amendments to clarify its authority under the CEA to collect
information and bring fraud actions in principal-to-principal transactions
in these markets, enhancing CFTC's ability to enforce antifraud provisions
of the CEA.12
10President's Working Group on Financial Markets, Over-the-Counter
Derivatives Markets and the Commodity Exchange Act (Nov. 9, 1999). Members
of group are the Chairman of CFTC, the Secretary of the Treasury, the
Chairman of the Board of Governors of the Federal Reserve, and the
Chairman of the Securities and Exchange Commission.
Also, in September 2007, CFTC conducted a hearing to begin examining
trading on regulated exchanges and exempt commercial markets more closely.
The hearing focused on a number of issues, including
o the current tiered regulatory approach established by the
Commodity Futures Modernization Act, which amended the CEA, and
whether this model is beneficial;
o the similarities and differences between exempt commercial
markets and regulated exchanges, and the associated regulatory
risks of each market; and
o the types of regulatory or legislative changes that might be
appropriate to address any identified risks.
11As stated by CFTC, the purpose of the proposed regulation is to make it
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 or pursuant to sections 2(d), 2(g)
or 2(h)(1)-(2) of the CEA or part 35 of the commission's regulations, on
exempt commercial markets operating pursuant to sections 2(h)(3)-(5) of
the CEA, on exempt boards of trade operating pursuant to Section 5d of the
CEA, and on foreign boards of trade (hereinafter referred to collectively
as non-reporting transactions); and to make the regulation clearer and
more complete with respect to hedging activity. The purpose of the
amendments is to clarify CFTC's regulatory reporting requirements for such
traders. 72 Fed. Reg. 34413..
12Section 4b of the CEA is CFTC's main antifraud authority. In a November
2000 decision, the 7th Circuit Court of Appeals ruled that CFTC only could
use section 4b in intermediated transactions--those involving a broker.
Commodity Trend Service, Inc. v. CFTC, 233 F.3d 981, 991-992 (7th Cir.
2000). As amended by the Commodity Futures Modernization Act of 2000, the
CEA permits off-exchange futures and options transactions that are done on
a principal-to-principal basis, such as energy transactions pursuant to
CEA sections 2(h)(1) and 2(h)(3). According to CFTC, House and Senate CFTC
reauthorization bills introduced during the 109th Congress (H.R. 4473 and
S. 1566) would have amended section 4b to clarify that Congress intends
for CFTC to enforce section 4b in connection with off-exchange
principal-to-principal futures transactions, including exempt commodity
transactions in energy under section 2(h) as well as all transactions
conducted on derivatives transaction execution facilities.
Given ongoing questions about the similarity of products traded on
the markets and how and whether exempt markets play a role in the
price discovery process and whether existing reporting
requirements are sufficient, we recommend that Congress take up
this issue during the CFTC reauthorization process to begin to
answer some of these questions and the implications for the
current regulatory structure in light of the changes that have
occurred in this market.
CFTC Engages in Large Trader Reporting, Surveillance, and Enforcement
Activities, but the Effectiveness of the Activities Is Largely
Uncertain
CFTC provides oversight for commodity futures markets by analyzing
large trader reporting data, conducting routine surveillance, and
investigating and taking enforcement actions against market
participants and others. The commission uses information gathered
from surveillance activities to identify unusual trading activity
and possible market abuse. In particular, CFTC's large trader
reporting system (LTRS) provides essential information on the
majority of all trading activity on futures exchanges. CFTC staff
said they routinely investigate traders with large open positions,
but do not routinely maintain information about such inquiries,
thereby making it difficult to determine the usefulness and extent
of these activities. According to recent data provided by CFTC,
about 10 percent of the enforcement actions involved
energy-related commodities. However, as with programs operating in
regulatory environments where performance is not easily
measurable, evaluating the effectiveness of CFTC's enforcement
activities is challenging because it lacks effective outcome-based
performance measures.
CFTC Oversight Includes Surveillance of Energy Futures Trading, but
the Full Extent of Follow-up Activities Is Uncertain
CFTC conducts regular market surveillance and oversight of energy
trading on NYMEX and other futures exchanges, focusing on
detecting and preventing disruptive practices before they occur
and keeping the CFTC commissioners informed of possible
manipulation or abuse. According to CFTC staff, when a potential
market problem has been identified, surveillance staff generally
contact the exchange or traders for more information. To confirm
positions and determine intent, staff may question exchange
employees, brokers, or traders. According to the staff, CFTC's
Division of Market Oversight may issue a warning letter or make a
referral to the Division of Enforcement to conduct a nonpublic
investigation into the trading activity. Markets where
surveillance problems have not been resolved may be included in
reports presented to the commission at weekly surveillance
meetings.
According to CFTC staff, they routinely make inquiries about
traders with large open positions approaching expiration, but
formal records of their findings are only kept in cases with
evidence of improper trading. If LTRS data revealed that a trader
had a large open market position that could disrupt markets if it
were not closed before expiration, CFTC staff would contact the
trader to determine why the trader had the position and what plans
the trader had to close the position before expiration or ensure
that the trader was able to take delivery. If the trader provided
a reasonable explanation for the position and a reasonable
delivery or liquidation strategy, staff said no further action
would be required. CFTC staff said they would document such
contacts on the basis of their importance in either informal
notes, e-mails to supervisors, or informal memorandums. According
to one CFTC official, no formal record would be made unless some
signal indicated improper trading activity. However, without such
data, CFTC's measures of the effectiveness of its actions to
combat fraud and manipulation in the markets would not reflect all
surveillance activity, and CFTC management might miss
opportunities to identify trends in activities or markets and
better target its limited resources. In response to our
recommendation, CFTC agreed to improve its documentation of its
surveillance activities.
CFTC Energy-Related Enforcement Actions Generally Involved Allegations
of False Reporting and Attempted Manipulation, but Its Program Received
a Mixed Rating and Lacks Effective Outcome-Based Performance Measures
CFTC's Division of Enforcement is charged with enforcing the
antimanipulation sections of the CEA.13 The enforcement actions
CFTC has taken in its energy-related cases generally have involved
false public reporting as a method of attempting to manipulate
prices on both the NYMEX futures market and the off-exchange
markets. CFTC officials said that from October 2000 to September
2005, the agency initiated 287 enforcement cases and more than 30
of these cases involved energy trading. In the past several
months, CFTC has taken a series of actions involving energy
commodities, including allegations of false reporting, attempted
manipulation of NYMEX natural gas futures prices, and attempted
manipulation of physical natural gas prices.
Although CFTC has undertaken enforcement actions and levied fines,
measuring the effectiveness of these activities is an ongoing
challenge. For example, the Office of Management and Budget's most
recent 2004 Program Assessment Rating Tool (PART) assessment of
the CFTC enforcement program identified a number of limitations of
CFTC's performance measures.14 As is the case with most
enforcement programs, identifying outcome-oriented performance
measures can be particularly challenging.15 However, as we point
out in the report, there are a number of other ways to evaluate
program effectiveness, such as using expert panel reviews,
customer service surveys, and process and outcome evaluations. We
have found with other programs that the form of the evaluations
reflects differences in program structure and anticipated
outcomes, and that the evaluations are designed around the
programs and what they aim to achieve.16 Without utilizing these
or other methods to evaluate program effectiveness, CFTC is unable
to demonstrate whether its enforcement program is meeting its
overall objectives. CFTC has agreed that this is a matter that
should be examined and has included development of measures to
evaluate its effectiveness in its strategic plan and has requested
funding to study the feasibility of developing more meaningful
measures.
attempt to manipulate the price of any commodity in interstate commerce,
or for future delivery on or subject to the rules of any registered
entity, or to corner or attempt to corner any such commodity or knowingly
to deliver or cause to be delivered for transmission through the mails or
interstate commerce by telegraph, telephone, wireless, or other means of
communication false or misleading or knowingly inaccurate reports
concerning crop or market information or conditions that affect or tend to
affect the price of any commodity interstate commerce...."
13Section 9(a)(2) of the CEA prohibits "(a)ny person to manipulate or
14The assessment includes a series of questions meant to serve as a
diagnostic performance tool, drawing on available program performance and
evaluation information to form conclusions about program benefits and
recommend adjustments that may improve results.
15GAO, Results Oriented Government: GPRA Has Established a Solid
Foundation for Achieving Greater Results, [24]GAO-04-594T (Washington,
D.C.: Mar. 31, 2004).
16GAO, Program Evaluation: OMB's PART Reviews Increased Agencies'
Attention to Improving Evidence of Program Results, [25]GAO-06-67
(Washington, D.C.: Oct. 28, 2005).
In closing, I would like to reemphasize the difficulty in
attributing increased energy prices to any one of the numerous
changes in the physical or derivatives markets. As I have
mentioned, our research shows that the physical and derivatives
markets have both undergone substantial change and evolution, and
market participant and regulatory views were mixed about the
extent to which these developments exerted upward pressure on
prices. Because of the importance of understanding the potential
effects of such developments in these markets, ongoing review and
analysis are warranted. As the scope of CFTC's authority is
debated, additional information is needed to understand what may
need to be done to best protect investors from fraudulent,
manipulative, and abusive practices. Such information includes
o how different or similar are the characteristics and uses of
exchange and off-exchange products being traded and do these
continue to justify different regulatory treatment;
o to what extent does trading in off-exchange financial
derivatives affect price discovery and what are the regulatory and
policy implications;
o how large of an effect are nontraditional market participants,
such as commodity index funds, having in these markets; and
o are the changes in the energy markets unique or are such
concerns also worth reviewing for other commodity markets.
By answering questions such as these, CFTC and the Congress will
be better positioned to determine what changes, if any, may be
needed to oversee these 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 might have.
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 Cody Goebel
(Assistant Director), John Forrester, Barbara Roesmann, and Paul
Thompson.
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Highlights of [27]GAO-08-174T , a testimony before the Subcommittee on
General Farm Commodities and Risk Management, Committee on Agriculture,
House of Representatives
October 24, 2007
COMMODITY FUTURES TRADING COMMISSION
Trends in Energy Derivatives Markets Raise Questions about CFTC's
Oversight
Energy prices for crude oil, heating oil, unleaded gasoline, and natural
gas have risen substantially since 2002, generating questions about the
role derivatives markets have played and the scope of the Commodity
Futures Trading Commission's (CFTC) authority. This testimony focuses on
(1) trends and patterns in the futures and physical energy markets and
their effects on energy prices, (2) the scope of CFTC's regulatory
authority, and (3) the effectiveness of CFTC's monitoring and detection of
abuses in energy markets. The testimony is based on the GAO report,
Commodity Futures Trading Commission: Trends in Energy Derivatives Markets
Raise Questions about CFTC's Oversight (GAO-08-25, October 19, 2007). For
this work, GAO analyzed futures and large trader data and interviewed
market participants, experts, and officials at six federal agencies.
[28]What GAO Recommends
As part of CFTC's reauthorization process, GAO recommended that Congress
consider exploring the scope of the agency's authority over energy
derivatives trading, in particular for trading in exempt commercial
markets. In addition, GAO recommends that CFTC improve the usefulness of
the information provided to the public, better document its monitoring
activities, and develop more outcome-oriented performance measures for its
enforcement program. CFTC generally agreed with GAO's recommendations.
Various trends in both the physical and futures markets have affected
energy prices. Specifically, tight supply and rising demand in the
physical markets contributed to higher prices as global demand for oil has
risen rapidly while spare production capacity has fallen since 2002.
Moreover, increased political instability in some of the major
oil-producing countries has threatened the supply of oil. During this
period, increasing numbers of noncommercial participants became active in
the futures markets (including hedge funds) and the volume of energy
futures contracts traded also increased. Simultaneously, the volume of
energy derivatives traded outside of traditional futures exchanges
increased significantly. Because these developments took place
concurrently, the effect of any individual trend or factor on energy
prices is unclear.
Under the authority granted by the Commodity Exchange Act (CEA), CFTC
focuses its oversight primarily on the operations of traditional futures
exchanges, such as the New York Mercantile Exchange, Inc. (NYMEX), where
energy futures are traded. Increasing amounts of energy derivatives
trading also occur on markets that are largely exempt from CFTC oversight.
For example, exempt commercial markets conduct trading on electronic
facilities between large, sophisticated participants. In addition,
considerable trading occurs in over-the-counter (OTC) markets in which
eligible parties enter into contracts directly, without using an exchange.
While CFTC can act to enforce the CEA's antimanipulation and antifraud
provisions for activities that occur in exempt commercial and OTC markets,
some market observers question whether CFTC needs broader authority to
more routinely oversee these markets. CFTC is currently examining the
effects of trading in the regulated and exempt energy markets on price
discovery and the scope of its authority over these markets--an issue that
will warrant further examination as part of the CFTC reauthorization
process.
CFTC conducts daily surveillance of trading on NYMEX that is designed to
detect and deter fraudulent or abusive trading practices involving energy
futures contracts. To detect abusive practices, such as potential
manipulation, CFTC uses various information sources and relies heavily on
trading activity data for large market participants. Using this
information, CFTC staff may pursue alleged abuse or manipulation. However,
because the agency does not maintain complete records of all such
allegations, determining the usefulness and extent of these activities is
difficult. In addition, CFTC's performance measures for its enforcement
program do not fully reflect the program's goals and purposes, which could
be addressed by developing additional outcome-based performance measures
that more fully reflect progress in meeting the program's overall goals.
Because of changes and innovations in the market, the reports that CFTC
receives on market activities may no longer be accurate because they use
categories that do not adequately separate trading being done for
different reasons by various market participants.
References
Visible links
15. http://www.gao.gov/cgi-bin/getrpt?GAO-08-25
16. http://www.gao.gov/cgi-bin/getrpt?GAO-05-525SP
17. http://www.gao.gov/cgi-bin/getrpt?GAO-05-525SP
18. http://www.gao.gov/
19. http://www.gao.gov/
20. http://www.gao.gov/fraudnet/fraudnet.htm
21. mailto:[email protected]
22. mailto:[email protected]
23. mailto:[email protected]
24. http://www.gao.gov/cgi-bin/getrpt?GAO-04-594T
25. http://www.gao.gov/cgi-bin/getrpt?GAO-06-67
26. http://www.gao.gov/cgi-bin/getrpt?GAO-08-174T
27. http://www.gao.gov/cgi-bin/getrpt?GAO-08-174T
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