Thank you for inviting me to speak here this afternoon at the Natural Gas Council Customer Summit. Before I begin, let me note that the views I express today are my own and not necessarily those of the Commodity Futures Trading Commission (Commission or CFTC) or its staff.
Some of you had the opportunity to hear my remarks last week at the Natural Gas Roundtable of Washington. In those remarks, I emphasized the point that one of the important roles that futures markets play in the economy is price discovery. On one level, the image that creates is one of prices being formed in the futures markets and participants in the physical markets simply taking the futures market price as given and applying them to their transactions.
While there may in fact be participants that price physical market transactions in that way, the story is often more complex. What I would like to do today is to expand somewhat on my remarks last week and speak more on market transparency—what it is and its function in markets. In this discussion, I will suggest that while disclosure of market information may appear in a simple analysis to enhance market transparency, requirements for disclosure of some kinds of information can actually harm market quality and lead to less transparency.
Let me begin by summarizing my comments from last week’s roundtable. The analogy I used to compare the physical natural gas markets to the derivatives markets was that of a dog and his tail. The physical markets are like the body of the dog in that they contain the fundamental information about the market. The tail is composed of trading markets like the futures markets. It is connected to the dog, but one of its primary functions is to tell us about the dog: is he happy or mad? does he need to be fed? or should we put a collar on him?
Futures markets are like the tail of the dog in that they tell us about the underlying market. In their price discovery function, they provide a mechanism for gathering information from market participants and distilling that information into a price. Now to some, that can seem to be a dangerous thing. It is not uncommon to hear market commentators expressing the view that the futures markets are being dominated by speculators, large hedge funds, and other money managers who push prices up beyond what market fundamentals would dictate.
While such a scenario is possible if the futures markets were exclusively populated by uninformed speculators, the fact that commercial interests also trade in the futures markets makes this scenario implausible. Commercial participants, who in academia we consider the most informed traders, are always in a position to discipline the price discovery process through arbitrage. That is, if prices move above what market fundamentals suggest is unreasonable, commercial interests can enter the markets to buy the under priced asset and/or sell the overpriced. The arbitrage link over markets and over time ensures prices are efficient, and by that I mean reflective of fundamental value.
It is for this reason that I argue that the futures market tail cannot wag the physical market dog. Ultimately the dog disciplines the tail, although as I have stated, the tail does convey useful information about the dog, just as futures markets convey important price signals with respect to physical markets.
But today, I would like to delve a little more into what information markets convey to us and how we as regulators and market participants use that information.
As you are likely aware, futures contracts are highly standardized in their terms. They call for the delivery of a specific quantity and quality of commodity, at specific delivery locations, on specific dates or schedules. Moreover, counterparty credit risk is essentially reduced to zero because a clearing house takes the other side of every contract and manages credit risk through the use of margin requirements, guarantee funds, and other means of financial risk management. In fact, the only variable in most futures contracts is its price. Most of the other variables that could lead to price differences from one transaction to another have been minimized through standardization.
Because of the standardization of futures contracts, the prices we observe for them can, and often do, serve as strong benchmarks for commodities. For example, the common practice for pricing physical market grain through the Midwest at local elevators is to quote the price off of the Chicago Board of Trade price. So, for instance, an elevator may offer to purchase corn from a producer for 5 cents under the Board of Trade settlement price.
In the grain markets, that 5 cents—what is called the basis—is an important pricing concept because it represents the difference between the price of the corn being priced on the Board of Trade and the price of corn that the farmer will deliver to his elevator. And let me stress that there may be a number of factors that influence the basis. First, the basis represents transportation costs of moving corn from the local elevator to the futures market delivery point. The basis will incorporate quality differences in the corn. It may also reflect credit risk to which the elevator is exposed if the contract is for forward delivery.
There are a host of factors that may cause the price of corn at the local elevator to differ from the price of corn on the futures market, but it is important to realize that the price of corn as discovered on the Board of Trade can and does serve as the benchmark—the starting point, if you will—for determining the price of corn out in the countryside.
The natural gas markets are no different. The price of natural gas, as determined on the NYMEX futures market, can and does serve as the benchmark for determining gas prices at other locations around the country. In the case of the NYMEX contract, the gas being priced is for delivery at the Sabine Pipeline Company Henry Hub in Louisiana over a one month delivery timeframe. Given the price of gas as determined on NYMEX, traders in the physical markets are left with the “simple” task of figuring out what differences exist between the gas they are trying to price and the futures market price.
Now I characterize this task as simple, but we all know that the task can be quite difficult. Unlike the grain markets, where the pace can afford to be more leisurely, for commodities like natural gas, and perhaps even more so electricity, time is of the essence. The pipelines that deliver natural gas from suppliers to users require a dynamic and continuous solution to balance supply and demand. We know, for instance that local shortages or bottlenecks in the delivery system can send prices soaring as demand tends to be inelastic on a short-term basis.
This raises the topic of transparency. Transparency has become a much bandied about term, but is has not always been made clear what is meant by transparency or what kind of transparency is needed or even possible in the physical markets. Price discovery, as I have just described to you, is the primary function of the futures markets and an important product of that is transparency. This price transparency results in easily accessible, highly efficient and useful prices for natural gas.
Without a centralized price to serve as a benchmark, pricing natural gas, or for that matter any commodity, would mean that parties to a transaction not only would need to address the idiosyncratic aspects of their transactions but also determine the fundamental, or benchmark, value for every transaction they enter. In many ways pricing transactions without the benchmark is a little like car shopping. Every deal is a unique pricing opportunity, where little knowledge—at least from the buyer’s perspective—exists about the true value of the car.
So for the natural gas market, the existence of centralized futures markets presents an excellent means by which to price a large component of a natural gas transaction. In essence, the basic price of gas has become quite transparent. What futures markets do not shed as much light is on the idiosyncratic aspects of a local transaction. Nonetheless, to the extent that a particular party gets a raw deal in a contract that it has entered into, that raw should be more or less limited to idiosyncratic features.
Of course, there are additional elements of transparency with respect to market information. In the futures industry, information is published not only on prices, but trading volume, open interest—which is the number of contracts that have been entered into but not yet closed out at any point in time. In addition, the Commission also publishes on a weekly basis a commitments of traders report that shows the amount of positions held by large traders in the markets as well as whether those positions are held by commercial or non-commercial participants.
As we consider this information, there is content embedded within that helps market participants and regulators evaluate the markets. For example, it is useful to know that a futures contract price that is based on the trading of 5,000 contracts a day is more robust than one based on the trading of 10 contracts. Such transparency can generally be good for the markets in that it can give us confidence in the prices we observe. But while some information about the underlying workings of a market can be good and help support the integrity of markets, too much or the wrong information can actually hurt markets. For example, while it useful to observe a certain level of commercial participation in a market, if we reveal information about particular participants in a market, we run the risk of negatively exposing those participants to front running by competitors and speculators. When that happens, those participants will tend to leave the market, or seek more opaque markets, taking whatever information or liquidity services they provide with them.
Let me be more specific. Recently in the futures industry there has been a call to provide a greater breakout with respect to the composition of commercial participants in the Commission’s Commitment of Trader reports. As I mentioned, the reports now contain two classifications of traders—commercial and non-commercial. A portion of the commercial category contains the positions of what some refer to as non-traditional commercial traders, meaning index-fund managers and swaps dealers. A growing number of market users would like to see that non-traditional group be broken out, and the Chairman of the CFTC has announced that the Commission staff is currently evaluating the desirability of doing so.
While I am still evaluating whether such a breakdown of this information is desirable, I think that as we move to revealing more information about trader’s positions and activity—we risk giving away the information market participants collected and brought to the market. And if traders can no longer profit from this proprietary information, they lose their incentive to collect it in the first place and accordingly exit the market. This ultimately results in less informative markets—that is less price transparency—and less liquid markets. So I would recommend caution when we talk about promoting transparency through the publication of information that may reveal positions and trading strategies of participants.
We can also talk about transparency in terms of requiring market participants to report their activity to regulators. Generally, I would support it if it helps me to do my job to police against fraud and manipulation, but if it creates moral hazards for the agency, then I would not. Many of you are aware of efforts by industry participants and some in Congress to require the CFTC to routinely collect information on physical and OTC transactions in the natural gas markets. Presumably regulators could use this information to police the markets for manipulative behavior.
While specific information about individual transactions can be quite useful to regulators when investigating alleged manipulative behavior, I continue to question the cost effectiveness of requiring the routine collection of such information and I question whether we are creating a moral hazard. The moral hazard is created when market participants begin to rely on the government’s efforts to police markets instead of relying on their own due diligence when negotiating contracts. If this happens, participants will tend to bring less information to the markets and the pricing mechanism becomes less efficient. We have seen a form of this occur in the natural gas markets where buyers at certain hubs have relied on published price indexes to set prices in contracts. The problem was that these indexes were based on very few negotiated transactions because most participants were simply pricing to the index. Ironically this behavior also makes it more difficult for the CFTC and other regulators to identify market abuses because prices become harder to evaluate.
Another problem that can result from placing greater reporting requirements on exempt markets is that it may cause participants to move their trading to less transparent venues. Often the trading on exempt markets is bilateral, though participants use a trading platform to communicate and execute their trades. Because of the bilateral nature of the trades, they could easily be moved entirely off the platform, where they would become less transparent to regulators and the markets. In addition, there always exists the possibility that markets could be moved offshore, where again they become invisible to regulators and the market.
As I discussed earlier, individual physical transactions in the natural gas market by their nature involve idiosyncratic terms and conditions. Unlike futures contracts, it is difficult to aggregate across these transactions to produce meaningful information. So for example, while a surveillance program may easily identify two transactions with diverse prices, determining why those prices differed would require much more effort to know whether the price differed because of legitimate market forces, or terms related to the contracts, or because of manipulative intent. It is my belief that any effective surveillance of these markets would certainly be extremely costly to build and possibly of very limited value. Moreover, those surveillance costs and the costs incurred by companies complying with reporting burdens ultimately are passed on to taxpayers and consumers.
Instead of attempting to design an expensive surveillance program to monitor these diverse and fragmented markets, I believe that we need to better appreciate the current regulatory and enforcement model we have in place and enhance these tools. Probably the most important tool that we have for enforcing market rules and practices are participants. Believe me when I tell you that when a market participant believes they are being harmed by another participant and they believe that the other participant is breaking the law, they are not shy about coming forward. Over the past few years, the Commission has brought a number of false reporting and attempted manipulation actions against traders in the natural gas markets. This activity was uncovered not through any routine surveillance of the markets, but through information provided by market insiders.
The second tool on which we rely is the price transparency of centralized futures markets. As I have said here today, these widely available prices benefit all market participants by identifying the benchmark price that they can use to assess market fundamentals. The CFTC has clear and broad authority to police these markets, to assure that these markets are free of manipulation. From a regulatory perspective, there are probably no other markets in the world that are more transparent then these. Moreover, through the authority granted to the Commission by Congress, the CFTC is also able to access a great deal of information on OTC and the physical markets as a result of their linkage to the futures markets.
As we move forward in the debate over transparency in the natural gas markets, I feel that we must be careful to define what we mean by transparency and be equally careful in evaluating how that publicly available information may be used. In some cases, transparency can be very beneficial to markets. At other times, transparency can be a detriment to the markets. I think too, that we must be careful to listen to what markets and their prices tell us. Unfortunately the debate over transparency in the natural gas markets is taking place at a time when market prices are high. We must be careful that our desire for cheap energy does not lead us to take hasty actions in the name of transparency when prices are really pointing to fundamental issues in the physical markets.
Thank you for your attention today, and I would be pleased to address any questions you have for me.
Last Updated: April 18, 2007